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The Imperative to Diversify Value Chains Post-Covid-19

BLOG - 23 June 2020

The Covid-19 pandemic has exposed some critical vulnerabilities in the production and supply chains the EU relies on. The first vulnerability is strategic: that of excessive dependence on China in sectors critical to the health and wellbeing of the EU’s population. This point was crystallized by Vera Jourova, European Commission Vice-President, when she observed that "this crisis [Covid-19] has revealed our morbid dependency on China and India as regards pharmaceuticals". Considering specifically the case of China: at the height of the pandemic, it was the key supplier of pharmaceuticals, medical equipment (such as artificial respirators) and personal protective equipment (such as medical masks). Across the globe, China appeared to partake in a form of Covid-19 diplomacy, providing critical supplies, contingent on political relationships. 

The second vulnerability highlighted by the crisis was logistical, namely the broader vulnerability of global value chains, particularly to chokepoints in Asia. The public health fight against Covid-19 involved a global patchwork of lockdowns and travel restrictions, leading, inevitably, to disrupted global trade. Timing didn’t help, because China’s lockdown was out of phase with those in Europe: just as China was resuming activity, Europe was locking down. The EU is highly reliant on China (and wider Asia) for much of its production and supply and, at times of significant disruption, distributed value chains spanning large physical distances seem intrinsically more vulnerable to perturbations. 

The strategic and logistical vulnerabilities exposed by the crisis are two distinct problems. Nonetheless, in some respects the policy response required to address them is similar: that of re-organizing value chains to make them more resilient, either to logistical disruption or to politics. This is driving a discussion around increasing resilience post-Covid-19 and one answer lies in diversification. This means diversifying value chains so that the EU is both less dependent on external production in critical sectors and, where it is dependent on external producers, ensuring that such dependence is diluted amongst a greater number of trading partners.

Considering first the challenge of supply chain disruption caused by Covid-19. This type of logistical disruption is impossible to avoid altogether – because unexpected events, either natural or man-made, are inevitable. Covid-19 wasn’t the first event of its kind in this regard. For example, the World Bank found anecdotal evidence of a retraction in global value chains following the Fukushima tsunami and nuclear disaster in 2011. Indeed, this is considered to be one potential contributing factor to the lowering of the global trade growth in the period that followed. The challenge then, is to try and increase resilience against unexpected events. The solution is complex, because it isn’t only about geography and who makes what. 

Being resilient often demands having sufficient ‘slack’ in the system so as to absorb shocks without upsetting the chain downstream. 

Being resilient often demands having sufficient ‘slack’ in the system so as to absorb shocks without upsetting the chain downstream. These shocks might only be short-term and the slack is there to give time for the upstream supply chain to adapt itself to the new normal. The difficulty is that, to date, such slack has been systematically driven down, in the pursuit of profitability. This type of resilience-building is expensive: it demands more storage, more waste and lower margins and, in any case, often the planned-for event doesn’t happen and these extra efforts aren’t repaid. 

The potential ‘no deal’ exit of the UK from the EU in March 2019 serves as a good example of a potentially disruptive event, involving a discontinuity in the conditions of production and supply. At the time, businesses recognized the risk of disruption from a no-deal Brexit, but they were loath to invest in their supply chains ahead of a potential cliff-edge. When they did, it was at significant cost, to build resilience that was ultimately never needed (and this situation risks repeating itself, as the current impasse in UK-EU future relationships negotiations means another ‘no deal’ cliff-edge looms at the end of 2020). Ultimately, building resilience in this way increases costs which, inevitably, get passed on to the consumer. 

Diversification of the value chain is part of the solution, because if disruption in one part of the world impacts one supplier, the chain is better able to adapt itself to replace that supplier with another from somewhere else. Physical location might also help, because it seems self-evident that a simpler value chain that is physically more compact is more difficult to disrupt. This pushes the concept of increasing production in the EU and being less reliant on foreign imports. Here, the idea is to build resilience by shifting production destined for European markets closer to Europe. 

The concept of the EU increasing its share of domestic production, particularly in strategic sectors such as healthcare, highlights a potential economic opportunity. Countries which had previously seen production outsourced abroad could now benefit from a reversal of this trend, with domestic production being on-shored, with its ensuing economic gains. On-shoring also sits well with a goal of increasing the EU’s strategic autonomy. To date, the concept of strategic autonomy had generally been limited to the EU’s ability to act according to its own best interests, in the context of foreign and security policy. However, in a world post-Covid-19, when treating the concept more holistically and having as a goal the need to assure the health and wellbeing of its peoples, it is clear that the concept of strategic autonomy should be treated more broadly. 

In this light, strategic autonomy demands the reduction in excessive dependence on other nations, notably China. Covid-19 may have exposed the EU’s reliance on China in the healthcare sector, but the problem doesn’t stop there. In rare earth metals, for example, some estimates suggest that China accounts for more than 85% of the global production capacity. These metals are crucial to components found in rechargeable batteries, computers and smartphones, wind turbines and solar cells, lasers, fibre optics and semiconductors, to name a few. The problem isn’t just a European one. A year ago, the U.S Commerce Department recommended the United States take urgent steps to boost domestic rare earth production, warning that a halt in Chinese supplies could disrupt global supply chains. It would, at least theoretically, be possible to diversify the sources of rare earths metals, because they are mined elsewhere in the world (at some expense, it should be added – rare earth metals can be expensive to extract and the methods used are site-dependent, making them difficult to duplicate elsewhere). More prosaic examples of reliance exist though, in industrial and consumer goods, machinery and equipment, footwear and clothes. Again, diversification, either to elsewhere in the world or to Europe, or both, would help dilute China’s strategic influence.

Beyond strategic and geopolitical considerations, there are also other trends pushing production away from China, including cost. Cost has always been a critical factor in the choice of production location, but increasingly, China appears to be losing its competitive advantage: some estimates point to it now being cheaper to establish and run a factory in Eastern Europe, for example.

In essence, if the EU wants to be a seller, it has to be a buyer as well.

This is without the future impact of decarbonization, where one could imagine companies being incentivized to reduce their carbon costs by being physically closer to the markets they are producing for. These trends could make production closer to Europe more attractive. 

These factors point towards increased on-shoring of production to the EU, yet on-shoring isn’t a perfect answer. The EU accounts for 15% of global exports (with about the same share of global imports) and as such, the EU needs a functioning global trading system, the pillar of which has been a network of free trade agreements with nearly 100 countries. There is a quid pro quo, because such agreements rest on the notion of reciprocity: that the EU opens its markets to third countries and receives access to third-country markets in return. It is an awkward ideological leap to expect to participate in this system as an exporter, while also systematically looking to reduce your reliance on imports. In essence, if the EU wants to be a seller, it has to be a buyer as well.

The Covid-19 crisis highlighted a second problem with an all-EU approach. The early stages of the crisis saw a global scramble for medical equipment and pharmaceutical products and, in the EU, many Member States acted reflexively, by requisitioning stocks and imposing export restrictions, even on products destined for other Member States. While the Commission intervened and persuaded Member States to lift restrictions, the fact remained that in crisis, Member States’ instincts were to ignore the Common Market and act independently. Extending this logic, it could be argued that any time a product has to cross an international border, a political risk is introduced into the value chain. Yet it is neither feasible nor necessarily desirable for all countries to domesticate their production. This strengthens the argument for diversification. 

Beyond on-shoring, the greater resilience would come from truly diversifying supply chains and, crucially, building production capacity in regions outside of Asia. As such, it must be a long-term ambition, supported by political commitment and engagement and requiring the EU to make broad use of a variety of tools, including development finance, political dialogue, existing community and commercial links and free trade agreements.  
 

 

Copyright : Ronny Hartmann / AFP

 

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