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Global Supply Chains: Trade And Economic Policies For Developing Countries

Discussion paper by Nicita, Alessandro, Ognivtsev, Victor and Shirotori, Miho/UNCTAD, 2012

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Although a substantial share of Global Supply Chains (GSCs) production processes is taking place in developing countries, the Least Developed Countries and other low-income countries lack the business supporting national policies to ensure that their participation in GSCs is more than that of providers of low value-added components.

UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT





ADVANCE UNEDITED VERSION


POLICY ISSUES IN INTERNATIONAL TRADE AND COMMODITIES


STUDY SERIES No. __





GLOBAL SUPPLY CHAINS:
TRADE AND ECONOMIC POLICIES


FOR DEVELOPING COUNTRIES




by



Alessandro Nicita
Victor Ognivtsev
Miho Shirotori



UNCTAD, Geneva












UNITED NATIONS
New York and Geneva, 2011





ii


Note

The purpose of this series of studies is to analyse policy issues and to stimulate discussions
in the area of international trade and development. The series includes studies by UNCTAD staff
and by distinguished researchers from academia. This paper represents the personal views of the
authors only, and not the views of the UNCTAD secretariat or its member States.

The designations employed and the presentation of the material do not imply the
expression of any opinion whatsoever on the part of the United Nations Secretariat concerning the
legal status of any country, territory, city or area, or of its authorities, or concerning the
delimitation of its frontiers or boundaries.

Material in this publication may be freely quoted or reprinted, but acknowledgement is
requested, together with a reference to the document number. It would be appreciated if a copy of
the publication containing the quotation or reprint could be sent to the UNCTAD secretariat at the
following address:



Chief


Trade Analysis Branch
Division on International Trade in Goods and Services, and Commodities


United Nations Conference on Trade and Development
Palais des Nations
CH-1211 Geneva





Series Editor:
Victor Ognivtsev


Officer-in-Charge, Trade Analysis Branch






UNCTAD/ITCD/TAB/56






UNITED NATIONS PUBLICATION


ISSN 1607-8291










© Copyright United Nations 2011
All rights reserved





iii


Abstract




Over the last three decades, global supply chains (GSCs) have increasingly gained
importance in linking developing countries to international markets. Today a substantial share of
GSCs production processes is taking place in developing countries. For developing countries and
their enterprises, GSCs offer opportunities, as well as challenges. GSCs, while greatly facilitating
access to developed countries' markets, also demand greater efficiency and competence from
suppliers. For developing countries, it is thus important to implement economic policies that while
increasing competitiveness of their enterprises, also improve their reliability and efficiency. In the
past, competitiveness of developing countries' enterprises was mainly based on trade policies, often
in the form of preferential market access. Trade policies, although still important, are not anymore
sufficient. The reason is not only due to the preference erosion and decline of tariffs, but also
because of the GSCs business model itself. In GSCs, competitiveness (and thus delocalization
choices) is determined by a wide range of factors, especially by the quality of policies influencing
of the overall business environment. In this regard, LDCs and other low-income countries are often
confronted with substantial disadvantages as implementing these policies require substantial
resources that are lacking. In the absence of business supporting national policies, LDCs and low
income countries would continue to participate in GSCs only as providers of low value added
components having only limited contribution to their development.






Keywords: Global supply Chains, Trade policy, International Trade, LDCs.

JEL Classification: F1


 
 








iv






Acknowledgements




We would like to thank Bolormaa Tumurchudur for excellent research
assistance. We would like to express our sincere thanks to Marco Fugazza
and Alberto Gabriele for comments at different stages of the preparation of
the paper.

Any mistakes or errors remain the authors’ own.







v


Contents
 




I. Introduction............................................................................................................................




II. Evolution of GSCs and developing countries ......................................................................




III. GSCs: trends in international trade .....................................................................................




IV. GSCs: trade and economic policies.......................................................................................




V. Rising along the value chain..................................................................................................




VI. Policy issues ............................................................................................................................




Bibliography ........................................................................................................................................





vi


List of figures




Figure 1. Value addition in a GSC....................................................................................................


Figure 2. Trends in international trade..............................................................................................


Figure 3. China's trade in intermediates within the East and South-East Asian region....................


Figure 4. Export sophistication.........................................................................................................






List of tables




Table 1. World trade in intermediates .............................................................................................


Table 2. Exports of intermediate products for developing/


transition country income groups and regions...................................................................


Table 3. Distribution of world trade in intermediate products across regions (2008) .....................


Table 4. Composition of intermediate exports across industries and regions .................................


Table 5. Average effectively applied tariffs on selected industries


(final and intermediate products).......................................................................................


Table 6. Trade policy and business environment, by income country groups ................................


Table 7. Importance of traditional trade policy versus overall business environment ....................






List of boxes




Box 1. "Buyer-Supplier" relational linkage strength of Global supply chains .............................


Box 2. Services offshoring............................................................................................................


Box 3. Bangladesh and Cambodia in Global Supply Chains in the Garment Sector....................




1


I. Introduction




Over the last three decades, the progressive liberalization of cross-border
transactions, advances in production technology and information services, and
improvement in transport logistics and services have provided firms with greater
incentives to fragment production processes and to geographically delocalize them. Global
supply or production chains (GSCs), where cost reduction strategies result in goods often
being produced with intermediate inputs originating from several countries, are now
common in many industries and extend over to an increasing number of developing
countries.


From an economic standpoint, the emergence of GSCs is related to the concept of
comparative advantage. By relocating production processes (i.e. R&D, concept, design,
manufacturing, packaging, marketing, distribution and retailing) in different countries,
transnational corporations (TNCs) can take advantage of the best-available human or
physical resources in different countries, with a view to maintaining their competitiveness
through augmenting productivity and minimizing costs.1


For developing countries and their enterprises, the potential opportunities from
joining GSCs are substantial. Indeed, integration into GSCs has become an important pillar
of their policies for export-led development. GSCs enable producers within the chain to
obtain modern management know-how, hands-on information on quality standards and
technology, and thus to become more competitive. Such producers also quickly learn about
demand patterns in high income markets and their consumer preferences.2 Participation in
GSCs could also create economy-wide externalities for developing countries, such as
employment, improvement in technology and skills, productive capacity upgrading and
export diversification into more value added. In turn, those externalities would increase the
attractiveness to more foreign direct investment. These potential gains explain the acute
interest of policymakers in many developing countries over ways to link their private
sectors to GSCs.


However, GSCs are fundamentally a business strategy of TNCs, and are driven by
their own business interests. Low labour costs alone are not a sufficient justification for
relocating a part of TNC’s production processes. GSCs also rely on sophisticated and
competitive networks of goods and information flow. Participating and upgrading along
the chains require not only manufacturing skills but also a sound business environment that
are often lacking in developing countries.


GSCs have different structure depending on three main factors: (1) the geography
and nature of linkages between tasks in the chain; (2) the distribution of power among lead
firms (TNCs) and other actors in the chain; and (3) the role of government institutions and
policies in structuring business relationships and industrial location.3



1 UNCTAD (2010a).
2 Gereffi (1999); Altenburg (2000); Tewari (1998).
3 Sturgeon and Gereffi (2009).




2


The first factor, the geographical structure, is determined by the extent of the
fragmentation of the production processes and by its delocalization. While the extent of
fragmentation is generally specific to the sector, choice on where to delocalize production
processes depends not only on production and trade costs but also on the potential size of
domestic/regional market, as well as on the proximity to high income markets. The extent
to which local markets are integrated with regional/international markets both in regard to
trade policies and infrastructure development is also important.


The second factor, the distribution of power among the various firms of the GSCs, is
reflected in the different organizational structure of GSCs. Their structure can be classified
in terms of the relational linkage between the buyers (lead firm) and their suppliers of
manufactures (Box 1). One extreme is the case of vertical integration where some of
manufacturing stages are directly owned by the lead firm while certain parts and
components may be bought from contract suppliers. The other extreme is the case of arm’s
length contractual relationship, where buyers do not necessarily know and do not own their
suppliers. Numerous types of different ownership structures can be found anywhere within
the wide spectrum of the “buyer-supplier” relationship.


Third factor is related to government intervention. Governments play an important
role in facilitating integration of domestic firms in GSCs. Governments have often
recurred to trade policies to increase competitiveness of their enterprises, especially by
seeking preferential market access. Indeed, trade policies, by lowering trade costs, can help
integrate domestic firms into GSCs. However, trade policies, although still important, are
not anymore sufficient in the GSCs business model. The removal of the behind-the-border
trade related barriers is also necessary.4 Moreover, policies aimed at the improvement of
the overall business environment are essential in facilitating integration of domestic firms
in markets that are increasingly dominated by GSCs.


The first two factors are exogenous for policy implications and are largely dependent
on the business model of a specific economic sector. Therefore, the special focus of this
paper is to provide some insights on the third factor so as to see how government
institutions and policies, particularly trade policies, may influence the participation of
developing country enterprises in GSCs, including progressive process and production
upgrading and export value addition with economy-wide effects.





4 UNCTAD (2006).




3



Box 1. “Buyer-Supplier” relational linkage strength of Global supply chains



(Weak) (Strong)
Market-based arm’s


length relationship
“Sticky” relationship Vertical integration


Ownership
structure


Lead firm (buyer) does
not own any of the
suppliers.


Lead firm (buyer) maintain
some degree of relational
linkage with suppliers


Lead firm (maker)
directly or indirectly
owns suppliers


Industry
characteristics


Low-tech requirement,
labour-intensive, low
design specification

economy of scale


Low-tech requirement,
labour-intensive, high design
specification

economy of scope


High-tech requirement
and design specification,
labour intensive or
capital-intensive
economy of scale &
scope


Product sectors Consumer non-durables Consumer non-durables Consumer durables
Product
characteristics


Standard, non-
differentiated products
(e.g. standard apparel,
electronics, toys),
long or short life cycle


Design- or process- or other
requirement-specific products
(e.g. designer-apparel,
footwear, electronics),
short life cycle


Quality-sensitive
(e.g. auto parts and
components, assembly),
long life cycle


Buyer
characteristics


Mega (low-price) retailers


International buyers (i.e.
triangular production
network)


Brand owners


International buyers (i.e.
triangular production
network)


Makers


Brand owners


Supplier
location


Low-income developing
countries


Low or middle-income
developing countries


Middle- or higher-
income developing
countries


Buyer-supplier
transfer of
technology


Unlikely Likely Necessary


Adopted from: Kaplinsky (2005) and Milberg (2004).

The market-based arm’s length buyer-supplier linkage is common in the industries whose
manufacturing requires low-tech, labour-intensive standard technique and where products are
standardized. As production and process requirements increase, or as final products become
more differentiated, buyers, or the lead firms’ chain management needs increase as well, thus
the buyer-supplier linkage tends to become stronger. In general, the trend observed is that
there are more low-income countries among low-cost suppliers of non-differentiated products,
and higher- to middle-income developing countries as suppliers of more differentiated
products.





4




II. Evolution of GSCs and developing countries


Although the use of foreign suppliers by lead firms can be traced back several
decades, it was not until the late 1980s that the outsourcing of production processes started
to characterize business models. Initially limited only to some sectors like textiles, clothing
and electronics, by early 1990s the process of globalization (where firms were increasing
their competitive advantage through global sourcing) was rapidly expanding to various
industries and engaging firms in a number of developing countries. In one of the first
comprehensive studies of new scenarios in global production, Gereffi and Korzeniewicz
(1994) stated: “In today‘s global factory, the production of a single commodity often spans
many countries, with each nation performing tasks in which it has a cost advantage”.


During most of the 1990s, delocalization and fragmentation were still limited to less
complex and more labour intensive parts of the production process. Most of the assembly
and component production requiring technical skills and know-how were still performed
by the lead firms (TNCs). Since then, progress in a number of areas has greatly contributed
to the establishment of GSCs. First is the rapid advancement in production technology,
enabling various industries to further slice up their production chains. Second is the
substantial reduction in information costs leading to a more cost effective relationship
between buyers and suppliers. Third is the overall decline in trade costs both in home and
host countries.5 A recent study by UN ESCAP identifies which trade facilitation measures
and policies could be most effective at reducing non-tariff policy-related trade costs. It
suggests that “improving port efficiency (liner shipping connectivity) and access to
information and communication technology facilities are essential to reducing trade
costs.”6 Those developments have provided great incentives to lead firms for delocalizing
further, including even the most complex production processes. Today, a large number of
goods are produced in a truly global factory: products are designed in one country,
assembled in another, with parts and components originating in third countries.


Delocalization of production processes encompasses not only manufacturing
processes but also services. Although services offshoring is still largely related to low-skill
processes, middle and high-skilled type of services are increasingly being offshored (Box
2). The increasing trend in the offshoring of these types of services may create great
opportunities for developing countries able to meet this demand in terms of human capital.



5 Jones Comfort and Eastwood (2005).
6 UN ESCAP (2011).




5




Box 2: Services offshoring

Starting from a virtually zero base, the offshoring of services has been rapidly


growing since the turn of the century. Precise data of the value of offshore services is
lacking, however estimates for 2010, indicate their overall magnitude in the range of 250-
300 billion US$ (Gereffi and Fernandez-Stark 2010). Besides conventional service sectors,
services which were traditionally embodied in the industrial manufacturing process are
also being increasingly offshored. Thanks to technological progress, services such as
R&D, design, elaboration, engineering, and other information-intensive activities as can
now be efficiently de-integrated and delocalized from the manufacturing process.
Although, offshoring of services is still largely related to low-skilled segment, middle and
high-skilled type of services are increasingly being offshored.



    Offshored services by segments (2005 and 2010) 


0


20


40


60


80


100


120


140


ITO (low-skills) BPO (mid-skills) KPO (high-skills)


Bi
lli


on
U


S$


Year 2005
Year 2010


 


Source: Gereffi and Fernandez-Stark (2010), based on OECD data.
Note: Information Technology Outsourcing (ITO) covering lower-skill segment (software
development, applications and infrastructure management, IT consulting, etc). Business
Process Outsourcing (BPO) covering the middle-skill segment (enterprise, human and
customer resource management). Knowledge Process Outsourcing (KPO) which includes
highly-skilled components (business consulting, market intelligence and legal services).




As discussed later, a growing number of developing countries, particularly in East
and South-East Asia, have been increasing their participation in GSCs as part of their
export-led growth strategies, which embraced inter-related industrial, trade and investment
policies. The key objectives were to (i) increase their integration in the world economy; (ii)
diversify their exports from commodities to more value added manufactures and services;
and (iii) most importantly, provide economy-wide development benefits in terms of better
employment and progressively higher living standards. A substantial number of
developing country enterprises managed to enter into labour-intensive manufacturing




6


segments of GSCs. Most of those enterprises are from middle income developing
countries.


Long-term development implications of participating in a GSC, however, remain
ambiguous. After two decades of intensive GSCs-building, developing country experience
of participating in GSCs is rather mixed. A GSC fundamentally is a business strategy of a
TNC, and it is never straightforward to merge business interests of a global firm with
strategies for a long-term socio-economic progress of developing countries participating in
a GSC. Perhaps, the biggest challenges for developing countries, especially for smaller and
less developed among them, and their enterprises are: (1) to ensure their progressive
movement upwards in terms of value addition in a GSC (as illustrated in Figure 1); (2) to
enable local enterprises within GSCs to move up the technological ladder; and (3) to
achieve economy-wide developmental impacts from integrating into GSCs.




Figure 1. Value addition in a GSC







7




III. GSCs: trends in international trade


Some insights on the evolution of GSCs can be inferred from the analysis of trade
data. Since GSCs are characterized by fragmentation, the aggregated value in trade of
intermediate products is highly correlated to their expansion. Figure 2 reports the value of
international trade in intermediates vis-à-vis that of other products.




Figure 2. Trends in international trade


0


1,000


2,000


3,000


4,000


5,000


6,000


7,000


19
93


19
94


19
95


19
96


19
97


19
98


19
99


20
00


20
01


20
02


20
03


20
04


20
05


20
06


20
07


20
08


20
09


Ex
po


rt
V


al
ue


, i
n


bi
lli


on
U


SD


Final Goods Intermediate Goods Raw Materials Capital Goods





Trade in intermediate products represents about 40 percent of world merchandize


trade. International trade in intermediate goods grew from about 1 trillion USD in 1993 to
roughly 6 trillion USD in 2008, before falling during the crisis of 2009. In this context,
GSCs are increasingly fragmented across a larger number of countries, each involved in
the assembly process at a different stage, thus resulting in multiple-border crossing of parts
and components before getting incorporated in the final product.


GSCs evolved from being mostly confined within developed countries to
increasingly integrate developing countries. In the early 1990s more than half of world
trade in intermediates products was between high income countries and only up to 10
percent was between developing countries. In 2008, North-South and South-North trade in
intermediates accounted for about 40 percent of trade in intermediates, with another 20
percent occurring between developing countries themselves (Table 1). Although the
economic crisis of 2009 has sharply reduced trade in intermediates, the trend towards an
increasing presence of developing countries in the global manufacturing and trade in
intermediate products has continued.









8


Table 1. World trade in intermediates


Values (billion USD) Percentages



Avg.


1993/94
Avg.


2007/08 2009
Avg.


1993/94
Avg.


2007/08 2009
North-North 780.7 2'387.2 1'704.2 58% 41% 40%
North-South 254.5 1'222.3 922.4 19% 21% 22%
South-North 191.3 1'074.3 758.5 14% 19% 18%
South-South 125.8 1'098.6 887.5 9% 19% 21%




The integration of developing countries in GSCs is not uniform and largely depends
on their income level (Table 2). Upper middle income countries’ exports of intermediates
take more than half of total exports of intermediates from developing countries. At the
regional level, East and South-East Asian region accounts for almost 2/3 of developing
countries’ exports of intermediates. Latin America and East Europe (including economies
in transition) represent another 30 percent. The remainder is shared between South Asia,
West Asia and North Africa, and Sub-Saharan Africa. For countries in those regions,
participation in GSCs, although increasing, is still rather limited.




Table 2. Exports of intermediate products for developing/transition country
income groups and regions




Average of
1993 &1994


Average of
2008 & 2009


2009


High Income Countries 1'035.2 3'609.5 2'626.5 8.7%
Middle Upper Income Coun 223.9 1'173.8 886.2 11.7%
Middle Lower Income Coun 65.2 798.2 622.3 18.2%
Low Income Countries 28.1 200.7 137.5 14.0%
Total 1'352.3 5'782.2 4'272.5 10.2%


Developing Countries Region
East and South-East Asia 192.0 1'343.1 1'075.2 13.8%
East Europe 40.8 372.3 231.1 15.9%
Latin America 58.3 279.0 220.5 11.0%
Middle East / N. Africa 4.1 37.2 24.9 15.8%
South Asia 9.7 74.2 49.3 14.5%
Sub-Saharan Africa 12.2 67.0 45.0 12.0%


Income Group /Region
Value of Intermediate Export, in billion US$ Annual


Growth Rate
(1993-2008)






Developing country participation in GSCs is still mostly related to supplying
developed countries’ markets. Although on the rise, South-South production networks are
relatively less developed and mainly limited to East and South-East Asia. Trade in
intermediate products within East and South-East Asia region accounted in 2009 for about
9.6 percent of world trade in intermediates (up from about 6.1 in 1993). Similar figures for
the East European and Latin American regions are much lower (about 1.9 and 1.1 percent
respectively). Other regions are lagging behind as their regional trade accounts for less
than 0.2 percent of world trade in intermediates. South-South chains that span across




9


regions appear to be still quite underdeveloped, even those based in the East and South-
East Asia region (Table 3).





Table 3. Distribution of world trade in intermediate products across regions (2008)


Region
High


Income
Countries


East and
South-East


Asia


East
Europe and


CIS


Latin
America


West Asia
and North


Africa
South Asia


Sub-
Saharan
Africa


All
Importers


High Income Countries 40.3% 10.4% 4.0% 3.7% 1.8% 1.1% 0.6% 62%
East and South-East Asia 10.1% 9.6% 0.9% 1.2% 0.5% 0.6% 0.3% 23%
East Europe and CIS 3.2% 0.4% 1.5% 0.2% 0.5% 0.1% 0.0% 6%
Latin America 2.9% 0.6% 0.1% 1.1% 0.1% 0.0% 0.1% 5%
West Asia and North Africa 0.9% 0.1% 0.2% 0.0% 0.2% 0.1% 0.0% 2%
South Asia 0.8% 0.3% 0.0% 0.1% 0.1% 0.1% 0.1% 1%
Sub-Saharan Africa 0.7% 0.2% 0.0% 0.0% 0.0% 0.1% 0.2% 1%
All exporters 59% 22% 7% 6% 3% 2% 1% 100%




The structure of GSCs is not static, but develops over time to take advantage of
changes in relative costs, as well as in economic and policy environments. In the case of
the East and South-East Asia region, the data illustrate the rising importance of China as
an assembly powerhouse (Figure 3). In relative terms, China intermediate exports to the
region have been declining constantly since the early 1990s. On the contrary, China has
become increasingly important for regional suppliers of intermediates. This may suggest
that GSCs are increasingly fragmenting the production processes, localizing their assembly
operation to China, while delocalizing the supply of part and components to other
countries in the region.




Figure 3. China’s trade in intermediates within the East and
South-East Asian region


0%


10%


20%


30%


40%


50%


60%


19
93


19
94


19
95


19
96


19
97


19
98


19
99


20
00


20
01


20
02


20
03


20
04


20
05


20
06


20
07


20
08


20
09


Sh
ar


e
of


In
te


rm
ed


ia
te


E
xp


or
t


Chinese Export to East & South-East Asia East & South-East Asian export to China


The delocalization of production processes across industries has often been shaped to
take advantage of a country’s comparative advantages (both in endowments and policy
driven dynamics) in specific sectors, with a creation of a relevant regional specialization
(Table 4). For example, a relatively higher efficiency and abundant skilled labour force is
one of the forces behind the connotation of East and South-East Asia as a supplier of ITC
products (about half of intermediates products’ exports in this region is in ITC products).




10


Similarly, geographic proximity and largely duty free access to consumer markets are
among the determinants of delocalizing the automotive industry in Latin America or East
Europe (about quarter of their exports of intermediates products respectively). Finally,
lower labour costs are one of the factors behind the localization of global production
chains in textiles and apparel in South Asia, West Asia and North Africa (about 60 percent
of all intermediate exports from those regions are in the textile and apparel sector).




Table 4. Composition of intermediate exports across industries and regions (2008)


Industry
High


Income
Countries


East and
South-East


Asia


East
Europe and


CIS


Latin
America


West Asia
and North


Africa
South Asia


Sub-
Saharan
Africa


Textile and apparel 5% 14% 9% 9% 43% 65% 17%
Power generating machines 7% 2% 8% 6% 4% 4% 5%
Metal working machines 2% 1% 1% 0% 1% 1% 1%
General industry machinery 12% 5% 8% 7% 4% 6% 18%
Information Technology and Communications 18% 49% 22% 28% 7% 7% 6%
Electrical machinery 7% 9% 11% 10% 11% 4% 4%
Road vehicles 24% 5% 21% 25% 21% 6% 31%
Furniture and parts thereof 2% 3% 6% 3% 2% 1% 3%
Others 24% 12% 13% 13% 7% 6% 16%
Value of Intermediates Exports, in billion USD 3'739.1 1'931.5 246.6 262.9 89.9 82.0 24.5



These trends in trade flows imply that delocalization of production processes in


GSCs depend not only on endowments, labour costs and productivity, but also on trade
and other economic policies.




IV. GSCs: trade and economic policies


Trade policies directly affect the integration of domestic firms into GSCs in two
major ways. First, trade policies can add to the cost of inputs. Excessive tariffs on
intermediate products make countries less attractive to global investment and are
detrimental to the localization of production processes. Second, unfavourable market
access conditions would put assemblers in a relatively disadvantaged position in
distributing final products to consumers. To minimize this cost, lead companies generally
prefer delocalizing the last blocks of GSCs in countries with duty free or preferential
access to final markets. This is one of the reasons why preferential trade agreements
improving access to developed country markets are important determinants in the
localization of production processes. Another policy response is illustrated by the WTO
plurilateral Information Technology Agreement (ITA), which eliminated MFN tariffs on a
wide range of computer related equipment (including semiconductors and software), as
well as telecommunication and certain office equipment. These goods represent a crucial
flow of international trade amounting to about 4 trillion USD in 2008. Today ITA has
73 WTO members States, both developed and developing countries and covers about
97 per cent of world trade in information technology products.


Trade policy is often directed to protect final products rather than intermediates. This
provides an advantage to the localization of the last blocks of production processes in
consumers’ markets. The relatively lower tariff on intermediates provides a greater
incentive to import them (and thus to be produced in developing countries). On the other
hand, the higher tariff on final products provides an incentive to localize assembly in large




11


(or potentially large) consumer markets, or in countries enjoying free access to consumer
markets. This trend, where tariffs increase along the production chain, is generally referred
to as tariff escalation. Tariff escalation is often used to provide an advantage to domestic
firms engaged in the assembly of the higher value-added final product rather than in the
provision of low-value added intermediates.




Table 5. Average effectively applied tariffs on selected industries (final and
intermediate products)







In general, tariffs applied on final goods are higher than those on intermediates
(Table 5). With the exception of two sectors (general industry and electrical machinery), in
all other industries, applied tariffs on final products are relatively higher. Low tariffs
contribute to the delocalization of production processes in industries such as ITC, while
higher tariffs on road vehicles play a role in keeping the assembly of these products in
developed countries. Still, for some economic sectors, there is no direct evidence that
tariffs affect the delocalization of production process. This suggests that other factors
(besides trade policies) may be of higher importance.


To illustrate the relative importance of trade policy versus other determinants of
participation in GSCs, Table 6 reports some indicators of trade policy versus other
economic policies (combined in an indicator of business environment), by income country
groups.




Average Tariff on:
Industry


Final Goods Intermediates
Textile and apparel 7.1 3.1
Power generating machines 3.6 1.9
Metal working machines 4.3 2.4
General industry machinery 2.9 3.2
Information technology and
communications 2.6 1.4
Electrical machinery 2.8 3.1
Road vehicles 5.6 3.3
Furniture and parts thereof 2.1 1.5
Others 2.7 1.9
Total 4.3 2.2




12


Table 6. Trade policy and business environment, by income country groups














Overall trade policy is captured by two indicators: effectively applied tariffs imposed


on intermediate products, and those faced by final products. The overall business
environment is measured by the World Bank’s Doing Business Index. This Index provides
a measure of various aspects affecting business environment, including government
regulations such as starting a business, dealing with construction permits, registering
property, getting credit, protecting investors, paying taxes, enforcing contracts and closing
a business. Although all these indicators normally ameliorate with the growth of GDP per
capita, they are also positively correlated with the participation in GSCs. Countries with
economies more integrated in GSCs tend to have more open trade policies, to face lower
market access restrictions in high income markets (which are the main location of lead
firms), and to have a more conducive business environment. The reason for this correlation
is that the effectiveness of business models behind GSCs is highly dependent on the above
variables.


Although appropriate trade policies and a favourable business environment are both
important in putting into place the conditions for countries to integrate into GSCs, their
relative importance differs. Table 7 provides an indication of the role played by traditional
trade policies in relation to that of the business environment.7 This table reports the
increase of participation in the global production chains (measured by the increase in trade
in intermediate products) that a given country group could obtain by aligning its policy to
the level of another country group.





7 The participation in global production chains is estimated econometrically with a panel gravity equation.
Table 7 illustrates the effect on the participation in GSCs (measured as trade of intermediate products) of a
change in trade policy and improvement in business environment.


Country Group


Tariff
faced by


Processed
and Final


Goods
(percent)


Tariff
imposed on
Intermediate


Products
(percent)




Business
Environment


Index
(lower
better)


High Income 0.95 0.25 24.23
Middle Income 1.50 1.37 83.47
Low Income 3.19 3.22 123.58
Least Developed 2.59 4.17 138.39




13


Table 7. Importance of traditional trade policy versus overall business environment
Increase in trade (percent) due to:


Policy change




Change in
Applied


Tariffs on
Processed
and Final


Goods


Change in
Applied


Tariffs on
Intermediates


Products




Change in
Business


Environment
Index


Middle income to High
Income 2.6% 4.8% 40.7%
Low income to Middle
Income 7.9% 7.9% 27.6%
LDCs to Middle Income 5.1% 13.1% 37.7%





By abating trade costs, more open market access conditions do contribute to the
integration of countries into GSCs. However, given the already low level of effectively
applied tariffs, the additional advantage provided by further trade liberalization through
unilateral measures or market access negotiations is generally not large. For example, for
low income countries, a reduction in the applied tariff on intermediates products from the
existing average of 3.22 percent, to 1.37 percent (a level similar to middle income
countries) would increase their trade in intermediates by about 8 percent. A similar effect
would result from an improvement in market access (a reduction in the tariff faced by their
final and processed products from 3.19 to 1.5 percent). It also appears that middle and low
income countries could achieve similar trade effects through a better functioning of
existing export processing zones (EPZs) and a more efficient management of formally
applied duty drawback systems so as to implicitly eliminate or reduce tariffs on imported
inputs for export oriented enterprises.


On the other hand, a sizeable improvement of business environment would result in
far more positive effects on growth of trade in intermediate products, particularly for
middle and low income countries (for both developing countries and economies in
transition).


Tariffs are traditional price-based trade policy instruments, while non-tariff measures
can also add to the cost of trading and thus have an impact on the extent to which firms
and countries integrate into GSCs. Although information costs of non-traditional trade
barriers are often internalized by the lead firms, some of these barriers still add to the
overall costs of moving the goods along the chain.


In particular, non-tariff measures such as standards, technical regulations, conformity
assessment systems, complex rules of origin, subsidies and restrictive trade related
financial and investment regulations that protect domestic industries from foreign
competition have today a relatively greater and growing importance in shaping the
participation in GSCs. Removal of such barriers through, e.g. a deeper integration through
regional preferential trade agreements (RTAs)8 is found to double trade in intermediate



8 In this paper, the term “RTA” refers to all types of preferential trade agreements,
including bilateral free trade agreements (FTAs).




14


products among their members.9 Today almost all RTAs include trade facilitation and
technical assistance measures. These agreements do facilitate the delocalization of
production processes by removing behind-the-border obstacles to trade.10


However, as an increasing number of countries, both developing and developed,
move towards freer trade via RTAs, the relative advantage provided by open trade policies
is not sufficient to make a country attractive for the localization of global production
processes.11 Economic policies that reduce overall business costs or minimize the risks
from international business relationships may be of greater value for facilitating integration
in GSCs. Thus, policies that improve trade related infrastructures, increase competition in
trade related services, facilitate business startups, guarantee the rule of law and contract
enforcement, and provide fiscal and other incentives to foreign firms are essential.


In addition, the effectiveness of government institutions and their capacity to
implement policies are critical. GSCs also often involve long term investments that require
equally long term government commitments with regard to stable and predictable policies.
For example, political instability and the resulting government policy instability is
detrimental for turning domestic firms into reliable suppliers of GSCs. Econometric
estimation suggests that an improvement in government effectiveness of low income
countries to match that of middle income countries would increase the former exports of
intermediates by almost 50 percent.


The larger importance of business environment and government effectiveness for
GSCs is directly related to their increasing sophistication and drive for efficiency. GSCs
are extremely competitive not only because they take advantage of localization due to
lower labour costs, but more so because such competitiveness comes from a sophisticated
management of the chain. The majority of modern GSCs appear to rely more on the ability
to move goods continuously, safely and economically than on lower labour costs.


In this regard, one of the key aspects of GSCs is synchronization: goods flow in and
out of chains in a just-in-time process, so to keep costly inventories at minimum.12
However, when inventories are low, and a problem occurs in any of the production blocks,
it quickly spreads along the entire chain with snowballing costs. GSCs are often as fragile
and prone to failure as is their weakest supplier. Thus, it is crucial that all players in a
chain are fully reliable. In practice, there is a tradeoff between reliability of suppliers and
production costs.


In general, the more knowledge-intensive a product is, the more GSCs are dependent
on specialized and reliable suppliers. This is one of the reasons why most of LDCs’



9 These results are based on econometric estimation where the effects of FTAs are
captured by a dummy variable.
10 Still, from an economic perspective, preferential trade agreements should be considered
as sub-optimal instruments as maintaining barriers against non-members (while allowing
free trade among members) could hinder “natural” expansion of fragmentation-based
specialization across countries.


11 Fugazza and Nicita (2011).
12 Inventories are rarely optimal and are often costly. This implies that lead companies in
GSCs would rather employ reliable and proven suppliers than rely on low cost but
unreliable ones.




15


enterprises are stuck in a low value added segment of chains, and are operating in sectors
were chains are shorter and less technologically intensive (i.e. apparel and agro-food
sectors).


Another issue that hinders participation of developing countries in GSCs is the
relative lack of medium and large size enterprises. Small enterprises often face additional
obstacles that make it difficult to enter GSCs. For example, GSCs require investments to
guarantee timely shipments and high quality parts and components. Difficulty to invest in
productive and trading capacity is one of the reasons why small enterprises are often
locked into low-value added production process with little opportunity to upgrade along
the value chain.13 Most importantly, small enterprises are also disadvantaged as they rarely
have management expertise able to meet the complex problems that GSC management
involves. Moreover, small enterprises often supply a single lead firm, thus making the
entrepreneurship less dynamic and more vulnerable to shocks.


An essential element in GSC integration is availability of skilled labour. Production
of goods for international markets, particularly by means of supplying a GSC, requires
skilled labour force, both with technical, managerial and entrepreneurial expertise.
Therefore, from a policy perspective, there is a need to invest in the development of human
skills and capabilities, as well as in knowledge based services. It is also important to allow
for qualified foreign labour permits so as to import missing critical skills.


Finally, in cases where the lead firm owns part of the GSC, tax policy is an important
determinant for localization of production. By looking at the differences in taxation across
countries, lead firms tend to optimize supply chains also based on the tax efficiency.




V. Rising along the value chain


Although participation in GSCs helped a number of developing countries to expand
export-oriented industries, in many cases, the value added from such activities did not
increase markedly over previous commodity-based exports. To rise along the value chain,
an industrial or process upgrading is required. Gereffi, Humphrey, and Sturgeon (2005)
define industrial upgrading as “the process by which economic actors – nations, firms and
workers – move from low-value to relatively high-value activities in global production
networks”.


Figure 4 reports the evolution of export sophistication originating from high income
countries and six developing regions between 1993 and 2008.14 Increase in the level of
export sophistication suggests that a learning and industrial upgrading is taking place in the
exporting region.






13 Lim and Kimura, 2010.
14 A country's overall export sophistication is measured by the Revealed Factor Intensity Index, an index
developed by Cadot, Shirotori and Tumurchudur (2010) which links product sophistication level to
endowments abundances of exporting countries.




16


Figure 4. Export sophistication




0


10


20


30


40


50


60


70


80


90


100


Sub-
Saharan


Africa


South Asia West Asia
and N.
Africa


Latin
America


East
Europe and


CIS


East and
South-East


Asia


High
Income


Ex
po


rt
S


op
hi


st
ic


at
io


n


1993
2008






Process upgrading occurred in most regions, although to a different extent. In 1993,


Latin America, East Europe and East and South-East Asia had largely a similar level of
export sophistication. By 2008, export sophistication increased in all of those regions,
however the largest increment was observed for East and South-East Asia. Similarly, in
1993 the average level of export sophistication of South Asian and Sub-Saharan African
countries were similar, however, by 2008, South Asian export sophistication was much
higher. Furthermore, some of these countries were able to increase their export
sophistication by transforming export-oriented industries (as parts of GSCs) from those
based on raw materials and low-technology manufacturing (agro-food, apparel, footwear,
etc.) to one dominated by medium technology exports.


An important policy question is why some developing countries were able to surge
ahead in diversifying into more value addition within GSCs, while others did not succeed.
Many of the factors, as mentioned above, are quite relevant in this regard. Indeed, sound
macroeconomic policies, favourable business environment, development of human capital,
economic links to high income markets, sector-specific industrial development policies,
natural resources endowments – all of these factors determine the success or failure of the
export diversification of countries. Still many questions remain open.15 To properly address
those questions, there is a need for more research and better data, including those on TNCs
as lead firms.


Knowledge of production processes is one of the keys to industrial upgrading and
export diversification.16 For countries that are lagging behind, knowledge must come from
absorbing it from elsewhere. GSCs chains can be a powerful force in enabling technology
transfers and industrial process upgrading. In this regard, many mechanisms were
examined, from arms-length technological “borrowing” to a range of practices that

15 For example, whether a concentrated industrial structure (higher R&D) is better than a flexible network of
small and medium firms (more dynamic business model), Wade (1990). Another issue refers to the role
played by export processing zones (or special economic zones) and other “concessional” policy instruments.


16 Kimura (2007).




17


encompass technology licensing, reverse engineering, the injection of equipment and
know-how through foreign direct investment, and firm-level adaptation to demands made
by both foreign affiliates and overseas buyers.17 One important question that needs to be
studied more deeply is what makes lead firms in GSCs transfer higher value added
processes to developing countries. So far, the evidence suggests that lead firms tend to
outsource lower value-added activities (including final assembly), while retaining control
over higher value-added areas of their “core competency like R&D, intellectual property,
design and distribution.




VI. Policy issues


Being able to participate in a GSCs may be a sign of a country’s growing productive
capacity. Moreover, having a strong relational linkage with the lead firm in a supply chain
could enhance a transfer of knowledge, technology and even financial capital into the
suppliers’ country. In this way, participating in a GSC can play a catalytic role to a
developing country’s economic growth through productive capacity upgrading. However,
such level of GSC participation appears to be possible only to countries which already
have some prerequisite productive capacity, those are mainly middle- to higher-middle
income countries.


Technology transfer within a GSC is not automatic. Lead firms, especially those of
products or production technique/processes with high intellectual property content, may
restrictively control technical and technological spillover to subcontract suppliers. In
addition, investment strategies of TNCs should be borne in mind. For example, there is
evidence to suggest that much of the US lead firms’ profits during 1996-2006 was
financialized (through share buyback or dividend increase) “… to raise shareholder value,
rather than investing in productive assets that raise productivity, growth, employment and
income.”18 Would a new model of social business-linked FDI, such as the Grameen
Danone Foods Ltd, provide a useful insight to a new architecture of a global/regional
supply chain?19





17 Gereffi (1994); Feenstra and Hamilton (2006).
18 Milberg and Winkler (2009).
19 In a “social business” model, there are “neither losses nor dividends”. All profits accrued from the
business activities are reinvested to increase productive and supply capacity.




18



Box 3: Bangladesh and Cambodia in Global Supply Chains in the Garment Sector

Least developed countries (LDCs) are not significant players in GSCs, except in the garment sector. In the
past decade, a large number of global garment buyers, many of which serve brand owners, set up readymade
garment factories in several LDCs such as Bangladesh and Cambodia. In a decade between 1997 and 2007,
exports of garments (classified as HS chapters 61 and 62) increased the share in their total exports from 67%
to 71% in Bangladesh, and from 51% to 86% in Cambodia. The share for 2008/2009 is estimated to have
increased for both countries. Garment exports from African LDCs also exhibited a strong growth in the past
decade, largely thanks to the preferential access to the US market granted under the African Growth and
Opportunity Act (AGOA).

The economies of Bangladesh and Cambodia have become highly dependent on the employment in the
garment industry. In Bangladesh, the garment industry absorbs about three million workers. In Cambodia,
some 280000 workers were employed in the garment industry in 2008, and up to 1.6 million people’s living
is believed to depend on the remittances generated by garment factory workers. But dependence on the
garment industry presents also a dilemma to the governments whose long-term goal is to achieve a stable
socio-economic progress, as the competitiveness of these countries arises solely from the competitive wages.
Bangladesh has the lowest labour cost in the world at 22 cents per hour, and Cambodia at 33 cents per hour.
On the one hand, maintaining wage competitiveness would exacerbate garment-factory labour unrest that
have been reported in the past year both in Bangladesh and Cambodia, while allowing wage rise in line with
the rise in consumer prices, particularly food prices, would risk an exodus of generally foot-loose GSC
buyers to other supplier countries. Moreover, the recent global economic downturn highlighted a
vulnerability of LDCs with high dependence on garment exports. Within a year from October 2008, the
number of operating factories in Cambodia dropped from a peak of 313 to 241, with most of the remaining
factories running at only 60-70% of their capacity. Almost 21% of total workforce had been laid off, at times
without receiving any compensatory pay.

Major challenge to these LDCs is to increase overall competitiveness in the garment industry, i.e. in the areas
of productivity, product quality and reliability in terms of supply lead-time. As regards productivity and
product quality, building managerial capacity of locals and eventually replacing foreign factory managers by
locals can improve communication at workplace, as well as increasing workers’ motivation with a better
prospect for advancement. The physical connectivity to the world market also needs to be improved.
UNCTAD’s Liner Shipping Connectivity Index revealed that the LDCs’ average ranking in 2010 was 111,
compared to 78 for other developing countries. Container shipping companies are less likely to provide
services to and from the seaports of LDCs because national trade volumes tend to be lower and the quality of
ports is such than they are less attractive for transshipment and transit cargo.





As regards low-income countries, being a part of a GSC could be seen as probably
the more rapid way to become integrated into the global trade in manufactures and
services. However, the segments within a GSC, in which low-income countries mostly
participate, are limited to the bottom of the value-added ladder with a low barrier to entry –
those are labour intensive products with low-tech requirements and low set-up cost – such
as assembly in apparel and light manufacturing industries (Box 3). Low barriers to entry
often create price-cutting competition among supplier countries. As a result, a declining
net barter terms of manufacture trade of such low-income countries was observed in the
past decade20. Also problematic is that the lead firm-supplier relational linkages in these
industries are often very loose and unstable. The lead firms benefit from the severe
competition among numerous and almost identical suppliers and select the ones that meet



20 Kaplinsky (2005).




19


their short-term requirements. Potential negative effects of such unstable contracts,
particularly to the local labour market, were noted by many researchers.21


The challenge to suppliers and governments of low-income countries is to transform
the declining net barter terms of trade into an increase in “income” terms of trade through
larger export volumes (i.e. winning over the competitors) or through concurrently
achieving a growth in factoral terms of trade, i.e. a productivity increase.


For a local supplier to win a more durable relationship with the lead firm, it needs to
become cheaper, better in quality, quicker in delivery, and more reliable than its
competitors within an industry. Such “process upgrading” could lead suppliers to move
upwards to a higher value-added segment in a GSC, e.g. a move from a standard mass
production into more design- and other requirement-specific production.


Firms in a low-income country often face higher obstacles in achieving both process
and product upgrading. Government support can play a role especially in regard to: (i)
investment promotion policies to attract more buyers (lead firms); (ii) reducing tariff and
non-tariff barriers for imported production inputs; and (iii) bottoming up the supply
efficiency, by improving business environment, transport, logistics, education and training;
(iv) guarantee long term commitments in policies (especially trade and fiscal policies) so
as to minimize the risk for foreign enterprises and business relationships.


Non-policy factors are also among the determinants of a successful process and
product upgrading. Those include: (a) length of value chain to the final product (or depth
in the manufacturing segment), i.e. how many parts and components to move into; (b)
product characteristics (standard or differentiated), (c) structure of a GSC (market based or
a sticky one, see Box 1 above); (d) interest of a leading firm in assisting the product
upgrading (though technology/financial injection); (e) market situation (competitors,
stepladders vacated or not, etc.), and (f) comparative advantage, including geographical
and/or population consumption assets (e.g. close to a big market, own large domestic
market). As Rob Davies, Minister of Trade and Industry of the Republic of South Africa
put it: “Identification and choice of sectoral interventions is based on identification of first-
order constraints that cut across most of these sectors and sectoral “self-discovery”
processes. The latter involve a combination of research of international and domestic
trends, consultation with key stakeholders – particularly business and labour, policy and
instrument design attached to appropriate conditionality and periodic review and
adaptation”.22


The size of a country matters in a GSC. A large domestic market by itself attracts
foreign firms to set up a basis and localize thereafter some or main segments of their GSCs
targeting both exports and domestic consumption. Smaller developing countries are having
less leverage in creating a strong relational linkage with the lead firms. A solution for such
countries is also to diversify into new markets, in particular to regional (neighboring)
markets, in addition to their efforts to integrate in GSCs.



21 Bergin, Feenstra and Hanson (2008), for instance, find that maquiladora industries in Mexico are
associated with U.S. offshoring volatility and fluctuations in employment.
22 See: http://www.unctad.org/Templates/Page.asp?intItemID=5717&lang=1 ()




20


A recent study by UNCTAD suggests that Asian LDCs’ exports to other developing
countries, which are mostly their neighboring countries, are higher in factor intensity.23
That is to say that South-South trade, especially within a region, may offer some
alternative upgrading opportunities to low-income countries. Governments within a region
can also collaborate with each other in the areas of improving market information flows of
a given industry/sector (e.g. agro-processing), or establishing a regional laboratory for
product quality assessment. A regional collaboration could be equally useful for R&D for
products/services that are best suited for the demand of regional consumers (with much
less disposable income compared to the OECD consumers), with an added new
technological element.


Distance is often assumed to be among the main determinants of trade costs and thus
also of countries’ participation in GSCs. However, it is not distance itself that is a direct
hindrance to trade, but rather transport costs and transport connectivity, which in turn are
related to the facility with which merchandise trade can be carried out. An UNCTAD study
on the Caribbean region found that distance explains around 20 per cent of the variance of
maritime freight rates, while competition among liner shipping companies and economies
of scales each have a far stronger impact on the freight rate. When there are 5 or more
competing carriers providing direct services, the freight rate is one third lower than when
there are four or fewer providers. This example suggests that strategic liberalization of
transport services, through its impact on competition and economies of scale can have an
important, in some cases perhaps decisive, impact on the establishment of regional trade
connections and the participation in GSCs.24


Transport infrastructure and services together with trade facilitation and modern
Customs procedures are a sine qua non both for export competitiveness and for a country’s
participation in GSCs. As global transport networks expand and ships get larger and port
traffic grows, many LDCs are lagging behind and are not catching up as regards their
access to shipping services. While globally the international liner shipping network is
expanding, for many LDCs the number of shipping companies providing services from and
to their ports is stagnant or even decreasing. Without effective international transport
connections, trade cannot grow.


While trade and transport facilitation is usually a good long term investment, it still
requires financial resources. Globally, during the recent years, technical and financial
assistance to support trade and transport facilitation has increased significantly. However,
most of this additional assistance has gone to middle income developing countries, and not
so much to LDCs. In LDCs, it appears that the resources of donors may compete with
other priorities, such as health or education. Many practical solutions to trade and transport
facilitation reforms require regional or bilateral cooperation, for example as regards transit,
the harmonization of documents, the recognition of certificates, transport infrastructure,
coordination at border crossings etc.






23 UNCTAD (2010c).
24 UNCTAD (2007).




21


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