Has COVID-19 Broken the Global Value Chain?

The coronavirus pandemic has not only disrupted lives and businesses, it has illuminated underlying fragilities in the global value chain (GVC) that drives economies around the world.

The smartphone you use many times daily is a product of a global value chain, designed by a company in one country, manufactured by another firm elsewhere, and distributed by dealers everywhere—all underwritten by global cash flows. Often these networks are established without much redundancy planning or other risk-mitigation factors to counter extraordinary shocks, like this one.

In a new paper, Laura Alfaro and Ester Faia explore the unraveling of GVCs and related disruptions to money flows caused by the coronavirus. Their paper is titled Pandemics Fragilities: The Double-Coincidence of a Halt in Hyper-specialized GVC and the Big-Dollar-Hunger.

Alfaro is the Warren Alpert Professor of Business Administration at Harvard Business School and a Faculty Research Associate at the National Bureau of Economic Research. Faia is a professor at Goethe University Frankfurt and a Research Fellow at the Center for Economic and Policy Research.

Sean Silverthorne: What has been the impact of the pandemic so far on the global value chain, and what more might we expect?

Laura Alfaro and Ester Faia: In 2012, a survey by the World Economic Forum and [the consulting firm] Accenture, devoted to assess the risk of a disruption in the global supply chain, had included a “pandemic" among the 18 categories of risk considered plausible. It assigned a probability of 11 percent to such a pandemic (against, for instance, a 19 percent assigned to global energy shortage or a 17 percent assigned to shortage of labor), making it not really that rare an event.

And here we are with a pandemic. The prevailing economic paradigm behind global value chains, generally a production network, suggests that firms should outsource to the countries with the lowest overall costs. (Firms could potentially source particular intermediate inputs from only one country.) Outsourcing, the fragmentation of production and lengthening of value chains, has allowed for a finer division of labor and greater gains from specialization—hyper-specialization—across countries. Just-in-time management practices also dictate holding minimal inventories to improve profits.

These outcomes are efficient assuming sourcing from a particular country involves zero risk. There is, however, a growing list of events that are overlooked by risk managers, ranging from natural disasters, to geopolitical, technological, contractual, or demand factors.

A first warning emerging from the unprecedented economic shock caused by the pandemic is that a specialized global value chain GVC represents a "trade fragility" and that the paradigm behind the GVC needs to be re-assessed. Production networks shall become more diversified, rather than clustered. Also, the network should rely on trusted nodes. Third, there should be higher transparency through data sharing in order to better track the chain of subcontractors.

Question: How has the coronavirus affected financial flows?

Answer: The halt of the GVC resulted in unintended consequences and fragilities on the monetary side. The appetite for dollar, which is already high after crises, is growing these days at unprecedented levels. During sustained interruptions of the GVC, like after the outbreak of the COVID-19 in China, many firms servicing the network stopped receiving payments in dollars (or perceived that payments would be interrupted).

Firms operating in the commodity markets also saw their revenues shrinking, and struggled to meet obligations in (dollar) debt. As a result, most of them turn to banks to obtain loans. The banks then turn to their central banks to obtain dollar funding. To satisfy this big demand the Federal Reserve on March 19 announced establishment of temporary US dollar swap lines with an expanded list of central banks, including a handful of economies (EMEs), Australia, Brazil, Denmark, Korea, México, Norway, New Zealand, Singapore, and Sweden. Many of the countries newly admitted in the swap line are pivotal in the global supply chain, either for Advanced Manufacturing and Services (South Korea, Brazil, Mexico) or for Innovative Manufacturing Activities, according to data from WEF in 2012. Other countries contribute commodities.

Question: For the general business practitioner, what are the major takeaways from your observations? How will their businesses be affected, and are there things they should be doing now to prepare or react?

Answer: The pandemic has made more evident trade fragilities and the potential exacerbation of monetary fragilities. The occurrence of a number of events that were considered rare is growing.

This implies that business managers, particularly those of companies operating in the GVC, shall now devote more efforts and resources to risk management practices and inventory management. The full focus on the efficiency and cost minimization shall be accompanied by more attention toward a diversification and also of the currencies used for transactions.

Question: What are some implications for policymakers?

Answer: Here there is role for local policies. Attention to risk does not mean walking away from globalization and global value chains. But it does entail paying attention to potential bottlenecks, risk, and diversification of trade partners. Economic policy should also further try to foster local currency debt markets, although this will have to wait for the recovery.

Related Reading

For a more detailed discussion of risk and global capital flows, see the paper Elusive Safety: The New Geography of Capital Flows and Risk.

About the Author

Sean Silverthorne is Editor-in-Chief of Harvard Business School Working Knowledge.

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