Chapter 4. Conclusion and Policy Implications
- Nagwa Riad, Luca Errico, Christian Henn, Christian Saborowski, Mika Saito, and Jarkko Turunen
- Published Date:
- January 2012
Shifts in the global trade landscape over the past few decades have resulted in increased interconnectedness and strengthened trade spillover channels. The expansion in global trade has been underpinned by a diffusion of key systemic players, both in size and in links. Not only has the number of key players increased, but there has been a shift in relative importance in global trade, from large advanced economies such as Japan and the United Kingdom to EMEs such China and India. Importantly, China is now on par with the United States—ranking first in systemic importance not only in terms of size but also in terms of significant bilateral trade relations. This has important implications on trade spillovers as the sources of demand shift in the process of rebalancing.
There is a high correlation between trade and financial interconnectedness. There is a strong overlap between countries hosting both systemically important trade and financial sectors, implying a heightened potential for these countries to transmit disturbances via either the trade channel or the financial channel, or both channels simultaneously. These countries would constitute a natural focus of risk-based surveillance on cross-border spillovers and contagion.
Changes in relative prices result in substantial responses in trade flows in Japan, the euro area, and the United States, and less so in China. Although still important, rebalancing effects are relatively small in China due to its downstream position in the production chain and greater content of imported intermediates in its exports. China’s role as an assembly hub for the region’s high-technology exports mitigates the impact emanating from relative price changes. The alternative simulation suggests the rebalancing impact is likely to be larger in the case where other countries in the supply chain also appreciate. Notwithstanding the stylized nature of the simulation exercise, the results for China are broadly consistent with findings of the April 2011 Regional Economic Outlook for the Asia and Pacific Region suggesting the impact in third markets to be more muted if only the currency of the final supplier appreciates as opposed to when other intermediate suppliers also appreciate. Exports of the three advanced economies—and in particular Japan—are significantly more sensitive to relative price changes given that these countries are located upstream in the production process.
Trade with supply chain partners is generally more resilient to exchange rate changes and rebalancing takes place predominantly outside the supply chain. The reason is not only the position of market power our simulation countries enjoy in their respective supply chain partners but also the perceived higher cost of breaking up a trading relationship. Imports from supply chain partners upstream in the production process also tend to increase less or even fall in response to an exchange rate appreciation in the simulation country. This is especially the case in China, a downstream country in the production process.
Real exchange rate shifts of the magnitude considered would not result in a substantial reorganization of trading networks and production chains. The simulations suggest that the magnitude of the trade response to exchange rate shifts differs by sector but the overall structure of export and import baskets remains broadly unchanged in the countries under consideration. Although subsectors react asymmetrically to exchange rate shifts, these differential impacts are not large enough to alter sectoral export shares significantly. This finding is generally consistent with the notion that export structures are path-dependent and reflect the outcome of long cumulative processes of learning, agglomeration, institution building, and business culture. Moving from a low-technology structure to a high-technology structure typically involves a broad and integrated set of economic policies conducive to technological absorption and adaptation.
Exchange rate appreciation may lead not only to an increase in a country’s share of high-technology exports but also to quality upgrading. The simulation results have shown that an exchange rate appreciation may lead to an increase in the share of a country’s high-technology exports. Although not captured in our model, this effect is likely to be further strengthened, namely via intraproduct quality upgrading. Since high quality goods are less sensitive to price shocks, exporting firms are more likely to be able to withstand competitive pressures emanating from shifts in relative prices. In the case of China and other EMEs with potential to appreciate in the near future, this effect may lead to increasing convergence not only in the types of products exported but also in terms of quality levels from the currently very disparate values.
The growing importance of global supply chains further increases the international transmission of shocks, including policy-induced ones. Compared to Europe or North America, global supply chains in Asia are more integrated regionally and their export structure is more intertwined. This makes them more vulnerable to country- or product-specific disruptions. Any disruption of trade flows, particularly in intraregional trade flows in Asia, could jeopardize the positive development observed in the past two decades. Protecting the free flow of inputs as well as outputs should be a top priority. This could be done in terms of binding the region’s unilateral tariff cuts in the WTO by concluding Doha, but could also be done by including all the key players in regional FTAs such as the TPP. An exclusion of a key player such as China in regional FTAs could create bilateral tensions and potentially undermine the free flow of goods underpinning the Asian supply chain.
The resilience of supply chain relations may be tested by the recent earthquake in Japan, although substitution away from Japanese exporters may be difficult in the short term. A disruption in the supply of sophisticated intermediate manufacturing inputs by an upstream exporter such as Japan is unprecedented and provides for a real-life experiment on supply chain resilience. In the short term, substitution away from Japanese exporters may be difficult given their dominant market position in key sophisticated intermediate inputs and possibly patent-related constraints. Nonetheless, a prolonged disruption in supply and a rundown of inventories may force firms to replace Japanese exports from other sources. A rethinking of the “just-in-time” production model may result in a reorientation of production and sourcing networks in global supply chains.
To increase resilience to international price shocks, policy makers should create an environment enabling firms to undertake quality upgrading of products. The aggregate impact of an exchange rate shock on trade flows is shown to be large in the long run and domestic firms’ profits will begin to be compressed in the short run as they struggle to retain export market share. With sectors experiencing a symmetric relative price shock, the most promising strategy for policy makers may be enabling firms to respond to unfavorable exchange rate movements via quality upgrading. Apart from providing a reliable macroeconomic environment, policy makers should therefore aim to lower costs of doing business and those of establishing trade relationships.