Are GVCs good for inclusive growth?

Christopher Findlay
Executive Dean of the Faculty of the Professions at the University of Adelaide
Vice-Chair of AUSPECC

There is strong evidence that businesses are doing things differently.  Production processes are being organized into a series of value adding steps in different locations, organized in what is being referred to as Global Value Chains. These chains offer new opportunities for developing economies to enter global markets, and provide options for adjustment to economies at later stages of developing undergoing structural change. They offer finer options for capturing the benefits of differences in competitiveness in production process and better growth prospects as a result.

Data from the ADB shows over the period 1995 to 2008 that, while the rate varies a lot, the participation in GVCs in nearly every Asian economy increased¹. An exception was Hong Kong, whose position remained stable, having already developed a sophisticated system of production and distribution.  Participation measures here refer to the extent to which imported inputs are used in local production and to which outputs are inputs into production elsewhere.  The phenomenon is relevant to goods production but also applies in services.

iGVCs offer many opportunities, as already noted.  But In the context of the current focus on inclusive growth, in APEC in particular under Philippines leadership, these developments also raise the question of whether GVCs are good for inclusion.   Three dimensions of inclusion are addressed here:

-     income of lower versus high skill labour at the worker level
-     income of SMEs vs large businesses at the firm level, and
-     at the economy level upgrading in general from low value (or income generating) added to high value added activity.

If GVCs are to promote inclusive growth new innovations in policy are needed.

With respect to lower versus high skilled labour, there is evidence that the share of value added in GVCs captured by high skilled labour has increased since the mid 1990s.²  This is the case in high income economies, but also in those at earlier stages of development.

The expectation might have been that GVCs would play a role to reallocate tasks in the production process around the world. High skilled tasks would remain in the economy with higher labour costs and others would move to lower labour cost locations, leading to different outcomes in the distribution of value added in to the two cases.  That high skilled labour appears to have captured more income challenges this expectation.

One explanation may be that the tasks being reallocated are relatively routine but require a reasonable level of skill to complete.  Those tasks however can be substituted for by capital embodying digital technology, eg greater automation on a production line. This has been happening in the course of the relocation of activities, it appears.  So the labour group that misses out are those with middle levels of skills.

The GVC phenomenon does not mean so much, in this view, for low skilled labour. Those workers find employment in tasks that involve more personal interaction, eg waiting in restaurants.  But they now compete with mid skilled labour released from other activities so their prospects are also challenged.

There are two responses to this issue. One is to raise the competency level of middle skilled workers, with well-defined programs for that purpose.  Another is to not forget the service sector – demands for its activities are increased by GVC development, and it is possible that employment increases there in transport, finance, etc, can offset the loss in the original areas of production. That appears to be the European experience.  But, and this is the first policy point, that requires a policy regime which is open to investment in services by both local and international firms. It also puts a much high emphasis on the importance on active labour market policies to facilitate that shift. As APEC reviews its agenda on structural reforms, making the connection between efficient factor markets, eg, labour and capital, and the GVC story is a priority.

Another issue is the participation in GVCs by SMEs.  GVC managers or leaders can be demanding customers in terms of delivery conditions and product quality.  Particular standards have to be met, in order to keep goods moving through the chain.  SMEs may find it relatively hard compared to large firms to invest in their workforce skills and production processes to meet these expectations. Again this points to a rich policy structural reform agenda to remove unnecessary barriers to SME upgrading and promote their engagement.

The question of upgrading is a related issue.  Economies generally enter GVCs at points of relatively low value added.   Their ambition is to capture more value over time, but they risk being stuck at their entry point.  

The options for upgrading including product and process upgrading within the same chain, but the evidence suggests lesser gains from these changes.  More attractive is to try to capture different functions within a chain or move to a new chain altogether.  What determines that trajectory?

In a joint paper for the G20, the OECD, the WTO and the World Bank³  identified a framework for the trajectory: including productive capacity (eg human capital), infrastructure quality, the business environment (eg access to finance, quality of regulation) and what they call industry maturity including intra-industry communication and capacity to coordinate activities.

Of main interest here is trade and investment policy, also listed in the paper for the G20. Relevant to successful entry and later upgrading in GVCs, and for SME participation, is an international economic policy which lowers the costs of operating the chains.  This must cover goods themselves but also the supporting service activities and investment by the chain managers as a bundle.  Also important is intellectual property policy (since GVC managers are handing over IP to participants) and trade facilitation, to speed up and the lower the cost of movement across borders.   Packaging matters.

This framework has a number of implications, for example

-    Complex coordination across domestic agencies is required to get the package right
-    The chapter structure of traditional trade agreements to shore up domestic commitments and facilitate GVCs may not be of much value – a cross cutting or sectoral approach may work better
-    The principles of traditional trade agreements may be of limited value, when they rest on closed membership since meeting the rules of origin to qualify for the benefits adds to business costs, the application of discrimination is difficult in dealing with NTMs, and the restricted membership does not facilitate natural evolution.  

Indeed, the ADB concluded recently that GVCs had grown despite overlapping FTAs in Asia, not because of them.

To conclude trade and investment policy matters for GVC development, but has to be applied in an integrated way, including in trade agreements. Doing so will raise business interest in trade agreements, and at the same time make it more likely that GVC development supports inclusive growth. This approach to trade policy is necessary but not sufficient for that outcome, and attention to other issues including training particular of mid skill workers will be important.   

In response to the key issue here, GVCs can be good for inclusive growth with the right policy settings.

This perspective raises challenges for the normal ways of doing things in regional economic cooperation. The value of traditional trade agreements is being challenged.  Responding to this challenge is especially relevant to the current focus on free trade in the Asia Pacific, and the design of institutional settings to support regional integration.  But while this perspective suggests a number of principles, there is no easy specification of the detail of the institutional design. That is a topic for further work, one to which PECC can make a significant contribution and especially now as APEC considers its own working program on the FTAAP. A traditional approach to its design would miss the mark for both GVCs and for inclusive growth.

¹ Fig 2.2.3 in http://www.adb.org/sites/default/files/publication/59685/ado2014update_1.pdf

² Fig 4 in https://www.aeaweb.org/articles.php?doi=10.1257/jep.28.2.99

³ http://www.oecd.org/tad/gvc_report_g20_july_2014.pdf