Trade in intermediary goods and industrial development

The merits of export-led development, based on the production of higher value-added goods, are now largely uncontested. East Asia’s economic ‘tigers’ – South Korea, Taiwan, Singapore and, to some extent, Malaysia – were themselves based on an economic development model that promoted an export-oriented manufacturing sector. Their successes have prompted many observers, as well as the International Monetary Fund, to recognize the positive impact that manufactured exports can have on a country’s income.

The idea being promoted is that by moving away from the production of basic primary goods, such as textiles and food products, towards more complex and higher value-added activities like car parts or batteries, developing countries can both secure higher returns and encourage technological upgrading. Although the idea itself is fairly simple, its concept relies on an understanding of international trade that does not reflect how trade actually presently functions: in today’s world both the inputs and outputs of production necessary for this higher value-added activity transact between buyers and sellers on a global scale and at levels that are much more specialized than before. This has led many to express that ‘tasks’ – or the finer levels of processes needed to produce a good – are being traded as opposed to complete goods, and that our classic interpretation of trade may not be up to par.

While many argue that this shift in trade from complete goods to intermediary inputs stands to benefit developing countries by providing them with a comparative advantage in areas in which they did not have one before, the complexity of today’s trade should caution restraint. The risk for developing countries lies in following too eagerly policy recommendations that may be ill-suited to promote the kind of development that benefited the likes of Singapore, South Korea and Taiwan through high value-added export-based industrialization. Little real economic benefits will accrue to developing countries if the new trading structure allows them to integrate into the global economy without giving them the means to retain its windfalls.¹

From conglomerates to global value chains

International trade has changed. Whereas firms previously undertook all the production functions necessary to produce a good, they have now become global agents who delegate various production processes to other highly specialized firms. This has resulted in the ‘slicing of the value chain’, as the Nobel prize-winning economist Paul Krugman put it. In other words, in an attempt to reduce their costs, modern firms have refined their own comparative advantage. International trade is no longer about trading complete goods amongst countries, as was the case during David Ricardo’s time, but about producing and sourcing highly specialized parts.

In today’s context, firms typically opt to entrust some of their least profitable production steps to smaller specialized units abroad in low-wage countries and to retain within their direct sphere of control those operations that are deemed most profitable to them (typically marketing as well as research and development). As a result, firms now tend to produce more intermediary and complete goods from highly processed inputs from abroad.

This spatial and organizational separation between headquarters and production centres however requires some form of structure. The global value chain (GVC) has emerged as the most cost-effective way for firms to coordinate production in today’s technologically advanced and integrated world to match buyers and sellers. In such a setting, firms rely on a ‘web of independent yet interconnected enterprises’ as Gary Gereffi calls them, to profit from differences in costs and prices across a wide array of firms and regions.

The chain of command that directs production hence no longer runs a vertical line stemming from the headquarters to subsidiaries/contractors. The automobile industry exemplifies this shift. Whereas automobile manufacturers used to rely on solid long-term links with their subsidiaries to source some of their inputs, these firms’ sourcing operations have now truly gone global and rely on the global value chain to effectively ‘bid’ on parts suppliers that offer them the best quality/price ratio. Developing countries should thus find ways of accessing and selling inputs in this global value chain.

This shift in the organizational structure of firms as well as the advent of global value chains has been brought about partly thanks to globalization. Globalization has reduced transaction costs amongst firms and has encouraged the geographical dispersion of production centres: a practice described in the literature as ‘vertical specialization’ or ‘intra-product specialization’. This trend has received much attention from trade theorists who appear divided on the applicability of classical trade theories to such specialized levels of international trade.

While some dismiss outright that this shift from trade in complete goods to highly specialized trade today represents a change from our understanding of the dynamics of why nations or firms trade, others are not so sure. As numerous academics have argued, most notably Richard Baldwin, Gene Grossman and Esteban Rossi-Hansberg, the old view of how trade operates is insufficient to deal with modern global production process in which tasks rather than goods are being traded. They suggest that a new framework is necessary – although they fail to offer any replacement – to understand its dynamics as classical theories cannot account for such levels of specialized trade amongst firms.²

How proponents claim this will help developing countries industrialize

Regardless of their position on the issue however, both classical economists and the proponents of a new approach, however defined, agree that this specialization of trade provides opportunities for developing countries. In their view, this ‘slicing of the value chain’, which allows for some parts the manufacturing process to be done by small, specialized firms, will give developing countries a comparative advantage. The relative simplicity of the range of tasks to be done, combined with the mechanized standardization of production, limits the scope of expertise required. Hence, a developing country’s advantage – understood to be its lower production costs due to cheaper labour – is now enough. After all, it need only worry about producing a specific part while the rest of the value-addition process is handed over to developed countries with the required technology and expertise.

Through this, it is believed that developing countries can attract industries specialized enough to manage economies of scale, and produce intermediary products that are of use to a number of developed country buyers. As with many East-Asian manufacturers, the goods produced – be they batteries or electric motors – are designed to be as standardized as possible to allow them to be used as inputs for a number of buyers for a number of different end uses.

Because of this, the proponents claim, it is believed that industrialization could occur naturally since developed country firms would transfer some of their technology to establish a production base in a developing country. While the idea is appealing, it relies on a number of assumptions which stand to severely limit developing countries’ chance to establish an export-manufacturing base.³

The myth of industrial upgrading

These misleading assumptions come from trade theories’ continued neglect to study the firm and how it interacts with the market: read, the real world. While true that some newer modes of thinking within the field of trade theories claim to include the firm, their models still consider the firm as a ‘black box’. A more in-depth look at how firms truly operate at the global level would reveal interesting nuances that would reveal trade theorists’ misguided claims that this shift from producing complete goods to manufacturing parts of a complete good, can benefit developing countries.

In proposing that today’s trade environment is beneficial for developing countries its supporters assume an efficient global market. While global value chains may appear to operate in an open market setting, many studies have revealed that this is not the case and that a hierarchal system of governance has in fact established itself within it. The scenario that has emerged is one where a small number of global buyers exercise significant clout within the GVC.

Globalization has assisted in the creation of a network where fewer buyers are able to access rich-world markets. This creates a condition of dependency on the part of developing country firms towards their buyers as, on their own they would not be able to access these markets. As Hubert Schmitz and Peter Knorringa lament, this means that ‘an increasing number of developing countries engage in contract manufacturing for a decreasing number of global buyers’. This is far from the classical trade theories assumption of perfect markets, in which buyers and sellers are anonymous and simply use the market as a place of exchange.

The existence of power structures within today’s trade structure limits the possibilities for two of trade theories’ claims about the benefits of trade specialization for developing countries: economies of scope and technological upgrading. The power structure present in the GVC binds developing country firms to contractual obligations with their buyer which in turn limits their opportunities for economies of scope by producing for multiple buyers.

Similarly, this form of ‘locked-in contract’ with buyers impairs the flow of technology. Developed country firms, worried about proprietary advantages and production methods, will not transfer technology if there are risks that their supplier might profit from this edge and then supply other buyers. This has already happened in China, where Danone, a French food-products giant, recently stopped investing in higher-technology at its Chinese-based subsidiary over fears that its Chinese partners would steal its proprietary technology. Although such transmission of technology is possible, this occurs more often in lower value-added manufacturing activities that use older technologies, and not in the production of high value-added goods that command higher prices.⁴

Implications for developing countries

But participation in global value chains, even at its lowest point of entry in the form of low value-added manufacturing, is necessary for developing countries to participate in the global economy as export-based manufacturers. The paradox presented by today’s trade in highly specialized goods is that while it may confer some opportunities for these countries to integrate into world markets, it does not create the proper environment to allow for the formation high value-added export based manufacturing. That is to say, trade theorists’ refusal to investigate the reality in which firms operate allows them simply to adjust their basic premise, which states that developing countries should squarely focus on their low-cost comparative advantage, to today’s reality – trade in ‘tasks’ as opposed to trade in complete goods. They claim that this premise holds even though the rise of globally integrated production processes has manifestly challenged our understanding of trade flows.

The danger for developing countries is that misunderstanding today’s trade environment may prompt some to enact policy prescriptions that would simply allow their countries to become ‘branch-plant’ economies, in which only low-value and low-return activities take place. In such a situation, very little profit would remain within the state to fund its development programmes. This is not to suggest that developing countries do not stand a chance in this trading environment dominated by global value chains, but rather to serve as a reminder that developing countries should not fall prey, again, to the siren’s call of theorists who claim that they should focus on their present ‘comparative advantage’. Rather, developing countries should ‘work’ on their comparative advantage by investing in education and research – efforts parallel to many existing development programmes – and by entering into partnerships that would allow both the transfer of technology, and the ownership on profits, to materialize. It is worth remembering that the East Asian economies did not develop their export-based manufacturing sector by listening to the policy prescriptions of those who recommended that they simply follow their ‘comparative’ advantage in assembling low-value goods thanks to their natural endowment of cheap labour. Interestingly, however, this is precisely the approach that is now being suggested by trade theorists.

The views expressed in the article are those of the author.

Footnotes