Asia's fast track development

The advent of global supply chains has provided Asian and other emerging economies with a fast track for development, as explains Professor Richard Baldwin.

International trade has always been a motor for economic development. But trade only became an important economic phenomenon with the "first unbundling" which started from the 1830s and accelerated in the 1870s. Until then, each village produced most of what it consumed -- production and consumption were "bundled" together geographically in each village. Transport costs were so high that most trade even between different villages was not profitable.

The steam revolution, especially railroads and steamships, made it profitable to spatially separate ("unbundling") production and consumption. Factories developed in cities. Workers flocked to cities from the countryside. Great efficiencies were generated as factories specialized and exploited comparative advantages. They also reaped economies of scale (bigger production runs means lower unit costs) and economies of agglomeration (firms clustering together with input suppliers and customers).

These cost effiencies of the first unbundling led to a boom in trade both within and between countries. It was now profitable for one town to sell its products to people in other towns and even to other countries.

This first unbundling drove industrialization and economic takeoff in the West, and the divergence between the West and developing countries, as the latter were left behind. But while lower transport costs drove the first unbundling, it resulted in coordination costs. To facilitate production coordination, all stages of the production process needed to be in close proximity, and usually under the one factory roof.

The strong development of US, Western Europe and Japan took place at the time of the first unbundling. At the time, development also required building a strong industrial base before becoming competitive, and usually involved some protectionist policies to nurture infant industries.

Then the information and communications technology revolution came along from the 1980s and reduced the costs of coordination. It made it possible to coordinate complex industrial processes at long distances. And the vast wage differences between advanced and developing countries made geographical separation (or "unbundling") of production stages profitable. Thus "headquarter economies" like Japan (or the US or Germany) outsourced labor-intensive stages of manufacturing to other economies like South East Asia or China ("factory economies"), thereby creating global supply chains.

A good example of the second unbundling is Apple's i-Phone. Its branding, design and marketing are undertaken in the US. Most of its high-tech components are produced in Germany, Japan and Korea. And finally, the lower value added assembly stage is conducted in China.

Following the second unbundling, 21st century trade involves several intertwined elements: trade in goods, especially parts and components; international investment in production facilities, training, technology, and long-term business relationships; infrastructure services to coordinate the dispersed production, especially services such as telecoms, Internet, express parcel delivery, air cargo, trade-related finance, customs clearance services, etc; and cross border flows of know-how such as formal intellectual property, and more tacit forms such as managerial and marketing know-how.

In addition to the unbundling of factories, offices have also been unbundled, as labor-intensive, electronically deliverable services have been outsourced. India and the Philippines have become leaders in "business process offshoring", especially as call centres.

The advent of global supply chains has thus opened a new fast track for development. All you need to do is to join global supply chains.

But joining these supply chains requires liberalizing trade and investment barriers, and implementing business-friendly policies. In this context, regional trade agreements which cover not only trade, but investment, competition policy and intellectual property rights (like the Transpacific Partnership currently being negotiated), can play a very important role in the development of global supply chains. The WTO's long-running Doha trade talks deal essentially with first unbundling issues.

While global supply chains have opened up a fast track for development, very few countries outside of Asia have implemented the necessary policies to take advantage of global supply chains. And even within Asia, there are some countries like India, Indonesia and the Phillippines which have many bureaucratic and regulatory barriers to doing business, and are riddled with corruption.

Japan is a curious case because it has been a leader in creating supply chains through its foreign investment Asia. At the same time, it is very closed to foreign investment within the country, and is probably missing out on opportunities for participating in supply chains created by other dynamic economies.

The offshoring of production stages has led to big changes in each stage's share of a product's value added. The manufacturing and assembly stage now accounts for a lower share than before of total value added, as many emerging economies compete to attract this activity. The initial stage of product concept, design and R&D, and the final stage of sales, marketing and after sales service now both account for higher shares of a product's total value added.

This is known as the "smile curve". Imagine a line that connects the relative sizes of the different production stages, starting with the initial stage, continuing with the manufacturing and assembly stage, and finishing with final stage. Over time, as emerging economies have competed with each other for the manufacturing and assembly stage, its relative share has declined, resulting in a bigger and bigger smile.

This highlights the fact that while emerging economies are now participating in global supply chains, their contribution to the overall value added is often minor. Again, the iPhone is a very good example where the Chinese-based assembly process only contributes 3 1/2 per cent of the total value added of the iPhone.

In this context, the challenge for emerging economies, which have entered global supply chains at the bottom, is to move up the value chain to higher value added activities. This is necessary because, as development proceeds and incomes rise, low-cost/labor-intensive production stages will be relocated to other lower-income countries (like Vietnam and Bangladesh today) -- the familiar flying geese pattern of development.

This means climbing up left and right sides of the smile curve such as by being involved in product concept, design and R&D and/or sales, marketing and after sales service. Participating in global supply chains provides a very important "learning-by-doing experience", with important knowledge and technology transfers. But climbing the value chain also requires big investments in human capital, technology and innovation.

Some countries are doing better than others in this regard. But without substantial progress, emerging economies which have entered the bottom of the global supply chain, risk getting stuck in the "middle income trap".