How to boost manufacturing in Latin America

Production processes have grown increasingly fragmented worldwide. Building entire supply chains in a country’s territory is costly and time consuming. While this was the route taken by many of today’s industrialised countries, several emerging markets are now joining international production networks to speed up their industrialisation process (Baldwin, 2012). Besides providing chances to diversify production and trade, participation in international supply chains is also associated with rapid learning, technology transfers, and knowledge spillovers (Fujita, 2011; Humphrey and Schmitz, 2000). Despite these potential benefits, few countries in Latin America and the Caribbean (LAC) are taking advantage of these new trends in the international organisation of production. This column summarizes the findings of a new report produced by the Inter-American Development Bank to identify policies that would allow countries in LAC improve their insertion in regional and global production networks. Access to the full report can be found in the following link: www.synchronized-factories.com

Low participation in global value chains

Alternative proxies of value chain participation support the general notion that Latin America’s participation in global value chains (GVCs) tends to be small. For instance, Figure 1 shows how intra-industry trade boomed in the Asia-Pacific region in the period 1985–2010 while increasing relatively slowly in LAC, particularly in manufactures.

Figure 1. Intra-industry trade indexes, regional averages

Source: Authors’ calculations based on data from Comtrade.

Following the methodology in Koopman et al. (2014), Figure 2 shows a proxy of GVC participation based on trade in value added. The combined measure of participation through upstream linkages (foreign value added in exports) and downstream linkages (value added used in the exports of third countries) indicates that LAC in general participates less than the EU and Asia in GVCs.

Figure 2. Foreign value added (blue) and domestic value added used in third countries’ exports (green), Average 2003–07

Source: Authors’ calculations based on data from GTAP 7 and 8.

In Figure 3 we employ the Dun & Bradstreet’s Worldbase dataset and we follow Alfaro and Charlton (2009) in identifying whether the relationship between a parent company and its subsidiary is horizontal (the parent and the subsidiary produce the same good), vertical (the subsidiary produces an input for the parent), or complex (the relationship is both horizontal and vertical). The figure shows the network of parents and their vertically linked subsidiaries around the world, a proxy of participation in GVCs led by multinationals. With the exception of Mexico, the participation of the region in this type of networks is clearly marginal.

Figure 3. Vertically linked foreign subsidiaries and their parents

Source: Authors’ calculations based on data from Dun & Bradstreet.
Note: The size of the circles in each country indicates the total number of parent companies located in that country that own vertically linked subsidiaries in other countries. The thickness and colour intensity of the lines represent the number of bilateral vertical subsidiaries between each parent country and a corresponding host country.

Finally, Figure 4 shows that participation through the exports of services that are intrinsically related to global supply chains, like “business, professional and technical services”, are lower than what should be expected from the region’s level of development. Therefore, it is relevant to ask, what factors are limiting countries in LAC to participate more in GVCs?

Figure 4. Exports of selected offshoring services and income

Source: Authors’ calculations based on the UN’s Service Trade Database.

Factors limiting participation in global value chains

One factor is related to the shortcomings in transport and logistics infrastructure. Figure 5 shows the potential increase in the number of vertically linked foreign subsidiaries if a country in LAC improves the quality of its logistics infrastructure to the average level in the EU-27. The results show that closing any of the gaps in port, airport and information and communication technology infrastructure generates noticeable surges in this proxy of GVC participation.

Figure 5. Simulated change in the number of vertical affiliates from improving logistics infrastructure to the EU-27 average

Note: The values for Haiti are represented on the right axis.
Source: Authors’ calculations.

A second area is related to the trade costs of crossing borders and in general to the topic of integration. Gains from tariff reductions are magnified when goods cross borders many times, as is often the case in international production networks. Also, to successfully target GVCs – particularly in developed countries – many potential suppliers in LAC will need to import high-quality inputs from other countries to complement their own production. In this way, high levels of protection at home will damage their ability to complement their own skills with the skills and capacities of suppliers in other countries.

Beyond the general area of trade costs, the emergence of global value chains has also brought to the forefront issues that policymakers had often overlooked previously. One of them is the issue of contracting institutions. Ambiguous practices and uncertainty in contract enforcement can generate distrust between parties of different countries, limiting their willingness to engage in cross-border transactions. Contractual frictions can be particularly harmful for transactions in global supply chains, where suppliers must often customise their production to the specifications of particular buyers, and where the parameters governing such specifications are typically set up in contractual agreements. The evidence shows that global firms can be reluctant to form partnerships with local suppliers located in countries where there is uncertainty and ambiguity in contracting practices.

Table 1 presents a battery of indicators that proxy the quality of contracting institutions for countries in LAC as well as in other regions. The table clearly indicates that LAC has a generally subpar record, compared with other regions. The consistency of these comparisons suggests that the region must improve its institutions charged with regulating and enforcing contractual agreements.

Table 1. Governance variables, simple average of countries in sample

Notes: The table shows the simple average of the countries in the sample. The variables are: (1) the number of procedures for enforcing a contract; (2) the time (in days) for enforcing a contract; (3) the cost (as a percentage of the claim) of enforcing a contract from the Doing Business dataset, data for year 2012; (4) an index of legal formalism measuring the number of formal legal procedures necessary to resolve a simple case of collecting on an unpaid check, from Djankov et al. (2003); (5) an index of legal structure and security of property rights, from the Fraser Institute, data for year 2012; (6) an index of property rights from the Heritage Foundation, data for year 2012; (7) an index of protection of intellectual property rights, from the Property Rights Alliance, data for year 2012; (8) an index of rule of law, from Kaufmann, Kraay, and Mastruzzi, 2006.
a: Higher value corresponds to worse governance outcome.
b: Higher value corresponds to better governance outcome.

Access to global supply chains is also seriously hampered by information deficiencies. The lack of adequate information can be particularly problematic for exporting inputs in international production networks. The information flows typically required to match a buyer and a supplier in an international supply chain can be vast. Many suppliers need to customise their production to the requirements of particular buyers, while buyers need to convey this information to the suppliers and make sure they are capable of delivering the product with the correct specifications. As a result, lack of information can easily keep potential suppliers on the sidelines, with buyers relying on a few known providers.

Governments can reduce the information gaps by promoting environments that facilitate exchanges of information between players in the industry or across industries. Programs could consist of some form of coaching, whereby a group of potential exporters meets with firms that have achieved success in the international markets. Alternatively, the government could help organise exchanges where the information gap is filled by current or retired staff from international buyers. Some information gaps can also be addressed by improving visibility through certifications. It is well known that global firms screen potential suppliers for compliance with relevant standards in their respective supply chains. The public sector could assist in promoting the establishment of local certification agencies.

Firms in LAC that cannot join global supply chains on their own would benefit from policies that promote collaboration or consolidation among themselves. The evidence indicates that firms seldom join international production networks on their own. Instead, these firms often leverage resources with other firms to achieve certain capabilities, address common barriers, or pay for the fixed costs of activities, such as attending an international trade fair. One area for potential public action, then, is to help create or improve the effectiveness of the mechanisms whereby firms can cooperate, such as business associations. Governments can also promote the consolidation of interested firms supporting programs for mergers and acquisitions.

Finally, since the accession to international production networks might be hampered by multiple shortcomings and market failures, it would be desirable to exploit synergies through a coordinated approach. One option is to create a body within the government, charged with coordinating the efforts of various agencies. In some countries these bodies have arisen to foster competitiveness. The design and architecture of such a body could remain flexible, incorporating relevant agencies as needed; it would be unreasonable to expect governments to be able to identify all possible market failures affecting GVC insertion in all the sectors of the economy. A more realistic approach would be to forge a clear channel of communication with the private sector for airing concerns and presenting proposals to agencies operating within such a government body.

References

Alfaro, L., and A. Charlton (2009), “Intra-Industry Foreign Direct Investment.” The American Economic Review 99, 5: 2096–2119.

Baldwin, R (2012), “Global Supply Chains: Why They Emerged, Why They Matter, and Where They are Going”, CEPR Discussion Paper Series 9103.

Fujita, M (2011), “Value Chain Dynamics and Local Supplier’s Capability Building: An Analysis of the Vietnamese Motorcycle Industry.” In M. Kawakami and T. Sturgeon (eds.), The Dynamics of Local Learning in Global Value Chains: Experiences from East Asia. Palgrave Macmillan, IDE-Jetro

Humphrey, J and H Schmitz (2000), “Governance and Upgrading: Linking Industrial Cluster and Global Value Chain Research.” IDS Working Paper No. 120, Institute of Development Studies, University of Sussex, Brighton.

Koopman, Robert, Zhi Wang, and Shang-Ji Wei (2014), “Tracing Value-Added and Double Counting in Gross Exports.” The American Economic Review, 104(2), 459-494

Published in collaboration with VoxEU

Author: Juan Blyde is a Senior Trade Economist at the Inter-American Development Bank.

Image: Employees work on the assembly line at the Renault plant in Sao Jose dos Pinhais August 2, 2012. REUTERS/Rodolfo Buhrer.