Lessons for COVID: How natural disasters reshape supply chains

COVID-19 has disrupted global value chains (GVCs). Some observers expect firms to respond by abandoning their pursuit of lower production costs in favour of building stronger resilience in production – by reshoring, nearshoring, and/or diversifying sources of production (e.g. Javorcik 2020, Kilic and Marin 2020, Lund et al. 2020, UNCTAD 2020). In contrast, others have argued that the same technological and institutional factors that have underpinned the international fragmentation of production in the past decades would make a retrenchment of GVCs post-COVID-19 unlikely, unless there is a radical change in the policy environment (Antràs 2021, Baldwin 2020).

The long-term impact of natural disasters on global value chains and their organisation is ultimately an empirical question. To understand how firms behave when faced with new risks, we examine in a recent paper how trade patterns adjusted in the longer term after the 2011 earthquake in Japan (Freund et al. 2021). Our results suggest reshoring, nearshoring, and diversification are unlikely, but production is likely to shift away from risky countries to which importers are highly exposed and towards low-cost producers and large countries.

Most of the existing literature on trade and natural disasters focuses on how GVCs transmit shocks in the short run, domestically (Carvalho et al. 2016) and internationally (Boehm et al. 2019). The literature on the Japan earthquake shows that the immediate effects were highly disruptive because there were few substitutes for Japanese suppliers. Boehm et al. (2019) find that Japanese multinationals in the US lost access to intermediate inputs and experienced severe reductions in production as a result. A shortage of over 100 parts left Toyota’s North American operations operating at 30% capacity for several weeks (Canis 2011).

We focus instead on the longer-term effects of the Japan shock on trade patterns, using data on two GVC-intensive industries – autos and electronics. The main result is that importing countries shifted away from Japanese suppliers of goods where they were especially dependent on these suppliers. Figure 1 shows the average shares of auto and electronics products imported from Japan by a group of importing countries which were large auto producers and electronics exporters. The left panel shows shares of imports from Japan for products where Japan was not a prominent supplier prior to the shock (i.e. accounted for less than 15% of total imports of that product by the country). The right panel focuses on imported products where there was greater dependence on Japanese suppliers (i.e. accounted for more than 15% of total imports in a product line). The figure shows that reliance on Japanese suppliers dropped sharply following the 2011 earthquake for the importer-product pairs most dependent on Japan. In both industries, the earthquake appeared to accelerate pre-existing declining trends, but the drop was precipitous - more than 10% - for the auto industry. These persistent declines show that large shocks do lead to a partial reconfiguration of supply chains: while less exposed importers return to near pre-crisis operations after the shock, it is the more dependent producers that tend to change production structures. The results complement those from Zhu et al. (2016), who use Japanese firm-level investment data from 2010-2013 to show that the earthquake increased manufacturing offshoring from Japan among firms in the prefectures most affected by the disaster.

Apart from the change in imports from Japan, we also investigate whether the 2011 earthquake led to a diversification of imports and to reshoring or nearshoring of production. We find, somewhat surprisingly, that importers more exposed to Japan before the 2011 earthquake did not increase import diversification in either auto or electronics. There is also no evidence that countries re-shored production. In fact, importers more exposed to Japan before the 2011 earthquake increased total imports to a greater extent than other importers, which is consistent with an intensification of offshoring rather than reshoring.

An important question relates to which countries picked up the slack as supply chains shifted out of Japan in the aftermath of the 2011 earthquake. We perform a difference-in-differences analysis, comparing shifts in trade patterns of high Japan-dependent products with other products, while controlling for importer and product specific time-varying shocks. We find that in the years following the shock, production relocation decisions were largely driven by economic fundamentals rather than policy. Developing countries, rather than top exporters, were the primary beneficiaries of relocation and production tended to relocate to larger countries, suggesting importers were seeking low-cost suppliers that could produce at scale. There is no evidence that supply chains were increasingly regionalised or that importers sought proximate suppliers, except in the case of final autos where transport costs are especially high.

For both auto and electronics, intermediate imports were significantly less affected by the shock than imports of final goods, consistent with work by Martin et al. (2021) on the persistence of intermediates trade. This finding suggests that GVC-links bind countries together in ways that are difficult to untangle following a crisis.

While the results of this research cannot be mechanically applied to the COVID-19 crisis, they provide some evidence on how firms react to import disruptions. First, firms do not necessarily reshore or nearshore to reduce risk. While more proximate production may offer easier managerial oversight, it does not necessarily protect against disruptions and could be prohibitively costly. Second, increased supplier diversification may not be feasible. While diversification could offer more protection against shocks in any one location, it also means sacrificing economies of scale in production and incurring the cost of finding and establishing relationships with many suppliers who can produce at a low cost and meet standards and customisation requirements. Third, GVCs may be harder to untangle than standard trade because intermediate inputs are less amenable to replacement by new suppliers than final goods, leading to more persistence in existing networks.

One important difference between the Japan shock and the COVID-19 crisis is that factories were destroyed in the former but not in the latter. The loss in production capacity may have accelerated and expanded the shift out of Japan since small differences in variable production costs would weigh more heavily on a firm’s decision to move to a new production location. In the current context, intact factories favour staying where you are: production costs in existing facilities are still relatively low compared to productions costs inclusive of the investment that would be required in a new facility. Pessimistic or uncertain output projections in some industries due to the pandemic could also reinforce the status quo by reducing the gains from moving to locations with lower variable costs of production. This structural inertia will further strengthen the persistence of trade patterns now compared to the response to the Japanese earthquake.

The big unknown is policy. Governments may not wait for firms to make decisions in response to COVID-19, because of geopolitical concerns as well as a perceived coordination failure – chasing efficiency over resilience may be optimal for one firm in a country but not for all firms if it leads to excessive national dependence on a single source. The result may be subsidies for reshoring, and tariff hikes to avoid becoming too dependent on any one country. Most notably, China has become the main hub of trade and GVCs for many products (Figure 2). Large policy shifts or even the threat of them could induce firms to seek other sources in products where national or global dependence is high. Many developing countries see this shift as an opportunity to enhance their participation in the world’s manufacturing production.

What products are most amenable to shifting to developing countries? Figure 3 shows China’s share in global exports for all HS 6-digit products and the income level of the typical exporter of the product (the so-called PRODY index). Products in the bottom right quadrant are products where China is the main exporter and production could shift relatively easily to other developing countries. The over 1000 products in this group contain both intermediates and final goods. In general, the top China share and low PRODY products tend to be simple manufactures and mostly final goods. Within autos and electronics, the products in this category are mainly inputs for radios and televisions. One important caveat is that governments are likely to target policy interventions on strategic industries, such as high-tech goods and health products. Given that many of the products where the world is most dependent on exports from China are simple manufactures-- things like umbrellas, Christmas tree lights, electric toasters, and artificial flowers --the scope for developing countries to benefit from reshaping resulting from policy intervention may be limited.

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