HOW IMPORTS IMPROVE PRODUCTIVITY AND COMPETITIVENESS

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1 HOW IMPORTS IMPROVE PRODUCTIVITY AND COMPETITIVENESS May 2010 How important is trade in intermediate goods and services? Why are firms outsourcing and offshoring? What is the role of regional trade flows? How are major emerging economies affected? What are the implications for trade policy? Further reading More information Overview Intermediate goods and services that is, products used as inputs to produce other products dominate trade flows, representing 56% of trade in goods and 73% of trade in services in OECD countries. Trade in intermediate goods and services are a direct consequence of the international fragmentation of production, the rise of vertical supply chains and related sourcing strategies of firms. Firms are outsourcing and offshoring in order to lower costs, acquire higher quality inputs, and generally improve their competitiveness. The implications are significant. Import barriers can deny firms access to the goods and services they need to compete internationally. Rather than protecting domestic jobs, trade restrictive policies can produce plant closures and job losses. On the other hand, more liberal trade policies allow firms to fully benefit from international production networks. Distance and security of supply are especially important considerations when externally sourcing the intermediate inputs upon which a production process depends, as delays would be costly. While global production networks offer the most widespread benefits, there can also be a regional dimension to firm sourcing strategies. Major emerging economies are well integrated into global production networks, with intermediates exceeding 70% of total goods imports. This provides benefits both to their own economies and to those with whom they trade. As the global economy begins to recover, but with employment growth lagging and high public debt levels in many countries, governments should have trade in intermediates in mind when formulating their trade policies. Imports can improve firm productivity and export competitiveness, and trade growth can contribute to global economic growth. More open markets offer widespread benefits, while protectionist trade policies impose high costs. This paper highlights the importance of intermediate goods and services in world trade. It is based on OECD Trade Policy Working Paper No. 93 Trade in Intermediate Goods and Services OECD 2010

2 How important is trade in intermediate goods and services? Trade statistics distinguish between three types of goods: intermediate goods, capital goods and consumption goods. An intermediate good is an input that is used to produce other goods or services and is used up in the production process. Capital goods are used in the production process but not used up, and a consumption good is the final product. For example, a digital camera is a consumption good, the electronic chip recording the picture is an intermediate good, and the machine tools required to produce the camera are capital goods. Intermediate inputs can also come in the form of services. For instance, the services offered by a consulting firm to an automobile company are intermediate inputs in the production of cars. OECD analysis shows that trade in intermediates dominates trade flows, representing 56% of trade in goods and 73% of trade in services in OECD countries. Overall growth in trade has been strong, so that while growth in trade in intermediate goods and services in recent years has totalled 80% and 50%, respectively, the share of intermediates in total trade has remained largely unchanged. Figure 1. Growth and importance of trade in intermediates for OECD countries Growth of trade in intermediates % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Share of intermediates in total trade Goods Services Goods Services Source: OECD Trade in Intermediate Goods and Services Database OECD

3 Why are firms outsourcing and offshoring? The terms outsourcing and offshoring often have negative connotations in the public mind, as they are associated with job losses. But the reality is quite different. When a firm sources intermediate inputs for its production process, it faces a choice along two dimensions: ownership and location of production (see Figure 2). Offshoring relates to the location of production and involves the firm moving the production of the intermediate input abroad. On the other hand, outsourcing indicates a change in the boundaries of the firm, where the firm assigns the production of the intermediate input to an independent supplier. Trade in intermediates will occur if the firm decides to offshore parts of the production process and to source the intermediates from a foreign country. Offshoring can take one of two forms: vertical foreign direct investment (FDI), where the intermediate is produced by a foreign affiliate of the firm, or offshoreoutsourcing, where the intermediate is produced by an independent foreign supplier. Vertical foreign direct investment will result in intra-firm trade between the parent and the affiliate, while offshore-outsourcing will lead to arm s length trade between the domestic firm and the foreign supplier. A firm may have always sourced an input from a foreign supplier, or may choose to do so in a changing context where it seeks to lower costs and improve its competitiveness. In either event trade in intermediates should not be seen as a loss of production to foreign countries but rather as an explicit decision by domestic firms to maintain or improve its productivity and its overall competitiveness. Failure to do so would mean job losses, not job savings. Figure 2. Sourcing strategies of firms: choices regarding ownership and location OECD

4 What is the role of regional trade flows? Figure 3. Intra- and inter-regional imports of intermediate goods (Billion USD, 2006) Note: The map reports imports of intermediate goods above 20 billion USD. Circles stand for intra-regional imports and arrows for inter-regional imports. Arrows and circles are proportional to the value of the flows. Worldwide vertical supply chains are built around trade in intermediates. Figure 3 illustrates this interdependence, and highlights the importance of regions and regional production networks in world intermediate trade. Europe, Asia and North America are the most important traders of intermediate goods. Overall trade in intermediate inputs is mostly between developed countries; flows with regions with developing economies are very small. The map also reveals some patterns of specialisation. Asia is a net exporter of intermediate goods to Europe and to North America while Europe is a net exporter to North America. The opposite pattern occurs for services, with Europe a net importer of intermediate services from North America. The largest inter-regional flow of intermediate goods is actually exports from the Middle East & North Africa to Asia. This relates to primary resources, such as oil or gas. Intra-regional trade is generally higher than inter-regional trade, indicating the importance of regional production networks. The highest value for trade within a region is observed for Europe, followed by Asia and North America. Intermediate imports are very sensitive to trade costs, which helps to explain why regional trade dominates trade in intermediates. First, firms engage in vertical FDI or offshore outsourcing to cut costs and improve their productivity. They can source inputs from different countries (and also domestically) so that an increase in these sourcing costs can quickly encourage firms to switch to another supplier. A second explanation is that production networks are subject to geographic and time constraints so distance can have a major impact on the decision to trade. When assembling complex goods or resorting to high skill services, remoteness is more a handicap than when supplying consumers, particularly if the work of firms and their suppliers is closely interlinked. Just in time' production and other 'lean' production processes are less able to accommodate hazards introduced by distance, such as a stop in the assembly line caused by a delay in the shipment of an input. A third explanation is that some intermediate inputs are of a bulky nature. This is the case for raw material inputs whose value is low compared to their weight. For these intermediate goods, the impact of distance is higher simply because transport costs are too high for these goods to be traded from a remote location. OECD

5 How are major emerging economies affected? What are the implications for trade policy? Brazil, China, India and Indonesia are major emerging economies, with whom OECD is building stronger co-operation, and are already significantly integrated into global production networks. Each of them has a share of intermediates in total imports of more than 70%, well above the OECD average of 56%. Emerging economies participate in various ways in global production networks, specialising either in the assembly of final goods or in the production of intermediates. Technological requirements, resource endowments, corporate strategies and demand factors related to customers tastes determine the pattern of specialisation. There is no one-size-fits-all strategy to become part of global production networks. Firms in emerging economies can also first specialise in the production of intermediate inputs because intermediates are less prone to home bias than final products. Once foreign firms producing intermediates are known and have more experience with the destination market, they can switch to the production of the final goods or services. For example, computer manufacturers in south-east Asia started by exporting parts and components to US and Japanese manufacturers and now have moved on to selling hardware to final consumers under their own brands. China s share of consumption goods in total exports was 31% in China still tends to be specialised in final assembly but is moving towards the middle of the production chain using imported intermediates for the production of other intermediates which are then exported (Uchida and Inomata, 2009). The importance of trade in intermediate goods and services relative to overall world trade, and the implications for policy, are not always well understood. Trade barriers are often justified as a means of reducing import competition and protecting jobs. But policies that restrict access to foreign sources of intermediate goods and services negatively affect the productivity and competitiveness of domestic firms. In the case of intermediates, in particular, trade restrictive policies are more likely to produce firm closures and job losses the very outcomes they were designed to prevent. Protectionist policies will also have a detrimental impact on a country s position in global production networks. Because tariffs on intermediates would increase the cost of production and reduce overall competitiveness, firms could be discouraged from investing, or even from maintaining investment, in a country. Tariffs on intermediate inputs that typically cross borders several times are cumulative; as such, they can add up to impose punitive costs on downstream users and eventually final consumers, and as a consequence stifle demand. Alternatively, an open trade policy would allow firms to fully benefit from international production networks. Trade in intermediates has an important regional dimension that warrants consideration. While regional trading arrangements generally offer much lower benefits than multilateral liberalisation, a regional approach can be complementary to, and over time support, more global market opening. Because trade in intermediates depends less on the size of the market and on the preferences of domestic consumers than trade in consumption goods, liberalising trade in intermediates may create new opportunities for emerging economies, and more generally for small economies, to become increasingly integrated into global production networks. Trade comprises both imports and exports; both are beneficial for individuals, firms, countries and global economic performance. OECD

6 Further reading De Backer, K. and N. Yamano (2007), The Measurement of Globalisation using International Input-Outpout Tables, OECD Science, Technology and Industry Working Papers, 2007/8, OECD Publishing. Measuring Globalisation: OECD Economic Globalisation Indicators 2010, forthcoming Miroudot, S., R. Lanz and A. Ragoussis (2009), Trade in Intermediate Goods and Services, OECD Trade Policy Working Papers, No. 93, OECD Publishing. doi: /5kmlcxtdlk8r-en. Miroudot, S. and A. Ragoussis (2009), Vertical Trade, Trade Costs and FDI, OECD Trade Policy Working Papers, No. 89. Uchida, Yoko and Satoshi Inomata (2009), "Vertical Specialization at the Time of Economic Crisis", in Inomata, S. and Y. Uchida (ed.), Asia beyond the Crisis: Visions from International Input-Output Analyses, IDE Spot Survey 31, IDE- JETRO. More information For more information on this subject, contact: Sébastien Miroudot: Rainer Lanz: Further details of OECD work on trade can be found on our website: Issued under the responsibility of the Secretary-General of the OECD. The opinions expressed and arguments employed herein do not necessarily reflect the official views of the OECD member countries. OECD