How persistent supply chain disruptions could affect euro area potential output

Prepared by Julien Le Roux

Published as part of the ECB Economic Bulletin, Issue 1/2022.

This box investigates potential long-term effects that current supply shortages could have on euro area potential output growth. Although initially assumed to be short-lived and confined to a few products (e.g. microprocessors) or countries (e.g. those that are manufacturing intensive), the supply shortages have been building up over time. Depending on the persistence of global value chain disruptions, firms might consider finding new suppliers, transport routes, locations of production and more broadly new supply chains. If this happens, sectors that have greatly benefited from international exposure and globalisation in terms of productivity growth might experience a decline in trend total factor productivity. All else being equal, this could lead to a trend decline in potential output growth for the most affected countries.

Neither economic theory nor empirical evidence provide clear-cut conclusions on the long-term effects supply shortages may have on businesses restructuring their supply chain. On the one hand, companies would only be prepared to bear the high cost of setting up new global supply chains if they were to consider supply shortages to be sufficiently long-lasting as to justify the expenditure. So far, when looking at survey data, business leaders have not anticipated much long-term change in their supply chains. However, recent developments in value chains may force them to reconsider their views on this.^[1] On the other hand, a substantial change in the geography of supply chains may happen because persistent supply chain disruptions are inevitably very costly for firms. The challenges presented by this reorganisation process could be exacerbated if the pandemic encourages an increase in protectionism and de-globalisation. Reorganising company supply chains is ultimately a question of arbitrage between reshoring expenses and the cost of persistent supply disruptions – both of these can be very high and difficult for firms to anticipate.^[2]

As the euro area is tightly integrated into global value chains, current disruptions and possible supply reorganisations are highly important for euro area economies. Euro area countries remain extensively involved in cross-border production chains and their participation in global value chains is relatively high compared with most other economies, including those of China and the United States.^[3] Different degrees of participation and positions in the value chain imply heterogenous effects of the coronavirus (COVID-19) pandemic across euro area countries. Larger euro area economies tend to be more upstream in the global production chain than smaller euro area countries. In upstream economies, the impact of global value chains on total factor productivity and potential output depends on efficiency gains achieved by dividing tasks according to comparative advantage. Conversely, smaller euro area countries – notably some eastern European countries – are, for instance, generally more downstream and rely heavily on global value chains for technology adoption and total factor productivity growth. It is also worth noting that euro area global value chains are typically regional, which makes them somewhat less sensitive to extra-European shocks.^[4]

It is important to consider whether present shortages are likely to constitute a structural shift in global value chains. Participation rose sharply in the early 2000s before falling temporarily in 2009. It then returned to its pre-crisis level the following year. In recent years, global value chain participation has flattened out (Chart A). Since the start of the coronavirus pandemic, there has been some evidence of firms reorganising themselves and their value chains but, so far, this remains mainly anecdotal and is not yet broad-based.^[5] Notwithstanding this anecdotal evidence, the long-term effects of the pandemic on trade and value chains are still largely uncertain. It remains unclear whether or not the pandemic has ended the protracted period of stagnation in global value chain participation, leading to a further decline.^[6]

Chart A

Global value chain participation in the largest euro area countries

(percentage of gross exports)

The effect of supply chain disruptions on potential growth is likely to depend on the duration of these disruptions. Theoretically, if supply chain disruptions are temporary these may not affect euro area potential growth. Temporary product or labour shortages lead to a decrease in firms’ capacity utilisation, which will affect the cyclical component of total factor productivity.^[7] The trend in total factor productivity is only affected if shortages lead to producers changing their supply chains, although there is still some debate on whether the overall economic effect would be negative or positive. Production onshoring and reduction in supply chain length is likely to reduce potential growth, as globalised production processes presumably reflect a more efficient allocation of resources that benefits from comparative advantages across countries. Long-lasting supply chain disruptions may also force companies to revise or postpone their investment plans and therefore alter the evolution of their stock of capital. On the other hand, global firms may reconfigure and optimise their global value chains. Greater resilience that comes with shorter supply chains and local access to strategic goods, spurred by digitalisation, the adoption of e-commerce, videoconferencing and robots, may revive trade flows, structurally change their composition (more towards services) and ultimately have a positive impact on trend total factor productivity.^[8]

A back-of-the-envelope calculation, using historical elasticities between global value chain participation and total factor productivity growth, suggests that the impact of current supply shortages on potential output would be limited. If supply bottlenecks persist over time and are not temporary, as currently assumed in the December 2021 Broad Macroeconomic Projection Exercise (BMPE)^[9], euro area potential output could be adversely affected. The estimated effect of a possible reorganisation of global value chains on total factor productivity is based on a recent paper which highlighted the nexus between the development of global value chain participation and total factor productivity growth.^[10] It is assumed that a reorganisation of global value chains would have a negative impact mainly via total factor productivity. To highlight the effects of possible reshoring, we propose two illustrative adverse scenarios.

We analyse two scenarios based, on the one hand, on the expected decline in trade following the coronavirus crisis and, on the other hand, on the decline in trade observed during the great financial crisis. In the first scenario, we estimate the impact of the coronavirus crisis on euro area trade using the trade openness ratio.^[11] Although slightly different in concept, trade openness is an empirically valid and timely proxy for global value chain participation.^[12] We depart from the assumed recovery of trade openness over the projection horizon (as assumed in the December 2021 BMPE) in this scenario and instead assume that global value chain participation is permanently affected in proportion with the decrease in the trade openness observed in 2021 and compared with the level that was anticipated in the December 2019 BMPE (Chart B). This represents a -0.6% deviation in euro area trade openness, with a large heterogeneity across countries (Chart B). The second scenario works directly with global value chain participation and assumes a permanent decline in participation equivalent to half of the shock observed during the great financial crisis. In this case, this represents a 1.8 percentage point decline in euro area global value chain participation. The disparity of shocks across countries is smaller in the second scenario than in the first. This stems from a more homogeneous decline in trade across euro area countries during the great financial crisis.

Chart B

Trade openness in the euro area and in the largest euro area countries

Ratio of the December 2021 projection over the December 2019 projection

(index)

For both scenarios, the effect of declining global value chain participation on potential output would be of a limited magnitude. In the two scenarios, elasticities, as calculated in an ECB Working Paper in 2018^[13], are applied to establish the effect on total factor productivity. The effect of the shocks is assumed to be one-half permanent and thus passes for half in the trend. As a result, trend total factor productivity would suffer a loss in the euro area ranging between -0.1 and -0.3 percentage points. Potential output would suffer a similar setback. This represents a limited impact in a context where trend total factor productivity of the euro area is expected to grow over the period 2021-2023, in cumulated terms, by 2.1% according to the European Commission’s Autumn 2021 Economic Forecast. This estimate obscures some heterogeneity across countries (Table A). For some countries, a more negative impact on total factor productivity and on potential output may materialise if trade were to be lastingly affected by the pandemic.

Table A

Impact of a reversal of global value chain participation on the level of trend total factor productivity

(percentage points)