ECDPM who captures valueStructural economic change occurs ever faster today, and challenges for individual workers, firms, and political entities grow in tandem with it. The global value chain (GVC) paradigm opens many opportunities and challenges for firms and workers both in developed countries and the emerging world. Their competitive situation is changing far quicker than before. Four paradigm changes can be attributed to the emergence of GVCs:

The strategic focus shifts from countries to networks, GVCs, or firms, meaning that specialisation is intensifying and comparative advantages are more dynamic.

The unit of analysis moves from industries to tasks and functions, implying that the units of decision-making become smaller and more decentralised.

Factor endowments and stocks are less relevant economically compared to flows, reflecting the enormous increase in speed and the dynamic nature of production today — knowledge has to be written off faster and acquired continuously.

A change of relevant barriers and stimuli from the public to the private shows that trade policy moves from taxing goods and services at the border, to a broader set of ‘behind the border’ measures, encompassing private standards.

Parallel to these recent developments in world trade is the increase of trade in services with foreign direct investment (FDI) flows shifting from the secondary to the tertiary sector. Services multinational companies (MNCs) are also establishing services GVCs in their own right. Further, the operation of GVCs increasingly depends on the availability of supportive services, which have become a key component of value added.

These changes are particularly important from the perspective of developing and emerging economies, which want to enter into upgrade in GVCs. The challenges are sharpened by the fact that GVCs are not evenly distributed, and not all countries are equally well placed to leverage them.

New options for multinational companies

To understand the problems for developing countries, one should consider the matter from an MNC point of view, in which locational decisions are the dominant criterion. The primary issue is what motivates the investment: resource-seeking; efficiency-seeking; or market-seeking.

If the purpose is to extract natural resources from the host nation for export, the investor is not likely to consider horizontal investments in ancillary activities unless these are wholly lacking and the investment cannot proceed without them.

Efficiency-seeking investment consciously seeks to access low-cost, productive labour and take advantage of broader efficiencies in infrastructure and logistics. Some kinds of efficiency-seeking investments, such as in the clothing industry, are very low margin activities sensitive to marginal cost increases. Other kinds, such as logistics or transportation companies seeking to leverage their locations, can be more enduring and have wider, positive developmental impacts.

Market-seeking FDI is generally there for the long haul and is the most sustainable. Over time, MNCs investing for this purpose are likely to locate more of their tasks in the host nation and its broader region, through constructing regional value chains (RVCs).

With this in mind we now briefly consider three core issues in the broader debate.

Key issues for developing countries: entrapment in comparative advantage?

Since resources are furthest upstream in GVCs, it follows that simply extracting and exporting them does not generate much value for the host economy. Therefore, critics worry that developing country resource exporters risk becoming embroiled in ‘resource traps’, and advocate diversification from resource exports to higher value-adding activities, especially manufacturing. The primary objection to the GVC narrative, therefore, is that its liberalising impulse will simply entrap developing countries in resource-intensive comparative advantage. To encourage domestic value addition, various coercive instruments are advocated, ranging from export to investment restrictions. This ‘resource nationalist’ perspective is gaining currency around the world.

The notion of resource traps is contested. The evident success of modern resource exporters such as the US, Australia, Sweden, Chile and Botswana suggests there is more to the story than the resource trap literature implies. Central to this is what happens to the rents derived from resource extraction. If they are invested in economy-wide cross-cutting enablers that upgrade conditions for business as a whole, positive outcomes are foreseeable. Much depends on the governance capacities and arrangements in the host nation.

Iniquitous outcomes?

Another concern applies primarily to labour-intensive GVCs. The fact that much of the value and profits, associated with, for example, the clothing-textiles-retail value chain are captured by ‘lead’ MNC retailers reinforces perceptions that the gains are unevenly distributed, while the human cost can be high.

Many observers also worry about the footloose nature of this FDI, since it is driven by low costs. MNC investors soon relocate to the next favoured destination. The core concern, then, is that the erstwhile host would not have built sufficient domestic value addition capability to reorient its participation in that GVC, notably to upgrade or diversify into other productive activities. Further, while the wage structure would have improved, and people would have been employed in low-wage activities for a while, some worry that the country risks becoming caught in a middle-income trap, unable to make the transition to higher levels of development. In addition, the low-wage jobs would have moved on. The notion of a middle-income trap is contestable on the same intellectual grounds as resource or poverty traps. Nonetheless, most GVC proponents would recognise these concerns.

However, regarding the ethical environments characteristic of low-wage, assembly driven GVCs, proponents note that MNCs, especially from developed countries, operate under various codes of conduct promulgated at the national and multilateral levels. MNC home nations enforce these codes, and so do domestic pressure groups, principally through generating negative publicity leading sometimes to consumer boycotts, for example. Developing country MNCs, by contrast, often do not operate under the same ethical constraints.

As in the case of resource governance, the role of the MNC host state in regulating and enforcing domestic working conditions is crucial. For example, targeted investments into training facilities and trainers in the industry concerned can make a difference. If approached collaboratively, MNCs’ global networks could be leveraged towards this end. Further, in the process of incorporation into GVCs, even if at the lower end, some skills and technologies will be transferred. The more absorptive the domestic environment is, the more likely this will lead to upgrading; host states can enhance the absorptive environment.

Race to the bottom?

A third argument derives from the liberalising logic inherent in the GVC perspective. Essentially, the business of attracting MNC FDI into host nations is akin to a beauty contest in which the contestants try to outdo each other to be noticed, and favoured, by the MNC ‘judges’. The logic of providing generous incentives is particularly prevalent in the manufacturing sector, but also applies in certain services GVCs, notably finance and the attraction of headquarters FDI. This could have substantial implications for host nations’ overall fiscal position as governments become increasingly generous in a competitive ‘race to the bottom’ of the fiscal pool. Such an outcome would have deleterious consequences for necessary developmental expenditures.

This argument is essentially one for adopting sensible incentives packages. Further, international investment promotion experience suggests that while incentives play a role in FDI location decisions, they are probably not decisive. Strategic factors, notably comparative advantages; competitive advantages; and the overall orientation of the host state towards FDI are more important. And of course MNCs are not likely to go where they are not wanted, meaning competition to attract them could conceivably lead to a ‘race to the top’, through business environment reforms in particular.

Policy implications

Thus developing countries face a strategic choice over their stance towards MNCs and GVCs. The core policy prescription advocated by critics is formulating conscious industrial strategies underpinned by ‘deliberative targeting’, in which the state consults actively with business in an iterative, bottom up process of identifying key blockages to domestic industrial development. This approach is gaining ground in Africa.

In this light, infrastructure is a decisive bottleneck to development in many developing countries. Further, the workforce has to be fit for the requirements of GVCs, which implies a solid knowledge and skill base (stocks) and — more important — the ability to adjust to new challenges (flows). Therefore, education plays a decisive role. Crucially, where skills are not available domestically, foreigners can be harnessed to fill the gap, and, in the process, train locals.

Additionally, business environment reforms are essential to improving economy-wide competitiveness, benefitting both local firms and MNCs. These are key horizontal elements of industrial strategy. But for many developing countries ‘just’ these horizontal elements require strong state capacities. Targeted interventions for particular firms or sectors also require strong state capacities but arguably deliver substantially lower benefits, and may also impose substantial costs.

Ultimately, the success of all policies depends on institutional qualities of the state, and on the market power the country has relative to MNCs that have other choices. Moreover, rather than coercive policy approaches, we prefer that governments should minimise political barriers to trade. This includes tariffs, subsidies, and other non-tariff barriers. This would enable MNCs targeted for inward FDI to establish their tasks in the host nation as efficiently as possible, thus maximising sustainability and linkage potential.

Therefore, governments, especially in developing countries, should consider the importance of the institutional quality and governance structure in their country. Corruption, poorly defined property rights, weak rule of law and the like, render all measures directed at investment conditionalities, human capital formation, infrastructure investments, and trade facilitation ineffective.

This article is part of the European Centre for Development Policy Management (ECDPM) GREAT Insights Magazine’s Sustainable value chains edition.

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