The most recent phase of globalisation was characterised by the geographical fragmentation of the production processes within networks of firms. Vertical integration helped international firms to improve their efficiency, while enabling them to react more rapidly to changes in international markets. However, this strong interconnection has created new channels for the propagation of adverse external shocks.
The disruptive potential of a failure in the international supply chain became larger with time; trade in manufactures represented a quarter of the world industrial output in 2000, this proportion doubled after only five years. Almost 30% of this trade is related to the exchange of intermediate inputs and goods for processing among firms. Indeed, the large drop in trade registered since the end of 2008 is attributed to the leverage effect induced by the geographical fragmentation of production (Tanaka 2009, Yi 2009).
The role of supply chains in amplifying the impact of the business cycle on trade is not only caused by a mechanical "multiplier effect", when firms adapt production plans to the anticipated demand. In times of recession, it has also a potentially disruptive microeconomic supply-side effect that amplifies the traditional demand-driven impact. A local disruption in the supply chain reverberates through the international network – since the intermediate goods traded are not commodities, but are specific to the client's need, it is not easy to shift to another supplier. In the automobile industry, for example, it takes six months to a year to change suppliers depending on how complicated the part is to produce. At best, the client-firms will suffer an increase in costs of production when shifting to alternative suppliers; at worst, some production lines will have to stop.
The transmission of financial shocks
To model the transmission of financial shocks through the supply chain, we build on two concepts initially introduced by the Physiocrats – supply-use matrices and monetary circuits – to simulate the interactions between “real” and “monetary” processes in an open economy (Escaith and Gonguet 2009).
The first building block of our model is using international supply-use tables to describe forward linkages of (representative) firms with a Ghosh matrix (analogous to a Leontief matrix). This tracks the transmission of supply shocks brought about by increases in costs of production.
The second building block of the model is the creation and destruction of endogenous money through the monetary circuit. A canonical version starts with a firm requesting credit from a bank in order to start a production process. The bank’s decision to grant the loan rests on (i) the macroeconomic perception of the systemic risk attached to the business cycle, (ii) a sectoral evaluation of the market prospects, and (iii) a microeconomic component in its evaluation of the firm’s capacity to manage properly the project and reimburse its debt.
Our version of the circuit introduces a fourth component, based on existing regulations governing the banking sector, such as Basel II.1 A bank’s decision to extend credit depends also on (iv) the status of its capital adequacy ratio, reflecting its previous loan activity (a stock variable) in relation to capital requirements set by the prudential or regulatory authorities. The repayment of outstanding loans not only “destroys money” as in a traditional monetary circuit, but it also allows banks to extend new credit within the limit of the prudential loans/assets ratio.
Table 1. A simplified representation of the real and monetary circuits
The record of debts and its ratio to the bank’s assets is a key feature of our model. It sits at a strategic crossroads between (i) flows and stocks, (ii) real and monetary stocks, and (iii) micro and macro effects:
- At the macro level, because risks and the market value of assets are strongly (negatively) related, the business cycle has a pro-cyclical effect on the banks’ propensity to extend new loans. When a downward phase turns into a recession, as in the present crisis, the price of assets may drop below a critical value, forcing banks to stop any new credit activity, cancelling existing credit arrangements to reduce risk exposure irrespective of the merit of investment projects and firms credit worthiness. This situation defines a "credit crunch".
- At the micro level, real and financial shocks combine into amplified effects. For the most vulnerable sectors, those that are both cyclical and vertically integrated (e.g., transport equipment), the conjunction of two waves of real shocks, supply- and demand-driven, resonates through the monetary circuit; it affects both flows variables (additional demand for credit money to cope with the shock) and stock variables (the credit rating of individual firms requesting additional loans and the capital adequacy ratio of the banks extending loans).
Thus, in a recession, the conjunction of real supply and demand shocks, on the one hand, and stock-flow financial shocks, on the other hand, may have large systemic effects. As the initial monetary shock reverberates through the production chains and affects final demand, more and more firms will face difficulties completing their production plans or selling their output. These disruptions occurring in the real economy feed back into the monetary circuit.
The disruption of the production chain and the build-up of undesired stocks impede the expected destruction of money and determine the accumulation of outstanding loans as well as a further downgrading of the exposed firms. Since the downgrading of an indebted individual firm affects the capital adequacy ratio of its lender, both flows and stocks are affected in the monetary circuit and all firms see their access to credit potentially restricted, even when there is no liquidity constraint in the monetary market. Cross-border loans, considered as more risky, are particularly vulnerable, especially when they involve developing countries.
If banks were originally operating at the limit of their institutional capacity (capital adequacy ratio) and if assets are priced to market, a resonance effect amplifies the back-and-forth transmission between real and monetary circuits, leading to strongly non-linear results. The chaotic behaviour of the international financial system at the end of 2008, and its dire consequences on the real economy and trade finance observed in 2009 are examples of such resonance and amplification. In that light, the present crisis should provide an opportunity to address problems of macro-prudential pro-cyclicality to minimise the risks of boom and bust cycles initiating from the financial sector.
Transmitting shocks in the Asia Pacific
We apply our model to the US and emerging Asia, a series of interlinked economies that are all key international and regional traders at different stages of industrial development. Supply shocks initiate from the manufactures sectors and are transmitted as described by the international input-output matrix. Based on the existing inter and intra-industrial linkages in 2000 and 2006, Japan is potentially the largest exporter of supply shocks. Malaysia and Thailand, on the other hand, are the largest importers of such shocks, because of the high degree of integration of their manufacturing sectors and their reliance on imported inputs from trading partners.
Between 2000 and 2006, China showed a notable increase in both forward international linkages and domestic backward linkages. As an exporter of "shocks" (i.e., a supplier of intermediate goods to the other economies), it matched Japan for greatest influence in 2006. But its vulnerability to an imported shock remained relatively stable, because Chinese manufacturers are increasingly relying on domestic suppliers for their industrial inputs.
For Japan and the US, the induced increase in production prices due to a failure of their Asian suppliers averages 2%. Because this impact falls disproportionately on a few firms, it may create serious microeconomic disruptions that turn into negative systemic effects, because those vertically integrated firms are also the most dynamic.
References
Escaith, Hubert and Fabien Gonguet (2009) "International Trade and Real Transmission Channels of Financial Shocks in Globalized Production Networks", Staff Working Paper ERSD-2009-06, WTO.
Tanaka Kiyoyasu (2009), Trade collapse and international supply chains: Evidence from Japan, VoxEU.org, 7 May.
Yi, Kei-Mu (2009). “The collapse of global trade: The role of vertical specialisation,” in Baldwin and Evenett (eds), The collapse of global trade, murky protectionism, and the crisis: Recommendations for the G20, a VoxEU publication.
1 Banks determine the required capital of lending by applying the risk weight that corresponds to the borrower's rating and then by multiplying the risk weight by the minimum requirement of capital. Because risks and the market value of assets are strongly (and negatively) correlated, the position in the business cycle has a strong pro-cyclical effect on the banks’ propensity to extend new loans.
