Why is global trade slowing down? Structural explanations based on elasticity of trade
A change in the composition of global trade towards products that have a lower elasticity. Another is that the slowdown simply reflects the end of the integration processes of China and central/eastern Europe – i.e. the high trade growth was largely a transitional phenomenon. A third is that it reflects the limits having been reached on the ability of (incentives for) firms to engage in the international fragmentation of production that is part and parcel of Global Value Chains
What’s at stake: This week’s data renewed concerns about developments in global trade as it showed for the last 6 months the biggest contraction in global trade since the end of the financial crisis. While cyclical factors may be at play, trade specialists have also advanced a host of structural explanations to explain the decline in the trade elasticity, ranging from a shift in the composition of trade to limits in the fragmentation of world production.
Motivation and stylized facts about trade elasticity
Bernard Hoekman writes that we should care about the growth performance of the trade/GDP ratio because trade is a channel for knowledge transfer (technology flows) and for specialization according to comparative advantage, thereby improving resource allocation and supporting higher economic growth and welfare (real incomes) over time. Another reason to care about whether trade grows faster than output is that net exports are a key channel for crisis-hit economies. If global trade is anemic, it becomes more difficult for these countries to address deficits and reduce debt.
Gavyn Davies writes that the expansion of world trade seems to have entirely lost its mojo. One of the most reliable rules of thumb in the post-war global economy has been that world trade volume tends to grow at about double the pace of global GDP. For example, from 1990-2008, global real GDP expanded at an annual rate of 3.2 per cent, while world trade volume grew at 6.0 per cent.Douglas Irwin writes that under normal conditions – that is, excluding wars and depressions – trade growth exceeds production growth. But the margin by which trade grows faster than production is not consistent. Bernard Hoekman writes recent history has, indeed, seen unprecedented high growth rates of global trade relative to global income.
Paul Krugman writes that ever-growing trade relative to GDP isn’t a natural law; it’s just something that happened to result from the policies and technologies of the past few generations. We should be neither amazed nor disturbed if it stops happening. It’s entirely reasonable to believe that the big factors driving globalization were one-time changes that are receding in the rear-view mirror, so that we should expect the share of trade in GDP to plateau — and that this doesn’t represent any kind of problem. In fact, it’s conceivable that things like rising fuel costs and automation (which makes labour costs less central) will lead to some “reshoring” of manufacturing to advanced countries, and a corresponding decline in the trade share.
Bernard Hoekman writes that there are different potential explanations of a ‘structural’ nature (that is, nonmacroeconomic) that can result in a decline in the income elasticity of trade. One is that it reflects a change in the composition of global trade towards products that have a lower elasticity. Another is that the slowdown simply reflects the end of the integration processes of China and central/eastern Europe – i.e. the high trade growth was largely a transitional phenomenon. A third is that it reflects the limits having been reached on the ability of (incentives for) firms to engage in the international fragmentation of production that is part and parcel of Global Value Chains. A fourth potential explanation is a rise in government support for domestic industries, reducing the incentives for firms and households to buy goods and services from foreign suppliers.
Cristina Constantinescu, Aaditya Mattoo, and Michele Ruta write that the information and communication technology shock of the 1990s led to a rapid expansion of global supply chains, with an increasing number of parts and components being imported, especially by emerging economies for processing and re-export. The resulting increases in back-and-forth trade in components led to measured trade racing ahead of national income. The transition to a world where production is increasingly internationally fragmented in the long 1990s is compatible with the higher long-run trade elasticity for that period. Conversely, the decline in the long-term responsiveness of trade with respect to income in the 2000s may well be a symptom that the technology shock of the 1990s has been absorbed and that the process of international production fragmentation has slowed down.
Mathieu Crozet, Charlotte Emlinger, and Sébastien Jean write that while the underlying determinants of the inflexion in the development of Global Value Chains remain to be identified, a few elements of interpretation can be put forward. First, financial stress may have increased the uncertainty associated with foreign trade relationships, for example through more difficult access to trade finance or through decreased confidence in the financial health of trading partners. Second, the Crisis period, as well as specific events such as the Japanese earthquake and the Thai flooding in 2011, may have led a number of firms to reconsider the cost of finely splitting their value chains across countries. In addition, it is likely that the development of GVCs has been facing declining returns, as the low-hanging fruit had already been picked before the Crisis.
Cristina Constantinescu, Aaditya Mattoo, and Michele Ruta write that the change in the world long-run trade elasticity is driven by a few countries that have a large share in world trade and/or are growing faster relative to the rest of the world. China and the United States turn out to be particularly important as they account for 13 and 20 percent, respectively, of the change in the world trade elasticity in the long 1990s, and for 32 and 8 percent, respectively, in the 2000s. In both cases, the elasticity of imports to their own GDP is significantly lower in the 2000s compared to the long 1990s.
Arnold Kling writes that as incomes rise in China and India, the “Samuelson effect” starts to kick in. That is, the comparative advantage of cross-border trade is reduced. More production is done in China when American wages are 10 times Chinese wages than when they are only 4 times Chinese wages (using made-up numbers here). Also, as the cost of robots comes down, they displace workers in all countries, and this also reduces the comparative advantage of cross-border trade.
Uri Dadush writes that the slowdown in investment could easily have accounted for more than half of the slowdown of world trade relative to GDP. Firms across the advanced countries have delayed replacing machinery, while nervous consumers have delayed buying houses, furniture, and washing machines. The production of these investment goods requires a lot of back and forth of raw materials, parts, and components across nations, as they are often at the core of so-called Global Value Chains. The import content of investment goods, for example, is estimated to be twice that of consumer goods, so that the slowdown in investment had a large disproportionate effect on trade. If this interpretation of the trade slowdown is correct, then trade growth is likely to resume to something much nearer to its customary rapid pace once the world economy returns to its trend growth path.
This article is published in collaboration with Bruegel. Publication does not imply endorsement of views by the World Economic Forum.