Global value chains: Primer

An export-oriented development strategy in Sri Lanka would mean that the country integrates itself into global value chains, instead of relying on its primary resource exports

By Reihshan Deen

Sri Lanka’s current rice shortage woes bring to a fore its import reliance and perhaps broader reflections on its trade and development strategy. There has been a growing understanding and increasing calls for Sri Lanka to have an export-oriented economy and export-led development strategy, at the very least as a sustainable way to gain the foreign exchange with which to purchase our imports. Of course Sri Lanka has always had exports; but what is meant by proponents of export-led development is to advance from Sri Lanka’s traditional reliance on the price-volatile, low value-added, mostly primary goods, but less volatile, higher value-added manufactured goods. 

At independence, Sri Lanka’s main exports were tea, rubber and coconuts, and after 77 years only apparel and textiles have substantially been added to the export mix, thanks to the garment industry. What is wanted, either implicitly or explicitly, is for Sri Lankan industries to integrate into global supply chains and to move up the value-chain. Though these terms may be bandied out, the layman may have, at best, a vague understanding of them. It is worth explaining and providing some insights into them to avoid misuse or misinterpretation and enable higher discourse. 

Although in the history of economic thought, the value of something has been much debated and theories of value abound, for our purposes, the economic value of a good or service is its market price. Value-added refers to the improvement in value of a good or service beyond the cost of its inputs – the difference in value of a good or service and the cost of materials and supplies used in its production. To illustrate this, consider a loaf of bread. Its inputs include, wheat, yeast, water, energy for heat, and the relative labour needed to produce said loaf. The value of that loaf should exceed or at least match cost of the materials needed to create it, otherwise producing said loaf would be a lossmaking venture. The excess in value of the loaf over its ingredients is its value-added, however slight it might be. 

Multiple stages of production

In the above loaf of bread example, there was one stage of production. There can be multiple stages of production, as outputs are used as inputs to create more complex products. For example, coal and iron ore is used in the production of steel, and that steel is used in the production of cars. These multiple stages can be seen as a chain of production, and as there are multiple inputs to complex products like a car, there can be multiple chains of production leading to the final product. There is value-added in each stage of production, with the steel having more value than the iron ore and coal, and the car having (substantially) more value than the steel. 

For some products, such as phones and computers, the production chain begins at conception and design and ends in the distribution and final consumption of product. These sequences of value-added activities that firms and workers perform in a chain of production from conception to final use are referred to as a value chain. The actual physical movement of goods along the value chain is referred to as a supply chain. 

In today’s world, a value chain can involve steps, processes and actors from many different countries – such is referred to as a global value chain. The iPhone, for example, is conceived and designed in the United States, is assembled in China (in Taiwanese owned factories) from components made in Japan, South Korea and the US, and from there shipped to its final consumers, including in the US. Such internationalised value chains are the results of technological change over the past two hundred or so years: the industrial revolution and subsequent innovations allowed easier and cheaper transportation of goods, and the information and communications technology revolution allowed for easier and cheaper communication of ideas and know-how. 

Production has been increasingly ‘unbundled’ as different production stages are placed in different countries and inputs sourced from multiple others. This has led to the trade in goods being increasingly not comprised of finished goods to be used in final consumption, but in intermediate goods, that is, goods used in the production of other goods. Indeed, this provides an interesting dilemma for tariff enthusiastic policy-makers; the US, through tariffs, may reduce its sourcing and direct trade of inputs (its ‘face-value’ trade) from China, and switch to sourcing inputs from Mexico, but Mexico itself sources the inputs to those inputs from China, therefore the indirect trade (or ‘look-through’ trade) of inputs from China would increase. A country integrating into a global value-chain means that firms and/or workers of that country are involved in one of the processes or stages of that value chain. 

Which stage of a value-chain?

Which stage of a value-chain should one wish to be at? Ideally, at the stage where there is the most value-added. In some industries, the value-added increases with each stage of production – as in more-or-less the loaf of bread example above. In industries such as the smartphone, computer, and other electronics industries, the value-added takes a different form. It is actually the conception and design at the beginning of production (the R&D stage) and the final sale and distribution (the marketing and distribution stage) that creates the most value-added, with the middling manufacturing and assembly stage creating the least. 

The value-added plotted against the stages of production in order therefore resembles a smile, and is described as a ‘smile curve.’ In the iPhone example above, firms in China are involved in the middling low value-added assembly stage, with Apple in the US involved in the high value added R&D and branding and final sale stage. A general pattern forms where advanced economies are involved in the higher value-added stages, and emerging economies are involved in the lower value-added stages. 

There are examples of countries such as China that begin integrating themselves in global value chains through the lower value-added stages and move up to the higher value-added stages, through processes of catch-up and spillover. Firms that are initially involved in assembling products in such countries make large investments and possibly short-term loss-making ventures to move into the higher value-added stages in order to catch-up; and firms in advanced economies involved in higher value-added stages, in order to increase efficiency and profit, outsource more stages to lower-cost emerging economies, providing investment and transfer knowledge and technology. 

Indeed foreign direct investment has also been shown to have caused direct or indirect spillovers such as improving the quality of local supplier firms and transferring know-how and increasing the skills of the workforce. In the example of China, firms such as Huawei were initially involved in assembly of other firm’s smartphones, before creating their own brand and smartphone and subsequently capturing that higher value-added stage. 

Lessons for Sri Lanka 

An export-oriented development strategy in Sri Lanka would mean that the country integrates itself into global value chains, instead of relying on its primary resource exports. It would mean that firms in Sri Lanka begin by involving itself in the lower value-added stages of production, like assembly of electronic goods, and gradually move up toward higher value-added stages. This requires foresight and creating favourable environments for FDI and with trade partners. Such involvement in global value chains would greatly aid in Sri Lanka’s development.

(The writer is an economics graduate with an MSc Economics from KU Leuven, and MA (Hons) Economics from the University of Edinburgh.)