Question

If you are asked to estimate the impact of the Trump tariffs on imports from China using the gravity equation. What would be the left-hand-side variable? And what would you include on the right-hand-side variable? Give your predictions on the sign of the coefficient for each variable included on the righthand-side. (positive? negative? or zero?)

Answer 1

Answer :

In the context of the trade conflict between the United States and China, global value chains (GVCs) are a potential factor amplifying the impact of higher tariffs on economic activity. Raising tariffs in a globalised world with international supply chains can have significant negative repercussions on economic activity. In general, global sourcing by firms implies that higher tariffs, usually imposed to protect a domestic industry, can lead to higher input costs for domestic producers. In addition, the effects of higher tariffs may be magnified by GVCs, especially in the case of multistage production processes, where goods move in a sequential manner from upstream to downstream with value added at each stage. Against this background, this box provides some evidence of the adverse effects of tariffs on economic activity in the context of global sourcing and GVCs.

GVC-related trade, defined here as those traded items that cross at least two international borders, expanded over the decade preceding the financial crisis (as a share of total trade), plateaued thereafter and declined during the most recent years with available data (see Chart A). GVC-related trade can be decomposed into the so-called backward and forward linkages. Forward linkages trade refers to a country’s value-added exports that are not absorbed in the final demand of that country’s direct trade partners, but (usually after some processing) are further exported to third markets. Backward linkages trade, on the other hand, comprises the foreign content used to produce a country’s exports. Industries further upstream in the supply chain (e.g. mining, product development) typically have a larger share of forward linkages, while more downstream sectors, such as many manufacturing industries, tend to rely more on backward linkages. Such considerations are of relevance in the context of the magnification effects of higher tariffs due to GVCs, since these depend, among other things, on the share of foreign value added in exports.

Intermediate goods trade can magnify the impact of tariffs on the economy, even more so if there is international multistage production. International trade models which include sectoral linkages and intermediate goods trade suggest higher welfare gains from trade liberalisation than models which do not include these features. This is related to the fact that – when allowing for global sourcing – reductions in trade frictions not only lower the price of final goods but also the input costs faced by firms. Accounting – in addition to this – for a global multistage production structure, where production stages are organised sequentially across borders, may magnify the effects of tariffs. First, as goods cross borders multiple times in international multistage production processes, they may be taxed each time a border is crossed. Second, tariffs are commonly levied on a good’s total (gross) import value, instead of the value added in the most recent production stage. As a result, the smaller the value added in the last production process (relative to its gross value), the larger the effective tariff rate applied to this production stage.

Empirical analysis suggests that tariff hikes can, over the medium term, significantly dampen the economic activity of industries which rely on foreign inputs. Global sourcing activities of firms mean that tariffs meant to protect specific sectors of the economy may at the same time hurt domestic producers in other industries by raising their input costs. Moreover, international multistage production implies that input costs are not only affected by a country’s own tariff schedule, but also by the tariffs applied to production stages further upstream. For example, a tariff imposed by the United States on Chinese exports may hurt Mexican firms downstream if they use US inputs with Chinese content. Consequently, the impact of tariffs on economic activity depends on a country-industry’s position in the supply chain. Chart B presents impulse responses of real industrial production to an increase by one standard deviation of a variable measuring “upstream tariffs” for country-industries with low and high backward linkages, respectively. While an increase in “upstream tariffs” does not significantly affect the real activity of industries with low backward linkages, significant negative effects are found for industries downstream in the value chain (i.e. with high backward linkages), which seems intuitive since their production process relies on foreign inputs. For such industries, a one standard deviation rise in upstream tariffs is associated with a decrease in industrial production by one percentage point after three years. This effect becomes statistically insignificant after six years.

Notes: Impulse responses refer to a tariff shock of one standard deviation. Country-industries with high (low) backward linkages are country-industries at the 80th (20th) percentile of the distribution of the variable. Backward linkages measure the foreign content in a country-industry’s exports and are computed using the approach of Borin and Mancini (2019)

The magnification effects of tariffs due to international multistage production mean that trade flows associated with downstream sectors are especially sensitive to tariffs, which is consistent with estimation results obtained from a gravity model. Since the value of output accumulates along the value chain, ad valorem trade costs (like tariffs) are higher in absolute terms for downstream producers. Moreover, international multistage production implies that the cost savings derived from relocation apply only to the value added of the particular production stage being relocated, while ad valorem trade costs are levied on the stage’s full value of output. Both aspects suggest that downstream sectors can be expected to be especially sensitive to tariffs, which would be consistent with tariff magnification effects due to multistage production. This can be tested empirically by employing an empirical gravity framework with tariffs, where bilateral industry-level exports are regressed on time-varying bilateral industry-level tariff rates and a battery of fixed effects to control for other trade cost components. The tariff coefficient is here allowed to vary with the degree of foreign content in bilateral exports in order to investigate whether a larger foreign content share (i.e. more backward) is associated with higher trade cost sensitivity. Empirical results indeed suggest that the sensitivity of trade to tariffs increases sharply with the foreign content in bilateral trade flows (see Chart C). While sectors with low backward linkages have a tariff elasticity of close to -0.8, it amounts to around -1.4 for sectors with a medium degree of foreign content, and it jumps to -2.1 for trade flows with high backward linkages. These findings are therefore consistent with significant magnification effects of tariffs in the presence of sequentially organised international supply chains.

Notes: Low, medium-low, medium-high and high backward linkages refer to the four quartiles of the distribution of the backward linkages variable. Backward linkages measure the foreign content in a country-industry’s exports and are computed using the approach of Borin and Mancini (2019). The dependent variable refers to bilateral industry-level exports, which are regressed on bilateral industry-specific tariff rates, controlling for other factors affecting exports with appropriate fixed effects.

In the light of the above, GVCs are often thought to play a role in the current trade conflict between the United States and China by amplifying the effects of tariff hikes. On the one hand, previous results suggest that tariffs that raise input costs can significantly dampen the output of sectors whose production processes rely on foreign intermediate goods. Since the tariffs imposed by the United States against China targeted a large number of intermediate goods, this channel may indeed be of relevance in the current trade dispute. On the other hand, the importance of magnification effects due to global multistage production are less clear and depend on the predominance of GVC-related trade in bilateral trade relations. OECD data for 2015 suggest that, overall, around 25% of the trade between the United States and China takes place in the context of GVC linkages (non-blue bars in Charts D). For both countries, this is below the total share of GVC-related trade in total exports as well as the (weighted) average share of GVC-related trade in global trade (Chart A), which in turn may be explained by the large distance between the two countries. Moreover, for US exports to China, forward linkages (yellow bars in Chart D) are relatively more relevant indicating that US exports to China are rather upstream in the value chain. By contrast, for Chinese exports to the United States, the share of backward linkages is larger (green and orange bars in Chart D), thus rendering these trade flows potentially more sensitive to the tariff hikes’ magnification effects linked to the multistage organisation of production discussed earlier.

Notes: The blue bars comprise both intermediate and final goods. GVCfw and GVCbw refer to forward and backward linkages. Exports include goods and services.

Sources: OECD inter-country input-output (ICIO) tables and ECB calculations based on Borin and Mancini (2019).