Building Back Better: Creating Resilience in Critical Supply Chains While Supporting Global Development

In April, Governor Andrew Cuomo made a common complaint about the global search for personal protective equipment (PPE) for healthcare workers in New York: “We are all shopping China to try to get these materials and we're all competing against each other." A month later, the BBC warned of a global shortage of food, quoting the National Union of Farmers in Wales’s call for “safeguarding domestic food security” and suggesting that food supply chains “need a rethink.”

COVID-19 has helped to elevate the structure and performance of global supply chains, from a relatively niche status to a matter of public debate and intense political interest. This is underscored by the fact that a Presidential candidate has made a supply chain plan part of his campaign. Many countries have faced difficulties in securing essential goods at various stages of the pandemic, and this has made the development of resilient and reliable supply chains for goods with national security implications a central policymaking concern, likely to feature in the UK’s Integrated Review and the subject of congressional hearings in the US. Political leaders around the world have made calls for “national” supply chains with the intent to force companies to re-think their global production networks and bring them on shore.

Policy forged at pace and during extreme circumstances will often leave something wanting. We want more resilient supply chains, but we shouldn’t sacrifice the benefits that existing supply chains have created, nor should we needlessly penalize developing countries in the race for resilience. In addition to stockpiling and regulation we propose the deployment of development capital to build global excess capacity in the production of essential items as preferable routes to resilience.

How resilient? To what? And at what (efficiency) cost?

The concept of resilience is not new to supply chains. A core element of supply chain success has always been its ability to successfully confront unforeseen disruptions.  However, it’s difficult to assess resilience until stress is applied. COVID-19 has brought enormous stress to bear on supply chains of both essential (e.g. PPE) and non-essential (e.g. haircuts) goods and services; hence nurses without visors, and the epidemic of “lockdown hair.” It has also brought the spectre of even more costly shortages: of glass vials for vaccines or soap bark tree for medicine production. These three examples illustrate three kinds of desirable resilience:

• Resilience to production disruption: haircuts have been difficult to obtain because the model for the production of haircuts took a long time to respond and adapt to the requirements of the virus. More generally, as some countries went into lockdown, products they play a key role in making became more difficult to source. Key pharmaceutical ingredients produced in China and India is one example.
• Resilience to sudden demand spikes (production capacity): PPE is being produced in vast quantities. The problem is that the pace at which demand has increased has far outpaced the ability of existing suppliers and supply chains to make it.
• Resilience to sourcing scarce raw material: If and when a vaccine for COVID-19 is developed, we may be limited by the available quantity of natural resources—the bark of soap bark tree for example. Without alternatives, demand may outstrip the supply response, resulting in either price rises or rationing—both of which will likely lead to inequitable outcomes.

It is possible to take action to increase resilience on all three of these dimensions, at a cost. Firms could invest in excess manufacturing capacity; or in supply chain redundancy to try and diversify production sources in a way that is uncorrelated to risk; and they may invest in research and development to find alternatives to scarce sources. However, they have not done so sufficiently to date. Understanding why is necessary before we can develop a policy response.

Efficiency is king: the evolution of supply chains to date

If resilience is so clearly a good thing, why is it not a default feature of production arrangements? Some companies and products do individually plan for some aspects of resilience in their business model: Pepsico sources coconut water from multiple suppliers, and builds in excess capacity to protect against the risk of disruptive typhoons, common in some coconut growing regions. Consumer electronics firms such as Apple also routinely build such supply redundancy in their supplier networks. They do this because the return to reliability exceeds the efficiency cost of maintaining redundant supplier contracts.

These counter-examples suggest one reason why most firms don’t do this: most lack either the market power or a clientele with the willingness to pay for private investments in substantial supply chain resilience. As a result, their incentive is to pursue maximum efficiency in production in normal times even if this comes at the cost of resilience to end-times. The pursuit of efficiency naturally leads to concentration—not simply because of labour costs (there are many places in the world with cheap labour)—but because of talent, know-how, and capital, all of which are costly to establish and confer a cost-advantage to early movers, thereby making it difficult to establish competing clusters.

It may be the case that powerful consumers, with some level of monopsony power, can compel investments in resilience, and share the costs with the firm. This could be the case when governments centrally purchase PPE from a few providers (and it is a traditional argument for divvying up large contracts in the US defense industry). However, resilience is a public good across all consumers, and individual purchasers in a more competitive market are likely to be unwilling to pay more for resilient supply without a mechanism ensuring they will disproportionately reap the benefits of resilience. Again, resilience is a form of insurance, and individuals and institutions often under-invest in insurance without additional incentives.

A similar problem arises when it comes to finding alternatives to scarce resources/input materials for products with highly uncertain demand. Investing in research to create a product that may only be in demand in rare and unpredictable circumstances is not an attractive proposition, especially because any patent protections might well be ignored or weakened on the grounds of the emergency situation. As a result, there will be systematic underinvestment in such research.

What can governments do?

Building resilience, then, has many of the hallmarks of a classic public good/positive externality problem. Resilience is costly, and the benefits to building resilience are imperfectly captured by any single firm or investor. A number of approaches can be taken to resolve this issue, but all have costs. We argue, however, that some of the costs are better-borne than others.

Reshoring

Reshoring production has been a popular proposal to counter supply-chain breakdowns. The logic of the proposal is that ‘if a product is produced in my country, I can institute an export ban when necessary, and guarantee my supply—to the extent that an export ban doesn’t disincentivize production.’ We argue that this is a loser on three grounds:

• First, by reshoring, we lose all the benefits in terms of cost that firms have accrued by locating production in places with cheaper labour and better production networks. And while we’ll make production more expensive, we won’t make it shock-proof. The reason New York faced shortages was that demand spiked. Imagine if Gov. Cuomo had built a bunch of factories outside Albany to produce enough PPE for New York’s usual needs. It would have produced more expensive PPE in normal times because labour, factory space, and the like cost more in Albany than Albania; and the state still would have faced shortages, because its needs increased far above that usual level. And note that demand for the components needed to make PPE also spiked worldwide. So, unless New York State invested in production capacity far outstripping normal demand all the way back through the supply chain to raw materials, the state would still have faced PPE shortages, despite higher prices in non-crisis times.
• Second, by reshoring, we correlate the risks we face: if an outbreak of a disease in the US or UK increases demand for medical equipment that is produced in the same country, it is likely that production will be disrupted. Again, the Welsh National Union of Farmers may think COVID-19 is a good reason to reshore agricultural production, but COVID-19 suggested why this can increase our vulnerability: UK farming relies on migrant labor that has been kept out of the country during the crisis. And attempts to get UK citizens to replace those workers were an utter flop. Thank goodness for food imports. The diverse production and supply chains of globalized trade are part of a risk reduction strategy.
• Thirdly, reshoring works against development, by penalizing poorer countries’ economies, when better policies (from a developed country perspective) can protect or bolster them.

Accelerating the pace of automation via R&D is another approach that has been explored. This has often been connected to reshoring, but needn’t be. But automation addresses only one kind of risk: the risk to production processes that are dependent on population-dense production facilities (think garment workshops, meat-packing plants). It does nothing about shortages of key inputs, or (in itself) capacity to scale up production; and in the extreme, wherever the automated factory is located it may still find itself unable to move products to meet consumers depending on the transport and movement restrictions in place there.

Stockpiles

Perhaps the simplest response to concerns over shortages is to stockpile supplies. The US has a Strategic National Stockpile, sadly run down in advance of the COVIC-19 epidemic, which had stores of PPE amongst other medical supplies. Similarly, the country has a strategic petroleum reserve. Well managed, stockpiling can be a reasonably low-cost mechanism to build slack into tight supply chains and allow rapid response to surging demand or dips in supply, although costs and complexity increase with supplies that have a short usable lifetime. The purchasing power created by a stockpile mechanism would also give governments the influence to demand more resilient supply as part of purchase agreements. This may also be an area for international cooperation: the UN Humanitarian Response Depot stockpiles emergency relief items, so perhaps an expanded set of well-managed global and regional stockpiles could ensure a greater range of supplies.

Regulation and monitoring

An additional option is to place key supply chains under regulation and monitoring for resilience. Certain regulated products, given “essential” designation might carry the requirement that they were sourced from suppliers who maintain excess capacity, or source each input of production from multiple, geographically dispersed suppliers. Potentially, there could be coordinated global agreement on these regulations which could be monitored by an international body to assess and score the resilience of key products.

These proposals come with two major drawbacks. First, regulatory requirements to keep excess capacity and redundancy in the supply chain at the level of the individual firm will be anti-competitive. They will increase the fixed costs of production, and build into the market structure an incumbency advantage, with firms sitting on excess capacity that can be deployed to temporarily lower the price of products under threat of entry by new firms. This means that the cost of regulatory-induced resilience will be slightly higher prices most of the time.

The second drawback is the ability to genuinely measure resilience. While academic scholars have highlighted how such supply chain “stress tests” could be conducted, there is limited empirical evidence that they would work in practice. One striking feature of the current pandemic is how countries that scored exceptionally well on measures of pandemic preparedness do not appear to have performed better in terms of controlling COVID-19. This is a widespread problem with measures of regulatory quality: take for example the weakness of the World Bank’s Doing Business Survey in measuring actual, rather than stated, practices.

Concessional investment to build resilience

An additional approach to address both geographical and production risk would be to use development finance institutions (DFIs) such as the UK’s CDC, the International Finance Corporation, and the US Development Finance Corporation. As colleagues have argued, they could invest in production capacity for (inputs to) essential items in places where there is currently little such production to diversify and expand sourcing. Concessional investment and patient capital will be necessary: even with cheap labour, a great deal of investment will be necessary to build the requisite knowledge networks and infrastructure for adequate production, and it is highly likely that efficiency in producing required-standard products will be lower to begin with. Such investments could create jobs, building new production capacities and knowledge, and allow countries to enter new parts of the product space, with likely knock on benefits for economic development. These will be pioneer firms, of the type that DFIs are meant to support.

Finally, it is worth noting that the best way to limit shortages is to control crises before they escalate. Countries that rapidly put in place distancing, masking, testing and tracing have not seen ventilator shortages or medical PPE shortages—because their hospitals have not been overwhelmed. Blaming global value chains may be a useful political strategy to shift blame and attention, but it doesn’t fix the underlying problem—and will make future crises even worse.  Again, autarky is a worse-than-useless tool to reduce vulnerability to shocks. We should build in better resilience, however. That is likely to be difficult; and there will need to be multiple strategies pursued. But aid can both contribute to the strengthening of global supply chains and the development of poorer countries. It’s time to start.

The order of authors on this blog post was randomized by a list randomizer tool.