Trade distortion and protectionism
When does industrial policy reduce supply chain risk?
Published 01 October 2024
Attempts to achieve multiple aims through industrial policy while simultaneously reducing risk was always going to be a tricky move to pull off. If industrial policies complement open trade and capital flows and spillovers are managed cooperatively, they may be a source of global resilience. If policies limit competition and the spread of technology, they are likely to be a source of vulnerability.
A raft of policy announcements in developed and developing nations shows that industrial policy is back and is once again a major tool for achieving three widely held policy aims.
The United States’ Inflation Reduction Act (IRA) and CHIPS and Science Act, India’s Make in India policy, and Indonesia’s commodity export bans are prominent examples of major industrial instruments that seek to stimulate flagging domestic economies post-Covid, support the energy transition, and reorient global trade in response to geopolitical tensions.
There is also resurgent global interest in supply chain resilience led by the wake-up calls nations received during the Covid-19 pandemic. While regional cooperative responses—such as Pillar II of the Indo-Pacific Economic Framework on supply chains—are slowly forming, supply chain outcomes are also explicitly or implicitly part of many recent domestic industrial policy efforts.
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Subsidies to support onshoring or friendshoring—or restrictions on trade to boost local production—sit alongside and across the economic stimulus, green transition, and geopolitical reconfiguration policy trifecta. Governments employing domestic industrial policies to expand into new markets are banking on the support of others looking to diversify their supply options.
A challenge with using industrial policy for multiple purposes is that the stated aims can conflict with each other. The IRA, for example, sought to use conditions on tax credits to boost electric vehicle (EV) uptake while favoring vehicles and inputs from friendly nations. The conditions posed major problems for EV manufacturers even in allied jurisdictions like the European Union and South Korea. While loopholes were eventually added to the law, dulling its trade impacts, the tension between low-cost emissions reduction and geopolitical decoupling remains.
Even in the national security domain, industrial policies have trade-offs which affect resilience. Export controls may be used to keep sensitive technologies out of an adversary’s hands. But they come at a cost, penalizing firms that make cutting- edge technology and potentially encouraging the adversary to step up their own innovation efforts. In a less rules-based world, green technology is not the only area where subsidy races are intensifying.
That doesn’t mean industry policy has no place in building more resilient supply chains. These policies have both positive and negative international spillovers. On the plus side, with open trade and investment settings, they can spur technical change that crosses borders, lowering costs throughout the supply chain and enabling more firms to start producing.
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Wind power technology is one example. Denmark began producing wind turbines in the 1980s, supported by price guarantees and favorable tax treatment but not trade restrictions. The subsidies helped firms learn by doing and were probably worth their costs. This know-how spread through Danish direct investment in Spain and Germany. In 2002, reflecting first-mover advantage, 92% of exported wind turbines came from Denmark. 10 years later, Germany accounted for 38%, Denmark for 22%, and Spain for 13%.
Today, capital and know-how are flowing from China and the US into regional producers of green technology and its inputs. Examples include Australia’s nascent lithium refining industry or EV manufacturing in Thailand and Malaysia. Openness among these ‘third countries’ is essential to reap the benefits.
But it does not always follow that having more sources of supply in world markets leads to lower global risk. The negative international spillover effects from industrial policy are well known. A subsidy in one country can harm competing producers in another or crowd out competition in third markets, even if those competitors are more productive. Exporting without the support of a large government becomes harder. Supply chains can become less flexible and less competitive.
China’s entry into and eventual dominance of markets in steel, shipbuilding, and photovoltaic cells are key examples and a topic that followed President Xi Jinping on world visits including his May 2024 trip to Europe. Distinguishing overcapacity from genuine technical leadership and economies of scale—such as in EV manufacturing, which has also benefited from massive state support— can seem a matter of perspective.
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Amid geopolitical tensions and with a hamstrung multilateral trading system, countries’ responses to supply chain risk have often been attempts to divert trade from China. The central plank of Make in India is a China Plus One strategy, in which Indian manufacturers are positioned as supplementary to Chinese supply. Indonesia’s nickel export ban was partly justified as a response to Chinese domination of nickel processing.
These efforts may appear to address the policy trifecta while diversifying global supply. The question is whether they enhance or diminish the competitiveness of their respective markets. If policies to diversify end up precluding the emergence of new sources of supply, there will be a resilience cost. If support becomes entrenched and fails to foster competition, the result can be an expensive supply bottleneck. These are the risks of seeking to emulate China’s strategies.
A concentrated global market does not necessarily mean vulnerable supply chains. For commodities traded on international exchanges, new buyers and suppliers can be found quickly, even if a dominant player restricts trade. Even markets for natural resources—in which countries are constrained by what they have in the ground—can shift away from dominant states over time as global rare earths exports since 2010 show.
But in other cases, the traded product may be highly differentiated and specialized and finding an alternative will take longer. Or as diesel exhaust fluid shortages in 2021 demonstrated, a critical input can be hit by a perfect storm of shocks and intervention is needed to stave off shortage. In cases like this, open trade policies coupled with stockpiles can be an appropriate option, insuring against risk while retaining flexibility.
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The multilateral trading system has the potential to manage negative spillovers in a way that maximizes global outcomes, including on supply chain resilience. While the political will for comprehensive World Trade Organization subsidies reform is absent, governments should seize opportunities at the margins. Policymakers would be better positioned for action on this issue if they knew more about the size of spillovers, which would require broad disclosure of data on competition and on supply chains themselves.
Attempts to achieve multiple policy aims through industrial policy while simultaneously reducing risk was always going to be a tricky move to pull off. If industrial policies complement competitive markets, trade and capital flows remain open and spillovers are managed cooperatively, they may be a source of global resilience. If policies limit competition and the spread of technology, they are likely to be a source of vulnerability.
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Author
Jason Tabarias
Jason Tabarias is a senior executive with a focus on economic and industry policy, social policy, and responsible global business.
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Author
Samuel Hardwick
He is an economist and PhD candidate in the Arndt–Corden Department of Economics at the Australian National University (ANU). His research is on trade, investment, and geopolitical risk, and the ways that institutions shape international economic exchange.
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