- Germany, uniquely among export-driven economies, has become more open over the past few decades and its supply chains have become longer and deeper--and therefore more vulnerable.
- Our analysis of Germany's supply chain has found that the country is about three times more exposed to a risk of deglobalization arising from China than Russia.
- We also determined that supply risks to Russia and China are different. Those regarding Russia are mostly related to backward linkages in low tech, that is, dependency to the country's oil and gas. Supply chain risks to China are mostly forward linkages--that is, German components integrated in Chinese productions--concentrated in high-tech and medium high-tech sectors.
- While Germany could diversify trading partners to reduce vulnerabilities in backward and forward supply trade linkages, innovation, and R&D - therefore investment - could help reduce unbalanced backward linkages, which often rely on hard-to-substitute commodities in the domestic production process.
Germany, the economic powerhouse in Europe, obtains much of its economic strength from trade--and the length and depth of its supply chains. Going global has been a deliberate process for the German economy. It took place, particularly through its industrial complex, in two phases triggered by two major political developments of the last 30 years: the disintegration of the Soviet bloc in the 1990s and the reintegration of China into the world economy in the 2000s. The expansion of German industry to the eastern part of Europe and to China was driven by economics, to benefit from lower labor costs and faster-growing end markets than in Western Europe.
Today, Germany ranks No. 2 in terms of trade balance, just behind China, but is unique in two respects:
First, the economy has steadily become more open over the past three decades while others have reversed course. The sum of exports and imports of goods and services now account for almost 90% of GDP, twice as much as 30 years ago. This trend contrasts with that of its peers, such as China, where trade openness has declined over the past decade. In the U.S., the exploitation of oil and shale gas has reduced international dependencies. The U.K., by pulling out of the EU, recently made the choice to renegotiate the terms of trade with its major trading partners (see chart 1).
Second, the country's domestic supply chain has become bigger, longer, and much more complex. German companies not only send many finished goods to serve global final demand. They also are involved in many production steps, so that German trade has a much higher content in the re-export of intermediate products than other major economies (see chart 2).
There is no doubt this strategy has increased economic welfare in Germany, including employment. But the degree and nature of internationalization achieved expose the country to shifts in international trade more than any other major economy. The Russia-Ukraine war and China's change in trade orientation are cases in point.
Here, to assess these vulnerabilities, we take a deep look at the German supply chain. We attempt to trace its international development from 1995 to 2018 using input-output analysis--a form of macroeconomic analysis based on the interdependencies between different economic sectors or industries. Indeed, we attempt to quantify these interdependencies by geography and technology.
Forward and backward trade linkages as markers of complexity and internationalization
German industry's supply chains diversified and became more complex as globalization unfolded. The share of foreign intermediary inputs in its domestic production almost doubled to 21% in 2018 from 13% in 1995. Plus, the German share of re-exported intermediate also almost doubled to 50% from 30% between 1995 and 2019, leaving behind both the U.K. and China. In contrast, the U.S. share fell below 16% during the period. These trends highlight Germany's much deeper integration in global supply chains.
A more complex global supply chain brings economic vulnerabilities along its width and length. The width of the supply chain represents the number of different inputs necessary at each step of production to get the next intermediary output. The length of the supply chain is the number of steps necessary to create the final product. For instance, the length of the German automotive industry supply chain would consider aluminum mined in China, reprocessed in Poland, built into a car rim in Italy, and assembled in a car in Germany. The width would, at the last step, account for all single parts sourced outside the company in the assemblage of the car. Of course, a possible interruption at any step of the supply chain, in any sector or at any border, could halt the entire production process.
To identify the vulnerabilities of Germany's complex supply chain, we examine the country's backward and forward linkages, using input-output analysis. Simply put, backward linkages of a product suggest that foreign inputs have contributed to domestic production. And forward linkage refers to a domestic input in foreign production.
The share of international inputs in German output, international direct backward linkage, nearly doubled to 9.9% from 5.5% since 1995. It is one of the most direct indicators of dependency on outside partners. That's because potential shortages of intermediary inputs, combined with low immediate substitutability, directly threaten production and factory closures. The increase in backward linkage comes from stronger integration with Western European partners and the opening of Eastern Europe and China as significant suppliers to Germany (see chart 3).
Symmetrically, the share of German production serving as intermediate products in foreign production is called international direct forward linkage. This shows the degree of integration of German products in global supply chains and underlines how much other countries depend on German products for their own production. Forward linkage of the German economy almost doubled to 11.5% from 6.1% in 1995. We find that 17% of consumption goods produced in Germany and 23% of intermediary goods were sold abroad in 2018 (versus 9% and 14%, respectively, in 1995).
A comparison between forward and backward linkages measures the balance of an internationalized supply chain and is an indication of trade vulnerabilities. Such a comparison for Germany (see charts 4a-d), shows that:
- The integration of Eastern European countries into German production chains has been strong and well balanced. The rise in forward and backward linkages was almost simultaneous and similar during the whole period.
- The linkage to China is also strong but presents a bias toward forward linkages that has strengthened continuously until 2014. At that point, China became Germany's first trade partner, but then stopped, possibly reflecting the change in the country's new orientation regarding world trade.
- Trade with the U.S. is also biased toward forward linkages, that is, toward more integration of German products in U.S. production than the other way around.
- Russia, in contrast to China and the U.S., presents a strong bias toward backward linkages. The specificities of the Russian economy, which mostly exports commodities to the rest of the world, especially energy, is one reason. Another factor is that the share of German components in Russian production has decreased since the first round of Western sanctions was imposed in 2014. We also note that the linkage of the German industrial complex to Russia is much less important than to Eastern European countries, China, or the U.S.
Direct Backward And Forward Linkage
Using first-order forward linkages certainly comes with a caveat. Direct linkage can tend to overrepresent the value added of the inputs used in production, considering that it "disregards" value added in all previous production steps, according to Johnson & Noguera. First-order linkages face, as much as conventional trade, the pitfalls of "double-counting," that is, overstating the domestic content of exports. This caveat in the end increases apparent trade vulnerability. However, low substitutability in the short run implies that first-order linkages can be considered to maximum output at risk of trade disruption.
Technology as another aspect of supply chain vulnerability
The concept of technology as a supply chain vulnerability has prominently reappeared on the political agenda in the context of the EU's recent policy of strategic autonomy, for instance.
In order to assess such dependencies for Germany, we look at the balance between forward and backward linkages by level of technology, using the OECD classification of sectors by R&D intensity. Technology-intensive sectors (pharmaceuticals, computers, electronics, and aeronautics) are among the most open and exposed to the world, implying long supply chains. Plus, the complexity of these products implies a large number of intermediate components. We find that the direct backward linkage of German industry to non-European partners is the highest among medium-tech sectors (including energy) and high-tech sectors (see table 1).
We compute for Germany the ratio of forward to backward linkages by geography and by technology: the closer it is to 1, the more balanced the German supply chain is. The more it is above one, the greater the bias toward a forward linkage of the German supply chain. The closer to zero, the greater the bias toward a backward linkage of the German supply chain. Unsurprisingly perhaps, the German supply chain has a forward linkage bias to high and medium-high technologies to all geographies and especially China. Therefore, the German supply chain is exposed to decisions by other countries aimed at protecting their own high-tech sectors. On the other hand, the German supply chain presents a strong backward linkage in low technologies, mostly in industries that transform commodities (metal, energy).
|Forward-Backward Ratio Of The German Industry Per Technology Level And Geography In 2018|
|%||High Tech||Medium High Tech||Medium Tech||Medium Low Tech||Low Tech||All|
|Rest of Asia||1.9||1.8||1.4||1.1||1.0||1.4|
|U.S. and Canada||2.0||2.0||1.7||1.2||0.6||1.3|
|Rest of world||3.7||2.4||1.2||0.5||1.0||1.3|
|Source: S&P Global Ratings.|
The input-output analysis also allows us to identify the share of output directly linked to these imbalances. We define "sectors at risk" to specific trade partners as the product of the share of the sector in Germany's gross output and the maximum of the direct backward and forward linkages. These sectors are identified using two criteria: First, the maximum value of backward and forward linkages must be above 1%. Second, it must not be more than twice the minimum. Summing across sectors at risk, we have the output at risk from trade imbalances with the partners. This calculation stands on a one-on-one transmission of the vulnerability from input to the output, and from the demand to the production (see table 2).
|German Output At Risk From Linkage Imbalances In Significant Sectors, By Partner Region|
|%||Western Europe||Eastern Europe||Russia||China||Rest of Asia||U.S. + Canada||Rest of world||Total|
|Output at risk, backward imbalance||0.4||0.1||0.2||0.1||0.1||0.1||0.4||1.3|
|Output at risk, forward imbalance||0.2||0.3||0.1||0.6||0.4||0.3||0.9||2.8|
|Source: S&P Global Ratings.|
Additivity is possible between countries, because the sets of trade relations with different countries are separate. Therefore, each direct linkage concerns a different sphere of the economy and proportion of output. Interestingly, Germany's output at risk from forward imbalances is the most important one, especially relating to China. As such, Germany's total output at risk from these trade imbalances amounts to 4.2% of gross output, but with a consequent concentration among European partners.
A more flexible and diversified supply chain--at what cost?
The main findings of our supply chain analysis are that Germany is more exposed to a risk of deglobalization arising from China than Russia. In light of current events, deglobalization or, here, the unraveling of supply chains, with the eastern part of the EU is not a risk. That's unless the Russia-Ukraine conflict spreads to neighboring countries. Second, we find that the risks of supply chain exposure to Russia and China are different. Supply chain risks regarding Russia are mostly linked to backward linkages in low tech, that is, dependency to Russian oil and gas. Supply chain risks to China are mostly forward linkages concentrated in high to medium-high tech sectors. These findings are certainly validated by current events, where Germany is scrambling to find other sources of natural gas other than those coming from Russia and to deal with supply chain disruptions arising from China's lockdown policies.
Reducing these vulnerabilities while continuing to reap the benefits of a global economy is no easy task. Germany's saliant backward linkages are often related to the use of specific commodities (like natural gas) in domestic production, for which there might be only limited possibilities for substitution or reduction, especially in the short term. It should be noted that commodities are scarce resources that are unevenly distributed on Earth. Therefore, reducing such dependencies often requires diversifying trading partners. In this context, Germany's membership in the EU is an asset. Another possibility would involve innovation, either to minimize the content of commodities in use or to increase their substitutability in the production process. Investment in R&D and new technologies are available avenues. On the other hand, the diversification of trading partners who can integrate German intermediate products into their own production and growth in domestic demand are possible avenues to minimize vulnerabilities in forward linkages.
Research contributor: Romain Grept.
S&P Global Ratings research
- Europe Braces For A Bleak Winter, Aug. 29, 2022
- Moving The Russia-Ukraine Scenario Needle: European Output At Risk, March 16, 2022
- OECD (2021) OECD Inter-Country Input-Output Database
- OECD (2020) "Trade Policy Implications of Global Value Chains," Trade Policy Brief February 2020
- Miller, R. E., Blair, P. D. (2009). "Input-Output Analysis: Foundations and Extensions," Cambridge University Press. Page 555 and thereafter.
- Johnson & Noguera (2013), "Trade in Value Added: Developing New Measures of Cross-Border Trade," Chapter 4, Accounting for Intermediates: Production Sharing and Trade in Value Added, World Bank
- Galindo-Rueda, F. and F. Verger (2016), "OECD Taxonomy of Economic Activities Based on R&D Intensity," OECD Science, Technology and Industry Working Papers, No. 2016/04
This report does not constitute a rating action.
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