Opinion | Covid-19, O-rings and the worry over supply chain disruptions
PremiumIndia must brace for the impact of a viral outbreak that has disrupted chains of supply in which every link matters
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PremiumThe global economy grew by an estimated $1.66 trillion in 2019. Around $0.78 trillion of that additional output came from China. In other words, China accounted for around half the global economic growth last year. It was expected to account for more than a third of global growth this year as well. These are useful numbers to remember while thinking about the impact of the coronavirus on the global economy.
China is the epicentre of the disease, which could yet become a global pandemic. It is quite likely that the Chinese economy has ground to a halt because of factory shutdowns across the country.
The first quarter of this year may see the Chinese economy stall. The bigger question is how soon will it bounce back in case the virus is brought under control. The International Monetary Fund estimates that Chinese growth in 2020 will see a 0.4 percentage point drop, leading to a 0.1 percentage point cut in its global growth forecast.
However, Kristalina Georgieva, managing director of the multilateral lender, has also said that it is looking at more dire possibilities. The actual situation could thus be far more complicated. China sits at the heart of global supply chains that keep the world economy humming. China is thus not just a source of final demand for consumer goods, but also a key supplier of intermediate goods to other countries.
A chart by Bloomberg Economics shows that large economies such as the US and Japan get more than a third of their intermediate goods from China. India also has a substantial exposure to China when it comes to the supply of intermediate goods. Global supply chains today work with minimal inventories; so, the transmission of the supply shock from China to the rest of the world depends on how much inventory other economies are holding right now—and if these inventories are enough to maintain production schedules till the Chinese economy recovers.
Even a small crack in the supply chain can throw entire industries into turmoil. Think for a moment about the O-ring problem. The American space shuttle Challenger exploded into a ball of fire soon after taking off in January 1986, killing all seven crew members. The commission set up by the US government to examine what went wrong showed that the sophisticated space shuttle was brought down because of one small component—the O-ring, a gasket that seals two surfaces. Physicist Richard Feynman famously showed during a televised hearing how the O-rings that went into the space shuttle malfunctioned at low temperatures.
He did it by simply dropping one of the gaskets into a glass of ice water. (Michael Kremer, who won the 2019 Nobel Prize for Economics, used this episode to write about the O-ring theory of production, in which even the smallest task matters as much as the largest.) Global supply chains have a variant of the O-ring problem. A malfunction in even a small part of the supply chain can have a huge impact.
And the coronavirus has hit the very centre of contemporary global supply chains, rather than some extremity. The supply shock also poses a policy challenge. Expansionary fiscal policy will have little impact when the problem emanates from factory shutdowns in China.
Higher government spending can help reopen factories that have shut because of weak demand, but not when they have been shut because of an exogenous shock such as the coronavirus.
What higher fiscal spending as well as easy monetary policy can do is to support demand in case these take a hit. What about India? There are already news reports about how domestic prices of some categories of medicines have begun to climb in recent weeks. In a detailed sectoral analysis on the possible impact of the coronavirus in India, rating agency Crisil has noted that sectors dependent on imported inputs from China could experience pain if the China shutdown continues beyond their current inventory holdings.
These sectors include auto components, consumer durables, mobile handsets, electronics, bulk drugs and solar panels. Sectors such as cotton yarn and polished diamonds that export to China can also get hit. However, some sectors such as leather and ceramics could benefit as Chinese exports to India decline. A lot thus depends on how successfully the spread of the coronavirus is contained, whether industries have enough inventories to maintain production schedules till the situation returns to normal, and how policymakers respond to the supply shock.
Temporary disruptions in global supply chains are not completely unusual. The world dealt with them in 2011 after an earthquake in Japan and floods in Thailand. However, the impact of supply chain disruptions because of natural disasters is far easier to estimate than that of a public health emergency such as the rapid spread of coronavirus. No wonder financial markets are very worried.
Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics
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