Expert view

Economic cooperation between countries is determined by many factors, from the different availability of natural resources, through the different development of industrial capacities, to the different technological level, quality of education and efficiency of countries. Since the creation of the modern (Westphalian) state, scientists have been interested in what factors encourage countries to trade with each other, what are the causes and what are the effects of trade between countries. Apart from the different availability of goods, the main cause of trade is the different prices of the same goods in different countries. It can be said that it is obvious. This is clear at first glance; however, it is not clear at first glance what are the reasons for the different prices of the same goods in different countries. This became the subject of scholarly study leading to foreign trade theories. In the first theories, with many assumptions, the cause of different prices was different labour productivity in different countries, in the production of the same goods. It is the theory of absolute advantages (Smith), based on the labour theory of value. Analysing and wanting to confirm the theory of absolute advantages, Ricardo came up with the theory of comparative advantages, showing that it is not necessary that a country has an absolute advantage in the production of a good, but that a country can have a gain from international exchange if it has different relative productivity in the production of goods. These theories explain international exchange in the dominantly agricultural society in which they originated. In an industrial society, differences in the price of the same products, with many conditions met (assumptions), is due to the different availability of production factors (labour and capital), which leads to different relative prices of them, which are transferred to production costs and finally to different relative prices of final goods. In an industrial society, different rates of innovation of new products and production processes as well as different rates of brand creation have become reasons for foreign trade. The reduction of communication and transport costs as well as the liberalization of world trade in goods and the movement of capital have further stimulated trade between countries.

Countries that are closer to each other and that are economically larger will have more mutual trade, and more distant and smaller countries will have less mutual trade, proves the gravity model of foreign trade. It got its name because of the similarity to Isaac Newton's law of gravitation, which states that every two bodies are attracted by a mutual force that is proportional to their masses and inversely proportional to the square of their mutual distance. The facts confirm that small neighbouring countries trade relatively more with each other than with a larger country further away. More distant countries, despite globalization processes, have different consumer preferences, often different product standards, as well as ways and culture of doing business resulting from different traditions. According to the gravity model of foreign trade, due to the greater distance, the greater development of trade between Croatia and Asian countries will not come naturally, that is, spontaneously. All the more so since Croatia is a small country by all standards and so far, there are no large companies that would have the economic, financial, organizational and managerial ability to significantly enter more distant and larger markets. On the other hand, the Croatian market is too small for Asian countries to invest more effort to enter the Croatian market. Their goal is the European market, primarily the European Union, especially its largest and most developed countries. According to its performance on the European market so far, China (as a central Asian country that has the strongest influence on the forms and size of Asia's trade with Europe) sees two markets in Europe: A and B. A market is a group of more developed European countries, and B markets are transitional, i.e., former socialist countries. Croatia belongs to market B.

Croatia should have a greater interest in greater economic cooperation between Croatia and Asian countries. Namely, as a small country, Croatia is naturally more dependent on foreign trade than a large country. The relatively high demand for imports comes from the demand for the consumption of products that it cannot produce itself for several reasons, firstly due to limited resources in a small country, and secondly due to slow technological development. The smaller the country, the greater the demand for imports. Imports are ultimately paid for by exports. However, the demand for Croatian exports from the world or Asian markets does not come spontaneously, or it does not come enough to cover Croatian imports. That is why Croatia needs to have a strategy, policies, institutions and incentives that encourage and create conditions for increasing exports. The increase in exports is not only necessary for paying for imports, but also for the development and growth of the entire economy. The structure of world demand (world market) and its development should be the starting point of Croatian export strategy. According to each part of the world market, considering its characteristics, it should be adjusted. One export policy cannot be valid for the entire world market.

The Asian market is one part of the global market, which also has its own internal structure. When creating a strategy for Croatia's economic cooperation with this market, it is necessary to start from its structure and its specificity, and on the basis of theories of foreign trade, test the possibilities and potentials of cooperation in order to choose the best model. Previous research, which is very limited, shows that almost any theory of foreign trade can explain part of the economic cooperation so far. From absolute advantages to the gravity model of foreign trade, all theories point to major obstacles to increasing cooperation between Croatia and Asian countries. For Croatia, these obstacles are greater with final products of greater complexity. The model of global value chains indicates the possibility of increasing trade and overall economic cooperation between Croatia and Asia. According to the model of global value chains, a country does not need to have a comparative advantage in the production of a complete, complex final product, but it is enough to have a comparative advantage in the production of individual components (parts, semi-products) that are incorporated into the final product in another country. International production, trade and investment are increasingly organized within so-called global value chains, where different stages of the production process are located in different countries. The entire process of producing goods, from raw materials to finished products, is increasingly carried out where the necessary skills and materials are available at a competitive price and quality. Similarly, trade in services is essential to the efficient functioning of global value chains, not only because services link activities between countries, but also because they help companies add value to their products. Inclusion in global value chains comes automatically from multinational companies if they recognize that some parts of their final product can be produced in a country with high quality and low costs. This improves a country's trade balance slightly. For quality inclusion in global value chains, a small and less developed country must have a strategy for inclusion in those global value chains for which it has the most conditions and in those for which it can create these conditions in a relatively short period of time: education, institutions, infrastructure, incentives, conditions for investment, and similar.

Of all the approaches to increasing cooperation between Croatia and Asian countries, and above all China, perhaps the model of global value chains is the most promising. However, without an expert and science-based Croatian strategy for the inclusion of Croatian companies in the production chains of Asian companies, there will be no significant developments. The first step should be to assess Croatian natural and acquired production specificities and, based on them, to assess in which production chains (activities) Croatian companies could be included in the short term, and what is missing for that inclusion. The second step should be an assessment of which activities Croatia could create conditions for the quality inclusion of Croatian companies in global value chains through a well-thought-out policy: education, building infrastructure and institutions, incentives, etc. 

The practical policy of inclusion in global value chains cannot be global (general) but specific, i.e. aimed at certain productions (activities) and certain parts of the world. If it is about orientation towards Asia or China, a "general" orientation towards that region or country is also not enough, but a specific orientation towards their chosen companies, usually larger ones that operate globally. This does not exclude the inclusion of smaller companies in the production chain if they are in the target activity (production). With this specific approach, it is necessary to analyse the applied technology, production processes and organization, business strategy, strategy of appearance on the global and European market, corporate culture, etc. of the target companies. The interstate agreements on economic cooperation themselves serve politicians more for showing themselves, than they have concrete results. All the more so because the difference in economic size between Croatia and China is enormous. Therefore, on the Croatian side, there should be a Croatian company with strong and well-organized support from the Croatian state, and on the Asian (Chinese) side, there should be a large or medium-sized company. Not even the largest Croatian companies have the economic, financial, knowledge, organizational and professional strength for significant business ventures with the Asian market, which is why smartly organized support from the Croatian state is necessary.

Global and national economies, industries, firms, households, and individuals have undergone frequent and severe shocks in the last two decades, with the combination of the idiosyncratic shock of the COVID-19 pandemic and increasing threats from climate change and geopolitical tensions being the most challenging. It is not in human nature to accept instability and uncertainty caused by these cascades of shocks, so it is not surprising that much effort has turned to the quest to minimize the impacts of this turbulence and create shock absorbers and shields. This ‘resilience seeking’ has affected decision- and policymaking at both micro and macro levels in all spheres of life.

The concept of economic resilience is not singular, it is dynamic rather than static, and importantly, it is typically taken to mean different things depending on whether it is considered to be pursued by a firm or a government.

Globalization enthusiasts believed that the protectionist reactions of many governments in the early months of the COVID-19 pandemic would dissipate with trade rebounding strongly later that year. Unfortunately, the angst towards dependency on foreign supply for essential goods to fight the pandemic expanded to other sectors and into policy priorities. The focus on extensively decoupling domestic markets (of the US and some other advanced economies) from suppliers in far-away foreign countries (most often, in China and some other Asian economies) has all but replaced all other policy options.

The benefits of easy access to goods and services in greater variety, often better quality, and importantly, at lower prices than it was possible to produce them domestically, which have been welcome during decades of growth of globalization, started to be re-evaluated. Companies that built their supply chains based on efficiency and so-called “just in time” operations were ‘advised’ to go to the drawing board and reorganize their suppliers so as to minimize or eliminate the risk of distance and crossing the borders multiple times. In other terms, they were expected to enhance their resilience to shocks from disrupted productions, transport, and delivery to local markets by switching their business model.

Resilience is not a foreign concept for businesses. It is also known as contingency business planning to address risks. Admittedly, the prime reasons for such risk assessments were related to natural disasters or political crises. Such shocks used to happen in a geographically localized space and as isolated incidents (e.g., Japanese Tsunami and Thai flooding in 2011). Until recently, there was not much economic research on the long-term consequences of significant shocks, such as catastrophic natural disasters, on the reconfiguration of global value chains and changes in patterns of trade. Of course, natural disasters destroy physical infrastructure in addition to causing other disruptions, and the responses are thus necessarily driven by different priorities. But one important lesson from this recent research is that the relocation of production and changes in supply chains continued to be driven by fundamentals and not policies. In other words, distance, size, and level of development were the crucial factors in determining new places of production /sources of supply – the same factors that have been playing the key role in decisions on offshoring. Significantly, the nearness of countries did not give them any advantages over those further away when the relocation decisions were made (hold onto this finding, we will return to it).

The COVID-19 shock did not cause a destruction of productive and trade infrastructure. However, disruptions due to closed factories, transport and trade routes across many countries caught many businesses operating as part of the supply chains unprepared. (The same goes for governments and the shortfalls in the public health sectors, but that is a topic for another blog.) Local consumers (of final and intermediate goods) had to face shortages, forced substitution, and steadily increasing prices. The calls to “bring the production back home” started to be converted into policy programs.

Several governments, including Japan, the EU, the USA, the UK, and the Republic of Korea among the advanced economies, have started to develop elaborate legislation and financial packages to provide incentives to companies to reconsider offshoring. The simplest way to reverse offshoring is to relocate or reshore production or business processes back home. It is important to understand that the reshoring decision requires the same decision-making as did offshoring in the first place. It requires a lot of data and information, as the process of reshoring, in most cases, is long, costly, and linked to additional risks. Furthermore, it is an investment decision that requires a predictable and stable business environment, not uncertainty and turbulence, which has surrounded us more or less since the Global Financial Crisis. Obviously, the difficulty of reshoring differs from sector to sector, if not product to product, but the fundamentals mentioned above will be essential when deciding. Even if the size of the market, distance, quality of infrastructure, automation which drives labor and other cost advantages work in favor of reshoring, if the home government does not offer monetary or other incentives, the decision by the business might be to stay overseas. Moreover, a significant proportion of research published early in the pandemic pointed out that there were no guarantees that reshoring would produce any better results in terms of resilient supply compared to the offshored one. After all, reshoring does not address the issue of single sourcing, which has been ranked towards the top cause of vulnerability. Indeed, recent findings based on a global and European survey of firms involved with supply chains show that just about 27% globally and 24% in Europe intend to shift their operations to the same country as the final market.

The better way to enhance resilience is to combine relocation with diversification of sources of supply. Where to source from?

One option, based on the need to control costs while diversifying, is to focus on the proximity between the source and destination (is this the final burial of the “death of distance”?). It points to the possibility of shortening the supply chain by nearshoring to a location closer to home. In other words, move the production of source components or final products to the near vicinity of their final markets in the hope of having shorter, more reliable, less risky, and increasingly sustainable supply chains.

Another option is to focus on “political” proximity or “like-mindedness” instead. The segregation between like-minded, trustworthy, or “friendly” countries and those that are not converts the nearshoring into “friendshoring,” that is a relocation of the offshored process/business to a location to a friendly country.

Sounds simple, even reasonable, until one asks, “who is a friend” in the context of relationships between countries, and is it the people, the government, or both that define the “common interests and values” that are often used as the defining element of the like-mindedness. Moreover, it appears that being like-minded doesn’t automatically carry the label of trustworthy or friendly. As we now know, the focus is on risks to national security that potentially arise from high dependence on foreign suppliers for essential goods and services, critical infrastructure protection, data protection, and similar. So, it is dependent on the perception of a national security risk by a country (let’s say the US) if a close political ally, say Canada or the Republic of Korea, will be facing entry barriers to the US market for say steel and aluminum.

Despite the hype built up around national security and friendshoring, it is difficult for firms to incorporate this type of risk into their decision-making. Many years of operating in an increasingly globalized world have conditioned firms to consider this type of (political?) risk only from the perspective of the target market for offshoring and investment. However, now the analysis must include the changing goalposts in their own country as trade and investment policies may sway widely upon reconsidering if the trading partner belongs to a friendly country or not. Should one go by the old adage “The enemy of my enemy is my friend” despite the shifting sands in the world?

Finally, let us ask how all of this matters for Croatia, its trade, and its firms. An excellent recent article by Cuckovic and Vuckovic, citing a number of other research papers, convincingly argues that Croatia is a laggard when it comes to either offshoring overseas or being a choice location for value chains production and processing. Based on the World Bank Enterprise Surveys, less than 10% of the monthly sales (on average) of the surveyed firms are linked to direct and indirect exports. This is a rather crude proxy for the intensity of participation in GVCs. The numbers reflecting the share of firms involved in direct and indirect exports, two-way trade including imports ‘imports for exports’ and some other indicators of participation in GVCs, look better, showing that between 30% and 50% of firms (being surveyed) could be linked to GVC trade. These are similar estimates as published in Kersan-Skabic and Perusko et al. Looking at some other measurements, for example, the WTO, GVCs linked exports make up 37% of Croatia’s gross exports (2018), with 13.3% being forward linkages and 23.7% backward linkages. The comparable numbers for Europe are 48.8% (with 21.2% forward and 27.6% backward linkages) and for Asia 44.4% (with 20% forward and 24.4% backward linkages). With such low participation in pre-Covid and post-Covid GVC trade, should Croatia be concerned about the above-discussed spread of policies towards nearshoring (or friendshoring)? According to the recent Reuters-Maersk report on the reconfigurations of supply chains globally and in the European Union, concerns are warranted. The table below reflects the geographic locations for nearshoring. Less than 25% of firms consider full reshoring, and then the preferred locations for shifting locations for either sourcing or processing do not include surprises. Croatia ranks 26th with 2.3% of firms making it a preferred location. The survey at the global level does not include Croatia at all, while the first five locations include Vietnam, India, Germany, Poland, and the United States.

If you are an optimist, you would think about how to turn this situation into finding ways to convert the pressures for reconfiguration, which are going to be the feature of international production and trade for some years to come, into opportunities for Croatian firms to increase their presence in international markets and to deliver the long-promised benefits of trade.

If you tend to be more of a realist, you should share the growing concerns, which are increasingly supported by evidence, about the economic and systemic costs of the fragmentation of the world economy caused by these new policies towards value chain production, trade, and investment.