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Globalization, China, and the "bullwhip effect"

Comment
The relationship of the United States and China offers a clear example of how the bullwhip effect applies on an international scale.

When we talk about the "bullwhip effect"—the magnification of order fluctuations at each upstream point in a supply chain—we usually are referring to a particular company's experience. But this phenomenon can also play out in a much larger theater. The relationship of the United States and China offers a clear example of how it applies on an international scale.

The bullwhip effect describes a phenomenon in which the impact of fluctuations in orders—and therefore in demand for parts and materials—becomes larger as demand works backward from the customer through to rawmaterial suppliers. It exhibits a "Hayekian" premise, named after Friedrich August von Hayek, the Nobel-prize winning economist who systematized the economics of capital structure, because it carefully considers the different stages of production, from higherorder, more capital-intensive goods to lowerorder goods that are closer to the consumer. Basically, this means that we should observe greater swings in production of the longerlived assets further back in the supply chain.

Article Figures
[Figure 1] U.S. sales volatility
[Figure 1] U.S. sales volatility Enlarge this image
[Figure 2] U.S.-China trade rises
[Figure 2] U.S.-China trade rises Enlarge this image

The bullwhip effect implies that inventories vary more than sales. In a macroeconomic setting, manufacturing sales will vary more than wholesale sales, which in turn will vary more than retail sales. As we move back through the supply chain, from consumer sales to more primary sectors of production such as manufacturing, we are moving further from the final consumer and into domains of greater variation. You can visualize it this way: retail is close to the bullwhip's handle (where action is initiated) and manufacturing is furthest away, down at the end of the whip.

This is easily observed when examining the relationships between manufacturing, wholesale, and retail sales during the past two recessions. (See Figure 1.) Both experimental and econometric evidence suggest that there are behavioral reasons for the bullwhip effect. Accordingly, a downturn in household consumption—even if it is premised on expectations rather than on economic fundamentals—is likely to translate into a larger downturn in manufacturing.

U.S. cutbacks dampen Chinese exports
Since the end of the Cold War, trade flows and the integration of global markets (globalization) have increased at a rapid pace. The entry of China into the World Trade Organization (WTO), along with a shift by India and some other developing countries toward market economies, has increased global trade and hence U.S. dependence on imports for domestic goods consumption. Meanwhile, China's industrial production reached historically high volumes and level of specialization. Anecdotal evidence indicated that certain regions of China were producing 70 to 80 percent of the global production of footwear, clothing, and other final consumer items.

These developments had a significant effect on U.S. supply chain dynamics and on the transportation sector in particular. In early 2003, U.S. imports recovered at an accelerated pace, along with Chinese exports, retail sales, and wholesale sales.

The rapid increase in imports from China had a direct influence on the U.S. domestic supply chain. The West Coast container ports were severely congested with Chinese imports from 2005 through 2007. Because imports were feeding into markets across the United States, they overheated the less-than-truckload (LTL) and intermodal rail systems. Government data, in fact, show that an import that enters the country on the West Coast has a larger impact on the U.S. transportation system than an import received in New York.

The tight relationship between the U.S. supply chain and China underlies a fundamental structural change in the U.S. economy. Harvard professor Niall Ferguson discusses this highly unusual relationship in his important book The Ascent of Money: A Financial History of the World. From the time of the Asian financial crisis in the early 1990s through the beginning of the recent global financial meltdown, there has been a symbiotic relationship between China and the United States, which Professor Ferguson has dubbed "Chimerica" (China + America). The Chinese were building up funds by means of currency interventions and purchases of U.S. debt instruments while Americans were piling on debt, expedited by the spectacular budget and trade deficits in the United States and easy monetary policy set by the Federal Reserve, especially during the critical years following the events of September 11, 2001. In essence, the Chinese were saving while Americans were consuming and spending.

Between the 2001 recession and the current "Great Recession," U.S. retail and wholesale sales growth was fueled by an import-heavy consumption boom. During that period, the level of imports and American retail sales started increasing at an accelerated pace, yet manufacturing sales hardly surpassed their pre2001 peak. When the U.S. economy started showing signs of weakness in the second half of 2007, many economists and industry analysts claimed that China had "decoupled" from the United States and would be less dependent on U.S. business.

However, the decline in Chinese exports in mid2008 proved the decoupling hypothesis to be false. When U.S. consumers curbed their spending during the global financial crisis, the impact on Chinese exports was highly significant. Thousands of mid-sized factories in China went out of business almost overnight, and millions of migrant workers headed back to their home villages. These and other data indicate that supply chain dynamics have become extremely volatile after a prolonged period of moderate volatility. They also make it clear that China remains tied to the U.S. economy; as long as it does so, it will feel the U.S. bullwhip effect.

Worries for "Chimerica"
During the first half of 2009, U.S. retail, wholesale, manufacturing, imports, and Chinese exports all began to rebound. (See Figure 2.) The strength of the Chinese economy also promoted the growth of U.S. exports. But that doesn't mean there is nothing to worry about. In fact, the key questions raised during the height of the Great Recession still await answers: Can Western countries still borrow money to fund their consumption imports, and if so, for how long? Will the world slip into a frenzy of protectionism? Will China become introverted and mimic its inward-looking past?

For now "Chimerica" will continue, as both nations stand to be net beneficiaries of this intricate economic relationship. However, as long as U.S. consumers and businesses continue to save more and reduce debt and the housing and non-residential investment markets remain depressed, U.S. supply chain dynamics are not expected to return to their 2006 peaks. Accordingly, supply chain professionals whose companies do business with China need to understand the bullwhip effect and be prepared to manage the effects of continued demand swings.

IHS Global Insight Inc. is a leading consulting company providing comprehensive economic information and forecasts on countries, regions, and industries with particular expertise in global trade and transportation. IHS Global Insight serves more than 3,800 clients in industry, finance, and government through offices in 13 countries covering North and South America, Europe, Africa, the Middle East, and Asia.

Chris G. Christopher, Jr., Ph.D., CBE is executive director of the U.S. Macro and Global Economics practice at the research and analysis firm IHS Markit.

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