This substitution effect is further influenced by the heightened uncertainty of future demand after the crisis, which may encourage firms to externalize further their sourcing in order to increase their flexibility in response to future demand stagnation or volatility. Nonetheless, the large declines in the volume of trade seen in the recent crisis indicate clearly that the demand effect has so far swamped the substitution effect.

The rise in trade elasticities, then, is due not to a rise in trade openness but to the rising sensitivity of trade to changes in GDP, that is, to the nature of GVCs, not to the globalization of production _per se_ . There are at least two reasons why the expansion of global value chains has increased trade openness and raised incremental import-GDP ratios. The rise in the incremental import-GDP ratio is the result of the magnitude and speed with which adjustments that take place when supply chains are well-coordinated by lead firms. An important reason for lead firms to establish global production networks in the first place is the flexibility they provide. GVCs allow adjustment to changes in market demand to occur quickly and for the risk of demand declines and inventory adjustment to be borne to a greater extent by supplier firms. Innovations in lean retailing, fast fashion and just-in-time inventory management control, and full-package outsourcing, have all been built on GVC governance strategies. Suppliers too have developed in a way that seeks to manage the environment of flexibility-seeking lead firms. Modular production processes give supplier firms capacity to serve different product lines and even different GVCs.<sup>13</sup> Adding to the speed of adjustment in trade in a downturn is that firms might make use of accumulated inventories first.<sup>14</sup> In a world of disintegrated production and lean retailing, the GDP downturn like that experienced in 2008-2009 resulted not only to larger declines in trade than previously but also at a more rapid rate. Recent research confirms that the trade collapse was “synchronized” across countries, which Baldwin (2009b) also attributes to the internationalization of the supply chain. Global value chains are a channel for the rapid transmission of both real and financial shocks. Shifts in demand for final goods can immediately affect flows of intermediates, especially when supplier contracts are short-term. Credit market problems, which can have a negative international “cascade effect” through global value chains, as the denial of credit to importers in one country can lead to credit problems for sellers in others, reducing their access to credit, affecting in turn their ability to import.<sup>15</sup>

# **3.4 Trade Credit Crunch**

There are strong indications of an additional factor at work today that has driven down international trade activity: the freezing up of lines of credit for undertaking international trade transactions, also known as trade finance. A survey of multinational buyers (i.e. lead-firms and higher-tier supplier firms in global value chains) indicates that the drop in orders may be more a function of “new credit bottlenecks” than declining final demand _per se_ .<sup>16</sup> Trade finance comprises a number of financial instruments, including letters of credit, pre-export financing, factoring and forfeiting, advance payment guarantees, export credit insurance and export credit guarantees.<sup>**17**</sup> The slowdown in trade credit provision has come as a result of more stringent bank credit and capital allocation criteria, growing distrust between international banking counterparts who must cooperate in the provision of trade credit, more stringent requirements on

> 13 Sturgeon (2004). 14 Freund (2009), Baldwin (2009b). 15 Escaith and Gonguet (2009). 16 Auboin (2009). See ICC (2009) for a survey measuring the decline in the volume of trade credit. 17 Drawn from Chauffour and Farole (2009), Appendix 1.

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