How fragile are European GVCs? The role of functional diversification and implications for industrial policy

This paper examines the relationship between functional diversification and foreign input reliance (FIR) in European countries, with a focus on manufacturing sectors. We propose that greater functional diversification is a key strategy to soften dependency on foreign inputs, thereby mitigating the risks associated with Global Value Chain (GVC) disruptions. We elaborate on recently developed indicators for GVC exposure based on international gross trade flows and test their association with a novel measure of functional diversification, proxied with data on Foreign Direct Investments (FDIs) across value chain activities. Our findings reveal that functional diversification is negatively associated with FIR, particularly from extra-EU sources, indicating that European countries can reduce exposure to GVC disruptions by diversifying value-adding functions. However, this relationship is also found with reference to the intra-EU FIR component, suggesting that functional diversification strategies undertaken at the level of individual member states may end up weakening European trade integration. We conclude that the EU’s Open Strategic Autonomy framework should carefully consider coordinated industrial strategies to strengthen the EU’s capacity to navigate GVC disruptions without undermining intra-EU trade ties.