Politics of Global Value Chains

The proliferation of global value chains makes the domestic production of goods increasingly dependent on inputs from foreign sources. Political tensions between countries have an impact on trade costs as they affect the international enforceability of contracts or result in impediments from authorities in the shipment or production process. By expanding their portfolio of foreign suppliers, firms and by extension entire economies are thus increasingly prone to the trade effects of adverse bilateral political shocks. In this paper, we aim to reassess the role of political relations on trade flows in light of these new developments and propose a new channel. We hypothesize that political relations matter more for imports of strategic inputs. Strategic inputs refer to inputs that a country uses intensively in its production process. We construct a simple model exhibiting input-output linkages to clarify the mechanisms at play. Using a new measure for countries’ dependence on these strategic inputs, we then test the proposed mechanism empirically by interacting the measure with an indicator of political relations in a structural gravity model. To address potential endogeneity issues we then perform an event study, in which the treatment is an exogenous adverse political shock. Using a new dataset on the status of diplomatic representation and monthly trade data, we exploit the recalling or summoning of the ambassador of a country as a shock to bilateral political relations. Results from both analyses confirm an economically and statistically significant effect that varies conditionaly on the dependence of the country on the imported input.