In a recent post, FSG showed how firms throughout Western Europe have been significantly more apprehensive about holding inventories ever since the financial crisis. This caution is a response to ongoing systemic uncertainty about future demand, exacerbated by slow growth in business activity and consumer credit. It has caused a massive drawdown in business inventory levels since 2011, and a corresponding major increase in the volatility of inventory levels.
This volatility is contagious because of a startling degree of macroeconomic synchronization between Western Europe and Central and Eastern Europe (CEE). Worse, it is amplified by the complex interconnections between CEE suppliers and partners or parent companies in Western Europe. This transmitted risk helps explain some of the uncertainty experienced by CEE firms. As Europe’s supply chains become ever more integrated, firms must deliberately and continuously adapt and grow more agile if they wish to survive, compete, and win in this unpredictable business environment.
Regional value chains help synchronize economic conditions in CEE and Western Europe
The growing integration between CEE and Western Europe is not news, but appears to have grown even more substantial since the financial crisis. Over 50% of CEE trade is with the eurozone, and by one estimate as much as 50% of all exports from the region can be tied to global value chain production. In context, value chain exports make up 44% of Hungarian and 37% of Czech GDP. In larger, more diversified Poland, the figure remains high but is closer to 20%. Another measure of this integration is that eurozone countries hold 75% of FDI stock in CEE.
This integration leads to significant synchronization of business cycles and economic activity. One mechanism is the change in inventories highlighted in part 1. As downstream companies adjust their inventory levels to respond to consumer demand, they put substantial pressure on upstream suppliers to follow suit. Suppliers have less information about initial consumer demand and may therefore overcompensate, increasing the volatility experienced by intermediate manufacturers. In this way, demand- or supply-side shocks are relayed to every link in a value chain, and output growth or recession is experienced simultaneously or with only a marginal lag.
The observed high inventory volatility in Western Europe is both a cause and a consequence of this phenomenon, but the impact on CEE is drastically amplified exposure to world business cycles. While inventories always fluctuate wildly and often determine a substantial part of any change in GDP, this effect is particularly strong in the CEE countries. In Poland and Hungary, more than 80% of cyclical variation in GDP can be explained by inventories, while in Bulgaria and Romania the figure is around 60%, with the Baltic States and the Czech Republic coming in at around 40%.
Responding to increased volatility of supply chains in Europe
Failure to effectively respond to volatility can be extremely costly. Inability to meet unanticipated supplier demands could tarnish relationships or result in lost contracts, while absorbing the cost of rushed production or preemptively holding excess inventory stocks is also unappealing. This may be particularly true for firms (or subsidiaries) in an intermediate position in a regional value chain with stringent requirements for rapid turnaround. While there are no silver bullets, the tenets of supply-chain management during periods of crisis highlight the need to increase flexibility.
- Plan for a new normal of high volatility of demand along supply chains: Evaluate firm exposure to positive and negative demand shocks and determine key areas for improvement. Use scenario planning to consider a range of possible demand situations, and stress testing to check for weaknesses internally or with critical suppliers. Plan future expansion around agile production methodologies.
- Move from fixed to variable structures: Negotiate smart contracts that adjust volumes according to economic realities and reduce delivery sizes to cut inventory buildup if economically practical. Improve supply-chain tracking and shorten the time needed to adapt to new information if early indicators are consistently reliable.
- Improve relationships with suppliers and clients: Work with customers to speed up notification about indicators of future demand, and ensure that suppliers are prepared accordingly as well. If building flexibility into contracts, require an adequate price premium for the service of guaranteeing consistent supply or cut service levels to meet minimum client requirements.
This issue of supply-chain volatility has long been present in the CEE business environment, but the current research confirms that it is industry-wide and unlikely to decrease in the coming years. Firms can only benefit from streamlining their operations in response.
****Note: Research, analysis, and writing for this blog post was led by FSG’s research intern, Edward Moe. This article relied upon data from ECB working papers.