## _cr13263

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### EXECUTIVE SUMMARY — Evolution of the German–Central European supply chain (GCESC) and trade linkages
- Since the 1990s a German‑Central European supply chain (GCESC) has evolved, linking Germany and the Czech Republic, Hungary, Poland and the Slovak Republic (CE4) in manufacturing for export.
- CE4 integration drivers:
  - large unit labor cost differentials with Germany (average exchange rate‑adjusted unit labor cost differential, 1995‑2009: between 35 percent (Poland) and 58 percent (Hungary));
  - geographic proximity, cultural similarities, and a similar sectoral structure to Germany;
  - adequate labor skills to support supply chain activities.
- Measurement differences (2009):
  - Germany exposure to EU (WIOT) = 48 percent; DOTS = 62 percent.
  - Germany exposure to rest of world (WIOT) = 33 percent; DOTS = 26 percent.
  - Implication: exposure to final demand outside Europe is substantially larger when measured by value‑added decompositions (WIOT) than by gross bilateral trade (DOTS).
- Sectoral export contributions (1995–2009):
  - Knowledge‑intensive sectors (transport and electrical equipment, machinery and chemicals) contributed about 50–60 percent of total export growth in Czech Republic, Hungary, and Slovakia; about 40 percent in Poland.
  - Knowledge‑intensive sectors comprise about 30–40 percent of CE4 domestic value‑added exports.
- Notable fact: 2009 marked the first year in which offshored production outstripped domestic German production of passenger cars.

### FINANCIAL LINKAGES SUPPORTING GCESC
- FDI and composition:
  - FDI comprised a much larger share of overall capital inflows to the CE4 than to some comparator European countries.
  - CE4 FDI stocks peaked in 2009 at 54 percent of GDP.
  - CE4 FDI was largely directed to manufacturing, notably motor vehicles and other transport equipment; average share (2005–10) of inward FDI to motor vehicles and transport equipment ≈ 7 percent for the CE4 versus around 2½ percent for the SP.
  - Much FDI to CE4 financed greenfield investments (expansion in productive capacity and a relatively stable source of external funding).
- Bank flows:
  - Cross‑border bank flows to the CE4 were less pronounced than to selected periphery (SP) countries; consolidated bank claims peak: CE4 ≈ 71 percent of GDP; SP ≈ 62 percent of GDP.
  - Cross‑border component: SP pre‑crisis peak ≈ 70 percent (2007); CE4 cross‑border claims were more stable 2007–2012.
  - Hungary had a larger share of cross‑border bank flows resembling the SP pattern; local lending by resident foreign branches/subsidiaries more pronounced in CE4 and supported by local deposits.

### MACROECONOMIC CONSEQUENCES AND POLICY IMPLICATIONS
- Business cycle synchronization:
  - Conditional correlation of CE4 output gaps with Germany increased over time for all CE4 countries except Hungary; rise in synchronization associated with size of German value added embodied in CE4 exports.
- Technology transfers and structural change:
  - Participation in GCESC led to technology transfers and accelerated income convergence in CE4.
  - Revealed Comparative Advantage (RCA) patterns (selected, manufacturing RCA values for 1995 → 2009):
    - Czech: Labor‑intensive 1.29 → 1.01; Capital‑intensive 1.30 → 1.16; Knowledge‑intensive 0.56 → 1.18
    - Hungary: 0.68 → 0.37; 1.06 → 0.77; 0.50 → 1.18
    - Poland: 1.95 → 1.52; 1.39 → 1.39; 0.59 → 0.93
    - Slovakia: 1.05 → 1.16; 1.61 → 1.41; 0.60 → 1.11
    - Germany: 0.64 → 0.64; 1.07 → 1.20; 1.48 → 1.49
    - China: 3.55 → 2.52; 1.03 → 0.66; 0.64 → 1.27
  - With the exception of Poland, CE4 countries largely “caught up” with Germany’s comparative advantage in knowledge‑intensive manufacturing.
- Spillovers and demand channels:
  - Much bilateral trade is in intermediate goods; German final demand is not the main determinant of CE4 exports to Germany.
  - German domestic demand spillovers to CE4 have increased but remain relatively small.
  - Exposure to rest of the world increased: spillovers from aggregate demand and policy actions in the rest of the world are now much larger than before.
- Importance of German balance sheets:
  - Healthy German balance sheets act as a shock absorber; more leveraged balance sheets and greater sovereign risk in Germany would magnify regional impacts of external shocks.

### SPILLOVERS TO DOMESTIC PRODUCTION (DVA vs FVA)
- Trends 1995–2009:
  - Share of domestic value added (DVA) in gross exports broadly declined; yet nominal DVA and DVA as percent of GDP increased.
  - Increases in domestic VA (percentage points of GDP): Hungary = 14; Germany = 10½; Poland = 8; Czech Rep. = 5½; Slovakia = 1.
  - Increase in domestic VA positively correlated with increase in foreign VA (FVA); Rahman and Zhao (2013) find causality runs from growth in FVA to DVA.
- Decomposition methodology:
  - WIOT (1995–2009) and Koopman et al. (2011) framework used to decompose gross exports into five VA categories (DVA final; DVA intermediate non‑reexport; DVA intermediate reexported; DVA exported and returned; FVA).
- Intermediates embodied in CE4 exports (percent of total CE4 exports, domestic VA only) — DEU → CE4 (1995 → 2009):
  - CZE: 8.45 → 9.75
  - HUN: 5.31 → 8.52
  - POL: 4.08 → 6.07
  - SVK: 4.63 → 7.20
- CE4 → DEU intermediates (1995 → 2009):
  - CZE: 5.53 → 5.82
  - HUN: 3.09 → 3.77
  - POL: 5.77 → 5.59
  - SVK: 3.68 → 4.20

### INCOME CONVERGENCE
- Mechanisms: productivity gains via technology transfers, financial deepening, and specialization in high‑productivity sectors.
- Empirical evidence:
  - CE4 economies (except Hungary) grew faster than predicted by initial income—GCESC membership accelerated income convergence.
  - Formal econometric results: interaction of initial income and foreign VA in exports shows quicker convergence where foreign VA share is higher; share of foreign VA in exports (as percent of GDP) has a positive and significant effect on average GDP growth.
  - Figure regression: y =  -7E-07x + 0.0374; R² = 0.28 (bubble size proportional to share of German foreign VA embodied in countries' exports as percent of GDP in 2009).

### EXPOSURE TO EXTERNAL SHOCKS — GIMF SIMULATIONS
- Model: six‑region GIMF (Germany; CE4; euro area excl. Germany; United States; emerging Asia; rest of world). Simulated 1 percent aggregate demand shock (private consumption and investment) originating in Germany or non‑European blocks under 1996 and 2011 trade matrices.
- Key simulation outcomes:
  - German domestic demand spillovers to CE4 increased over time but remain relatively small.
  - The CE4 is only slightly more vulnerable to domestic German demand shocks in 2011 vs 1996.
  - Impact on German GDP of a domestic aggregate demand shock declined substantially between 1996 and 2011 (Germany export‑to‑GDP ratio doubled from 24 percent to around 48 percent).
  - Non‑European demand shocks: real GDP in Germany and CE4 dips below baseline considerably more in 2011 than in 1996 due to greater openness and larger size of the “rest of the world” (especially emerging Asia).
  - A fully co‑ordinated non‑European fiscal action of a given magnitude (in percent of GDP) would have a much greater impact on both German and CE4 economies than a purely German fiscal action of the same magnitude.
- Caveat: model does not capture concentration risk in sectors (e.g., automobiles) that could transmit disproportionately large shocks.

### IMPORTANCE OF GERMAN BALANCE SHEETS — “ANCHOR OF STABILITY” SCENARIOS
- Current situation:
  - German balance sheets generally healthy; low debt‑to‑GDP ratios in household, corporate and government sectors.
  - Germany’s safe haven status reflected in growing divergence in yields between Germany and other countries in the region.
- Fragile‑Germany calibration (illustrative):
  - Sovereign debt‑to‑GDP ratio increased by 30 percentage points.
  - Corporate spreads assumed to increase by about 350 basis points (150 basis points transitory; 200 basis points persistent).
  - Higher share of liquidity constrained households and higher corporate leverage.
- Simulation results:
  - Negative impact on real GDP from an aggregate demand shock is much larger when German balance sheets are weaker due to a stronger financial accelerator.
  - Larger German contraction transmits across borders, producing more pronounced declines in real GDP in CE4 and rest of euro area with feedback effects.
- Policy implication:
  - Healthy German balance sheets act as a public good—generating positive spillovers and buffering the GCESC against external shocks.
  - Strengthening household, corporate, and sovereign balance sheets is important domestically and for trading partners.

### THE AUTOMOBILE INDUSTRY — Stylized facts and sectoral implications
- Germany passenger car global market share: around 20 percent as of 2012.
- Passenger car production (1992–2011):
  - Domestic German production remained around 5.5 million vehicles per year.
  - Foreign production increased more than threefold, reaching 7.1 million by 2011; 2009 was first year foreign production overtook domestic production.
- 2012 passenger car statistics (multiple of 1999 level; employment ratio to manufacturing employment 2010; share in total exports 2011; contribution to exports growth since 1995):
  - Czech Rep.: 3.4; 11.7; 17.1; 50.7
  - Hungary: 1.7; 9.9; 8.7; 32.2
  - Poland: 1.2; 6.9; 12.7; 53.7
  - Slovakia: 7.1; 11.3; 21.5; 53.4
  - Germany: 1.1; 11.8; 17.4; 10.1
- Corporate income tax rate (2011): 19 percent in all CE‑4 countries compared with 29 percent in Germany.
- Automotive sector outcomes:
  - Vehicle production peaked at nearly 3 million in 2012 across CE4.
  - Automotive sector accounted for over half of the cumulative increase in exports since 1995 in CE4 countries (except Hungary where contribution was 32.2 percent).

### POLICY IMPLICATIONS AND RECOMMENDATIONS (emphasized by CE4 policymakers and staff)
- Maintain and safeguard competitiveness in knowledge‑intensive sectors as unit labor cost differentials with Germany narrow.
- Continual upgrading of labor force skills and investment in human capital (technical training, vocational education, business apprenticeships) to remain part of GCESC or branch into more specialized export activities.
- Consider policies to improve attractiveness for supply chain activity (e.g., tax breaks for companies providing technical education, cited by Czech authorities).
- Diversify export markets and product lines to reduce vulnerability to external shocks.
- Strengthen household, corporate, and sovereign balance sheets to reduce amplification of shocks domestically and across the GCESC.
- Recognize complementarity between foreign VA and domestic VA—policies to attract FVA are likely to produce positive domestic spillovers rather than crowd out domestic production.

### KEY EMPIRICAL FINDINGS & SELECTED STATISTICS (preserved exactly)
- WIOT vs DOTS exposures (2009):
  - Germany exposure to EU (WIOT) = 48 percent; DOTS = 62 percent.
  - Germany exposure to rest of world (WIOT) = 33 percent; DOTS = 26 percent.
- Sectoral contributions to export growth (1995–2009):
  - Knowledge‑intensive contribution: Czech, Hungary, Slovakia ≈ 50–60 percent; Poland ≈ 40 percent.
- Increase in domestic VA (percentage points of GDP) 1995–2009:
  - Hungary = 14; Germany = 10½; Poland = 8; Czech Rep. = 5½; Slovakia = 1.
- CE4 trade with Germany (1995–2011 cumulative change):
  - CE4’s imports from Germany grew by 8½ percent of GDP (cumulative basis); Czech Republic at 10½ percent of GDP.
  - CE4 exports to Germany increased by nearly 10 percent of GDP on average.
- CE4 2012 averages:
  - Imports from Germany: 16 percent of GDP.
  - Exports to Germany: 18 percent of GDP (behind only the Netherlands at 22 percent of GDP).
- FDI stock positions:
  - CE4 FDI stocks peaked in 2009 amounting to 54 percent of GDP.
- Bank claims (consolidated BIS statistics) peaks:
  - CE4 ≈ 71 percent of GDP; SP ≈ 62 percent of GDP.

*International Monetary Fund — GERMAN‑CENTRAL EUROPEAN SUPPLY CHAIN CLUSTER REPORT (excerpts from content unit _cr13263 - Box 1; Trade Linkages; Background Notes; Annexes).*

### EXECUTIVE SUMMARY

### EXECUTIVE SUMMARY

### Evolution of the German–Central European supply chain (GCESC) and trade linkages
- Since the 1990s a German-Central European supply chain (GCESC) has evolved, manufacturing goods for export to the rest of the world; bilateral trade linkages between Germany and the Czech Republic, Hungary, Poland and the Slovak Republic (henceforth CE4) expanded rapidly.
- CE4 integration drivers cited:
  - large unit labor cost differentials with Germany;
  - geographic proximity, cultural similarities, and a similar sectoral structure to Germany;
  - adequate labor skills to support supply chain activities.
- Exposure to final demand outside Europe is substantially larger when measured by value-added decompositions than by gross bilateral trade:
  - Germany’s exposure to the EU under the WIOT is 48 percent versus 62 percent implied by DOTS;
  - Germany’s exposure to the rest of the world is 33 percent versus 26 percent implied by DOTS.
- A substantial fraction of CE4 exports pass through Germany before export outside the EU.
- Sectoral export growth (1995–2009):
  - In Czech Republic, Hungary, and Slovakia knowledge-intensive sectors (transport and electrical equipment, machinery and chemicals) contributed about 50–60 percent of total export growth;
  - In Poland knowledge-intensive sectors contributed about 40 percent of total export growth;
  - Knowledge‑intensive sectors comprise about 30–40 percent of CE4 domestic value‑added exports.

### Financial linkages supporting GCESC
- FDI comprised a much larger share of overall capital inflows to the CE4 than to some comparator European countries; portfolio investment and cross-border bank flows were relatively less important for CE4.
- The CE4 received FDI that was largely directed to manufacturing, in particular motor vehicles and other transport equipment.
- Much of FDI to CE4 financed greenfield investments (an expansion in productive capacity and a relatively stable source of external funding).
- 2009 marked the first year in which offshored production outstripped domestic German production of passenger cars.
- Cross-border bank flows to the CE4 were less pronounced than to selected periphery (SP) countries (Greece, Italy, Portugal, Spain); CE4 foreign bank financing included a relatively larger share of local lending by resident foreign branches and subsidiaries, which is more stable and less prone to sudden reversals.
- Notable heterogeneity: Hungary had a larger share of cross-border bank flows resembling the SP pattern.

### Macroeconomic consequences and policy implications
- Business cycle synchronization:
  - The business cycles of the CE4 countries have become more synchronized with Germany; the conditional correlation of output gaps against Germany increased over time for all CE4 countries except Hungary.
  - The rise in synchronization is associated with the size of German value added embodied in CE4 exports.
- Technology transfers and structural change:
  - Participation in the GCESC led to technology transfers and accelerated income convergence in CE4.
  - Export growth in knowledge‑intensive sectors was particularly rapid and the share of these sectors in domestic value‑added exports has increased.
  - Revealed Comparative Advantage (RCA) patterns evolved in line with technology transfers: with the exception of Poland, CE4 countries largely “caught up” with Germany’s comparative advantage in knowledge‑intensive manufacturing; there has been a loss of comparative advantage in labor and capital‑intensive sectors but RCA remains greater than one in most cases (except Hungary in some categories).
- Spillovers and demand channels:
  - Much bilateral trade between Germany and the CE4 is in intermediate goods; final demand in Germany is not the main determinant of CE4 exports to Germany.
  - German domestic demand spillovers to the CE4 remain relatively small; the growth of the supply chain increased exposure of Germany and the CE4 to final demand outside Europe.
  - Spillovers from aggregate demand and policy actions in the rest of the world are now much larger than before.
- Importance of German balance sheets:
  - Balance sheet fundamentals in Germany are a key determinant of the magnitude of shock spillovers to CE4 countries and beyond.
  - Currently, sound German fundamentals act as a shock absorber; more leveraged balance sheets and greater sovereign risk in Germany would considerably magnify the regional impact of external shocks.

### Policy implications and recommendations (as emphasized by CE4 policymakers)
- Safeguard enhanced competitiveness in knowledge‑intensive sectors as unit labor cost differentials with Germany narrow.
- Continual upgrading of labor force skills is necessary for CE4 countries to remain part of the GCESC or to branch out into more specialized export production activities.

### Key empirical findings and statistics (selected)
- WIOT vs DOTS exposures (2009):
  - Germany exposure to EU (WIOT) = 48 percent; DOTS = 62 percent.
  - Germany exposure to rest of world (WIOT) = 33 percent; DOTS = 26 percent.
- Sectoral contributions to export growth (1995–2009):
  - Knowledge‑intensive contribution: Czech, Hungary, Slovakia ≈ 50–60 percent; Poland ≈ 40 percent.
- 2009: offshored production of German passenger cars surpassed domestic German production.

### Revealed Comparative Advantage (RCA) in manufacturing (selected entries from Rahman and Zhao (2013))
- Manufacturing 1995 / Manufacturing 2009 (Labor‑intensive / Capital‑intensive / Knowledge‑intensive)
  - Czech: 1.29 / 1.30 / 0.56 → 1.01 / 1.16 / 1.18
  - Hungary: 0.68 / 1.06 / 0.50 → 0.37 / 0.77 / 1.18
  - Poland: 1.95 / 1.39 / 0.59 → 1.52 / 1.39 / 0.93
  - Slovakia: 1.05 / 1.61 / 0.60 → 1.16 / 1.41 / 1.11
  - Germany: 0.64 / 1.07 / 1.48 → 0.64 / 1.20 / 1.49
  - Portugal: 3.42 / 0.94 / 0.57 → 2.08 / 1.43 / 0.60
  - Spain: 0.93 / 1.21 / 1.04 → 0.97 / 1.29 / 0.98
  - Ireland: 0.34 / 1.79 / 1.01 → 0.11 / 0.72 / 0.89
  - Greece: 1.56 / 1.26 / 0.03 → 0.33 / 0.72 / 0.20
  - China: 3.55 / 1.03 / 0.64 → 2.52 / 0.66 / 1.27

*Prepared by Shekhar Aiyar, Bartek Augustyniak, Christian Ebeke, Ehsan Ebrahimy, Selim Elekdag, Nir Klein, Subir Lall, Hongyan Zhao (all EUR) and Dirk Muir (RES); Approved by Ranjit Teja.*

### 14.      Integration into the GCESC has greatly enhanced CE4 competitiveness in knowledge-

### _cr13263 - 14.      Integration into the GCESC has greatly enhanced CE4 competitiveness in knowledge-

### C. Spillovers to Domestic Production
- Shares of domestic value added (DVA) in gross exports have broadly declined, but DVA has increased significantly in nominal terms and as a percentage of GDP.
- The increase in domestic VA was positively correlated with the increase in foreign value added (FVA).
- Rahman and Zhao (2013) find econometric evidence that causality runs from growth in FVA to DVA.
- Attracting FVA as part of vertical supply chain integration:
  - Complements rather than substitutes for domestic production.
  - Creates demand for ancillary products and services.
  - Expands the production possibility frontier and spurs employment and growth.
- Policy implication:
  - Policies to improve an economy’s attractiveness for the supply chain are unlikely to come at the expense of domestic industries and generally produce positive spillovers.

### D. Income Convergence
- Trade and supply chains may foster growth and income convergence through:
  - Productivity gains supported by investment embodying technological transfers with spillovers.
  - Financial deepening.
  - Specialization in highly productive sectors leading to economy-wide efficiency gains.
- Empirical observations:
  - CE4 economies have generally grown more rapidly than can be explained simply by initial income, suggesting GCESC membership accelerated income convergence.
  - Within a sample of European countries, CE4 (except Hungary) lie above the regression line, implying faster-than-average growth controlling for initial income.
  - A formal econometric approach allowing the beta convergence coefficient to vary with foreign VA in exports confirms the importance of the supply chain (see Background Note 1).

### Exposure to External Shocks
- A six-region version of the IMF’s Global Integrated Monetary and Fiscal (GIMF) model captures GCESC evolution and shock transmission (Background Note 3).
- Simulation of a 1 percent aggregate demand shock (private consumption and investment) originating in Germany or non-European blocks shows:
  - German domestic demand spillovers to the CE4 have increased over time but remain relatively small.
  - The CE4 is only slightly more vulnerable to domestic demand shocks in Germany in 2011 than in 1996.
  - The impact on German GDP of an aggregate demand shock originating within Germany declined substantially between 1996 and 2011.
  - Germany’s export-to-GDP ratio doubled from 24 percent to around 48 percent.
  - Because Germany is more open in 2011, it experiences more “leakage” and a lower domestic impact multiplier; spillovers are increasingly directed toward trade partners outside Europe, including emerging Asia.
- Non-European demand shocks:
  - Real GDP in both Germany and the CE4 dips below baseline by considerably more in 2011 than in 1996 due to greater openness and larger size of the “rest of the world” (especially emerging Asia).
  - A fully co-ordinated non-European fiscal action of a given magnitude (in percent of GDP) would have a much greater impact on both German and CE4 economies than a purely German fiscal action of the same magnitude.
- Note:
  - Increasing external exposure has been accompanied by concentration risk in sectors such as automobiles, which could transmit disproportionately large shocks if hit (model does not capture this).

### E. The Importance of German Balance Sheets
- Current situation:
  - Balance sheets in Germany are generally healthy with low debt-to-GDP ratios in the household, corporate and government sectors (Background Note 3).
  - Germany’s safe haven status is reflected in growing and persistent divergence in yields between Germany and other countries in the region.
- Model simulations (GIMF) under an alternative “fragile” German balance sheet scenario show:
  - The negative impact on real GDP from an aggregate demand shock is much larger when German household, corporate, and sovereign balance sheets are weaker.
  - A stronger financial accelerator amplifies the downturn via larger corporate credit spreads, higher government debt stock, and greater share of liquidity constrained households.
  - Larger economic contraction in Germany is transmitted across borders, causing more pronounced declines in real GDP in CE4 countries and the rest of the euro area, with feedback effects that further impair GCESC countries.
- Policy implication:
  - Healthy German balance sheets act as a public good, generating positive spillovers and buffering the GCESC against external shocks.

### Key Conclusions (summary of findings and policy dialogue)
- Conventional trade statistics are a poor guide to bilateral export exposures for supply chain countries:
  - Value added decomposition shows CE4 bilateral exposure to final demand in Germany is much less than implied by IMF DOT statistics; exposure to the rest of the world is much greater.
  - For Germany, exposure to European countries (including the CE4) is substantially lower, and exposure to non-European countries higher.
  - Authorities saw merit in examining consolidated external positions to net out supply chain-related intermediate goods trade.
- FDI has supported GCESC evolution:
  - Large inflows of FDI to CE4 countries; pattern differs from some European comparators where FDI was less important and portfolio inflows more so.
  - Greenfield investment comprised a much larger share of FDI than mergers and acquisitions in the CE4.
  - Much FDI was in the transport sector, consistent with offshoring of the German automobile industry.
  - Hungarian authorities noted FDI inflows were more stable during the global crisis and tended to finance production, whereas portfolio inflows had earlier fueled an unsustainable consumption boom.
  - Consensus: such FDI represented the “best” form of external financing.
- Foreign bank finance and cross-border flows:
  - On a consolidated basis, foreign bank financing in the CE4 since 1995 has been broadly comparable to SP countries, but cross-border component was much larger for SP.
  - In the CE4, local lending by foreign-owned but domestically resident subsidiaries was more pronounced and supported by local deposits.
  - Distinction between cross-border and locally-supported foreign bank financing is crucial for vulnerability assessments.
  - German bank penetration in CE4 was not commensurate with GCESC activities; Austrian banks had a “first-mover” advantage in the region.
- Technology transfer and knowledge-intensive sectors:
  - Participation in GCESC led to considerable technology transfers to CE4.
  - Export growth in knowledge-intensive sectors has been particularly rapid in CE4.
  - The sophistication of domestic VA embodied in overall exports increased rapidly.
  - With the exception of Poland, CE4 countries have largely “caught up” with Germany’s comparative advantage in knowledge-intensive manufacturing sectors.
  - Data limitations leave open whether growth represents true technology transfer/human capital development or primarily low-skilled assembly in high-tech industries; heterogeneity across firms is important.
  - Example: Skoda (Volkswagen) develops workers’ technical skills and produces relatively high value added components; other foreign-owned plants may specialize in downstream activities.
- Complementarity between FVA and DVA:
  - Increase in foreign value added in CE4 exports appears to have spurred domestic value added.
  - Supply chain activities lead to greater synchronization of business cycles among GCESC countries.
  - Production within a vertically specialized chain is not a “zero sum game”; potential employment gains from spillovers should be considered in labor market reforms and industry-labor negotiations.
- Safeguarding competitiveness in knowledge-intensive sectors:
  - With income convergence and narrowing of unit labor cost differentials with Germany, CE4 countries may struggle to sustain current supply chain roles and benefit further from vertical specialization.
  - To remain part of the GCESC or branch into more specialized export production, CE4 countries will likely need to:
    - Continue investing in human capital and upgrading labor skills to cement comparative advantage.
    - Move up the value chain, following examples in Asia, notably China.
  - Authorities agreed on the importance of gradual movement toward more sophisticated activities; German authorities noted no imminent threat to CE4 positions.
  - German business surveys show CE4 remain favored destinations for supply chain investment due to skilled labor forces and track records.
  - Policy examples and suggestions:
    - Technical training and vocational education combined with business apprenticeships (the German model) were highlighted.
    - Czech authorities cited Skoda and are considering tax breaks to companies that provide technical education.
    - Hungarian and Polish authorities pointed to skills shortages linked to ageing populations, requiring multi-dimensional policy action.

*International Monetary Fund — GERMAN-CENTRAL EUROPEAN SUPPLY CHAIN CLUSTER REPORT (excerpts from content unit _cr13263 - 14.)*

### 31.      German domestic demand spillovers to the CE4 have increased over time but remain

### German domestic demand spillovers to the CE4 have increased over time but remain

### German domestic demand spillovers and supply-chain dynamics
- German domestic demand spillovers to the CE4 have increased over time but remain relatively small.
- Explanation: the supply chain nature of trade integration means final demand in Germany is not the main determinant of CE4 exports to Germany.
- Consequence: German fiscal policies aimed at stimulating or contracting domestic demand have a relatively limited impact on CE4 economies.
- Distinction clarified in discussions:
  - Domestic demand spillovers from Germany are relatively small.
  - Demand spillovers related to the production chain are large, but originate in countries to which goods are finally exported. These production-chain spillovers can increase business cycle synchronization between Germany and the CE4.

### Openness and exposure to non-European shocks
- Because the GCESC countries have become more open, spillovers from the rest of the world are now much larger.
- In response to non-European demand shocks, real GDP in both Germany and the CE4 dips below baseline by considerably more in 2011 than in 1996.
- Indirect effects amplify downturns as intra-European economic activity slows and acts as an additional drag on growth.
- A fully co-ordinated non-European fiscal action of a given magnitude (in percent of GDP) would have a much greater impact on both the German and CE4 economies than a purely German fiscal action of the same magnitude.
- Authorities’ observations and implications:
  - Exposure to external shocks has increased substantially with the evolution of the GCESC; this is a key policy challenge going forward.
  - Small size of some CE4 countries relative to supply chain firms can magnify shocks (example: Nokia’s loss of market share after the financial crisis had a large impact on Hungary’s exports).
  - Diversification of export markets and product lines could help reduce vulnerability to external shocks.
  - Debate on exchange rate flexibility:
    - Polish, Hungarian and Czech authorities: a flexible exchange rate provides an important buffer against volatile external demand.
    - Slovak authorities: flexible exchange rates were not very helpful in 2008-09 amid collapsing external demand; a fixed exchange rate reduces currency risk within the supply chain. Slovakia has enjoyed vigorous growth in exports and GDP under the euro.

### Trade-linkage trends and magnitudes (CE4 — Germany)
- Between 1995 and 2011:
  - The CE4’s imports from Germany grew by 8½ percent of GDP (cumulative basis), with Czech Republic at 10½ percent of GDP.
  - CE4 exports to Germany increased sharply by nearly 10 percent of GDP on average.
- In 2012:
  - The CE4’s average imports from Germany: 16 percent of GDP.
  - The CE4’s average exports to Germany: 18 percent of GDP (behind only the Netherlands at 22 percent of GDP).
- Heterogeneity within CE4:
  - Poland’s GDP is about 54 percent of the CE4’s GDP.
  - Poland’s sum of overall imports and exports: 74 percent of GDP (compared to an average of 157 percent of GDP in rest of the CE4 countries).
  - For Czech Republic, Hungary, and Slovakia: imports from Germany are between 15 to 21 percent of the countries’ GDP; exports to Germany amount to 16 to 24 percent of GDP.
  - For Poland: exports and imports to/from Germany at 10-11 percent of GDP.
- Sectoral note: knowledge-intensive sectors, particularly transport and electrical equipment, account for the CE4’s largest bilateral trade with Germany; increased links in these sectors have led to technology transfer and gains in comparative advantage.

### Balance sheet fundamentals and spillover amplification
- Balance sheet fundamentals in Germany are an important determinant of the magnitude of shock spillovers to CE4 countries.
- At present, German balance sheets are generally healthy:
  - Low debt-to-GDP ratios prevail in the household, corporate and government sectors.
  - Germany is regarded by investors as a safe haven.
- Simulations indicate:
  - More leveraged balance sheets and greater sovereign risk in Germany would considerably magnify the impact of external shocks.
- Policy implication: healthy German balance sheets act as a public good—generating positive spillovers that serve as a buffer against external shocks for the whole GCESC.
- CE4 participants broadly agreed on the advantages of the supply chain being anchored by a country with strong fundamentals and low sovereign risk.

*GERMAN-CENTRAL EUROPEAN SUPPLY CHAIN—CLUSTER REPORT—FIRST BACKGROUND NOTE—TRADE LINKAGES (July 1, 2013).*

### 12.      The CE4’s high degree of integration into the supply chain reflects a host of factors.

### The CE4’s high degree of integration into the supply chain reflects a host of factors

### A. Factors underpinning CE4 integration
- Geographic proximity to Germany, cultural similarities, and high unit labor cost differentials.
- The average exchange rate-adjusted unit labor cost differential between the German manufacturing sector and that in the CE4 during 1995-2009 ranged between 35 percent (Poland) and 58 percent (Hungary).
- Similar sectoral structure across the CE4 suggests adequate labor skills to support the GCESC.
- Rahman and Zhao (2013) computed the industrial similarity index relative to Germany and showed that the CE4 countries had strong similarities with Germany even before integration into the supply chain.

### B. Shortcomings of traditional trade statistics
- Official trade statistics are measured in gross terms and include both intermediate and final goods.
- In supply chain activities where imported intermediates are re-exported after processing, export figures tend to be inflated and do not adequately reflect domestic value added (VA), which matters most for domestic employment and economic growth.
- High and positive correlation of the CE4 countries’ imports from and exports to Germany (1995-2012) illustrates these shortcomings and suggests:
  - A large part of the CE4’s exports to Germany contains German intermediates imported and processed in the CE4; and
  - The share of the CE4’s foreign VA in these products is relatively high.

### C. Decomposition methodology for gross exports into VA exports
- Analysis uses the World Input-Output Table (WIOT) annual time series for 1995-2009 for 35 sectors covering forty countries.
- Follows Hummels et al. (2001) measure of vertical specialization (import content of production for exports).
- Builds on Koopman et al. (2011) framework to decompose gross exports into five categories:
  1. Domestic VA (DVA) in final goods.
  2. DVA in intermediate goods not processed for further exports.
  3. DVA in intermediate goods processed for re-export to third countries.
  4. DVA exported to another country but returns back to the original country for exports to a third country.
  5. Foreign VA (FVA) used as input into exports.
- Components (1)-(4) measure exports created domestically; (1)-(2) are stand-alone exports; (3)-(5) indicate supply chain-related exports (upstream: (3)-(4); downstream: (5)).

### D. Evolution of domestic and foreign value added exports (1995–2009)
- Share of FVA in exports increased considerably across CE4 and Germany between 1995 and 2009.
  - Hungary’s FVA increase was 14 percentage points, bringing FVA share to 43 percent.
  - Poland registered the smallest increase in FVA and continues to maintain a relatively high share of domestic value exports.
  - German VA in the CE4’s exports increased by about 2 percentage points (except Hungary at 4 percentage points).
- Supply chain integration led to:
  - Higher intermediates from other countries (“other countries’ VA”); and
  - Increased intermediates exported by the CE4 to Germany for further processing.

- Table: Intermediates embodied in CE4 exports (Percent of total CE4’s exports) — calculation includes only domestic VA
  - Intermediates from DEU embodied in the CE4’s exports:
    - CZE: 1995 = 8.45; 2009 = 9.75
    - HUN: 1995 = 5.31; 2009 = 8.52
    - POL: 1995 = 4.08; 2009 = 6.07
    - SVK: 1995 = 4.63; 2009 = 7.20
  - Intermediates from CE4 embodied in DEU’s exports:
    - CZE: 1995 = 5.53; 2009 = 5.82
    - HUN: 1995 = 3.09; 2009 = 3.77
    - POL: 1995 = 5.77; 2009 = 5.59
    - SVK: 1995 = 3.68; 2009 = 4.20

- Secular decline in the share of DVA in gross exports with timing:
  - Majority of decline occurred during 1995-2002.
  - During 2003-2008 contraction was moderate until a trough in 2008.
  - In 2009, DVA share increased by about 4-5 percentage points on average, consistent with a shortening of value chains during 2008-09.

- Despite falling shares, nominal DVA and DVA as a percentage of GDP increased between 1995-2009:
  - Increases in domestic VA (percentage points of GDP): Hungary = 14; Germany = 10½; Poland = 8; Czech Rep. = 5½; Slovakia = 1.
  - Increase in domestic VA was positively correlated with increase in FVA; econometric evidence (Rahman and Zhao, 2013) suggests causality runs from growth in FVA to DVA (FVA complements, not substitutes, domestic VA).

- CE4 prominence in German VA:
  - CE4 countries are the only group among European countries recording a significant increase in German VA as a share of total exports between 1995 and 2009.

### E. Sectoral patterns and knowledge-intensive manufacturing
- Knowledge-intensive sectors (transport and electrical equipment, machinery and chemicals) made the largest contribution to export growth, 1995-2009:
  - In Czech Rep., Hungary, and Slovakia these sectors contributed about 50-60 percent of total exports growth.
  - In Poland they contributed about 40 percent of total exports growth.
  - Knowledge-intensive sectors account for about 30-40 percent share in countries’ domestic VA exports.
- Knowledge-intensive sectors show cumulative increases in both DVA and FVA since 1995, with a strong positive correlation between the two:
  - Hungary recorded the sharpest increase in both domestic and foreign VA (the latter largely reflecting German VA).
  - Czech Rep. and Slovakia also registered considerable increases.
  - Poland and Germany registered more moderate increases, reflecting larger GDP sizes.

### F. Export exposure based on recipients’ final demand (WIOT vs DOTS)
- Exposure measured by recipients’ final demand (WIOT) differs from proximate demand (DOTS) in supply chain contexts.
- Germany’s exposure to the EU:
  - WIOT = 48 percent; DOTS = 62 percent.
  - Germany’s exposure to the rest of the world: WIOT = 33 percent; DOTS = 26 percent.
  - Interpretation: Germany exports intermediates that are further processed in downstream EU facilities (including the CE4) and then re-exported outside the EU.
- CE4 exposure to Germany:
  - Under WIOT, CE4 exposure to Germany is significantly lower than implied by DOTS, indicating CE4 exports often pass through Germany before onward export outside the EU.
  - Under WIOT, CE4 exposure to the rest of the world is significantly higher than under DOTS.
- Implication: DOTS figures can misrepresent countries’ exposure to trading partners’ final demand in presence of vertical specialization; this affects calibration of economic models assessing vulnerabilities to external demand shocks.

### G. Box: The Automobile Industry (CE4 and German supply chain)
- Germany’s passenger car global market share: around 20 percent as of 2012.
- Offshore production in the CE4 became significant; 2009 marked the first year foreign production overtook domestic production.
- Domestic German production remained relatively constant at around 5.5 million vehicles per year between 1992 and 2011.
- Foreign production increased more than threefold in the same period, reaching 7.1 million.
- CE4 shift began mid-1990s; drivers included geographic proximity, relatively low unit labor costs, favorable tax environment, and a highly qualified workforce with automotive expertise.
- Corporate income tax rate in 2011: 19 percent in all CE-4 countries compared with 29 percent in Germany.
- CE4 automotive outcomes:
  - FDI inflows into the sector increased markedly from the mid-1990s; vehicle production peaked at nearly 3 million in 2012.
  - Automotive sector accounted for over half of the cumulative increase in exports since 1995 in all CE4 countries except Hungary (still a very substantial contribution).
  - Employment in the automotive sector increased somewhat; sector’s capital- and knowledge-intensive nature limited its overall direct employment impact.

*Source: IMF staff calculations based on the WIOT; Koopman et al. (2011); Rahman and Zhao (2013); Hummels et al. (2001).*

### Box 1.The Automobile Industry (Concluded)

### Box 1.The Automobile Industry (Concluded)

### Automotive Sector: Some Stylized Facts
- 2012 Passenger Car Production in multiple of 1999 level; Employment (ratio to manufacturing employment, 2010); Share in Total Exports (2011); Contribution to Exports Growth Since 1995* (percent):
  - Czech Rep.  3.4 11.7 17.1 50.7
  - Hungary  1.7 9.9 8.7 32.2
  - Poland  1.2 6.9 12.7 53.7
  - Slovakia  7.1 11.3 21.5 53.4
  - Germany  1.1 11.8 17.4 10.1
- *Change in automobile exports between 1995-2011 relative to the 1995 total export level.
- Decomposition findings:
  - The share of German value added (VA) in total exports increased in all the CE4 countries between 1995 and 2009.
  - The share of domestic VA declined by about 12 percentage points (on average) between 1995 and 2009.
  - Despite the declining share of domestic VA in total exports, the automobile industry registered a significant increase in domestic VA in percent of GDP.
  - Domestic VA increase exhibits a positive and strong correlation with the increase in foreign VA in this sector.

### A. Technology Transfer
- Integration into the supply chain, particularly in knowledge-intensive sectors, enabled CE4 countries to enhance:
  - the technology content of their exports, and
  - the sophistication of domestic VA embodied in overall exports.
- Mechanism: German firms provided technology and know-how to ensure high-quality components (Jabbour and Mucchielli, 2007; Pack and Saggi, 2001).
- Use of Revealed Comparative Advantage (RCA) calculated on domestic VA (Rahman and Zhao, 2013) to assess competitiveness and technology transfer.
- Table 2 (RCA in Manufacturing) — RCA values for 1995 and 2009 by sector group:
  - Manufacturing 1995 / Manufacturing 2009
  - Labor-intensive / Capital-intensive / Knowledge-intensive  |  Labor-intensive / Capital-intensive / Knowledge-intensive
  - Czech                      1.29                      1.30                      0.56  1.01 1.16                      1.18
  - Hungary 0.68 1.06 0.50  0.37 0.77 1.18
  - Poland 1.95 1.39 0.59  1.52 1.39 0.93
  - Slovakia 1.05 1.61 0.60  1.16 1.41 1.11
  - Germany 0.64 1.07 1.48  0.64 1.20 1.49
  - Portugal 3.42 0.94 0.57  2.08 1.43 0.60
  - Spain 0.93 1.21 1.04  0.97 1.29 0.98
  - Ireland 0.34 1.79 1.01  0.11 0.72 0.89
  - Greece 1.56 1.26 0.03  0.33 0.72 0.20
  - China 3.55 1.03 0.64  2.52 0.66 1.27
- Key findings from RCA and sectoral analysis:
  - With the exception of Poland, CE4 countries have largely “caught up” with Germany’s comparative advantage in knowledge-intensive manufacturing sectors.
  - There has been concomitant loss of comparative advantage in labor- and capital-intensive sectors, though the RCA index often remains greater than one (except in Hungary).
  - Trends differ from selected periphery (SP) euro-zone countries: Ireland and Spain lost comparative advantage in knowledge-intensive sectors; Greece and Portugal retain comparative disadvantage.
- Forward-looking challenge and policy implication:
  - Progressing income convergence and narrowing unit labor cost differentials with Germany may make it harder for CE4 to sustain current role in the GCESC.
  - Recommendation: Continue investing in human capital and maintain high-skilled labor to cement comparative advantage and potentially develop upstream supply chains in the CEE region (following the Chinese example).

### B. Business Cycles Synchronization
- Empirical observations:
  - Conditional correlations of CE4 output gaps with Germany’s output gap increased when comparing 2001Q1-2006Q4 with 1995Q1-2000Q4, correlated with the size of German VA embodied in countries’ exports.
  - For other CEE countries, output synchronization seems to have diminished over time.
  - Including the crisis period shows an increase in bilateral correlations of CE4 output gaps with Germany’s output gap, though the relationship weakens somewhat.
- Empirical strategy and measures:
  - Synchronization measured via: rolling correlation of real output growth (7-year window); rolling correlation of output gaps; Local Gaussian Weighted OLS (LGWOLS) for time-varying co-movements.
  - Models exploit exports’ decomposition into domestic and foreign VA, and control for bilateral correlates including bilateral FDI and bank flows from Germany.
- Estimation results and interpretation:
  - Higher vertical trade integration with Germany contributes to closer business cycle co-movement (Table 1A in Annex 4); result robust across synchronization measures and after addressing endogeneity.
  - The marginal effect of vertical supply chain links with Germany is stronger for CE4 than for euro-zone and other sample countries.
  - Downstream links (share of foreign VA embodied in countries’ exports) are statistically significant; upstream/downstream separation found downstream link significant.
  - Bilateral FDI flows are not significant; bank flows are negatively associated with business cycle co-movement, suggesting financial integration can amplify differences in business cycles.

### C. Income Convergence
- Theoretical channels by which trade and supply chains can foster growth and convergence:
  - Productivity gains via investment embodying technological transfers with spillovers.
  - Financial deepening and economic diversification.
  - Specialization in highly productive sectors generating efficiency gains.
  - Empirical literature (Saito et al., 2013) finds output growth associated with greater exporting and importing of VA; higher VA exports relative to GDP associated with higher growth.
- Stylized evidence:
  - Income convergence in Europe is evident; CE4 countries (apart from Hungary) lie broadly above the regression line in Figure 14, implying faster growth than average controlling for initial income—potentially reflecting rapid increase in VA in knowledge-intensive activities.
  - Figure 14: y =  -7E-07x + 0.0374; R² = 0.28 (bubble size proportional to share of German foreign VA embodied in countries' exports as percentage of GDP in 2009).
- Formal empirical estimation (cross-sectional growth equation; Annex 5):
  - Results (Table 2A in Annex): statistically significant income convergence in the sample (coefficient on initial real per capita income is negative and significant).
  - Interaction: quicker convergence speed for countries with strong vertical trade linkages (coefficient on interaction between initial income and foreign VA in exports is negative and significant).
  - Share of foreign VA in countries’ exports (as share of GDP) has a positive and significant effect on average GDP growth.
  - Interpretation: positive contribution of foreign VA (FVA) to growth in recipient countries decreases with the level of economic development (proxied by initial per capita income).
  - Results robust to IV estimation accounting for endogeneity of foreign VA.
  - Tests: joint significance tests do not reject non-linearity; identification tests indicate the selected instrumental variable is strongly correlated with endogenous foreign VA variables.

### Concluding Remarks
- Trade linkages between Germany and the CE4 strengthened significantly since the mid-1990s, exceeding linkages with other countries, including within the CEE region.
- Drivers: German firms relocated parts of production to CE4 to exploit proximity to Germany, cultural similarities, and a low-cost but highly skilled labor force.
- Sectoral concentration: integration has increased prominently in knowledge-intensive sectors, particularly the automotive industry, which was a major contributor to CE4 export growth.
- Export decomposition into domestic and foreign VA:
  - Foreign VA’s share in total exports increased significantly, reflecting CE4 integration into the GCESC.
  - Domestic VA increased dramatically in nominal terms and as percent of GDP, showing a strong and positive link with change in foreign VA—indicating complementarity rather than substitution.
  - Supporting evidence: Rahman and Zhao (2013) find higher foreign VA contributes to higher domestic VA.
- Role of the GCESC in intra-EU trade:
  - Final-demand-based export exposure shows GCESC strongly present in EU trade.
  - Germany’s exposure to the EU is significantly below implied exposure under conventional direction-of-trade statistics, while its exposure to the rest of the world is much higher.
  - Implication: a large part of Germany’s trade with the EU consists of intermediates processed in downstream economies and re-exported outside the EU.

*Source: Box 1.The Automobile Industry (Concluded), TRADE LINKAGES, INTERNATIONAL MONETARY FUND*

### 44.      The GCESC has brought new opportunities and challenges for the CE4. The analysis

### _cr13263 - 44.      The GCESC has brought new opportunities and challenges for the CE4. The analysis

### GCESC impacts on the CE4
- Rapidly gained comparative advantage in knowledge-intensive manufacturing sectors, suggesting a considerable technology transfer.
- Contributed to rapid export and GDP growth to date.
- Risks and challenges:
  - Narrowing unit labor cost differentials could undermine the CE4’s competitive position.
  - Other CEE countries have made substantial progress in removing impediments to trade and becoming more attractive as potential members of the supply chain.
- Macroeconomic linkages:
  - Integration into the GCESC has fostered higher business cycle co-movement with Germany over time.
  - The GCESC has increased exposure of member countries to the rest of the world, implying that the efficacy of domestic policies aimed at stabilizing economic activity may have weakened.
  - The GCESC is anchored by Germany—a country with strong balance sheets and safe haven status—which could act as a source of stability in the face of external shocks (some evidence provided by background paper #3).

### Trade linkages and literature context
- References and prior findings summarized (selected):
  - Balassa 1965: “Trade Liberalization and ‘Revealed’ Comparative Advantage”.
  - Hummels, Rapoport, and Yi 1998; Hummels, Ishiib, and Yi 2001: studies on vertical specialization and the changing nature of world trade.
  - Koopman, Wang, and Wei 2008; Koopman, Powers, Wang and Wei 2013: tracing value-added in global production chains.
  - Timmer et al. 2012: The World Input‐Output Database (WIOD), Contents, Sources and Methods.
  - Feenstra and Hanson 1996/1997: Foreign investment, outsourcing and relative wages.
  - Di Giovanni and Levchenko 2010; Kose and Yi 2001: trade, vertical linkages, and business cycle comovement.
- Empirical and theoretical contributions noted across the literature include vertical specialization, technology transfer via supply links, and the link between trade integration and business cycle synchronization.

### Annex 1 — The World Input-Output Table (WIOT) used in the study
- Database coverage and period:
  - Covers 27 EU countries and 13 other major countries in the world for the period 1995 to2009.
  - The 40 countries included cover more than 85 percent of world GDP.
- Constructional differences and data sources:
  - WIOT relies on national supply and use tables (SUTs) rather than input-output tables as basic building blocks.
  - Uses national SUTs, National Accounts time series data for industry output and final use, and bilateral international trade data in goods and services.
- Construction steps:
  1. Time-consistent output and final consumption series in national accounts used to benchmark national SUTs to ensure meaningful analysis over time.
  2. National SUTs combined with international trade statistics to construct international SUTs, splitting product use between domestically produced and imported.
  3. International SUTs for each country combined into a world input-output table.
- Services trade:
  - No standardized database on bilateral services flows; collected from various sources (including OECD, Eurostat, IMF and WTO), checked for consistency and integrated into a bilateral service trade database reported at Balance of Payments codes.
- Rest of the World (RoW) treatment:
  - A region called the Rest of the World (RoW) proxies for other countries; production and consumption in RoW modeled based on totals from the UN National Accounts, assuming an input-output structure equal to that of an average developing country.
  - Imports from RoW are given as share of imports from RoW from trade data applied to imports in the supply table; exports to RoW defined residually and additional constraints added when negative exports resulted.
- Notes on SUT availability:
  - SUTs typically available for a limited set of years; benchmarking on consistent National Accounting System time series links tables over time meaningfully.

### Annex 2 — Decomposition methodology (Koopman et al. framework)
- Framework scope:
  - m-country world, each country produces goods in n differentiated tradable sectors; modeled as an Inter-Country Input-Output system with block partitioned matrices.
- Key matrices and vectors (conceptual):
  - X_i: n×1 gross output vector of country i.
  - F_ij (denoted ܻ_{ij} in source): n×1 final demand vector showing demand in country j for final goods produced in country i.
  - A_ij (denoted ܣ_{ij}): n×n IO coefficient matrix giving intermediate use in country j of goods produced in country i.
  - Leontief inverse blocks (denoted ܤ_{ij}) give the amount of gross output produced in country i required for a one-unit increase in final demand in country j.
- Downstream tracing of exports:
  - Gross exports from i to j (denoted ܧ_{ij}) decomposed into final goods and intermediates and subdivided into processed-and-consumed, processed-and-re-exported, and processed-and-exported-back components (equation (3) in source).
- Value-added (VA) decomposition:
  - Direct VA coefficient vector for country i: (denoted ܸ_i) equals one minus the intermediate input share from all countries: ܸ_i = u - Σ A_{·i} (equation (4) in source, where u is a 1×n unity vector).
  - Domestic VA and foreign VA in total exports:
    - Total exports from i: ܧ_{i*} = Σ_j ܧ_{ij}.
    - Gross exports divided into domestic VA (DVA, denoted ܸ_{V}) and foreign VA (FVA, denoted ܸ_{F}): equation (5).
    - Expressions for ܸ_{F} and ܸ_{V} given in equations (6) and (7) of the source:
      - ܸ_{F} = Σ_j ܸ_j ܤ_{j i} ܧ_{i*}
      - ܸ_{V} = ܸ_i ܤ_{ii} ܧ_{i*}
- Five VA categories in gross exports (from combined downstream and VA decomposition, equation (8)):
  - (A) Domestic VA in the form of final goods and services consumed by the direct importer.
  - (B) Domestic VA in the form of intermediate inputs used by the direct importer to produce its domestically consumed products.
  - (C) Domestic VA in the form of intermediate exports used by the direct importer to produce goods for third countries.
  - (D) Domestic VA in the form of intermediate exports used by the direct importer to produce goods shipped back to source country.
  - (E) VA by foreign countries embodied in country i’s gross exports (foreign VA).
- Formal matrix of VA-by-source in gross exports (VAS_E):
  - Elements of VAS_E provide VA by source in gross exports between each country pair; diagonal elements correspond to domestic VA in each country’s exports; off-diagonals give foreign VA embodied in each country’s exports.
- Participation measures:
  - Downstream Participation (DP): sum of off-diagonal elements along a column equals VA from foreign sources embodied in a country’s gross exports (denoted ܲܦ_{i}).
  - Upstream Participation (UP): sum of off-diagonal elements along a row equals a country’s VA embodied as intermediate inputs in all other countries’ gross exports (denoted ܷܲ_{i}).

*Source: _cr13263 - 44.      The GCESC has brought new opportunities and challenges for the CE4. The analysis*

### Annex 3. Classification of Me

### Annex 3. Classification of Merchandise and Services Exports

### Categories and sector mapping
- Sector 1: Agriculture, Hunting, Forestry and Fishing
- Sector 2: Mining and Quarrying
- Sector 3: Textiles and Textile Products
- Sector 4: Leather, Leather and Footwear
- Sector 5: Wood and Products of Wood and Cork
- Sector 6: Manufacturing, Nec; Recycling
- Sector 7: Food, Beverages and Tobacco
- Sector 8: Pulp, Paper, Paper , Printing and Publishing
- Sector 9: Coke, Refined Petroleum and Nuclear Fuel
- Sector 10: Rubber and Plastics
- Sector 11: Other Non-Metallic Mineral
- Sector 12: Basic Metals and Fabricated Metal
- Sector 13: Chemicals and Chemical Products
- Sector 14: Machinery, Nec
- Sector 15: Electrical and Optical Equipment
- Sector 16: Transport Equipment
- Sector 17: Construction
- Sector 18: Sale, Maintenance and Repair of Motor Vehicles and Motorcycles; Retail Sale of Fuel
- Sector 19: Wholesale Trade and Commission Trade, Except of Motor Vehicles and Motorcycles
- Sector 20: Retail Trade, Except of Motor Vehicles and Motorcycles; Repair of Household Goods
- Sector 21: Hotels and Restaurants
- Sector 22: Other Supporting and Auxiliary Transport Activities; Activities of Travel Agencies
- Sector 23: Private Households with Employed Persons
- Sector 24: Electricity, Gas and Water Supply
- Sector 25: Inland Transport
- Sector 26: Water Transport
- Sector 27: Air Transport
- Sector 28: Post and Telecommunications
- Sector 29: Real Estate Activities
- Sector 30: Financial Intermediation
- Sector 31: Renting of M&Eq and Other Business Activities
- Sector 32: Public Admin and Defence; Compulsory Social Security
- Sector 33: Education
- Sector 34: Health and Social Work
- Sector 35: Other Community, Social and Personal Services

### Aggregation into sectoral groups (as used in the analysis)
- Primary and Natural resources: 28,30
- labor-intensive manufacturing: 1,2
- capital-intensive manufacturing: 4,5,6,16
- knowledge-intensive manufacturing: 3,7,8,10,11,12
- labor-intensive service: 18,19,20,21,22,26,35
- capital-intensive service: 17,23,24,25,27,29
- knowledge-intensive service: 31,32,33,34
- health/education/public service: 9,13,14,15

*International Monetary Fund — Annex 3. Classification of Merchandise and Services Exports*

### 12.      The pattern of German claims on the CE4 and the SP is broadly similar to the global

### 12.      The pattern of German claims on the CE4 and the SP is broadly similar to the global exposures, but with some notable nuances

### Overview
- Germany has sizeable claims on the CE4 and on the SP.
- CE4 FDI stocks from Germany are substantially larger relative to the SP.
- Germany’s portfolio claims on the SP are much larger relative to those on the CE4.
- Other Central and Eastern European countries (OCEE) display patterns closer to the CE4, but with stock positions around one third of the levels discussed for the CE4.

### A. The Evolution of FDI Stock Positions
- FDI stock positions as a percent of GDP in the CE4 are nearly twice as large as those in the SP.
  - CE4 FDI stocks peaked in 2009 amounting to 54 percent of GDP.
- Despite the global financial crisis of 2008-09, the stock of FDI was relatively stable.
- FDI is decomposed into three components:
  - (i) Equity capital (purchase of shares of an enterprise in a foreign country, with a 10 percent participation threshold)
  - (ii) Reinvested earnings (the part of an affiliate’s earnings accruing to the foreign investor that is reinvested in that enterprise)
  - (iii) Intra-company loans (short- or long-term borrowing and lending of funds between direct investors—parent enterprises—and affiliate enterprises)
- The stock of intra-company loans and reinvested earnings (as a percent of GDP) is larger in the CE4 than in the SP, reflecting more stable ongoing relationships.
- CE4 FDI stocks are characterized by a larger share of greenfield investments:
  - Greenfield investment is associated with expansion in productive capacity and is a more stable source of funding, less prone to sudden reversals.
- Sectoral allocation:
  - A larger share of CE4 FDI was channeled to manufacturing sectors central to the GCESC, notably motor vehicles and other transport equipment.
  - As a share of total FDI, the stock of inward FDI channeled toward motor vehicles and other transport equipment hovered around 2½ percent for the SP, while the average over 2005–10 was around 7 percent for the CE4.
- Implication: FDI flows promoted financial resilience and fostered technology transfers, innovation, competition, efficiency, employment, and overall economic growth.

### B. The Evolution of Bank Claims
- As a share of GDP, post-1999 patterns of bank claims across the CE4 and the SP are broadly similar, though levels differ:
  - Bank claims (consolidated BIS statistics) peak at around 71 percent for the CE4 and 62 percent for the SP.
- In 2011:
  - CE4 bank claims hovered around 60 percent of GDP.
  - SP bank claims declined markedly and settled at half of the pre-crisis peak.
- Cross-border bank claims (BIS locational statistics) show:
  - A sharp upward trend in cross-border claims on the SP with a pre-crisis peak of 70 percent in 2007.
  - CE4 cross-border claims were quite stable as a share of GDP throughout 2007-2012.
  - For the SP, there is evidence of abrupt deleveraging: stocks in 2012 were around half of the 2007 levels.
- Cross-border banking claims are identified as the least stable form of external financing; sharp reversals in these flows are associated with slower growth and financial instability.
- Differences within the CE4:
  - Hungary had a much larger share of cross-border bank flows (pattern more closely resembling the SP).
  - Poland, as the largest member of the CE4, accounts for over 50 percent of CE4 GDP; scaled-by-GDP statistics can understate Poland’s dollar-denominated position.

### C. German FDI Facilitated Beneficial Medium-Term Spillovers to the CE4
- Summary of key findings (Figure 11 synthesis):
  - Outstanding portfolio stock positions in the SP (both globally and from Germany).
  - FDI stocks are larger in the CE4, consistent with the GCESC relationship.
  - While banking claims are broadly similar overall, cross-border banking claim differences between CE4 and SP are significant.
  - After the global financial crisis, FDI stock increased across regions, portfolio positions decreased (especially for the SP), and bank claims displayed a pronounced decline for the SP.
- Interpretation:
  - Financial integration between the CE4 and Germany evolved more durably owing to the predominance of FDI associated with the GCESC.
  - Both global and German FDI exposures were larger in the CE4 and were directed to manufacturing—particularly motor vehicles and other transport equipment—and included a substantial share of greenfield investments.
  - The SP attracted a greater share of portfolio and cross-border banking flows, which exacerbated overheating pressures and were more prone to abrupt reversals.
  - In general, FDI flows promoted durable growth in the CE4, while non-FDI flows contributed to macroeconomic and financial imbalances across the SP.

### CE4 Internal Differences and Panel Evidence
- Figure 12 snapshot notes:
  - Poland shows lower stocks as a share of GDP due to scale (Poland accounts for over 50 percent of CE4 GDP).
  - Hungary has the largest FDI position as a share of GDP, the greatest share stock of portfolio investment, and sizeable banking claims relative to the other CE4 countries.
- OCEE (Bulgaria, Croatia, Estonia, Latvia, Lithuania, Romania, Slovenia, and the Ukraine) display patterns closer to the CE4 but with lower stock positions (around one third of CE4 levels, as noted earlier).

### Concluding Remarks and Key Conclusions
- Two key results:
  - The stock of FDI in the CE4 as a share of GDP—particularly from Germany—is substantially greater than in the SP, with a larger share directed toward greenfield investments and toward manufacturing, especially motor vehicles and other transport equipment.
  - Foreign bank financing played a substantial role in the CE4, but cross-border bank flows were less pronounced than in the SP; cross-border bank lending is unstable and reverse sharply in crises.
- Overall assessment:
  - German FDI helped transmit beneficial medium-term spillovers to the CE4, providing funding and technology transfers that supported the development of the GCESC and durable longer-term growth.
- Supporting evidence cited: the faster pace of income convergence in the CE4 associated with rapid expansion of exports from knowledge-intensive sectors (Augustyniak and others, 2013a).

*Source: _cr13263 - 12. The pattern of German claims on the CE4 and the SP is broadly similar to the global exposures (IMF chapter text).*

### INTRODUCTION

### INTRODUCTION

### Overview of the German-Central European Supply Chain (GCESC) and paper objectives
- A dynamic supply chain has developed between Germany and the Czech Republic, Hungary, Poland, and Slovakia (hereafter, the CE4), referred to as the German-Central European Supply Chain (GCESC).
- Motivating questions:
  - How has deeper supply chain integration affected the nature of spillovers over time from global and regional shocks? What role is there for policies?
  - Do German fundamentals—its central position in the supply chain, safe haven status, and robust balance sheets—act as an anchor of stability that helps the region better cope with external shocks?
- Approach: Quantitative, model-based simulations using the IMF’s GIMF model (a multi-country DSGE model).

### Model and methodology
- Model: IMF’s GIMF (Global Integrated Monetary and Fiscal model), a multi-region dynamic stochastic general equilibrium (DSGE) model with optimizing agents.
- Key model features:
  - Households with finite planning horizons; some households are liquidity constrained (non-Ricardian features).
  - Firms are domestically owned, employ capital and labor, and produce tradable and nontradable intermediate goods.
  - Includes a financial sector a la Bernanke, Gertler and Gilchrist (1999) with a procyclical financial accelerator: the cost of external finance facing firms rises with indebtedness.
  - Fiscal and monetary policies matter because of finite horizons, liquidity constraints, and other frictions. Government debt is held domestically as nominal, non-contingent, one-period domestic currency bonds; only U.S. dollar one-period bonds are traded internationally.
  - An annual version of the model is used.
- Simulations: Counterfactual experiments tracing transmission of global and regional shocks on real GDP under alternative calibrations.

### Calibration and trade-link representation
- Six-region version of GIMF:
  - (i) Germany
  - (ii) CE4 (the Czech Republic, Hungary, Poland, and Slovakia)
  - (iii) the euro area excluding Germany
  - (iv) the United States
  - (v) an emerging Asia block
  - (vi) the rest of the world
- Trade structure: Each region exports and imports final (consumption and investment) and intermediate goods; model calibrated to capture changing trade ties across the GCESC.
- Trade openness changes highlighted:
  - Exports as a share of GDP rose in Germany and in the CE4 between 1996 and 2011.
  - Exports to each other increased dramatically; intermediate exports across the GCESC increased substantially.
  - Implication: The growth in intra-supply chain trade in intermediate goods implies final demand in Germany is not necessarily the main determinant of CE4 exports to Germany.

### Counterfactual calibration to assess German fundamentals
- Alternative calibration simulates Germany with more fragile balance sheets to gauge implicit stabilization benefits of strong German fundamentals:
  - Households calibrated to be more liquidity constrained.
  - Corporates more leveraged (strengthening the financial accelerator).
  - Government more indebted.
  - Loss of Germany’s safe haven status is assumed, implying higher sovereign yields and higher corporate borrowing costs.

### Key simulations and shock definitions
- Aggregate demand shock: 1 percent aggregate demand (private consumption and investment) shock originating in either Germany or the non-European blocks (Emerging Asia, the U.S., and remaining countries). Simulated under trade matrices calibrated to 1996 and 2011.
- Fiscal stimulus shock: A debt-financed two-year 1 percentage point increase in government consumption in Germany (stimulating domestic demand); treated as another form of aggregate demand shock.

### Main quantitative findings and interpretations
- Domestic impact of aggregate demand shocks:
  - An aggregate demand shock of similar magnitude yields a smaller contraction in German output in 2011 relative to 1996. One factor: German export-to-GDP ratio rose to around 48 percent from 24 percent (Table 1), increasing leakage and lowering the impact multiplier.
  - In 2011, depreciation of the real effective exchange rate and a larger net export response help stabilize GDP more than in 1996.
- Spillovers from Germany to CE4 and rest of euro area:
  - German spillovers to the CE4 have increased over time but remain relatively limited. Reason: much of the increased intra-supply chain trade occurs through intermediate goods, so German final demand is not necessarily the main determinant of CE4 exports to Germany.
  - German spillovers to the rest of the euro area remain negligible and have not changed materially over time because (i) trade between Germany and the rest of the euro area did not increase as much as within the GCESC, and (ii) the rest of the euro area is much larger, so a German shock is smaller as a share of their GDP.
- Exposure to global shocks:
  - Germany and the CE4 are more exposed to global shocks in 2011 than in 1996 because both have become more open and more integrated with each other and the world.
  - Non-European (rest of world) demand shocks generate larger downturns in Germany and the CE4 in 2011 than in 1996; indirect intra-European slowdown compounds the decline.
  - For 2011, spillovers to the CE4 from the rest of the world are greater than those from Germany. Reasons:
    - Germany accounts for five percent of global GDP in 2011, while the rest of the world makes up about 80 percent of worldwide output.
    - Increased openness makes these economies more sensitive to global business cycle fluctuations.
    - A greater share of CE4 exports depends on final demand in the rest of the world relative to Germany because of increased trade in intermediate goods.
- Role of German fundamentals:
  - Germany plays the role of a regional anchor of stability by better absorbing shocks from other trading partners instead of amplifying their transmission across the GCESC, owing to strong fundamentals—including sound balance sheets and safe haven status.
- Importance of balance sheets:
  - Weaker balance sheets magnify domestic impacts of shocks and amplify cross-border spillovers through a stronger financial accelerator. Strengthening household, corporate, and sovereign balance sheets is important domestically and for trading partners—especially those with tighter trade links due to supply chain arrangements.

### Policy implications emphasized
- German fiscal stimulus is likely to have a relatively small impact on the CE4—and more broadly, on the rest of the euro area. Although German spillovers to the CE4 (including fiscal-related spillovers) have increased over time, they remain limited because of the supply chain nature of trade integration.
- Strengthening domestic balance sheets (household, corporate, sovereign) reduces the amplification of shocks domestically and abroad and is thus a priority for both countries and their trading partners.

*Source: INTRODUCTION (IMF staff calculations).*

### 23.      The growth impact of a domestic fiscal stimulus has changed over time. While an

### _cr13263 - 23.      The growth impact of a domestic fiscal stimulus has changed over time. While an

### Fiscal stimulus: changing domestic impact and limited spillovers
- Findings on domestic impact of government consumption shocks:
  - In 1996, an increase in domestic government consumption used to raise real GDP above baseline by about 1.3 percent.
  - In 2011, the impact declined to a deviation from baseline of around 0.7 percent.
  - Reason: increased openness of the German economy leads to a greater degree of leakage.
- Findings on cross-border fiscal spillovers from Germany:
  - German fiscal stimulus is associated with small spillovers to the CE4 and the rest of the euro area.
  - Simulations (Figure 3) suggest the maximum impact on CE4 real GDP deviation from baseline is about 0.13 percent in 1996 and 0.16 percent in 2011.
  - Explanation: supply chain nature of regional trade integration means final demand in Germany is not the main determinant of CE4 exports to Germany.
- Policy implication:
  - Limited fiscal spillovers imply that fiscal stimulus in Germany is likely to have a relatively small impact on the CE4—and more broadly, to the rest of the euro area.
- Interaction with global fiscal stimulus:
  - Members of GCESC, being more open, are more sensitive to a concerted global fiscal stimulus (a simultaneous increase in government spending by the non-European regions).

### Financial shocks and the financial accelerator
- Nature of the shock and transmission:
  - Considered shock: a 100 basis point exogenous increase in the corporate external finance (risk) premium.
  - Higher spreads contract aggregate demand by raising borrowing rates, increasing opportunity cost of investment, and suppressing capital expenditures.
  - Weaker activity impairs corporate balance sheets, increasing risk profiles and triggering endogenous increases in the external finance premium.
- Dynamics and persistence:
  - Effects on GDP are more protracted relative to aggregate demand shocks because adjustment requires corporate deleveraging and balance sheet repair.
  - Weaker corporate balance sheets (for example, higher debt ratios) can amplify shocks by an even greater extent and for much longer, so even seemingly small shocks can disproportionately contract output.

### German balance sheets and the “anchor of stability” role
- Assessment of German fundamentals:
  - German non-financial corporate sector and especially households appear robust by debt-to-GDP measures.
  - Germany’s safe haven status supports relative soundness of its public sector balance sheet.
  - While the debt-to-GDP ratio in Germany increased after the global financial crisis, currently it is still lower than other large European economies.
  - The growing and persistent divergence in sovereign spreads between Germany and other economies in the region is roughly around 500 basis points; this is associated with steep uptrends in household and corporate lending spreads in some large economies and drags on consumption and investment growth.
- Illustrative fragile-Germany scenario (alternative calibration):
  - Sovereign debt-to-GDP ratio increased by 30 percentage points to match indebtedness of large European economies.
  - Corporate leverage ratios increased to match higher levels prevailing in the region.
  - Share of liquidity constrained households raised to replicate economies with less efficient capital markets.
  - Loss of Germany’s safe haven status assumed, implying higher sovereign yields and an attendant increase in corporate borrowing rates.
  - Corporate spreads assumed to increase by about 350 basis points, of which 150 basis points is transitory and 200 basis points more persistent owing to a structurally different economy (no longer a safe haven).
- Simulation results:
  - Germany with more fragile balance sheets experiences a much larger negative real GDP impact from a domestic aggregate demand shock, due to a stronger financial accelerator mechanism and compounded higher yields and leverage.
  - The larger German contraction is transmitted across borders, producing more pronounced declines in real GDP in the CE4 and the rest of the euro area; these wider slowdowns feed back to GCESC countries.
  - Quantitative context provided in text:
    - The German economy is about 30 percent greater than the second largest economy in the euro area.
    - Germany’s openness is around 98 percent (exports plus imports as a percent of GDP).
    - The average ratio for the next three largest economies (France, Italy, and Spain) is around 60 percent.
- Robustness:
  - Alternative calibrations reduce the degree of fragility (for example, temporary increase in corporate spreads of 100 basis points rather than 150 basis points) but the qualitative message remains: weaker balance sheets compromise resilience.

### Summary conclusions and policy-relevant implications
- Core findings:
  - Spillovers from Germany to the CE4 have increased over time reflecting evolving trade linkages (including GCESC), but remain quite small.
  - Limited fiscal spillovers reflect supply chain trade integration: final demand in Germany is not necessarily the main determinant of CE4 exports to Germany.
  - Germany acts as a regional anchor of stability owing to sound balance sheets and safe haven status; this helps absorb shocks instead of amplifying them across the GCESC.
- Policy recommendations and implications:
  - Fiscal stimulus in Germany is likely to have a relatively small impact on the CE4 and the rest of the euro area because of the supply-chain nature of trade integration.
  - Greater trade openness in Germany and the CE4 implies greater exposure of the GCESC to global shocks.
  - Strengthening household, corporate, and sovereign balance sheets is important domestically and for trading partners—particularly in the context of a supply chain arrangement—because more fragile balance sheets result in larger domestic and cross-border growth losses.

*Source: IMF staff calculations and analysis as presented in the supplied content.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr13263.pdf_