Reversing globalisation: Near shoring, reshoring or staying put?
Cheap labour and even cheaper shipping made offshoring incredibly attractive. Has that gamble backfired and are manufacturers about to bring production back or are they fighting impossible economics? Eft asks experts from PwC, McKinsey and Zencargo to find out
We have been living through remarkable times when it comes to manufacturing, technology and trade. Virtually every single item we consume has been shaped through transformative tradewinds that have opened up new markets, both in terms of consumers for export but also labour forces for production. The lure was irresistible for many manufacturers, who saw the chance for a competitive advantage, especially when such cheap resources were combined with the possibilities of just-in-time production.
Alongside this trade revolution, shipbuilding became cheaper and the ships themselves bigger and more efficient. Ports became increasingly able to dock massive container vessels holding huge numbers of ISO-standardised containers, meaning it wasn’t only manufacturing that crashed in cost but the ability to transport the goods as well.
The result was massively globalised trade, where finished products could have components from dozens of countries and require tens of thousands of transport miles. Apple works with suppliers in each populated continent on earth, with its iPhone supply chain stretching across 43 countries, and even with this level of sophistication, smartphones are exponentially more powerful but, in real terms, cheaper than ever before.
The benefits have been enormous but have we reached the end of the road for this dominant trend of globalised production?
China: The poster child of globalisation
Perhaps the best way to tell the story of trade and manufacturing and where it might lead is through the economic evolution of China.
The rise of China to global, economic superpower has been the story of low-cost, export led manufacturing and how that has transitioned over the last 40 years.
First it started on the very cheapest rungs of manufacturing, making items such as textile products, and through a potent mixture of Foreign Direct Investment (FDI), centralised planning, improved regulation, and a greater allowance for private-sector economic activity, China was able to capture more of this trade.
Find another country where you can just start up a new factory with 30,000 people. China is the only place you can do it
This snowballed rapidly, until the Chinese government was able to use a hard-won reputation for prudence, a strong economy and major surpluses to build out key infrastructure, thus attracting more manufacturers. Eventually China was able to move much of its manufacturing up the value chain to auto parts and electronics and now it aims for the very highest technology and a desire to transition away from heavy industry and manufacturing low-cost goods.
“China is unique,” says Jan Nicholas, Partner at PwC Hong Kong, “in that China has the scale to be able to satisfy a lot of people. I have a client that runs very large factories and the way they see it is where else in the world can you put a factory with 30,000 people right away? Find another country where you can just start up a new factory with 30,000 people. China is the only place you can do it.”
However, there are now plenty asking questions about whether that transition can be sustained as the current crisis has thrown into light vulnerabilities already becoming more obvious in the face of the trade war. Politicians and pundits are now asking whether it might be wise to make less in China and more at home, or at the very least, in a wider variety of countries.
Have we then reached the apex of globalisation and will companies genuinely look to change modes of production?
The cold light of crisis
First it is worth asking why is this suddenly a more prominent issue?
“We basically had the same discussions after the Fukushima [nuclear accident], after the Thailand flood, after the volcano in Iceland,” points out Knut Alicke, one of the partners at consulting giant McKinsey & Company, “and it is always the same pattern. People are excited and say ‘we need to do something’, then six months later no one talks about it. So why should it be different this time?”
People are excited and say ‘we need to do something’, then six months later no one talks about it. So why should it be different this time?
Nicholas also brings up Fukushima as an example of a prior disruption. “Immediately, after the Fukushima disaster, we saw a lot of companies interested in supply chain risk and diversification. But what they found is that after that then the pressure from the market, pressure from investors and consumers, pushed people away back into the consolidated and concentrated supply chain footprints they had before.
“Risk usually falls further down on decision making behind cost, being close to the market, speed, skill set, scale, those sorts of things.”
However, things are different this time believes Alicke. “First of all this is much more of a crisis than before and I think the combination of shareholders pushing for resilience, governments pushing for resilience and the companies themselves, means it will be different this time. This isn’t a binary shift from zero to 100. This is probably more a gradual movement towards supply chain resilience and that is why I am convinced that we will see capabilities or functions or processes being established that ensure a resilient supply chain.”
We’re already seeing businesses like Nike looking to diversify their production, while countries like Japan and India offering land and money to encourage businesses to move their manufacturing out of China
Richard Fattal, Co-Founder and Chief Commercial Officer, Zencargo echoes these sentiments. “While many businesses have aggressively pursued outsourcing as a means to reduce costs, the current situation has exposed the risks of having production further away. Usually the issues we see are on the supply side, such as delays in manufacturing or transport. However, the long lead times and large minimum order quantities that these supply chains require are an even bigger problem when there is a change in demand, as there is now. We’re already seeing businesses like Nike looking to diversify their production, while countries like Japan and India are offering land and money to encourage businesses to move their manufacturing out of China.”
The winners and movers
This burden has fallen unevenly and will drive the reaction to the crisis as some are forced to move far faster than others.
Both Nicholas and Alicke immediately pick out three sectors that have come under intense scrutiny due to supply chain disruption caused by lockdowns in key countries or regions: Pharma, automotive and electronics.
“Pharma is highly centralized or concentrated, high tech,” says Nicholas. “You need the high skills, you need the infrastructure, you need the engineering talent, you need the trained workforce and the labour cost as well.”
The centralisation is creating a push factor to “be less dependent on India and China in terms of their Active Pharmaceutical Ingredient (API) production, which currently stands at 80% of production in those two countries,” estimates Alicke.
They don’t have just one tier. They have seven tiers, eight tiers
Alicke also notes that electronics followed a similar path of skills and production bases. “The reason why electronics has ended up in Asia is because, originally the labour costs of the assembly to put everything together was much cheaper and because the final assembly was in Asia. Then the parts that went into the final assembly got manufactured in Asia, and so on and so forth. The entire value chain consolidated around a few industry hubs.”
One of those hubs for both electronics and car parts was in the Hubei region, where the virus originated. “If you think about the Wuhan region in China, that was an electronics manufacturing hub,” explains Alicke. “They, alongside the automotive industry, have the most complex supply chains. They don’t have just one tier. They have seven tiers, eight tiers and so on.”
The easy stuff to move – a lot of that has gotten squeezed out already
“Automotive has been … caught out … because of parts,” Nicholas also notes. “A lot of the manufacturing that is happening, for example, in Japan and Korea, depends on parts that come out of China. And so, the high value stuff, they do in the high labour cost countries and the parts and other components that go into them, they take advantage of the labour arbitrage and lower cost places.”
This labour cost difference will mean that industries at other end of the skills and cost spectrum are not going to be moving much more than the shifts that have already occurred over the last five years.
“The easy stuff to move – a lot of that has gotten squeezed out already. A lot of the garment manufacturing and footwear manufacturing, the things that are easy to diversify because of the tariff and trade war, in the last couple of years a lot of that has shifted,” says Nicholas.
“If you consider the whole apparel sector … here the cost pressure, I would assume, is still so high, that they will still keep their production sites in Asia and would not necessarily relocate,” agrees Alicke.
This means that some countries have been seen big inflows of capital and jobs. “Throughout Southeast Asia, companies have been moving in and its generally stuff that was hit by the tariffs and stuff that is relatively easy to move,” says Nicholas.
Both Alicke and Nicholas note Vietnam as a huge winner. “We have seen Chinese companies move to factories to Southeast Asia. Vietnam has an incredible wage inflation and Vietnam is basically full right now,” says Nicholas, who even admits that “I have friends that bought real estate in Vietnam a few years ago and I kick myself for not doing that”
In the long term, this shift will come to down to a balance of risk and unit economics
A long-term transition
Any transition isn’t going to be easy for these more complex industries given the talent and capital goods required to have an efficient operation.
“In the long term, this shift will come to down to a balance of risk and unit economics,” believes Fattal. “China has a huge head start in relationships, specialisation and technology. This means they can offer extremely competitive pricing which may give businesses second thoughts, especially when considering the time and cost of moving.”
You need to distinguish that there are components and technology where the knowledge and the capabilities are only in Asia
“You need to distinguish that there are components and technology where the knowledge and the capabilities are only in Asia,” admits Alicke. “That might be China, or South Korea, or Japan, or might now possibly be Vietnam. So, to relocate this into Europe is clearly not feasible, because you not only need to tell them to move over the machinery and the plant and everything, but you also need to build the capability. We just don’t have the people who are able to do this. This will take longer.”
Nicholas agrees that it is hard to shift from Asia, and the region’s giant in particular, as “China is actually very well optimized to do all of this stuff. Great infrastructure, great capabilities, great scale, good costs, great logistics.… They have really spent decades building out this portfolio of advantages, very, very strong advantages. I don’t think that, absent policy changes, that many companies are going to find it attractive to go through the pain of leaving.”
However, policy changes are coming, particularly in some of those key sectors mentioned earlier.
Policy as a push factor
“There will be regulations. I am convinced governments will put in incentives in critical industries and the pharmaceutical industry is one of those, to make sure they are, I would say, a bit more diverse,” believes Alicke. “Does that mean it will go down from whatever it is now to 50% or 30%? No but it will start to regionalize.
The European governments are thinking about incentives to regionalize production
“In Europe, what I see, especially for the health sector, is that governments are thinking about this. The European governments are thinking about incentives to regionalize production. I can imagine something like the earthquake stock they have in Japan.
“Because they suffer from earthquakes in Japan, they store products that are considered essential, such as spare parts for oil parts, pharmaceutical products and some other basic products such as food and so on. They need to have a certain stock available because if there is an earthquake you don’t want to run out of stock within a matter of days. Something similar to this I assume will be pushed in Europe. It will take a bit of time to be implemented and it will be a combination of increasing stock and near-shoring and double-sourcing.”
The number one thing they are talking about right now is ‘how do I respond if policies change?’ It’s not about the economics right now, it’s not about the virus, it’s really about how our governments are going to react
Fattal also sees “The most likely future” as “a hybrid model that spreads risk. We predict that businesses will keep significant portions of production in the Far East, possibly expanding to rising stars such as Vietnam, Indonesia and Turkey. However, for high value SKUs there will be value in working with small run specialists closer to home, which will benefit countries such as Turkey and Bulgaria.”
Nicholas says “The wild card” to keep an eye on through all of this “is geopolitics.
“I have multiple clients right now that are talking through ‘how do I deal with this?’ They all are talking in terms of years to do transitions. But they also want to be flexible enough to be able to react quickly as policies change. And the number one thing they are talking about right now is ‘how do I respond if policies change?’ It’s not about the economics right now, it’s not about the virus, it’s really about how our governments are going to react and what the policy response is going to be and how do I put myself in front of that policy response so that I can be flexible enough to react to it? So, the thing is their timeline is going to be years. If they have to respond to someone else, they will have to go a lot quicker.”
From 10 years before where everything was going global, the last 10 years was already going regional and this I would say is just accelerating it
Risk and reward
Even though these short-term push factors are top of mind right now, there is a longer-term trend at play points out Alicke. “The McKinsey Global institute did a study on global trade flows. In that we can see that in the last 10 years, global flows have started to regionalize. From 10 years before where everything was going global, the last 10 years was already going regional and this I would say is just accelerating it.”
They also recently did another survey of Small and Medium Enterprise “in Germany and one of the questions was ‘Are you considering near-shoring?’”, to which “25% said yes.”
Alicke therefore believes that over “next couple of months where you are evaluating a suppliers, you will look at ‘should we change?’ ‘Should we force them to be more regional?’ Or another option is to build up inventory. In the end this is all for resilience and resilience can be [derived] from closer production and it can also be through increasing inventory.”
Even if the manufacturing moves back, it’s likely going to be highly automated, it’s likely going to be run very lean with just in time production, with very low inventory levels
He thinks that “this will be done in a way where you define the risk index and then you understand, for example if there is an electronic component that is manufactured in China, Korea and Japan, then the risk index is much lower because you have a back-up solution. If China goes into lockdown, you can still go to South Korea. If there is something where China is the sole supplier for this specific technology, then you consider building up capacity.”
Nicholas agrees that for everyone right now “Big risk assessments [are going] to happen across the supply base and that companies will make decisions about their suppliers based on risk right now because they have to.”
However, cost will still be the overriding driver. “You are not just going to put a 1950’s car factory into Detroit and have it profitable and have people buy the products,” warns Nicholas. High-cost, high-skill manufacturing need to take into account cost arbitrage and “productivity levels. So even if the manufacturing moves back, it’s likely going to be highly automated, it’s likely going to be run very lean with just in time production, with very low inventory levels.”