Is Industry 4.0 driving the backshoring of manufacturing activity?

COVID-19 has prompted many analysts and politicians to advocate in favour of rebuilding regional supply chains.1 However, a subtle but important distinction must be made between efforts to improve supply chain security by strengthening existing local supply options and attempts to encourage the return of industrial activities that were previously moved overseas (backshoring). In this article, we specifically reflect on the potential for backshoring in the wake of the COVID-19 pandemic.

As economies internationalize, foreign direct investment (FDI) in the form of overseas production plants becomes part of the game, with the relevant factories often becoming embedded in their foreign environment over time. This means that they develop a symbiosis with their environment from a production and/or sales perspective.

Take the Basque Country, for example, where foreign plant openings by Basque firms have grown much faster (7.5 per cent per year) since the 2008 financial crisis than exports (3.3 per cent per year). The steadily growing number of foreign production locations suggests that Basque firms rarely close production plants located abroad once they have opened them. Consequently, prior to the pandemic, there were no clear signs of backshoring strategies.

This was also the conclusion of a 2019 study2 based on a survey of Basque firms with overseas production sites, which manifested that backshoring is a rare phenomenon.

Moreover, when looking at the totality of Basque production activities abroad, it turns out that only some 2 per cent of all foreign production plants established by Basque firms have become subject to backshoring, and only 4 per cent of all Basque firms with foreign production plants have taken backshoring decisions.

Scholars have pointed to different types of drivers or catalysers behind backshoring decisions. First, there is a mismatch between the products an overseas manufacturing plant produces and the demand specifics of the surrounding markets it is supposed to serve.3 Second, overseas locations lose their cost advantage due to rising labour costs in situ and/or due to a higher adoption rate of new technologies in high cost locations.4 Third, there is a growing quality and (delivery) service handicap for overseas production sites that are located far from the end markets they deliver to.5 Fourth, there is a “made in” aspect related to manufactured products, which customers are increasingly aware of/sensitive to.6

The role of technology ought to be key in particular in relation to points two and three. Hence, in the current era of digital transformation and advanced manufacturing, it seems relevant to assess whether the adoption of Industry 4.0 technologies influences the attitude of businesses towards backshoring.

What can we learn from the companies that participated in the above-mentioned Basque study about the role of technologies in backshoring decisions? And are such lessons likely to remain valid in the wake of the COVID-19 pandemic?

The respondent firms generally agreed that locations with high labour costs are more incentivized to adopt digital technologies than locations where basic factors of production, including (manual) labour, are less costly. As such, it makes sense to implement digital technologies in those locations where they generate the greatest cost savings.

In addition, the companies stated that they prefer to pioneer digital technologies at their home base. On the one hand, this is motivated by corporate strategy, as they wish to develop and centrally manage digital core competences and keep high value-added activities close to headquarters. On the other hand, developing and implementing new technological applications that can deliver a competitive advantage based on trusted relationships with partners with whom they share a geographical and cultural proximity, makes sense from a partnership building perspective.

Whether the above-mentioned conditions are sufficient to motivate backshoring decisions, depends, of course, on the location-specific technological/industrial context, that is, on the circumstances in the decision-taking company’s home base and the overseas location, where its production activities take place.

Among others, the quality of the digital-industrial ecosystem in a company’s home base versus that of its overseas location (i.e. whether the mother company and/or its foreign subsidiary can surround itself with developers of digital and advanced manufacturing technologies to spur the adoption of such technologies) plays a role. This implies that locations with a vibrant ICT ecosystem and advanced machinery suppliers will more likely profit from backshoring.7

One way of assessing the digital adoption rate among firms is to delve into the European Union's Digital Transformation Monitor, against which we benchmarked firms in the Basque Country. What we found was that the surveyed Basque companies revealed a superior digital technology uptake profile than the participants in the Digital Transformation Monitor survey.8 9

Whether a high adoption rate of digital technologies actually leads to a backshoring of production activities from overseas locations will, in part, depend on the efforts foreign locations put into digitalizing their own manufacturing activities and encouraging companies in situ to adopt Industry 4.0 technologies. In this regard, emerging economies do not display a uniform picture. While some countries, such as China, are determinedly taking giant leaps forward (e.g. Made in China 2025 10), other emerging economies and companies (in Latin America, Africa, Southeast Asia) are struggling to keep up in this technology race.11 In other words, the backshoring of manufacturing activities from Latin America, for example, may be more likely than the relocation of industrial production from China.

On the other hand, the commercial outlook of the markets that manufacturing activities can serve is a relevant variable for determining whether backshoring makes sense. The current pandemic seems to mark a global watershed between those economies weathering the COVID-19 storm fairly well and those that are not. While most countries and regions are witnessing a stagnation of their GDP, the outlook for East and Southeast Asian economies is more optimistic. Notably, China, Viet Nam and some other Southeast Asian countries are likely to rebound quickly from the corona dip. At the same time, the projections for other emerging economies, particularly in Latin America and Africa, are less promising.

The prospects for economic recovery are likely to impact the geography of backshoring moves, especially if — as has been the case for most Basque overseas factories — foreign production investments are predominantly driven by a market-seeking motive. If market seeking is the main rationale for choosing an offshore production location, areas that will see a downturn in demand will be more susceptible to backshoring. Based on the current projections, this would be less the case for East and Southeast Asian economies and more so for Latin American economies.

What are the implications of these findings for industrial policy? The key finding is that backshoring decisions are made at the intersection of various factors. While upgrading and reorienting local innovation ecosystems towards ICTs and other key enabling technologies that support Industry 4.0 cannot guarantee backshoring (or the avoidance of offshoring), it will certainly help. Moreover, given the broader need to facilitate digital and green transitions in all economies, such approaches to policy seem like a good investment by all means. 

As for managerial implications, the optimistic economic outlook for economies in East and Southeast Asia, in particular China, means that developing “insidership” in those markets continues to be important12, alongside making the supply chains that depart from those locations more resilient13.