Quo vadis supply chains?

Even the most ardent proponents of the type of globalization we became accustomed to in the early 2000s are now accepting that we have entered a phase of de-globalization and decoupling of global value chains (GVCs). The underlying reasons for this trend (political, protectionist, environmental and economic) have already been extensively discussed. Add technology, such as robotization and smart factories, and a greater focus on supply chain resilience to the mix, then there is no stopping this trend from taking over. The question therefore is not ‘whether de-globalization is actually happening’, but rather ‘what does this mean for international business?’. Another question that arises in this context is how this development can be effectively managed to keep at least parts of our free trade system intact.  

We are witnessing changes in supply chains on a scale that is fundamentally turning industry logic upside-down, and their effects on energy markets serve as a useful analogy. 

What impact will these changes have on GVCs? Much like with the revolution in energy markets, the depth and duration of these changes will largely depend on how long this current phase of ‘disturbed equilibrium’ will last. The changes will gradually become more irreversible the longer this period of ‘disturbed equilibrium’ lasts. The Ukraine crisis might have led to a cooling of relations between the West and Russia and a blip in oil and gas supplies; we might have even returned to the initial status quo. Yet with no signs of the armed conflict letting up, public opinion (and by extension, political options) is shifting. Europe has started expanding its infrastructure and pursuing  new energy relationships (e.g. brokering new gas deals with Qatar, building liquefied natural gas (LNG) terminals across the continent, or driving the European Hydrogen Backbone initiative coupled with a rapid expansion of renewable energy production). A return to the status ex ante would in the meantime be costly, considering the stranded assets this would give rise to.

Similarly, after two years of supply chain problems, the majority of efficiency-seeking foreign direct investment (FDI) firms have started searching for alternative suppliers. Some may have found alternative suppliers in the wider Regional Comprehensive Economic Partnership (RCEP) area, whilst many more are shortening their supply chains and sourcing much closer to home. While China +1 might contribute to diversifying supply chains (e.g. by sidestepping the CCP’s policy on COVID-19 lockdowns), it does not solve the problem of over-extended supply chains, freight-cost hikes and harbour closures. The more companies invest in robotization, the more experienced they become in applying smart-factory technology, and the less likely it is that they will want to rely on suppliers on the other side of the globe.

Hence, it is no longer about saving costs. No costs can be saved when wages and labour costs in China’s coastal regions are exploding and shipping costs are skyrocketing. The fact that importing companies faced recurring stockouts during the COVID-19 pandemic and that many European factories were brought to a grinding halt has invariably led to a shift away from a business model based on efficiency-seeking FDI in low-labour cost countries.

These developments are also reflected in current narratives around the globe. The narrative that GVCs serve as protection against domestic demand shocks is increasingly being replaced by the narrative that GVCs are the backdoor through which economic difficulties afflicting other parts of the world are imported. For example, both the 2008 financial crisis and more recently the COVID-19-induced lockdowns caused economic difficulties across the world. The underlying logic hitherto supporting globalization is therefore about to be reshuffled.

The implications of this “rebalancing” are difficult to pinpoint. It may result in a reduction of trade flows, while we might see an increase in FDI activity. With the strengthening of regional blocs (European Union (EU), United States-Mexico-Canada Agreement (USMCA), Regional Comprehensive Economic Partnership (RCEP), see map below), trade flows are bound to become less global and more regional. Accordingly, firms will aim to have a regional hub in several regions to run and coordinate their economic activities from there.

One sector of the global economy which has largely remained exempt from these developments is raw materials. The transition towards renewable energy will increase demand for rare minerals. In this context, the much-discussed ‘friend-shoring’ is simply not an option, as these minerals might not be located in ‘friendly’ countries. In the long run, however, the same logic applies: the more raw materials are weaponized, the more intensively countries will look for alternative sources, such as recycled or synthetic materials, which will further impact global trade and investment flows.

For the rich countries in the West, such a “rebalancing” will likely imply a loss in purchasing power, as negative inflation imports, i.e. cheap goods from low labour-cost countries fizzle out. Yet it is the least developed countries, those that balanced their books by selling low-skilled labour, that will be hit hardest. Firms will also have to adjust – the pandemic has highlighted the need for greater insights into supply chains. Developing better foresight about where potential shutdowns might occur next requires investments in technology.

One of the biggest challenges is determining where we currently stand. Headline trade and investment figures are actually of little help. Firstly, FDI figures by definition measure the past, and in an era characterized by rapid changes, a “backward-looking” approach systemically trails behind the curve. Secondly, policy discussions are often led on a very high level of aggregation; the total amount of energy being imported into Europe will presumably remain roughly the same over the course of the next few years. The far more interesting question is where will it be coming from? Access to very detailed figures, disaggregated by products, supply and demand locations will become even more crucial. This is also true for trade figures, which measure the extent of global and regional trade, the structure of GVCs and the ultimate flow of finished goods and payment streams. Even if these figures are no more than a rear-view mirror, they are currently the best we have, and in times of flux and uncertainty, we have to take whatever we can get.