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Global sourcing in a world less flat

By Dan Braga, Drew Erdmann, Yogesh Malik, and Aurobind Satpathy

21 April 2009

John Maynard Keynes, the great British economist, is suddenly back in vogue. During the current global economic downturn, you hear his name invoked in discussions regarding stimulus packages in the United States, China, Europe, and elsewhere aimed at preventing a 21st century Great Depression.

But Keynes also speaks to those contemplating the potential patterns of global sourcing and trade in the coming decades. In writing The Economic Consequences of the Peace in 1919, he considered the state of globalization on the eve of the First World War:

The inhabitant of London [in August 1914] could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages; or he could decide to couple the security of his fortunes with the good faith of the townspeople of any substantial municipality in any continent that fancy or information might recommend…. But, most important of all, he regarded this state of affairs as normal, certain, and permanent, except in the direction of further improvement, and any deviation from it as aberrant, scandalous, and avoidable.

Sound eerily familiar? Almost like the world had been flattened before.

So Keynes reminds us of three basic lessons. First, globalization is not new. Second, the fabric of globalization is woven equally from the warp of politics within and among countries and the weft of individual business decisions. Third, globalization’s progress is not inevitable. As Keynes and members of his generation who survived the First World War knew well, globalization can be fragile indeed.

The current global downturn has laid bare the simplistic assumptions under many a global sourcing strategy, as Keynes could have anticipated. A misguided sense of security and predictability began to permeate sourcing decisions during the past two decades. International trade exploded, driven in part by the opening of previously closed markets in both Asia and Eastern Europe. Sourcing from so-called low-cost countries blossomed. China emerged as an economic powerhouse and supplier of choice in many sectors. Progress and prosperity appeared inexorable. Echoing Keynes’ man of London of 1914, many at the start of the 21st century “regarded this state of affairs as normal, certain, and permanent,” and bet their sourcing strategies on it.

Then came, in short order, financial contagion, the bust of the commodity boom, the collapse of international trade, and the worst global economic downturn since the Great Depression. The new uncertainties can bewilder. Consider recent headlines on the future costs of sea transportation and their implications: in the summer of 2008 The Wall Street Journal and The New York Times both suggested high transportation costs might soon make Asian sourcing prohibitively expensive in many industries, and then in January 2009 the Journal noted without irony that containers are moving virtually free of charge in a sea of shipping overcapacity. Tracking the headlines leads to confusion, not clarity, in thinking about an enduring strategy.

So how can we navigate global sourcing opportunities and risks in the face of this uncertainty?

We at McKinsey undertook a major research effort, tapping our global network and cross-industry expertise to answer this question.¹ Only charlatans or fools would pretend to predict the exact contours of the global sourcing landscape 3 to 5 years hence, let alone 20 years. However, organizations can and should confront the uncertainties head-on in a rigorous, fact-based way, rather than trying to wish them away. Deep understanding of global forces and scenario-based analysis provides a more realistic approach to test potential sourcing strategies than betting on a single view of the future. While there are many potential industry-specific subtleties that can be teased out using this approach, three major themes emerge.

First, the underlying logic driving global sourcing will endure despite the recent economic turbulence. Whatever the scenario, global sourcing makes sense as long as low-cost countries remain. And there is no reason to believe that significant gaps among countries will disappear. Take labor costs: while Chinese labor costs have been closing in on US costs in percentage terms since the mid-1990s, the gap in absolute terms between Chinese and US manufacturing labor costs per hour is projected to increase to more than $26.00 in 2013, from roughly $17.50 in 1996. Regional variations in material inputs (such as steel) also place offshore sourcing at an advantage in many categories. And we should expect the expansion and increasing sophistication of supplier networks in the major developing countries – such as China, India, and Brazil – that will account for the majority of global economic growth and new consumers in the coming decades. At the same time, balancing out basic price considerations, time-to-market considerations (for example, customized products with short lead times, such as some high-tech items), sensitivities to transportation costs (automobile assembly, for instance), and other factors will keep some level of production close to the consumer.

Second, relative cost advantages are dynamic, not static. We should not be surprised to see intensifying competition within low-cost countries, as regions vie to attract investment and jobs. Again, consider labor costs. Just as there can be significant cost differences between, say, factories in Michigan and Alabama in the United States, China is hardly monolithic: we already see significant variations between labor costs between Shanghai and the interior; likewise in India. States will compete with each other for business. At the same time, companies will find intensifying competition for their business between low-cost countries. In the lead-up to the current crisis, the Chinese economy’s steady growth helped fuel wage inflation that has in turn given other Asian “ultra” low-cost countries a potential edge. For example, in 1997 labor costs were roughly equal between China and Vietnam; a decade later, a Chinese manufacturing worker cost nearly three times as much as his or her Vietnamese counterpart. The impact of such changes is not theoretical. In 2009, for instance, Nike expects to make more shoes in Vietnam than China for the first time in its history.

Third, politics will matter—a lot—to the future of global sourcing. They always have, of course, but the relative stability of the late 1990s and early 2000s masked this reality. Looking to the future, public policies will influence the trajectory and pace of change across many variables commonly viewed as simply “economic.” For instance, the Chinese government is not standing idly by in the face of trends that are eroding Chinese competitiveness. While the Chinese government seeks to devise policies to rebalance its economy toward more domestic consumption, value-added tax rebates, industrial subsidies, and currency policy support exporters. The Chinese government can pull all these levers and more to flip the best case economics back in China’s favor for strategic industries. But every country can play that game—and they are.

Whether or not countries will agree to play by common rules in international trade or pursue their own nationalist or regional policies will be critical. Today, the picture in overall trade policy remains mixed. World Trade Organization membership grew and average tariff rates fell between 1988 and 2007. Businesses are more interconnected than ever before. Even before the onset of the current crisis, however, there were signs that that global commitment to an open international trading order was eroding. The WTO’s Doha Development Round of trade talks have been on life support for years. Since 1995 the number of regional trade deals—which are inherently discriminatory—has increased over three fold. Equally troubling for an open international trading system, BBC World Service polling revealed that majorities in eight of the top ten economies, including the United States, thought that globalization was moving too fast for their tastes by January 2008.

In the current economic crisis, most countries have not yet succumbed to the temptation of significant beggar-thy-neighbor protectionism. But if the downturn broadens and deepens, politicians may not be able to resist the potential short-term political appeal of economic nationalism or regionalism. Last November, the ink had barely dried on G-20 ² leaders’ statement committing themselves to fight protectionism before protectionism’s creep resumed. According to the World Bank, 17 of the G-20 have implemented protectionist measures in the three months following the Washington, DC, summit. So far the wealthier countries have resorted to subsidies—think of the automobile industries in Argentina, Brazil, Canada, France, Germany, United Kingdom, the United States, and others—while developing countries tend to erect trade barriers. Security, safety, and environmental regulations could become new forms of protectionism.

We will not hazard to predict whether during the coming decades globalization will resume, regionalism will rise, or extreme economic nationalism will triumph. But we are confident that the companies most likely to survive and thrive in the coming years will have internalized Keynes’ foundational insight that their global sourcing strategy must adapt to a complex interplay of forces, both economic and political. As competition heats up among low-cost countries within and among regions, successful companies will develop a deeper understanding of the global forces influencing their sourcing economics, thereby allowing them to anticipate potential “flips” among optimal sourcing locations. In the coming years, executives will need to understand the nuances of the local politics in their critical sourcing countries—for instance, state politics in India—as much as they do their own home states. With investment in the knowledge of local politics and suppliers, companies will be able to lobby and persuade to shape their business environments in other countries. Others may diversify their sourcing portfolios across regions—say, China and Mexico—to hedge against potential shifts in transportation, critical input, and tariff costs. Some US companies may conclude the uncertainties facing their industries are too great and thus decide to minimize risk by moving some sourcing categories back from Asia to within NAFTA ³ and DR-CAFTA ⁴ or even onshore again. Organizations will recruit, train, and retain different talent to navigate these sourcing decisions, or be left behind.

Whatever the future may bring, the ability to understand global forces at play and employ fact-based analysis that envisions a range of scenarios will provide competitive advantage over those organizations that continue to deny the uncertainties and plan for only one “possible future.”

¹ Contributors to the development of and analysis informing this study include Stacey Galvez and Sunil Manhapra, both consultants in McKinsey’s Chicago office.
² The G-20 member countries are: Argentina, Australia, Brazil, Canada, China, the European Union, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom, and the United States.
³ North American Free Trade Agreement.
⁴ Dominican Republic–Central America Free Trade Agreement.

Comment [27]

Agree? Disagree? Let us know what you think. Please include your full name with your comment. Comments may be edited.

Globalization and Global Sourcing are without a doubt connected to the growth of economy in general. People working in the global sourcing sector of a company need excellent job trainings. They have to pull together so many different aspects of economy, politics and also the culture of different countries. The job as a Global Sourcing Manager is getting more and more challenging, especially in times of crises. We are studying Business at the Private University Schloss Seeburg in Austria. After reading this article we identified that in Austria an appropriate apprenticeship for the profession as a Global Sourcing Manager is still missing. Special courses at Universities should be established and companies will have to invest more in the personnel development to be successful with their global sourcing strategy.

Posted 10 December 2009, 06:47 by Kahlert, Steiner-Holzmann, Gruböck, Private University Schloss Seeburg
The article does indicate that the trend towards globalization is like a force of nature constantly eroding trade barriers. If the impact of the First World War made rich nations more nationalistic, the Second resulted in a greater spirit of free trade and investment flows in the developed world. The march of globalization will soon resume since protectionism can only be short term and all statesmen must ultimately have the well being of their compatriots uppermost in their minds.

Posted 3 May 2009, 10:31 by Avimukt Dar
The article reveals in more ways than one the fuzzy and diffused logic of a increasingly flattened and globalizing world in an era of decisive uncertainty. Thus it it says much less than what it does not say: the role of national and international regulators as also the financial system that do auto correct and evolve and self regulate with changing times. The emerging order out of the financial chaos will for sure lay the foundation for a much more flat, much more equitable and a boundary less world. It is but inevitable that the emerging economies such as China and India will lead this movement as also the path from unilateralism to multilateral ism and finally to globalization for a more equitable world order.

Posted 2 May 2009, 07:33 by Dr Anoop Swarup
Globalisation / Trade / expansion existed in past ( Eygptian Greek , Romans , British empire ).. The scale , level of integration may vary

World also goes through cycle of openess nnd being closed or so called self sustaining .

In next few years if umemployement grows we may again see a bout of protectism

Posted 30 April 2009, 12:53 by Shailesh Naik
The great economist Keynes has decribed the globalization as it was in the 19.th century and the beginnings of the 20. th century.
What has been changed since them?

The contemporary globalization is mainly based on technological innovation, the internet, aviation, space sattelites. That make the transportation and use of informational
resources to industrialized and as well as developing countries possibel.
Getting new information resoruces are in low cost countries and hig cost countries probabyl cheap and fast.
The creation and management of economic value for the improvement of competitive advantage has won new dimensions.

Posted 30 April 2009, 11:24 by Yusuf Gokce
The article is beautiful but answers nothing.

The global sourcing in the end of 20th century in my point of view is the final phase of the diffusion of the accumulated techno-economic paradigms (Perez’s term)since the last great depression. The production instruments are allocated and placed to low-cost, former marginal economies and the financial and monetary power were kept in the high-income economies.
The crisis is a collapse of the whole system from the top. China resists till now better because it is at the bottom and the low end of the system. But if the top invents and creats new real industries – it seems it is a must, otherwise I cannot see how the crisis ends up – it will be the end of the bottom: there will be, a period after the crisis, NO sourcing from low-cost economies, China, etc. The show must go on, but the old days will end.
The day that high-income economies invented new industries, will be the day of the end of crisis, and will be the starting day of the real economic crisis of outsourcing economies, especially like China, given its current policy hoping that after crisis, the Western economies will come back to re-source again. But it might have to wait another 30 years to receive the diffusion of the new paradigm

Posted 29 April 2009, 08:18 by Wei ZHAO
This is a very interesting futuristic insights. However one has to pay careful amount of consideration to the technological changes that may flip around the whole equation of low cost geographies. Another point to factor in; is the political stability and influences that provide for safer production envirnoments.

On the other hand; the American auto industry may have to consider total dependence on foriegn locations for most of their income while reducing their labor cost drastically at home. The only way clearly helping the concept would be reduction of labor cost.

The protectionsim played by governments among the WTO members will continue no matter what ground rules are put in place.

A.ANWAR

Posted 29 April 2009, 06:52 by A. ANWAR
For all the globalization and entire market to work, it is necessary to have a demand and market at one end. At the other end there should be a capacity available to fulfill this demand.

For all the scenarios of Globalization 2.0 to work, it is necessary to have a robust end market – such as US / North America / Europe etc. This market must be in a position to pay for the services bought at other end of the world. And it should also be able to bear costs of brining the products at their door step.

Britain (and to an extent Europe) became less significant, the moment it lost its ability to coerce and dictate policies on colonies and buy basic materials at low cost. At other end, Russia (or USSR if you like) became less powerful the moment it lost ability to control the easter European countries and their economies.

These were purely political forces at work.

In case of US / North America, another major force is at play. Entire North American economy has been on borrowed time. From individuals who were buying on credit and by pledging tomorrow’s income , even retirement funds. Corporations were buying on basis of a strong dollar. And to cap it all, the Government was borrowing from all sources. The chickens have come home now. The Sub Prime was only the current reason. But fundamentally, this cycle could not be sustained in any long run.

These two major factors are essential to consider. If as the biggest buyer – the world over, US is not able or willing to buy from world market place, entire basis and drive for the Globalization is at risk.

Only silver lining here is that other major consumption centers are emerging. China, India, Brazil and Russia may be able to help here.

Chinese economy is expected to grow. But their track record of growth is based on exports. It will be their domestic consumption that would be the basis for real and sustainable growth.

Similar situation exists for India, Brazil and Russia as well. For all these countries and societies to generate that kind of growth in global business, several changes are required all over.

To start with, these countries expect good quantum of manufacturing and all value add to happen right at their location.

Secondly, for a good part these countries also either directly have the capability to make this happen or they have potential to make it happen as well. This would mean that only way US or other major economies will contribute value is through their technological and managerial expertize.

This will put current infrastructure and setup of existing supply chains out of fashion. It will mean that entire wheel will have to be reinvented.

Lastly, it would also mean much different type of educational and other readiness of people in US and other developed economies. The recent Op Ed – “Swimming Without a Suit” by Thomas Friedman in NY Times gives a gloomy picture on that front too.

My take, the recession may reduce in intensity, but basic structure correction is more essential and will give better lasting results. Otherwise we will be playing the game with weaker foundations and will be in for more such shocks in future.

Posted 29 April 2009, 06:06 by Shashank Tilak
Such a multi-dimensional issue! One aspect not getting so much air play is the social implication in the OECD. The field has ben left to the anti-globailsation lobby to play as they will. Letting them have the ground is a risk to all businesses and to freedom. Whilst a strong argument against the anti – globablisation lobby is the horrible consequences of the last two major breakdowns of globalisation in 1914 and 1939 (in terms of dates I speak as Brit!), it is a negative argument. It would be good if McKinsey were to champion secenario planning for public policy in the OECD. We need to demonstrate the overall balance sheet, and define the mitigations for the downside, because, we need to be clear, there are some. As societies we ignore the downsides at our peril, but by addressing them turn them into further opportunities.

Posted 29 April 2009, 05:09 by Will Mathieson
This is a really good article that I will recommend to my MBA students. It points out the uncertainty of the future and the need to consider a range of possible futures. I think that the uncertainty is even greater than you indicate. We are the start of a huge transition in the world economy and world politics. The trio of threats: peak oil, climate change and population growth are all coming to a head over a similar timeframe. The respite as the recession pulls oil prices back is temporary. The transition the world needs – and that the world will eventually get – is the Sustainable Revolution. I wrote about this in my book Adapt and Thrive: The Sustainable Revolution published last year. I wrote (before the current crisis hit):
‘Such global economic interdependence has not been seen before. Is this a strength or a weakness? Is the world financial system a robust self-regulating system or a house of cards waiting to collapse? The amorphous nature of the system makes it hard to judge. It is certainly looking like a system in which we all either stand or fall together. It may be that more connections bring greater resilience and reduce the chances of collapse, but if collapse does come, there will be no hiding from the consequences.’
Adapt and Thrive: The Sustainable Revolution, Susta Press (2008).

Posted 29 April 2009, 04:26 by Peter McManners

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