The era of globalization which brought cheap goods, low inflation, rapid growth and inexpensive capital is transitioning to a new state. Globalization is not dead, but the makeup of its participants has shifted and the rules of global trade continue to be rewritten as businesses diversify where they source and make their goods. The impacts of these structural changes are profound.
This isn’t a new narrative; world trade as a percentage of world GDP has been on a downward slope since the global financial crisis. But strained government relations and new policies have pushed manufacturing further into this new era. As a result, industrial companies will need to assess alternative strategies and operational locations.
Trading with unfriendly nations like Russia is taboo. Trade with China in certain technologies related to telecom, computer chips and surveillance is verboten. The number of businesses and people on the U.S. Commerce Department’s restricted entity list doubled to nearly 1,200 between 1997 and 2000, and the world put 9,098 new sanctions on Russia since the start of the invasion into Ukraine. The saber rattling with China plus another term for current Chinese leadership is leaving businesses wary of further investment in the country.
Of course, global trade wasn’t always this way. The world embraced its last surge in global trade when the Berlin wall fell in 1989. Global trade became policy. In 1995 the World Trade Organization was founded to reduce tariffs, make trade smooth, predictable and free. Then China joined the WTO in 2001, codifying its shift as the factory of the world and the United States led the way by investing over $118 billion in China by 2021. U.S. living standards rose as did a global middle class through access to lower priced easy flowing goods, and job creation. Growth was high, and inflation stayed low.
But all of this has changed. Since 2016, the year-over-year percentage change of new U.S. foreign direct investment in China consistently slowed to single digits—signaling a more tepid investment appetite.
Starting in 2018, the United States slapped tariffs on Chinese goods, and a trade war began. Then in early 2020, the pandemic sent shockwaves through global supply and demand. Two years later, war broke out in Europe and exacerbated inflation through the energy and commodity channels. Geopolitical tensions reset to cold war levels.
These events individually weren’t tipping points, but their cumulative shocks echoed throughout policymaking bodies and boardrooms the world over, leaving an indelible mark on the global economy.
New math, new incentives, different options
The total historical cost of U.S. foreign direct investment in China of $118 billion is slanted heavily to the manufacturing sector, with 48.2% (or $56 billion) going to food, chemicals, metals, machinery, computers, electrical equipment, transportation and other. After that, wholesale trade is the largest non-manufacturing sector and represents 15.5% or $18.3 billion of U.S. investment. These sectors represent the core investments in China that make and move goods and rapid change in these areas is difficult.
Now, calculations made 15 to 25 years ago about where to source and manufacture goods are outweighed by security interests, increased risk, productivity losses, higher costs and uncertainty.
A recent mix of legislative incentives and deterrents are creating an about face and helping create a U.S. renaissance in manufacturing for semiconductors, telecom materials and 5G infrastructure. Other incentivized U.S. investment priority areas include green energy equipment, active pharmaceutical ingredients, and strategic and critical minerals.
In August 2022, legislators signed the CHIPS and Science Act into law, directing $200 billion in spending on R&D and over $52 billion on semiconductor manufacturing over the next 10 years.
That same month, the Inflation Reduction Act was codified into law and will invest $369 billion in energy security and climate change programs over a 10-year period.
This leaves a multitude of other consumer goods and industrial manufacturers that invested in China assessing alternative strategies. It is unrealistic to believe many of these businesses will return to the United States.
Barring immediate strategic needs or government incentives, locations for such operations will continue to depend on labor, access to materials, transport costs, proximity to end customers and a new risk profile.
For businesses that explore alternatives, the key options are to continue to invest in China and do business as usual, curtail new investments in China but maintain operations there, close operations and relocate within the Asia Pacific region, or near-shore to a country like Mexico.
Whatever route companies take, they won’t be able to ignore China’s market. It is the United States’ largest goods and services trading partner, and future market access is important. Additional U.S. investment in China is likely to continue its taper compared to prior periods in favor of other markets like India or Mexico, but the extent of that slowing investment remains to be seen.
How should businesses adapt?
Manufacturers need to consider a host of internal and external factors when deciding whether to explore alternative locations, and the weight of each of those factors will vary business by business.
Internal factors include whether the organization has the management capacity and experience to develop a new manufacturing strategy.
This includes time to research options, seek input from team members and stakeholders, calculate the financial and non-financial impacts, evaluate risk, create an investment schedule and roadmap for decision makers.
External factors include transportation and logistics costs and options, labor, material sourcing, customer proximity, ease of operating, technological requirements, cost of capital, tariffs, taxes, regulatory requirements, and of course geopolitical risk.
Projects like these are disruptive for many of today’s lean management teams and the substantial level of effort and potential capital investment will deter some businesses from making changes to where they operate. But given the shifts in globalization, businesses need to thoroughly examine whether diversifying their locations will maximize their long run prospects.
Change equals opportunity
Businesses that diversify their manufacturing footprint should use the opportunity to ask themselves what they can do better. Answering this question can unlock unexpected enterprise value.
Adopting new productivity-enhancing equipment and state-of-the-art technology, for instance, can reduce reliance on labor, lower variable costs and maximize long-term capital investments.
A way to explore these options before making costly decisions is the use of digital twin technology to create 3D models of shop floors, equipment layouts and employee productivity to run a myriad of scenarios to solve for the most efficient use cases.
Solving for access to talent and labor, no matter the country, will present challenges compared to China; no country except India will match the size of its workforce. Augmenting labor and automating tasks will be a necessity in scenarios where labor costs and access to workers are higher.
Whatever the mix of key driving factors for each business, manufacturers that reassess what this new global picture means for their operations can likely find efficiencies in terms of transportation costs, energy or raw materials. Operating in new locations can create different tariff opportunities, transportation savings, and landed cost savings.