The Road to War: The War For Manufacturing and Cold War 2.0

With TPP in the process of being ratified and the American presidential race well under way, focus has again returned to the war for manufacturing (and manufacturing jobs) and its future in America.  Boston Consulting Group released a remarkable survey a few weeks ago, which can be viewed here (pdf), here (slideshare) or here (scribd).  It's worth posting the executive summary here to see its significance:

Executive Summary

Key takeaways from BCG's fourth annual survey of U.S.-based manufacturing executives

1)  Interest in reshoring production to the U.S. remains strong, and the percentage of companies actively moving operations back to the U.S. continues to increase

  • 17% of respondents report actively reshoring production today, 2.5x the number that were actively reshoring in 2012
  • More companies are moving from "consideration" to "action"

2)  The U.S. has surpassed China and is outpacing Mexico as the most likely destination for new manufacturing capacity to serve the U.S. market

  • 31% of executives would put new capacity to serve the U.S. market in the U.S. versus 20% who would choose China
  • Significant reversal from two years ago, when China was favored by 30% to 26%

3)  Key drivers of expanding manufacturing capacity in the U.S. include costs, access to a skilled workforce, and increased local control to drive quality and innovation

  • Companies that are reshoring most often cite core cost factors–shortening supply chains, reducing shipping costs–as biggest reasons
  • Access to a skilled workforce is also a key reason; 2.7x as many respondents cite increased skilled labor as a driver for moving production to the U.S. compared with those who cite it as a reason for offshoring from the U.S.

4)  Investment in automation and other advanced manufacturing is seen as an opportunity to further drive efficiency and U.S. competitiveness

  • 56% believe that decreasing costs in automation have improved their product competitiveness
  • 71% believe that advanced manufacturing technologies will improve the economics of localized production

5)  Prospects for job creation remain strong

  • Executives who anticipate net job gains within the next five years outweigh those predicting declines by a 2-to-1 margin

This isn't an unanticipated development.  In 2014, BCG's analysis showed that the US had nearly reached parity with China in terms of manufacturing costs:

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And I'm certain that with China's wage growth, America's wage stagnation, and the dramatic fall in energy prices, that the manufacturing cost differential has further narrowed, perhaps reaching parity.

To quote myself from mid-2014, commenting on how the US trend of outsourcing manufacturing to China had changed from a synergistic activity to a value-destroying one:

…the US can manufacture components that China then assembles, and both are counted as manufacturing. The US can even manufacture in China, and the profits from the sale of the products will belong to the American company that contracted out the product. The way it works in a world where IP is respected, this relationship can work very well, and has. That's a win-win situation: the US company profits, and the Chinese get jobs. 

The problem with China's case, in particular, is that the IP is not respected, so the subcontractor simply copies the product and applies his own brand, thus keeping all of the profit for himself without having expended anything on R&D.

When this happens, manufacturers pull back from manufacturing in China, because no manufacturing cost is low enough to have your product stolen and used against you. In that case, one absorbs the higher cost of manufacturing elsewhere, and then it's a lose-lose proposition: lost profits for the US company, lost jobs for the Chinese economy. This is also the case when dealing with the value chain completely within China: Company A does the R&D, then hires Company B as a subcontractor to manufacture. Since Company B can then just steal the designs, which are already in its hands, and then sell the product under Company B's brand, Company A is destroyed.

This creates a vicious circle that discourages R&D in China, and discourages high-value manufacturing in China. How can China progress to the next stage of development, when by definition, the strength of developed countries is in R&D and high-value manufacturing? Either China will change, and start respecting IP, or China won't progress.

The pressure that China is now facing has to do with the automation component that you discussed by introducing the article. Now China's labor advantage dissipates, and a company can choose to manufacture using robots in the US, or robots in China. Why would the company choose Chinese robots for manufacture, and risk its IP being stolen, when it can safeguard its IP by choosing US robots? Add in cheaper energy costs, and the US starts to appear to have the outright advantage when it comes to choosing a location to manufacture.
 

Cold War 2.0, Trade Edition?

It's a buyer's market, and whomever is able to generate the demand will be able to drive the manufacturing growth.  I've discussed before how the TPP has been perceived as either a simple regional trade deal or an attempt to contain China, but it's possible that re-shoring will tip the scales in favor of the containment camp.  Within the new mega-regional trade blocs (TPP and TTIP), the United States is, in a subtle way, reconstituting the Bretton Woods order.  Instead of binding the financial system to the dollar, it will be global trade that is centered around a newly competitive U.S., with trade rules crated by the U.S. (in concert with its trade partners) to secure the Washington Consensus of liberalized free trade, while respecting intellectual property rights, labor rights, the environment, and other American priorities.  China's main point of leverage vs. the U.S. is its primacy as the world's largest trading nation.  By redirecting trade flows through the U.S. network and binding the trading partners to a high-standards framework, China's ability to build trading relationships with these countries may be impaired.  Without the trade carrot, what incentive would China have to deploy AIIB funds to build infrastructure in those countries?  Moreover, since the TPP is open to new entrants, with South Korea already indicating a desire to join, the clock is in favor of the U.S. while China pursues grinding new trade deals.

While this is a significant and positive development for the US, one negative outcome of the reshoring and automation revolution is that it will deprive the other emerging market economies of the well-trodden save/invest/export growth model pioneered by Japan, perfected by the Asian Tigers, and scaled up by China.  The likes of Indonesia, Africa, or even TPP members like Vietnam may not enjoy the kind of windfall from China's move up the value chain that once might have been expected.  Those low-cost industries that China sheds may now end up staffed by robots, rather than low-skill, low-wage labor in the developing world.

China's primary windows of opportunity are in Central Asia and Africa, and it has been aggressively pursuing upgraded economic relationships, (and in some cases, security relationships) in those regions.  While the automation revolution and re-shoring play themselves out, China has been investing heavily in Africa and Central Asia to bolster its influence.  We may see a bifurcated world emerge as a result of these trade deals, with North America, parts of South America, Europe, and Southeast Asia in a new American bloc, and China, Russia, Central Asia, the Middle East, and Africa constituting a competing bloc.

It's far too soon and too speculative to tell how this will play out, let alone identify these developments as part of a new Grand Strategy on the part of the U.S. or China.  Indeed, returning to the present, it may be too soon to get excited about this possibility, as the last ISM manufacturing index showed that manufacturing in the U.S. is as weak as it was during the financial crisis:

 

Only time will tell how the war for manufacturing plays out.  We'll revisit this topic later as new developments emerge.