The Short-Term Struggle Will Be In Balancing Higher Interest Costs With The Need To Invest More In Defense
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Globalization is fragmenting fast
It seems that the “good times” of freewheeling globalization are ending, with national security interests and ideology now taking priority over economic logic. The result is a fragmented world—with trade barriers and increasingly regionalized trade zones—underpinned by ideology, geopolitical alignment and perceived national security considerations. These developments, already underway, have hardened and accelerated over the last year. As the rush to recalibrate global supply chains develops, there appears to be a tendency for western firms to reduce their exposure to a single country. This appears to point to an eventual diversification of supply chains, by geography as well as by process. The RussiaUkraine war has forced management teams to urgently reconsider their supply chains. Are they secure? Are they diversified? Where are the vulnerabilities? The experience of the pandemic and China’s Zero COVID policy underlined the vulnerability of the optimization of supply chains based on economic considerations alone. We believe many chief financial officers (CFOs) will reminisce the days when one supplier in China was enough. “Just in Time” gives way to “Just in Case!”
As national security considerations have come to the fore, boardrooms around the world are debating the merits of “friend shoring,” in other words, building supply chains only in geopolitically friendly countries. This is great news for countries like Mexico, where unit labor costs are now at a discount to China’s, and its proximity to the United States, coupled with the long experience of the maquiladoras (the Spanish word for the manufacturing plants servicing the United States from locations close to the United States-Mexico border). According to the Federal Reserve Bank of Dallas, the maquiladoras accounted for 58% of Mexico’s manufacturing GDP and 48% of industrial employment in 2021. The scale of this manufacturing ecosystem, along with the logistics infrastructure, make Mexico a winner, in our opinion.
Over the past 30 years, many countries with high debt burdens generated economic growth—via exports into a free and open globalized world—to work their way out of the burden. That avenue seems to be closing now.
The challenge for CFOs, of course, is that these moves are permanent; they have a direct impact on working capital requirements and on earnings. At a time when interest rates are higher and availability of finance is more constrained, the challenge of recalibrating these supply chains becomes even more complex. Furthermore, there is now a concern that CFOs ought to consider excluding banks from certain jurisdictions from their financing rounds, lest their roles become politically inconvenient down the line.
Global trade can no longer be a route out of debt
Over the past 30 years, many countries with high debt burdens generated economic growth—via exports into a free and open globalized world—to work their way out of the burden. That avenue seems to be closing now. The focus on “friend shoring” and on diversifying supply chains is evidence that companies are making a concerted effort to eliminate overdependency, as much as it is to stay clear of domestic political pressure from government or from customers. Examples can be found in the Japanese beer company Kirin severing links with the Myanmar junta. For an indebted middle- or low-income economy, the range of options appears to be shrinking. Low unit labor costs are not a big enough draw, nor is the promise of multi-year tax breaks for investment in manufacturing. For western companies, the struggle to provide sufficient transparency of supply chains inevitably drives managers to consider domestic or neighboring countries as safer alternatives. As a retired auto parts executive told me, “The closer to home, the better the transparency!” The likelihood is that any manufacturing that does “come home” will probably generate less new jobs and rely more on automation. We believe, the short-term struggle will be in balancing higher interest costs with the need to invest more in defense, in the transition to a green energy, and in pro-growth policies.
