Breaking up is hard to do*

The events of the last couple of years have made us acutely aware of our dependency on global supply chains, many of which lead to not-so-friendly nations. One of the major investment trends for the coming five to ten years I expect to see is the trend towards breaking up global supply chains, diversifying them and moving some production closer to home.

One of the biggest problems for backshoring efforts is that moving production from low-cost countries to Europe or the United States is costly because labour costs are much higher here. Thus, the backshoring trend in my view will take on two major forms. On the one hand, production processes that can be automated can be brought home. In this case, I wouldn’t be too hopeful for major increases in employment or wages. Instead, companies will likely invest in robotics, automated machines and digital equipment. On the other hand, backshoring may not come all the way back to the United States or Western European countries but stop at nearby low-cost countries such as Mexico and the Caribbean, or Eastern and South-eastern European countries.

But no matter the details, the shifts will be quite significant as a new study by the Bank of England demonstrates. The chart below is the key exhibit. It shows their estimates for the percentage of total intermediate goods sourced by the nations in the top row from the countries in the vertical row on the left. The left-hand chart shows the share in 2018 and it makes clear that China accounts for about 3% to 7% of all intermediate goods in most countries. That doesn’t sound like much but look at the right-hand chart. There we see the change in percentage points from 1995 to 2018. The diagonal entries in the table show how much of intermediate goods production has been outsourced during that time. For example, globalisation meant that 4% of intermediate goods used in the United States are now produced abroad instead of at home. In the UK, it is 6.5% and in Germany, France, and Japan, it is slightly above 10%.

Reversing these global supply chains could lead to a large increase in producer prices. As I have written here, for every percentage point increase in the manufacturing market captured by six large emerging markets producer prices may rise by three percentage points. Assume that one third of our dependency on global supply chains will be replaced by backshoring activities over the coming decade, thus unwinding globalisation as fast as it originally emerged over the last 25 years. In that case, countries like Germany would see producer prices rise by some 10% over the coming decade due to de-globalisation, or roughly 1% per year. In the UK that number would be 0.6% per year and in the US 0.4% per year. This additional producer price inflation has to either be paid for by lower profit margins of businesses or by higher consumer price inflation. In reality, it is likely to be a mix and my best guess at the moment is that inflation may be as much as 0.5% per year higher in the coming decade if that backshoring trend really takes off. As the song goes, breaking up is hard to do. Deglobalisation will come at a cost and will take a long time.

Import share of intermediate goods in different countries (left) and change from 1995 to 2018 (right)

Source: Baldwin et al. (2022)

*For those who once again don’t understand my obscure music references, here is a video: