Thursday, August 21, 2008

Globalization: where to from here, part 2

This continues from my previous post on how globalization got us to this point. Now I will go into speculation territory, and try to see where it goes from here. If you haven’t already read them, some of my previous posts here, here, and here indicate my thoughts on where we might go.

In a nutshell, my opinion is that the current inflation is going to be a major equalizer for the global economy.

The inflation we’re experiencing right now is a natural outgrowth of economic development world-wide. Because the benefits of globalization have finally spread to the far quarters of the world, we recently experienced a faster rate of demand creation than existing levels of commodity production can adequately supply.

The inevitable ramification, due to law of supply and demand, is to increase input commodity prices, and consequently, effect a demand destruction in all areas. This destruction will stop when prices across the board decline to levels affordable to a viable number of global consumers and corporations.

A large part of demand destruction will be at the expense of smaller market players who do not currently enjoy economies of scale in their level of business. Inflation will eat into their profits, leaving only companies with larger profit margins who can weather the twin evils of escalating input costs and declining revenues. Large companies are at an advantage. A further qualification though - it is the large, streamlined company that is closest to its market that will be left standing.

Both the developed and developing worlds will probably each have to become more equally divided into being both consumer and producer economies. Developed markets will probably get back some manufacturing advantage, while developing markets will have to find more local businesses that produce local goods for more local consumers, rather than purely for export.

Companies from the developed world will likely focus more on their home markets, or those markets where they have the greatest competitive advantage. They will probably scale back in some foreign markets, leaving wide open opportunities for local companies in those markets to fill.

The question is, however, which of these foreign markets vacated by multinationals will have a big enough local demand to sustain a viable local supplier? On a case to case basis, some locals stepping up will find the chance to gain market traction. Likely, these will be in the consumer staples industries, retail, and banking, precisely those industries where the largest multinaltionals are currently scaling back the most.

However, these local companies will have a natural limit to their growth, and that limit is what local demand can sustain. Companies located in countries with smaller populations or poorer citizens will therefore will likely remain smaller than those in countries with larger and more prosperous countries. Most likely, just as the market suspects, after this crisis, the biggest competitors of US and European countries will be those from the BRIC countries.

Some manufacturing workers in the developed world will probably get back their jobs, once growth comes back, because this time around, cost differentials between the First and Third World will have narrowed. Moreover, companies will be more streamlined than they were before globalization, to make up for the fact that more of them now flourish worldwide.

Some back office process outsourcing will also likely be scaled back , as inflation in developing markets makes the cost of locating labor there comparable to just locating them in the home markets of the outrsourcers. Some companies will still accelerate outsourcing though, specifically in those areas where developing countries have already developed a local infrastructure that can sustain a competitive advantage to developed markets. Processes that would otherwise be done by highly paid staffers in the developed world will continue to be outsourced, i.e., tax and legal back office support, and maybe finance and accounting support, too.

Developing countries that peg their currencies to the US dollar will have to decouple, or the slowdown in the US will spread more deeply into their economies. The falling value of the dollar will make inflation more unbearable to their local consumers, many of whom already earn less than their US counterparts, and hence, are likely to sustain greater demand destruction if their dollar-pegged currencies fall further in value. This is certainly not a good way to create a viable local economy that can take the place of falling US consumer demand.

The developed world will remain the font of innovation, and this will be the basis for any resurgence in their part of the world. Developing markets still cannot innovate as fast or as dramatically as the West. Perhaps it has something to do with having a smaller home consumer market with which to experiment new products on.

So while much of the developing markets will probably specialize in the lower-cost standardized products, companies from the industrialized world will continue to make profitable niches in more customized, high-end products. Developing markets seem to excel at doing standardized processes more cheaply and more consistently in greater amounts, while developed countries seem to excel at tinkering with existing products. That's a big reason why companies from the developing world counter-intuitively establish subsidiaries in more expensive locations such as the US, to be in the thick of innovation.

This also indicates that once growth comes back in the world, and consumers in the developing world reverse the demand destruction happening right now, many of them will again want to buy goods manufactured in the developed countries. Whether because of better research, design, or innovation, products from the US for example, remain coveted status symbols in much of Asia.

Once the financial markets get through with their current panic, product innovation rather than financial innovation will be the focus of investments in the developed world. The growth in the financial markets will likely swing back to venture capitalists and private equity, while hedge funds will probably scale back.

Economists have always argued that markets eventually find an equilibrium. I think this is going to be the case. But since countries and companies have for long erected many barriers and constraints toward reaching this sooner, the pain we are now experiencing in reaching equilibrium is going to be more painful and more lingering than otherwise it would have been.

In the end, my feeling is that globalization will find its equilibrium. There might eventually be some minor variations to what I envisioned, as individual market participants try to outwit the market, but the world will eventually settle to a new equilibrium.

Looking at it from an even longer –term view, though, changing global demographics will also make a difference in the kind of new world order we achieve. That is an even bigger challenge to project, and I will leave that for someone else to tackle.

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