Nice article in this week’s Economist about the downside of outsourcing (see Trouble with Outsourcing). This is a topic I’ve recently discussed in this blog (see Reevaluating Outsourcing).

According to the Economist:

Outsourcing has transformed global business. Over the past few decades companies have contracted out everything from mopping the floors to spotting the flaws in their internet security. TPI, a company that specialises in the sector, estimates that $100 billion-worth of new contracts are signed every year. Oxford Economics reckons that in Britain, one of the world’s most mature economies, 10% of workers toil away in “outsourced” jobs and companies spend $200 billion a year on outsourcing. Even war is being outsourced: America employs more contract workers in Afghanistan than regular troops.

Can the outsourcing boom go on indefinitely? And is the practice as useful as its advocates claim, or is the popular suspicion that it leads to cut corners and dismal service correct? There are signs that outsourcing often goes wrong, and that companies are rethinking their approach to it.

These are not new questions. These issues are central to the fields of international business and strategy (see also Williamson and Transaction Cost Economics). In fact, outsourcing has been one of the hottest topics in both literatures for at least the last 25 years.

But the topic is certainly worth revisiting every once in awhile. And although the economics of outsourcing can be compelling, it is also important for managers to keep in mind that outsourcing is not without strategic consequences.

As the Economist recognizes:

Outsourcing can go wrong in a colourful variety of ways. Sometimes companies squeeze their contractors so hard that they are forced to cut corners…Sometimes vendors overpromise in order to win a contract and then fail to deliver. Sometimes both parties write sloppy contracts. And some companies undermine their overall strategies with injudicious outsourcing.

It is this last outcome that poses the greatest strategic threat. When firms outsource important value-creating activities, it often portends a phased exit from a part of the business that later precludes them from reentering that business.

Think Apple.

For a long time, Apple refused to follow the industry trend to outsource elements of the value chain – operating system, hardware, peripherals. Instead, they remained staunchly closed and proprietary. Apple was roundly criticized for doing so. Most industry analysts had written them off, and Apple was, at one point, on the verge of extinction.

However, it is Apple that got the last laugh.

Apple was ultimately able to benefit from their decision to keep much of their value chain in-house. Indeed, they experienced a miraculous recovery sparked by the innovation that their integrated approach allowed. Their competitors, by contrast, had jettisoned many of the complementary value-chain activities that, in the long run, helped differentiate Apple. As a result, many are now struggling.

One extreme example: IBM. The mighty IBM, king of the PC, fell prey to the very industry outsourcing trend that they helped create, …and they are now completely out of the PC business.

The moral of the story: Beware the long-term consequences of outsourcing.

The Economist recently published an interactive cross-country comparative global housing bubble tool. I’ve pasted a screen shot below, but visit the site to play with the various combinations and permutations of country-specific housing variables (see Global Housing Prices).

What I found striking from examining different countries and time periods is that although the housing bubble is nearer the bottom than the top in the US, there are many countries in which housing prices still seem lofty (e.g., Hong Kong, France, China, Australia, Switzerland, Belgium). Moreover, I didn’t fully appreciate how much larger the bubble was in countries like the UK, Ireland, and Spain than in the US. I knew the housing bubbles in those countries were larger, but in some cases (depending upon the specific time period), the bubble was up to 5x larger than in the US.

Interesting stuff!

Interesting article in the NY Times summarizing a recent Asia Society report about the prospects for Chinese direct investment in the United States (see Chinese Investment Bypasses U.S.).

Flush with capital from its enormous trade surpluses and armed with the world’s largest foreign exchange reserves, China has begun spreading its newfound riches to every corner of the world — whether copper mines in Africa, iron ore facilities in Australia or even a gas shale project in the heart of Texas.

[A new study]…forecasts that over the next decade China could invest as much as $2 trillion in overseas companies, plants or property, money that could help reinvigorate growth in the United States and Europe.

But the report…also warns that the United States risks missing out on a large share of the Chinese investment boom because of politics, a growing rivalry between the two nations and deep-seated perceptions that Chinese investments are unwelcome in America.

Chinese firms engaged in about $5 billion in direct investment in the U.S. in 2010 (see the Asia Society Report on Chinese Direct Investment), representing 10% of China’s total outward direct investment of around $50 billion.

With China’s vast reserves, my expectation, consistent with the conclusions of the Asia Society report, are for that figure to grow exponentially in the next few years. Of course, that’s from a very low base – Chinese outward direct investment currently accounts for only 5% of global outward direct investment flows (by comparison, the U.S. accounts for 25% of such flows).

Insofar as political meddling in Chinese direct investment into the U.S. is concerned, I am generally against political interference in cross-border M&A and greenfield transactions. If a transaction truly raises national security concerns then I see a reason to examine the deal more closely; however, such transactions are extremely rare. My hunch, though, is that politicians (on both sides of the aisle) feel compelled to weigh in on deals when they ought not to, …largely for the purpose of scoring political points.

Some of the high-profile Chinese deals that were politically overly-scrutinized include Lenovo’s acquisition of IBM’s PC business and CNOOC’s attempted acquisition of Unocal. In fact, CNOOC walked away from the Unocal deal, one which did not pose much of a security risk, because they felt that the political hurdles were too great.

In this sense then, I agree with the findings of the Asia Society report that the U.S. should openly encourage Chinese direct investment. In addition, the inward direct investment process should be safeguarded from undue political interference and/or influence.

Inward investment (not just from China, but from any country) brings jobs, tax receipts, and an increase in consumer welfare; it provides an alternative investment outlet for Chinese reserves; and it affords Chinese firms an opportunity to learn valuable skills and capabilities from their acquisition targets (see Chinese Acquisitions for more on this topic).

To me, all the political posturing toward Chinese investment into the U.S. is reminiscent of that which took place in the 1980′s when Japan was the investment scapegoat of choice. As it turns out, many Japanese investments had a positive impact on the U.S. economy (think automakers like Toyota and Honda opening assembly facilities in the U.S.). In some cases, however, Japanese investors ended up buying high only to eventually sell low (think Rockefeller Center and Pebble Beach).

I, for one, wouldn’t be surprised if many Chinese investments followed that latter path…

I have been teaching courses on International Strategy for more than a decade now, and I often find myself in the unenviable position of trying to dispel common myths about globalization. I’ve found the task especially difficult in an era in which many students come to class having only been exposed to Thomas Friedman’s well written, but often misinformed, best seller on the subject – The World is Flat.

I was therefore pleasantly surprised when I opened my digital issue of The Economist last week to find the work of Pankaj Ghemewat highlighted (see The Case Against Globaloney). Ghemewat, one of the leading scholars in the area of International Strategy, has done some interesting fact-based work on the realities of globalization. As I have long tried to convince skeptical students, the realities are far more modest than Friedman, and many in the mainstream media, would like for us to believe.

According to the article:

…[E]verybody seems to agree that globalisation is a fait accompli: that the world is flat, if you are a (Tom) Friedmanite, or that the world is run by a handful of global corporations, if you are a (Naomi) Kleinian.

Pankaj Ghemawat of IESE Business School in Spain is one of the few who has kept his head on the subject. For more than a decade he has subjected the simplifiers and exaggerators to a barrage of statistics. He has now set out his case—that we live in an era of semi-globalisation at most—in a single volume, “World 3.0”, that should be read by anyone who wants to understand the most important economic development of our time.

Mr Ghemawat points out that many indicators of global integration are surprisingly low. Only 2% of students are at universities outside their home countries; and only 3% of people live outside their country of birth. Only 7% of rice is traded across borders. Only 7% of directors of S&P 500 companies are foreigners—and, according to a study a few years ago, less than 1% of all American companies have any foreign operations. Exports are equivalent to only 20% of global GDP…

What about the “new economy” of free-flowing capital and borderless information? Here Mr Ghemawat’s figures are even more striking. Foreign direct investment (FDI) accounts for only 9% of all fixed investment. Less than 20% of venture capital is deployed outside the fund’s home country. Only 20% of shares traded on stockmarkets are owned by foreign investors. Less than 20% of internet traffic crosses national borders.

And what about the direction rather than the extent of globalisation? Surely Mr Friedman (author of “The World is Flat”) and company are right about where we are headed even if they exaggerate how far we have got? In fact, today’s levels of emigration pale beside those of a century ago, when 14% of Irish-born people and 10% of native Norwegians had emigrated…

Mr Ghemawat also explodes the myth that the world is being taken over by a handful of giant companies. The level of concentration in many vital industries has fallen dramatically since 1950 and remained roughly constant since 1980: 60 years ago two car companies accounted for half of the world’s car production, compared with six companies today…

This sober view of globalisation deserves a wide audience. But whether it will get it is another matter. This is partly because “World 3.0” is a much less exciting title than “The World is Flat” or “Jihad vs. McWorld”. And it is partly because people seem to have a natural tendency to overestimate the distance-destroying quality of technology. Go back to the era of dictators and world wars and you can find exactly the same addiction to globaloney.

I’ve long been a fan of Pankaj’s work. I think it’s among some of the most provocative, carefully conducted work in the field (full disclosure: he is a frequent visitor to the Stern School). That notwithstanding, if you haven’t already, check out of the full Economist article (The Case Against Globaloney); and for those of you interested in the full monty, you can find his book here (see World 3.0) to judge for yourself.

Maybe, just maybe, this will finally make my job a little easier…

Fascinating read in the March 2011 issue of Wired magazine documenting an increasing trend among U.S. small businesses: They seem to be bringing manufacturing work that had been outsourced to China back stateside (see Small Businesses Buck Trend, ht Jon).

According to Wired:

For US firms, the decision to manufacture overseas has long seemed a no-brainer. Labor costs in China and other developing nations have been so cheap that as recently as two or three years ago, anyone who refused to offshore was viewed as a dinosaur, certain to go extinct as bolder companies built the future in Asia. But stamping out products in Guangdong Province is no longer the bargain it once was, and US manufacturing is no longer as expensive. As the labor equation has balanced out, companies—particularly the small to medium-size businesses that make up the innovative guts of America’s technology industry—are taking a long, hard look at the downsides of extending their supply chains to the other side of the planet.

“Companies are looking to base their decisions on more than just costs,” says Simon Ellis, head of supply-chain strategies practice at IDC Manufacturing Insights, a market research firm. “They’re looking to shorten lead times, to reduce the inventory they have to carry.” When accounting giant KPMG International recently asked 196 senior executives to list their top concerns for 2011 and 2012, labor costs ranked below product quality and fluctuations in shipping rates and currency values. And 19 percent of the companies that responded to an October survey by MFG.com, an online sourcing marketplace, said they had recently brought all or part of their manufacturing back to North America from overseas, up from 12 percent in the first quarter of 2010. This is one reason US factories managed to add 136,000 jobs last year—the first increase in manufacturing employment since 1997.

The US certainly isn’t on the verge of recapturing its past industrial glory, nor can every business benefit by fleeing China. But those that actually build tangible goods should no longer assume that “Made in the USA” is an unaffordable luxury. Unless a company is hell-bent on selling the cheapest goods possible, manufacturing at home makes more sense than it has in a generation.

This is not inconsistent with the anecdotal evidence that I have gathered from my interactions with managers. I have found that managers typically overestimate the benefits of offshore outsourcing (i.e., the ability to access cheap labor) and underestimate its costs (e.g., those born out of cultural, political, economic, and regulatory differences across countries). Unfortunately, many only learn the hard way – they commit to the outsourcing strategy before they discover the costly mistake.

The article continues:

Once they do [outsource], these businesses often realize something profound: China isn’t the great deal they expected. A January 2010 survey by the consulting firm Grant Thornton found that 44 percent of responders felt they got no benefit from going overseas, while another 7 percent believed that offshoring had actually caused them harm. One big reason for this growing dissatisfaction is quality…In addition to quality issues, subcontracting also exacerbates a second major problem with Chinese manufacturing: the lack of safeguards on intellectual property…Finally, sheer distance remains an intractable problem.

The Wired article provided a nice read, touched on some important points, and offered some interesting vignettes. I encourage you to take a look for yourself.

That said however, the issue is not all that new. It is reflective of a long-standing debate in the international business literature, and reminds me of a similar article written in the Harvard Business Review nearly 25 years ago (see Manufacturing Offshore is Bad Business).

Although I agree that there are compelling business reasons to consider offshore outsourcing, it is also important for managers to recognize that the practice is not without strategic consequences.

Wonderfully rich exposition of the economic competition between China and the U.S. from The Economist (see China Overtakes U.S.).

Constant worrying about exactly when the superpower will fall into second place is causing anxiety throughout American society…[but] in some important fields, China has already surpassed America.

Great stuff!

I appeared on the CBS Evening News this Saturday night discussing Wael Ghonim and Google. This builds on a story that originally appeared in the Wall Street Journal on a similar topic (see Google Tiptoes Around Hero).

The original discussion (both with the WSJ and CBS) centered on the responsibility of Google for the behavior of its employees in foreign countries. The basic question was: How should multinational firms behave in foreign countries?

I mentioned that this debate is really not all that new, and certainly not unique to Google. These issues have affected multinational firms for as long as they have existed – e.g., pollution of the local environment, treatment of host country workers.

The questioning then quickly turned to the possible repercussions for Google to having an activist like Wael Ghonim as an employee. This is where this specific case differs quite substantially from the “typical” problems faced by multinationals.

The interesting thing in this case is that every time we hear the name Wael Ghonim we generally also hear “Google Executive”, as if it meant something that he were an employee of Google.

In my opinion, this issue has very little to do with Google per se. Sure, Ghonim is an employee of Google, but he pursued his interests on his own time, …and those pursuits had very little to do with Google’s day-to-day. It’s not like he engaged in his activism as a representative of Google, or even on its behalf.

But that begs the question: Regardless, is it a good thing or a bad thing for Google that the media associates Ghonim with the company?

That’s more complex. To the extent that his actions jeopardize Google’s relationships in Egypt, throughout the Middle East, or in any other country that views Google as a potential threat to political stability, Ghonim’s celebrity could have some negative ramifications for Google. But conversely, there are some for whom the brand just became more valuable – e.g., those who, for whatever reason, make positive associations between Google and civil liberties/human rights. And for some (think disenfranchised youth yearning for a voice), Google just became a pretty cool place to work.

Anyhow, the entire CBS piece appears below…

…for those who cannot view the embedded video, you can view it on the website at http://www.cbsnews.com/video/watch/?id=7344453n

The Council on Foreign Relations recently posted an interesting graphic on the U.S. trade balance in the wake of the financial crisis (see It’s Almost All Good).

The basic idea: Since the financial crisis, the U.S. trade balance has improved with just about every country but China.

That the trade balance has improved vis-a-vis most trading partners is not surprising given the 15% (or so) drop in the value of the U.S. dollar since 2006. That it has worsened vis-a-vis China in spite of that stylized fact virtually assures that it will continue a hot-button issue among U.S. policymakers, and further threaten to escalate bilateral trade tensions (see also So Much for the Flexible Yuan and China Not a Currency Manipulator?).

As I mentioned last summer:

…don’t be surprised if the trade deficit and cries of unfair trade practices begin to occupy a more prominent place in political discourse.

We certainly live in interesting times…

Interesting article in yesterday’s NY Times (see China’s Race for Patents) echoing my sentiment from several months ago about the dangers for developing countries of falling into a commodity trap (see Taiwan’s Lessons for China).

According to the NY Times article:

As a national strategy, China is trying to build an economy that relies on innovation rather than imitation. Clearly, its leaders recognize that being the world’s low-cost workshop for assembling the breakthrough products designed elsewhere — think iPads and a host of other high-tech goods — has its limits.

Absolutely. I’ve been arguing this for awhile. There’s only so much development that a model based on cheap labor and export-led growth can deliver. As I pointed out in my previous post drawing similarities between Taiwan and China:

Taiwan’s overall economic development over the past 50 years has been nothing short of spectacular. And there is no doubt in my mind that China is trying to emulate elements of Taiwan’s development strategy. However, a strategy centered almost exclusively around manufacturing (whether it be in high tech or other industrial goods) comes with some serious risks.

The problem with such a strategy is that it relegates developing country firms to junior partner status, dependent upon a system in which they manufacture (for export) the designs of others. In the extreme, this results in a commodity trap.

The key for countries like China is to transition, at some point, from an economy that simply manufactures the goods that are designed and developed elsewhere to one in which innovation, creativity, and high value-added services take root. Unfortunately, these transitions are difficult, and take an inordinate amount of time.

As the NY Times article emphasizes:

…can China become a prodigious inventor? The answer, in truth, will play out over decades — and go a long way toward determining not only China’s future, but also the shape of the global economy.

“The leadership in China knows that innovation is its future, the key to higher living standards and long-term growth,” Mr. [David] Kappos [Director of the USPTO] says.

Despite China’s inevitable rise, Mr. [John] Kao [an innovation consultant] said, the United States has a comparative advantage because it is the country most open to innovation. “American culture, more than any other, forgives failure, tolerates risk and embraces uncertainty,” Mr. Kao says.

Many innovative products and technologies, he says, will be made elsewhere. “But America’s future lies in being the orchestrator — the systems integrator — of the innovation process,” Mr. Kao said.

In many respects I agree with Mr. Kao. It will take a long time for developing countries like China that rely on manufacturing for export to close the innovation gap with the West. I have discussed these issues in various blog posts (see Emergence of Emerging Market Innovation, China Attracting High-Tech Research, China Alternative Energy, and Globalization Discontents).

At the very least, China’s leaders recognize, and openly acknowledge, the issue. And the first step in any solution lies in problem recognition.

In contrast with Pepsi, which deepened its involvement in Russia by acquiring Wimm-Bill-Dann (see Pepsistroika), Wal*Mart has decided to forego opportunities in Russia for the time being (see Wal*Mart Closes Russian Office, ht Sid).

U.S. retail group Wal-Mart Stores Inc will close its Moscow office amid a lack of acquisition opportunities, abandoning for now its long-running quest to enter the Russian market.

“We continue to be excited about our international business, including markets where we already operate, such as Brazil, China and India, where we have tremendous growth opportunity,” McMillon [EVP at Wal*Mart] said in the statement.

…overseas retailers have found it tough to succeed in Russia…with Sweden’s IKEA at times complaining openly about corruption and a surplus of red tape.

This represents a wise exercise of restraint on Wal*Mart’s part. It is, indeed, incredibly difficult for foreign retailers to succeed in Russia, one of the riskier emerging markets (see Doing Business in a Developing Country or Russia and the BRICs).

And when comparing Pepsi’s decision to acquire Wimm-Bill-Dann with Wal*Mart’s decision not to acquire a Russian retailer, the difference in operational experience makes all the difference. Pepsi has 30+ plus years worth of experience operating in Russia that predates its Wimm-Bill-Dann acquisition. Wal*Mart, by contrast, has very little experience operating in Russia to draw on.

What’s more, Wal*Mart’s performance in other foreign markets, most notably in China, have not suggested that it has a consistent track record of operating profitably in the developing world.

My kudos then to Wal*Mart on their wise non-entry decision.