World trade outsourced

The United Nations Council for Trade and Development has issued its annual World Investment Report this week. It has chosen an interesting theme to build its report around, the importance of so-called non-equity modes of international production.

That’s quite a mouthful and needs explanation. Foreign direct investment tends to catch all the limelight when one talks of about international production. FDI, whether in the form of greenfield FDI or in the form of foreign equity investments, is characterized by the foreign ownership of shares in some way or another. Hence all this hullabaloo about the various FDI ceilings imposed in different sectors: 26%, 51%, and so on.

A key reason why FDI is important for a country, besides the cash coming into the domestic economy, is that it helps to integrate a bit of that country’s economy into the global supply chains that are the pounding heart of the global trade system. This is the source of China’s trillions: it is the hub of almost every global manufacturing chain that one can think of.

But such supply chain integration can be had without the necessity of buying shares. Economists, well-known for their literary flair, have a lovely term for the alternative: non-equity modes (NEM) of international production. Instead of MNC A buying up Local Company B, it can simply build a solid relationship with Local Company B and have it supply the parts or sell the products on a contractual basis. The latter is seen as less stable because the MNC obviously has less control over quality, product development and intellectual property.

But the nature of corporate relationships is getting more intertwined. So NEMs are spreading. And how. The UNCTAD report digs up impressive figures for NEMs of different varieties in 2010: contract manufacturing and services outsourcing is a $ 1.1-1.3 trillion business, franchising $ 330–350 billion, licensing $ 340–360 billion, and management contracts $ 100 billion. It found that among the biggest sectors where NEMs was common was garments, footwear, toys, electronics and auto components. China is the biggest player in the first four industries and a key beneficiary of NEMs.

India has seen a major slippage in FDI the past few years. This is a setback for its strategic plans to become an alternative hub for the global supply chains, stealing a little of this action from China. And staying ahead of other contenders like Indonesia and Vietnam. UNCTAD recommends it does more NEMming.

In theory this should be a cinch. After all, India’s massive business process outsourcing firms like TCS and Infosys live off of NEM work. And we shouldn’t forget pharma contract manufacturers like Piramal. But it is in manufacturing in particular where India can’t get a foothold, though auto components are experiencing a frisson of accomplishment.

Unfortunately this is unlikely to change unless India changes its judiciary’s slow ways, its infrastructure gets moving and, generally, red tape is brought under control. Other studies have shown that the more costly and the more uncertain the ability to enforce contracts and manage supply relations in non-equity situations, the less likely a foreign firm will go down that path. Instead they will prefer to exert control by buying a chunk of the shares of its domestic partner. And it is sadly well-recorded how long and how expensive it is to enforce a contract in India.

The auto components industry shows that NME methods can work. India’s auto parts guys work well in global supply chains without selling equity to their clients. The recent free trade agreements with Japan and South Korea will further help strengthen that networking. At the heart of any NME success in India will be less governance reform, which will crawl along, and more about the reputation and integrity of large Indian corporate houses in the international system. Which, I should add, is pretty much the story of so much of the resurgence of India.

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