The Regionalization & The Globalization Penalty

The Regions of the Present and of the Future

Picture of Earth

Regionalization

Apparently, when companies shop the world market, they mainly shop & sell at three regions: North America, East Asia & Pacific, and Europe. In other words, we don’t quite have globalization, but rather regionalization:

Here's the reality check: In 2021, North America, East Asia, and Europe gobbled up 85% of global trade. The rest of the world? Well in Africa, the Middle East, South Asia, Latin America, the Caribbean, Russia, and Central Asia represent the other 15%.

You may have thought the world is globalized since multinationals like Boeing sources from 65 nations and Coca Cola is in almost every nation on earth but for every international Boeing or Coca Cola, you have 10K regional or local firms.

Guess what? The average traded good doesn't exactly rack up frequent flyer miles - we’re talking less than 3000 miles (4830 km). 3000 miles is about the distance of from Boston to Los Angeles or Seoul, South Korea to Singapore, So the average distance is still within a region among these trade hubs.

What separates nations from becoming truly global are lack of universal regulations. There are many laws, regulations, and controls that prevent us from truly being a global world. A perfect example is that Facebook is banned in China.

Most firms in East Asia and Europe keep companies regionally close due to culture and time zones. In addition, because of free trade agreements, this makes rules and regulations streamlined, making it easier for companies to do business in a country that has free trade agreements with.

Origins of Regionalization

Europe, thanks to the EU, became a regional powerhouse, In Europe, they were losing their colonies left and right. Britain lost its cash cow in India in 1947, Britain and France were embarrassed losing the Suez Canal in 1956, France fought two bloody wars in Indochina (France, Laos, and Cambodia) and Algeria, and Netherlands fought hard to maintain Indonesia. In order to stay relevant, Europe integrated their economies. First treaties united energy and steel production(1952) to make war between historic enemies France & Germany unthinkable, the bloc removed tariffs on each other (1957), streamlined regulations (1986), and finally united currencies & passports (1992). Brexit was probably not wise.

East Asia, on the other hand, relied more on industry leaders for regionalization. As Japan re-industrialized they needed cheap labor as they reached a labor shortage in the 1960s. Wages were too high in Japan and Japan wasn’t open to mass immigration, so Japanese executives hunted to build factories in nations they formerly occupied for cheap labor. In the 1960s-1970s, Japanese wages were nearly 6x South Korean wages, 5x Taiwanese wages, 2x Hong Kong & Singaporean wages.

Japan mainly invested in these Asian countries because they were all open to foreign investment. Firstly Japan paid reparations for colonializing and occupying East Asian countries between the 19th century Imperial Era to WW2. In addition, the Japanese government would assist their executives by providing grants & loans for construction for infrastructure, schools, sanitation, hospitals ports, roads, power stations, cables, water filtration, railways dams, in these four nations and Indonesia, Malaysia, and Philippines. At this time, Communist countries like China and North Korea were opposed to foreign direct investment or official development assistance. Vietnam was divided and bombed, Laos and Cambodia were in a civil war, and Burma was unstable.

By the 80s and 90s, Singapore, Taiwan, South Korea, and Hong Kong were becoming rich and they too hunted for cheap labor. Simultaneously, China and Vietnam abandoned orthodox communism, embracing only the authoritarianism without the Marxism and they opened up their economies to foreign investment.

North America created the North American Free Trade Agreement in 1994, which was later replaced by the USMCA in 2020.

Areas that Lack Regionalization

The Middle East was loaded with oil & gas so they nationalized their economies from Western Oil Majors, formed oil cartels and squeezed profits from nations that needed their oil. As discussed before, oil & gas are much bigger markets than any other commodity by an order of magnitude. To put this in perspective, the natural gas market in 2021 is worth $440B… 57x bigger than the cobalt market in Congo. 40% of oil and 30% of gas exports come from the middle east as of 2021.

Most of Africa, Latin America, and South Asia embarked on a strategy called import substitution industrialization. The idea was selling commodities and crops to the world, and use the funds to subsidize industrialization. The idea sounded great on paper, but the problem with this strategy is threefold:
#1 The implementation of the strategy was too internal looking. The strategy doesn’t involve competing in manufacturing in world markets but focused on building internal markets that depend on subsidies from the government to survive and supply domestic consumers.
#2, It didn’t involve integrating into supply chains. Most of Africa or Latin America is at the tail end of a supply chain of just exporting the raw commodities. These countries mainly nationalized their resources and tried to process and produce themselves with results ranging from mixed success to terrible failure. Both of these regions lack extensive involvement in processing or production to add value to commodities. They both ended up at the end of supply chains sending out commodities and buying back finished goods. The “meaty middle” of the supply chain is where you get technology transfers, sustained foreign direct investment, “learning by doing”, innovation, sophisticated jobs, managerial expertise, ability to diversify the economy, and faster & inclusive growth. During this time, these regions has lacked the ability to enter in these supply chains which could have given it the ability to achieve more economic growth that isn’t dependent on commodity prices. It is thanks to North American & East Asian regionalization which transformed Mexico and Vietnam from petrostates to 2nd tier manufacturing states. Meanwhile Brazil is still mainly a commodity and food exporter.

#3 The strategy was working as long as commodity prices were high, but when the commodity buyers entered recession in the 1980s, commodity prices dropped Latin America entered a debt crisis (1982-1989), India had a debt crisis and needed an IMF bailout in 1991, and Africa suffered a TWO-DECADE Debt Crisis between 1981-2000 until commodities rose again in the 2000s.

The Soviet Union used to be a nation & trade union that was almost entirely interregional trade. But once it broke off in 1991, the 15 nations pursued their own trade strategies. The Baltics states (Estonia, Latvia, Lithuania) joined the EU. Russia formed the Eurasian Union with Belarus, Kazakhstan, Kyrgyzstan, and Armenia, but the Eurasian union barely trades with each other. Azerbaijan, Ukraine, and Georgia pursued their own policies. Kazakhstan, Russia, Kyrgyzstan, Tajikistan, and Uzbekistan are integrating more with China in the Shanghai Cooperation Agreement.

Why Did Firms Regionalize and Not Globalize?

In 2011, Mckinsey interviewed 500 companies, 50 executives, and 600K employees and they discovered an interesting tidbit called the “Globalization Penalty”. In that dataset, Mckinsey identified 20 “local champions” and 18 “global champions”. What Mckinsey found was that firms make more money when they go abroad but stay in their region. Their profit margins go up because they are taking advantage of cheaper labor while still making high quality & affordable products. Germany’s Merecedes-Benz made new plants in Hungary and Slovenia and Germany’s Volkswagen opened up factories in Czech Republic and Slovakia. In 1993, German wages were 6x Hungarians and Czechs. In 2022, the gap has been closing with German wages still double than they were in the 90s, but now German wages are now 2 to 3x Hungarians and Czechs. Going abroad brings new markets for the firm to sell to, takes advantage of different labor skill sets, and achieve economies of scale.

However, going too far afield can hurt profits. Global players struggle with shared vision, macroeconomic issues in the new country, maintaining standards, and building crucial relationships. A perfect example is on December 6th 2023, American firm Procter & Gamble ended its manufacturing operations in Nigeria. The firm complained about Nigerian business environmental differences and depreciation of naira eroding profits. Five years earlier in 2018, Procter & Gamble closed its $300M production plant in Nigeria, one year after it opened. Other foreign firms like GlaxoSmithKline, Guinness, and other firms also divesting or ending operations.

When firms leave their region and go further abroad, their profit margins tend to go down. Mckinsey identified three reasons for this:

1. “High-performing global organizations are consistently less effective at setting a shared vision and engaging employees around it than are their local counterparts.”

2. “These global leaders also find maintaining professional standards and encouraging innovation of all kinds more difficult.”

3. “Because they do business in multiple countries, they find it more challenging than local leaders do to build government and community relationships and business partnerships.”

Companies that went more global faced more issues.

The issues don’t stop there. Other issues could be lack of trust, different legal systems to adapt to, ease of doing business in that nation, or lack of a free trade/preferential trade agreement with that country. Whatever the issues are, the frictions exist.

America never embraced regionalization the same way Europe and East Asia did. NAFTA integrated some industries but only 48% of trade is between the three nations, which is less integrated than the two hubs. As a result of not having the integration, some of the supply chains, especially electronics, relocated to East Asia. Which regions will regionalize more in the 2020s and 2030s? Africa? The Middle East? Latin America?

Where are the new spots for Investment?

In 2022, the world had a net inflow of ~$2T of foreign direct investment. Let’s see where that net investment was deployed to.

East Asia received the most net investment in the world, receiving $645B in 2022. A third of the $645B is invested in the Association of South East Asian Countries (ASEAN), a economic union of South East Asian countries like Singapore, Vietnam, Laos, Indonesia, Thailand, Brunei, Cambodia, Laos, Malaysia, and the Philippines. Europe received $480B and North America received $440B.

Besides the big three, Latin America & Caribbean and South Asia are the next two largest regions of where capital is being deployed to. Middle East & North Africa is next. The two smallest regions are Sub-Saharan Africa where only $7.2B of investment capital is deployed to, and due to the Russian-Ukraine war, the Russia & ex-USSR region has lost nearly $30B.

If I were to bet, I would bet my money on India & Bangladesh integrating with the East Asian trade hub. But I don’t see India or Bangladesh integrating with Pakistan due to historical issues. Either way, those two countries are the rising stars of the future.

Links are underlined!

Special thanks to: Shannon O Neil for writing this great book