Keep your FriendShoring Close and your Offshoring Closer

Last week, during a speech in South Korea, U.S. Treasury Secretary Janet Yellen, said: 

“These recent shocks to the global economy have refocused global attention on the importance of economic resilience and addressing supply chain vulnerabilities. Working with allies and partners through “friend-shoring” is an important element of strengthening economic resilience while sustaining the dynamism and productivity growth that comes with economic integration.” 

Friend-shoring or Ally-shoring, as some refer to it, is the idea that one should limit supply chain networks to friends or allies, and countries that are politically aligned. The term builds on the notions of onshoring, nearshoring, and offshoring. 

What’s the rationale? 

“In doing so we can help to insulate both American and Korean households from the price increases and disruptions caused by geopolitical and economic risks […] In that sense, we can continue to strengthen the international system we’ve all benefited from, while also protecting ourselves from the fragilities in global trade networks.”

Secretary Yellen then added: 

“The efficiencies we gain from strong bilateral ties with friends help drive down prices and support U.S. jobs, workers, and consumers.”

On the surface, this may sound like a good idea. But is it?

In order to answer this question, we should focus on the main concerns and potential risks that come with it. 

The Upside

Over the last two years, politicians have mainly focused on supply chains, which (starting with COVID) have been increasingly strained. These supply chains, be they cars, semiconductors, Boba tea, or Kettlebells, were further exposed to political risks from China’s Zero-COVID policy, which inflicted longer delays and added uncertainty. Things got worse with Russia’s invasion of Ukraine, which resulted in wheat shortage and significant increases in energy prices. 

On the other hand, the impact of the semiconductor shortages on many industries also raised concerns in the US and the EU, considering how exposed these supply chains are to the risk of a potential invasion of Taiwan (where most fabrication is done) by China.

A few days ago, Ford announced that it plans to manufacture 600K electric cars by 2023. These cars will need batteries, and according to a White House supply-chain report published in June 2021, China currently refines 60% and 80% of the world’s lithium and cobalt respectively, two core critical mineral inputs for high-capacity batteries.

And indeed, in certain areas, we already see firms and governments working to move away from China in order to reduce their exposure to geopolitical risks. In the US, this resulted in a rare, bipartisan bill to help Intel build significant local capacity. 

The WSJ published an article on how the US and Australia are working together to build rare-earth mining and processing facilities in both countries. The EU and the US have started discussions to help semiconductor manufacturers such as Intel bring back manufacturing to the US. 

In theory, friend-shoring sounds like a great idea. Primarily in areas that are deemed critical to the future economy: electric vehicles, semiconductors, and health care equipment. 

But two questions arise: is it feasible, and is it a good strategy? 

Feasibility

Let’s look at the semiconductor industry:

“The most advanced semiconductor lithography machines—EUV tools made by the Dutch company ASML—consist of several modules incorporating hundreds of thousands of components sourced from multiple tiers of nearly 800 global suppliers. The modules are built at 60 ASML locations around the world and shipped to the Netherlands for assembly.”

And this is only for tooling. For the fabrication stage it’s similar, with Intel investing in 7 nm fabs in the United States and the EU, targeting production around the end of 2023 (if all goes well).

“However, for the moment, all of the capacity for making chips at the seven nm and smaller nodes—which is essential to the development of advanced chips for artificial intelligence (AI)—resides in Taiwan and South Korea.”

And,

“Both the United States and the European Union are extremely weak in the so-called back end of the semiconductor production process: assembly, testing, and packaging (ATP). These functions have largely been outsourced to East and South Asia, primarily for lower-cost production.”

So friend-shoring is nice but very hard if neither you, nor your friends have the capacity to build. But this is exactly the point (you may argue): long term planning to reduce the geopolitical risk on these supply chains. 

The Downside

But beyond feasibility, I am not sure this is a great strategy for a variety of reasons, such as:

It will harm developing countries. While there are many recent attacks on globalization, it is clear that it has brought prosperity to many developing countries. Raghuram Rajan wrote recently that friend-shoring will: 

“...exclude the poor countries that most need global trade in order to become richer and more democratic. It will increase the risks that these countries become failed states, fertile grounds to nurture and export terrorism.”

A recent article estimates that in decoupling supply chains:

“...the US loses 1% in economic output, but India loses 9% and other developing countries lose 7%. The burden of friendshoring will fall disproportionately on the countries that cannot afford it.”

It will increase prices. Back in 2014, when the words “inflation” or “supply chain” were not yet part of our daily vocabulary, MarketPlace claimed that an all-American iPhone would cost at least $2,000. The entire global economy is based on comparative advantage and labor arbitrage. Any time you restrict choices, you are increasing costs. 

It may further harm the US worker. One of the main criticisms of friend-shoring is that it’s just short for “decoupling from China but not onshoring yet.” Without getting too much into politics, it is very clear that the backlash we see in Trumpism (and to some extent Brexit) is driven by the fact that the local worker feels that the global economy serves the “elites,” those who buy the newest iPhones, etc., but leaves the local worker that lives in the rust belt (for example) exposed. 

The book Failure to Adjust draws on the fact that in the name of national security and securing relationships with countries, the US opened its market and did little to require from other countries to do the same for US products, hence hurting the US worker while failing to help them adjust to this new reality. 

For example, after World War II, geopolitical factors drove US trade policies, which in an effort to help Japan rebound from the war, opened its market. Japan remained an ally, but a later attempt, during the Clinton-era, to force Japan to open its market to US automakers didn't fare all that well. 

One can view the relationship with China similarly. The trade policy with China was motivated by the idea that two countries that have McDonald's will never go to war. But as the war in Ukraine showed, this is not the case. The Chinese market has been tough for most US and EU players (with a few exceptions such as KFC and Apple). Uber, Facebook, and Google are examples of such challenges. So are we doing the same now with other countries: throwing the US workers under the bus of “resilient supply chains”?

But I’m not completely sure friend-shoring will even achieve its goal, and in my opinion, it will reduce one risk but may increase others. 

When firms build their supply chains, they usually do so to maximize profits (or shareholder value). To do so, they need to reduce the cost of their products while hedging against other risks, thus the goal of a global network is to build a flexible, resilient network of suppliers. While I understand that many firms neglect this, the final goal is hedging against risks (rather than just reducing costs). 

What are these risks?

The trivial ones are supply risks, the fact that some suppliers may default or run out of capacity (what we call availability risk), and cost risks, the likelihood of some raw materials or components becoming too expensive or that shipping to a specific country is going to become too expensive. A global network that balances on- and offshoring is well protected from such risks. And indeed, you can build a friend-shoring network that is somewhat global. 

But there are many other risks visible on the horizon such as: geopolitical risks, the risk of a country taking an action that severs the relationship with other countries, resulting in availability risk. There is a growing healthcare risk, COVID-19 is only one example of what will be the norm in the mid and long term. Lastly, Cyber hacking and ransomware risks will also become more prevalent. 

But note that these three risks are heightened in a friend-shoring network. The last two I mentioned (healthcare and cyberattacks) are actually highly correlated among friendly countries, as travel and telecommunication networks are highly connected, creating much bigger exposure for supply chains. 

I would argue that even geopolitical risk is now highly correlated. We can all agree that the entire supply chain cannot be decoupled. Some components will be purchased outside the friend-shoring network, and given this fact, they will most likely be components that cannot be made within the network. The odds are that everyone will be purchasing these same components (or materials), creating even greater exposure and a very correlated one. This is what we are now seeing in the EU with Russian energy. Of course, there are many assumptions here, but I’m merely trying to show that not all geopolitical risks can be hedged. And this without  considering that as governments change, so will “their friends.” 

The baby formula shortage is one example where an attempt to create a safer product resulted in a very fragile supply chain. 

The book 1177 BC details Eric Cline's hypothesis for the Late Bronze Age collapse of civilization that ended the Mycenaean, Minoan, Trojan, Hittite, and Babylonian cultures. His argument is that while we tend to think that we are experiencing real globalization, back then, the world was almost as global as it is now. The book describes a world in which the main players, the Egyptians, Hittites, Canaanites, Cypriots, Minoans, Mycenaeans, Assyrians, and Babylonians, had significant trade commerce and cultural relationships. 

In an effort to explain the collapse, the author presents evidence to support a “perfect storm” of “multiple interconnected failures,” from climate (famines) to geopolitical (sea people), to change of warfare technology (from Bronze to Iron). 

Sounds familiar?

Friend-shoring makes a “perfect storm” like this more likely ... not less. 

On the internet, we see almost a complete decoupling: China and the US have two very different internets, and the EU, with its tougher regulation, is emerging as a separate one. I don’t think this is feasible or advisable for the global supply chain. Are there geopolitical risks? Yes. Is there any solution which can solve all of them? I don’t think so. 

It seems to me that friend-shoring is just another buzzword to justify our own failure to adjust.