The High-Wage Paradox - A Closer Look

Its what Deloitte calls the "high wage paradox" - if foreign direct investment (FDI) be perceived as a means to relocate manufacturing production, sourcing and processing, one would expect such activity to increase in the emerging, low-cost countries and decrease in the developed, high-wage countries. However, as the following figure from a recent Deloitte study illustrates, while FDI in high wage countries has remained fairly steady between 1999 and 2002, hovering at approximately US$25 billion per year, global investments in low-wage countries reflect a drop of 83 percent from US$12 billion in 1999 to a mere US$2 billion in 2002.

Deloitte points out that this conversion of capital to expense (through arm's length outsourcing contracts and the like) reflects a failure of the US firms to take direct control of their manufacturing activities. They predict that this shift in the hub of manufacturing activity will be accompanied by an allied shift in the hub of innovation activity, thereby creating competition in the low wage countries that will likely dent the competitiveness of US firms.

Deloitte may well find the solution to the high-wage paradox in one of its earlier reports, "Calling a Change in the Outsourcing Market". More than 70% of the survey respondents in the study cited negative experiences with outsourcing. The financial ramifications of failed outsourcing relationships are pronounced and include an adverse impact on customer value and overall firm competitiveness. These ramifications are aggravated when the process is located offshore and governed through captive units. As outlined in an earlier post, the need to extract value from an asset, a volatile labor movement that disrupts captive operations, and pressure from local managers seeking independence, allied with the frustration felt by headquarters about running a distant unit are some of the factors that adversely impact the management of captive units. Citigroup's recent divestment of its 43% stake in i-Flex Solutions, GE's offloading of 60% of its stake in GE Capital International Services to a pair of private equity firms are responses to such difficulty in management of captive units.

Further, corporate governance and regulatory compliance issues have emerged as significant influencers of M&A activity in the emerging economies. For example, in a recent survey by AT Kearney that assessed the FDI confidence index of various countries (and oh, China ranked first), 30% of investors indicated that corporate governance would pose a risk to their firms' operations compared to 25% who said the same last year. Therefore, M&A decisions are increasingly impacted by factors such as infrastructure, financial and political climate, safeguards for intellectual property and quality control, factors which may outweigh the cost advantage of low-wage countries.

Finally, US firms invest where they've already created assets. The FDI flow mirrors the distribution of accumulated capital stock of the US firms. 61% of U.S. FDI stock is in the top
10 recipient developed countries, whereas only 17 percent is held in the top 10 recipient developing countries. This, of course, is not a causal link, it only emphasizes Deloitte's findings.

As the outsourcing market matures and aligns itself with normative guidelines for design and management of outsourcing relationships, we may witness an increase in investor confidence and a surge in U.S. FDI in emerging low-wage countries. Right now, they're treading slowly.