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Many people fear that the availability of cheap global labor in our increasingly integrated world economy—or "globalization,"—is prompting companies to relocate production abroad. Yet a recent study by the European Commission (EC) suggests that high labor costs aren't so much the problem as the European Union's failure to cope with increased international competition and an accelerated speed of technological change.
The increased integration of the world economy has led not only to a sharp rise in global trade of finished goods, but also in the share of intermediate inputs that are traded internationally. This is a reflection of the internationalization of production, which means strong export growth is no longer fully translating into increased domestic production.
In Germany for example, a country that traditionally could rely on export demand to generate growth, there are fears that cheaper labor in the new eastern EU member countries is prompting companies to relocate part of their production process there. Word of a "bazaar economy" is making the rounds.
EU HOLDS UP WELL. The European Commission's new economic paper, Globalisation: Trends, Issues and Macro Implications for the EU, though, suggests that the EU as a whole has so far held up quite well. The study differentiates between foreign outsourcing, i.e., contracting out part of the production process to foreign suppliers, and offshoring, which entails moving production abroad by creating foreign subsidiaries.
The impact of foreign outsourcing can be assessed by looking at trade data and changes in intermediate goods and services imports, which can be used as a proxy for voluntary relocation of work activities. Shifts in the foreign direct investment (FDI) component of capital flows, on the other hand, can be used as an indication of offshoring.
And finally, import penetration ratios vs. growth rate differentials can be used to assess changes in the demand for domestic- and foreign-produced goods and services, which sheds light on the involuntary element of work relocation.
IN LINE WITH WORLD. According to the Commission, the overall global outsourcing market grew by around 3 percentage points of gross domestic product (GDP) in the last decade, from 8.25% of world GDP in 1990 to 11.25% in 2003. The gain is due equally to increases in intermediate services and intermediate goods. This highlights the breadth of the trend: The total EU outsourcing market is an even larger percentage of the economy than for the world as a whole, amounting to 14.75% of GDP in 2003. However, the increase in the 1990 to 2003 period was roughly the same as for the world as a whole, so at least the European share is not rising.
A look at the data shows that the EU's import of intermediate goods has been rising significantly, but at the same time, exports have expanded. According to the Commission, the EU had a constant net surplus on intermediate goods and services traded over the period from 1992-2003, which in fact rose from just 0.5% of GDP in 1992 to 1.4% in 2003. The gain was due to roughly equal growth in intermediate goods and services.
This would suggest that the EU has actually benefited in relative terms with regard to outsourcing. It is worth pointing out, however, that recent euro zone data paint a slightly different picture, and our analysis shows that imports of intermediate goods are not only rising sharply, but also outstripping exports.
NET IMBALANCE. A look at capital flows and net FDI demonstrates the impact of globalization on domestic investments. The EC study shows that stocks of foreign capital as a share of world GDP have increased dramatically since the early 1980s, and especially in the 1990s. FDI constitutes a big part of these flows over the last 10 to15 years, and the inward stock of FDI rose from just around 9% of world GDP in 1990 to close to 23% in 2003. In comparison, during the 1980s, the increase was much more subdued, with the inward stock of FDI rising less than 3 percentage points of world GDP.
Looking at data for the EU shows a sharp increase in the share of inward FDI as a percentage of GDP, but as the study points out, the net position tells a very different story. The net positions for the EU deteriorated significantly over this period. From a position of broad balance in the early part of the 1990s, net FDI outflows from the EU reached over 9% of GDP in 2001 before falling back somewhat in 2002 and 2003.
This trend marks a significant break from the 1980s, when the EU was either in broad balance or slight deficit. And our graph shows that the negative trend is ongoing for the euro zone. The development is to a large extent due to the opening up of China, where net stock of FDI has grown from around 5% of GDP in the early 1990s to over 30% in recent years.
DEMAND SHIFTS. Despite the sharp rise in the EU's net outward FDI, it still amounted to only a small part of the total capital stock of around 300% of GDP in 2003, which puts developments in perspective. Also, as the European Commission has pointed out, part of this is due to "horizontal FDI" outflows, which are geared toward absorbing and acquiring new technologies abroad, rather than "vertical FDI", which are often intended to make use of low labor costs abroad. So not all offshoring is due to labor costs.
The third element of work relocation regards global demand shifts. Looking at import penetration ratios, the EC study suggests that there is a shift in demand towards goods produced in the rest of the world. It seems that technical progress elsewhere has helped other countries gain market share in areas previously dominated by the U.S. or EU. Indeed, EU imports of capital and intermediate goods, as well as high technology products, now constitute a higher share of overall imports.
POTENTIAL BENEFITS. In total, outsourcing in the EU is growing, but at a restrained rate. And though the net FDI position is negative, it is not alarmingly so. But when it comes to import ratios, the EU is not coping well with increased competition from a more integrated world and the accelerated pace of technological change this entails.
The bottom line is that it is not cheaper labor abroad that is a threat to EU growth, but the lack of innovation and a failure to keep up with global technological innovation. Raising innovation and investment in research would not only help to boost long term growth potential, but also help the EU benefit further from globalization.
Note that, according to the commission, around 20% of the increase in living standards over the period 1950 to 2002 can be attributed to the EU's growing integration into the world economy. If you take the effects of intra-EU trade flows into account, the benefits are pushed up to an estimated gain of 30%. This highlights the potential benefits of globalization to the region.
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