Comparative & competitive advantages

It is July 2011 and 65 of 76 Thai provinces have just been declared flood disaster zones. Lives and livelihoods are in tatters. The effects are ripping through communities. When the final count is eventually tallied, assessed and verified, official records will show the devasting impact of Tropical Storm Nock-ten: 815 deaths (with three missing) and 13.6 million people affected overall. Some areas remained underwater until 2012.

In addition to the tragic human impact, the storm had far-reaching commercial implications. One industry particularly affected was disc drive manufacturing.

As the second-largest producer of hard disk drives at the time, Thailand supplied approximately 25% of the world's production.¹ The flooding of factories caused great disruption, with estimated related costs for one of the leading manufacturers – Western Digital – running into the hundreds of millions of US dollars. And while some factories in the same location but on higher ground faced less disruption (such as Seagate), prices for most hard disk drives almost doubled globally, taking approximately two years to recover.^2,3 Many leading industry analysts predicted worldwide shortages of hard disk drives – something that did not actually materialize as manufacturing capabilities came back online.

Did such an extreme event – arguably a forewarning of the dangers of supply chain concentration – change corporate strategy and cause management teams to build more resiliency into their operations? The answer – perhaps surprisingly – is no.⁴ To appreciate why, and also draw broader lessons across different sectors and regions, we need to better understand the decision-making factors influencing supply chains.

The implications of the Thai floods extend far beyond disk drives. After all, the rise of global value chains has resulted in production networks expanding across the globe.

The lure of low-cost labor locations and increased costs associated with spreading operations across multiple locations has led to key production capacities agglomerating and concentrating in specific regions of a single country. Whether implicitly or explicitly, the relentless pursuit of optimal resource allocation has caused management executives to make probability judgements on the likelihood of disruptive and expensive upstream events occurring.

A recent report from the OECD quantified the extent of this high-risk strategy in various geographies and markets.

Figure 1: The geographic concentration of intermediate goods exports is high is some sectors

A share of top five countries in world exports of intermediate goods by industry, 2018

Figure 2: The geographic concentration of production is also very high for individual products

Percent of global production

To understand why such industrial concentration has persisted it helps to remember that, for the last few decades, the global economy has remained on a steady geopolitical equilibrium centered on a few key pillars:
globalization, free movement of goods, capital, technology and people, and the role of the private sector. In other words, the incentives for real-world diversification were low.

However, this equilibrium is shifting. A pivot towards deglobalization, protectionism, and rising trade barriers of goods, labor and increasingly capital is causing the economic and political world to fragment, with
governments reassessing their political priorities. Issues such as energy security, access to essential resources, defense, resilience of supply chains, as well as strategic positioning around artificial intelligence and technology, are at the top of their political agendas (and in their spending
plans).

As a result, and after decades of relative stability, corporate management teams worldwide are being forced to carefully consider the makeup and configuration of their supply chains. In theory, companies are incentivized financially to reduce the risks of costly disruptions to production.

Yet, as Figure 3 from McKinsey shows, despite some pandemic-triggered excitement around ‘plus-one’ value chain strategies, it is not yet clear how much site location diversification and near/friend-shoring is actually
happening. Less expensive and operationally intensive measures like increased inventory buffers appear to be winning the day. Like all great hangovers, the immediate effects fade, and – in this case – a heady mix of short-term efficiency gains and sunk-cost fallacy prevails.

Figure 3: Companies’ intentions and implemented actions to boost supply-chain resilience

Percent of respondents to McKinsey survey of global supply-chain leaders

In our 2024 UBS Reserve Management Seminar Survey (RMS) of central bankers, the most cited risk facing the global economy was further escalations in geopolitical conflicts.

This is hardly surprising given the ongoing military conflicts in Europe and the Middle East, the confrontation between China and the US, and the latest wave of protectionist measures announced or launched by the US and Europe.

Figure 4: Main concerns impacting the global economy

What are the main risks that the global economy is currently facing?

Indeed, national security breaches, as well as the potential social costs from disruptions to production and any knock-on unavailability of products, could ultimately impact the economic, health or military security of a country, according to the OECD.⁵

A tangible example of how geopolitics are influencing supply chain configuration is technology and the race for supremacy in artificial intelligence. The CHIPS Act in the US is a prime example of industrial strategy in action; a protectionist measure in the face of significant competition from China. With 60% of all semiconductors and over 90% of the most advanced chips manufactured in Taiwan, there is strong strategic rationale for diversification.⁶ Public policy drives private sector behavior.

Geopolitical risk is notoriously difficult to diversify away from. However, both governments and firms must find effective ways of continually measuring these such risks and, as the OECD points out, “come up with proportional measures to mitigate them.”⁷

Interestingly, few of our central banking survey respondents flagged climate change and other sustainability factors as a significant risk. Yet, Everstream – a supply chain analytics firm – listed their top five supply chain risks for 2024 as:⁸

1. Extreme weather
2. New environmental regulations that could create disruption to operations
3. National protectionist measures, particularly between the US and China
4. The potential for escalating tension over Taiwan and its political status with respect to China
5. Shortages of agricultural commodities

Sustainability and geopolitical issues dominate the list. There could be many reasons for this disconnect. Firstly, it could simply be the difference between top-down and bottom-up views. Perhaps more likely though, it could reflect the growing interconnections between geopolitics and sustainability. A growing linkage between the two has been glacially forming over the last decade or so, and across multiple dimensions of each. This means that, depending on your perspective, you may view an issue like energy security primarily as geopolitical, sustainability, or both.

Global relations and geopolitics are typically shaped by the needs of countries to have access to the resources necessary to prosper and develop: a) energy/material; b) technology; and c) human capital. Current geopolitical developments – deglobalisation, fragmentation, protectionism and conflicts – reflect the political efforts made by nations to have a reliable access to these ’production factors’.

So, while geopolitics has a large impact on all these resources, so too do sustainability issues (such as via the impact of climate change on human capital through migration and health, among other things).

A prime example of where supply chain concentration and the interplay between geopolitics and sustainability overlap is electric vehicles and renewable energy demand. China dominates the supply of rare earth minerals, giving it significant geopolitical leverage over countries transitioning to green energy. In response, the European Union and the US are reshaping their supply chains to reduce dependence on China for key materials that are crucial for electric vehicle batteries.

Figure 5: Concentration of production of critical raw materials is high

Note: Concentration of production in Panel A is measured by the Herfindahl-Hirschman index (HHI). In Panel B, 3-letter country ISO codes for countries that are not in the OECD and are not among the key partners and the accession countries refer to: Democratic Republic of the Congo (COD), Morocco (MAR), Mozambique (MOZ), Myanmar (MMR), Russia (RUS) and Zimbabwe (ZWE).

As ex-ECB governor Draghi wrote in a recently published report, “Decabornisation can be an opportunity for Europe, both to take the lead in new clean technologies and circularity solutions and to shift power generation towards secure, low-cost clean energy sources in which the EU has generous natural endowments.”⁹ In other words, reduce reliance on a single supplier, and improve supply chain resilience while meeting sustainability goals.

From a sustainability perspective, it is not just environmental factors overlapping with geopolitics. Social considerations are increasingly intertwined and likely to influence corporate and investors’ outcomes.

International value chains have traditionally been built to have better and cheaper access to resources, including human capital. As companies explore the shortening and diversification of their supply value chains, labor demand could shift across sectors, countries and regions. Some countries will likely benefit – for instance the Indian skilled labor force might have an advantage over China facing increasing opposition and scrutiny over immigration. As such, companies arguably face increasing risk of the lack of skilled labor should their value chain not be sufficiently diversified.

The demand dynamic for human capital is shifting, too. As the need for digital skills increases, while historically demand for non-skilled labour has led to China becoming a prime location, India, Vietnam and Mexico are likely to benefit as well. Equally, climate-related migration is now the largest form of migration and growing. Therefore, the interplay between geopolitics and local immigration policies is only set to grow.

This is where active policy engagement by companies and investors could play a key role. While engaging with governments and multilateral organizations is not a new concept in sustainable finance circles, as geopolitical complexity increases it is likely to become ever more important.

After all, governments can play a role to support resilience in supply chain management (as shocks can impact economies). Governments can model concentration and bottlenecks using stress testing for essential supply changes and then making sure regulations are supportive and not an additional source of uncertainty.

We should also remember that the interplay between climate change and geopolitics also creates opportunities. For instance, the reconfiguration of international supply chains driven by technology and resilience can become an opportunity for companies to improve the sustainability profile of their operations and be better prepared for the tightening sustainability-related regulatory environment.¹⁰

Active investors are judged on return outcomes, and not on perceived decision quality – often summed up by the notion that the market can stay irrational longer than most of us can stay solvent. This can play psychological tricks; the fear of missing out adds pressure to take excessive risks by concentrating in a few momentum stocks.

Similarly, management executives face the temptation to push the risk boundaries in favor of higher supply chain concentration. As we try to peek into the future, it seems inevitable that a more nuanced and subtle approach to international supply chain management will emerge. The practicalities of running a global business mean executives will have to balance the benefits of supply chain diversification with the cost efficiencies of concentration. The optimal strategy will likely differ across firms and sectors.

Updated risk models will need to reflect shifting trade policy and labour dynamics across the globe. Strategic decisions around manufacturing hubs will also need to factor into the evolving geographic realities of various regions and locals, not least how climate and nature crises are interconnected and influencing various societies and overall geopolitical trends.

Among other things, this should include analyzing the political stability and regulatory environment. Companies can use scenario planning to anticipate how different geopolitical developments might play out. An example would be to plan for scenarios where a country withdraws from a climate agreement or new sanctions are imposed.

The world today looks and feels very different from the one thirteen years ago, when risk managers and corporate executives at Thailand’s disk drive manufacturers huddled around boardroom tables debating the pros and cons of diversifying their supply chains.

Headlines about extreme weather events, indicating a direct link to climate change, are now commonplace; they weren’t back then. Should floods happen again in Thailand tomorrow – just as they are today in Spain – would the same conclusions be reached? Perhaps not.

¹ "Thailand floods to put the grinch in Christmas" Carey, Adam (29 October 2011).
² Thailand Flooding Cripples Hard-Drive Suppliers, The New York Times, 6 November 2011
³ "Storage Pricewatch: HDDs back to pre-flood prices, SDDs grow as $/GB holds steady". ExtremeTech. 19 April 2013.
⁴ UBS Asset Management (based on contact with various media and investor relations contacts), September 2024.
⁵ Risks and opportunities of reshaping global value chains, OECD, 2023.
⁶ https://www.cfr.org/article/onshoring-semiconductor-production-national-security-versus-economic-efficiency#:~:text=But%20even%20that%20understates%20
Taiwan's,chips%20are%20manufactured%20in%20Taiwan.
⁷ Risks and opportunities of reshaping global value chains, OECD, 2023.
⁸ Extreme weather is 2024’s top supply chain risk: Everstream, Supply Chain Dive, 11 January 2024
⁹ Draghi Competitiveness Report, 2024
¹⁰ 2024 Reserve Management Survey, UBS Asset Management, March 2024.