Which type of globalization is characterized by countries trading with few barriers?

Although output and trade continue to increase in absolute terms, trade intensity (that is, the share of output that is traded) is declining within almost every goods-producing value chain. Flows of services and data now play a much bigger role in tying the global economy together. Not only is trade in services growing faster than trade in goods, but services are creating value far beyond what national accounts measure. Using alternative measures, we find that services already constitute more value in global trade than goods. In addition, all global value chains are becoming more knowledge-intensive. Low-skill labor is becoming less important as factor of production. Contrary to popular perception, only about 18 percent of global goods trade is now driven by labor-cost arbitrage.

Three factors explain these changes: growing demand in China and the rest of the developing world, which enables these countries to consume more of what they produce; the growth of more comprehensive domestic supply chains in those countries, which has reduced their reliance on imports of intermediate goods; and the impact of new technologies.

Globalization is in the midst of a transformation. Yet the public debate about trade is often about recapturing the past rather than looking toward the future. The mix of countries, companies, and workers that stand to gain in the next era is changing. Understanding how the landscape is shifting will help policy makers and business leaders prepare for globalization’s next chapter and the opportunities and challenges it will present.

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Global value chains are undergoing five structural shifts

The 1990s and 2000s saw the expansion of complex value chains spanning the globe. But production networks are not immutable; they continue to evolve. We observe five major shifts in global value chains over the past decade.1. We refer primarily to nominal trade and GDP values reflecting current exchange rates in dollars. These values embody both quantity and prices.

1. Goods-producing value chains have grown less trade-intensive

Trade rose rapidly within nearly all global value chains from 1995 to 2007. More recently, trade intensity (that is, the ratio of gross exports to gross output) in almost all goods-producing value chains has fallen. Trade is still growing in absolute terms, but the share of output moving across the world’s borders has fallen from 28.1 percent in 2007 to 22.5 percent in 2017. Trade volume growth has also slowed. Between 1990 and 2007, global trade volumes grew 2.1 times faster than real GDP on average, but they have grown only 1.1 times faster than GDP since 2011.2. Trade volumes are measured by trade in real prices. See World trade statistical review 2018, World Trade Organization, 2018.

The decline in trade intensity is especially pronounced in the most complex and highly traded value chains (Exhibit 1). However, this trend does not signal that globalization is over. Rather, it reflects the development of China and other emerging economies, which are now consuming more of what they produce.

Exhibit 1

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2. Services play a growing and undervalued role in global value chains

In 2017, gross trade in services totaled $5.1 trillion, a figure dwarfed by the $17.3 trillion global goods trade. But trade in services has grown more than 60 percent faster than goods trade over the past decade (Exhibit 2). Some subsectors, including telecom and IT services, business services, and intellectual property charges, are growing two to three times faster.

Exhibit 2

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Yet the full role of services is obscured in traditional trade statistics. First, services create roughly one-third of the value that goes into traded manufactured goods. R&D, engineering, sales and marketing, finance, and human resources all enable goods to go to market. In addition, we find that imported services are substituting for domestic services in nearly all value chains. In the future, the distinction between goods and services will continue to blur as manufacturers increasingly introduce new types of leasing, subscription, and other “as a service” business models.

Second, the intangible assets that multinational companies send to their affiliates around the world—including software, branding, design, operational processes, and other intellectual property developed at headquarters—represent tremendous value, but they often go unpriced and untracked unless captured as intellectual property charges.3. Some trade in intangible assets is captured in trade statistics through intellectual property charges. These flows are sometimes driven by decisions of multinationals on where to put ownership of these assets based on tax considerations. See Thomas Tørsløv, Ludvig Wier, and Gabriel Zucman, The missing profits of nations, NBER working paper number 24701, June 2018, revised August 2018; and OECD/G20 Base Erosion and Profit Shifting (BEPS) Project, final report, OECD, May 2015. Years of R&D go into developing pharmaceuticals and smartphones, for example, while design and branding enable companies such as Nike and Adidas to charge a premium for their products.

Finally, trade statistics do not track soaring cross-border flows of free digital services, including email, real-time mapping, video conferencing, and social media. Wikipedia, for instance, encompasses 40 million free articles in roughly 300 languages. Every day, users worldwide watch more than a billion hours of YouTube’s video content for free, and billions of people use Facebook and WeChat every month. These services undoubtedly create value for users, even without a monetary price.

We estimate that these three channels collectively produce up to $8.3 trillion in value annually—a figure that would increase overall trade flows by $4.0 trillion (or 20 percent) and reallocate another $4.3 trillion currently counted as part of the flow of goods to services. If viewed this way, trade in services is already more valuable than trade in goods. This perspective would substantially shift the trade balance for some countries, most notably the United States. This exercise is not meant to argue for redefining national trade statistics. It simply underscores the underappreciated role of services, which will be increasingly important for how companies and countries participate in global value chains and trade in the future.

3. Trade based on labor-cost arbitrage is declining in some value chains

As global value chains expanded in the 1990s and early 2000s, many decisions about where to locate production were based on labor costs, particularly in industries producing labor-intensive goods and services. Yet counter to popular perceptions, today only 18 percent of goods trade is based on labor-cost arbitrage (defined as exports from countries whose GDP per capita is one-fifth or less than that of the importing country).4. If we vary the ratio of GDP per capita of the exporter and importer from 2 to 10, we find that labor-cost arbitrage ranges from 5 to 30 percent of overall global trade. In other words, over 80 percent of today’s global goods trade is not from a low-wage country to a high-wage country. Considerations other than low wages factor into company decisions about where to base production, such as access to skilled labor or natural resources, proximity to consumers, and the quality of infrastructure.

Moreover, the share of trade based on labor-cost arbitrage has been declining in some value chains, especially labor-intensive goods manufacturing (where it dropped from 55 percent in 2005 to 43 percent in 2017). This mainly reflects rising wages in developing countries. In the future, however, automation and AI may amplify this trend, transforming labor-intensive manufacturing into capital-intensive manufacturing. This shift will have important implications for how low-income countries participate in global value chains.

4. Global value chains are growing more knowledge-intensive

In all value chains, capitalized spending on R&D and intangible assets such as brands, software, and intellectual property (IP) is growing as a share of revenue. Overall, it rose from 5.4 percent of revenue in 2000 to 13.1 percent in 2016. This trend is most apparent in global innovations value chains. Companies in machinery and equipment spend 36 percent of revenue on R&D and intangibles, while those in pharmaceuticals and medical devices average 80 percent (Exhibit 3). The growing emphasis on knowledge and intangibles favors countries with highly skilled labor forces, strong innovation and R&D capabilities, and robust intellectual property protections.5. Some trade in intangible assets is captured in trade statistics through intellectual property royalties, which are influenced by tax considerations. But the creation (rather than final ownership location) of intangible assets takes place in countries with talent, legal protections, and innovation ecosystems.

Exhibit 3

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In many value chains, value creation is shifting to upstream activities, such as R&D and design, and to downstream activities, such as distribution, marketing, and after-sales services. The share of value generated by the actual production of goods is declining (in part because offshoring has lowered the price of many goods). This trend is pronounced in pharmaceuticals and consumer electronics, which have seen the rise of “virtual manufacturing” companies that focus on developing goods and outsource actual production to contract manufacturers.

5. Value chains are becoming more regional and less global

Until recently, long-haul trade crisscrossing oceans was becoming more prevalent as transportation and communication costs fell and as global value chains expanded into China and other developing countries. The share of trade in goods between countries within the same region (as opposed to trade between more far-flung buyers and sellers) declined from 51 percent in 2000 to 45 percent in 2012.

That trend has begun to reverse in recent years. The intraregional share of global goods trade has increased by 2.7 percentage points since 2013, partially reflecting the rise of emerging-market consumption. This development is most noticeable for Asia and the EU-28 countries. Regionalization is most apparent in global innovations value chains, given their need to closely integrate many suppliers for just-in-time sequencing. This trend could accelerate in other value chains as well, as automation reduces the importance of labor costs and increases the importance of speed to market in company decisions about where to produce goods.

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One of the forces reshaping global value chains is a change in the geography of global demand

The map of global demand, once heavily tilted toward advanced economies, is being redrawn—and value chains are reconfiguring as companies decide how to compete in the many major consumer markets that are now dotted worldwide. McKinsey estimates that emerging markets will consume almost two-thirds of the world’s manufactured goods by 2025, with products such as cars, building products, and machinery leading the way. By 2030, developing countries are projected to account for more than half of all global consumption. These nations continue to deepen their participation in global flows of goods, services, finance, people, and data.

The biggest wave of growth has been happening in China. Previous MGI research highlighted China’s working-age population as one of the key global consumer segments; by 2030, they are projected to account for 12 cents of every $1 of worldwide urban consumption. As it reaches the tipping point of having more millionaires than any other country in the world, China now represents roughly a third of the global market for luxury goods. In 2016, 40 percent more cars were sold in China than in all of Europe, and China also accounts for 40 percent of global textiles and apparel consumption.

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The rise of domestic supply chains in China and other emerging economies has also decreased global trade intensity

China’s rapid growth has made it a major part of virtually every goods-producing global value chain. Overall, it now accounts for 20 percent of global gross output, up from just 4 percent in 1995. In textiles and apparel, electrical machinery, and glass, cement, and ceramics, it now produces nearly half of global output.

But as its economy has matured, China has moved beyond assembling imported inputs into final products. It now produces many intermediate goods and conducts more R&D in its own domestic supply chains. This is the second factor dampening global trade intensity in goods. In computers and electronics, for instance, Chinese companies are developing the kind of sophisticated smartphone chips that China once imported from advanced economies. Building more vertically integrated domestic industries enables China to capture more value added—and simultaneously bring jobs and economic development to its poorer inland provinces.

Other developing countries are beginning to exhibit the same structural shifts seen in China, although they are at earlier stages. In textiles and apparel, for instance, production networks spanning multiple stages are consolidating within individual countries such as Vietnam, Bangladesh, Malaysia, India, and Indonesia.

As a group, emerging Asia has become less reliant on imported intermediate inputs for the production of goods than the rest of the developing world (8.3 percent versus 15.1 percent in 2017). By contrast, in developing Europe, where economic growth has been slower, companies have continued to integrate into the supply chains of companies in Western Europe. The decline in trade intensity reflects growing industrial maturity in emerging economies. Over time, their production capabilities and consumption are gradually converging with those of advanced economies. Declining trade intensity in goods does not mean globalization is over; rather, digital technologies and data flows are becoming the connective tissue of the global economy.

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New technologies are changing costs across global value chains

The explosive growth of cross-border data flows, highlighted in MGI’s previous research on digital globalization, is ongoing. From 2005 to 2017, the amount of cross-border bandwidth in use grew 148 times larger. A torrent of communications and content travels along these digital pathways—and some of this traffic reflects companies interacting with foreign operations, suppliers, and customers.

Instant and low-cost digital communication has had one clear effect: lowering transaction costs and enabling more trade flows. But the impact of next-generation technologies on global flows of goods and services will not be as simple. The net impact is uncertain, but in some plausible scenarios, the next wave of technology could dampen global goods trade while continuing to fuel service flows.

Digital platforms, logistics technologies, and data-processing advances will continue to reduce cross-border transaction costs and enable all types of flows

In goods-producing value chains, logistics costs can be substantial. Companies often lose time and money to customs processing or delays in international payments. Three sets of technologies will continue to reduce these frictions in the years ahead.

Digital platforms can bring together far-flung participants, making cross-border search and coordination more efficient. E-commerce marketplaces have already enabled significant cross-border flows by aggregating huge selections and making pricing and comparisons more transparent. Alibaba’s AliResearch projects that cross-border B2C e-commerce sales will reach approximately $1 trillion by 2020. B2B e-commerce could be five or six times as large. While many of those transactions may substitute for traditional offline trade flows, e-commerce could still spur some $1.3 trillion to $2.1 trillion in incremental trade by 2030, boosting trade in manufactured goods by 6 to 10 percent. Continued rapid growth in small-parcel trade would present a challenge for customs processing, however.

Logistics technologies also continue to improve. The IoT can make delivery services more efficient by tracking shipments in real time, and AI can route trucks based on current road conditions. Automated document processing can speed goods through customs. At ports, autonomous vehicles can unload, stack, and reload containers faster and with fewer errors. Blockchain shipping solutions can reduce transit times and speed payments. We calculate that new logistics technologies could reduce shipping and customs processing times by 16 to 28 percent. By removing some of the frictions that slow the movement of goods today, these technologies together could potentially boost overall trade by 6 to 11 percent by 2030.6. The academic literature finds that a 1 percent reduction in trade costs can result in a 0.4 percent increase in trade flows. See Simeon Djankov, Caroline Freund, and Cong S. Pham, “Trading on time,” The Review of Economics and Statistics, 2010, Volume 92, Number 1.

Automation and additive manufacturing change production processes and the relative importance of inputs

Previous MGI research has found that roughly half of the tasks that workers are paid to do could technically be automated, suggesting a profound shift in the importance of capital versus labor across industries. The growing adoption of automation and advanced robotics in manufacturing makes proximity to consumer markets, access to resources, workforce skills, and infrastructure quality assume more importance as companies decide where to produce goods.

Service processes can also be automated by artificial intelligence (AI) and virtual agents. The addition of machine learning to these virtual assistants means they can perform a growing range of tasks. Companies in advanced economies are already automating some customer support services rather than offshoring them. This could reduce the $160 billion global market for business process outsourcing (BPO), now one of the most heavily traded service sectors.

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Given the shifts in value chains, companies need to reevaluate their strategies for operating globally

Both the costs and the risks of global operations are shifting. Several imperatives stand out for global companies in this landscape:

What types of globalization that focus on trading with other countries?

What are trade barriers globalization?

What type of globalization is trade?

What are the 3 types of globalization?