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The Power of the Wave Principle

The Outsourcing Circle of the Global Economy

Economics / Economic Theory Aug 16, 2010 - 06:23 AM GMT

By: Akhil_Khanna

Economics

Best Financial Markets Analysis ArticleA lot has been written, over the years, about the benefits of outsourcing and its effects on the profitability of the global corporations.

This article aims to draw attention towards the Long Term effects of outsourcing to the same corporations doing so.


Short Term Outsourcing Benefits :

The short term benefits of outsourcing are as follows :

  • The corporations in developed countries are able to produce cheaper goods and services resulting in increased profit margins by shifting their manufacturing and service industry bases to the developing countries.
  • The increase in profitability enhances the bonuses paid out to the top management of the companies.
  • The increased profitability also leads to increase in stock prices, dividends in the initial phase during which outsourcing is in progress. This leads to major stock market revaluation based on extraordinary profit margins and projections of continuing the same over the years to come.
  • There is a great demand for labor and investment in developing countries to cater to the needs of demand of outsourcing both for manufacturing and services industries leading to increased incomes for the citizens and businesses of these countries.
  • This robust demand leads to increase tax collections by governments of developing countries who invest it in developing the infrastructure of their own countries.

There is an overall feel good factor in both the developed and developing countries which leads to carefree spending worldwide by individuals, corporations and governments. Their attitude towards borrowing and spending to meet their day to day expenditures too becomes casual as expectations mount of good times to continue forever.

Outsourcing Benefits Taper Off 

A few years into outsourcing and the following changes start taking place :

  • All the corporations and their competitors in the developed countries have shifted their manufacturing and services industry base to the developing countries. Those who did not went out of business due to lack of competitiveness.
  • Now the cost of getting their goods manufactured or services are similar all across the industry. The corporations start resorting to price cuts in order to stay competitive.
  • The cost of doing business in the developing countries goes up due to the increase in salaries, rents, infrastructure etc. leading to an increase in cost of producing the goods and services.
  • This results in lower profitability margins and resulting in lower share prices, dividend payout etc. The result is lower profitability projections and lower disposable incomes in the hands of investors.
  • The biggest blow to the corporations are falling worldwide demand for their goods and services.

The reason for this is explained using an example.

Mr. Jones was working in a company in U.S. earning USD 30,000/- p.a. He spent almost all his earnings (Savings rate in the U.S. was negligible) in living a comfortable life for himself and his family. He spent his earnings in buying the latest LCD Screens, I-pods, Laptops, Taking vacations, Regularly eating out etc. 

He found his salary remaining stagnant due to outsourcing process taking place in his company. He continued his lavish lifestyle by taking on credit card debt or refinancing his mortgage expecting his income to gradually increase in the future. The credit was easily available as the bankers who gave him the loans were getting their commissions / bonuses based on quantity of loans given rather than it’s quality.

Gradually he too found his job outsourced to Mr. Shyam in India for USD. 3000/- p.a. and he was given the pink slip. Now Mr. Jones is no longer able to meet his basic living expenses and he finds that after the credit crises banks are unwilling to extend credit to him for consumption. He has now to depend on unemployment benefits to survive.

Now Mr. Shyam who was earlier earning USD 1500/- p.a. has doubled his income. He has doubled his monthly expenses from USD. 1000/- to USD 2000/- henceforth. (The savings rate for developing countries is still north of 30%)

Using this example the demand for finished goods and services has shrunk by more than 90%. Mr. Jones and Mr. Shyam together used to spend more than USD 30,000/- earlier whereas their total spending has dropped down to less than USD 3,000/- henceforth (taking into account the unemployment benefits of Mr. Jones and the increased spending of Mr. Shyam).

Even if Mr. Shyam’s income doubles the total demand for goods and services is not going to be positively impacted in any major way as it would take 10 Mr. Shyam’s expenditure level to substitute one Mr. Jones spending power.

Multiply this example by the no. of people laid off in developed countries and replaced by ones in developing countries and you would get an idea of the demand destruction having taken place worldwide due to this popular phenomenon.

  • The increasing levels of unemployment results in two fold hit to the governments of the developed countries. The tax collections of those governments goes down substantially and their expenses increase multifold due to increased unemployment benefits for their citizens.
  • These governments are forced to either borrow more from other countries to meet their expenses or increase the taxes on the profitable corporations in their own country.
  • The resultant rise in domestic unemployment forces the politicians of  the developed countries to raise protectionism measures and create conditions that discourage outsourcing of jobs to other countries or make it more expensive to do so.

Long Term Effects on Corporations

The corporations in the developed countries are hit by :

  • Increasing Cost of Production of Goods and Services.
  • Falling Sales Revenues.
  • Higher Taxation Rates.
  • Falling Profitability Margins.
  • Difficulty in raising new debt to repay old ones.
  • Increase in their cost of borrowing.
  • Fall in stock prices makes it difficult to raise further capital.

The businesses in the developing countries are also hit by most of the aforementioned factors alongwith the negative impact of the efforts of the governments of developed countries to discourage or stop outsourcing. The slack in their export earnings are not compensated by the increase in the domestic demand for their goods and services due to the sensible decision of the domestic population to have a higher rate of savings.

Conclusion

The unemployment rate worldwide is going up and there is a continuous process underway of replacing high paying jobs with lower ones. This also includes highly qualified people taking up low paying or part time jobs just to keep themselves employed.

This is a gradual and painful adjustment process which will unfold over the coming years resulting in lower standard of living for a majority of the worldwide population due to falling incomes and existing debt burden. The government policies of rock bottom interest rates is not going to increase the demand for additional debt to fund a comfortable lifestyle by the consumers. This is due to the lack of the confidence in increased future earnings or asset prices by them.

The resultant demand destruction will lead to many corporations to reduce their production capacities and lower their profitability / incur losses due to the debt burden they are carrying from their earlier capacity expansion exercises.

The most difficult task for the governments around the world will be to fund the expense of their own existence after having grown exponentially during the last few decades. They will be forced to reduce the strength and salaries of their employees, their pension benefits, unnecessary war expenses, increase their operational efficiencies or face the consequences of sovereign default. The option of increasing tax rates on already burdened consumer and corporations is not available to them.

All the above measures will result in tough living conditions for the majority of population till the excess debt and leverage has been washed away from the global economy. The stimulus measures given by the governments just prolongs the de-leveraging period without any benefits in the long run whatsoever. It also makes the final adjustment much more painful as more the debt and leverage in the system the longer it will take for the adjustment process to run through. The sooner de-leveraging is done the faster the real economic recovery can start on the basis of renewed savings, sensible and responsible spending and increasing employment.

By Akhil Khanna

akhil.capricorn@gmail.com

Previous Articles written by the author

  1. Financial Speculation, The Global Casino
  1. Key Financial Markets and Economic Forecasts for 2010 and Beyond
  1. Financial Crisis 2008-2009, The Seeds of the Credit Crunch
I am an MBA Finance from the University of Sheffield, 1992 and have more than 15 years of experience in the field of Financial Management. I am a keen student of the Flow of Money around the World and enjoy studying the fields of Currencies, Stock markets, Commodity Markets and Bonds.

© 2009 Copyright Akhil Khanna - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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