The 2011 World Investment Report from the United Nations Conference on Trade and Development (Unctad) introduced a new term to the lexicon of international trade and investment: non-equity modes (NEM) of international production and development.

The term establishes a new category to describe a $2000bn-a-year phenomenon reshaping patterns of global trade and supply chains – the diverse range of activities that multinational companies farm out to foreign suppliers or franchisees. It includes contract manufacturing, services outsourcing, contract farming, franchising and licensing, as well as other forms of contractual relationships. In total, NEMs account for about 21 million jobs worldwide, the report estimated.

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“This report breaks new ground because it puts a name on a collection of activities that have gradually emerged but have not been seen as sharing an identity,” says James L Bacchus, chair of law firm Greenberg Traurig’s global practice, former chair (chief judge) of the appellate body of the World Trade Organisation, and current chair of a working group revising the International Chamber of Commerce’s guidelines on international investment.

NEM rise

Though the $2000bn value of NEM exports is significantly less than the $6000bn generated in 2010 by foreign affiliates of multinationals through FDI, NEMs are particularly important in developing countries and are growing rapidly, Unctad reported.

Unlike FDI, where a multinational controls its foreign operations by holding at least a minority equity stake in them, NEM control is exercised through contract specifications relating to design and quality, production standards, or a required business model that the local partner must abide by.

"The choice is thus no longer between control through ownership (FDI) or no control (trade), but between a range of modes in which control is exercised in various configurations and to various degrees," the report stated. It is analogous to a 'make or buy' decision.

Extending reach

“[Multinationals] are generally prepared to externalise any activity that is not fundamental to competitive advantage in their market or industry” if it can be done elsewhere at lower cost with little risk, according to the report.

NEM arrangements can be complements or substitutes for FDI in creating global value chains. Multinationals opt for FDI or an NEM strategy based on an analysis of the risks and advantages of each approach, as well as its feasibility. The end result may be a complex mix of directly owned, partially owned, contract-based and arm's-length operations.

A key element in assessing risk, according to Mr Bacchus, is the strength of the rule of law, especially with regards to intellectual property. In his view, if companies feel their private contractual arrangements and IP will be respected by the courts and the legal system in the host country, they may be more likely to enter an NEM arrangement instead of FDI.

Contract manufacturing and service outsourcing tops the list of NEM activities with most sales generated, value added, exports, worldwide employment and employment in developing countries, the report stated. In the auto industry, it accounts for 30% of global exports and 25% of employment – less than in electronics or the garment, footwear and toy sectors. In these industries, by cost of goods sold, more than 50% of production is outsourced; the share for pharmaceuticals is much less – 40% for generics and just 20% for branded drugs.

Multinational outsourcing

Some contract manufacturers and IT outsourcing companies have become multinationals in their own right. Electronics manufacturing is heavily concentrated in East Asia, especially China. Ten manufacturers account for two-thirds of activity in this sector – often with operations in other countries such as Brazil, India, Mexico and Turkey. In contrast, in the garment and footwear industries a host of small suppliers tend to serve a few global brands.

Intermediaries that provide value-chain management services have also evolved. A few are themselves multinationals such as Hong Kong-based Li & Fung, which specialises in supply-chain management for leading retailers and brands worldwide via an extensive global network. 

In information technology and business process outsourcing, India leads with multinationals such as Tata Consulting Services, Infosys Technologies and Wipro.

Adopting NEM strategies

The report identifies several factors likely to expand the use of NEM strategies. Among them are “the increasing fragmentation of production processes between locations, growing sophistication in codification of knowledge and prevalence of industry standards, improving intellectual property protection regimes”, as well as the growing technological sophistication of partner firms.

In some cases, restrictions on FDI such as caps on foreign ownership may force companies to adopt NEM strategies.

According to the report, countries can enhance their attractiveness as locations for NEMs with many of the same policies that draw FDI. In addition, initiatives to upgrade technology, quality or productivity standards can boost the number of businesses available to partner with multinationals, and, along with access to capital, stimulate activity.

A country’s general infrastructure is as important, says James R Markusen, a professor at the University of Colorado and author of a book on the role of multinationals in the international economy. “The whole legal and institutional framework of reliable government is very important whether for FDI or arm's-length contractual arrangements. Low wages are not the primary determinant. Multinationals are holding out a carrot, but in exchange they want good governance.”

Developing potential

For many developing countries, the stakes are enormous. Unctad estimates that 18 to 21 million people worldwide are directly employed in both skilled and unskilled work under NEM arrangements – 80% in developing or transition economies. In addition, there is direct employment in contract farming, as well as significant indirect employment. The report cites the example of Nestlé, which has more than 550,000 small farmers under contract around the world to produce the ingredients for its food and beverage businesses.

Contract farming can also benefit participating farmers by providing them with a market for their products and training in efficient agribusiness, such as how to grow the right product in the right way with delivery at the right time, Mr Markusen says.

International hotel chains operating through management contracts or franchises with local businesses in developing countries also boost employment, with an average 8:1 ratio of staff to guests, and generate secondary employment opportunities.

Further benefits

Besides jobs, NEM activities can contribute to GDP, promote technology transfer, serve as a route to market for countries aiming at export-led growth and help build industrial capacity.

However, the report noted NEMs also poses risks for host countries. Local companies focused on cutting costs may provide poor working conditions. Multinationals may pull up stakes and move to lower-cost locations, and sudden swings in the business cycle can lead to mass unemployment.

The International Chamber of Commerce group has not yet decided whether it will address NEM issues in revising international investment guidelines. However, Mr Bacchus says the subject is likely to be on the agenda in April when Unctad’s global investment conference meets in Doha, and the business community is expected to urge the G-20 to address the issue at an upcoming meeting. “This is a cutting-edge issue,” he says.