Pandemic a warning to diversify supply chains outside of China

The Covid-19 pandemic will quicken the diversification of manufacturing supply chains out of China to reduce businesses’ reliance on “the world’s factory”, finds a new report.

Strict lockdowns imposed in January on Wuhan and other cities in the Hubei province, a global manufacturing hub and the reported source of Covid-19, caused chaos for companies needing to ship out components from China to other markets. Orders were cancelled, procurement was complicated and workforce shortages meant labour-intensive production was stalled.

China is now struggling with a new challenge, one of demand rather than supply. International orders are flatlining as many of China’s trading partners remain in partial or full lockdowns. Despite Beijing rolling out a stimulus package and reopening factories, the global slowdown has put pressure on the country.

“It is doubtful whether the Chinese manufacturing sector can orchestrate a recovery purely on its terms. Multinational companies are facing a challenging choice between self-preservation and supplier solvency,” reveals the report, titled Pandemic quickens diversification of supply chains beyond China, by Verisk Maplecroft, a global risk analytics and advisory company, and Wood Mackenzie, a global commodities research group.

While businesses were already making plans to move their supply chains out of China pre-Covid-19, the pandemic will quicken this process, finds the research. GTR speaks to co-author of the report Kaho Yu, senior analyst for Asia at Verisk Maplecroft, about what is in store for manufacturing supply chains in Asia.

 

GTR: What problems did businesses that rely on Chinese production face when Covid-19 cases began to increase and travel restrictions were put into place?

 Yu: In the first quarter of the year, we saw mass interruption to supply chains. It is not just about the supply and demand dynamics; it is about the collapse of entire logistics networks. There were major delays and the delays led to orders lost, delivery failures as well as delayed payments. We have also seen small and medium-sized enterprises (SMEs) declare bankruptcy because of these delays. SMEs often supply the bigger companies, the state-owned companies, and if they disappear the chain is broken. Procurement in the larger firms has been disrupted, so the pandemic has created chaos in the supply chain business.

Companies are realising that they are overly reliant on one or maybe two supply centres or manufacturing hubs. In the last few decades, many companies have relied solely on supply from China. If it gets into trouble, like we have seen with the pandemic, then a lot of these companies are stuck, suddenly finding out that they do not have alternative suppliers (Figure 1). The pandemic has been a warning to diversify supply chains outside of China to avoid similar disruption in the future.

Figure 1: Chinese supply of raw and intermediate products dropped in Q1

 

GTR: Where will manufacturers go if they move from the key production hubs where they are currently located?

Yu: The question is complicated because it really depends on which industry you are looking at. For automotive companies, a lot of them cannot leave China because they build those vehicles to be sold in China, it is a domestic operation (Figure 2). If the business in China is not working, then the only choice is to shut it down rather than move it out because if the factory is moved overseas to, say, Southeast Asia and then products are sold back to China, they are imports and will be subject to tariffs and extra costs. Therefore, the Japanese and American auto companies located in China, for example, will very likely stay in the country.

However, that does not mean that they are not planning to diversify parts of their supply chain. They may plan on moving some component production away and not the manufacture of the car. They could move component making to Southeast Asia because they are not necessarily selling those components in China. For example, many Japanese auto makers are shipping the components back to Japan or elsewhere. They could move the factory, produce the component, and ship it back to Japan. This is called a partial diversification of the supply chain.

Figure 2: Japanese manufacturers in China: Sales in transport and electrical machinery in 2019

In terms of relocation destinations, Southeast Asia is likely to be a very attractive option because the region is expected to receive more investment as it has flexible investment policies. Even more importantly, the labour cost in Southeast Asia can be quite low, which is very attractive.

 

GTR: What strategies are businesses taking to diversify their supply chains out of China?

Yu: Businesses are beginning to look elsewhere for production alternatives but, at the same time, it is impossible for them to leave China entirely and move to another place, as China has its own advantages, namely big markets and relatively low labour costs. For example, it would be impossible for Japanese and American auto companies to go back and produce domestically because the production costs would be far higher. For these companies, they are trying to balance between staying in China and moving away. Now they have come up with a strategy that says: ‘We can stay in China, but we have to pick another country or destination as an alternative, it has to be China plus one.’ The plus one can be anywhere, Vietnam, Thailand, Mexico or even India, but the idea is that China is the core and a back-up production plan is in place.

Diversification is not something entirely new. Companies have been looking at this already, but in the beginning they were relocating within China. A lot of the factories were in the coastal areas – these areas are richer and home to the buyers of electric cars, for example. Then, because of high operating costs, manufacturers started relocating to inner China. Now it is at the stage whereby inner China is also getting expensive, and that’s one reason why companies are looking to move. This has been compounded by the trade war in the last few years, with the pandemic now serving as another key driver.

However, with the pandemic, a lot of companies will not make any big decisions yet because there is too much uncertainty. But we do expect to see companies shifting parts of their operations overseas in the next one to two years.

 

GTR: If supply chains move out of China, which countries are likely to be beneficiaries?

Yu: If the diversification happens quickly then Vietnam, Thailand or even Mexico will benefit from it manufacturing-wise. If we are looking at finance, then Singapore or even Japan could benefit.

In China, the pandemic and the trade war has meant that operations are exposed to external risk, and that’s why investors are trying to diversify their capital. They do not want to invest too much in China and Hong Kong. If they have to look for another destination in Asia then, of course, they must find somewhere which is maturely developed as a financial hub and which also has a strong legal system. In Asia, there are not too many options; examples include Tokyo and Singapore. They are not just financial centres, they have strong legal systems that rely on rule of law, which is why these places could attract the relocation of some assets.

 

 

The post Pandemic a warning to diversify supply chains outside of China appeared first on Global Trade Review (GTR).

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