The world’s factory in COVID-19: Can China secure its supply chain kingdom?

The Chinese economy has faced dramatic challenges over the past two years. The US/China trade war and the COVID-19 pandemic have delivered short-term shocks and left lingering long-term questions unanswered too.

Perhaps most prominent of those is whether the fragilities exposed over this period will prompt global companies to shift supply chains away from China. The tit-for-tat tariffs that marked Beijing’s fractious relations with Washington, and the startling impact of the virus, have left the future structure of the global supply chain in doubt.

Before answering this question, we need to first understand why China has become the centre of the global supply chain, and why so many multinational companies choose to manufacture their products so far from home.

Exhibit 1: Manufacturing value added for China, US and EU

Source: World Development Indicators, as of 04/09/2020

Over the past four decades, we can put this down to three major motivating factors.

First, and most obvious, is the low cost of production. Attractive labour, land and utility costs helped China to attract a large amount of foreign direct investment during the initial phase of its economic take-off.

Second, China boasts the world’s most comprehensive industrial and manufacturing production system. With 41 industrial divisions, 207 groups and 666 classes of products and services[1], China is the only country in the world to cover all categories of the UN’s industry classification. From a supply perspective, this comprehensive manufacturing ecosystem – coupled with a abundant supply of low-cost, highly-educated work force – is a major motivation for moving production to China.

Third, from a demand perspective, China is the world’s most populous country with a domestic consumer market that will soon surpass the US to become the world’s largest. In addition, China has a comprehensive logistics network, allowing multinational companies to ship products manufactured in China to other countries in Asia and access a huge market of 4.5 billion people. This adds enormous commercial potential to companies active in China.

So how have the trade war and COVID-19 affected the-above characteristics that contributed to China’s role as the pre-eminent global manufacturing hub?

One thing that is clear is that costs will rise. Multiple rounds of tariff increase as a result of the trade war have significantly raised the price tags of Chinese products, particularly in the US. Industries with low profit margins, such as textiles, clothing and toys, which have already started to move out of China before the trade war, will now likely accelerate production relocation as a result of the pandemic. The days of relying on cheap Chinese production to attract foreign investment are over.

It’s not clear yet how big a factor China’s huge breadth of manufacturing capability will be in convincing multinationals like Apple to hold fire on a drift towards the exit, but it is certainly clear that the great potential of Chinese domestic market remains unchanged. Companies such as McDonald’s, Starbucks and Tesla – which sell to China’s 1.4 billion consumers – will not leave the Chinese market simply due to the impact of COVID-19, especially since the pandemic is unlikely to have a lasting impact on China’s medium to long-term economic fundamentals.

Overall, it is unrealistic to expect China to emerge from the recent events unscathed: increased tariffs, worsening US-China relations, and the embedded risks of highly-dependent production process witnessed during COVID-19 will collectively have an impact on China’s position in the global supply-chain.

But notwithstanding the direction of change, there are several reasons why we believe the global supply chain readjustment will be a slower process than many expect.

First, the impact of the COVID-19 is global, and the shocks that China endured in terms of the economic shutdown are now being repeated in other countries. Moreover, the Chinese economy is among the first to emerge from lockdowns and is currently helping multinational companies to resume production. Hence, there are no sufficient grounds to support the view that COVID-19 itself will severely undermine China’s position in the global supply chain.

Second, investors pay close attention to the short-term performance of listed companies. If one decided to shift its supply chain away from China while its competitors stayed put, the costs of such a transition could hit the companies’ bottom-line, lower its stock price and put pressure on its management team. such a “first-mover disadvantage” may imply that supply chain restructuring could be less extensive than anticipated – or at least that the trend will bump up against some structural resistance in its early stages. Some US companies are moving to a “China plus 1” strategy, with the 1 being a back-up option to China, as opposed to moving everything out of the Mainland.

Finally, the Chinese government will unlikely stay put to watch its economic advantages drift away. The trade war has forced the government to accelerate reforms in the past three years, including the opening up of China’s financial system, tightening protections of intellectual property rights, introducing more competition to previous monopoly industries, and the shortening of the “negative list” for foreign direct investment. The effects of these measures – designed to retain existing supply chains and attract new investment – should start to deliver results.

In short, there are tools at Beijing’s disposal to maintain China’s competitiveness as multinational companies reconsider their supply-chain configurations. China has been a beneficiary of globalisation of the past two to three decades, which allowed its economy to rise to the status of the world’s preeminent manufacturing powerhouse. But If this process is about to reverse in the coming decades, China will have to face up to the challenges brought by deglobalisation, where holding onto its slice of the pie will be difficult as the overall pie shrinks. Maybe the best China can do in this environment is to perfect its own economy in the hope of slowing the inevitable and minimizing its effect.