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Supply chains - Will companies

move essential functions back to the West?

July 2020

Overview

The outbreak of Covid-19 has exposed the flaws in supply chains across the world, especially in the West. Over the last couple of decades, China has grown to become the most important supply hub in the world. Everything seemed to run smoothly until the beginning of this year when China could no longer keep their manufacturing plants open, as the government imposed a strict lockdown to curb the spread of the virus in the country. With this disruption in global supply chain operations, some economists are predicting that many jobs will now move from China to the West, whereas others predict that South Asian countries such as India will emerge as attractive alternatives to China. 

The impact of Covid-19 on global supply chain operations 

China, over the last couple of decades, has grown in stature to become the central hub in many global value chains. For instance, in 1990, China accounted for just 2% of global merchandise exports, and its market share has been increasing ever since in the years that followed. 

China’s surge in popularity as a global trade hub was driven by a few demographic characteristics, including: 

  1. Significantly low labour costs in China in comparison to the United States and other western countries. 

  2. The efficiency and effectiveness of its highly skilled workforce. 

  3. The lack of bureaucracies related to global trade and exports. 

  4. The tax policy of the country which is highly favourable for exports. 

  5. The state-controlled currency that has made Chinese products cheaper in global markets in comparison to products manufactured in other Asian and western countries. 

The first blow to China’s dominance in global supply chain operations was dealt when the United States implemented tariffs for products imported to the country from China; the second fell with the outbreak of the virus. The two parties had just signed the Phase 1 trade deal in early-January to reach some middle ground regarding trade tensions when Covid-19 struck and paused the positive momentum. 

Below are a few examples of the global dependence on China, which came to light as manufacturing activities in the country reached a standstill: 

  • Chrysler Automobiles announced in February that the company is temporarily halting production at its factories in Serbia as necessary parts are no longer being manufactured in China due to the lockdown. 

  • Hyundai suspended most of its vehicle production as necessary components required in its manufacturing process were not coming in from China. 

  • Apple confirmed in February that plant closures in China are likely to lead to a massive decline in the number of devices manufactured this year. 

  • There is a shortage of bridal gowns in America as most plants in China remain closed. According to CNN, more than 80% of western-style gowns are sourced from China. 

These are just the tip of the iceberg in every sense. China is one of the leading suppliers of medicine and medical equipment to the global market: the now popular N95 masks, for example, are mainly manufactured in China. Companies of every shape and size are impacted by the lockdown in China, and this has prompted many governments and entrepreneurs to rethink their supply chain strategy entirely. 

It’s not the western world that will benefit from a move out of China 

The United States government will certainly make this an opportunity to bring back jobs to America from China. In fact, this has been one of the most touted goals of the American President since taking office more than 3 years ago. The sentiment of Americans toward China has deteriorated in the last few years as well, which is a confirmation of the rising tensions between the two nations. 

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The key is to understand the reasons behind China’s rise to the top as a global manufacturer, which was highlighted in the first segment of this analysis: if companies decide to move their manufacturing plants and outsourced business operations from China back to the West, their objective of reducing costs cannot be achieved due to the high cost of labour and the tax implications. Therefore, companies would rather let their manufacturing plants remain in China than to move them back to the likes of the United States and the United Kingdom. This is where countries such as India come into play. 

India has already emerged as a global hub for the software industry, and many technological giants such as Google have hired tens of thousands of Indian IT professionals in tech hubs such as Mumbai and Bengaluru. The country is now making the necessary regulatory changes to attract manufacturing companies as well. Some of these changes include:

  1. Relaxing regulation regarding a company’s ability to fire employees;

  2. Approving 100% ownership by foreign investors of a company based in India; 

  3. Relaxing local sourcing rules that have historically prevented companies such as Apple from manufacturing their devices in India; and 

  4. Reducing corporate tax rates for manufacturing companies. 

 

In addition to these measures, India benefits from its demographic characteristics as well: the young workforce, the low cost of labour, the close proximity to China that enables cheap imports and exports, the massive consumer base of over a billion people, and the strong economic growth expected in the next couple of decades, are some of the factors that make India a viable alternative to China. For many global companies, India is now the number one target market into which to sell their products and services, and it seems reasonable to move manufacturing to India to further reduce their costs considerably. This trend is very similar to what happened with China two decades ago: as China emerged as the most important target market for American companies, these companies were quick to move their manufacturing operations to China. 

 

The World Bank reported earlier this year that the ease of doing business in India had significantly improved over the last two years, which is yet another positive development. 

Yet India is not alone in being an attractive new destination for companies: Mexico, Vietnam, and Thailand are also compelling alternative manufacturing hubs to China. 

 

Conclusion 

As Covid-19 wreaks havoc in global trade activities, the World Trade Organization expects a loss of approximately $50 billion in trade activities as a result of the manufacturing shutdown in China and has revealed in stark relief the current over-dependency on China. Many companies and governments are already forming plans to overcome this situation and diversify their supply chain operations across a few countries to avoid a similar setback in the future.

 

The increasing trade tensions between the United States and China is also playing a major role in this phenomenon, as companies seek to work around the tariffs imposed on China by shifting their manufacturing plants from China to other countries.

 

Contrary to the belief that these business operations will shift from China to the western world, there is good reason to believe that Asian countries such as India, Thailand, and Latin American countries such as Mexico and Brazil will be the main beneficiaries of this exodus due to in part to their broadly favourable demographic characteristics. 

About the author(s)

Harold Alby is a managing director and chief operating officer at Inova Capital. Justin Inniss is a managing director at Inova Capital.For more details on our insights please get in touch with us at Inova Capital AG on +41 415616905. Inquire about our ideas and nowcasting capabilities.

Source: Pew Research Center

There is some progress in America’s attempt to bring back jobs. For example, Taiwan Semiconductor announced a plan to build a chip fabrication plant in Arizona and the Federal government awarded a $354 million contract to Phlow Corp, a Virginia based start-up, to produce generic drugs. However, a closer look at the big picture reveals that the biggest beneficiary would be Asian and Latin American countries that are proving to be viable alternatives to China.