Will Supply Chains Really Move as a Result of Covid?

July 27, 2020

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The global spread of Covid has disrupted supply chains of manufacturers around the world, leading both management and governments to consider substantial changes to how these supply chains operate.  As economies tentatively open up again, companies are now starting to dig into the full set of risks and opportunities that such moves would create. What are they actually doing?

Government

Governments became very vocal on supply chain during the crisis, stating ambitions to bring manufacturing they deem key back into their home market, often explicitly calling out China as geography they want to source less from.  Governments have multiple levers available to achieve this – they can legislate, they can subsidize, they can sanction and they can exhort and they are using them all.

The most black and white action governments can take is to legislate a requirement for local production – to sell PPE in a country it must be produced in that country and also that its raw materials must be produced in that country.  For steady state demand for products like PPE that require little capital, this is relatively easy to implement, although buyers end up paying more.  Corporates will see a profitable market opportunity and act.  It is much harder though to create surge capacity as countries find themselves reliant on smaller local suppliers. The solution is stockpiling with its in-built risks of obsolescence and tying up capital that governments always face pressure to spend elsewhere (as we saw with the running down of the UK PPE stockpile prior to COVID).  The US government is also considering requiring local production for certain pharmaceutical raw materials and advanced semiconductors.  This is more capital intensive and less economically attractive for the manufacturer and only likely to be implemented at small scale

Governments can also leverage their own direct purchasing power, requiring that government departments and even state-owned enterprises buy local, as China does for multiple technology products.  Many European governments with national healthcare systems do the same in buying medical equipment. In extreme cases, this can mean only buying local from local companies, nothing non locals do to reconfigure their supply chain will get them back into the market.

The US government was already using tariffs to pressure companies to shift their supply chains pre COVID.  The tariffs on goods exported from China to the US mainly damaged smaller exporters (about 50-50 Chinese and foreign businesses) from China, who had no experience in producing anywhere else.  Their goods ended up costing more to consumers in the US and demand fell.  In contrast global manufacturers for whom China was simply one part of a network of manufacturing sites simply reconfigured.  Production for the US (typically 15-20% of output for a tech manufacturer) might move to Mexico, Vietnam or India and production for some other markets move back into China.  The US consumer paid more than before but not as much as simply applying the tariffs would have required.  Unintentionally, these tariffs have increased the volume of exports from manufacturers in China being sold and shipped direct to consumers in the US as businesses realized that low value imports into the US are not subject to tariffs.

The Japanese government has led the way on subsidizing companies to move production from China to Japan.  US$650mn has been given to 87 Japanese companies, around US$8mn each.  For this to be economic for the companies, the business being moved must be modest in scale and non-capital intensive, most likely that part of China’s exports based on lower value assembly of components imported from abroad.  The Japanese companies involved likely feel there is broader long-term benefit to be gained from the government as a result of getting on board with this specific move.

Sanctions are a lever mainly used by the US government. Their key impact is to inject uncertainty into manufacturing supply chains.  If corporates fear that their parts of their supply chain could be cut off from them at a couple of days’ notice, as happened last week, then they must either ensure that they have the options to shift their sourcing patterns instantly or they must move away from the population of suppliers vulnerable to sanctions. 

Exhortation and encouragement by government asking corporates to move supply chains closer to home are in isolation unlikely to be impactful, especially as corporates face a post COVID era of weaker demand, weaker balance sheets and lower profits.

Consumer Actions

Consumers are exerting only limited pressure on corporates to reconfigure their supply chain.  That could change as NGOs focus more on aspects of supply chain in the future.  The rise of “buy local” in the agriculture supply chain could come manufacturing also but has not yet really done so.  Currently the majority of consumers still focus on brand, value and price in making a purchase.  The country of origin label on the package is not yet a key factor.  However, some corporates are anticipating that this will soon change, especially in the US, and are establishing final assembly operations in Vietnam and India that would allow these countries to appear on the box as the country of origin for the goods.  This does though have the impact of lengthening supply chains and may not address the future needs of activist consumers. 

Boards should expect greater scrutiny of supply chains both from ESG oriented investors and activist consumer groups in the future.  Questions will not just be asked about environmental standards, labor practices and focus on the United Nations sustainability goals.  They will also be asked about resilience and companies may be required to publish qualitative and quantitative assessments of their crisis readiness. Greater board action on this is needed.

Corporate Actions

Prior to COVID, corporates were facing the pressure of rising costs, especially labor costs, in their supply chains in China.  This led to two actions: firstly, to invest more capital to substitute for labor in factories in China (a first wave of Smart factories equipped with the Industrial Internet of Things) and; secondly to move the export-focused part of their business out of China.  Both trends have been underway for many years, textile production moving to Bangladesh and Vietnam, electronics assembly to Vietnam and the Philippines.  An additional factor pulling production out of China more recently is that some middle-income markets have reached a critical size, justifying local production (often nudged along by import tariffs).  Chinese mobile phone producers, Oppo and Vivo, putting factories in India, Samsung and Lenovo putting plants in Brazil are examples. It is Chinese companies making these relocation decisions, not just multinationals.

COVID raised many questions in the boardroom about the resilience of supply chains. In the first quarter of the year this meant supply chains in China.  Since then the scope of the debate has broadened substantially.  For example, one US consumer tech company has found itself unable to send management and engineers to its plants in Mexico or China for months.  The quality of local leadership in the plant in China means all is going well there, while the Mexican plant is really struggling. As a result, production is being shifted from Mexico to China. 

As corporate teams dig into the cost and other trade offs associated with increasing supply chain resilience, they are addressing some tough questions:

  • The cost of making a change – Capital in the ground can range from a few million to billions of dollars.  A petrochemical processing plant or a semiconductor plant could never be moved, even a modern electronics assembly line be hard to move.  Is a corporation prepared to write off a currently valuable asset?  Few are.  The potential loss is not simply financial capital, it is also in human capital. Years of accumulated experience in local management cannot be instantly recreated elsewhere. 
  • Ongoing operating costs – For low margin manufacturers, a 1% increase in total costs wipes out much of their potential profits.  For these manufacturers the cost of “greater resilience” has to be low or they will focus on sustaining a lower cost operating model and betting that the next crisis is many years away.  Splitting or moving manufacturing may lead to higher logistics costs (as inputs still are sourced from China to the new overseas factory) and to lower economies of scale.  Belief on when the next supply chain disruption might occur is a key input into management thinking – if the expected timing is beyond the time horizon of the top management team, their incentive may well make less change than is optimal. Boards will need to challenge hard on these recommendations to ensure they are robust
  • Relative resilience of China.  Corporations have found since March higher levels of resilience in their operations in China than expected. Workers have been keen to return to offices and factories, supply chains rapidly overcame bottlenecks, export capabilities reopened quickly and government leant in hard with support for export-oriented businesses.  More broadly, government and manufacturers are using the crisis to create a major step up in investment in the digitization of their operations – shifting to the cloud, deploying blockchain solutions in supply chain, AI and IOT in factories at scale, actions that have the potential to substantially improve the productivity and so cost position of factories in China.  Clearly these levers can be applied globally, but if they are applied faster and at greater scale in China, it adds to the weight of argument to keep production in China.

The evolution of leading Korean manufacturers illustrates these overall forces.  A decade ago, Samsung was best known in China for manufacturing mobile phones and white goods, employing tens of thousands in their factories, with limited capital invested in the ground.  Today, the majority of their mobile phones are produced in Vietnam and India, none in China, and their major business in China is a US$10bn plant producing semiconductor memory chips with a fraction of the earlier number of workers.  LG has gone through a similar evolution from white goods to become the #2 EV battery manufacturer for China’s world leading (in size) electric vehicle market

The initial reaction to the global spread of COVD of “get our supply chain away from China” is being replaced by more nuanced, more thoughtful analysis that will undoubtedly lead to a continuation of the preexisting trend of moving manufacturing out of China.  China is responsible, according to Morgan Stanley, for over 80% of all assembly in the technology industry. That number should not go higher.  More markets outside China are reaching critical mass and warrant local production and government actions around the world will pull some manufacturing closer to home.  Yet the China market itself will continue to grow, so that even with the loss of some export business, in-China manufacturing volumes may not shrink.  Local manufacturers in China will not stand still. COVID has woken many up to the need to embrace technology in their operating model and supply chain at scale for the first time.  And as so often in the history of China’s economic development, they will attempt to leap from far behind best practice to defining what best practice is in only a few years.  Those that succeed will lay the foundations for resilient supply chains that continue to run through China.

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