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Five Suggestions for China's Engagement in the Restructuring of Global Supply Chain amid the COVID-19 Pandemic Shock
Date:07.26.2020 Author:Huang Qifan

Abstract: In this article, the author analyzes the changes the pandemic has brought to the global supply chain, the difficulties foreign enterprises will encounter when moving their production facilities out of China, and China's advantages in keeping the supply chains from relocation. The author offers five suggestions for China to effectively respond to the restructuring of the supply chain.

In the face of the COVID-19 crisis, some politicians from western countries especially the US have called for decoupling from China, asking their businesses to withdraw investment and manufacturing from China, and made a series of moves in this direction. In response, China must remain calm and patient, promote progress through stable development, find innovative solutions, and expand the market by further opening-up. China is not afraid of a handful of hostile Western political forces. It should make every effort to boost domestic development, expand international cooperation and seize opportunities in the restructuring of the global supply chain.

I. Market is the most effective means of resource allocation. "Decoupling" and "manufacturing relocation" go against market rules. They come purely from the political agenda of a few politicians.

The horizontal layout and structure of global supply chain are formed in the process of the free flow of production factors global driven by market forces in search of optimal resource allocation. They were established in the past few decades and had remained relatively stable until the outbreak of the COVID-19 pandemic. When multinational companies reallocate production factors, they care more about efficiency, economic benefit and cost rather than the wishes of a few politicians. If foreign companies such as US firms withdraw from China, they will have to shift production bases, rebuild production facilities in the United States and other places, and find new partners along the supply chain. This process will encounter a series of insurmountable difficulties in addition to huge costs:

First, it is hard to secure the amount of capital required to rebuild the supply chain. The outbreak has lasted for nearly half a year. The operations of many companies have come to a standstill, and the cash flows are strained. Few manufacturing companies can rely on their own resources to invest in the construction of new factories. Some governments promised to assist companies in moving back their facilities, but the subsidies might only cover reallocation expenses but no other expenses such as new investment needed. The capital market, suffering from declines in firms' performance, has temporarily lost the ability to provide financing for the construction of new factories. It is not in line with market rules, nor is it reasonable to ask companies to risk capital chain breakage or even bankruptcy only for political purposes. Companies will not follow such ideas.

Second, it is not easy to form complementary industrial clusters. If a company moves back to the United States, it not only involves the relocation of the company itself, but also that of its complementary firms along the supply chain. Given the highly specialized division of labor in the manufacturing sector, a manufacturing enterprise usually relies on hundreds or thousands of complementary enterprises, most of which are unlikely to move to the United States. Without these complementary enterprises, the firm will face the risk of supply chain disruption and consequently a rapid increase in manufacturing costs, which is also inconsistent with market rules. That is why Cook repeatedly refused Trump's request to move Apple's production base from China back to the US. Apple would not survive the relocation because it would not be able to establish its supply chain in the US. Apple had not left China in the three years before the pandemic, and now relocation will only become more difficult.

Third, the quality of industrial workers is an important factor to be taken into consideration. When selecting production sites, manufacturing companies not only considers the cost of labor, but also the quality of labor. Comparatively speaking, labor costs in Europe and the US are higher than that in China. While labor costs in Southeast Asia may be lower, the labor quality in that region is not up to par. After nearly 40 years of industrialization and informatization, industrial workers in China now boast both high quality and comparative advantages in cost. Of the migrant workers from rural areas, 90% are the young generation with secondary school or high school diplomas. The education level of China's young people, including those from the countryside, ensures the comparatively high quality of labor in China.

Fourth, the US economic structure restricts the development of the manufacturing sector. To develop certain industries, you must consider not only the superstructure, the will of government agencies, but also the economic foundation of a country, including its economic and industrial structure, as well as the structure of the financial system, etc. Considering the economic structure of the US, the service sector including the financial industry accounts for 80% of the economy, and manufacturing accounts for only 13.5%. The US relies heavily on import of manufactured products, and its economic structure is not suitable for developing the manufacturing industry. Even from a financial point of view, it is because of the massive import of industrial products that the US can reap the benefits of seigniorage by paying for imports with dollars. In this sense, if US takes up manufacturing, the hegemony of US dollar will be challenged and the benefits of seigniorage will be lost. Therefore I don't think the economic, financial and industrial structure of the US will go back to what they were 70 years ago.

Fifth, the infrastructure in the US cannot accommodate the manufacturing industry. Generally speaking, the United States still boasts high-quality infrastructure, but these facilities mostly serve the population of cities with service industries. Infrastructure for railways, ports, information networks and construction of industrial areas has become inadequate due to the decline of the US manufacturing industry in recent years. Building these facilities in a short period of time requires huge investment from the government and enterprises, which is hardly possible. In the sector of communications, for example, only large cities are well equipped with communication facilities, no matter 3G, 4G or 5G base stations. In the so-called industrial areas in suburbs and the rural areas, communication facilities are a far cry from those in China. This is because the US telecommunications companies are private firms, and they are unwilling to invest in places where the communication density is not high and return on investment is low. Therefore, there are only about 0.4 million 4G base stations in the United States as opposed to the 4.6 million in China, though the areas of the two countries are about the same.

In summary, the reshuffle of the global supply chain will not lead to decoupling from China as some Western politicians hope, but under market forces, it will become more vertically integrated, more diversified and resilient. China plays a key role in the global supply chain. The advantages of China's manufacturing industry have been recognized globally. Owning to a comprehensive industrial system and sophisticated infrastructure, China has the advantages of better supporting facilities and lower overall costs, and can possibly support the reform of global supply chain. In addition, China has a huge domestic market. Over the past decades, foreign-funded enterprises that have invested in China have sold more than 70% of their products in the Chinese market, and 30% are exported to Europe and the United States. This means that when a foreign company leaves China, it will lose 70% of its market share. This is also a decisive factor that keeps supply chains in China.

II. The pandemic has driven the restructuring, not only the relocation of the global supply chains.

The development of the manufacturing industry worldwide over the past two decades has produced a horizontal distribution across the global supply chain. However, there are too many production links along the chain, the shipping distances are too long, pushing up logistics costs and delivery time, and adding to risks of breakage of supply chains. In the face of global crises such as natural disasters, pandemics and social unrests, the supply chains could be easily disrupted, and global manufacturing could be devastated.

To deal with the vulnerability, the best solution is to restructure the supply chain by forming vertical integration by setting up industrial clusters in Asia, Africa, Europe or America. These industrial clusters will realize both horizontal division of labor as well as vertical integration, therefore can effectively resist shocks to the global supply chain. This restructuring will bring the most competitive businesses worldwide to regions  with sound industrial bases, while the profits are still distributed among companies in all countries which have participated in the process, so it is still horizontal division of labor.

At present, a great many concerns have been voiced about supply chain relocations as a result of the pandemic. A recent report by Morgan Stanley has shed some light in this regard. According to the report, the actual decision makers in the global supply chain, or the multinational corporations (MNCs), have agreed to exactly the opposite—that the crisis will slow down the relocations started since the beginning of the trade war. This is very important. Amid the trade war, there were indeed businesses which showed signs of moving out of China, but the pandemic has slowed that process. Morgan Stanley summarized two main reasons:

First, relocation will inevitably incur new investment costs, but no one has the intent to invest in a recession-clouded world. It will take at least two years before the US and European economy can get out from under, while most emerging markets in Latin America, eastern Europe and Southeastern Asia have weak links and are vulnerable to chain reactions caused by pandemics, exchange rate fluctuations and debt burden, therefore are highly risky. As such, MNCs' top priority in the near future is to maintain cash holdings and reduce expenditure, as opposed to incurring additional costs such as those associated with relocation. Morgan Stanley' survey showed that many foreign companies have postponed their plans made before COVID-19 outbreak about investing in new factories outside of China or automating their productions back home.

Second, China's edge in building industrial clusters is unparalleled. Take the TMT (technology, media, telecom) supply chain for example. Almost all leading businesses around the globe believe that the management capabilities that China demonstrated when restarting its economy further proved its incomparable competitive edge in the manufacturing industry over other emerging markets. It took the country only two months after the lockdown to bring the virus under control and resume production activities. China has largely outperformed Southeast Asian countries and other potential relocation destinations in public health management, such as applying health codes, temperature checks, mandatory use of masks, and partitioned canteens, as well as the ready compliance of the workers. As opposed to China, the latter are experiencing more severe production standstills.

The above analysis by Morgan Stanley is quoted here to show an objective observation of the situation of MNCs amid the pandemic.

Morgan Stanley's survey also indicate that, although no one is sure what the post-pandemic world will be like, it's widely recognized that the outbreak will urge businesses to attach greater importance to digital infrastructure development, including cloud and remote services, as well as Internet of things (IoT). China is stepping up the building of digital infrastructures including 5G data hubs and IoTs and other new infrastructures, which will enhance rather than hamper its commercial infrastructures in the future.

In conclusion, the global supply chain is going through some profound change than simple business relocations; the restructuring is based on the need to improve productivity as well as the conditions of infrastructures and business environments worldwide. This will also bring into life a new industrial structure featuring vertically integrated industrial clusters.

I believe that MNCs are rational in this aspect, and will not be misled by what the politicians bluster. They will rationally plan the supply chain restructuring.

III. Opportunities for China's manufacturing industry

It's important for Chinese manufacturers to understand that supply chain disruptions, reduced orders and the resultant production standstill were caused by the pandemic, and does not have much to do with either "decoupling" or "withdrawal of investments". Chinese manufacturers should be confident of their competitive edges and avoid exaggerating difficulties by mistakenly assuming that US politicians are solely to blame for all the troubles. Despite widespread concerns over decoupling, Chinese manufacturers need to be aware that the supply chain disruptions and losses of orders are the fallout of the pandemic, rather than political clamoring.

Therefore, China should carefully think about how the global supply chain will be reshaped, fully tap into its institutional advantages, reinforce infrastructures that underpin industrial clustering, work to forge a fresh industrial ecosystem based on new technologies, and promote the digitalization of traditional sectors.

To this end, I propose the following five measures:

1. Optimize China's supply chain by improving the weak links. Some of these weak links could be fatal, because once they get disabled by uncontrollable political factors or natural disasters, the entire supply chain would break down. That's why China must force itself, amid the global supply chain restructuring under the pandemic's blow, to realize the local production of key parts, step up R&D efforts to make technological breakthroughs, and ultimately replace the imported parts with self-made ones. Having industrial clusters is the greatest advantage of China's manufacturing industry. The evolving global industrial landscape urges it upon China to improve the weak links in its supply chain, fully leverage its competitive edges including the low costs of labor and supply chains and friendly business environment, improve supporting facilities, and strive to attract more leading firms worldwide to join the industrial clusters in China. Only by further opening up the market, can China protect itself from other countries' decoupling moves.

2. Boost domestic demand, and encourage export-oriented businesses to explore the domestic market. China's exports last year was placed at around 2.6 trillion yuan; as COVID-9 swept across the world, exports in the first quarter this year declined by 11.4%, and the second quarter will only see worse performances, because back in the first quarter everyone was still buying things from China, but in the second quarter, economies around the globe, especially the United States and Europe, get bogged down and their orders for Chinese goods and services have subsequently slumped. This is what makes me believe that the export figure for the second quarter will drop further. Unfortunately, the pandemic is going to prevail for quite a while, and Chinese exporters will bear extreme pressures with very few orders and ruptured capital chains over a long time.

In other words, the recovery of China's exports actually depends on the containment of the virus across the globe. So far, the number of confirmed cases across the world has ballooned to over 5 million; I believe it will climb up to over 8 million by the end of June, and the number for the whole year will be over 15 million. That means the global economy will remain in the doldrums for a rather long period of time, and as a result, orders for Chinese manufacturing will continue to be depressed. In response, China needs to adopt new and targeted measures to restart its domestic economy, and encourage export-oriented businesses to tailor their products to domestic demands and expand domestic sales instead.

However, turning to the domestic market will induce higher costs for these businesses because when they were exporting previously, no taxes were levied on the products; but now they have to pay value-added taxes (VATs) at the rate of 13% or other taxes. Hence, it is better to provide these firms with preferential policy support for some time to help them adjust, for example, allowing them to sell previously exported products domestically without withdrawing tax rebates or charging VATs.

3. Encourage traditional sectors to digitalize themselves and expand the domestic markets with new technologies. Large population base, abundant natural resources and a huge GDP have given rise to an enormous domestic market in China, and sizable potential market space based on technological advances exists for every sector. Take the energy industry for example. In the total of over 600 million tons of petroleum consumed in China, 4.5 million tons are imported, and the rest are produced domestically. But with future economic development, the demands for energy will further rise, perhaps to 7, 8 or 9 million tons. If all additional demands will have to be met with imports, China's overreliance on import of energy poses a serious risk.

In fact, with the largest coal reserve in the world, China has an annual coal output of 5 billion tons; even after the destocking endeavors over the past years, it still stands high at 3.8 to 4 billion tons, so coal production in China is more than sufficient. Coal has the potential to replace petroleum as the main industrial chemical feedstock, if not for the concern that it could cause more pollution than petroleum. So China needs to develop clean technologies and use them in coal gasification, coal-to-liquids, and coal chemical processing. For instance, Shenhua Group is working on coal-to-liquids and coal chemical processing technologies. I have seen it firsthand, and its clean energy technologies are world-class. I think there should be more trailblazers like it. If a gigaton of coals are used to develop coal chemicals or converted into liquids and gases, China’s demand for crude oil could be reduced by 100-200 million tons, since four to five tons of coals could be turned into one ton of oil and gas. In this case, we could expand the domestic demand, rather than simply cutting the overcapacity of coal production.

Another example is car ownership. As of June 2019, the number of cars owned per 100 persons in China were 17.9, while in developed countries, it was about 30, showing that there is still room for car ownership to rise in China. In particular, with the popularization of new energy vehicles and the digital transformation of cars, clean energy in the auto industry will see huge growth into the future, which will also promote the development of infrastructures in the cities. Therefore, for now, we should not restrict the demand for cars by measures such as capping car purchase and sales, and plate licenses for fear of environmental pollution, and pressure on city transportation. The price of a car registration plate now is eighty or ninety thousand yuan in China, and it could take three years to obtain one because it is sold through auctions. As a result, car sales are cut by millions each year. We should explore new models of auto consumption and reshape the vehicle registration policies to release the demand for car consumption and expand the domestic market for the auto industry.

4. Attach more importance to the value of online market and give full play to cross-border e-commerce. During the pandemic, turnover of China's e-commerce giants Alibaba and increased rather than decreased, which fully reflects the stark difference between online and traditional markets, as the former can effectively circumvent the barriers to transactions created by physical distancing during the outbreak. Therefore, China should further take the advantage of cross-border e-commerce platforms and enhance their capabilities in serving the markets of various countries, in particular those along the Belt and Road. Engaging these countries will help increase China's exports and imports.

One judgement that could be made is that ten years later, the total volume of global trade could be composed of three parts—one third of traditional trade, one third of processing trade which was formed over the past 10 years, as well as one third of cross-border e-trade. Such a trend may indicate huge growth potential for cross-border e-commerce.

However, although China has the most advanced e-commerce industry in the world, most of the e-commerce businesses are inward-looking. Take Alibaba for instance, over 80% of its business is domestic trade, only 10% is international trade. In this case, although Alibaba's total business scale is much larger than that of Amazon, the scale of international orders on Amazon's online platform is four times that of Alibaba. This shows that there's still a long way to go for China’s cross-border e-commerce industry, which is critical to market expansion in the future.

5. Expand import to achieve balanced development between import and export. China’s foreign trade was $4.6 trillion last year, with $2.5 trillion export and $2.1 trillion import. While China has the highest trade volume in the word, its export volume is also the highest in the world, which can easily trigger trade conflict. US is the largest importer in the world with $2.6 trillion of import, while China’s import is about $2.1 trillion, $500 billion less. If we could increase import to $2.5 trillion or $2.6 trillion through measures such as cutting tariffs, and become the largest importer in the world, it could mean much more than being the largest trading nation or largest export country in the world. An export superpower is not necessarily an economic power; however, becoming the largest importer in the world will allow China to become a true global economic power.

The first benefit of becoming a major import country is reduced trade friction with other countries. Once China becomes the largest importer, every country would rush to seek cooperation and partnership with China since China is their biggest potential client. Secondly, it also goes without saying that it is easier for an importer to obtain pricing power in many areas. Thirdly, the currency of the import country will likely become the pricing currency used in global trade, and hence the hard currency. Fourthly, being a major import country can promote cross-border settlement in RMB, enabling payment of some import in RMB, which will help balance the international payment associated with trade. Fifthly, increase of import can also drive the change of Chinese people's consumption structure, and the upgrade in the industrial and supply structure. All of these are factors that China should pay close attention to when adjusting the industrial structure.

At a meeting of the Standing Committee of the Political Bureau of the CPC Central Committee on May 14, for the first time the Central Committee mentioned "the creation of a new development pattern where domestic and foreign markets can boost each other", which not only put forward the plan for stabilizing economic and social development, but also pointed direction for Chinese enterprises during the reconstruction of global supply chain.

Overall, during the restructuring of the global supply chain, market plays an important role, and having a comprehensive supply chain domestically is the most critical factor. In addition, internationalization, legalization and marketization of the business environment are fundamental elements. Innovation of core technologies and strengthening the weak links are also crucial. Ultimately, deepening reform and opening-up provides the driving force for development.

Making progress in these areas will not only boost China's economic development, but can also respond with real action to the political rhetoric of western countries regarding "withdrawal of investment", "decoupling from China", "anti-globalization" and so on. I am confident that Chinese firms will break the technological blockade against China, bolster the weak links in the supply chain, and that China will have the most competitive industrial clusters in the world eventually.