The iPhone was designed at Apple’s headquarters in Cupertino, California, but its parts were made by suppliers in 43 countries and six continents via an incredibly complex supply chain. The global supply chain is the epitome of the intensive drive for efficiency, necessitated by fierce global competition. China emerged as the center of the global supply chain and the de facto “factory of the world” after it joined the World Trade Organization in 2001.
The configuration of production facilities is based on a global model whose primary objective is to increase efficiency. Many considerations enter into the calculus that shapes the global supply chain. First and foremost, the configuration of the global supply chain aims to minimize costs, including the labor cost, the cost of transporting the components for final assembly, and the assembly cost itself. It is no coincidence that the global supply chain has increasingly consolidated production in economies with abundant capable labor, better infrastructure, and lax environmental regulations, primarily those based in China, Taiwan, Vietnam, or other Asian economies. Second, the global supply chain tends to locate the production facilities close to the consumers of the final products. The emergence of the huge Chinese middle class and their purchasing power further enhances China as the leading destination for foreign direct investment. These two factors combine to make China the central link of the global value chain.
Of course, cost minimization is not the only consideration for the configuration of the global supply chain. When a firm like Apple sources iPhone components from 200 suppliers over 800 production facilities in numerous countries, it must manage a multitude of risks judiciously. These include mundane risks such as exchange rate risks and potential delays in the delivery of key components. Global value chain management handles these risks with remarkable effectiveness via hedging, stockpiling of inventories of key components, and multi-sourcing.
COVID-19 does not change the fundamentals
COVID-19 certainly disrupts the global value chain, and we are interested in how COVID-19 may reconfigure it. When facing bona fide uncertainty, it is useful to take a step back to understand how the fundamentals, as described above, shape the future. Some factors that made China into the factory of the world had already been evolving before the COVID-19 pandemic.
There are both negative and positive developments. First, labor costs have risen sharply from 2011, when China reached the Lewis turning point due to several converging forces, including the depletion of the surplus labor from its agricultural sector and the rapidly changing demographics induced by the three decades of the one-child policy. “Made in China” is not so cheap anymore. Second, decades of rapid economic growth with lax environmental regulations inevitably resulted in unbreathable air in many Chinese metropolitan areas. Green and sustainable development has become the mantra of the new growth model in China. Environmental costs of producing in China, which were unaccounted for in the race for China to become the factory of the world, are now finally factored in as a part of the cost , as they should. On the positive side, the elusive purchasing power of the Chinese middle class finally became a reality. China is now the world’s largest automobile market. The Chinese consumer market is about to overtake the United States as the world’s largest.
Even though the labor cost in China has risen sharply in recent years, increases, at least in the major manufacturing centers in Eastern and Southern China, China’s vast Central and Western provinces still have inexpensive labor and affordable living costs. Fast infrastructure development makes them attractive production locations to serve both Chinese and global consumers. The U.S.-China trade war from 2018 injected geopolitical uncertainty into the picture. Many firms contemplating moving their production lines from Guangdong or Jiangsu provinces to Western China may scale back their plans with a sharpened focus on serving only the China market. However, Southeast Asian countries such as Vietnam, Cambodia, and Indonesia seemed to be a safer production location as a result of the U.S.-China trade tensions. China may not feel the impact in the short term, as it still enjoys many advantages such as agglomeration efficiency and superb infrastructure, but in the medium term China can not ignore the impact from the U.S.-China conflicts on the global supply chain relocations.
COVID-19 heightens worries, reveals China’s strengths, but expedites ongoing changes
These factors were already serving to loosen the screws that held China at the center of the global value chain, and then comes the COVID-19 pandemic. What will the impact of the pandemic be on the changing landscape of the global value chain a decade from now?
The biggest revelation from the pandemic is the importance of supply chain robustness. A survey conducted by the Institute For Supply Chain Management in March 2020 found that nearly 75 percent of companies reported supply chain disruptions in one form or another due to coronavirus-related transportation restrictions, and the figure is expected to rise further over the next few weeks. In addition, the survey also found that almost half of the companies lacked any semblance of a contingency plan for their supply chain disruption.
The Chinese political system has shown its strength in controlling the pandemic. Once the government recognized that the novel coronavirus is highly contagious, with a rather high mortality rate, the powerful Chinese state machinery was in full force. It enforced strict lockdowns of the country’s epicenters, facilitated rapid mobilization of resources to assist the epicenters, and implemented technology-based tracing of interpersonal contact to prevent new waves of outbreaks. Given its efficacy in battling this pandemic, or likely any future epidemic or pandemic, China would emerge as a desirable location for the global supply chain. Firms would obviously prefer to locate their factories in an area where disruption from the pandemic has a more limited duration.
However, this argument holds only if the global value chain remains centralized in one country—mainly China. The new recognition for the importance of supply chain resilience or robustness is likely to lead to regionalism in organizing global supply chains. By that, we mean that the global value chain will likely become multi-centered. That is, having the factory of the world will be replaced by having one factory for each region. Currently, China is the factory of the world. The regionalism of global supply chains will diminish the centrality of China in the global value chain.
The COVID-19 pandemic introduces no new forces in the reconfigurations of the global value chain; it simply intensifies the existing forces of heightened geopolitical risks that the U.S.-China trade war unleashed. There was already talk of supply chain diversification by building redundant capacity, sourcing from multiple producers in multiple locations, re-clustering the network of component production/sourcing around major consumption centers, and politically forced decoupling, leading to the development of multiple manufacturing clusters. The COVID-19 pandemic will simply reinforce this dynamic, and expedite this reconfiguration.
It is economics
However, ultimately, companies act according to economics. This means China will remain one of the centers of the global value chain because of the many advantages that made China into the current factory of the world. Rising labor costs notwithstanding, the looming automation wave will allow China to remain cost-competitive. The enormous Chinese domestic market will grow larger as Chinese policymakers deepen reforms—such as a better social safety net, affordable housing, rural land reform—that will both expand the size of the Chinese middle class and make those individuals more willing to spend rather than save. The sheer size of the Chinese market will keep and further attract China-based manufacturing.
We should also recognize the efficiency-robustness tradeoff in supply chain regionalism, or diversification. Not exercising comparative advantage is inefficient, as is decoupling and building excess capacity. Regionalism also means losing economies of scale, which results in fewer incentives for innovation effort. Talk of sourcing all medical supplies domestically may over-estimate the need for robustness at the expense of efficiency, or may simply be politicians’ paranoia. Stockpiling could have achieved medical supply safeguards without sacrificing production efficiency. An even better solution to future global health crises would seem to be creating a global health organization to play a similar role to the International Monetary Fund and provide medical supplies to countries of need. We hope that the world will not take away the wrong lessons from the words of paranoid politicians.
What should China be wary of?
To what extent should China be concerned about the coming shift to regionalism in the global supply chain? Many people are concerned about the consequences of unemployment. Indeed short-run adjustments is necessary, but the long-term equilibrium unemployment rate is determined by a labor market’s ability to adjust to market changes, not by trade balance. After all, the Chinese labor force is rapidly aging and shrinking. If anything, automation, which is a response to the aging workforce and technological progress, is the more important concern when it comes to employment than the shift of the global supply chain. The Chinese domestic market is huge and most of it is yet untapped. The concern in China is about a looming labor shortage and thus the need to take up smart responses, like automation, to meet production demand.
China has also become an important source of outbound foreign investment, so one may argue that losing inbound foreign direct investment is not as much of a concern. On this point, we caution against this complacency. Foreign direct investment as a result of multinationals locating their supply chain in China should get more credit for playing an important positive role in raising China’s economic efficiency. Beyond employment and growth, foreign direct investment brought important and large positive spillovers to the productivity of domestic firms via two channels: (i) showcased innovative technology and management, and (ii) intensified market competition.
Without foreign firms, Chinese domestic firms, whether private or not, may play a very different competition game. The winners are less likely the fittest, but more likely the most connected. The competition from foreign firms in China puts pressure on Chinese domestic firms to improve corporate governance, both at the company and the market level. As more multinationals move their supply chains out of China, there will be less competition in the market for corporate control, and less competition for investment opportunities. Worse yet, the connected uses the opportunity to slow down meaningful improvement in supply-side management in the country.
The de-coupling phenomenon has negative ramifications in markets with less-than-fully developed market and legal institutions. For China, this is the more worrisome implication of the post-COVID-19 global supply chain reconfiguration. It is the most urgent time to intensify the advancement of market and legal institutions in China to ensure that the most productive firms emege as the winner in the race for market shares.
(Hanming Fang, University of Pennsylvania; Bernard Yeung, National University of Singapore.)