“Where does an 800-pound gorilla sit?”
“Anywhere it wants to.”
In many, many companies’ supply chains, China is the 800-pound gorilla. And many companies established manufacturing and sourcing operations in and with China back when the gorilla weighed only 250 pounds, or 400. Things are different now.
Recapping China Risk Factors, Which Have Been A Concern for Years
Two and a half years ago, we wrote what I thought was an important post about the risks of doing business in and with China. I identified 14 “wild cards” that we hoped our clients would understand as potential game-changers for their businesses, and not in a good way.
Among the “wild cards” we dentified were “Trump tariffs”, democracy-suppression in Hong Kong, increasingly aggressive Chinese rhetoric relating to Taiwan, U.S. sanctions against Huawei and FBI investigations of intellectual property theft originating in China and targeting U.S. businesses.
One thing I did not identify in 2019 as a China risk was a coronavirus that would sweep the globe, paralyzing trade and killing millions. But here we are.
2. China’s COVID Supply Chain Risks
Just over two years ago, the Chinese government locked down 50 million residents of Wuhan and surrounding cities in Hubei. You don’t need me to recap the events of the past two years, but interestingly, while much of the world has returned to some semblance of business as usual during the past six months, China is trapped in 2020, pursuing a “zero-COVID” policy its leaders have assured the Chinese people is a strategy superior to the one followed by most of the rest of the world (which admittedly resulted in millions of deaths).
At this writing, Shanghai – with its 26 million residents – is in near-total lockdown, as are the manufacturing centers of Dongguan and Shenzhen in southern China; Changchun and Jilin City in Jilin Province; and Langfang, near Beijing. To understand the scale of the lockdowns, Dongguan, which most people who don’t manufacture goods in China have never heard of, has 7.5 million residents, nearly twice as many as Los Angeles, which is the second-largest U.S. city by population. Shenzhen, which (partially) emerged from its own lockdown just over a week ago, has a population of 12.6 million and accounts for 16% of China’s high-tech exports. It is to hardware manufacturing as Silicon Valley is to software innovation.
The effect on manufacturers is already profound. Some global companies (e.g. Toyota, Volkswagen) have halted production; others are prioritizing work for their biggest customers, at the expense of their smaller ones. If you’re Apple or Nike, you may continue to receive product; if you’re Acme Widget Co., you may not. I have been on the receiving end of many phone calls and emails from “Acme Widget like” companies that involve the plaintive question: “Do you have any ideas on where I can get the widgets we will need to stay in business?”
A recent Foreign Policy article about potential COVID-related problems for China manufacturers noted that many supply chains are too complex to fully comprehend. “‘Most companies simply have no way of knowing all the participants in their supply chain,’ said Michael Essig, a professor of supply management at Bundeswehr University in Munich, in 2019. He added, ‘Let’s assume that a global company like Volkswagen has around 5,000 direct suppliers and that each has around 250 subcontractors. That means that the company has 1.25 million second-tier suppliers. With each additional step, the supply chain grows exponentially.’”
An additional complication for supply chain managers and CEOs is the perennial difficulty of obtaining accurate information about China. “State secrets” can include “secret matters in national economic and social development”; information that “harms the political or economic interests of the state in its dealings with foreign countries”; and information that “weakens the economic or technological strength of the nation.”
In 1992, China’s National Administration for the Protection of State Secrets issued a regulation – Regulation on the Protection of State Secrets in News Publishing – specifying the obligations of news and media organizations in relation to the protection of state secrets. Article 7 reads: “Information intended to be made public by news publishing units or by units that provide information shall be checked by those units in accordance with the relevant regulations on the protection of state secrets. Where it is unclear whether or not a piece of information involves state secrets, such information shall be submitted to the relevant department in charge or to higher authorities or units for examination and approval.”
What is a China state secret? The state will decide.
Business managers must consider issues including foreign ownership restrictions, currency devaluations, exchange rate volatility, currency transfer limits, industry regulation, corruption, intellectual property theft, taxes, and local sourcing requirements.
Many of these risk factors are less predictable in China (and other emerging and frontier markets) because the political situation and the foundations of governance are less certain than in, say, Denmark. As a result, companies that deal with China must not only de-risk projects, but also de-risk markets and the central and local governments.
3. China Supply Chains and their Political/Military/Human Rights Risks
In addition to COVID-related challenges, manufacturers face the even greater problem that for a long time (pretty much ever since it acceded to the WTO), the Chinese government has used trade relations as a domestic and foreign policy weapon (e.g. against Lithuania, Norway, Australia, the U.S. and more). In addition, it has made other threats that affect pretty much every consumer on earth.
Until recently, most foreign companies have tried to stay removed from Chinese politics, but CCP oppression of Uyghurs and Hong Kong democrats (among other factors) has mobilized consumers – and many legislators – worldwide against the regime. Over the past three years or so it has gotten exponentially harder to just “do business”.
We have written often over the past few years about the many calls and emails we have received and are receiving from clients and prospective clients who want to know how they can shift their manufacturing out of China. See How to Move Your Manufacturing Out of China Safely and Manufacturing Outside China: Nike Likes It And You Should Too for our thinking on what companies should do.
4. China Supply Chains and the Sunk Cost Fallacy
But here, I want to wrap up with a brief discussion of a behavioral issue that economists call the sunk cost fallacy. A related behavioral theory is known as “plan continuation bias”, which describes the preference of many decision-makers to continue with an existing strategy despite changes in the conditions that justified the launch of that strategy.
Since China’s entry into the WTO in December 2001, “the West” has engaged wholeheartedly with China, and there have been many winners, both inside and outside of China. Some analysts say the West (I use the phrase to include all of China’s developed world trading partners) is inextricably tied to China, and for some companies, that is true (for the time being, at least). Others are overcoming their plan continuation bias and are heading for the exits.
This huge change in global manufacturing and trade was nicely summarized for me recently by a client who is looking at moving production from China to Mexico or Colombia, and jokingly said, “Stop the supply chain. I want to get off.”