Five Potential Shocks to your Chinese Supply Chain in 2023

Last year, I asked my good friend Andrew Hupert to explain what is involved in moving manufacturing from China to Mexico. I chose Andrew for this because he has spent so much time in both China and Mexico, navigating their manufacturing systems from the inside.

My law firm frequently consulted with Andrew when we first started doing China legal work, and at that time Andrew was living in China. Though Andrew had for decades tied his life and career to China, he — like me — was one of the earliest proponents of a post-China manufacturing world. So much so that Andrew moved to Mexico, reinvigorated his Spanish language skills and began helping companies — especially companies looking to leave China — navigate Mexico. Who better, then, to write about what it takes to leave China (in whole or in part) for Mexico than Andrew Hupert?

Andrew wrote a series of five posts on the differences between China and Mexico manufacturing and I urge you to read all five of these:

Then at the end of last year, we wrote Three Things Everyone Leaving China for Mexico Should Know, as an introduction to what we expect will be a roughly ten part series to be written over the next 7-9 months. Already this month, we’ve written Three Mistakes We Made in China and Three Things We’ll Get Right in Mexico and Mexican Supply Chain Management: You’re not in China Anymore.

The below was written by both Andrew and me (mostly Andrew) and it constitutes our third piece in the series.

Andrew and I also will be putting on a free online Q & A session on February 23 on what it takes to move manufacturing from China to Latin America. If you have any questions you want us to answer at that event, please send those to us at [email protected] To register CLICK HERE.

 

Many decision-makers are still early in the process of moving at least some of their supply chain out of China. As 2023 gets rolling, time is not on your side. If you don’t make real choices now you may find that the choice will be made for you. Supply chains between China and the United States remain at great risk of being disrupted (again) in the near future. Companies that have diversified their sources for products will have a competitive advantage, while those still overexposed to China will suffer.

A. China Supply Chain Shocks 

The most likely source of supply chain shocks will be from governments, and they will probably be mistakes. My number one candidate is bad regulations – written, interpreted, and enforced for non-economic goals.

Would governments/parties knowingly shoot themselves (and their own economies) in the foot just to score a zingy 15 second soundbite on the news? Yes. Of course they would. Are you new here?

Shock to the system. Let’s define the phrase supply chain shock as an unexpected, unplanned disruption in your supply chain. It doesn’t have to be a crisis or a war. A repeat of 2022 would be more than enough. If your Chinese-made products can’t be produced and/or delivered for an unknown period of time in 2023, it will not be easy to justify or recover from. The list we’ll be discussing below discussing are not black swan events. We know they may occur. In 2021 and 2022, most were all in the same boat, even if it was stacked up off the coast of California. This time, there will be winners and losers. See What Is a Supply Shock and What Causes It?

The possibility of another international business shock in 2023 is real and rising. I’ve identified 5 classes of possible events that can wreck your firm’s supply chain. The odds of any one of these happening in 2023 in a way that crushes your China supply chain are fairly low, but the odds of at least one of these happening in 2023, are actually quite high.

1. US government actions. Regulations, restrictions, and much more.

2. Chinese government/Communist Party actions. Retaliation, industrial policy, lockdowns, and much more.

3. Technical divergence. China is getting good at manufacturing things we don’t use.

4. Populism/Nationalism. US populism. Chinese nationalism.

5. Economics. Rising costs, recognizable risk, compliance, and more.

Let’s look at each of these classes individually, and then we’ll talk about ways you can mitigate your risks

1. US government actions

The US has been officially labelling China a strategic competitor since then Vice President Pence’s speech to the Hudson Foundation on Oct 4, 2018. See China, the United States and the New Normal. We don’t expect any radical new policy moves from the United States regarding China, but I’m very concerned about the unforeseen impact of a new wave of anti-China regulations.

The new bi-partisan Congressional “Select Committee on the Strategic Competition Between the United States and the Chinese Communist Party” was set up to target China with new regulations and restrictions. That is its function and it is the ideal forum for Republicans and Democrats to fight for the title of toughest on China. And with 82% of Americans viewing China unfavorably and 75% viewing China as an enemy, playing tough against China makes for great politics You may love your Chinese team/supplier/factory manager, but that means very little to a poltician who sees that 82% figure and it means nothing to a U.S. customs agent who needs you to comply with existing or future regulations by demonstrating that you are NOT

– using slave labor in Xinjiang

– using materials that have been produced by oppressed people

– harming human rights

– harming religious freedom

– making use of non-certified IP

– engaging in non-market activities.

or anything else covered by regulations that will undoubtedly be very popular in the home districts of Congresspeople.

2. Chinese government actions

And let’s not discount the possibility that China may wreck the supply chain – intentionally, through miscalculation, or by non-market actions.

First off, remember that China is still very much a command economy that constantly uses its clout to punish its enemies. See e.g., Amid Tension, China Blocks Vital Exports to Japan, Norway and China Restore Ties, 6 Years After Nobel Prize Dispute, China has put Canadian canola oil in the middle of a wider geopolitical dispute, China’s Economic Retaliation over South Korea’s THAAD Deployment, China rushes through law to counter US and EU sanctions, Australia seeks end to China’s trade sanctions, China’s Sanctions Regime and Lithuania. China has sanctioned just about everyone at one time or anther and it is even quicker to impose sanctions against any country that has the nerve “to try to stop China’s peaceful rise” by imposing sanctions against China.

With Biden committed to cutting China off from any technologies that might have military uses, the odds of the United States and China going through round after round of sanctions and counter-sanctions in 2023 are high. Chinese negotiating culture favors “divide and conquer” tactics, and it allows or restricts access to key resources (including money) strategically.

But when it comes to China my biggest fear is what might happen accidentally. Another major outbreak (Covid or whatever may pop up in the future) may spark a repeat of the lockdowns and shipping bottlenecks we saw in 2022.

When discussing government-driven shocks, we can’t ignore the very large, very angry elephant in the room.  Any sort of military conflict between the US and China may serve up a severe disruption to supply chains. And though we do not expect a formal declaration of war or anything even remotely similar, we are concerned that the boat bumps and plane buzzes that are Standard Operating Procedures in China’s military could lead to a small or even not so small military conflagaration between the United States and China. China claims a lot of territory that the US doesn’t recognize. Under normal circumstances, these situations get de-escalatedI’m also concerned that China’s aggressiveness towards neighboring countries like Japan, the Philipines, India, or Vietnam, could boil over in a way that harms China-U.S relations as well. A minor altercation could easily spiral into a major supply shock.

And then there is the fact that China and Russia have what Xi Jinping calls an “unlimited friendship.” Just today, the New York Times reported on how “Russian Agents are Suspected of Directing Far-Right Group to Mail Bombs in Spain.” Will Russia engage in similar tactics in the United States? And if so. — or even if it confines such tactics to U.S. allies — will U.S. politicians simply ignore China’s “unlimited friendship” with Russia? We think not.

3. Technical divergence and competing interests

This one is a little more distant, but since we’re talking about what can go wrong in the supply chain it’s important to note the changes in China’s domestic industries. China has been justly vilified for stealing IP, but the silver lining there was that we were all on the same industrial roadmap. The basic materials, parts, components, and finished goods were pretty much identical for both economies, ensuring that China’s massive industrial machine was always churning out plenty of useful output.

Now, however, we’re starting to stray apart with China developing expertise in areas in which the US isn’t particularly active.  Batteries, rare earth mineral refining, drones, high speed rail, and green technology are all areas where China has emerged as a technological leader. It wouldn’t surprise anyone if, in the near future, China announced a radically different semiconductor architecture. The point here is that for the first time, a large portion of China’s domestic production is no longer compatible with Western technology. Will next-gen mobile technology (7G, for instance) only work with Chinese chips or hardware? Don’t discount the possibility that international brands may get squeezed out of access to materials or processes that are in short supply. When bottlenecks occur, Chinese Communist Party officials may have a say in how scarce materials and resources are allocated. Spoiler alert: Huawei will have better access than Cisco.

4. Populism/Nationalism

As discussed above, Anti-Chinese sentiment is on the rise in the United States. Anti-American sentiment is also rising in China. Chinese popular opinion is heavily influenced by the party. Propaganda works, even when it’s clearly propaganda. See How China’s online hate campaigns work. We are constantly hearing of mistreatment of Westerners in China and with so many countries mandating COVID testing of people incoming from China, we expect things will only get worse. See Foreigners in China in the Time of Coronavirus. We suggest you read this Linkedin post and note how few people are at all surprised by it.

This rising nationalism/hatred from both the United States towards China and China towards the United States does not bode well for future business relations.

Will a close relationship with China harm your brand image in domestic markets? Though it’s impossible to predict the future, the very existence of the term “friendshoring” indicates that it may. This may not be a big concern for B2B transactions but it’s already a growing issues for consumer brands, in both countries.

5. Economics, Risk and Governance.

Even without COVID, strategic competition, and the fear of populist backlash, China has become a for more expensive and difficult place with which to conduct business over the last few years. Labor in China has become relatively expensive (both in terms of salary and in the costs of maintaining and discharging employees), and the costs of other inputs have also been rising. When China was a low-risk, predictable production center, rising costs were manageable. But after the problems of the last two years, companies are reassessing the risks inherent in a purely Chinese supply chain. In 2022, a partner or owner of a Western brand producing in China could claim that disruptions and delays were impossible to anticipate. That won’t work anymore.  Fiduciaries may be held liable for ignoring the risks of supply chain interruptions, especially if it seems they are flouting or evading US law.

And finally, companies need to consider China’s constantly evolving operating environment as a regulatory Catch 22. The Xinjiang situation is a good example of this. As a US brand, you will be expected to demonstrate that you are not benefiting from slave labor in the Xinjiang region. But when you (or more likely, your Chinese or Chinese American country head) attempt to verify and certify the origin of your product’s materials, you may find yourself “invited to tea” by the CCP. See also Xinjiang Cotton and the Shift in China’s Censorship Approach and U.S. Bans Xinjiang Cotton to Combat Slave Labor. If your staff in China (especially those with US family or connections) gets in trouble with Chinese authorities for attempting to comply with your orders, you may be held responsible.

The point here is that the risks of manufacturing in China are growing.  If you are still relying on a purely Chinese supply chain, you can’t legitimately claim ignorance to the risks.

B. Mitigate Your Risks NOW

If you haven’t started your actual planning for mitigating your China supply chain risks, you are exposing yourself to risk, and there’s no reason to think that your competitors are in the same position. You are putting your firm at a disadvantage.

Vietnam is not a great emergency fallback option. It is a very solid option for many companies, but if you’re not already well on the way to negotiating a serious deal there, you may be too late as many (most?) factories and logistics companies are already at capacity. A call from Samsung gets local officials and economic planning people hopping, but SMEs are already having a tough time finding the best options. Vietnam is small by Chinese manufacturing standards, and they are not as anxious for your deals or dollars as China was when it was on the way up.

India is rising, but it is still a very difficult country in which to conduct business and many of the companies with which we have worked that went into India, left it within a year. It is not for the faint of heart.

Mexico is a solid option for brands selling to the US (or engaged in that supply chain). But it too is filling up. The challenge for China-oriented managers is that Mexico is filling up via US expansion of existing operations (including companies like Toyota).  Companies already in Mexico are growing their operations there while the China-based operations are merely contemplating some kind of Mexico thing. The best strategic planners in the world (auto industry, aviation, mining) are doubling down on Mexico and that is driving up prices for the best real estate in the best border states.

Final word

We are pretty much wrapping up on the “why you should diversify” topic and moving on to nuts & bolts strategic planning basics.  It is possible to gradually transition your supply chain out of China, but there aren’t any off-the-shelf, integrated solutions.  You’ve got to develop your own plans, and you don’t have an endless amount of time.  When I [Andrew] first returned to  studying Spanish three years ago while I was still living in Vietnam, people were justified in pushing back against the idea of US-China disengagement. They were waiting for things to get back to normal.  Now it seems that North American supply chains are the new normal. It’s time to take action.

 

For a free 30-minute introductory discussion about transitioning your supply chain to Mexico, email Andrew at [email protected]

For a free 30-minute introductory discussion about the legal issues involved in transitioning your supply chain from China to Mexico (or to anywhere else), email Dan at [email protected]