After decades of uninterrupted growth in global trade, which led to ever greater specialisation, efficiency and lower inventory levels, the twin shocks of the trade war and the pandemic require an urgent reassessment of how to organise supply chain in the future. This post will outline some key considerations and trade-offs in the search for more robust solutions to reduce supply chain risk. The focus will initially be on choices and trade-offs within Asia before exploring the challenges if re-shoring.
What price for what labour?
A manufacturer needs to think long and hard when choosing a location. There are many factors that need to be weighed in finding the right spot and often, compromises have to be made to ensure production remains efficient and economical. The first consideration for a location is often the supply of labour.
India is a good example of a large labour pool. However, only 30 million people in India are in manufacturing compared to 100 million in China. Urbanisation is still lower there and livestock farming is a much bigger employer than manufacturing. Vietnam and Philippines have an even smaller pool which is a tenth of China’s. The foremost concern for labour-intensive manufacturers would be labour costs as well as wage growth, such as in the apparel sector where 20% of costs come from labour. The apparel sector also normally employs at minimum wage. China’s minimum wage is almost double that of Vietnam, Cambodia and Indonesia with Bangladesh being on the extremely low side.
Vietnam has frequently been suggested as a good alternative location outside of China. Comparing China and Vietnam shows that the minimum monthly salaries in Vietnam range from US$120 to $173, which is below the US$265 to $329 in China (Shenzhen, Kunshan, Chongqing and Chengdu). The minimum wage requirements in Vietnamese industrial parks such as Bac Giang, Bac Ninh and Binh Duong are around 50% lower than cheaper inland locations like Chongqing or Chengdu.
Labour cost advantage exists as long as productivity growth remains above the wage growth. According to the Institute Labour Organisation, the representative manufacturing hourly wages in USD for US, China, Mexico and Vietnam show China at double the rate of Vietnam, with Mexico right in the middle.
Manufacturing labour costs per hour for China, Vietnam and Mexico from 2016 to 2020 (USD)
Average hourly earnings in U.S. manufacturing from 2006 to 2019 (USD)
In Vietnam, between 2017 and 2019, the minimum wage and average salary have increased by around 6% and 5% respectively annually. Apart from the minimum wage, other considerations include the remuneration of supervisors that can speak both English and Mandarin, or other mother tongue of the employer. Language skill is important when setting up at a foreign location.
Even if labour is plentiful and the wages are relatively low, cultural differences become a major operational challenge and may be the difference between success and failure. An example that comes to mind is the 2019 Netflix documentary “American Factory”. This program about a newly opened Chinese-owned glass factory in Ohio exemplifies the huge differences between the workers in America and the China, not only in skills but also in work ethic and culture.
Quoting from the FT, “the culture clash sees the Chinese regularly describe American workers as inefficient or fat-fingered. Americans complain about Chinese disrespect for local laws, a lax approach to health and safety and mandatory overtime that eats into the weekend.”
Infrastructure includes utilities (water, gas, internet, electricity and waste), transportation access and land to build on. The more heavily reliant on these a manufacturer is, the higher the standards need to be, not just at the national but also at the local level. A garment maker can get by with diesel backup for a few hours but a chip foundry needs the very highest quality of everything.
An adjacent but not much thought of factor is environmental pollution. According to YOFC, an optical fiber maker, Indonesia tends to have cleaner air than Wuhan which makes the manufacturing of optical fiber easier.
Regulatory requirements, policies and tariff burdens can incentivise a manufacturer to select a particular location. In Vietnam for example, tech companies are allowed tax exemptions for the first two years and a 50% tax reduction for the next four years. Apart from tax incentives, governments can also play a huge part in funding support, providing cheaper land and subsidising research and development.
At the same time, forcing foreign investors to partner with locals and share IP can very easily deter investment. A careful balance between maintaining firm-specific IP protections and raising the general local level of know-how can make an attractive combination.
Proximity to the supply chain is also important because of higher transportation costs and longer shipping times. The US-China trade war has propelled some companies in the Greater China tech space to expand to Vietnam because of its proximity. For Chinese factories situated in Vietnam, these are within two to three hours’ drive from Guanxi on the Vietnam-China border.
The costs of shipment from Chinese cities to Vietnam is higher than shipment to domestic cities because of the distance. For instance, average distance from Kunshan, a city near Shanghai where the factories of several tech companies are located, to four cities in Northern Vietnam is 29% more than the distance to Chengdu or Chongqing.
The alternative is sea freight but this will take longer as compared to road. The average number of shipment days from coastal cities in China to Hai Phong port in Vietnam is six days and to Ho Chi Minh port is seven days, both longer than the maximum 4 to 5 days it takes to ship domestically.
Limited port capacity also reduces capacity. UNCTAD shows Vietnam’s share of global container port throughput is only around 2% as of 2017 versus 33% for Greater China. According to World Shipping Council, 16 ports in Greater China are among the top 50 world container ports by shipment volume in 2018. Only two ports from Vietnam are on the list – Ho Chi Minh port and Cai Mep port, which rank 26 and 50, respectively.
From a paper by Antràs and de Gortari “On the Geography of Global Value Chains”, “With costly trade, the optimal location of production of a given stage in a GVC is not only a function of the marginal cost at which that stage can be produced in a given country, but is also shaped by the proximity of that location to the precedent and the subsequent desired locations of production. We show that, other things equal, it is optimal to locate relatively downstream stages of production in relatively central locations.”
Barriers to diversify
There are several reasons that it might not be ideal to diversify location at all. Using China-Vietnam as an example, China’s emerging wafer producers and leading memory start-ups could expand semiconductor production to Vietnam to avert tariff issues but the industry is still at an infant stage. China needs to catch up to the US in terms of innovation and leading-edge technology.
In terms of talent supply, Vietnam cannot produce the same number of engineers as those in China. Perhaps the solution is to attract Vietnamese students to study and train in China. In terms of non-engineering talents, challenges include training workers who have no prior experience in specialised products and raw material procurement as well as management.
From the International Labour Organisation, “investing in human capital via extensive training and education, as well as improving the innovative capacity of clusters within a process of both economic upgrading for firms and social upgrading for labour can support the competitiveness of these clusters in global markets. The process of industrial upgrading must be accompanied by a process of social upgrading for labour, which involves improved working conditions for workers, as well as providing social recognition and greater opportunities for education and professional training that would raise their skills, incomes and human capital.”
In addition, the supply chain is still under development in Vietnam. Compared to China with easy access to materials, equipment and services as well as the fact that major global suppliers are situated there, Vietnam is still incomplete. Vietnam will still need major support links from China to operate as part of supply chains. Hence, any US trade policies adverse to China will still hit the production in Vietnam.
The hysteresis effect in trade shouldn’t be overlooked when there is a regime change in trade policies. The presumption is that companies will shift production to lowest costs locations. Incomplete supply chains can result in higher costs as the incomplete parts need to be outsourced more expensively. Hence, a location change is not necessarily feasible should trade policies become unfavourable.
These outsourcing costs usually end up being passed on to consumers. This is possible as long as the prices remain competitive. The inconvenience of the exercise, the uncertainty of how long the new policy will remain unchanged and the unfamiliarity of the possible new locale deter production from being moved and firms opt instead to remain in China with its vastly more comprehensive supply chain ecosystem.
At the end of the day, the diversification out of China rests on how entrenched China is in the global value chain such that a true decoupling would be too costly, and the continuing trend of protectionism.
A few sector examples
The US has issued many trade regulations concerning semiconductor manufacturing and technology IP for the past year, making it more difficult to situate in China. For the US, pressure via trade regulations is possible as long as the US remains the leader in this field, especially at the higher level of complexity such as software design and semiconductor manufacturing.
On the other hand, after over twenty years of building infrastructure for this industry, China is migrating to upstream semiconductors. US trade policies have accelerated China’s localisation of their semiconductor supply chains. China’s domestic diversification of their supply chains have given new opportunities for emerging local suppliers.
The massive scale of some Chinese brands has also allowed domination of their own domestic markets. Experience at supplying a market this large leads to a rapid move up the learning curve. The ability to directly interact with intermediate and end consumers also helps in product improvements.
In a Goldman report on semiconductors, “The long-term winners in China semiconductors are leaders in technology, scale and SKUs and are best placed to benefit from the localisation of supply chains. A cycle of accelerated tech migration, expanding product lines and rising market share will drive outsized earnings growth over the next five years.”
As for smartphones, in 2019 there were 149 Apple suppliers in China. Southeast Asia countries will stand to benefit if these suppliers have to relocate. There are talks of shifting a fifth of iPhone production from China to India over the next five years with most of the production for export. In comparison, Google’s Pixel 4 phone is rumoured to be partly manufactured in Vietnam. The company is planning to repeat it this year with its new low-cost Pixel 4a as well as its next flagship model Pixel 5.
According to the BGR site, “Google is not as heavily tied to China from a manufacturing standpoint as a company like Apple is, so a move like this doesn’t entail the logistic headache that you might imagine. Google shipped 7 million smartphone units last year, compared to the 200 million or so Apple sells every year, according to data from IDC… This shift is both fortuitous and yet still problematic for Google, which had already converted a factory in Vietnam for exactly the kind of production it will now be ramping up there. However, there’s still one hiccup the company hasn’t figured out how to overcome yet – the fact that many of the components that need to be supplied for the Pixel production still come from within China.”
In other words, the supply chain ecosystem still needs time to be built.
A recent ING report stated that “Supply chains in the automotive industry consist of a large group of specialised suppliers that are clustered within regions. Most value is added in the region where the cars are sold, but the inter-regional links were still able to stop the global automotive industry in its tracks early in the Covid-19 outbreak. The lockdown in Hubei province in China forced factory closures in Europe weeks before European countries went into lockdown. The costs of supply chain disruption are considerable.
In early June, the European Automobile Manufacturers Association (EAMA) reported that factory shutdowns due to Covid-19 (30 days on average at the time of reporting) had resulted in a production loss of 2.5 million vehicles in Europe, of which around 617,000 were in Germany, the hub for European car manufacturing.”
For the automotive industry, finding remedies is a gigantic task. Diversifying suppliers who need to produce to detailed specifications, quality and safety standards and holding more inventory where many of them are bulky is difficult and costly. However, even though it took a long time, it is possible to do – witness how Slovakia and Mexico have become a vital supply backbone in Europe and America over the past few decades.
People vs. robots
Covid-19 has impacted labour supply such that automation efforts are likely to be accelerated. In the long run, this will reduce the importance of labour when choosing a location. The consideration of whether to automate depends on how long a product is in production, the construction of the product, the type of labour required for automation and of course, the number of engineers and tech personnel needed.
From a recent Goldman Sachs report, “automation has the potential to reduce the number of traditional line workers in phone assembly but create new engineering roles. One expert estimated that automation can reduce the number of people needed for final assembly by 40% to 70%. However, this would require OEMs to change the product cycle or design to make automation practical.”
The number of robots shipped to China is the highest in the world, although at 140 per 10 000 employee, robot penetration per employee is still higher in more developed markets.
The Republic of Korea has 774 industrial robots per 10 000 employees, more than twice the number of Germany (third with 338 units) and Japan (fourth with 327 units). Singapore leads with 831 robots installed per 10 000 employees.
This chart from an IFR 2019 presentation shows the region where automation is the highest:
After eight years of strong automation growth, annual installations of industrial robots in China is experiencing a slight dip. Whether this slowdown in China is a continuing trend remains to be seen. Having said that, China has surpassed the global average (99 units per 10 000 employees). Considering Tesla and others are in the midst of expanding their operations there, we should not be too worried about automation stagnation in China.
In keeping with the previous China-Vietnam comparisons, the annual industrial robot shipments in China were around 17 times that of Vietnam in 2017. Vietnam also has the lowest number of industrial robots installed per 10 000 employees among the Asian countries, a far cry from Chinese levels.
David Autor and Elisabeth Reynolds, in their recent Hamilton project paper “The Nature of Work after the COVID Crisis: Too Few Low-Wage Jobs” write, “In interviews of small and mid-size manufacturing firms conducted by the MIT Work of the Future Task Force during the crisis, several employers reported that, rather than shut down or curtail production, they found instead that it was feasible to reconfigure their lines to be less labour-intensive without sacrificing output.”
Forced automation may be the trend for many manufacturers who find themselves subjected to greater protectionist tariffs and difficulties in finding labour that meet requirements. Autor and Reynolds conclude in the paper that the unexpected pandemic has “simply brought the possibility of an increasingly automation-intensive future closer to the present.”
A side note on Global Value Chains
We can no longer think of trade simply as a Ricardian comparative advantage, although that consideration still stands too. Instead, we must look at global value chains (GVCs) which is about combining value added from different sources.
A more complex definition would be “a global value chain or GVC consists of a series of stages involved in producing a product or service that is sold to consumers, with each stage adding value, and with at least two stages being produced in different countries. A firm participates in a GVC if it produces at least one stage in a GVC.”
A measure of the length of supply chain can be derived from ‘value-added to gross exports ratio’. A long supply chain is where each country specialises in producing a small part of the final goods, and then intermediate products are shipped across country borders multiple times before finished goods are made. In such a case, the ratio of total value-added exports to total gross exports is relatively low.
A trend of shortening the supply chain in China has begun even before the trade war. The share of products made in complex GVCs in most industries (except a few such as electronics, automotive and textiles) have seen a decline on average since the global financial crisis.
It is misleading to look at bilateral trade imbalances as Trump and Navarro do, especially when trade is usually reported in gross rather than value-added terms and doesn’t capture a country specialising in assembly of foreign parts at the end stage of the global value chain.
The politics of GVCs
The recent crises have highlighted how more complex GVCs can lead to less resilience. This has started to influence how governments form trade policies as well as trade agreements with other countries. The structure of GVCs could also influence governments’ strategies where governments increase protectionism to cement the strength of domestic manufacturers in important industries.
According to an article in Foreign Policy, “China frequently uses non-objective claims on product regulations as Europe does, to block imports on alleged health or safety grounds. US-European disagreements have entrenched the idea that product regulations are purely a national matter, even if they are often intentionally used to block trade”. It’s not just China, trade has become a highly political issue everywhere else, as can be seen by Brexit and Trump’s talks of “bringing the jobs back”.
This dream of Trump might not be that simple. The number of manufacturing jobs in the US from early 2000 (i.e. even before Covid-19 struck) has been roughly flat due to outsourcing and automation. It is unlikely this trend will change as the considerations of economic costs and sheer practicality have not changed either. Policies that cause only parts of the supply chain to move may not create many jobs.
Estimates are that a moving smartphone production to the US would lead to a 37% increase in production costs, which in turn would lead to a 15% increase in the price for consumers. It would also take at least five years to move supply chains for smartphones to the US. A 46% increase in production costs if moved for apparel would lead to a 14% increase in the retail price. Incidentally, China is a larger market for phones and apparel than the United States. The US is not competitive with respect to labour as labour is the main driver of higher costs in the US (95% of increase in total costs for smartphones and 100% of increase in total costs for apparel).
On the other hand, the Chinese problem currently is not with labour costs but talent, as well as how to provide IP protection such that innovation can flourish. Having said that, labour costs are rising rapidly in China, reducing this competitive advantage. In fact, labour cost per unit of output after adjusting for exchange rates has more than doubled in China from 2001 to 2017. This has already made an impact as can be seen from the decline in China’s share of global exports in labour-intensive sectors from 2015 to 2019.
Quoting the NYT, “The challenge today is that an enormous manufacturing ecosystem is required to make products for mass markets, and that ecosystem has largely moved to mainland China, where some 450,000 people have worked at a single iPhone plant.”
Nevertheless, onshoring is not just about efficiency and costs. It may have intangible benefits such as ESG. A smaller carbon footprint and more carbon-efficient local production is a boon for the environment. Better labour laws ensure that production is not marred by human rights issues. Near-shoring means that production is closer to the demand and this too, bears some of the same benefits of onshoring. This may not be a long-term advantage either as China has become serious about decarbonisation.
As tempting as it is to keep trade policies out of politicians’ hands, trade represents legitimate democratic choices that voters and politicians need to make. Unfortunately, this political process is not very representative of the people and often abused by administrators and lobbyists.
Reducing supply chain risks
GVC participation by manufacturers are usually not anonymous, one-shot transactions as described in traditional trade theory. Manufacturers often require highly specialised and custom inputs on repeated basis. Manufacturers spend a lot of resources in searching and contracting these suppliers, building a custom production network that cannot be redesigned overnight.
An analysis of aggregate network metrics made by the ECB describes the structure of GVC as, “very centralised and asymmetric networks, with a few large economies acting as hubs. These networks are also characterised by small-world properties, showing a hierarchical structure with a dis-assortative pattern.”
The US-China trade war and now Covid-19 have forced businesses to think about building resilient supply and distribution systems. Right now, that means shifting supply relationships to firms that have proved capable of continuing production even in the midst of a pandemic and continuing trade war.
Manufacturers with more advanced production processes will be favoured as less risky if they have the ability to scale quickly and have chosen locations in politically and economically stable countries. In addition, scaling known products and processes lowers costs and lead times.
Resilience is not only about reliability but also about redundancy and the ability to rebalance load away from stressed supply chains. This is too big a task on a local level but it is easier to carry out with large global networks of supply system. Consequently, this will create strong incentives for incumbents to consolidate.
Companies that have the capacity to consolidate some parts of the chains are able to build these networks. Those that offer a platform for this networks of supply chains as well as those who operate on these platforms may stand to have an advantage over those who don’t. Perhaps future supply chains will be dominated by MNCs which are global in stature but maintain strong local presence, enabling them to easily rebalance production during disruptions.
Governments too, can play a part in reducing supply chain risks. Traditional trade agreements have always focused on specialisation within their own borders rather than studying the production networks within and across borders. Governments might support weaker nodes by giving incentives for redundancies, or multiple governments can work together to strengthen the networks’ resilience. Trade agreements can be written with a view of how industries involved in complex GVCs can withstand tail risks. This way, supply chain resilience does not have to depend only on the actions of MNCs and lead firms of a production network.
Building this resilience may lead to higher costs through more consolidation, more locations, less competition and higher inventory levels. Prudent action by governments and companies is required to keep these ongoing costs to minimum. Let’s hope that in future crises these efforts will more than pay off through much smaller economic damage.