Re-aligning global value chains

An intriguing area at the intersection of geo-politics and world economy, with far-reaching implications, is the impact of Covid 19 on the global value chains (GVCs). In fact, it can be argued that the Covid 19 is only hastening a set of forces which have already been set afoot by the US-China trade war.

Japan has been leading the charge in making realignment of the GVCs an explicit goal in the name of diversifying away and reducing the excessive reliance on China,

In its emergency economic package adopted on April 7, the Japanese government called for the re-establishment of supply chains that have been hit by the virus's proliferation. It earmarked more than 240 billion yen (about $2.2 billion) in its supplementary budget plan for fiscal 2020 to assist domestic companies to move production back home or to diversify their production bases into Southeast Asia. It is a tidy sum of money.

It was later passed by the Cabinet,  

Japan's cabinet in April earmarked 248.6 billion yen ($2.33 billion) for subsidies to businesses that move production back to Japan, covering up to two-thirds of relocation costs.

Japan has struggled with supplies as it tries to ramp up production of medical equipment and other Covid gear,

Japan had struggled to ramp up domestic production. The country's reliance on China for most of its supply of face masks left it unable to keep up with a spike in demand, spurring electronics maker Sharp to begin production. Securing medical supplies to tackle the pandemic has become a primary concern for world leaders. Such shortages have brought back to the fore a long-running debate in Tokyo over pulling manufacturing out of China. With the COVID-19 crisis making the economic security stakes clearer than ever, the government has begun to act... Chief Cabinet Secretary Yoshihide Suga, in an interview with Nikkei, stressed the need for greater self-reliance. "Looking at masks, for example, 70% to 80% are produced in China," he said. "We must avoid depending excessively on particular countries for products or materials and bring home production facilities for goods needed for daily life."

Besides Japan, the US too has been promoting partnerships among like-minded nations like Australia, Japan and India to relocate factories out of China.

Two things. One, the idea of shifting away from China, is embodied in the China plus one strategy adopted by several multinational corporations in recent times. This shift, motivated by the need for diversification and rising labour costs, has been underway for sometime now,

Pou Chen, the world's largest contract footwear maker, has also scaled back its Chinese manufacturing over the years, from 29% in 2014 to 13% in the first quarter of 2019 in terms of total shipments.

Two, shifting out of China is not easy.

Sample Tim Cook himself on why Apple is so focused on manufacturing in China,

The number one reason why we like to be in China is the people. China has extraordinary skills. And the part that's the most unknown is there's almost two million application developers in China that write apps for the iOS App Store. These are some of the most innovative mobile apps in the world, and the entrepreneurs that run them are some of the most inspiring and entrepreneurial in the world. Those are sold not only here but exported around the world... China has moved into very advanced manufacturing, so you find in China the intersection of craftsman kind of skill, and sophisticated robotics and the computer science world. That intersection, which is very rare to find anywhere, that kind of skill, is very important to our business because of the precision and quality level that we like... The products we do require really advanced tooling, and the precision that you have to have, the tooling and working with the materials that we do are state of the art. And the tooling skill is very deep here. In the U.S., you could have a meeting of tooling engineers and I'm not sure we could fill the room. In China, you could fill multiple football fields... China stopped being the low-labor-cost country many years ago. And that is not the reason to come to China from a supply point of view. The reason is because of the skill, and the quantity of skill in one location and the type of skill it is.

A feature of China's manufacturing prowess is the localisation of specific export sectors in a single city or county. There are more than 500 such specialised towns, with some being responsible for 63% of world's shoes, 70% of its spectacles, and 90% of its energy saving lamps.

Sample this about coffin-making,

The coffin-makers of Zhuangzhai, a leafy township of 100,000 people in the eastern province of Shandong, are a case in point. Between them, Zhuangzhai’s three main manufacturers export 740,000 coffins annually, almost all of them to Japan. With just under 1.4m deaths in Japan last year, that gives one Chinese township something around half the Japanese coffin market. 

This is a source of immense strength. It creates an unmatchable manufacturing eco-system. So production is not easily replaced, even if Japan wants to diversify away from China, 

The largest local firm is Yunlong Woodcarving, which ships 20,000 coffins to Japan each month. Its 56-year-old founder, Li Ruqi, has coffin-making in the blood... In 1995 his firm began supplying a Japanese coffin-maker with panels decorated with phoenixes and lotus flowers. Most were carved from the wood of the paotong, which grows all around Zhuangzhai... Some Japanese clients did try sourcing coffins in Vietnam and Indonesia, he concedes. But they found that workers in South-East Asia lacked “discipline”, so returned to Shandong. His corner of China has paotong trees, skilled labour and trusted suppliers. “Price-wise, talent-wise, this place is pretty far ahead,” he says.

However, it is also a source of risk, as seen by the plight of the bra-making town of Gurao.

So there is the challenge of availability of the required conditions to shift large value chains. Vietnam has been the standout beneficiary. But given the scale of realignments and its own smaller size, Vietnam too may be reaching its limits in absorbing businesses relocating out of China. Labour costs are rising and shortages are being felt, and land prices have become prohibitive. And with technology companies coming in large numbers, the lower value manufacturing may be getting displaced from the country. Vietnam appears to be moving up the manufacturing value-add escalator.

"Companies in traditional industries will be squeezed as tech companies are also heading to Vietnam," said Karen Ma, an analyst specializing in emerging markets at Hsinchu-based Industrial Technology Research Institute. "Meanwhile, the cost of expansion there will definitely become much more expansive. ... Most of these existing players in the textile and footwear industry will face a dilemma: Where should they go if they are leaving Vietnam? Currently, there are not many choices for them left in the region as Laos and Indonesia have not yet reached Vietnam's level in terms of infrastructure and quality of the workforce."

But India has to get several things in order before it can become a serious contender. It faces several headwinds as it grapples with efforts to attract companies. For a start, it is currently not anywhere near being a serious proposition for those looking to move out of China,

Nomura Group Study found that in 2019, out of the fifty-six companies which shifted their production out of China, only three of these invested in India; while 26 went to Vietnam, 11 to Taiwan, and 08 to Thailand. In April 2020, Nikkei noted that out of the 1,000 firms which were planning to leave China and invest in Asian countries, only 300 of them were seriously thinking of investing in India.

Further, as Irene Yuan Sun wrote in Bloomberg, India needs to shake off its false confidence,

The fantasy, most common in India, that a country might somehow “leapfrog” from a rural, agriculture-heavy economy straight to a services-based economy is just that: a fantasy. South Asia can’t afford to lose this chance to grow its manufacturing sector. Attracting manufacturing investments will require, first and foremost, that governments in the region acknowledge the competition is passing them by. India, for example, must abandon its overconfidence that investors will come simply for its large population.

Or this,

India has been overplaying its demographic advantage for too long. Even its market is not large or rich enough to allow economies of scale for manufacturers -- unlike China's. Indian wages are low compared to China -- but so is its labor productivity.

Then there is the rise of protectionism,

Donald Trump said he could levy new taxes on American companies that move their manufacturing bases from China to any country other than the United States. Donald Trump has termed taxation as an incentive for companies to return the manufacturing to the United States... Donald Trump said instead of giving incentives to American companies to bring their manufacturing back to the country he would instead tax them for moving anywhere other than the United States. The President of the United States that they will not be doing much for the companies to get them back to the US. He instead said that the companies will have to shift back for the country.

Then there are the numerous questions about India's readiness. Sample these statistics,

The World Bank estimates that between 2014 and 2018 manufacturing declined marginally, from 15.1% to 14.8% of GDP... A recent study by Nomura found that of 56 companies that relocated production from China between April 2018 and August 2019, only three chose India. Nearly half went to Vietnam.

Rahul Jacob who has written extensively on the issue of problems faced by textile exporters is not very optimistic,

The Modi government has instead been arguing that the covid-19 crisis will allow India to position itself as a manufacturing alternative to China... V. Elangovan, who heads a regional buying agents group in Tiruppur... has heard such predictions before. For the past couple of decades, companies in the West have been looking to diversify their outsourcing requirements and pursuing a China+1 strategy.

“India has never been a candidate; the ecosystem is not there. We cannot replace China for 50 years to come," he told a roundtable organized by Apparel Resources, an online trade publication. Impressed by how well the finance ministry in Dhaka works with garment manufacturers and exporters in Bangladesh, Elangovan had a more realistic goal for India: “Let’s compete with Bangladesh."

More from him here, pointing to the fact that talks of shifting production out of China has been on since 2010 but is unlikely to materialise given what China has to offer,

Despite some labour-intensive production moving to Vietnam and Bangladesh, a decade on, China still bestrides apparel and clothing accessories exports like a giant fending off Lilliputians... China + 1 as a sourcing strategy again goes back a decade or so but multinationals have had limited success diversifying away from China... Kathrin Hille, Greater China correspondent for the Financial Times in Taipei, who has for several years covered Foxconn, the largest contract manufacturer in the world for Apple, predicts that smartphone assembly is unlikely to move substantially from China. “Foxconn has more than a million workers in China. If you ask manufacturers about moving to Vietnam or elsewhere in South-East Asia, they say they can’t build factories of more than 20,000 workers there," Hille said, pointing to Foxconn townships in Zhengzhou and Shenzhen in excess of 200,000 workers each. “It’s not just a question of population size. The model doesn’t work elsewhere."

What complicates matters is that any serious attempt at attracting manufacturing will also involve deft use of industrial policy, which in turn is complicated by weak state capacity and the problem of going against the grain of orthodoxy and conventional wisdom. While the former is well known, the latter is equally important.

Given its deficient industrial base and manufacturing capacity and also given the cheap competition from China, fostering local manufacturing (Make in India) demands some kind of infant industry protection. However, this will be seen as a throwback to the earlier regime of autarky and Nehruvian socialism. It will also be a blow on the country's investor perceptions.

The track record of the country's businesses in this regard does not inspire any confidence that this time will be different. Instead of using the protections to grow productive businesses and capture export markets, India's entrepreneurs and corporates became comfortably ensconced and feasted on the domestic market. Once the economy liberalised, the floodgates opened to foreign competition, the local businesses fell away quickly. Businesses are not alone to blame, since governments did little to foster export competition and enhance productivity. This is a story that Joe Studwell describes in great detail contrasting the differing fortunes of North and South East Asian economies, with India and its companies closely resembling the latter.

The plethora of Free Trade Associations (FTAs) have ravaged all sectors. Sample this from Sunil Suresh, chairman of Stanley Lifestyles, a maker of leather furniture who also contract manufactures for Ikea,

“Currently, the furniture industry has zero duty on imports from FTA nations. Many Chinese companies are routing furniture through companies they have bought in countries such as Vietnam, Malaysia, Thailand, but import duty from Western nations such as the USA, Germany and Italy is only at 10 per cent. If there was a structure similar to that for imported cars, manufacturers would be more inclined to set up shop in India and work alongside local players. Imports will stop and the ecosystem will grow”.

And this,

Dhiren Gopal, director at furniture maker Featherlite Group, says more state support is needed. “What’s needed is a level-playing, field which is absent, since mainstream companies in special economic zones can import furniture duty-free,” he said.

It is the same everywhere, footwear to textiles, mobile phones to electronics manufacturing.

The Government of India have initiated measures in this direction. The latest being the new Electronic manufacturing policy, EMC2.0, which targets attracting the largest electronics manufacturers with production linked incentives (PLIs) and ready factory sheds and plug-and-play infrastructure. And the establishment of Empowered Group of Secretaries to co-ordinate attracting investments into the country.

In this context, some of the standard arguments in foreign media about India are pure trope,

Many sectoral regulations are problematic for investors. For instance, price controls on medical devices cap manufacturers' profits. India's raw material protectionism, especially related to synthetic fibers and steel, raises the cost of production in downstream industries. And its e-commerce policies discriminate against foreign companies like Amazon and Flipkart-Walmart.

One could write this on just about every emerging economy, especially so China. And such regulations have been the industrial policy foundations of economic growth of all countries. 

Update 1 (01.12.2020)

NAR on the growing Chinese global trade dominance despite headwinds.

Nikkei analyzed data on 3,800 products compiled by the International Trade Center and found that there were 320 products in 2019 in which China held a share of more than 50% in export markets. By comparison, in 2001, when China joined the World Trade Organization, the number was 61 products. The number of products of which China had a high share stopped increasing from 2016 onwards, when U.S. President Donald Trump took office and then the trade war began, but the number increased again last year.