Trade & Supply Chain

Breaking up is hard to do: decoupling and how to prepare

Published: Jan 2023

China’s role as the world’s manufacturer is changing thanks to political, ethical, and logistical pressure. The founder of China-based manufacturer Velong Enterprises explains that his customers are calling for a dual supply chain. But lifting up his Chinese operation and dropping it into a new location is far from easy.

Shipping container port in Hong Kong

For Jacob Rothman, President and CEO of Velong Enterprises, a China-based manufacturer of kitchen and household products for export, the only way to navigate the worrying and deteriorating environment for manufacturers in the country making wares for the global market is to be proactive. “You can either sit here and wait for orders and customers to erode or you can prepare to move manufacturing to different spots around the world,” says Rothman, an American who set the company up 20 years ago, speaking from Velong’s Shanghai headquarters. “America’s left and right are concerned about China, and China is saying it wants to focus on the domestic economy and is going after its top companies in an ideological shift that is worrying for businesspeople,” he says.

For Velong’s customers, which comprise renowned global retailers and brands, the current situation is a bad dream. But reality is also beginning to dawn. Velong has already set up new operations in Cambodia and India to run alongside its six Chinese factories and Rothman is now scouting new sites in Turkey and Mexico. But customer requests that the company increases safeguards and contingency in a hybrid supply chain based on production in China alongside other locations around the world are growing increasingly urgent. “Almost all our customers want to hear that we are opening other factories outside China. This seems to be the winning formula.”

What’s happening

A cocktail of escalating China-US tension on everything from trade, technology, and Taiwan to new US and EU sustainability rules, higher Chinese production costs, and the toll of endless pandemic lockdowns is threatening to unravel decades of economic integration between China and the west. All the while China’s Dual Circulation Strategy places greater emphasis on its domestic market and targets reduced reliance on exports, driving greater independence and internal focus.

Witness how at the end of last year, ongoing pandemic restrictions upended production at Foxconn’s Zhengzhou plant, a place called iPhone City. Like other Apple manufacturer Pegatron, Foxconn has now pledged to increase investment in alternative production facilities in India and Vietnam. The pandemic has taken a huge toll on Velong’s 1,200 China-based staff, adds Rothman, describing how international employees have left the company, fearful of being trapped in their homes because of lockdown rules and desperate to get their children back into open schools.

Even if China unravels its zero covid strategy, the political situation makes continued decoupling likely. The US Chips and Science Act has pledged huge investment to boost domestic research and manufacturing in the semiconductor industry and comes alongside throttling back on physical and intellectual exports of cutting-edge technology. The expanding definitions of nationally sensitive industries and technologies has limited foreign direct investment and barred cross border data transfer creating a compliance risk for western and Chinese businesses, explains Amanda Chen, a Partner with RHTLaw Asia’s Corporate & Capital Markets Practice who flags ride hailing app DiDi’s US$1.2bn fine for violating China’s data security laws as a vivid example of what can go wrong.

Add tariffs and new rules to the mix. Companies from camera-maker GoPro to shoemaker Crocs cite new tariffs and other government-driven trade restrictions as their reason for cutting production in China of goods destined for the US and shifting closer to home. Rothman says US tariffs have not been particularly damaging for his business – rather than hurting manufacturing operations in China, he says US consumers felt the pinch of tariffs most. But he notes a changing ethical tide is driving friend shoring and reshoring trends. New sustainability rules are forcing companies to have much better sight of their supply chain like new EU and US laws prohibiting the import of goods made with forced labour with implications for products made in factories in China’s oppressed Xinjiang region.

Manufacturers moving out of China and softening US China trade is more drip-drip than on a grand scale and isn’t impacting every sector. The US Department of Agriculture reported US farm exports to China hit a record in 2021. Textile and furniture sectors have exited China over the last decade because of costs rather than any wider decoupling trend, and multinational companies will always seek to buy the cheapest, best quality and most quickly produced goods, regardless of geopolitical noise. Still, experts confirm a steady, gradual, diversification trend gathering pace. “Step by step the chain is moving out,” says Ivan Lam, an analyst at Counterpoint Research. “It’s most visible in consumer electronics and smart devices.”

Key considerations

India is one of the most popular destinations for consumer electronic and smart phone groups setting up new production facilities. Building manufacturing operations in India lands companies in one of their biggest markets, explains Lam. “They want to kill one bird with two stones. It’s the same reason why they originally set up shop in China.” Only India has a similar size population and potential labour force to be the world’s new manufacturer, adds Rothman. “Demographics are the most important thing in manufacturing.” But he says every new market has challenges compared to China. “The world seems to want Chinese equipment, Chinese engineering, product development, know-how and customer relations, but picking up Chinese operations and dropping them into a new location for the same price is challenging.”

Japanese and Korean traditional consumer groups have set up shop in Vietnam. Like South Korea’s Samsung, Vietnam’s biggest foreign investor and exporter – but it has taken years. Today Samsung accounts for one fifth of Vietnam’s total exports from its phones and parts factories in the northern industrial hubs as well as operations in the south where it pumps out fridges and washing machines. “Vietnam wants to be the next China, but it took Samsung ten years to build up its manufacturing base in Vietnam,” says Lam.

One of the key benefits of Vietnam is lower production costs compared to China where the strong yuan and a rise in the minimum wage has pushed up costs. Jack O’Sullivan, founder of e-bike company Modmo, speaking to Treasury Today in 2021, said one reason for locating his production facilities in Vietnam in a factory in Ho Chi Min was plentiful, cheap labour.

Still, Lam warns that companies must balance cost benefits with the need for a skilled labour force. Manufacturers in China have benefited from a skilled, blue collar work force thanks to government investment which may not be matched in other locations. “Foxconn plans to expand its Indian operations, but they will have to rely on local governments bringing workers into the towns, and local authorities providing schools,” he says.

You can either sit here and wait for orders and customers to erode or you can prepare to move manufacturing to different spots around the world.

Jacob Rothman, President and CEO, Velong Enterprises

Manufacturers’ ability to source product components outside China is another challenge. Mexico doesn’t produce the right steel for Velong’s range of grilling and kitchen tools, timers and thermometers, for example. At its Cambodian factory, most parts are imported from China anyway, and if tensions in the region rise, shipping out of Cambodia will be challenging.

Most of the work at contract manufacturer Foxconn’s Indian production facilities is focused on assembly and packaging even though the plant has been up and running since 2019. Depending on the model, Lam estimates between 40-50% of Foxconn’s iPhone components are sourced and shipped from China and assembled in India. “The whole thing needs to change. You don’t want to pay shipping costs,” he says. It was a similar story at Modmo. Ebike parts were shipped into Vietnam from China, sourced from diverse Chinese suppliers marketing their products on Alibaba. In contrast, many bike part suppliers in Vietnam don’t even have websites.

Elsewhere, suppliers scouting new facilities must weigh the cost of land rental and tax policies. Lam notes China’s tax policies have “always been favourable” compared to some countries that “charge to export.” Companies manufacturing in Vietnam for European buyers benefit from its trade agreement with the EU whereby 99% of tariffs will go to zero over the next six years. Ultimately, relocation will be driven by cost factors and led by incentives from local governments, surmises Lam. “It’s a very simple financial calculation that comes down to what a company can gain from shifting out.”

Tools

Treasury Today interviewees report a range of strategies and tools for corporates wanting to shore up their supply chain. Echoing the same message Rothman increasingly hears from Velong’s customers, RHTLaw’s Chen advises corporates establish dual supply chain systems in a strategic overhaul whereby one chain supplies the Chinese market and the other customers in the west. It requires a flexible corporate structure to oversee both supply chains and should include replacement capabilities for each market separately, she says. “Establish a task force to closely track developments and share information in key markets to develop global strategies and mitigate the effects of decoupling.”

Other strategies centre around resiliency. Stewart Dunbar, co-author of ‘Improving Supply Chains in the Oil and Gas Industry’ told Treasury Today that Maintenance, Repair and Operations (MRO) supply chains – prevalent in the energy sector where many supply chains involve replenishing equipment and services rather than making things to sell to an end consumer – can prepare for decoupling.

The sector sources much of its spare part requirements and equipment from China and struggled to secure supplies during the pandemic. And these groups can’t easily switch to near-shoring or manufacture equipment and parts close to production sites because many of the regions they operate don’t have the required production capacity, labour or skills. But because oil and gas groups control their own demand, they can be better prepared by putting in place robust maintenance strategies, ensuring capacity (or spares) on hand for critical equipment failures. He also urges MRO treasury and procurement teams to not just view supply chains through a cost lens because sourcing a more durable, better-made component means it will need replacing less.

For corporates identifying new suppliers in new locations, supply chain finance is a valuable tool, says Parvaiz Dalal, Global Head Payables Finance at Citi. Supply chain finance offers new suppliers the ability to access cheaper and consistent funding by leveraging the buyer’s strong credit rating and get paid cash when goods ship and are accepted by buyers. “Supply chain finance really does change the gamut around moving from one location to another. New suppliers sourcing finance on their own and putting their own balance sheet on the table is unreliable and costly,” says Parvaiz who counsels stressed supply chains are not only influenced by decoupling trends. The pandemic, war in Ukraine and inflation are also to blame.

If decoupling trends gather pace, Dunbar warns against the temptation to return to ‘just in case’ supply chains. Back in the 1990s, the proliferation of ‘just in case’ procurement strategies left companies with “millions of dollars” of inventory lying around. “You will pay dearly for ‘just In case’,” he says. Instead, he suggests strategies like shared sourcing. In this approach, different companies use the same distributor to supply the same item, rather than each company holding inventory. This strategy could also be managed internally within the company. For example, a company could set up its own regional or global spare parts centre that feeds the locations with product as and when, keeping inventory low but ensuring constant availability from a single point.

A comparable type of shared sourcing worked for the oil and gas industry at the height of the pandemic. In some regions, oil groups cooperated sourcing health and safety goods and services in short supply by sharing contractors and equipment. “It was a case of asking your competitor to help you out. No one wants a safety failure in the industry,” says Dunbar.

Companies can prepare for supply chain disruption by moving away from contractual relationships with their suppliers, he continues. Rather than have a relationship structured around fulfilling a contract, supplier relationships could be based on partnerships. In turn, companies should understand that a supplier may only have the capacity to fulfil limited customer orders and will do so according to their internal perception of the right customer to serve. “Companies need to change and view things slightly differently,” he says.

Helping others is also a byword at Velong. Large state-owned Chinese companies have already diversified manufacturing across ASEAN in China-plus one strategies, visible in the spike in ASEAN exports. However, uprooting and moving production is a Herculean task for the average Chinese manufacturer. Yet these companies make most of the goods stacked on the shelves in western stores. Rothman, unlike his manufacturing peers, many of whom don’t speak English and are struggling to renew passports or apply for visas because of government restrictions, is in a position to scout new facilities, figure out logistics and test pricing and the availability of raw materials and labour. It’s why he’s exploring new manufacturing sites in Mexico and elsewhere, not only for Velong, but for other Chinese manufacturers across an array of sectors.

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