How does the U.S.-China trade war affect supply chains in Asia? How are companies manufacturing in China coping with the prospect of a protracted trade war or even the U.S.-China economic decoupling?

Chinese companies have been doing several things. First, they have been moving some of their production for the US market to offshore factories, typically to other countries in Asia like Vietnam, Indonesia, and Cambodia which have begun to increase exports to the US. They retain their factories in China, but at the same time open a separate factory for export just to the US in these other countries. Second, they are focusing more on the domestic market. Because China has such a large consumer base, it leads many exporters to adopt a two-path strategy. They want to keep their production active in China for the domestic market, but they also seek alternative export links to the US from countries that don’t face the tariffs.  Finally, some companies shift their export market from the US to other countries or set up production inside the US to circumvent the tariff barriers. For instance, Foxconn announced that it will set up some plants in the US, though they haven’t been completed yet. There is a wide range of response these Chinese companies can have. However, most of them are just waiting with the hope that the trade tension will de-escalate.

The lower-middle income countries in Southeast Asia such as Vietnam and Indonesia became favored destination for shift in supply chains and had a chance to grow. What characteristics of these countries make them the beneficiaries? Will supply chain relocation expedite the process for them to upgrade within global value chains?

These countries have relatively abundant supplies of low-cost labor. They also have skilled and productive workers in key areas of manufacturing. They need to have suitable and relatively complete supply chains. It’s not a matter of simply moving the final stage of assembly for these products; they also have to relocate the key inputs and components within the supply chain if the relocation is long-term. More importantly, these countries are geographically close to China, so it lowers transport costs.

China also relies on Chinese business communities located in these countries. In Vietnam, there is a large group of Chinese expats that have set up business operations there, making it much easier to find appropriate factories and deal with local regulations because they are people from the same language and cultural community as the mainland Chinese suppliers.

It definitely helps them upgrade within global value chains. The US has high standards in terms of price, quality, delivery schedule, etc. In order to comply with those standards, the new supply chains have to be quite good, which potentially helps them move into new industries or move to high-value added products within these industries.

Vietnam would be different from Indonesia in the sense that Vietnam is much more industrially diversified. You can go to Vietnam for apparel, footwear, electronics, automotive equipment, etc. Whereas Indonesia has a more limited set of industries and a less diversified manufactured economy; it also doesn’t have such a large overseas Chinese community as Vietnam does. It’s located further from the US, making shipping costs higher. Vietnam, in many regards, is the most ideal location for companies in China to move production to, but Vietnam is already close to the limits of its production capacity. It can’t match China’s scale. All other countries, including Bangladesh and Cambodia, are much more limited in terms of the number of industries they could handle.

What are the main challenges facing companies trying to relocate their supply chain out of China into neighboring countries?

One of the challenges is finding suitable suppliers. The volume of sales coming out of China is so large that no other single country can pick that up, so these countries might have to expand the list of good suppliers in order to take more orders coming from China.

Another challenge is the completeness of supply chains in these countries. What makes China so competitive is not just that it has large factories to assemble final goods, but all the components and even raw materials needed to produce these goods are also located in China. When Chinese suppliers expand to other countries, they have to be sure that appropriate inputs are available for the upstream parts of the supply chain. For example, the key input for the apparel industry are textile fabrics and yarn, so Chinese companies should offshore to places that also have a suitable textile industry that can supply those factories. They can still import some materials from China, but there should be key building blocks for inputs. Therefore, finding countries that have enough industrial diversification to cover the main areas in a supply chain besides the final assembly is an important consideration.

The final challenge is finding countries where the labor force is big enough. Cambodia specializes mainly in apparel, but the Cambodian labor force isn’t very large, diversified or skilled. India is also frequently mentioned as an offshore location site, but India has a big domestic market that absorbs much of the country’s production capacity.

In a few industries, some of these countries can reach a similar level of productivity as China, such as footwear in Indonesia and apparel in Vietnam. But for electronics and other consumer goods, it is much more difficult. One of the greatest advantages of China is that it created the notion of “supply chain cities.” China has towns that specialize in particular products like neckties, socks, leather goods or chairs. This high level of specialization in a particular place within China means all the major component industries can be located near the final assembly plants. These production hubs are spread over large regions in China. This is something that no other country has been able to match, and thus China has a far greater breadth of consumer goods production. It can offshore some of these products to other countries, but it couldn’t offshore this wide range of industries. Therefore, some of the exporters are clearly going to suffer losses because there are not enough places elsewhere in Asia to make that relocation happen. Even countries like Vietnam can only handle a small portion of what China makes.

Given China’s highly integrated up-stream, mid-stream, and downstream manufacturing landscape, will moving some supply chain out of China result in fragmentation and higher production costs?

It’s a tricky question because if the costs go up elsewhere, will this change US demand for those products? In key industries like apparel and footwear, the production costs stay pretty similar. However, for more sophisticated products, like smartphones and home appliances, then it will become more expensive. One of the implications of Trump’s trade war is that it will be slower and more costly for many goods to enter the US market even if Chinese companies relocate production elsewhere. Therefore, the trade war creates an incentive for some US companies to bring that production back home.

The problem with this trade war logic is that in many industries the way production now takes place is far more automated than it was 15-20 years ago, even in China. Even if the US were to bring back industries like apparel or furniture production, the kinds of plants would be using different automation technologies and thus need workers with different skills.

“American Factory” is a Netflix documentary about a Chinese automobile windshield factory that came into Ohio four years after a General Motor closed a plant there, and it shows the difference in skill and technology in some of these newer automobile plants versus the more traditional ones. People don’t realize how much China has moved to high-scale production in these factories, and the production lines are more automated and mechanized. Therefore, the workers carry out different tasks, and I’m not sure if the traditional workers in the US 20 years ago would have the required skills to work in these industries nowadays. US workers certainly could become very productive in those same industries, but it requires more experience and learning.

The global electronics industry has perhaps the most sophisticated supply chain. How has the U.S. blacklisting of Huawei and other Chinese tech companies affected this supply chain?

The blacklisting of Hauwei has a big impact because the US market for its information technology products is really big. If the US raises security concerns about these companies, then other countries would follow suit, like Canada, Australia and various European countries. Huawei, in particular, has very diverse products. The biggest concern with Huawei lies in the telecom side of its business. Huawei is also in a very tough race with 5G technology, in which telecom companies in the US have also been very involved. Restrictions on Huawei truncate sales of both telecom equipment and mobile phones. Google has announced that if Huawei phones are blacklisted, they are not going to provide the Android support services that its mobile phone would need in the US. Such restrictions have a big spillover effect. Other countries in Huawei’s ecosystem become less likely to commit, thereby reinforcing Huawei’s interest to look back to the Chinese domestic market. This increases the likelihood that we end up with two-tier technology systems for telecom. The two-tier technology standards systems haven’t worked out very well. Generally, there is the tendency toward one global standard emerging as a winner.  It would be hard for China to have one 5G system and the US a separate one. In the end, one of them is likely to win out. Huawei now encounters a big setback as the US tries to block it.

However, Trump’s blacklisting of Huawei could also be counterproductive for the US because Huawei’s products and telecom infrastructure initiatives in many Belt and Road Initiative (BRI) countries in South and Central Asia, the Middle East, Eastern Europe and Africa are very well received. It is pushing Huawei to develop this alternative set of technologies that could be available to a lot of these countries. In fact, the two different technology systems could generate more price competition in the market and offer more options. It is definitely possible that in the area of 5G, a two-tier system could be sustainable for a while. With the BRI, China can be less reliant on its domestic market. With this telecom initiative, China is bringing in many countries in Asia, Africa and Eastern Europe that will have interests in using China’s technology. Because 5G is such an important technology, this may be one of the exceptional cases where a two-tier system can have a sustaining power.

What is the impact of relocation of supply chain so far on China? How is China coping with the relocation of supply chain? In your interview with BRINK, you mentioned that one way for China to adapt the shifting supply chain is to focus on sales to the larger domestic market. How possible do you think it is for China to shift away from an export-oriented economy to a consumption-oriented one?

China would have wanted to do that anyways. An important part of industrial development is using the export-oriented economy as a way to learn about the technologies in different industries, about consumer preferences and branding, etc. Taking what it has learned from exporting to the rest of the world and applying it both to its domestic economy and other surrounding economies definitely gives China a much healthier form of sustainable economic development. If it was only exporting, China will bump into a lot of glass ceilings, for example, companies will not want China to go into branded products. But with a growing domestic market, China can develop its own brands and do its own R&D. In some ways, that would be part of a natural progression, and the trade war accelerates this process. It is a positive for China to be able to use its domestic market as a way to climb up the value chain further and faster.

China has one other big advantage, which is its advanced e-commerce application. Because of e-commerce, China is able to find additional ways of linking consumers and suppliers around different kinds of new product offerings.  China could use that to further stimulate development of some of the industries. But the final factor to consider is that if e-commerce in China remains localized as China continues to wall off its internet to foreign companies, it is very hard for Chinese firms like Alibaba to become global players. At some point, even if China is developing its own branded products, it wants to be able to sell them to the global market. Otherwise it really will face technological limits on how far it can advance if it keeps looking inward.

Lenovo is one of the companies that was born global because Lenovo bought IBM’s PC business in 2005, but other Chinese brands like Haier appliances are largely seen as China-centric. Therefore, I think China would want to find ways to get out of this trade war so that it could have companies that are fully global players and can take advantage not only of their scale economies, but also participate in global markets that require them to develop products in different ways than the domestic market. A lot of that learning is a part of keeping a brand competitive. Ultimately, the biggest economies will want to be in as many global markets as possible and not be constrained even in a very large domestic market.