Home / Opinion / Views /  Mint Explainer: The supply chain is dead. Long live the supply chain

A month into Russia's invasion of Ukraine, BlackRock CEO and chairman Larry Fink announced the end of globalisation.

In his 2022 letter to shareholders in March, Fink, whose company is the world’s biggest asset manager with more than $10 trillion, said Russia decoupling from the global economy was going to prompt companies and governments to re-evaluate their dependencies and re-analyze their manufacturing and assembly footprints.

If you also consider fears of China decoupling from the global economy in near future, given the possible invasion of Taiwan, you would be nodding at Fink.

If globalisation is dying, so is its poster child—the global supply chain that connected the rich and poor countries, rushing goods, capital and technology across borders.

Trade policies triggered the global spread of production; lower costs in Asian countries as well as advances in logistics and communication made that model sustainable. Supply chains made it easier for poor countries to turn into manufacturing power houses. These countries did not need to create products from scratch. They could create expertise in just one stage of production—for example, assembly—and still export high-tech goods.

Supply chains led to deindustrialisation of the North and industrialisation of the South. So much so that just-in-time supply chains made it possible for companies in rich countries to stock only what they immediately needed, relying on the supple and quick supply chains originating in low-cost countries to replenish stocks as orders came in. Companies in rich countries saved money from not having to keep large inventories and build warehouses. As production spread over the world, each part got to do what it could do the best and the cheapest. Supply chains helped rich countries focus on advanced manufacturing, technological research, marketing, etc.

Covid, Ukraine and now Taiwan are forcing the companies in North America and Western Europe to switch from just-in-time to just-in-case supply chains.

Covid could be brushed aside as a Black Swan event but Russia‘s isolation and now tensions over Taiwan point at a developing world order where sanctions, export controls and conflicts will radically realign the global manufacturing which had come to resemble a great world wide web. That makes the future of global supply chains uncertain—hence the clamour for the just-in-case model.

The discourse behind disruptions

Not long ago, supply chain was a niche subject. Covid brought supply chain to the dinner-table conversation. For common people in Western countries, empty aisles in stores became an evocative visual of broken supply chains. Firms that had come to take supply chains as an immutable truth of global economic order got a rude shock. Most people saw one rare natural calamity disrupting the economic order. That was true. But supply chains were expected to come under pressures before Covid struck.

A McKinsey & Co. research on supply chain disruptions estimated that a single prolonged production-only shock would wipe out between 30 and 50 per cent of one year’s EBITDA for companies in most industries. And an average company can expect to have a month to two months’ disruption of production every 3.7 years. These were not distant future risks but current, ongoing patterns, McKinsey had warned. It was a prescient analysis because McKinsey had started its research at the end of 2019 keeping in view the US-China trade war, much before Covid struck supply chains.

What the McKinsey research implies is that Covid or no Covid, supply chains will continue to be under pressure. This has been proved true recently.

Last week, the New York Federal Reserve said in its latest update to a worldwide index of supply problems that stress on global supply chains eased in July to the lowest level since January 2021 as port congestion and other snags eased, Reuters reported. The regional bank’s Global Supply Chain Pressure Index is now down more than 50% from last December’s record high.

When this report came out, US House Speaker Nancy Pelosi visited Taiwan, creating a new threat to supply chains. Even a minor conflict on Taiwan can disrupt global supply chains because the Taiwan Strait is the primary route for ships passing from China, Japan, South Korea and Taiwan carrying goods from Asian factory hubs to markets in Europe, the US and all points in between. According to Bloomberg, almost half of the global container fleet and a whopping 88% of the world’s largest ships by tonnage passed through the waterway this year.

What McKinsey sensed well before Covid was not threats from just individual events but risks from an emerging discourse—signalled by Donald Trump’s tariff war on China—which made supply chains vulnerable in long term. Conflicts in Ukraine and now tensions on Taiwan are manifestations of this emerging world order.

Firms have now realised the subservience of economic relations to geopolitical factors and the need to realign their supply chains accordingly. Behind the scramble for onshoring, near-shoring and friend-shoring is not just the disruptive events of recent past, but the disruptive global discourse that can make it difficult for supply chains to work as they do for a long time to come.

More emerging threats

The successive crises of Covid, Ukraine and now Taiwan have dramatically shaken the supply chains and the results are for all to see. But there are factors still shaping up which can force the existing supply chains to radically alter their geometry—even after current disruptions subside.

BlackRock CEO Fink may have overstated his case by seeing in Russia's economic isolation the end of globalisation. But Fink could be proved right if you consider possibly more serious and long-term disruptions to supply chains coming up.

In June, the Uyghur Forced Labor Prevention Act (UFLPA) came into effect in the US. It was passed by the US Congress last year with a rare bipartisan support. The UFLPA presumes that all goods, wares, articles, and merchandise mined, produced, or manufactured wholly or in part in the Xinjiang Uyghur Autonomous Region of China or by entities with any connection to the Uyghur economy are products of forced labour and prohibited in the US.

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The US accuses China of running mass internment camps where more than a million Muslim minority detainees are coerced into forced labour and subjected to other human rights violations. China has an elaborate production ecology that also includes its Belt and Road Initiative sprawling across the world. The Act will impact millions of businesses which get tainted by any association to factories in Xinjiang which are accused of coerced labour. Cotton and polysilicon, which is used in solar panels, are major products of Xinjiang. Agricultural and electronic products and minerals from Xinjiang land up in many other countries as raw and intermediate goods. 

The ban won’t mean anything if other western countries do not participate in it because products can be channelled through different countries. But Russia-like sanctions on the Xinjiang economy will certainly jeopardise global supply chains. And imagine the West sanctioning more such areas across Asia, Africa and Latin America.

There's another long-term risk shaping up. The European Union has proposed a law based on ESG (environmental, social, and corporate governance) approach. The law will require EU companies to do supply chain due diligence by auditing suppliers along the entire supply chain, and all entities with an established business relationship, for compliance with ESG standards.

Increasingly, following the EU, the western countries will adopt laws requiring companies to integrate ESG due diligence into their supply chains. At present many low-cost countries where supply chains originate are low in governance too. Their production facilities will fall foul of many western ESG standards.

Clamour for the just-in-case supply chains

Originally popularised by Toyota in Japan, the just-in-time model prioritised lowest production cost, high efficiency, speed and low wastage. The just-in-case supply chain model relies on building stocks and diversification of suppliers. Add to that shorter supply chains which western governments and companies now want. A survey by SAP UK has found 84% of UK businesses are planning to move on from just-in-time supply chain model to the just-in-case.

A significant decoupling of existing supply chains is on. In EY AM&M Supply Chain Survey during Q1 2022, 53% of respondents had already near- or re-shored some of their operations in the last 24 months, and 44% said they were planning new or additional near-shoring activities in the next 24 months. To increase geographic diversity and reduce risk, 57% said they had established new operations in one or more additional countries in the last 24 months and 53% are planning to do so in the next 24 months. That’s a considerably large number of firms realigning their supply chains.

Companies in rich countries Companies in the US are looking at Mexico and Latin America for new manufacturing destinations while those in Western Europe would want their manufacturing to shift to Eastern European countries.

Is a world without existing supply chains possible?

It may be easier for US consumer goods firms such as Nike, Adidas and Mattel to shift production to Latin American countries or Mexico, but it’s a tough proposition for, say, electronic goods companies which rely on low-cost manufacturing destinations that have built whole ecosystems of required talent and resources over long years.

Reeling in the supply chains will not only entail upfront investments in new plants but will also result in higher costs and inefficient production. Latin America will take a very long time to turn into another China, Vietnam or even Bangladesh.

After decades of getting used to long and complex supply chains, self-sufficiency in manufacturing seems an elusive goal. Diversifying suppliers and keeping sufficient inventories also do not make much business sense as they are akin to just paying for insurance.

The western governments can help bring back manufacturing only in case of critical industries. Across the board on-shoring looks impossible. That’s why last month in South Korea, US Treasury Secretary Janet Yellen spoke of “friend-shoring", which means taking supply chains to allies and friendly countries. The idea of friend-shoring is itself an admission that near-shoring or on-shoring across the board are not viable solutions. Wages and costs could be growing fast in China but there is still a big gap with advanced western countries. The western governments can dole out funds to companies producing critical products such as semiconductor chips for local manufacturing but not to those producing, say, toys.   

Recognising that reeling in supply chains is not the best solution, the US is also trying to create alliances with Asian countries other than China in search of resilient supply chains. The US is trying to forge a partnership of 18 economies, including India, the US and the European Union (EU). It has unveiled a four-point roadmap for building collective, long-term resilient supply chains, including steps to counter risks arising from dependencies and vulnerabilities.

US secretary of state Antony Blinken and secretary of commerce Gina Raimondo outlined this roadmap recently following a virtual supply chain ministerial meeting.

The China Plus One strategy

Supply chain uncertainty has brought China Plus One strategy back in vogue. Essentially a diversification of suppliers like the just-in-case model, the strategy gained attention a decade ago. Under this strategy, companies go to other Asian countries to add to their existing manufacturing in China. Apart from diversification of risk, China Plus One offers new market access in smaller countries and lower costs as China's economy matures, tax incentives erode and wages rise.

In March, a Parliamentary Standing Committee on Commerce suggested that India should go for the China Plus One strategy to turn into an alternative investment destination for companies that intend to substitute their supply chains originating in China. Vedanta Chairman Anil Agarwal has said as geopolitics and geoeconomics are evolving, India is unquestionably in a prime position as the entire world seeks to implement a China Plus One strategy.

The supply chains as we know them may be dying off, but the world just can't do without them. It seems they are here to stay in one or the other form—shortened, scrambled or realigned.

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