The Curious Case of Trade with China

"At bottom, every state regards another as a gang of robbers who will fall upon it as soon as there is an opportunity."

- Schopenhauer

There’s no doubt about how global supply chains have been disrupted due to the pandemic caused by Covid-19, and there is no dearth of literature on how China is emerging to be a vulnerable, almost single-point-of-failure in Global Value Chains. As global leaders point their politically-loaded guns towards China, one, for being the source of the Covid-19 virus, and two, for bringing global value chains and supplies of even essential items in certain countries to their knees, the case for de-risking by reducing dependencies on China seems to be gaining ground, or at least, growing much louder.

Unsurprisingly, the common man thinks companies moving out of China will naturally move to India, much to the benefit of the ‘other’ nation with a billion-strong population. But how likely is that? And does recent military skirmish at the Indo-Chinese border lead to any of these conditions changing rapidly? Let’s find out.

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Let’s first try figure out why all the hullabaloo about businesses going into a limbo due to a crisis back in China.

China has emerged as the world's factory in the past few decades, and now produces almost twice as much as the US, the next biggest producer in the world.

Well, China is arguably the world’s factory, being the largest manufacturer and exporter of goods and services. In the year 2018, China produced $4 Trillion worth of merchandise, leading its next biggest competitor in terms of value of goods produced by a huge margin of almost 2x. This translates to China producing 28.4%, that is, nearly a third of the world’s output all by itself. The dominance in producing goods is clearly indicated by the share of global output depicted here, with only China and the US enjoying spoils in double digits of percentage, and there too, China leading the US by almost twice.

So what if China produces a lot? Sure, it is the most populous country in the world, it needs to produce what It needs to consume. Even after discounting local consumption, China remains a heavyweight and that is clearly explained by looking at the percentage of global exports enjoyed by the major economies of the world. Again, China is the undisputed leader, and leads the next best country, the USA, by a margin of almost a third.

China is seen comfortably leading the rest of the world in terms of value of exports to other countries, exceeding the US, its next best competitor, by almost a third.

Clearly, it is a case of near-monopoly in the manufacturing space, and when China goes down, the other countries go down too.

Now, it is not true that China is extremely independent in production, and for a lot of products, even China needs to import inputs to produce a final/intermediate good. For example, a ball point pen being sold in the USA today might have been sourced from China, whose ball point tip would quite likely be sourced in turn from Japan, Germany or Switzerland. In fact, China, the producer of 80% ball point pens in the world, only recently in 2017, was able to produce a ball point pen independently. This goes on to say how truly global the Global Value Chains are. And these Global Value Chains are devastated.

So how has Covid-19 affected Chinese manufacturing, exports and how exposed the Global Value Chains passing through China are?

Industrial production in China, rising steadily through the past two decades, has seen a dramatic and sharp fall due to the Covid-19 pandemic.

The effect has been severe, industrial production has fallen by a combined 13.5% YoY for January and February 2020, and the severity is just amplified by the fact that even in percentage points, the current decrease is too large to be compared with the decrease at the time of the SARS outbreak of 2002-03 or the Global Financial Crisis of 2008-09, let alone comparing the absolute values which would have grown a lot in the past decade or two.

As trade comes to a halt, Chinese exports to the rest of the world dropped, causing a break in some essential products, showing how deeply embedded it is in modern Global Value Chains.

Quoting the WEF, China’s position at the heart of many GVCs is illustrated by the fact that the production decline is also associated with major contractions in international trade flows. The country's imports decreased by 4 per cent in US dollar terms in January and February combined from the same period a year earlier, while exports dropped by 17 per cent over the same time period, according to the official Chinese trade statistics.

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While these factors surely give us an idea of how severely shaken China’s businesses would be at the moment, interesting to note here would be, this is not the only occurrence of interruption expected in China’s business operations. China was the first country to be widely affected by the Covid-19 pandemic, and hence the first one to curb economic activity by undergoing a lockdown. This created a supply shock across the global value chains. In due course, it will be the first to recover and hence complete the cycle. However, when it does start recovering, the rest of the world will be on its lowest point or approaching it. That will again create a demand shock.

That said, the jury is still out there to predict what will be the eventual result of this curbed economic activity. Will demand see a lower dip than supply, or vice versa?

Chinese exports and imports both have dropped significantly, bringing trade around the world to a near standstill.

Now you might be interested in applying the whole Keynes vs Sey’s debates on supply and demand, but analysing this disruption mandates us to go further beyond that. We have already seen how a twin-shock to Chinese businesses can, and eventually will devastate global value chains, dropping imports, exports and trade in general. Industries like automakers, electronics manufacturers, shoes and apparels are already reeling from severe shortages of supply of components and even finished products, forcing companies like General Motors and Ford to even delay launches of new models indefinitely across the world.

Consider the US, China’s largest export partner, accounting for US$ 4186 billion worth of exports, nearly 17% of the total. The US’ Motor Equipment Manufacturers Association signed a US$ 8.3 billion preparedness act, out of which, an amount up to US$ 7 billion worth of loans might be extended to assist small businesses and preserve pay checks across the industry. As of March 2020, close to 20% retailers’ supply chains stood affected by the shocks. Shoemaker Steve Madden, with some of the biggest exposure, has said about 73% of its goods are sourced from China. For Best Buy, it is 60%. For online furniture company Wayfair, it is about 50% of goods. Each of American Eagle, Kohl’s and Calvin Klein owner PVH source about 20% of goods from China.

The logisics industry has had to endure a double whammy, with mismatch and shortage of both demand and labour. this has brought even industries that are still running optimally to a standstill since what use is a product if it cannot be transported to its consumer?

A major factor behind this supply shock, apart from shut factories, can be easily attributed to lack of logistics services. Meaning even when goods are ready for transportation, it is very difficult to find manpower to work for transporting the goods, given the current state of pandemic and the very probable loss of life.

That said, it is not entirely true that the markets currently are in a position to lap up any and every product offered to them at the moment. With curbed economic activity, incomes are hurt. Small businesses find it tough to sustain and pay salaries. Corporates see pay cuts, and start-ups, even the large, well-funded ones, are seeing pay cuts and massive, headline-making layoffs. Jobs in the unorganised, informal economy, topped by lack of social security benefits, have been totally destroyed.

India's urban poor, bereft of any job security and employment benefits, migrated back to rural natives in large numbers, with a significant percentage vowing to never come back and leave the security of familiar settings.

With an estimated 84% Indian homes losing income in April, and an estimated 122 million losing their jobs, the World Bank expects approximately 12 million Indians to be plunged into poverty this year.

A spending cut is inevitable. We see a huge drop in spending at a household level. Consider the direct cash transfers by the government of India as a support to the lower income groups, that cash lies idle in bank. Families want to save money for even rainier days. It is not that these accounts are dormant, the Jan-Dhan bank accounts in India see an average of 1.2 transactions per quarter, compared with a global average of 1 transaction per quarter as found by the World Bank. However, with income drying up and future prospects quite uncertain, families just want to save whatever they can.

Hence a bigger concern than shocks in supply, which will inevitably bounce back as lockdowns ease and factories re-open, given falling and falling costs of credit across the world, might as well be a sustained dip in demand, primarily due to reduced income and changed spending patterns and preferences across sectors and demographics.

As the younger generation locks itself down, it has realised that it spends way more than what is required to fulfil basic needs of life. There are already pledges about cutting spending when things become normal. Moreover, this has implications for the automobile, events, and hospitality industries, as the spending on experiences might move on to being replaced by basic needs or savings.

The average basket size in the FMCG sector has surely increased, but the product mix of the average basket has seen a huge change, and it looks like the change is here to stay.

For example, for the food industry in particular, the focus of the average consumer might shift from dining out to cooking lavishly at home, and this increases the prospects of retailers and processed food companies, like frozen foods and other ready-to-cook material.

MTR Foods saw demand for its ready-to-cook and ready-to-eat offerings rise by 20% and sales of essentials like spices and vermicelli went up by 15% during the lockdown, despite being able to serve only 50-60% of its partnering retail stores. iD Fresh Foods, operating in the same space of ready to cook food, saw a similar performance, increasing revenues from Rs. 20 crores to Rs. 24 crores during the lockdown, despite a stark decrease in the number of retail outlets served. Marico too saw a 22% rise YoY in its food segment.

However, retailers and industries should beware of revenge spending, a situation when people indulge in spending on items and in quantities after a prolonged period of restricted/discretionary spending that they otherwise would have not.

What remains to be seen is, has the current crisis changed shopping patterns permanently, or is it just a case of pent up demand? Will the decrease in spending forced by an overall drop in household income levels and a huge increase in the number of people expected to be pushed below the poverty line persist, or come back to normal levels? If it will bounce back, what will the approximate timeline be?

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This brings us back to the question, given all this information, does India stand to benefit? This in itself is a two-pronged question, a function of the number of firms moving out of China, and the percentage of those firms moving to India.

Leaving China immediately for other manufacturing locations is something that is out of the question. Not only this, a mass exit situation in the near future too seems unlikely, given that China has spent the last couple of decades building the infrastructure needed to become a manufacturing powerhouse and stands apart from the rest of its competition.

1. Modern products require high degree of specialisation. The glory days of single, vertically integrated manufacturers like Ford or General Motors are long gone. Technology today is just too complicated, and it is impossible to possess all the skills that are necessary in just one place. Consequently, manufacturers have turned to specialists and subcontractors who narrowly focus on just one area – and this helps achieve economies of scale reducing costs across industries and products.

2. As outsourcing takes centre-stage in production strategies, managers quip that “Operations management leadership has turned into procurement leadership”. In an emergency, when a company suddenly needs to scale up, it finds itself ill-equipped, both on counts of skill and infrastructure. The process includes setting up the supply chain for all of the raw materials, designing an assembly process with the appropriate tooling and fixtures, building or securing test equipment, establishing testing and quality procedures among countless other details, and mastery in this simply can't be achieved overnight.

Interesting to note here would be that the principles of lean production and the thinking of “inventory is evil”, coupled with the managerial fallacy of considering cost reduction to be a viable business strategy has led industry to this pitfall. But what gives hope is as companies realise this fallacy, they are starting to take steps towards rectifying this situation.

Something that is undoubted is that firms will try to de-risk and reduce their presence in China, or other low-cost manufacturing centres, as locations shift from just low-cost production centres to more strategic regional centres of production.

This is the time when the concepts of “China+1” and “near-shoring” will take centre-stage.

China+1 production strategy suggests that a firm should move a part of production out of China, so as to avoid being heavily exposed to China, but still keep a part of production there again for the same reason but with the alternate manufacturing centre. This, coupled with the nascent success of fast-retail, a supply chain method that tolerates higher production and logistics costs to reduce the inventory TAT and allows production to be adjusted more frequently according to the demand and consumer trends and preferences, has propelled the importance of near-shoring as a production strategy.

But there is no denying the fact that the factors that once made the case for moving production to China, themselves give reasons for the opposite today.

1. Cheap oil prices in the 1990s justified the economics of outsourcing production to China for US firms, but these prices have more than tripled in the last decade, pushing up logistics costs significantly. Coupled with the recent availability of cheap shale in the US, this means that for some industries, the lower cost of manufacturing in the United States may outweigh the lower costs of shipping goods from China.

2. In the last few years, labour costs in China have increased annually by almost 20% versus 3% in the United States and 5% in Mexico. China’s minimum wages, which now range from about US$ 140 to US$ 346 per month, are set at the provincial level. India’s minimum wages similarly vary across states and range from about US$ 66 to US$ 202. Mounting U.S. tariffs on Chinese goods over the past year have only strengthened the case for India as a cost-effective manufacturing alternative. And importers of labour-intensive products, like garments and textiles, are in the best position to realize cost savings by moving to India.

3. Cheap sensors, fast computing, and new technologies have led to new user-friendly manufacturing automation that increases productivity. This improvement in productivity changes the economics and reduces the importance of low labour costs. As a result, the focus of manufacturing companies is more on skilled workers than on countries with low labour costs.

For high tech industries recreating the infrastructure in China somewhere else would be expensive and difficult to do. In contrast, it will be easier for footwear and apparel companies to move to lower-cost locations. Manufacturers of heavy products such as appliances or cars that are heavily influenced by shipment costs may find it beneficial to move production closer to market demand.

Now, if we funnel down to firms that move production out of China, back into India and other south-east Asian countries, what are the odds they’d chose India?

This question is somewhat easier to answer than the previous ones. India’s scale and size, both, of the available young labour pool and consumer pool, with a population nearing 1.4 billion people, make a strong case for the consumer story for every industry. This has resulted in India enjoying a favourable position among the south-east nations with the EU and American blocs.

The emergence of the Economic Prosperity Network might be necessitated by a wily, hostile and unreliable China, but India and Vietnam will need continued support and favourable policy from the US to be able to dethrone China from the heart of Global Value Chains.

The US, while launching scathing verbal attacks coupled with trade wars and sanctions on China, is pushing to create an alliance of trusted partners dubbed the Economic Prosperity Network. It would include companies and civil society groups operating under the same set of standards on everything from digital business, energy and infrastructure to research, trade, education and commerce, he said. The U.S. government is working with Australia, India, Japan, New Zealand, South Korea and Vietnam to “move the global economy forward,” Secretary of State Mike Pompeo said April 29. These discussions include “how we restructure ... supply chains to prevent something like this from ever happening again,” Pompeo said.

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The recent border skirmish at the LAC between India and China, which unfortunately led to the martyrdom of 20 Indian soldiers, has caught the fury of the Indian masses and political outfits and the general public have upped the demand for a nation-wide civil boycott of Chinese products.

Not only this, the government is being pressurised to cancel trade deals and infrastructure projects awarded to Chinese companies. While the Rs. 1,126 cr tunnelling project Delhi-Meerut metro rail awarded to the Shanghai Tunnel Engineering Company has come under the clouds, the Dedicated Freight Corridor Corporation of India (DFCCIL) has already decided to terminate Rs. 471 cr signalling contract with Beijing National Railway Research and Design Institute of Signal and Communication Group Co Ltd, citing a poor progress of only 20% in the past four years, while there is also talk of the government having signalled to Indian mobile carriers to avoid technology outsourcing to Chinese firms.

It is difficult to say at this moment whether this campaign would prove to be sustainable and damaging to China in the long run or not, but sure, China has alot to worry about given the pandemic, military tensions, and possibly significant loss of trade on account of both. It will be interesting to see how China wriggles out of this situation, and how much of state intervention do the Chinese firms require.

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With such favourable conditions presenting themselves, the Indian centre and state governments, although grappling with the ongoing Covid-19 pandemic, should leave no stone unturned in attracting manufacturing, even incentivising them to move out of China. Though it becomes imperative to note that there looks to be no near-term solultion to trade tensions between India and China.