In the light of the COVID-19 pandemic, companies need to re-examine their supply chains and devise contingency plans.
By Adjunct Associate Professor Gordon LAM and Professor ZHANG Hongtao,
Department of Information Systems, Business Statistics & Operations Management, HKUST Business School
Before the pandemic, globalization had led to the world becoming flat, and value chains ran across many countries. This meant that supply chains were stretched and extended to include many more mutually dependent links. But the existence of more links in supply chains means that the chance of errors and risks goes up. Strong mutual dependency also made the stability of each link (or each cluster of links) a prerequisite for business viability. Yet absolute stability is nothing but a dream, so when all one’s eggs are put in one regional or national basket, no matter how safe that basket may appear to be, it is a only matter of time before something will rock it. So reorganizing the supply network to create multiple sourcing should be on the agenda of every multi-national company.
Nevertheless, it is painful and time consuming to move large parts of a value chain away from China. There are several reasons. First, that China became the “Factory of the World” is not the result of anyone’s smart planning, or any one visionary leader’s policy. It is by and large the result of organic growth over several decades. Second, parts of the value chain that are outside of China have been optimized to work with the China Factory in order to derive higher profits. The downside of a system optimized for maximum profits under a given condition—that the China Factory is used and kept working—is that the system is incapable of a quick adjustment when that condition is no more due to reasons of international politics.
As it took decades for manufacturing to move into China, it will take a considerable amount of time for manufacturing to move out of it. Apple Computer is a good example. Most iPhones are made in China, not because of its cheaper labor, but because clusters of supporting industries, and a vast multitude of highly qualified engineers, are readily available. It will be extremely hard to replicate this humongous organically grown structure in India, or elsewhere, in just a few years.
The garment and fashion industry is another example. For many fashion brands, shifting garment sourcing from China to alternative countries of production in Asia is not a viable solution for a number of reasons. These are mainly connected to matters of materials, capacity, and capability. First, the textile and apparel supply chain in Asia is highly reliant on China’s supply of fabrics and garment accessories, and other inputs. Second, many neighboring countries are already facing capacity constraints (e.g., Vietnam’s capacity is currently full). This is because US retailers have been moving some of their production to these countries in order to reduce exposure to sole-sourcing from China since the China-US trade war. Third, skill-sets, craftsmanship and product offerings of some other producer countries such as Bangladesh and India are still unable to match or substitute for those available in China.
National Security and Political Health
Profitability is not the only consideration. For the US and EU, one side of the coin is certainly financial gain and economic benefit, but the other side is national security and political health. The working of the global village is predicted on trust and security. Just as a normal person will choose his and his family’s life over wealth, a normal country will choose its own security, and its citizens’ security, over a living standard built on imports from an antagonistic country. The coronavirus pandemic has demonstrated to the Western world that key medical supplies are as critical to a country’s well-being as advanced military weapons. One should expect to see bigger and more powerful governments in Western countries following the pandemic. These governments will direct, encourage, entice, or coerce manufacturing of products key to national security back to the home country, or to regions that they can trust, or control, and with whom they share moral values.
Certainly, some kind of delinking or weak-linking with China will happen, slowly for some industries and faster for others. This will also be accelerated by the aging of the population of China. As an abrupt migration from China will cause too much supply disruption, the US government may gradually increase the tariffs on imports from China, one year after another.
When security takes precedence over costs, and manufacturing moves out of China, where will the products be made? We believe it depends on the nature of products. Roughly, the manufacturing of low-end products will mostly move to India and other Asian countries like Vietnam and Indonesia. Mid-end products will be manufactured in South Korea, Taiwan and Mexico, and the manufacturing of high-end products will go back to Japan, Europe, and the US. How quickly the migration of manufacturing out of China occurs depends on how quickly these countries build up the required manufacturing capability and capacity, including infrastructure and clusters of support networks.
Supply Chains at Risk
At present, the knock-on effects of the pandemic have begun to multiply as more and more countries implement stringent containment and prevention measures (cancelation of international flights, border shutdown, traffic restrictions and special quarantine requirements at borders). An obvious one is that moving goods within and out of certain countries becomes difficult and costly. For many industries, supply chains could be at risk at both ends — the supplier and the consumer. Production suspension due to government-mandated lockdowns or quarantine requirements, shortage of components, logistics delays, a slump in consumer demand and the accompanying liquidity issue, could cause the sudden collapse of certain parts of a supply chain. This could further lead to a domino effect of disruptions along the same supply chain due to supplier-client dependencies and complexity of global production networks. For many companies, particularly SMEs, surviving this unprecedented crisis is real struggle.
While a temporary production shutdown may be tolerable, an economic recession and a slump in global demand are going to weigh more heavily on supply chain stakeholders. The fashion industry has borne the brunt of demand-side disruptions brought by the pandemic. Due to large-scale shop closures and low consumer spending on goods, except food and necessities, European and US fashion retailers, including small specialty retailers, fast fashion leaders and larger discounters, as well as popular e-commerce sites and even luxury brands, have been busy cutting their previously planned production orders, or postponing product shipments, in the past few months. Worse still, as the COVID-19 pandemic drags on, widespread business closures and layoffs could further stifle consumer spending.
While Western retailers are now facing an acute liquidity crunch and credit issues, the same problem could ripple through the whole supply chain, pushing thousands and millions of manufacturers, particularly small and medium-sized factories, toward the edge of bankruptcy. This could lead to a structural change in global supply chains. As a result of COVID-19, we would expect the digital transformation of the supply chain to speed up, and a rise in the number of e-Commerce-driven demand chains. Whether there will be a change of inventory management practice (contingency stocking, 30-day buffering) and an acceleration of reshoring is yet to be seen.
Consumption Habits May Have Changed
At the same time, some consumption habits may have permanently changed, in which case a number of categories/sectors will see faster growth in the new retail environment. For instance, health and hygiene related consumption, such as those pertaining to personal hygiene products, disinfectants, fitness training, and medical check-ups, will remain high, or even increase for an extended period after the outbreak. The boost to online entertainment and remote working/learning could also be a permanent shift, which would create additional demand for software and mobile apps for online reading, online working platforms, remote conferencing, etc.
The most urgent task facing the whole world now is to battle the COVID-19 pandemic together, before the global public health crisis causes any permanent disruption to the global economy and global supply chains. This requires that an open, efficient and multilateral global trading system be carefully maintained to facilitate the flow of goods and information, especially during a time when the flow of people is being restricted.
In addition, supply chain stakeholders, including raw material and component suppliers, manufacturers and retailers, should work together to keep workers paid and supply chain partners alive. Only in this way can we hope for a quick return to supply chain normalcy after what is perhaps the worst crisis in decades.
In the longer term, companies need to thoroughly re-examine their supply chains and devise contingency plans and risk management policies. Businesses should avoid an ‘all-in’, cost-focused sourcing strategy and maintain a base of multiple suppliers for each critical part of their supply chain that are ready to ramp up production in case a few of them are lost due to unexpected events. They therefore need to build a more diverse and agile supply chain, albeit at somewhat higher costs, with both a diversified sourcing portfolio and a broad supplier network. For this reason, companies with a strong global supplier network and deep relationships with suppliers will be in the best position to meet the new challenges in this era of disruptions and expected unpredictability.
Hong Kong’s role diminished
In anticipation of incoming waves of change, the role of a bridge between China and the Western world that Hong Kong has maintained since Deng Xiaoping’s era, although not vanishing, will be diminished. This will have severe implications for trading and supply chain management firms such as Li & Fung. They should not just move with the trend, but also jump ahead of it, so that they remain viable players in the new global environment.
For example, Li & Fung may still leverage its connections with producers and suppliers in Asia and Eastern Europe, but it may have to depart from its asset-light operating model of not owning factories or warehouses. As the brand name retailers will take the opportunity of value chain reshuffling to secure their own sources of supply, the role of a pure middle-man and supply chain agency traditionally played superbly by Li & Fung may not suffice anymore. The recent decision to privatization taken by Li & Fung seems to afford the company more freedom to make some long-term changes. It may consider closer cooperation with some key, capable factories which have long been partners, and incorporate them into a digitized supply chain.
About China
“As it took decades for manufacturing to move into China, it will take a considerable amount of time for manufacturing to move out of it.”
About Hong Kong
“The role of a bridge between China and the Western world that Hong Kong has maintained since Deng Xiaoping’s era, although not vanishing, will be diminished.”