Post-coronavirus, expect manufacturing to make a mass exodus from China

Firms across the world are rethinking their supply chains as they discover that links to the world’s factory are more fragile than they bargained for
Drugs are a particularly sensitive area: no nation wants to depend on supplies from a potential adversary that can use delivery as a strategic weapon

Neil Newman

Published: 7:00am, 4 May, 2020

Why you can trust SCMP

Three months ago, I made a quick family trip to the United Kingdom and, arriving in Sussex, some odd experiences were waiting for me. First, the surface sanitisers I’d ordered from Amazon were a no-show and the British company making them sent me a message instead: “Plastic bottles shortage due to the [ coronavirus] issues in China.”

Second, the mobility scooter I planned to buy with my dad was out of stock at the wholesaler. Although many models are made in the European Union and the UK, all the electric motors and clutches are imported from China and had run out.

Third, on a visit to a small 4G intercom firm eyeing Hong Kong and Asia as new markets, I was greeted by a CEO tearing out what was left of his hair trying to source a critical, but common, component to keep the assembly line going. The firm’s supply had run out – as had the local supermarket’s stock of paracetamol to deal with his headache.

An out-of-stock pharmacy in Rustington, Sussex, England. Photo: Neil Newman

Three diverse British businesses in distress was not a coincidence. And it soon became apparent that the problem was far more widespread, highlighting critical weaknesses in modern manufacturing: the fragility of supply chains and the reliance on logistics to bring in components and deliver finished products. It was clear that it did not matter which part was missing from the parts shipment, whether hi-tech electronics, common electric motors or a humble HDPE spray bottle; a broad systemic failure was taking place.

NOT JUST SMES AT RISK

Small firms are the lifeblood of the UK economy. And across sectors, from electronics and consumer goods to automotive parts, medical equipment and pharmaceuticals, they rely on supply chains that lead back to the major overseas manufacturer: China. This is, of course, a global phenomenon, and not limited to just small companies in the UK. Large international firms, particularlydrug manufacturers in Japan and the United States, have suffered as foreign sources of key ingredients have gone offline, with no domestic suppliers to turn to.

Coronavirus crash: for value investors, Covid-19 can be a crisis and an opportunity

This concern has been highlighted by the United States Food and Drug Administration, which estimates that 72 per cent of active drug ingredients used in the making of finished drugs in the US come from foreign sources. Drugs and medical equipment are particularly sensitive topics, given the current pandemic, as no nation wants to be dependent on supplies from a potential adversary that can hijack and divert shipments, or use selective delivery as a strategic weapon. Exports of pharmaceuticals will always be at risk when domestic demand is a priority.

THE REPATRIATION OF MANUFACTURING

Already a few years ago, rising manufacturing costs in China along with weakening domestic economies in Japan and Taiwan had prompted some repatriation of manufacturing and decentralisation of supply chains. In 2016 the Japan External Trade Organisation estimated, based on its annual surveys of everything made and sold by Japanese companies, that goods “made and sold” overseas peaked at 58.3 per cent. That year foreign direct investment into China from Japan fell by 14.3 per cent. This year, we may see a mass exodus from China as the Japanese government tries to encourage Japanese firms to hasten the move of their factories back home, something the Europeans and Americans are also keen to do.

Coronavirus shows the global economic system is no longer fit for purpose

BUILDING RESILIENCE AFTER COVID-19

With unemployment surging and companies furloughing a significant percentage of staff, less money and more debt will linger after the coronavirus crisis. Like many governments, the UK is pumping enormous amounts of money into businesses to support cashflows and salaries, and Downing Street expects that the funds will put firms in a stronger position to tackle future crises.

In my opinion, there are three strategic changes that investors will need to see take place to feel comfortable with business continuity risk.

1. Managers of small and medium-sized businesses as well as the planning departments of large firms will have realised the need to pay greater attention to supply-chain risk. The evidence of this would be some kind of “supply chain continuity planning”, much the same as Business Continuity Planning which has been a fixture of the finance industry for the last 30 years. I expect this to be particularly prevalent in pharmaceutical and medical industries, but it will affect all companies sourcing small and cheap, but critical, components overseas.

2. The dependence on logistics will have been reduced, resulting in greater sourcing of local components and suppliers integrating vertically with manufacturing. Additionally, production of goods will need to move closer to target markets. This year we have seen shipping severely hampered, and airfreight unable to pick up the slack, despite higher costs, due to border restrictions. This especially impacts perishable goods, as highlighted by the problems facing farmers in Europe.

3. Companies will have stocked up on more emergency cash. Due to the coronavirus crisis, the bankruptcy rate of well-known and smaller firms alike is set to rise, and this is likely to continue long after we return to some kind of “normal”.

Activist investors who have long criticised cash hoarding and have pushed for distributions to shareholders will face stronger headwinds. Company management will have good reason to simply say they are saving for a rainy day and point to the cash crisis of 2020. Inefficient use of capital – by activist investor standards – may just become the normal again.

There is no reason to think that Covid-19 will be a one-off event, and the hard lessons learned now are all-important for the businesses that survive. Consumption globally will clearly suffer, and the recovery will be a lengthy process. Any investor looking at companies, now that markets have crashed and the dust is settling, faces a tough challenge and will certainly have to take a close look at how companies are prepared for the next unthinkable crisis. ■

Neil Newman is a thematic portfolio strategist focused on pan-Asian equity markets

Help us understand what you are interested in so that we can improve SCMP and provide a better experience for you. We would like to invite you to take this five-minute survey on how you engage with SCMP and the news.

Post