A USD 1 trillion opportunity in de-risking global supply chains
When people around the world started panic-buying of face masks in early February, not many realised that about half of the world's masks were produced in China. With various parts of the country in lockdown and factories shut for weeks following the pandemic outbreak, getting a steady supply of face masks or similar protective equipment became a challenge. It was not merely an issue of supply and demand. The empty shelves in pharmacies highlighted what it could mean when global supply chains, which have become increasingly complex over the past decades, are disrupted.
The impact goes beyond just the medical sector. Producer of half of the world's goods, China is also the fourth largest source of automotive parts worldwide. Hubei province, with its capital Wuhan at the centre of the COVID-19 outbreak, is home to manufacturing plants for companies including General Motors, Honda, Nissan, Peugeot Group and Renault. Supply shortages from Hubei, exacerbated by logistic disruption due to less available air freight, led to massive global production slowdowns.
The COVID-19 crisis has underlined the vulnerability of global supply chains like no other. But long before the pandemic, global supply chains have been undergoing a fundamental change for several reasons.
Diminishing cost arbitrage advantages
According to a survey by Japan External Trade Organisation (JETRO), the monthly cost of manufacturing labour in China was more than double that of Vietnam1. Wages in Thailand, which exports similar products, are 25% lower2. Diminishing cost competitiveness in China has prompted manufacturers to explore alternative options in other Asian markets.
Rising political risks
Since 2018, rising US-China trade tensions have also cast a spotlight on growing exposures to political risks. Our sigma report shows that from 2018 to 2020, US tariffs levied on Chinese goods have amounted to approximately USD 375 billion. The fear of a prolonged trade war was driving 82% of global and 93% of Chinese respondents to change their supply chains, according to a survey of 600 multinationals in early 2019.
With US elections around the corner, a key question is how political risks could evolve. To me, there is no question that trade tensions will remain high either way. In a Biden administration, I would think more multilateralism will prevail, but higher tariffs are unlikely to be lifted and changes in global supply chain will continue to evolve. A calibrated reduction in tariffs over time in a Biden Administration will probably depend on greater market access for services (financial, healthcare, education, legal, logistics etc.), which is also in China's state interest, besides tackling the questions of protecting intellectual property rights, transfer of technology and state subsides.
More globally, governments' responses to COVID-19 have demonstrated how international cooperation can be interrupted in times of crisis. Reports show that as of 21 March 2020, 54 countries had taken certain measures in restricting trade of medical products to prioritise domestic needs.
Increasing costs from disaster events
In the early years of globalisation, large supply chain disruptions were considered tail risks. However, the growing impact of climate change on extreme weather events hitting industrialised areas has resulted in serious disruptions to international trade and supply lines in recent decades.
In 2011, the confluence of the monsoon season and severe rainfall triggered by Tropical Storm Nock-ten resulted in severe flooding that interrupted production of everything from cars to computer disk drives in Thailand. At the time, approximately 19% of Thailand's manufacturing firms were integrated in global production networks. As a result of the heavy flooding, seven industrial estates were closed and automotive exports of Thailand contracted more than 50% in November3.
Supply chain risk and drivers of change
Where are the next supply hubs?
The risk of having one dominant production source is increasingly evident, fuelling demand for more resilient and sustainable sourcing strategies. The COVID-19 crisis has been instrumental in highlighting the risk and accelerating the restructuring of supply chains. A UBS survey in early 2020 shows that 44% of manufacturers surveyed have increased intentions to relocate operations out of China due to the pandemic4.
But, where to?
Swiss Re Institute's scorecard shows that Southeast Asian markets are top on the attractiveness league table due to their growth potential, export-oriented model and competitive labour costs. Vietnam scores the highest, followed by Cambodia, Malaysia, Thailand and the Philippines.
But economic reasons are not the only considerations for relocation of manufacturing bases. China's sophisticated supply chain clusters, skilled workforce and established logistic competence cannot be replaced overnight. Hence, instead of seeing manufacturers moving out completely, a "China+1" strategy will likely be more prevalent.
Production relocation scorecard (normalised z-score)
Seizing the USD 1 trillion opportunity
Swiss Re Institute estimates that the transition to more resilient global supply chains would generate close to USD 1 trillion additional export and investment value in the relocation and reshoring economies. This could enhance annual gross domestic product (GDP) growth in the new host markets by 0.7%, and by 0.2% in the reshoring markets, a boost much needed in a post-COVID world.
This is an area where governments of these potential new hubs can play a more active role to seize the opportunity.
We have seen Southeast Asia take some positive steps in that direction over the years. Thailand, for example, approved a package last year that cuts taxes by half in exchange for foreign investment. In the same year, Malaysia signed off on a batch of incentives worth about RM 1 billion (USD 240 million) in a bid to attract investments from overseas corporations and start-ups5. Indonesia looks to follow the course.
As the opportunity looms, bolder steps can be taken.
Relocation of manufacturing lines requires a large amount of initial lock-in investment, assessment of local regulations and legal structures, establishing new logistics arrangements, recruitment and coordination with the local government in various areas. Every step the government takes to improve the ease of doing business can be a deciding factor in attracting manufacturers looking to mitigate their supply chains risks.
De-risking GSCs: the role of insurance
As recent events threw the inherent vulnerabilities of global supply chains in the limelight, many organisations are considering various strategies to reduce supply chain exposures. It takes time for relocation or reshoring to materialise, particularly amid a global environment that is still grappling with the wide-ranging impact of COVID-19. Even if risk diversification efforts were carried out smoothly, there would always be times when risks cannot be entirely avoided.
This is where insurance can help. For instance, contingent business interruption (CBI) insurance is designed to cover property risks of an external party, such as a supplier. In the event of disruption at a supplier's premises due to physical damage, the insurance payouts will provide the extra funds needed for seeking alternative suppliers or to cover profit loss. The disruption from Thailand floods (2011) is one typical case where businesses could have benefited from CBI insurance products. Unfortunately, a high proportion of supply chain losses remain uninsured today.
In the longer term, insurance will be a critical enabler for global supply chains restructuring. Production relocation and reshoring will fuel demand for construction of new factories and facilities; regional governments are gearing up investment in infrastructure to attract manufacturers seeking alternative hubs – all of these activities will generate additional demand for insurance protection. Swiss Re Institute estimates that the overall income effect would generate an additional premium volume of around USD 63 billion over a five-year transition period.
Building supply chains resilience may have a hefty price tag on it. Moving production lines away from the most cost-efficient options could slow down global growth in the long run. But it also brings along a USD 1 trillion opportunity and a more resilient and sustainable future for governments and businesses around the world. Both of which are dearly needed in a post-pandemic world.
1 Survey on Business Conditions of Japanese Companies in Asia and Oceania. JETRO, November 2019
3 Chongvilaivan, op. cit.
4 The CFO surveys from US, North Asia and China show firms plan to move c. 20!30% of their production capacity out of China. See Supply chains are shifting: how much and where? UBS, 15 June 2020.