“Made in China” in Deglobalisation

For professional clients only 2 September 2020 Research & Strategy Insights

Preserving “Made in China” in deglobalisation

Locking in supply chains requires continued reforms and opening up

Aidan Yao, Shirley Shen, Senior Economist Economist (Non-China Asia) Macro Research & Core Investments Macro Research – Core Investments

Key points China riding high on globalisation

• After decades of rapid growth, the progress of The powerful rise of globalisation has been one of the globalisation has slowed since the global financial crisis, defining economic developments of our time. By spreading with its fate further complicated by rising protectionism, production across multiple countries connected via trade and political interference and the COVID-19 outbreak. integrated supply chains, the global economy has achieved momentous efficiency gains and created tremendous values • As the biggest beneficiary, China stands to lose the most in for those involved in the process. As the tissue that connects the event of deglobalisation. So far, however, evidence of “economic organs”, international trade has experienced a disruptions has been scant, with some indicators showing boom since the 1980s. Combined export and import values that China’s market share in trade and manufacturing has surged from 35% of the world’s GDP to over 60% just before in fact risen despite the trade war and pandemic. the onset of the global financial crisis (GFC). Exhibit 1 shows that such stellar growth would not have been possible • This is not to say that China is immune from any supply without the propagation of the multi-country production chain shifts. Some low-margin businesses have already systems that significantly lifted foreign contributions in exited the country in light of rising costs. In contrast, overall trade value-added. foreign firms seeking to tap China’s vast domestic market and supply chain ecosystem are unlikely to leave easily. Exhibit 1: Spreading global supply chains boosts trade Global trade as % of world GDP vs. foreign value added (FVA) in • We think the deglobalisation trend will continue but have exports as % of domestic value added (DVA) varying impacts on different industries. In addition, the 65 % % 44 reshuffling process could be slow and gradual, hampered 60 Trade % GDP [Lhs] 42 by the current pandemic and China raising the cost of 55 FVA % DVA in trade [Rhs] 40 38 exits through its own reforms. 50 36 45 • 34 The propagation of the “China Plus One” model could 40 allow China to maintain some influence over the supply 32 35 chains spreading to other Asian countries, turning “Made 30 in China” to “Made around China” that ends up 30 28 1986 1990 1994 1998 2002 2006 2010 2014 2018 expediting regionalisation at a time when globalisation is Source: World Bank, UNCTAD, HSBC and AXA IM Research, as of Aug 2020 in retreat.

Exhibit 2: China has transformed from a small to prominent player in global supply chains

Source: OECD and AXA IM Research, as of Aug 2020

China has been among the biggest beneficiaries and drivers well underway before it became a widely-debated topic of globalisation. Its successful integration into the world’s following the Sino-US trade war and COVID-19 pandemic. economy – by leveraging its abundant supply of cheap labour, natural resources and pro-business policies – has led to a Despite the shrinking pie, China has continued to gain market profound change in China’s role from an insignificant regional share in trade and manufacturing. By deploying some of its trade player to one of three vital connectors of global supply “RMB4 trillion” stimulus after the GFC to upgrading manufacturing chains (Exhibit 2). Today, China is both the world’s largest infrastructures, China has managed to buck the declining manufacturer and trading nation, backed by the second trends seen in other manufacturing powerhouses and risen largest economy with over 800 million workers. Any disruptions to the top of the global league table since 2010 (Exhibit 3). At to its production system, as recently demonstrated by the COVID almost 30% of the global market – doubled since 2008 – outbreak, could send shock waves across global supply chains, China’s manufacturing value added (MVA) is now the size of affecting economies that would not otherwise be impacted the US, Japan and Germany combined. without the integrated web of shared production and trade. While some of these gains were used to meet rising domestic Globalisation already in trouble since GFC demand, significant growth in manufacturing was also a result of increased production collaboration with others. However, the rapid rise of globalisation ran out of steam Exhibit 4 shows that China’s contributions to MVA elsewhere after the global financial crisis. Global trade as a share of GDP have risen strongly, reflecting a strengthening of its flatlined in the early part of the last decade (Exhibit 1). In production ties with others within its supply chain networks. part, this reflected a normalisation after a period of exceptional growth, thanks to shifting consumption patterns Trade war adds insult to injury from easily tradeable goods to services. The decline, however, sharpened more recently as governments around Building on the natural protectionist tendency in the period the world tightened trade regulations and pursued of feeble growth, the Sino-US trade war presented yet protectionist policies that aimed at keeping growth within another setback to globalisation. Four rounds of tit-for-tat their borders.1 The deglobalisation process was, therefore, tariff increases saw the average import duties for both countries Exhibits 3, 4, and 5: China bucks the declining trend in global manufacturing and gains shares in trade and foreign direct investment despite the trade war Share of global manufacturing value added Change in manufacturing value added contributed China trade & FDI % of world by China and the US from 2009 to 2015 % % % China Germany USA Japan 14 30 30 25 Percentage points FDI [Lhs] China US 12 25 25 20 Trade [Rhs] 10 20 20 15 8 15 15 10 6 10 10 5 4

5 0 2 5

0 -5 0 0 2004 2006 2008 2010 2012 2014 2016 2018 VT TH MA MX PH KR ID TW IN US JP AU SG CN 1970 1976 1982 1988 1994 2000 2006 2012 2018 Source: World Bank, UNCTAD, WITS, OECD TiVA and AXA IM Research, as of Aug 2020

1 The Economist, “Globalisation in Retreat?” Economist Corporate Network, 2013

Exhibits 6, 7 and 8: China loses market share in the US but gains supply chain connection elsewhere Change in share of inputs from China and the US in Change in US import share between 2017 and 2019 economy's exports from 2017 to 2019 1.0 Percentage point 1.0 Percentage points China US 0.5 0.8

0.0 0.6

-0.5 0.4

-1.0 0.2

-1.5 0.0

-2.0 -0.2

TH TH

MX TW MA Source: UN Comtrade, UNCTAD, OECD TiVA, HSBC, AXA IM Research, as of Aug 2020 climb to above 20%, resulting in large declines in bilateral trade However, deglobalisation is unlikely to prove a cyclical flows. With higher tariffs and political frictions creating a hostile phenomenon. After decades of pursuing free trade and lower business environment, many multinational corporations (MNCs) tariffs, the world is experiencing a reversal in all these trends are under pressure to reconsider their operations in China, (Exhibits 9 and 10). As rising populism and inequality fan leading to fears that a large shift in supply chains could scepticism about globalisation, China needs to be prepared undermine China’s economic competitiveness and prosperity. for a world that could retrench further into protectionism.

Contrary to those fears however, the actual trade and foreign Our previous research2 offers a framework for thinking about direct investment (FDI) flows since 2017 reveal a very different the potential supply-chain moves in and out of China. It puts picture (Exhibit 5). It is true that China has lost export market MNCs into three groups: 1) companies operating in China for share in the US to the likes of Mexico and Vietnam (Exhibit 6). its low cost of production; 2) those for its large domestic But its exports to the rest of the world have increased over market; and 3) those for the comprehensive supply chain the same period, with global gains more than offsetting US networks. In reality, these categorisations are not mutually losses. As a result, China’s total export share has in fact risen exclusive, with many companies drawn to China by more by about half a percentage point since 2017 (Exhibit 7). than one attribute. Still, corporate leaders tend to think in relative importance of their objectives, which makes the China has achieved this in part due to export diversion. By above classification still a relevant, albeit simplified, starting selling inputs to third countries for assembly before final point to analyse the issue. products are shipped to the US, it has successfully circumvented some of the import duties imposed by We think the companies that are most likely to exit China are Washington. Such a strategy has also pulled China’s those which are cost-sensitive. Factor costs, including labour, production partners closer to its supply chain orbits, making land and utility have risen significantly over the past decade. them more dependent on its provision of inputs (Exhibit 8). Within the manufacturing sector, salaries of front-line workers and engineers have risen 30% since 2013 to levels that are Winner does not take all now only behind Korea and Taiwan in Asia (Exhibit 11). Not surprisingly, industries with low profit margins have already China so far seems to be doing a decent job at protecting its started to relocate to South East Asian (SEA) countries in supply chains from the trade and COVID disruptions. recent years, a trend that could be strengthened by higher tariffs and the pandemic. Exhibits 9, 10 and 11: Globalisation in retreat; rising labour costs force supply chain changes in China Global trade as % of GDP vs. weighted average Number of trade agreement notifications to the WTO global tariffs Number Number 40 350 10 % % 0.25 Weighted average tariffs [Lhs] Goods [Lhs] 9 35 300 0.30 Trade % GDP [Rhs, inverted] 30 8 Services [Lhs] 250 0.35 7 25 Cumulative TAs [Rhs] 200 6 0.40 20 150 5 15 0.45 100 4 10 0.50 3 5 50 2 0.55 0 0 1990 1994 1998 2002 2006 2010 2014 2018 1980 1988 1996 2004 2012 2020 Source: WTO, UNCTAD WIPO, JETRO and AXA IM Research, as of Aug 2020

2 Yao, A., “The world’s factory in COVID-19: Can China secure its supply chain kingdom?”, AXA IM Research, 18 May 2020

Exhibits 12, 13 and 14: China has moved up the value chain in exports, and become a major source of FDI and the largest consumer market China - share of total exports across industries Vietnam foreign direct investment by major countries Comparison between China and US 10 Exports % share 4.0 US=1, bar labels=actual size 9 3.5 $1.9tn 8 1997 2017 7 CN 3.0 China US 6 Others 24% 2.5 5 350mn 32% 2.0 4 33% $277bn $5.6tn 100mn 3 1.5 2 $0.6tn 170mn 22% $187bn $5.5tn 99mn KR 1 1.0 21% 0 UK… 0.5 0.0 US… SG Retail Middle classLuxury good Tourism Total retail Puplation NE TH 13% Ecommerce population market size spending sales worth 2% TW 2% 4% sales (% world) abroad >US$110th Source: CEIC, Vietnam government, various sources and AXA IM Research, as of Aug 2020 However, instead of treating this as de-facto evidence of Not all are heading for the exit deglobalisation, we see it also as part of a natural progression of the Chinese economy moving up the value chain. One For the second group of companies, those in China for its manifestation of the latter has been the changing pattern of domestic market, we think the chance of leaving is quite low. Chinese exports, which were dominated by lower-value- China has now overtaken the US as the world’s largest retail added products, such as apparel and footwear some twenty market, with higher luxury goods and tourism spending years ago, but are now led by high-margin goods, such as supported by a burgeoning middle class that is already twice electronics and autos (Exhibit 12). Likewise, China’s global the size of the United States’ (Exhibit 14). Recent surveys market share in footwear and textiles has fallen over the past from the American and European Chamber of Commerce in decade, while that in electronics and machineries has risen. China showed that a vast majority of respondents, who are “in China for China”, have no intentions to leave despite the To ensure the commercial viability of low-margin businesses, trade war and COVID-19 (Exhibit 15).4 China has been investing heavily in its neighbouring countries for lower cost of production (Exhibit 13). Anecdotes from the Finally, the most uncertain response lies with businesses European Chamber of Commerce (EuCham) suggested that it which are drawn to China by its manufacturing ecosystem. is the Chinese companies – more than foreign firms – that On the one hand, the reasons to stay remain as strong as has driven a large portion of supply chain relocation to the ever, with China’s infrastructure quality, logistic networks SEA region in recent years. But instead of doing so to replace and supply of educated workforce unmatched by its 3 “Made in China”, our research showed a rising co- emerging market peers (Exhibits 16 and 17). China is also the dependency between China and its supply chain partners, only country in the world that can produce in all 666 suggesting again a broadening of China’s production orbits industrial sub-categories of the United Nation’s industry beyond its borders. classification, creating an unparalleled manufacturing network that can support just about any supply chain configuration.5

Exhibits 15, 16 and 17: Many foreign firms do not plan to exit, lured by China’s infrastructure quality, logistic networks and skilled workforce % of survey responents not planning to leave China Chinese college graduate, postgraduate and 100 % engineering graduate EuCham AmCham '000 Persons College graduate [Lhs] 90 '000 Persons 8,000 Postgraduate [Rhs] 700 80 Engineering graduate [Rhs] 7,000 600 70 6,000 60 500 5,000 50 400 4,000 40 300 3,000 30 200 20 2,000 100 10 1,000 0 0 0 2017 2018 2019 2020 1997 2000 2003 2006 2009 2012 2015 2018 Source: AmCham, EuCham, World Bank and AXA IM Research, as of Aug 2020

3 Shen, S. and Yao, A., “Asia supply chains: a potential shock to growth”, AXA- example invested over $5bn in 2019 to manufacturing electric cars in IM Research Insights, 12 May 2020 Shanghai for the world’s largest auto market. 5 4 Over 80% of surveyed companies in the AmCham and EuCham surveys are http://www.gov.cn/xinwen/2019-9/20/content_5431714.htm in “made in China for China” businesses, which may bias responses. Tesla for

Exhibit 18: China is the world’s largest personal protective equipment manufacturer, with developed countries as its largest customers Global share of China's exports of Personal Protective Equipment China - % of exports by destination US EU Japan UK HK Korea Others Protective garments 60 30 24 6 4 3 33

Respirrators and masks 59 39 18 10 5 3 25

Medical goggles 51 27 19 3 4 18 29

Medical shoe covers 15 22 13 7 4 5 49

Hospital gloves 8 44 13 10 3 30 0% 10% 20% 30% 40% 50% 60% 0% 20% 40% 60% 80% 100% Source: UN Comtrade, PIIE and AXA IM Research, as of Aug 2020 However, these merits now need to be weighed against and maintaining the status quo, with the actual changes more higher tariffs, potential sanctions, technology restrictions and nuanced and sector specific. Below are four conjectures: heightened political pressure, which are all parts of the “new First, the Personal Protective Equipment (PPE) industry will normal” business environment that MNCs must adapt to. likely see some dramatic changes to its supply chains. The COVID-19 pandemic has exposed the vulnerability of countries So far, the evidence of supply chain shifts by this group is outsourcing these products from foreign suppliers, compromising rather mixed. Hard data on trade and FDI is hardly showing any security for efficiency. We expect heightened political signs of capital flight from China. However, pursuing production pressure and tougher regulations to force a reshoring of PPE diversity and reducing concentration risks are among the key production globally. Being the largest supplier of these issues facing business leaders, with some surveys6 of foreign products, with its biggest customers – US and Europe – most firms indeed indicating a higher propensity to exit China than wary of national security risks (Exhibit 18), China stands to those shown by the AmCham and EuCham surveys. lose the most from a material shift in these supply chains.

We think some supply chain reshuffling – at the expense of Second, the technology industry is also susceptible to large China – is inevitable, although this may not occur at the pace changes as the global tech war rages on. While conflicts and form anticipated by most. We discuss four conjectures between the US and China have been the most eye-catching, on future supply chain changes in the next section. plenty of frictions elsewhere – in tech regulations, digital taxation, cybercrimes and anti-monopoly lawsuits – could Four prognoses on supply chain reshuffle also change how the industry operates and supply chains are deployed. Our previous analysis7 showed that electronic Our overarching prognosis is that many companies will not see manufacturing accounts for more than half of Asia’s export the supply chain repositioning as an “either/or” decision. The value added, with China at the centre of the production practical choice probably lies in between exiting China completely ecosystem (Exhibit 19). The potential losses for China in this area could be substantially larger than that for PPE.8

Exhibit 19: China lies at the core of Asia’s supply chain ecosystem, which is dominated by electronic manufacturing Sector share of Asia's value added in UPSTREAM CHINA DOWNSTREAM Asia and developed markets' contribution to China's China's contribution to Asia and developed Chinese exports exports markets' exports Others, -6.4 TWN VNM 10.6 11.1 17% -3.1 KOR Processing MYS 5.3 5.2 -3.0 MYS Refining THA 5.9 4.6 -2.8 SGP Input HKG 8.0 2.2 Transport, 3% -2.0 THA provision TWN 4.2 3.2 Electronics, -1.8 PHL Chemicals, Assemble KOR 4.3 3.1 Asia and DM as final demand 54% -1.7 VNM 8% Re-export PHL 4.2 1.2 -0.8 JPN SGP 2.2 2.2 Asia and DM as exporters Textile, -0.7 HKG IDN 3.5 0.5 -0.7 IDN 11% JPN 3.2 0.4 Machinery, 6% -0.3 EMU IND 3.1 0.5 Food&beverage -0.3 IND USA 2.4 0.2 % GDP % GDP -0.2 USA EMU 1.7 0.5 s, 1% -7 -6 -5 -4 -3 -2 -1 0 0 2 4 6 8 10 12 14 16 18 20 22 24 Source: OECD TiVA and AXA IM Research, as of Aug 2020

6 For example, various of USB surveys of MNC CFOs this year showed 60- reportedly investing large sums in Vietnam to hedge China risks. With the 85% of foreign firms are planning to move parts of their supply chains out of competition around 5G heating up between China and the US/European China. See UBS Evidence Lab inside: Supply Chain Decoupling Accelerating? – Union, supply chains centred on these technologies for products, such as China CFO Survey March 2020. autonomous driving vehicles, industrial robotics, and basic consumer electronics, could all be disrupted if tariffs and sanctions are used to get an 7 See Shen, S. and Yao, A., (2020) referenced in footnote 3. edge in the competition. 8 Already, there have been some high-profile moves out of China in recent years, with Foxconn redirecting some operations to India and Samsung

Beyond the manufacturing of electronics lies the more Exhibit 20: Emerging market countries in Asia could systemic issue of a potential “tech decoupling” on a global gain the most from the supply chain reshuffle scale. As the world’s leaders in technology are increasingly Competitive score and changes in exports, manufacturing value added competing in what’s perceived as a zero-sum game, supply (MVA) and foreign direct investment (FDI) between 2019 and 2014 Index chains built on foundational technologies, such as 5G, could 101.0 Aggregate [Lhs] % 3.0 be fractured by multiple technical standards and incompatible 100.5 Changes in exports, MVA and FDI [Rhs] 2.5 networks. With global manufacturing increasingly fused with 100.0 2.0 technology, such tech fragmentation could speed up 99.5 1.5 deglobalisation in the real economy, undermining the 99.0 1.0 prospects for not just China, but the world at large. 98.5 0.5 Our third prediction is on timing – in the absence of strong 98.0 0.0 political pressure, the supply chain reconfiguration will be a 97.5 -0.5 slow and gradual process. With the ongoing pandemic, IN VT MX BR ID PH RU MA TH TW SG KR JP corporates have significantly scaled back capital expenditure. Source: World Bank, multiple sources and AXA IM Research, as of Aug 2020 In China, despite the initial outbreak, the country is now From “Made in China” to “Made around China”? leading the rest of the world in controlling the virus and resuming production. This is not the best time for MNCs to The upcoming supply chain reshuffle will undoubtedly create redirect supply chains away from a base where the winners and losers. China’s inevitable losses, particularly in operational capacity is most secure and reliable. low-value-added segments, could benefit other emerging market

countries. Some of those may be from outside the region, like In addition, investors pay close attention to the short-term Mexico – given its proximity to the US, but we think the majority performance of listed companies. If one decided to shift of the reshuffle will occur within Asia. Given that no-one in the production while its competitors stayed put, the cost of such region can replace China any time soon, they will be dependent a transition could hit the company’s bottom line and stock on its provision of inputs, which may end up strengthening price, forcing decision-makers to think twice before China’s position at the centre of Asia’s supply chain implementing sweeping changes. ecosystem. With the right reforms and cooperative mindsets,

China could orchestrate a transition from “Made in China” to Finally, continued reforms in China could raise the opportunity “Made around China” that accelerates Asia’s regional cost of exits. Recent moves by Beijing to reduce FDI restrictions, economic integration at a time when globalisation is in retreat. strengthen intellectual property protection, accelerate financial sector liberalisation, and open up monopoly industries9 are The above version of supply chain reshuffle could have a all aimed at creating a more accessible market and levelling benign impact on China’s long-term growth. Even without the the playing field. While these moves may not prevent supply adverse – deglobalisation and protectionist – shocks, China’s chains from leaving China, they could slow the process. own maturing economy will require it to abandon some low-

margin businesses for higher value-added activities, creating Our final conjecture concerns the leavers, among whom few, a natural shift in its supply chain compositions. in our view, will likely abandon China completely. This is consistent with recent surveys showing that a popular There are, of course, risks of more pernicious changes, if: approach among MNCs is to develop a “China Plus One” model, whereby only a fraction of their operations in China 1. A wider political divide forces a greater “decoupling” are moved to another country to serve as China’s back-up. between China and the US/ the west,10

2. A lack of adequate reform by Beijing to lock in foreign Compared to reshoring or a replacement strategy, the China investment and supply chains, and Plus One model may in fact strengthen China’s supply chain 3. A more serious tech fragmentation causes collateral linkages with its trading partners. Among those who are most damage to the real economy. likely to benefit are India and Vietnam in this region, based on our analysis of labour costs, infrastructure quality, ease of In all these cases, the potential loss in economic efficiency doing business, economic competitiveness and political stability. would not only set back China’s long-term growth, but also add Our relative competitiveness scores, presented in Exhibit 20, pains to a global economy that is already struggling to have correlated well with recent trade and FDI flows. recover from the severest recession in generations.

9 Yao, A., “US-China: A silver lining in a strained relationship”, AXA-IM context. For more detail, please see Page, D “US presidential election Research Insights, 15 January 2020. preview: You’re fired?” AXA-IM Research & Strategy Insights, July 2020 10 We do think a Biden administration may approach China differently at least on trade issues by relying more on a multilateral, instead of bilateral,

6 For professional clients only 2 September 2020 Research & Strategy Insights

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