By KT Arasu, CME Group
IN ONE LOOK
- Plans to relocate manufacturing operations to a second or third country could prove costly and complex in the face of pandemic-era realities
- Relocating operations must consider a variety of challenges ranging from infrastructure to the availability of skilled labor and rising wages in emerging markets
The nature of globalization is changing. Supply chains are challenged – by tariffs, the pandemic and Russia’s invasion of Ukraine. The recommended strategy is resilience through diversification. The logistics are incredibly complex.
We will look at some of the main factors driving this change.
Tariffs, Russia and Ukraine
Let’s start with the tariffs introduced by the United States in 2018 that led businesses and consumers to pay more for products imported from countries where the tariffs were applied. What started as a trickle with tariffs on $8.5 billion on solar panel imports and $1.8 billion on washing machines from China snowballed into tariffs on $350 billion of Chinese imports. Customs duties were then imposed on steel and aluminum imports mainly from Canada, EU, Mexico and South Korea.
What we have learned from the tariffs imposed by the various countries – the United States, China, the European Union, Canada, Japan, Mexico and others – is that such measures, once introduced, can remain in place even when the changing political climate. For example, the Biden administration has yet to remove all tariffs that went into effect during the Trump years, although some of the tariffs are being removed following Russia’s invasion of Ukraine to help reduce inflationary pressures.
Russia is a major exporter of oil and food products like wheat. The US embargo on imports of Russian oil helped push futures prices above $100 a barrel and gasoline prices at the pump above $4 a gallon. The EU, which gets 26% of its oil and 40% of its natural gas from Russia, is considering banning imports of Russian oil. The war also increased shipping costs which were falling after the pandemic’s big peak when demand for manufactured goods increased.
Shipping costs are higher but are well below pandemic highs
The lessons of the pandemic
The pandemic has taught us that different approaches to managing COVID-19 have led to very different challenges for supply chains, depending on location. Specifically, there are big differences between China’s Zero-Covid policy and the less stringent approaches taken in the United States and Europe.
Millions of people in China are stuck or have their movements restricted while hundreds of businesses have halted operations as the government tries to contain a new wave of the pandemic. The restrictions come at a time when China’s economic growth has slowed since the last quarter of 2021. In contrast, in the United States, the mask mandate while traveling on public transport has been overturned by a US court and attendance at open events is increasing. as the spring weather encourages people to go out more – although attendance at public places is still far from pre-pandemic levels.
Strategy is easier than logistics
From a strategic perspective, companies around the world are rethinking their supply chains. Yet, from a logistics perspective, companies are quickly realizing that changing supply chains can be difficult. Two important things companies consider when offshoring are maintaining or improving market share and effectively managing operational costs while trying to improve supply chain resilience.
Some companies may be confident that they can pass the additional costs on to their customers, but others may be concerned that if a major competitor sticks with its old low-cost model, it could take market share at a lower cost. In other words, changing supply chains involves some game theory in terms of what competitors might be doing.
The Organization for Economic Co-operation and Development (OECD) said in a report that greenfield investment in emerging markets and developing economies in 2021 was 43% below 2019 levels. Greenfield is a form of investment foreign direct where a parent company builds its operations from scratch in another country. The decline in this type of investment reflects the difficulty of moving supply chains.
Challenges of relocation operations
Let’s look at some of the cost and complexity considerations of moving a production center from one country to another or setting up a parallel manufacturing center in a second or third country.
Input power: When moving to another country to manufacture a product, a company must ensure that the country to which it is relocating has the raw materials necessary to manufacture its product. For example, if you make furniture, you will need to choose a country that has the appropriate type of materials to build your furniture. The raw material usually needs to be close to your factory location and you need to ensure that there are suitable modes of transportation to get the raw materials to the factory. There must also be relatively inexpensive labor to ensure your competitiveness.
Output delivery: How do you deliver the finished product to your customers? The company needs access to suitable roads, railways and ports from the new manufacturing site to deliver products to customers in other countries. Shipping costs from the point of manufacture to destination markets could also play an important role in establishing new operations in a second or third country.
Reliance on highly specific, single-source inputs: Some key inputs for some manufactured goods are scarce or produced in only a few places. For example, the Republic of Congo is the world’s largest producer of cobalt. Manufacturing processes dependent on highly specific inputs from relatively few sources will struggle to protect themselves.
The cost of inputs increases: Input costs (output prices?) are currently rising faster than the rate of consumer price inflation. This higher cost factor comes at a time when one may wish to reduce manufacturing costs. The U.S. producer price index for all final goods and services is (April 2022) 11% higher than a year ago, while the goods component of the consumer price index production is at a higher level of 16%.
Skilled labor: Relocation operations depend to a large extent on the availability of skilled labor or a pool of workers who can be easily trained in skilled operations. The availability of labor in China has been one of its advantages, but this position is contested by emerging countries like Vietnam, the Philippines, Bangladesh, Mexico and others.
Wages: Salaries are increasing in many countries, which also makes the process more expensive and difficult. Higher wages may also come with a higher likelihood of labor disputes, strikes and work stoppages. For example, port unions on the West Coast of the United States are currently negotiating a new labor contract.
Prices paid by wholesalers have increased
A tight labor market pushed wages up
Ability to pass on costs: Companies in different sectors will have different opportunities to pass costs on to their customers, and this will depend in part on their competitive environment. Companies with strong competition and tight margins are much less likely to change their supply chains unless absolutely essential.
Unrelated but simultaneous considerations: Central banks withdraw their accommodative measures, which has repercussions on currencies. The Japanese yen had crashed to a 20-year low against the US dollar amid diverging monetary policies between the two countries – the Federal Reserve has raised rates by 75 basis points in two moves since March, while the Bank of Japan eases its monetary policy. Politics. The People’s Bank of China is also easing, with the yuan falling to its lowest level in a year against the greenback.
Yuan weakness reflects Chinese growth concerns
At the end of the line
From a strategic perspective, it remains to be seen whether we are entering a period of de-globalization and economic fragmentation. From a logistical point of view, the process of relocating operations is difficult, complex, takes years and is expensive, with a relatively high risk for the capital investment.
Some companies may find it difficult to pass on costs in industries with high competition and tight margins, while managing the effects of inflation and changing central bank policies.
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