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October 12, 2020

Perspectives on China from the Middle Market

Lately, there has been discussion around the impact of trade disputes, pandemics and exchange rates on the supply chains of middle-market manufacturers and distributors, as well as those selling products within China. Industry experts Tom Bonney and Jay Boyle assembled their points of view from their respective advisory and accounting work for U.S.-based middle-market businesses and China-based firms.

Ground Level Data from China

We begin with a sample of the latest "official" data from China:

  • Second-quarter GDP growth rate of 3.2%, with the economy showing substantial improvements month-over-month since February 2020.

  • May unemployment was at 5.7%. However, this excludes workers who migrated from the Chinese countryside to the cities and industrial parks, as well as to other countries, to work on projects funded by the Chinese Belt and Road initiative. Many of these migrant workers returned home or were stranded in the destination country and are not included in the official unemployment figures.
  • By June 2020, 93% of industrial state-owned enterprises and 84% of state-owned construction enterprises reopened.
  • Nearly 800,000 companies are expected to close for good by the end of 2020.
  • By late April, nearly 75% of Chinese companies were back at work in the office or plant with masks and other precautions.
  • China’s interior suffered severe flooding this summer that has impacted production and manufacturing supply chains, particularly along the Yangtze River, affecting Wuhan and Chongqing. This flooding, along with an outbreak of swine flu, has caused food shortages and inflation pressures.
  • The trend of foreign direct investment into China has been improving since February 2020 as international investors see China as one of the first countries recovering from coronavirus.

Potential Shift

Projection

A significant shift to home office operations

Very low likelihood. Not in line with the Chinese management style. By late April, 75% of companies were already working onsite.

China-U.S. Decoupling

Politically prioritized and low-value-add supply chains can be moved, but others are much more difficult. The China demand market is a factor; not only the supply side. It's not a "Cheap China play; it’s quality and cost-effective economy of scale; difficult to recreate in other countries.

Other countries also moving supply chains out of China

Not much higher ratio than before the pandemic. Even so, some companies have increased their presence in China during the last couple of months.

A massive exodus of foreign investment

On the contrary, China’s actual utilized FDI increased by 15.8% in July 2020, and there is an expected increase in M&A in the next year. China is now considered much more stable and recovered than other countries.

 
  • In an April 2020 Ernst & Young survey, 57% of Chinese companies thought they would be involved in some aspect of M&A in the next 12 months.

The National Association of Manufacturers China Briefings

The National Association of Manufacturers was engaged by the U.S. House of Representatives China Task Force to provide input on key topics such as strengthening manufacturing supply chains in the United States, and promoting workforce development and immigration policies that close the manufacturing skills gap. They also worked together to devise targeted approaches to strengthen national security and promote effective strategies to level the playing field on trade for manufacturers to compete with China.

The recently released task force report includes:

  • Trade agreements – Congress and the Administration should ensure the aggressive enforcement of the U.S.-China "phase one" trade deal and set a clear strategy for "phase two" negotiations. The report also broadly supports trade agreements and negotiations as a tool to strengthen global relationships and better compete with China.
  • World Trade Organization (WTO) reform – The report explicitly calls for Congressional passage of a bipartisan resolution supporting the WTO. It also encouraged the development of new rules and reforms at the WTO to address China’s problematic trade behavior, while calling for a WTO Director-General's election.
  • Supply chains – The report includes various measures and recommended legislation to strengthen domestic production in specific sectors, including defense, rare earths, semiconductors, medical equipment and pharmaceuticals. It calls on the administration to expand partnerships with the private sector to support supply-chain shifts and make securing supply chains a priority in trade and economic discussions with other countries.
  • Technology and export controls – Congress should fully implement all recent changes to export control laws and regulations, including swift implementation of the Export Control Reform Act. The reform act includes the implementation of export controls on emerging and foundational technologies.
  • Export financing – The report supports critical U.S. export finance efforts, such as those at the Export-Import Bank and the U.S. International Development Finance Corporation, as part of efforts to counter China’s Belt and Road Initiative.

6 Perspectives for U.S. Manufacturers & Distributors with Relationships in China

  1. Historically, China has been a manufacturing destination due to its low cost and large labor supply. Many U.S manufacturers that had substantial investments in Chinese supply chains are now diversifying to low-risk and cost-effective locations such as South East Asia and Africa. While seeking diverse supply chains, businesses must also remember to double-check country risk for even the smallest component used in production.  
  2. Notwithstanding number one above, most U.S. manufacturers and distributors are not pulling out of China. In some instances, they are investing more in China to serve the local market. In other situations, where there is a need for a massive scale and in some applications quality, China remains the preferred destination.
  3. The weakest link in the post-COVID supply chain is not getting people back to the production floor but rather the overall logistics associated with getting product through China and on to maritime vessels. Transportation was hit hard during the pandemic, with many ships sitting idle. We expect the shipping capacity to be tight and freight rates to rise as port bottlenecks develop. Companies should issue purchase orders and book shipments as early as possible. This additional cost of transportation could add pressure on consumer prices.
  4. The fragility of "Just in Time" and lean manufacturing were highlighted during the pandemic. Manufacturing operations can reduce this risk by carrying additional raw material inventory. However, maintaining high levels of finished goods poses its own risk as consumer demands are likely to be volatile in today’s environment.    
  5. Have your compliance house in order. Local Chinese governments’ tax bases were severely eroded during the crisis, leaving many foreign-invested enterprises the subjects of audits by their local tax bureaus. China’s laws are often intentionally vague. The tax code is likely to be reinterpreted as local governments become desperate for funds. Secondly, verify the integrity of your supply chain. U.S. agencies have recently issued new rules requiring the U.S. not to receive any goods made with forced labor from Xinjiang or Tibet. 
  6. For U.S. manufacturers and distributors with operations in China, your business will be the last to be considered for a loan or any trade credit from the Chinese government in difficult times. Cash is the ultimate insurance policy in any crisis. U.S. businesses in China should reassess their transfer pricing and dividend repatriation policies. They might also need to pay deposits to keep afloat small suppliers that supply critical components to production.

For Further Discussion

Reach out to Tom Bonney or Jay Boyle to share your thoughts and ongoing perspectives on this topic.

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