Supply chain reconfiguration set to accelerate, benefitting se asia

Over the last three decades of rapid globalisation, global corporations created new supply chains by breaking down production processes and allocating slices of production to locations which could produce them most efficiently. This helped to create production networks that spanned many countries, with a particular product often crossing borders several times before the final good reached the consumer. China was at the centre of this network, with Southeast Asia playing an important role as well. Now, a confluence of factors is helping to reconfigure these supply chains. The resulting relocation of production is likely to be an important factor shaping the Southeast Asian region’s economic prospects in coming years.

Several themes stand out as we survey recent trends in this reconfiguration. First, the process seems to be speeding up. Second, how this reconfiguration actually occurs is itself changing, with some signs of more re-shoring and near-shoring rather than the offshoring which is what benefits our regional economies. Third, even though China remains a highly competitive place for manufacturing,activities are still moving out of China – this is probably because the geo-political concerns are so compelling that companies find that there is little choice but to accept the inefficiency that comes along with reconfiguration. Fourth, while the emphasis has been on reconfiguration in manufacturing activities, new trends are emerging in the offshoring of business services, which will benefit India and the Philippines, often seen as laggards in manufacturing.

The process of reconfiguration is accelerating

Studying corporate announcements, we notice that there has been an increase in the number of companies deciding to move production. There are good reasons for this pickup in the momentum of supply chain reconfiguration.

First, many companies had planned to restructure their production networks but their plans had been disrupted by the pandemic. Now that the pandemic has been declared over by the World Health Organisations, companies are dusting off those plans and actually implementing them.

Second, firms have realised that geo-political risks have deteriorated in the meantime, with little sign of the frictions between the US and China easing. If anything, the tensions between the two have intensified and both sides are taking more aggressive actions against the other. The Ukraine war has also forced companies to look at political risks more closely. Where war or other extreme political shocks were considered highly unlikely in the past, some firms have now changed their view. A war, say over Taiwan, is now not so unthinkable any more. In addition, many firms were shaken by policy decisions in China. The extreme restrictions to tackle the pandemic disrupted production in unexpected ways. Recent changes in the Chinese government’s approaches to foreign companies have also worried these firms – such as the arrests of some expatriate staff for espionage. Global corporations that might have hesitated to undertake the onerous and risky process of reconfiguring their production are therefore coming to the conclusion that they can no longer avoid a restructuring.

Third, an additional inducement for a makeover in production operations has been the game-changing shift in industrial policies in developed countries. The US and Europe have adopted policies to encourage and indeed favour domestic production. The case for re-thinking existing production networks has therefore strengthened as the incentives to change have become more attractive.

Fourth, there is a shift in consumer sentiment and among corporate buyers, which compels firms to shift out of China. Dell’s CEO noted that his firm is “intently focused” on purchasing components from outside China after pressure from customers to do so.

The restructuring of production is taking on new forms

A firm faces several choices as it sets about reconfiguring their production grids. If activity has to move out of China, it could be offshored – i.e., moved to another low-cost production base which could be distant from the final consumer of that good. Or the manufacturing process can be “near-shored” or moved to a low-cost production base geographically close to the final consumer. Or it could be “re-shored” or brought back to the developed economy from which it had been moved. More recently, another phrase has entered the jargon – “friend-shoring” where the activity is moved to an ally of the firm’s home country.

If we study recent corporate announcements, we can see a shift in the patterns of reconfiguration.

First, where before near-shoring was not so prominent, it now looks like more firms are considering this option. Perhaps because of concerns of resilience of supply chains during a crisis or because rapidly changing consumer preferences make a nearer production base more attractive, more producers seem to be shifting production out of China to a low-cost production base close to the final market. Mexico is an undoubted winner in this respect. Since 2020, US imports of manufactured goods from Mexico have grown by 26%. Many US and European companies have added production capacity in Mexico: in 2022 – including Tupperware, Hasbro, Tesla, and Mattel. More industrial parks are being built in Monterrey while industrial parks are almost at full capacity in Tijuana. We expect Turkey and Morocco to also gain from this trend as these economies have competitive manufacturing sectors and preferential access to the European market.

Second, while re-shoring remains the choice of a small minority of global firms, there are a few more companies moving production to the developed-country home base. The Kearney Reshoring report for 2022 found that 46% of surveyed CEOs expect to execute a reshoring strategy in the next three years: that is more than double the share in 2021. Additionally, Kearney’s 2023 CEO survey finds that 96% of surveyed CEOs who considered reshoring their operations, have decided to re-shore, or have already re-shored, an increase from 78% in 2022.

Third, notwithstanding these trends, most firms still seek to offshore their production if they are restructuring operations. Where this is the case, the change is that whereas Vietnam was an overwhelming favourite for offshoring, other countries are also gaining in the reconfiguration process. Countries such as India, Indonesia, Malaysia and Thailand are also being considered.

Firms are moving even where this results in a loss of efficiency

The movement of more production to India – despite concerns over infrastructure, government regulations, an inadequate base of component suppliers and issues with the availability of skilled labour – is instructive. It strikes us that geo-political compulsions are now so strong that companies will restructure their production grids even at some cost to efficiency.

What is also interesting is that companies are finding ways to mitigate the challenge by coaxing their efficient sub-contractors and suppliers from China to move with them so as to create a viable ecosystem elsewhere. An example is how one of the world’s largest wind-turbine manufacturers built two new factories in south India to replace production once undertaken in China. The company managed to persuade 85% of its suppliers to join them in shifting to India.

India is in a unique position because its large potential consumer market is a huge draw for global corporations. Given expectations that its economy will continue to expand at a pace that will double the size of its economy every 10-11 years, India offers a scale of upside in consumer spending that no other country can match. In this context, global firms may be willing to tolerate some degree of efficiency loss in order to establish a manufacturing presence there.

Reconfiguration is also beginning to be evident in services

Supply chain reconfiguration is often seen as only evident in manufacturing. But we are also seeing supply chains in the service sector also undergo changes.

An example is in accountancy. For reasons that are not very clear, the United States is producing far fewer accountancy graduates than in the past. Concerned about the lack of supply of such staff, a firm like BDO USA is now planning to double the size of its offshore workforce. Out of the 12,000 staff on its payroll, BDO USA plans to have 5,000 at its offshore joint venture “BDO Rise” within five years. The firm is reported to be planning to add thousands of jobs overseas, largely in India where it already has 2,000 people.

While India is likely to be chief beneficiary of this shift, other countries could also gain. The Big Four accounting firms have been setting up significant offshore bases focusing initially on India. But we are now seeing them establish such services bases in Malaysia, Argentina, China, Mexico and the Philippines. Some of these firms now employ almost as many people outside the US as they do in it.

In other words, supply chain reconfiguration is not only restricted to manufacturing but can also be found in services to some extent. In Asia, we believe that India and the Philippines will be winners from this trend even as others such as Malaysia to be the main winners.

Final thoughts – what other changes should we expect?

Supply chain reconfiguration is going to accelerate and the early winners such as Vietnam will not be able to absorb the volume of production shifts that are likely. Policy makers in developing countries can now see the huge opportunities that are opening up if they can secure a good part of this production relocation. Since no other country can offer the size of the market like India can, these other countries must think of other ways of enhancing their credentials as new destinations for manufacturing and services being offshored. What can they do?

First, one reason why Vietnam was so successful was its aggressive pursuit of free trade agreements that gave it an extraordinary level of trade connectivity and market access. So, countries that once disdained high-standard trade agreements such as the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP) may now decide to take the plunge. For example, now that the elections are over in Thailand, we would not be surprised if the new government overcomes internal opposition and puts in an application to join the CPTPP.

Second, since foreign direct investment will go into the economies that have the right balance between affordable labour costs and skilled workforces, countries need to expand their skills development programmes, particularly in vocational training.

Third, more countries are pursuing industrial policies more aggressively so as to attract investors – a trend that could become more pronounced. India has its Production Linked Incentives scheme where companies are given financial incentives to increase production of selected products in the country. This scheme has been credited with India’s success in the export of mobile phones. India has gone from making 9% of the world’s smartphone handsets in 2016 to a projected 19% this year according to some analysts. Indonesia has also pulled off a success with its export ban on nickel which resulted in massive investments in nickel-related industries such as nickel smelting, batteries and electric vehicles. As a result, Morowali in Sulawesi has become a new pole of growth in Indonesia. However, experience shows that industrial policies have to be carefully designed otherwise there could be downsides.

In short, there will be big changes in supply chains in coming years and those countries that get their policies right will be the main winners.