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Cutting China From Supply Chains--Easy To Say, Hard To Do

Chart 1


(Editor's note: This is a cross-divisional thought-leadership report issued by S&P Global with contributions by S&P Global Ratings and S&P Global (China) Ratings. Each are separate, individual divisions of S&P Global/SPGI. This report does not constitute a rating action, neither was it discussed by a rating committee.)

Trade disputes and pandemic disruptions raised questions on China's position as the world's factory. The country relies on free-flowing trade and open access to offshore markets. Recent COVID lockdowns and ongoing trade tensions work against this. S&P Global Ratings believes China's record of maintaining and building on its central role in global production underscores the resilience of its export engine and the pull it continues to exert on manufacturing supply chains.

This resilience is somewhat counterintuitive. The country's labor is no longer especially cheap, and Beijing's "dynamic-zero" COVID policies expose it to lockdowns that disrupt producers. Under the pandemic's transport disruptions, regions such as the U.S. and Europe are becoming wary of their dependence on goods made in China.

Despite these tensions, global product makers continue to keep most of their plants in the country. Entrenched production infrastructure, proximity to suppliers, and large pools of skilled, trained labor make major relocations unattractive. China's vast, fast-growing markets are also incentivizing them to build more facilities for production and research and development. These factors are long term in nature and are likely to remain at play beyond current lockdowns, as such measures have proved to be temporary so far under the pandemic.

This phenomenon is perhaps most apparent in two global sectors: autos and technology hardware. We examine both to illustrate the gravitational forces pulling entities and production to China. The auto case shows how supply chains are drawn to China, while the tech case shows how difficult it is for firms to leave once they are embedded there.

Although disruptions can come from current headwinds, these cases show how China plays a critical role in certain industries--now and in the future.

Tension And Pestilence Test Resilience Of China's Production Share

Trade tensions, pandemic disruptions, and rising calls to be less dependent on Chinese production have complicated China's place in global supply chains. China is exposed to these headwinds. Its share of exports to the U.S. has been on a declining trend as trade frictions intensified from 2017.

Yet China retains its hold on global production. Its share of global exports has more than doubled since 2000 to the current 17.4%. It has also recovered some lost ground in the past two years as COVID disrupted production in other countries (see chart 2).

Compared to before the trade war, imports from China are now much higher in the EU and just moderately lower in the U.S. (see chart 3). This is the case even though the country's market share eased as commodity price rose and as production and exports from other countries recovered from COVID dislocations.

This may sow the seeds for more trade friction. The push to boost domestic production and to regain control of supply chains from China have become nothing less than proxy battles in the global geopolitical competition.

Chart 2


Chart 3


To this end, China has launched broad policies such as "Dual Circulation" while the U.S. has erected sweeping trade barriers and technology controls. More will follow in the years to come. COVID has only exacerbated tensions by causing transport disruptions that challenged globally distributed supply chains built to minimize costs.

Ironically, these factors may reinforce rather than weaken China's place in global manufacturing. As producers manage supply chain squeezes triggered by COVID or by a fresh round of tariffs, they are rethinking logistics.

The solution for many: move production and supply chains physically closer to your largest and most promising markets. For vertically integrated industries that rely on economies of scale to control costs, this means larger and larger parts of the supply chain need to be situated in those markets.

The Tug Of China's Large, Fast-Growing Markets

This phenomenon is clear in the auto industry. China has one of the largest and fastest-growing car markets in the world. It grew at a compound annual rate of 13% over the last two decades, and now accounts for a third of global sales.

These factors, along with technological momentum, are getting the attention of global manufacturers. This force is reshaping the auto industry and has persisted so far through the pandemic and the trade war.

As trade confrontations intensified, China's share of global auto sales and production dipped by one and a half percentage points over the three-year period between the end of 2016 and the end of 2019. However, the lost ground was regained and surpassed quickly thereafter as COVID spread around the world (see chart 4).

Chart 4


This resilience is in part due to the potential for further growth in China's auto market. Despite decades of rapid expansion, passenger vehicle ownership in the country remains low. In 2021, China had 206 cars per 1,000 people, less than a quarter of that in the U.S. (901) and less than a third of that in Western Europe (653).

According to research by the Chinese Automotive New Consumption forum, Generation Z consumers in China--those born in the mid to late 1990s--are ready to spend more than twice as much on big-ticket items such as autos compared with their peers in the West. As this generation of buyers gains purchasing power, auto sales in China should grow faster than those in the U.S. and Europe.

These factors imply substantial room for growth over the long term. This is a key attraction for global manufacturers. While relative production levels have stagnated in the U.S. and declined in Europe and the rest of the world, that of China continued to climb over the past few years (see chart 5).

Chart 5


The European Auto Case: Deep Roots Against Coming Headwinds

The European automakers illustrate well how the lure of China's market on global manufacturers has strengthened over the years.

These firms have been making cars in China for decades (see sidebar). They are drawn by the country's growth and supply-side advantages. Factors such as supportive governments, proximity to raw materials, and cost-effective labor and components create conducive conditions for them to set up facilities in the country--and for their suppliers to follow.

China's consolidated regulatory framework is also attractive to European firms that spent much of their time and resources navigating the fragmented regulatory landscape of the EU.

From a small base in the early years, European firms have built their operations in China into a sizable part of the market, much larger than that of their U.S. peers. Their joint ventures now capture a fifth to a quarter of the passenger vehicle sales in the country (see chart 6a), versus 9%-10% of U.S. brands.

Chart 6a


Chart 6b


The long journey and sizable presence of European automakers have given them deep roots in China that have proved resilient to trade tensions. The Chinese government previously required foreign automakers to set up joint ventures with local firms to access its markets. This requirement was lifted last year to allow global firms to further deepen their footing in the country.

BMW AG has increased its stake in a joint venture with local partner Brilliance China Automotive Holdings Ltd. to 75% from 50% in February this year. This came just a month after Stellantis N.V. announced its intention to increase its stake in a 50-50 joint venture with Guangzhou Automobile Group Co. Ltd. to 75%. More global manufacturers may follow despite trade and geopolitical tensions.

In the early stages of their presence in China, European firms' partnerships with local carmakers mainly focused on building manufacturing capacity. Their rapidly expanding production base in the country attracted supply chains and auto-part suppliers, whose revenues in China grew fivefold over the past 10 years (see chart 6b).

New Pull Factors From A New Industry

The Chinese government sees electric vehicles (EV) as a strategic sector. It has pushed a series of wide-ranging initiatives to promote the growth and technological advancement of the industry throughout the EV supply chain (see table 1 in the Appendix).

Despite COVID, China's EV sales doubled last year from less than 1.5 million units to over 3 million, exceeding that of the U.S., the EU, and the rest of the world combined (see chart 7). The country's momentum in this emerging sector is the latest lure for global manufacturers.

Chart 7


The U.S. Tech Case: When Supply Chains Are Entrenched In China

Globalization and China's entry into the World Trade Organization in 2001 has led the manufacturing of technology hardware to become ever more entrenched in China.

Producers have redesigned supply chains over past decades with China at the center. While the European auto case shows how China's large market drew supply chains to its shores, the tech case shows how challenging it is to relocate once they are entrenched in the country.

An Industry Well-Suited For Global Production

The costs of shipping tech products is minor relative to their value. This allows firms to source globally and maximize efficiency gains from comparative advantages across regions.

As a result, tech hardware supply chains are designed to cluster manufacturing facilities around a center. This set-up reduces supplier delivery time and minimizes the many process steps between suppliers and manufacturers. It also enhances production flexibility to help firms meet changes in customer demand quickly.

This clustering is crucial, given hundreds of parts go into smartphones, servers, notebooks, etc. from different parts of the world, and as the production process often requires works-in-progress to be shipped back and forth.

The final assembly mostly takes place in China due to its skilled labor, developed infrastructure, business-friendly regulations (see table 2), and proximity to suppliers and end-markets in Asia. These efficiencies made China the preferred destination for manufacturers and led them to set up hubs throughout the country for key technology products (see chart 8).

Chart 8


Trade War, COVID Led To Many Questions But Limited Action

Trade confrontations and COVID disruptions have prompted policy makers and industry leaders in some countries to question whether tech supply chains are overly concentrated in China.

Under these tensions, hardware makers have considered reducing their reliance on production in China. Yet, relocations away from the country so far have been limited to certain products or to marginal capacities.

For example, Google LLC plans to shift the production of its new Pixel phones to Southeast Asia. Microsoft Corp. plans to move the production of its personal computers to Southeast Asia.

Dell Technologies Inc., HP Inc., and their manufacturers Quanta Computer Inc., Inventec Corp., Compal Electronics Inc., Pegatron Corp., and Wistron Corp. have also contemplated relocating some assembly to Southeast Asia, Mexico, and Eastern Europe.

These plans, however, are far short of a reorientation of their global production footprint. For smaller original equipment manufacturers (OEMs), such plans are not likely to be considered at all, given they do not have the scale, efficiency or leverage to negotiate for preferred treatment elsewhere.

As a result, the overall effect of the trade war and COVID are not particularly visible in China's tech production and export volumes. Traditional industry factors, such as cyclicality, have so far had a much greater influence on the industry than geopolitical factors.

Chart 9a


Chart 9b


Breaking Up Is Hard To Do

Why are tech hardware makers resistant to relocating from China? The country no longer offers the lowest labor costs when compared with Southeast Asia and Eastern Europe. However, it is structurally embedded in many tech supply chains, making it difficult and costly for manufacturers to relocate.

Technological advancements in even basic hardware such as mice and keyboards mean that competitiveness is increasingly less about just labor costs. It still typically makes more economic sense to add rather than reduce capacity in China, factoring in logistics, set-up costs of new facilities, availability of skilled, trained labor, and the lower productivity of start-up operations.

A major relocation away from the country may also incur disruption risks. It could lead to push-back from local stakeholders concerned about job losses and slower growth.

It may also alienate Chinese consumers, who have boycotted brands for perceived slights in the past. For example, boycotts triggered by a U.S.-South Korea missile agreement in 2017 hit Samsung's then 20% smartphone market share. This gave an opening to Chinese brands, which subsequently pushed Samsung's market share to the current single digits.

These factors mean that any capacity diversification away from China will be gradual and carefully considered, and will likely require the help of subcontractors with established footprints elsewhere. It may also be confined to new products or marginal capacities.

Why It's Not Easy For Apple To Be Far From The Tree

Among hardware OEMs, Apple Inc. has been particularly reluctant to move its core manufacturing and assembly base away from China despite rising trade and geopolitical tensions.

The production of its iPhones, Macs, iPads, and wearables are well established in the country. The supply chains of these products are complex and difficult to relocate. Their component suppliers are concentrated in China, as are highly skilled labor that have been trained over decades to Apple's quality standards. Similar time may be needed to replicate this set-up elsewhere.

Apple also wants to maintain proximity to Greater China, the region with the world's most populous consumer base, one that accounted for a fifth of the company's total revenues last year.

Given this, diversification efforts have been limited and confined to strategic areas. For example, it moved the production of some AirPods to Vietnam to leverage the country's growing audio expertise. It moved limited iPhone assembly to India to avoid a 20% tariff on imported smartphones. It also moved the production of certain advanced products (for example, the Mac Pro) to Texas due to their complexity.

Apple, through its contract manufacturer Hon Hai Precision Industry Co. Ltd., will manufacture more of its products in India and elsewhere to diversify production and access emerging growth markets. However, this will be a long process across many decades for Apple as well as many of its U.S. tech peers.

The Convergence--China's Pull On The Future Of Auto And Tech

The futures of the auto and tech firms are becoming intertwined in China in the emerging electric vehicles (EV) and autonomous vehicles (AV) industries. Both are finding fertile grounds for growth and R&D in China, adding to the country's lure for future supply chains.

EV penetration rates in China have doubled in the past few years to three times that of the U.S., and similar to that of Europe (see chart 10). Active government promotion was a key contributing factor behind this rapid adoption.

Chart 10


China is pushing the development of EVs and AVs and is promoting areas critical to the future of these industries. The government's highest levels have specified goals in these areas in the country's long-term plans, and top ministries and state organs have been implementing related policies (see table 1).

Progress in these areas are particularly important to AVs. These vehicles bring together the tech and auto industries through its advanced technology requirements. Semiconductors with high processing power and energy efficiency, 5G technology that facilitates data capture and communication, and operating systems that can process mobility data in real time will be vital for the functioning of these vehicles.

Past cases show the importance of first-mover advantages and global standards-setting for emerging technologies (see sidebar). Chinese policymakers appear to be guided by these lessons in areas such as 5G, internet of things, artificial intelligence, and clean energy.

The "China Standards 2035" plan shows this recognition by laying out long-term strategies for these industries (see table 2). It expands on the goals of "Made in China 2025" to promote Chinese high-tech firms. These plans involve providing subsidies, developing intellectual property, encouraging public-private collaboration, and integrating new technologies into future supply chains.

Such programs have encouraged a tripling of tech investments under public-private partnerships in China in recent years, to over Chinese renminbi (RMB) 1.2 trillion per year (see chart 11).

We expect the country to make progress toward these goals, which will help attract global manufacturers and their supply chains to the country.

Chart 11


The Draw One Sector Can Exert

China's current edge in the EV sector is in part due to the strength of its battery industry.

The country makes half of the world's EV batteries, with production volumes that exceed Europe by a third, the U.S. by three times, and the rest of the world, by seven times (see chart 12a).

Chart 12a


Chart 12b


Critical mass of that scale provides advantages in not just production but also research and development. In China's case, this applies throughout the supply chain, given the country also has a leading share of most steps in the EV battery production process (see chart 12b).

Global automakers have clear competitive advantages in the R&D and design of vehicles built on the traditional internal combustion engine. However, electric vehicles changed the industry. As the EV industry advanced, its center of gravity shifted to China, where the production of battery and electronic components are concentrated. Since batteries are a core technology behind EVs, they are key to the industry's future as it transitions from mechanics to mechatronics.

These dynamics mean that China, as a center of world battery production, is also positioned to become a global R&D hub for EVs. Other facilitating factors include vast markets, developed supply chains for auto and tech, and large pools of engineering and computer science graduates that support both ecosystems. These factors may be behind Tesla Inc.'s decision last October to set up its first R&D center and engineering team in China.

Some Chinese battery makers are also helping to attract global manufacturers as they leverage their critical mass to innovate. For example, Contemporary Amperex Technology Co. Ltd., the world's largest EV batteries supplier, licensed its cell-to-pack technology to Hyundai Mobis Co. Ltd. last year. Zhejiang Geely Holding Group Co. Ltd. also signed a memorandum of understanding last year with Renault S.A. to explore opportunities to co-develop energy-efficient vehicles.

We expect to see more technology developed in China over time as the EV and AV industries advance with the help of these factors. This tug on global supply chains is driven by the future rather than the past for both the auto and tech industries, providing the country added resilience against coming headwinds and temporary disruptions, whether from trade tensions or pandemic lockdowns.


Table 1

China's Policy Support For Batteries, Electric Vehicles, Intelligent Vehicles
Policy name, issuing department, and description
September 2013 Notice On The Continued Development And Broadening Application of NEVs (MOF, MST, MIIT, NDRC): launched purchase subsidies for buying NEVs.
April 2015 Notice on the 2016-2020 Financial Support Policy for the Promotion and Application of NEVs (MOF, MIIT, MST, NDRC): stipulates amount, products, standards, and requirements for firms to receive subsidies, and states policy expectations for the development of the new energy auto industry.
November 2015 Notice On The Requirement of Traction Battery Industry (MIIT): first batch of battery manufacturers that are qualified for battery production in China.
January 2017 Regulations on the Access Management of NEV Manufacturers and Products (MIIT): clarifies definitions of NEVs, plug-in hybrids, pure EVs, and fuel cell vehicles.
April 2017 Medium and Long Term Development Plan of Automobile Industry (MIIT, NDRC, MST): promotes coordinated and development of the whole supply chain, establish "whole vehicle-parts" cooperation, improves mechanisms for cost and benefit sharing in innovations, encourage cooperation in R&D and procurement, sets long-term goals for market share of key new energy vehicle firms.
September 2017 Measures on the Parallel Management of Average Fuel Consumption and NEV Credits for Auto Firms (MIIT, MoF, MoC, GAC, GAQSIQ): launches dual-credit scheme to promote production and quality upgrade of EVs, implements fuel consumption credit accounting, sets NEV credit ratio requirements, requires traditional automakers to raise R&D on NEVs, promotes NEV industry.
April 2018 Special Management Measures for the Market Entry of Foreign Investment (Negative List) (2018 Version) (NDRC): announced gradual removal of foreign ownership restriction in the auto industry.
June 2019 Notice to Abolish The Notice On The Requirement of Traction Battery Industry (MIIT): abolished the whitelist of battery manufacturers.
February 2020 Innovation and Development Strategy for Intelligent Vehicles (NDRC, MST, nine other ministries, commissions): promotes innovation, ecology, infrastructure, regulations, standards, supervision, and security for intelligent vehicles; aims for large-scale production of intelligent vehicles capable of autonomous driving or other market-oriented applications.
April 2020 Notice on Improving Financial Subsidy Policy for the Promotion and Application of NEVs (MoF, MIIT, MST, NDRC): extended NEV subsidies period to end 2022; clarifies aims of subsidies reduction for NEVs; optimizes tech thresholds; accelerates withdrawal of backward production capacity; implements differentiated subsidies; improves policy accuracy, and accelerates EV deployment in specific areas.
October 2020 Energy-saving and NEV Technology Roadmap 2.0 (MIIT): sets industry development milestones for 2025, 2030, and 2035; sets goal that, by 2035, NEVs to be half of all vehicle sales, hydrogen fuel cell vehicles to reach 1 million, and all passengers vehicles to be hybrids or fully electric.
November 2020 NEV Industry Development Plan 2021-2035 (State Council): clarifies long-term goals for NEVs. By 2025: make major breakthroughs in key technologies (e.g. batteries, drive motors, vehicle operating systems), reduce average power use of pure passenger EVs to 12.0 kWh/100 km, and for NEVs to be one-fifth of all vehicle sales. By 2035: pure EVs to become mainstream new vehicles sold, public vehicles to be fully electric.
December 2020 Notice on Further Improving the Financial Subsidy Policy for the Promotion and Application of NEVs (MoF, MIIT, MST, NDRC): clarifies subsidy standards for production of different vehicle products; products tested with the old standards can enjoy subsidies if they meet policy requirements; encourage active defect investigations and voluntary recalls; strengthen management of investments and capacity expansions to prevent excesses.
NEV--New energy vehicle. EV--Electric vehicle. MST--Ministry of Science and Technology. MoC--Ministry of Commerce. GAC--General Administration of Customs. GAQSIQ--General Administration of Quality Supervision, Inspection, and Quarantine. kWh--Kilowatt hour. km--Kilometer. NDRC--National Development Reform Commission. NMSAC--National Manufacturing Strategy Advisory Committee. R&D--Research and development. MoF. Ministry of Finance. STA--State Taxation Administration. MIIT--Ministry of Industry Information Technology. Source: Chinese government releases, S&P Global Ratings.

Table 2

China's Push To Compete In Tech And Keep Producers In The Country
Policy name, issuing department, and description
June 2014 National Guideline for the Development and Promotion of the IC Industry (State Council): sets up the National Industrial Investment Fund; focus on developing design, manufacturing, package testing and equipment materials; provides support in all areas (e.g. finance, tax, promotion, talent, foreign cooperation).
May 2015 Made in China 2025 (State Council): defines IC and special equipment as new generation IT industry and included them in the 10 key breakthrough development fields; focuses on: improving IC design and building IP, application adaptability of domestic chips, core chips for national information and network security use, independent capabilities for packaging and testing, high-density packaging and 3D micro-assembly technologies.
December 2016 Guideline on State Informatization for the 13th Five-Year Plan (State Council): promotes innovation in IC; deploys chip design and R&D for new computing, 5G, intelligent manufacturing, industrial Internet, internet of things; promote 32nm/28nm and 16nm/14nm IC production lines; develop 10nm/7nm technology; develop R&D and industrialization of chip-level packaging, wafer-level packaging, silicon through-hole and 3D packaging; and break throughs in electronic design automation software.
January 2017 Guidance Catalogue of Key Products and Services of Strategic Emerging Industries (NDRC): defines IC design and services as key products in the catalogue.
February 2018 Green Paper on Technological Innovation in Key Areas of Made in China 2025--Technology Roadmap 2017 (NMSAC): lays out goals, priorities, strategic support and safeguard measures for 10 key industries including new generation IT; promotes innovation and gathering of resources and social capital in manufacturing.
November 2019 Guidance Catalogue for Industrial Structure Adjustment 2019 (NDRC): promote advanced packaging and testing industries including ball grid array, pin grid array, chip scale, multi-chip, land grid array, system-in, flip-chip, wafer level, micro electro-mechanical system.
August 2020 Policies to Support the High-quality Development of the Integrated Circuit and Software Industries (State Council): support IC and software industries in taxation, investment, financing, R&D, import/export, talent, IP, market application, and international cooperation.
December 2020 Announcement on Corporate Income Tax Policy for Promoting High-quality Development of the Integrated Circuit and Software Industries (MoF, STA, NDRC, MIIT): increased support by launching the first 10-year income tax exemption policy for the industry.
March 2021 Outline of the 14th Five-Year Plan (2021-2025) for National Economic and Social Development and Long-range Objectives through 2035 (State Council): promote IC industries by implementing smart and green manufacturing projects, developing new models of service-oriented manufacturing.
IC--Integrated circuit. IT--Information technology. IP--Intellectual property. 3D--Three dimensions. nm—Nanometer. STA--State Taxation Administration. MST--Ministry of Science and Technology. MoC--Ministry of Commerce. GAC--General Administration of Customs. GAQSIQ--General Administration of Quality Supervision, Inspection, and Quarantine. kWh--Kilowatt hour. km--Kilometer. NDRC--National Development Reform Commission. NMSAC--National Manufacturing Strategy Advisory Committee. R&D--Research and development. MoF. Ministry of Finance. STA--State Taxation Administration. MIIT--Ministry of Industry Information Technology. Source: Chinese government releases, S&P Global Ratings.

Editor: Jasper Moiseiwitsch

Digital Design: Evy Cheung

Related Research

This report does not constitute a rating action.

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