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  • Writer's pictureMMGMC

The Great Decoupling

Why Corporations Must Drive Supply Chain Security By Diversifying Away From China

Let's face it. China ate our lunch in manufacturing.

Since China's 2001 entry into the World Trade Organization, China has successfully organized its massive population, created world-class infrastructure, and leveraged predatory domestic market access tactics and intellectual property appropriation to aggressively industrialize at the expense of the West.

According to World Bank figures, China represented just 9.4% of global manufacturing capacity in 2005 with the U.S. and Japan being number one and two at 21.8% and 13.5% respectively. By 2020, China had propelled itself to the top spot with 28.5%, while the West's share declined from 70.5% to 53.2% (including Japan and South Korea), a 17-point decline almost exactly matching China's 19-point gain.

The globalization engine that has lifted over 1.2 billion people out of poverty in just 30 years and raised living standards across the rich world has recently sputtered, with China becoming the West's declared geopolitical rival.

According to Pew Research, a full 82% of Americans now have a negative view of China, compared to a neutral perception just five years ago.

The first inklings of trouble were the 2019 Trump China tariffs followed by outright supply chain chaos in the wake of the COVID shut-downs and reopenings. More recently, the Russian invasion of Ukraine, inflation, China's persistent threat to Taiwan, and a frightening baby formula shortage have brought the otherwise arcane workings of the global supply chain into stark public focus.

It's also undeniable that the Biden administration failed on supply chain security.

The Biden administration's 2021 "Executive Order on America's Supply Chains" instructed seven departments to prepare detailed reports, correctly stating that "...more resilient supply chains are secure and diverse — facilitating greater domestic production, a range of supply, built-in redundancies, adequate stockpiles, safe and secure digital networks, and a world-class American manufacturing base and workforce"

A year later the reports are in, including the Department of Energy's which somehow became a report on "Securing the American Clean Energy Supply Chain" with an entire section devoted to "wind supply chains", while regular Americans can't afford gas and get their hands on baby formula.

The administration has lost serious credibility on supply chain security, and things will get worse in the short-run as the Fed's tool kit of demand-reducing actions cannot address supply shortages in highly inelastic food and energy markets.

Should we look to the private sector? The diversification of supply chains is a more massive undertaking than we think.

Companies act when lost sales due to unavailability of supply exceed the cost advantage of China sourcing, when alternative sources are available. In the long run this is a solvable problem. By 2050, China will represent only 18% of the global workforce vs. 23% today, with the non-Western, non-China labor force projected to be 2.7 billion or 64% of the global labor pool, many at much lower manufacturing wages levels than China's.

In the short-term, however, there simply isn't enough non-China industrial capacity available and a run for the exits could look like a game of musical chairs. Radical suggestions like "Reshoring" and "Friendshoring" are just catchphrases with little practical relevance.

Most corporations have barely enough staff and capabilities to maintain their existing supply chains. Reconfiguring supply chains from a cost focus to a resiliency model is a critical and massive undertaking that will require years and large investments to accomplish.

Strategically sourcing new supply chains requires a highly analytical approach. Buyers and suppliers need to negotiate new long-term relationships that have teeth, i.e. committed pricing that incorporates changes in raw material costs, labor, and parts specification and covers the entire volumes of purchases. Too often, the "tail" of thousands of smaller purchases are completely unpriced and contain excessive supplier margins.

Buyers need a more detailed understanding of supplier economics, but unlike Pentagon-style cost-plus pricing, smart buyers use competitive cost models, where key cost components are competitively bid and then reassembled to form the basis of long-term pricing agreements. As a case in point, suppliers are now pushing through price increases due to inflation with many buyers not having any sense of how much is justified and how much is incremental supplier margin.

China is not invincible. Its key comparative advantage is still a large and low-cost labor force, versus the West's knowledge, innovation, values, and culture. The same playbook that enabled China's development over the past twenty years can be used to diversify away from China. The problem may be tedious and complex but is eminently solvable, with corporations doing most of the heavy lifting out of economic self-interest.

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