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Trade and geopolitics

Supply chains are trying to diversify. Will ASEAN step in?

Published 01 June 2022

China's strategic miscalculations in recent years may present an opportunity for ASEAN nations to assume a larger role in global supply chains. With their long-standing economic linkages to the region, Japan and the European Union could be the key players in accelerating supply chain diversification into Southeast Asia.

What happened to supply chain diversification?

As the combination of China’s “zero Covid” policy and Russia’s invasion of Ukraine wreak havoc on global supply chains, the likelihood of an accelerated redistribution of global manufacturing production is rising.

During the last four years, talk has been plentiful of the need to diversify the supply chain, thereby increasing its resilience. However, little tangible progress has been made.

According to World Bank data, China’s share of global manufacturing value-added has continued to rise throughout the period of friction between China and the United States. In 2016, China commanded a 23% share of global manufacturing. By 2020 (the latest available data), China’s share had risen to 31%.[1]

World Bank data draws on national accounts data and, therefore, is only as good as the national GDP statistics. With that in mind, the direction of travel, if not the magnitude, is corroborated by China’s share of global exports. Between 2016 and 2020, China’s share of global exports rose from 13% to 14.6%.[2] Furthermore, according to the State Administration for Foreign exchange (SAFE), China’s goods exports in 2021 grew by 28% in dollar terms, implying further market share gains.[3]

Thus, despite all the talk, the world’s dependence on China for manufactured goods has risen, not fallen, over recent years. Perhaps this should not be a surprise given that China’s total gross fixed capital formation is larger than the United States, Japan, and Germany combined. For ASEAN countries, however, the combination of this and the current hiatus in supply chains may well present an opportunity.

ASEAN’s opportunity

The ten ASEAN member states have a combined GDP of about US$3 trillion and a population of 660 million. They have long been enmeshed in the global trading system and indeed have trade-to-GDP ratios well above global averages. With per capita GDP of US$4,500, ASEAN member countries in aggregate now represent a far less costly source of labor than China.

Indeed, in aggregate, ASEAN’s export performance between 2016 and 2020 has more or less matched that of China. ASEAN’s exports grew 21%, from US$1.15 trillion to US$1.39 trillion, while China’s grew 23% from US$2.1 trillion to US$2.59 trillion.[4]

However, from the perspective of economic actors viewing ASEAN as an alternative supply source to China, two factors must be considered.

Firstly, much of the growth in ASEAN trade has been with China itself. ASEAN’s exports to China grew 51% between 2016 and 2020, while exports to the rest of the world grew by 16%. While exports to China account for only 15% of total exports, their recent rapid growth has fed a narrative that ASEAN’s economic future is intertwined with China’s.[5]

Secondly, ASEAN economies are increasingly dependent on China for imports that feed into their exports. Imports from China grew 33% while imports from the rest of the world grew 13.8%.[6] This backward integration into China reduces the importance of ASEAN as a source of risk mitigation. Any interruption to trade with China would quickly feed through into trade with ASEAN if producers in Southeast Asia could no longer source key components from China.

The role of the EU, Japan, and others

Much of the discussion around dependency on China has been linked to the US-China rivalry. But the war in Ukraine and the pandemic-induced supply chain disruptions have broadened the number of countries currently assessing the risks to their supplies posed by unforeseen events.

Furthermore, it is a mistake to assume that only the US and China have economic interests in ASEAN. Japan has long been a key development partner for Southeast Asian nations and European countries have deep and long economic linkages to the region.

Looking at FDI flows into ASEAN in the last five years, the European Union (when combined with the UK) invested slightly more than the United States, with each accounting for about 12% of total FDI inflows. Japan accounts for a further 12% of investment. Combined, South Korea and Taiwan account for a further 6%. China accounts for only 8% of FDI from the last five years, although a truer picture would arise if Hong Kong’s investment tally is included with China’s. The total would then rise to 15%.

Not all of Hong Kong’s FDI will ultimately stem from China. The 15% number should be treated as a maximum. It is clear that the vast majority of FDI into ASEAN – 85% plus – does not come from China.

The US-led effort to reduce dependency on China may not have born much fruit yet, in part because its multinational corporations are notoriously independent from government set agendas. In the EU, Japan and Korea, the linkages between the corporate sector and government run much deeper. In these countries, governments potentially exercise a greater degree of sway over economic actors.

A further issue is that supply chain diversification is expensive in terms of new investment. This duplication is a real cash cost, while the risk posed by supply concentration is a theoretical cost until the risk materializes, as it is happening now. Furthermore, part of the rationale for China-based manufacturing is to service the domestic market in addition to overseas markets. Until very recently, the narrative around China’s future growth has remained extremely positive in most people’s minds.

Another important factor is that an increasing proportion of Chinese exports are from Chinese companies rather than MNCs and hence perhaps more “sticky”.

The question then arises: How fast could these FDI flows (and indeed domestic investment) be used to turn ASEAN into a truly vertically integrated manufacturing hub that is not reliant on backward integration into China? Can ASEAN truly become an efficient source of risk diversification for supply chain managers seeking to lower dependency on China?

Current investments have not been sufficient. The EU, UK, US, Japan, Korea, and Taiwan have invested a little more than US$500 billion into ASEAN in the past five years, of which only US$150 billion has been for manufacturing. That amounts to US$ 30 billion a year – or almost the same amount of total manufacturing FDI into China, per official numbers. Far from capital constraints, a certain degree of institutional obstinacy may be perpetuating the world’s manufacturing dependency on China.

Of course, China’s scale and indeed skill in manufacturing, as well as mercantilist policies, were also key drivers in obtaining market share; these factors created the value opportunity that market economies sought to exploit. These attributes have served MNCs well over the past twenty years and there is a natural reluctance to explore alternative investment destinations. Until the pandemic, the China operations of MNCs enjoyed growing importance within MNC structures and the importance of a “China strategy” has been repeated time and again to shareholders as a differentiating management policy. This makes it harder to back-track from because, in extremis, it requires a “mea culpa” that putting all the shareholders’ eggs in one basket was a mistake.

With their long histories of state-guided industrial policy, Japan and the EU could well be the key players in accelerating diversification. The passing of Japan’s new Economic Security Law and the EU’s Global Gateway policy are the most recent manifestations of close government-corporate cooperation in industrial policy.

Indeed, China followed many facets of the development models forged by Japan, Germany, and South Korea. It is ironic that, in the current political economy, “democratic-mercantilists” may lead the global push for supply chain resilience at China’s expense.

Perhaps President Xi Jinping’s biggest miscalculation in recent years is twofold. Firstly, he may have underestimated the impact of the war in Ukraine on Europe’s and Japan’s view of economic security – and what such a misjudgment means for Chinese manufacturing dominance in the future.

Secondly, he may have underestimated the degree to which the costs of his zero-COVID policy may induce policy responses from both importers and alternative production destinations to challenge China’s domination of supply chains. Given the balance of ASEAN’s investment and trade linkages, Southeast Asia is well placed to benefit from these miscalculations.

1. World bank open database.
2. Ibid
3. SAFE balance of payments data.
4. ASEAN database and World bank open database.
5. ASEAN database.
6. ASEAN database.

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Stewart Paterson

Stewart Paterson is a Research Fellow at the Hinrich Foundation who spent 25 years in capital markets as an equity researcher, strategist and fund manager, working for Credit Suisse, CLSA and most recently, as a Partner and Portfolio Manager of Tiburon Partners LLP.

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