The United States and China remain locked in a scrum over trade, present truce notwithstanding. Beijing is grappling for leverage while struggling to keep its own side intact. One of its greatest risks: Some of the biggest exporters in China could simply decide they want no part of this game, take their ball and go, if not home, to some other low-cost manufacturing hub.

According to a Peterson Institute for International Economics study, the first two rounds of U.S. tariffs disproportionately affected U.S. imports from China-based affiliates of multinational firms, rather than Chinese-owned firms. According to an October study conducted by the American Chamber of Commerce in South China – China’s most export-heavy region – around 85 percent of U.S. companies in the region said they were suffering from the new tariffs, compared to around 70 percent of their Chinese counterparts. In other words, the firms in China hurt most by the trade war are the ones most capable of leaving. More than 70 percent of U.S. firms with operations in China surveyed said they were mulling whether to delay or cancel new investments in China or considering leaving for greener, cheaper pastures altogether. (Just 1 percent of the firms said they were planning on moving operations back to the U.S.)

There have been growing hints that a nascent exodus is underway. Samsung, the world’s largest smartphone maker, which has been increasingly relying on factories in Vietnam and India, announced last week it would end production at its factory in Tianjin. On Dec. 5, Pegatron, a key supplier of components for Apple products, announced it’s moving some production to a new factory in Indonesia. Over the past year, Japan’s Panasonic, Suzuki and Nikon all announced closures in China in favor of Southeast Asian hotspots, including Thailand and Singapore, as well as Mexico. Even Foxconn – the paragon of efficient manufacturing at a staggering scale in China – is reportedly eyeing a move to Vietnam.

But there’s a big difference between “considering relocation” and packing up the moving vans, and that difference will define how bad things get for China. This Deep Dive examines China’s vulnerability as the trade war accelerates the rerouting of global supply chains. It looks at what advantages China’s neighbors can dangle in front of firms eager to avoid U.S. tariffs and rising labor and land costs in China, but also considers the reasons why many firms will opt to keep some of their operations in the Middle Kingdom.

Why Firms Are Souring on China

Multinational firms were eyeing the exits in China long before the election of U.S. President Donald Trump, who rode to office threatening a trade war with Beijing. This happens when a country starts to get rich. As China has become wealthier, the increase in living standards has pushed labor and land costs ever higher and driven political demand for costly environmental regulations. And so Chinese exports have become less competitive, giving foreign firms cause to look to more affordable alternatives. The challenge for China intensified as its neighbors in South and Southeast Asia, in particular, began investing heavily in manufacturing and export infrastructure (particularly since they put the regionwide Cold War chaos largely behind them). In northern Vietnam, for example, wages are little more than half those in the manufacturing heartland of southeastern China. As a result, foreign investment has surged in Vietnam, rising nearly 8.5 percent in the first half of 2018 over the same period in 2017 – itself a record year. Across Southeast Asia, net foreign direct investment inflows jumped 18 percent year on year during the first half of 2018 to $73 billion, according to United Nations figures.

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This ordinarily wouldn’t be all bad news for a country like China. Rising wages generally lead to a more upwardly mobile and less restive populace, and greater consumer power makes a country less vulnerable to a sharp downturn in exports. But the trade war threatens to magnify at least three problems particular to China.

First, the Communist Party of China deeply fears social unrest and thus cannot tolerate the kind of spike in unemployment that would accompany short-term periods of economic disruption. More than 200 million Chinese people work in manufacturing. It’s bad for China if firms hit by tariffs have to start downsizing. It’s a whole lot worse if firms begin abandoning the country altogether and new foreign investment simply dries up.

Second, there are effectively two Chinas. Though the coasts have become wealthy and are scrambling up the manufacturing value chain, like Japan and South Korea did before them, vast swaths of the country – home to hundreds of millions of people – have been left behind, meaning low-skill, labor-intensive manufacturing sectors like apparel are necessary to meet China’s employment needs. (China accounted for just over 30 percent of global apparel exports last year, but this is down from 40 percent eight years ago.) Most of these industries have thus far been spared from U.S. tariffs, but if Trump ever follows through on his repeated threats to effectively tax all imports from China, such operations would be the easiest to move to countries like Bangladesh, Vietnam and Cambodia.

Third, high-value exports like electronics, metals and auto parts – sectors critical to China’s efforts to escape the middle-income trap – are the main focus of the U.S. trade offensive. Exporters in China facing 10 percent tariffs have largely been able to weather the added costs due to a weaker yuan, tax and regulatory changes and the fact that U.S. consumers are absorbing some of the costs. But the tariffs will jump to 25 percent on March 2 if the two countries are, as we expect, unable to reach a comprehensive deal. A 25 percent tax can’t be shrugged off so easily.

These new costs aren’t the only factors making multinational firms uneasy. Businesses are worried about running afoul of forthcoming U.S. rules banning U.S. government agencies from purchasing any products made in factories containing communications or surveillance equipment produced by five Chinese tech giants – tech that’s hard to avoid inside China. There is widespread suspicion that doing business in China means handing over proprietary intellectual property and technology to local competitors. There’s also concern that China will retaliate against the U.S. tariffs by boosting informal barriers to trade. (More than half the firms polled in the October American Chamber of Commerce survey reported an increase in non-tariff barriers such as stricter regulatory scrutiny and slower customs clearance times.) And now, the U.S.-China trade war appears at risk of devolving to tactics like hostage-taking following the U.S.-requested arrest of the CFO of Chinese firm Huawei in Canada and China’s subsequent detainment of three Canadians.

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In short, the trade war has created a confluence of pressures on exporters in China. And the siren song of nearby manufacturing hubs – on both ends of the manufacturing value chain – is sounding ever sweeter.

Reasons to Stay Put

Still, there are ample reasons for firms in China to stay put. Less than 19 percent of Chinese exports in 2017 went to the U.S., and other major consumer markets have yet to follow the U.S. lead in imposing tariffs on China. So many of the biggest manufacturers in the country – ones that serve consumer markets across the globe – will be reasonably well-equipped to absorb the tariff costs and keep at least some of their Asian and European Union-focused operations in place.

For firms dependent on the U.S. market, relocating is neither quick nor cheap. Relocation requires new facilities, new workforces to recruit and train, new regulations to navigate, new bribes to pay and new hiccups that can cause catastrophic disruptions. Deep-pocketed multinational firms may be able to swing this, but the small and medium-sized enterprises that China relies on most for employment operate on thinner margins and generally can’t afford missteps.

All told, relocation is generally a three- to five-year process, according to the Economist Intelligence Unit. U.S.-China trade tensions aren’t going anywhere, but that doesn’t mean the current U.S. tariffs will last forever. Companies will be loath to take on the costs of moving unless it becomes clear exactly how the trade war will shake out. Moreover, if the Trump administration is truly bent on restoring lost U.S. jobs and bringing the broader U.S. trade deficit down, it will need to apply tariffs to other low-cost manufacturers, too. We don’t think this will be the case outside of a few sectors; the broader geopolitical concerns that have bred support for the White House offensive against China do not apply to policies targeting U.S. friends and allies. But the risk of firms finding themselves in the same situation elsewhere is still high enough to give them ample reason to move slowly.

Indeed, even with U.S. tariffs, China is likely to remain competitive as a manufacturing hub. Rising labor and land costs in China are offset (to some degree) by the efficiency of locating operations there. China’s coastal export cities are well-oiled machines: Home to 13 of the world’s 50 largest ports, China’s superb infrastructure reduces time to market. And a massive, well-trained workforce – at more than 630 million strong, twice the size of all of the Association of Southeast Nations members combined – allows companies to scale up quickly and respond to rapid shifts in consumer demand. Perhaps most important, the dense clustering of industries in different parts of China allows for tightly integrated supply chains and the “just-in-time manufacturing” that companies have come to rely on to stay nimble, responsive to market changes and profitable.

Some of these advantages would inevitably be lost outside of China, even though South and Southeast Asia are dotted with advanced manufacturing hubs. Some, like Penang and Port Klang in Malaysia and Thailand’s eastern seaboard, have excellent infrastructure and deep experience in high-tech industries. Some, in countries like Bangladesh, Indonesia and India, have large, low-cost labor pools. Given its proximity to Guangdong, Vietnam offers firms the rare advantage of being able to maintain cross-border supply chains.

But few neighboring manufacturing hubs offer all the advantages China does, and those that do are quickly getting crowded, pushing up labor and land prices and eroding their cost advantage. In Vietnam, for example, land costs in key industrial zones near major deep-water ports have reportedly increased more than 25 percent over the past year alone. As a whole, ASEAN has the world’s third-largest labor force at more than 350 million workers. The bloc is trying to ease the movement of capital and goods and harmonize regulations among its member states through the establishment of the ASEAN Economic Community. But implementation has been very slow, and the group remains rife with both formal and informal trade barriers. ASEAN integration is further hindered by extraordinary geographic fragmentation in Southeast Asia, which is not only home to sprawling archipelagos and unforgiving tropical terrain, but also highly vulnerable to natural disasters. According to the Asian Development Bank, ASEAN states together will need to invest more than $60 billion annually in infrastructure, particularly in energy and transport, over the next 12 years to sustain the bloc’s economic growth. The more a firm’s supply chain is dispersed in multiple countries and the more it has to rely on clogged ports or an untrained labor force, the more likely there are to be delays, hidden costs and so forth.

India perhaps comes closest to matching China’s competitive advantages. Last year, India’s labor force clocked in at a hefty 520 million people, and because of extreme class disparities, it can meet the labor cost needs of firms up and down the value chain. It’s particularly competitive in the garment industry, thanks in part to robust local cotton production. But in 2017, India accounted for 1.7 percent of global merchandise exports compared to China’s 12.8 percent – in part because India’s strengths are mainly in services and low-end manufacturing as it still lacks the infrastructure needed for high-end manufacturing. Due to factors like the convoluted regulatory environment, in 2017, India ranked just 77th on the World Bank’s ease of doing business index (a jump of 23 spots over 2016), compared to 46th for China, 27th for Thailand and 15th for Malaysia. So, despite India’s draws, only 6.5 percent of U.S. firms in China surveyed in a September report by the American Chamber of Commerce said they were considering relocating to India, compared to 18.5 percent for Southeast Asia.

There’s another huge (and growing) incentive to stay in China: It is now home to the second-largest consumer market in the world. According to Bain, if current trends hold, household consumption in China is expected to grow around 5-6 percent annually over the next decade, as some 180 million more people move into the middle class. General Motors sold more than 4 million cars in China in 2017 – over 1 million more than it sold in the U.S.

Even as Chinese economic growth slows – and even if things get really rough for China in the coming years – there are massive consumption gains still to be made as rapid urbanization and technological proliferation boost living standards. Rising competition from Chinese firms to meet this demand is already putting multinational companies at a disadvantage. Many cannot afford the loss of tariff-free access – and, potentially, the political favor often necessary to avoid unexpected hiccups in China – that would come with abandoning the country altogether. ASEAN alternatives, though growing in their own right (the bloc is expected to have the world’s fourth-largest consumer market by 2050), just don’t have the same allure. That’s especially true since the U.S. withdrawal from the Trans-Pacific Partnership. Signatories like Malaysia and Vietnam won’t be able to dangle tariff-free access to the U.S. market unless the United States re-embraces global trade. We expect this to happen eventually, but it could take decades.

The Bottom Line

Nonetheless, firms are increasingly routing their supply chains around China, and the trade war will inevitably accelerate this shift. Well-resourced multinational firms are already well-practiced in building out sprawling global supply chains and have no loyalty to China. They rely too heavily on seizing even minor cost and efficiency advantages, and are too concerned about the political and investment climate in China and enduring tension with the U.S., to stand pat. Infrastructure buildups in low-cost manufacturers in Southeast Asia and Latin America, along with the proliferation of bilateral and multilateral free trade agreements promising preferential trade access to major consumer markets like the EU and Japan, will further narrow China’s long-held advantages. (Ironically, China’s Belt and Road Initiative may work against Chinese interests as its projects help improve rival manufacturers’ competitiveness.)

Even Chinese firms have been increasingly keen to get in on the action, opening large manufacturing operations staffed by local labor in countries like Vietnam, Malaysia and Ethiopia. (Since 2000, in fact, Chinese firms have spent more than $9 billion on 869 greenfield investments in the U.S. alone, according to the Rhodium Group.) After all, Japan sidestepped the middle-income trap by evolving from export powerhouse to investment powerhouse over the past two decades, in large part by becoming one of the first advanced economies to move much of its manufacturing abroad. Chinese firms seeking to dodge tariffs will naturally want to follow suit. The question is whether the employment-obsessed CPC, which would rather see its firms move to lower-cost regions in inland China, will let them.

On the whole, the shift away from China will happen more gradually and haltingly than the headlines may suggest – absent a catastrophic deterioration in China’s domestic political situation or escalation in tensions with the U.S. Given the costs of moving and risks of leaving, perhaps the biggest shift will be that new investments increasingly go elsewhere. And among foreign firms that are motivated by U.S. tariffs to leave, the relocation will generally be partial, confined to operations (like final assembly) that minimize supply chain disruption while satisfying U.S. rules of origin requirements. In other words, they’ll be looking to manufacture just enough of a product elsewhere to stamp it with: “Made anywhere but China.”

Phillip Orchard
Phillip Orchard is an analyst at Geopolitical Futures. Prior to joining the company, Mr. Orchard spent nearly six years at Stratfor, working as an editor and writing about East Asian geopolitics. He’s spent more than six years abroad, primarily in Southeast Asia and Latin America, where he’s had formative, immersive experiences with the problems arising from mass political upheaval, civil conflict and human migration. Mr. Orchard holds a master’s degree in Security, Law and Diplomacy from the Lyndon B. Johnson School of Public Affairs, where he focused on energy and national security, Chinese foreign policy, intelligence analysis, and institutional pathologies. He also earned a bachelor’s degree in journalism from the University of Texas. He speaks Spanish and some Thai and Lao.