Chain reaction

Does the trade war really spell the end for China’s manufacturing base?


Goodbye garments: some business is heading to China’s Asian neighbours

The way that Donald Trump tells it, China’s manufacturing sector is close to collapse, fatally wounded by Washington’s tariffs on Chinese imports.

Last month the American president was celebrating how China’s supply chain was “breaking up like a toy because companies are moving out”. A few days later he talked again about how Beijing was desperate to call a halt to the trade row. “You know why they want to make a deal?” he crowed. “Because they’re losing their jobs, because their supply chain is going to hell and companies are moving out of China and they’re moving to lots of other places, including the United States.”

But if Trump’s tariffs really are designed to torpedo China’s manufacturing base, he may have to think again.

Washington will have announced levies on about $550 billion of Chinese goods, when the full tariff quotas come into effect at the end of this year. That could affect up to 5% of China’s manufacturing capacity, according to calculations from Qu Hongbin and Jingyang Chen, two economists at HSBC.

But the impact of the tariffs isn’t going to be the same across the manufacturing sector at large. Much depends on the type of goods being made. Lower-end, more labour intensive industries such as furniture and textile production are taking the biggest hit, with companies shifting their factory lines to countries like Vietnam, Cambodia and Bangladesh. Yet that was already happening before the trade row, because of increases in wages and changes in environmental regulations, which have made Chinese factories less competitive. Policymakers in Beijing have generally accepted the exodus as inevitable too, preferring to focus on a future of more sophisticated manufacturing.

All the same, HSBC reckons that US tariffs will speed up the shift of low-tech and low-value added production to other countries.

How about higher value-add industries like electronics and electrical equipment? In some areas, they are being damaged by the tariffs as well, the analysis from HSBC suggests. For example, the Chinese market share in US imports of printed circuit boards has fallen to 25% from 70% since the first duties were levied in September last year.

However, the wider impact isn’t quite as dramatic, making it unlikely that suppliers in sectors like electronics are going to implode in the way that Trump has been predicting.

There are three main reasons. Firstly, China is now the world’s biggest market for consumer electronics. Making the goods in close proximity to that demand is important, which is why American firms have wanted more of their supply chains in the Middle Kingdom as well. China’s factories are also less reliant on parts and capital equipment from overseas than previously. Both factors mean that the focus on doing business with the US isn’t quite as fundamental as it was in the past.

Third, China’s production clusters are now so deep and diverse that it isn’t practical for American firms to simply uproot to other markets. The days of the Chinese offering little more than an assembly line of pitifully paid workers are drawing to a close – today they are just as likely to be making the parts that go into the final goods or the capital equipment in the factory. Apple has more suppliers based in mainland China or Hong Kong (about a fifth of the total) than American and Japanese ones, for instance.

It’s not just the density or interconnectedness of these supply chains. Other countries can’t compete with China’s massive investments in roads, power and ports; nor can they provide the same quality of workforce. By the World Economic Forum’s count, there were 78 million skilled workers in China in 2015 (defined as workers with a higher education), which was 32 million more than Vietnam, Malaysia, Thailand, the Philippines and Indonesia combined.

Taken together, these strengths make production in China quicker, less expensive and more efficient, HSBC says.

That’s not to say there aren’t other ways that Washington might make life more difficult for Chinese manufacturers – especially in disrupting the supply of the key parts they still source from American suppliers. Embargos of this type are going to pose a challenge, especially in the short term. A blockade on components brought telecoms maker ZTE to its knees last year (see WiC406), forcing President Xi Jinping to ask Trump to intervene personally to unfreeze the pipeline of parts.

This year there’s been another stop-start skirmish over supplies of American components to Huawei and 68 of its affiliates. The Shenzhen-based giant has reacted by trying to source more of these components from other countries, or by making more of them at home in China (see WiC423). Huawei announced this week that it has eliminated all US components from its 5G base stations. But the pressure is still significant where alternatives are less readily available, such as flash memory (see WiC456). A 90-day pause on Washington’s original ban is set to expire in November.

Another potential weapon in Trump’s arsenal would be starving the Chinese of American capital. Hence the talk in Washington of taking measures to delist Chinese companies from US bourses and limiting American investor exposure to the Chinese market via government pension funds.

Officials are also said to be examining restrictions on Chinese companies in stock indexes managed by US firms (think MSCI) as well. That would have repercussions for billions of dollars in investment, Bloomberg said last week.

Speculation about the strategy prompted a sell-off in the S&P 500 Index, as well as sudden falls in the US-listed shares of companies such as Alibaba, and Baidu.

A scenario like this would be a role reversal of major proportions. After years of criticism of capital controls in China, the Americans would be erecting them themselves. And they would be doing so at a time when the Chinese are starting to remove more of the limits on foreign investment in their own financial markets.

The more immediate picture is that the trade war is showing little sign of curtailing foreign direct investment into China. Non-financial FDI is running at almost $140 billion annually. Investment has been growing at about 3% annually since trade tensions began, according to Nicholas Lardy at the Peterson Institute for International Economics, a non-profit research institution based in Washington. That’s a similar pace to the previous five years.

Most of the companies in the US–China Business Council (an organisation of about 200 American firms that trade with China) think that investment will continue to flow. A full 97% of the council’s members say their operations in China are profitable, and 87% report that they have no plans to relocate any of their activities to other countries.

Some of the difficulties of ‘reshoring’ manufacturing jobs back to the US were brilliantly revealed by the recent Netflix documentary American Factory too (see WiC464).

In the meantime there is little sign that the Chinese supply chain is being eroded, because of the tariff pressure from Washington.

“Trump’s claim that an exodus of foreign firms will force China to capitulate to US demands to settle the trade war is wishful thinking at best,” Lardy concludes.

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