The great supply chain relocation – pitching South-East Asia amid China woes

Regional supply chains have been in the spotlight recently with COVID-19-related disruptions in China. We explore how companies can expand operations into South-East Asia, and the possible risks they may face.

An attractive proposition

Even before the onset of COVID-19, multinational companies had already started diversifying their supply chains beyond China, owing to tariffs arising from US-China trade tensions. The pool of companies deliberating supply chain relocation has grown in recent months as frustration with COVID-19 management policies in China – a key manufacturing and supply chain node for many businesses – continues to mount. US, European and Japanese chambers and companies in China have spoken out against the lockdowns and wisdom of “dynamic zero” COVID-19 policies. Some appear ready to exit the Chinese market and relocate production to countries and regions that have more readily adopted endemic policies.

South-East Asia is one such region, with most countries reopening their borders, dropping or significantly loosening quarantine and testing requirements, and easing domestic restrictions. Vaccination rates are also relatively high, and continued efforts to localise vaccine-production will mitigate the risks of future healthcare crises and the need for nationwide lockdowns to deal with new variants.

Bucking the trend of economic nationalism and outright protectionism elsewhere in the world, South-East Asia is also likely to become increasingly intertwined in regional and global trade as it tries to navigate its way through big power rivalry, making it an attractive region for companies looking for a long-term export base. The region is already part of the Regional Comprehensive Economic Partnership (RCEP) that covers a market of 2.2bn people. 

Moving next door

Companies considering diversification into a South-East Asian country should first look at the complexity of their supply chains and the support that the country has in place for manufacturing operations. For example, companies involved in traditional manufacturing of goods with short supply chains, such as footwear and apparel, are more likely to be able to relocate their whole supply chain. Vietnam, Malaysia and Thailand have benefitted from previous rounds of supply chain relocation, both before and during the pandemic – largely due to an established electronics and medical devices manufacturing base, supportive transport and logistics infrastructure, and pro-foreign investment regimes.

Companies should be prepared for extended, even unpredictable, processes that require careful management to avoid operational and reputational risks. Timelines may not be fixed, as illustrated by the abrupt 2019 move by a Japanese consumer electronics company of their factories from China to Thailand to cut costs. Shifts may also be gradual processes carried out over multi-year periods. A US garment brand, through a five-year plan that ends in 2023, reduced sourcing from manufacturers in China and turned towards several other countries, including the Philippines. A US toymaker over the past ten years also decreased sourcing from manufacturers in China and increased the number of suppliers it had in various countries, including Vietnam, citing “enterprise risk reasons”.

Friend or foe

With US-China tensions likely to persist in the coming years, policies by the US and its close diplomatic allies to encourage or compel the decoupling of supply chains from China will serve as another potential driver for companies to seriously consider diversification. Such policies will more likely apply to critical sectors and goods, such as semiconductors and pharmaceutical ingredients. They will also nudge companies to consider relocating production from China to countries that share ideological affiliations with the US and its allies – a strategy the US referred to as “friend-shoring”. For firms involved in critical sectors, producing and sourcing from such countries will be crucial to mitigating risks of supply chain disruption posed by geopolitical tensions in the long term. 

One challenge that foreign companies are likely to face as they survey South-East Asia for “friend-shoring” options is the tendency of most countries in the region to adopt hedging strategies vis-à-vis the US and China. These governments may resort to influencing regulatory practices – which are less likely to attract scrutiny – rather than overt regulatory frameworks to emphasise which foreign investments they are keen on. Political instability and changes in government could also trigger shifts in foreign policy preferences and consequently render “friend-shoring” strategies less effective as countries previously deemed friendly turn lukewarm or hostile.

Yet companies need not be price-takers in such a complex environment. Understanding how South-East Asian governments signal their foreign investment preferences in practice – as opposed to only looking at formal regulatory structures that govern foreign investment – is a crucial step towards reducing uncertainty. The second would be to assess the risk of domestic political changes and implications on a country’s foreign policy vis-à-vis the US, China and other major powers.

Look across the region

Nevertheless, South-East Asian markets are far from homogeneous and a one-size-fits-all approach to market entry is unlikely to fare well. Countries in the region have different business risks that require sustained attention and management. Vietnam promises long-term political stability and a pro-foreign investment regime but is currently grappling with heightened risks of electricity shortages and labour activism. Established manufacturing bases like Malaysia and Thailand offer robust logistics and transport infrastructure and relatively non-hostile industrial relations but have higher labour costs and pose reputational risks linked to allegations of forced labour in sectors such as electronics and medical devices manufacturing. Integrity risks also require careful management in numerous markets across the region. 

Companies should also be wary of emerging risks that will apply to different degrees across the region for at least the next few months as the implications of the conflict in Ukraine continue to ripple through the world. Persistent energy and fuel shortages of varying severity will contribute to operational risks and also drive inflation.

Companies should conduct a full review of their existing supply chains to understand current risk exposure, before contemplating which risks the business can and is willing to mitigate, and finally identifying a diversification strategy involving products, services and locations that can best mitigate those risks and build overall resilience. In comparing countries across the region, one way to reduce the uncertainty around risk exposure is to conduct a benchmarking exercise and compare risk levels across a range of factors, including security, labour, infrastructure and access to external markets.