Supply Chains in a Volatile World

The AP News had an interesting article this week regarding the fact that “Shipping snags prompt US firms to mull retreat from China.”

You may have read similar articles repeatedly over the last few months (maybe years, or shall I say, decades), so this may not be entirely new, and may prompt you to ask whether there is anything new here at all!

But I think that If you read closely, some aspects require more attention. 

Let’s start with the statistics. According to a survey by AT Kearney, 52% of U.S. manufacturing executives surveyed said they have begun buying more supplies within the United States in response to COVID-related supply disruptions. Another 47% percent said they plan to reduce reliance on supplies or factories from a single country, 41% of whom said they specifically wanted to cut their dependence on China.

I am usually skeptical of surveys. It’s one thing to ask firms about what they plan and it’s another thing to ask what they have done. But these surveys are, at the very least, a good indication of any “wind of change”.

In trying to explain why this is the case, it is essential to look at the long-term trends.

The long-term trend is, and already has been for several years, to pull out of China in favor of Mexico and Vietnam. AT Kearney has been following these reshoring trends for quite some time now. 

While the overall growth in imports from China has been slowing and has effectively flattened over the last couple of years, we see a significant increase in imports from Vietnam.

Along similar lines, when taking a closer look at the data, imports from China in 2019 had already declined. A similar study by AT Kearney shows that the loss on China’s end was mainly to other low-cost countries (LCC) and Mexico, or Europe (primarily for European firms). Note that these numbers precede COVID. 

So, these trends are definitely not new. What is new then?

In an effort to explain this trend, the article mentions the story of Eric Poses, a game maker who is among those making these choices:

"Like other importers, Poses is contending with a perfect storm of supply trouble — rising prices, overwhelmed ports, a shortage of ships, trains, trucks — that is expected to last into 2022. The experience proved disturbing enough that Poses is reconsidering a cost-saving decision he made five years ago: to shift production of his games and toys out of the United States to China. Now, he thinks, it might make sense to bring production back — at least to Mexico, if not the United States — to protect him from the risks of relying on factories an ocean away in China." 

And then Eric finishes with the sentence that caught my eye more than anything in the article. 

“I’m willing to make smaller margins,” he said, “if it means less anxiety.”

Anxiety...

Anxiety has clearly been amplified since COVID started. Although anxiety regarding supply and demand is as old as civilization, we witnessed a significant shift in supply-chain-related anxiety around the time the Trump administration started toying with the idea of tariffs. The situation started to deteriorate during the early days of COVID and things have only become worse since then. These events are, of course, not only relevant to China, but recent events have impacted China as well, which only got worse with the recent weather: 

"Supply chains have faced a string of bad luck this year. A Covid-19 outbreak among port staff was to blame for a partial closing of Yantian in May, leading to container goods piling up for a month. As ships diverted away from southern China, some factories in the nearby manufacturing hub of Guangdong shut down because of excess inventory that couldn’t be exported, according to analysts and logistics intelligence firm project44."

So is it just “bad luck” or is there something more structural? My claim is that, although one should not overlook specific situations and disruptions, a more important factor is the processes that their accumulation creates, and with it the anxiety these processes induce. In other words, I think the trend we see is more closely related to anxiety from the overall situation, rather than any single specific event. 

Anxiety is a feeling; a sentiment. From the supply chain point of view, I will refer to it as volatility. 

Why Volatility? Why Now?

In the research paper I co-authored with Jan Van Mieghem, we study how firms should allocate their orders between a near-shore supplier (Mexico) and an offshore supplier (China). The leading trade-off is that the offshore location is usually cheaper in terms of sourcing costs (even if all tariffs are included, and sometimes even if transportation costs are included). Yet, since it has a longer lead time, it requires carrying more inventory (both in terms of safety inventory and inventory along the supply chain). The implication is that there is an optimal level of splitting between these two locations. The optimal policy is when the firm orders its base demand from the offshore location and covers the surges in demand from the nearshore location. The policy, which we called Tailored Base Surge policy, is one that many firms follow and performs quite well in practice. 

The paper’s main conclusion is that the amount sourced from China is affected by many expected factors: the cost difference, the scale, and the cost of holding inventory. However, all of these have a second-order effect. Their impact diminishes as they grow. The only aspect that has a first-order impact is volatility. Every increase of volatility, no matter how slight, either on the demand side or the supply side, immediately translates into a change in allocation. Specifically, it reduces the optimal amount firms should allocate to China. 

Why is volatility so impactful? If firms like to provide a reasonable service level while also keeping costs low, they have to hedge against this uncertainty. The only way to hedge against risks while still sourcing from offshore locations is by holding inventory. As volatility increases, so does the amount of inventory needed. So, at some point, sourcing closer to home starts to make more sense.  

Where is volatility coming from? It can be weather-related disruptions (typhoons in China, drought in Taiwan, February’s Texas storms), it can be a demand surge induced by the pandemic (as previously discussed), or it can be created by other firms’ strategies (as we saw in the chip manufacturing shortage).  

But let me add one more source of volatility: (unexpected) government laws and regulations. And in this case, I would like to start with government regulations related to COVID and travel:

"China’s uncompromising approach is increasingly an outlier as major western economies turn to vaccination to keep hospitalizations and fatalities low amid resurgent outbreaks. Even other places that have stamped out the virus, like Singapore, say they are pivoting to treating Covid-19 as a persistent, endemic condition."

This tells us what the role of a country’s government will be over the next few years: offering stability that allows the firms within the country (and with it, its workers) to thrive. 

We have seen different approaches: New Zealand, for example, sealed the country and recently even suspended its only travel bubble with Australia. And while, on one hand, this creates stability internally, on the other, it reduces the ability to engage in any supply chain business. Apart from tourists, the travel ban also impacts sourcing managers that need to travel to find suppliers and partners. Zoom calls are effective only for some time when you need to build a supply chain. After a while, you really need to go and visit your partners. While New Zealand is not a big exporter (beyond agriculture), this approach does reduce its viability even further. 

The US, who decided to take a different approach, has worked with Mexico to vaccinate supply chain workers. This approach allows businesses to plan their overall orders, knowing that, while disruptions may occur, there is an attempt to create normalcy. 

A similar statement came after talks between the US and Korea, discussing the notion of resilience and supply chain normalcy between the countries. 

I think the last few months have shown that COVID is going to be endemic in the population.  Any policy that is too harsh and thus unsustainable (like extended lockdowns or 3-week quarantine, regardless of your vaccination status) is not sustainable and will only add to the volatility. 

I am not implying that countries should stop taking measures, but policymakers don’t seem to realize that the anxiety these measures induce has a far more significant impact.

Specifically, we should understand that the positive impact of stability is far more significant than any tariff or other regulation. 

I am not saying that it's going to be easy. Balancing health concerns with economic concerns is not a trivial matter. There is no simple cost-benefit analysis when you have (uncertain) costs on one side and human life on the other. But it's clear that a policy that adds more volatility to an already volatile world is not helping make such decisions.

But I should also say: if policymakers are aiming to bring manufacturing back to their countries, then, by all means, volatility is your friend! 

If you read the article and think that China is losing its role as the center of the global supply chain, you are mistaken: China is in great shape, overall. It is still the biggest exporter to the rest of the world and thus the supply chain center. It is still the fastest-growing market, and it has capabilities and proximity of manufacturers that just cannot be matched at this point. Within a very short walk in Shenzhen, you can find all of your supply chain needs. Something that just cannot be said about any other location.  

But as we witness more volatile demand and supply over the next few years, we will also see a return to nearshoring. Something that started happening well before COVID, but seems to only be accelerating thereafter. 

If you are working at a firm, and are currently charged with making these choices, I would love to hear your opinion.