- Rising labor costs and COVID-19 are speeding up production diversification away from China.
- Diversification from China has spilled over from trade to technology, especially due to the US stance on Chinese 5G telecom providers.
- These trends will have a much larger impact on Asian economies, which will result in both winners and losers.
Global implications of diversification away from China
The process of production diversification away from China started long before the escalation of US-China trade tensions, partly reflecting rising labour costs in China. This process has accelerated since 2018 owing to the US-China trade dispute, and the COVID-19 pandemic will further hasten this process as nations and multinational corporations place security and resilience ahead of efficiency, adopting the so called China plus one strategy (this strategy suggests that instead of investing only in China, diversification of the business into other countries is a more economical and safer long term option) for risk mitigation. We don’t expect an imminent full-scale decoupling as there are draws that will result in China continuing to attract more foreign direct investment (FDI). We also see implications for the rest of the world as multinational corporations diversify from China, including the emergence of winners and losers.
The proliferation of global value chains and the seamless process through which countries specialise in intermediate goods that feed into the supply chains centred on China has enabled firms to work more efficiently and for lower costs. This could change. As supply chains are diversified away from China, including via reshoring, the world economy will have to contend with short supply chains, more concentrated value addition, longer inventory cycles, lower productivity and potentially higher costs over medium term. Developing countries will receive much lower FDI inflows and there will be less scope for knowledge/technology spill overs, both for China and other countries. It is also possible that diversification extends to services, with both countries relying less on tourism and education revenues from China.
However, the process of diversification from China will result in both winners – from trade relocation, and losers – countries that are a part of existing supply chains.
Countries that could be labelled winners amongst the EM’s are mainly Asian countries. India could benefit from its large market size and potential while Singapore’s advantage lies in its ease of doing business, economic and political stability and trade openness. Two non-Asian countries in the top 10 winners are Poland and Czech Republic, owing to their favourable investment climate.
Countries that supply intermediate goods to China as part of the supply chain that ends in China could lose on account of the diversification. Asian countries again are at risk, including Taiwan, South Korea and Malaysia. The value-added by industry across Asian countries shows that computer & electronics, textiles, leather & footwear and machinery & equipment sectors are the most exposed.
Diversification from China has spilled over from trade into technology and this intersects with foreign policy. The US has recently taken actions to safeguard the telecom networks against hypothetically potential risks posed by the vendors from its rival country, resulting in much higher cost of telecom equipment, but benefiting European firms (Nokia, Ericsson).
Overall, the process of diversification from China is likely to be gradual but is inevitable. The process will reverse some of the gains enjoyed globally such as higher productivity and lower costs, but it is also likely to create winners and losers in the process.
For further insight on the world post Covid-19, read our full report here.
Chief Economist, India and Asia ex-Japan
Chief China Economist
Southeast Asia Economist
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