Epidemic tests China’s supply chain dominance

Beyond China’s much larger economic size, it is important to note that China is now much more integrated in the global value chain. By moving up the ladder, China has become a much more important player in exporting intermediate goods than before, which means that any disruption in its production capacity could affect the rest of the world more severely than in the past.

It is worth noting that this transformation is asymmetric in nature as China has been reducing its reliance on foreign inputs while it has continuously increased its exports of intermediate goods. This implies that any disruption to China’s value chain reverberates globally as factories elsewhere become more dependent on the intermediated goods imported from China. Given the current disruption to China’s supply chain onshore – total quarantine in Hubei province and limited elsewhere – the high dependency on Chinese capital and intermediate goods means that the ability to substitute imports from China for others is rather limited, at least in the short run.

Beyond the exports of intermediaries, some countries have become very dependent on China as their own companies have moved a good part of the production to China. In other words, the large stock of foreign direct investment (FDI) that developed economies have accumulated in China also explains why Covid-19 is an important global shock. This is especially true for Japan, South Korea and Taiwan and, interestingly, it goes beyond their production in China. The reason is simple: While those three economies have been diversifying their FDI away from China into Southeast Asia, the reality is that those countries are also heavily dependent on China for their value chains. In other words, the economic impact of the Covid-19 may well show that the degree of diversification achieved by Japan, South Korea and Taiwan with their near-shoring away from China into Southeast Asia has been rather limited.

All in all, the Covid-19 outbreak is putting the well-established model of integrated supply chains of production to a test. This is because China has becoming too central to the global value chain and too important, and the shock has actually hit there, at the epicenter. A very likely consequence of this will be a much faster re-shoring of the value chain to other destinations. Destinations will be chosen on the basis of many factors but the Covid-19 outbreak is clearly adding two. First, there should not be as much concentration of the supply chain as there was for China in the past. Second, over-dependency on sourcing in China will be discouraged. This is clearly good news for countries like Mexico, but also Eastern Europe.