News headlines often highlight the role of geopolitics and the COVID-19 pandemic in driving Western-based multinational companies to relocate their supply chains away from China. This, in turn, fuels a narrative that emphasizes these factors as the primary catalysts for change in global supply chains and China’s manufacturing sector.
As trade flows shift away from the intense period of globalization to something more fragmented, geopolitical factors are indeed playing a role. Governments are promoting and incentivizing the onshoring and friend-shoring of manufacturing, and many multinational companies are looking to diversify their supply chains.
However, for China, we think the situation is more complex and less pessimistic than mainstream headlines portray.
First, the high complexity of global supply chains, combined with the extensive scale of China’s industrial sector and manufacturing competencies, makes it undesirable and unrealistic for many multinational companies to make a complete break with China anytime soon, in our view.
Second, for years China’s manufacturing sector and global supply chains have evolved in response to forces that are unrelated to the current trade and political frictions between the U.S. and China.
Even if onshoring and friend-shoring trends pick up pace in developed countries, we think the mutually beneficial relationships that China has forged with numerous multinational companies over more than four decades will keep China integrated within the global economic and investment landscapes.
Supply chains are far more interconnected and complex than imaginable
Companies producing complex products often have four or more layers of thousands of suppliers.
According to consulting firm McKinsey & Co., technology companies have 125 tier-one suppliers (i.e., the direct suppliers of the final product or the fully built components used to create the final product) and more than 7,000 across all tiers, on average.
An auto manufacturer typically has around 250 tier-one suppliers, but the number increases to 18,000 across the full supply chain.
The complexity of global supply chains frequently results in interdependencies between companies in countries with upstream products or materials.
For example, as the 10 ASEAN* countries of Southeast Asia have built out their manufacturing competencies, they have become more connected with China’s manufacturing supply chain. ASEAN members imported $177 billion of goods from China in 2012. In just 10 years, this more than doubled to $388 billion by 2021.
China’s imports to ASEAN have more than doubled in the past decade
U.S. dollars (billions)
Line chart showing ASEAN countries’ import value from China for the period of 2012 through 2021. The chart shows imports steadily rising over the years and more than doubling from $177 billion in 2012 to $388 billion in 2021.
*The Association of Southeast Asian Nations (ASEAN) is a regional intergovernmental organization comprising 10 member states: Indonesia, Malaysia, the Philippines, Singapore, Thailand, Brunei, Cambodia, Laos, Myanmar, and Vietnam
Source - Statista, RBC Wealth Management; yearly data through 2021
The ASEAN region remains highly dependent on China’s inputs and capital goods, which are essential to products manufactured in those countries. If multinational companies want to produce more goods in the region in the coming years, we think Chinese production will also play a meaningful role in the supply chain.
China’s vast manufacturing footprint
The “Made in China” label is familiar to many people, yet the full scale and scope of Chinese manufacturing may still be underestimated.
Chinese manufacturing has ranked first in the world in terms of scale for over a decade. In 2021, China accounted for 30 percent of global manufacturing output, according to the UN. By comparison, the EU in aggregate accounted for 16 percent, the U.S. 15 percent, and Japan and Germany accounted for six percent and five percent, respectively.
Currently, China is the only country in the world that conforms to the standards of all manufacturing-related sections of the UN’s statistical reference classification system. This illustrates the wide breadth of China’s production capacity. Designations for many of its industries rank first in the world.
China’s rise as an intellectual property leader also contributes to the sophistication and development of its manufacturing base.
In 2019, China overtook the U.S. to become the largest source of international patents filed under the World Intellectual Property Organization’s (WIPO) Patent Cooperation Treaty.
China filed the most Patent Cooperation Treaty applications in 2022
Bar chart showing the top 10 countries filing the most patent applications under the World Intellectual Property Organization’s Patent Cooperation Treaty (PCT). Applicants from China filed 70,015 PCT applications followed by the U.S. (59, 056), Japan (50,345), the Republic of Korea (22,012), Germany (17,530), France (7,764), the UK (5,739), Switzerland (5,367), Sweden (4,471), and the Netherlands (4,092).
Source - World Intellectual Property Organization statistics database (February 2023), RBC Wealth Management
As China migrates from being a low-cost manufacturing hub to one that increasingly focuses on innovation and complex manufacturing techniques, we think the country will maintain its manufacturing dominance while at the same time make inroads into emerging and strategic fields such as electric vehicles (EV), telecommunications, bioengineering, artificial intelligence (AI), and other areas.
Manufacturing competencies have become more technologically advanced
China has established comprehensive supply chains across various industries over the past few decades, largely thanks to the localization process of multinationals and strategic joint ventures. These collaborations have enabled China to acquire technologies and know-how, and have laid the foundation for its own technological innovation.
In recent years, the West has started implementing restrictions on China’s access to critical technologies, such as AI, quantum computing, and advanced semiconductors, raising concerns about the country’s ability to move further up the supply chain and achieve its stated “technological self-reliance” goals.
This could pose challenges to China’s technology development and potentially slow it down. However, it’s important to remember that China has demonstrated an ability to overcome the impact of technological restrictions in the past. Two examples include the Tiangong space station and China’s development of EVs.
Tiangong: From the sidelines to an independent space power
The International Space Station (ISS) is a co-operative program between the U.S., Europe, Russia, Canada, and Japan. It has welcomed astronauts from 21 different countries as of June 2023.
In 2011, the U.S. Congress passed a law which was signed by the president prohibiting the country’s National Aeronautics and Space Administration (NASA) from funding or engaging in direct, bilateral cooperation with China, thus effectively preventing China from joining the ISS.
In response, China spent the next decade developing and launching individual modules to complete its own permanent space station called Tiangong, or “Heavenly Palace,” in 2023.
Tiangong established China’s independent presence in space. It enables the country to conduct advanced scientific research and represents a significant, game-changing step for China as a global space power. With the ISS scheduled to be retired in 2031, Tiangong would then be the only space station in operation.
Auto industry: From nascent to high tech
A comprehensive supply chain developed over the past few decades paved the way for China’s technological advancement in the automotive industry.
The general rule of thumb is, the larger the production scale in a particular manufacturing segment, the easier it is to improve production efficiency, product quality, and technology.
China has sought to overcome technology hurdles by putting in place national policies and capital support, nurturing domestic talent, and forming strategic, mutually beneficial alliances with other nations.
China’s development of its automotive industry, particularly its rapid progress in EV technology, provides insights into the country’s ability to scale up production into higher-tech manufacturing.
The auto sector in China saw rapid growth after the government’s Reform and Opening-up period in the late 1970s and 1980s. The industry formed joint ventures with foreign automakers such as Volkswagen, General Motors, and Honda.
At first, China’s auto industry relied heavily on foreign technologies, particularly when it came to engines and transmission designs—core components of internal combustion vehicles.
Over time, China developed extensive auto supply chains and manufacturing capacity, while actively encouraging the development of skilled engineering talent.
By the early 2000s, China started to explore alternative energy vehicles. In the 2010s, the government introduced a series of policies designed to support research and development (R&D) and encourage EV adoption.
Many of the technologies and production techniques used in traditional vehicle production can be transferred to EV manufacturing. At the same time, the core components and technologies of an EV include the battery, electric motor, and electronic control system, which vary greatly from the components that make up a traditional vehicle with an internal combustion engine.
With robust manufacturing know-how and supportive public incentives, China’s automotive industry was able to free itself from the technological constraints of traditional fossil fuel drivetrains and make inroads into more advanced, cleaner technologies.
A recent report from Patent Result highlights China’s lead in EV charging patents. From 2010 to 2022, Chinese companies submitted 41,011 patent applications in this field, which is 52 percent higher than that of Japan and nearly three times the number of U.S. EV charging patents. China has now become the largest exporter of new EVs, overtaking Japan, the U.S., and Europe.
China’s shift away from labor-intensive manufacturing
Other factors that have little to do with the current geopolitical frictions between the U.S. and China have also helped to transform Chinese supply chains and manufacturing processes. These mostly stem from China’s own economic development.
Over the past 20 years as China’s economy has grown markedly, labor costs have more than doubled, forcing labor-intensive industries such as footwear and apparel manufacturing to relocate to countries with more affordable labor—in many cases to ASEAN countries.
This process can be traced back to when China began upgrading its manufacturing sector more than a decade ago.
Some labor-intensive industries began to move away from coastal manufacturing hubs into less developed inland cities and provinces.
Later, as labor costs increased there as well, production began migrating abroad with Chinese-owned factories popping up in ASEAN countries. The range of Chinese manufacturing investments in the region includes textiles, consumer electronics, EV supply chains, pharmaceuticals, and others.
As of 2021, China has become the third-largest international source of foreign direct investment in the ASEAN region at $14 billion, following the U.S.’s $40 billion and the $21 billion that ASEAN countries invest in each other.
Supply chain diversification: Less than what is advertised
Although there has been some degree of supply chain diversification away from China, this change is not as significant as one might assume. A good example comes from the electronics and machinery sector, which is the largest goods category in global trade.
The sector is dominated by China in exports but has been shifting somewhat to ASEAN countries in recent years. China’s electronic exports by value to the U.S. decreased by 10 percentage points from 2018 to 2021. Most of the slack was taken up by ASEAN countries, according to a study by Macro Polo, a U.S.-based think tank connected to the Paulson Institute (founded by former U.S. Treasury Secretary Hank Paulson).
One may easily draw the conclusion that China has been losing ground to ASEAN countries in global manufacturing. However, the data tell a different story. ASEAN countries’ gains in global manufacturing are comparatively minor; the region’s market share climbed slightly from around three percent in 2010 to about five percent by 2021, while China’s share rose from 20 percent to 30 percent over the same period.
The data indicate to us that while some of the final assembly of manufactured products may have shifted from China to ASEAN, China’s overall manufacturing capacity has remained elevated.
China has been gradually replacing labor-intensive industries with more advanced and higher value-added manufacturing. Prime examples of this structural transformation are the export boom of three renewable energy products: new energy vehicles, solar cells, and lithium batteries.
As China moves up the supply chain, its economy is becoming more complex
Harvard Economic Complexity Index rankings; “1” is the most complex
Line chart showing various countries’ (Japan, the U.S., China, Mexico, India, and Vietnam) complexity rankings from 1995 to 2020. Japan has been ranking first in the index since 1995. China’s ranking improved to 18th in 2020 from 46th in 1995. The U.S.’s ranking has trended slightly down over the years and ranked 14th in 2020, while Mexico was 29th in 1995 and rose to 20th in 2020. India’s and Vietnam’s rankings increased from 60th to 46th and from 107th to 57th, respectively.
Note: Economic development requires the accumulation of productive knowledge and its use in a wider range of more complex industries. The Harvard Growth Lab’s Economic Complexity Index (ECI) assesses the state of a country’s productive knowledge. As the number and complexity of a country’s exports increase, the country’s ECI moves toward “1”; for example, in this data, Japan has consistently had the highest ECI of 1, whereas Vietnam currently has the lowest at 57, although its score has been improving.
Source - Harvard Growth Lab, RBC Wealth Management
Simultaneously, China has shifted its trade model away from processing trade, which relies on supplied materials or components. Processing trade has historically been used by manufacturers seeking access to specialized inputs or lower labor costs. Its share in China’s total exports has decreased to around 20 percent, down from 55 percent in 2000. At the same time, finished goods export unit values have continued to rise, signaling an ongoing industrial upgrade.
As Chinese manufacturing has become more complex, the value of vehicle exports has surged
U.S. dollars (millions)
Line chart showing China’s monthly export value of mobile phones and vehicles from May 2020 through May 2023. In May 2020 vehicle exports totaled $1,305 million and they have been increasing (last reading was $7,758 million). Vehicle export value has now caught up with that of mobile phones (last reading was $8,101 million), traditionally an important export segment.
Source - RBC Wealth Management, Bloomberg; monthly data through June 2023
Will China remain an attractive investment destination?
China and multinational corporations built mutually beneficial relationships after the country’s Reform and Opening-up period in the 1970s and 1980s. China acquired technology and management know-how from multinationals, while these companies enjoyed low production costs in China and higher profits (which we think boosted stock prices), as well as access to China’s large domestic market.
However, more recently, multinationals have begun reassessing the business environment and their investment plans in China.
In a survey conducted by the American Chamber of Commerce in China, the share of multinational corporations perceiving China as one of their top three investment priorities dropped from 78 percent in 2012 to 45 percent in 2022.
Uncertainty around China’s policy environment, multinationals’ expectation of slower economic growth, and overall uncertainty about the U.S.-China economic and political relationship were the top concerns of survey respondents. Other concerns stem from China’s aging demographics and the country’s restricted access to key technologies. Rising competition from Chinese domestic players also poses challenges to multinationals.
Despite these concerns, in our view, China still presents opportunities that cannot be ignored.
With its GDP accounting for 18 percent of the global total, we think the size of China’s economy alone demands attention from multinationals. The country has the world’s largest middle-income class. Based on McKinsey’s estimates, more than 40 percent to 50 percent of China’s population will live in high-income cities by 2030.
In sectors such as automobiles, luxury goods, and industrial equipment, China’s market contributes 25 percent to 40 percent of global revenues. In our view, this makes it hard for multinational corporations to choose to not compete in the Chinese market.
Intel’s CEO Pat Gelsinger has acknowledged that maintaining access to China’s semiconductor market is very important due to the revenue opportunities and because that revenue helps fund Intel’s R&D and internal expansion.
During a moderated discussion at the Aspen Security Forum in July, Gelsinger said: “Right now, China represents 25 to 30 percent of semiconductor exports. If I have 25 or 30 percent less market, I need to build less factories. We believe we want to maximize our exports to the world … You can’t walk away from 25 to 30 percent and the fastest growing market in the world and expect that you remain funding the R&D and the manufacturing cycle that we’ve released. We want to maximize. And right now semiconductors are the number two export to China behind that strategic category of soybeans, and there’s not even a close number three. This is strategic to our future. We have to keep funding the R&D, the manufacturing, et cetera ...”
To capture opportunities in China and manage risks at the same time, multinationals have various options to organize their supply chains, such as adopting an “in China, for China” approach, where components are manufactured in China for its domestic market. Multinationals could also adopt a “China plus one” strategy, by establishing an extra regional supply chain outside of the country to reach China and surrounding markets, or by maintaining a global supply chain utilizing China as one component.
Expanding, not reducing, trade ties
Global supply chain diversification doesn’t have to be a zero-sum game.
With labor-intensive supply chains shifting away from China, countries such as Vietnam, India, Cambodia, and Mexico could expand their shares of global manufacturing. The onshoring and friend-shoring trends are also likely to benefit some industries in the West.
But the dependency on China’s upstream materials and goods means the country can likely still grow its manufacturing sector and move up the supply chain.
China continues to trade with countries globally and seeks to expand trade ties. Rather than “deglobalizing,” China is experiencing a shift in trade flows, adjusting its focus towards strengthening its Belt and Road Initiative and cooperation with countries and regions including Russia, the Middle East, Central Asia, and ASEAN. This shift aims to reduce China’s reliance on the West and expand trade ties with a broader range of countries, or the 80 percent of the rest of the global population.
Having said that, not all supply chain shifts will necessarily prove cost-effective. In some cases, countries might construct redundant manufacturing capacities driven by national security concerns, potentially resulting in increased end-product prices.
For example, chips made in Taiwan Semiconductor Manufacturing Company’s (TSMC) U.S. factory are likely to be 15 percent to 20 percent more expensive than those made in Taiwan and China, according to semiconductor research and consulting firm SemiAnalysis.
An evolution, not a breakdown
Deglobalization is a complicated topic, and recently has become a geopolitically loaded term. However, beneath the surface, one finds that the shift away from the period of intense globalization that occurred from the 1980s through 2008 to something more fragmented is a natural evolution of international trade and commerce. Substituting the idea of “supply chain transformation” for “deglobalization” perhaps provides more clarity.
Conceptually, it is akin to the market forces of supply and demand optimizing the allocation of resources to find a natural equilibrium in a period in which national security and sovereign development are being prioritized. The evolution could depend on costs, manufacturing complexity, as well as legal and political frameworks, among other factors.
Throughout modern history, many economies have successfully navigated supply chain transformation including Great Britain, the U.S., Japan, and the “Four Asian Tigers” (South Korea, Taiwan, Hong Kong, and Singapore). We do not believe the China experience will prove to be any different.