Supply Chain Strategy Collides With Pandemic Reality

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AT-A-GLANCE

• Plans to relocate manufacturing operations to a second or third country could prove costly and complex in face of realities of the pandemic era.
• Companies are facing a business environment where central bank policies in U.S. and Europe are shifting from one of accommodation to higher rates and quantitative tightening.
• Reshoring of operations needs to consider a variety of challenges from infrastructure to availability of skilled workforce and rising wages in emerging markets.
• The inability to pass on costs to consumers in industries that are highly competitive and the need to maintain market share could be a hurdle for relocating operations.

The nature of globalization is changing. Supply chains are challenged – from tariffs, the pandemic and Russia’s invasion of Ukraine. The strategy recommendation is resiliency through diversification. The logistics are incredibly complex.

In this article we will look at several defining events that have had a significant impact on consumers, global commerce, bilateral trade relations and the global economy, namely the trade tensions of 2018 and the pandemic that spread across the world two years ago., and Russia’s invasion of Ukraine.

Tariffs, Russia and Ukraine

Let’s start with the tariffs that were initiated by the U.S. that led to businesses and consumers paying more for products imported from countries where the duties were applied. What started out as a trickle with tariffs on $8.5 billion in imports of solar panels and $1.8 billion in washing machines from China snowballed into tariffs on $350 billon of Chinese imports. Tariffs were then imposed on imports of steel and aluminum mostly from Canada, E.U. Mexico and South Korea.

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What we have learned from the tariffs imposed by the different countries – U.S., China, the European Union, Canada, Japan, Mexico and others – is that such measures, once introduced, can remain in place even when the political climate changes. For instance, the Biden administration has yet to remove all of the tariffs that went into effect during the Trump days in office, although some of the tariffs are being removed in the wake of Russia’s invasion of Ukraine war to help reduce inflation pressures.

Russia is a major exporter of oil, and food products like wheat. The U.S. ban on Russian oil imports helped rally futures prices to over $100 per barrel and gasoline prices at the pump to over $4 a gallon. The EU, which gets 26% of its oil and 40% of its natural gas from Russia, is considering banning Russian oil imports. The war has also elevated shipping costs that were on their way down after the big spike during the pandemic when demand for manufactured goods surged (Figure 1).

Figure 1: Shipping costs tick higher but are well below pandemic highs

Lessons from the Pandemic

What the pandemic has taught us is that different approaches to managing COVID-19 have led to very different challenges for supply chains, depending on the location, and specifically the differences between China’s Zero-Covid policy and the less stringent approaches in the U.S. and Europe.

Millions of people in China are in lockdowns or have their movements restricted while hundreds of businesses have halted operations as the government tries to contain a new wave of the pandemic. The restrictions come at a time when China’s economic growth has slowed since the last quarter of 2021. By contrast, in the U.S., the mask mandate when traveling in public transportation has been struck down by a U.S. court, and attendance at open events is rising as spring weather coaxes people into going out more, although the attendance at public venues still remains far behind the pre-pandemic levels.

Strategy is easier than Logistics

So, from a strategy perspective, companies all over the world are re-thinking their supply chains, yet from a logistical perspective, they are rapidly realizing that shifting supply chains can be arduous. Two important points companies consider when reshoring are maintaining or improving market share, and managing operational costs effectively while trying to improve supply-chain resiliency.

Some companies may feel confident they can pass on the extra costs to their clients, but others could be concerned that if a major competitor stays with its old low-cost model, they can grab market share with lower costs. That is, one consideration in shifting supply chains involves some game theory in terms of what one’s competitors might do.

The Organization of Economic and Co-operation and Development (OECD) said in a report that greenfield investments – a form of foreign direct investment where a parent company builds its operations from the ground up in another country that includes the construction of buildings -- in emerging markets and developing economies in 2021 were below pre-pandemic levels in 2019 by 43%. This is a reflection of the difficulty of moving supply chains.

Challenges to Reshoring Operations

Let’s look at some of the cost and complexity considerations in uprooting a production center from one country to the next, or in setting up a parallel manufacturing center in a second or third country.

Input supply: In moving to another country to manufacture a product, a company needs to make sure the country it is relocating to has the raw materials to produce your product. For instance, if you are in the business of making furniture, you’d need to pick a country that has the relevant type of materials to build your furniture. The raw material typically has to be close to where your plant is located, and you’d need to ensure there are proper modes of transportation to get the raw materials into the plant. There also has to be a relatively low-cost workforce to ensure your competitiveness.

Output delivery – How do you get the finished product delivered to your clients? The company needs access to proper roads, rail lines and ports from the new manufacturing site to deliver the products to customers in other countries. Shipping costs from the point of manufacturing to destination markets could also play an important role in setting up new operations in a second or third country.

Dependency on highly specific and single source inputs – Some key inputs to certain manufactured goods are rare or are produced only in a few places.  For example, the Republic of Congo is the world’s key producer of cobalt. Manufacturing processes dependent on highly specific inputs from relatively few sources will find it hard to hedge.

Input cost increases – Input costs (producer prices) are currently rising more rapidly than the rate of consumer price inflation. This higher cost factor comes at a time when one may want to decrease manufacturing costs anywhere else you can. The U.S. Producer Price Index for all final goods and services is running (as of April 2022) at 11% above a year ago, while the goods component of the producer price index is running at a more elevated 16% (Figure 2).

Figure 2: Prices paid by wholesalers have been rising

Currently, input costs (producer prices) are rising more rapidly than the rate of consumer price inflation. This higher cost factor comes at a time when one may want to decrease manufacturing costs anywhere else you can. The U.S. Producer Price Index for all final goods and services is running (as of March 2022) at 11.2% above a year ago, while the goods component of the producer price index is running at a more elevated 15.7%.

Skilled labor – reshoring operations depends to a large extent on the availability of a trained workforce, or a pool of workers that can be readily trained in skilled operations. The availability of labor in China has been one its advantages, but that position is being challenged by emerging nations like Vietnam, Philippines, Bangladesh, Mexico and others.

Wages – Wages are rising in many countries, which also makes the process more expensive and difficult (Figure 3). Higher wages may also be accompanied by a higher probability of labor strife, strikes, and stoppages, which adds another layer of complication. For example, the current labor negotiations related to U.S. west coast ports, a key entry point for imported goods.

Figure 3: A tight labor market has pushed wages higher

Ability to pass on costs – Companies in different industries will have varying opportunities to pass on costs to their clients, and this will depend in part on their competitive environment. Companies with strong competition and tight margins are much less likely to shift their supply chains unless absolutely essential.

Unrelated, yet simultaneous considerations – there are other transitions taking place – for example, central banks withdrawing accommodation with FX implications (yen, euro), climate and possible sea level rises over next decade. The Japanese yen had slumped to a 20-year low against the U.S. dollar amid a divergence in monetary policies between the two countries – the Federal Reserve has raised rates by 75 basis points in two moves since March, while the Bank of Japan is easing monetary policy, along with the People’s Bank of China, with the yuan falling to a one-year low against the greenback (Figure 4).

Figure 4: Yuan’s weakness reflects concerns over China’s growth

This post contains sponsored advertising content. This content is for informational purposes only and not intended to be investing advice.