A client said to me the other day, “We have been diversifying away from China manufacturing for several years, but even with our efforts, only about 10% of our supply chain is outside China. We have had a very hard time finding reliable suppliers who can replicate what our core China suppliers do for us. About 20% of our China manufacturers make 80% of our products. Even if we wanted to, we could not pull back from China any time soon.” You may have had similar thoughts over the past many months as you have watched your supply chain stability and your profit margins declining behind the double-sided great wall of looming tariffs and trade bans.
China-U.S. country relations, starting with the trade tariffs (Round 1 on July 6, 2018; Round 2 on August 23, 2018; Round 3 on September 24, 2018 and May 10, 2019; and Round 4 on June 17, 2019) and intensifying with the Huawei ban and its growing repercussions, have made China manufacturers and their U.S. customer relationships extremely difficult. What began with wary watchfulness turned to alarm, and now flabbergasted panic by companies (U.S., European, and others) who were not paying enough attention to the tea leaves. Last year we began warning our readers that the U.S. and China were on a collision course, mainly due to China’s ongoing (a) reluctance or inability to adequately police its companies’ business practices or (b) (more likely) purposeful implementation of its master “Made in China 2025” plan to complete its great technological leap forward by subsidizing its homegrown industries, limiting access by foreign companies to its markets, and assisting its companies with systematic forced technology transfers and cyber intrusions (ok, a lot of people just call it theft).
Many U.S. and European companies have been working with Chinese manufacturing companies for years, even decades, and many have developed good to great relationships with their China suppliers. These strong relationships foster stability, which allows companies to invest in other parts of their businesses to stay competitive and increase their profit margins. Trade wars, tariffs, and product and country bans introduce significant new and likely long-term instability (risk) into the global marketplace and shrink profit margins quickly by disrupting global markets. Many businesses have entered into joint ventures and strategic partnerships with Chinese companies, invested on the ground in China with wholly foreign owned entities (WFOEs/WOFEs), and hired Chinese employees (Apple supports about 5 million jobs in China, and Foxconn, Apple’s Taiwanese subcontractor, provides another 1 million jobs in China). The U.S. government may be able to pivot on trade at the pace of two tweets per minute, but the average company doing business with China cannot.
Like our client I mentioned above, many U.S. companies working with Chinese counterparts have learned that decoupling from China manufacturing and diversifying supply chains is at least to some degree desirable, but understanding this does not change their economic reality. In this ongoing and late-hour appraisal of China risk vs. reward, here are several questions to consider:
- Is it too late to start diversifying my supply chain? It is never too late, but if you are just now asking the question, know that diversifying into other markets will take time and money, and it will be stressful and challenging. But it can and should be started now. The alternative is to just sit back and hope that the U.S. and China will reach a trade agreement even though the two countries are at loggerheads with no signs of thawing. Even if President Trump’s comments that the U.S. is “not quite ready” to make a trade deal with China give you hope that this storm will be short-lived, China’s government is so concerned with maintaining control and social stability that Xi Jinping would rather encourage China’s 1.4 billion population to engage in another “long [economic] march” against the tyrannical U.S. than open China’s markets and engage in fair competition the way most of the rest of the world does. If the CCP cannot keep the Chinese economy booming, then it will settle for misdirection. Either way, the Chinese populace stays focused on external factors and does not pause to question the shortcomings of its leadership. That means keeping people’s bellies full and their minds and hands busy with work. It is the same tactics my father used to keep me out of trouble as a teenager in the sweltering summers in Platteville, Wisconsin.Meanwhile, forward-thinking companies (and risk-averse companies) will continue to look to other markets where more general principles of the rule of law and market forces and low or no tariffs provide more certainty.
- Where can we move our manufacturing to outside China? There are a host of countries eager to engage with U.S. companies. Much of your analysis will depend on your industry. Are you in a high tech industry? What inputs do you need? Do you need human labor or will machines fill the need? Countries like Vietnam, Thailand, Philippines, South Korea, Turkey, Malaysia, Taiwan, and Mexico offer opportunities to diversify supply chains, and each has its own set of factors to analyze. One of the things we as international lawyers are finding so fascinating is where our clients are ending up; it is often not where we expected. Each company has different goals and wants and needs and each product is different.
- Can my good relationship with my Chinese supplier overcome this? As we discussed in a prior post, your longstanding relationships with your Chinese suppliers are important and you can establish new relationships in China based on the new current reality. It’s time to explore your network and call in your favors in China to help buy you time to diversify while you hunker down and watch President Trump’s Twitter feed.
- What is the likelihood that your China manufacturer will steal your IP and compete with you in other markets, including the U.S. market? That risk is probably increased, but it will depend on both your relationship with your supplier and how much the trade war is hurting them. If their other customers are leaving, they will probably try to keep their best customers happy. They will not be able to compete with you in the U.S. market because even if they try to leapfrog you and sell directly to your customers, the tariffs will apply equally to your new direct competitor. If you keep your China manufacturer filling orders for foreign markets, they will have less time to wonder if now is the right time to steal your IP and woo your customers.
- What is the likelihood that the Chinese courts will enforce any future claims you have against a Chinese company? This is an ongoing risk for companies doing business with China, especially now. But having good contracts in place is always the first place to start because your China counterparts know that you know how to play in China on China’s terms and in their language. Keeping the communication lines open will let you know whether your counterpart is about to renege on your trade relationship, and then you and your China lawyers can discuss the potential of litigating your case in China.
Sound business principles continue to remain relevant. U.S. companies have to stay nimble and engage their customers. This means setting a strong culture course for your business of ongoing innovation and customer service. Why? Innovation means the assurance of your company continuing to stay relevant in the marketplace and command a profit, even if it is diminished due to the trade war. Even if your Chinese supplier could cut and paste your company to China and become your direct competitor, they cannot replicate your customer engagement or your culture of innovation overnight. It will be a long road ahead. Dig in and start your diversification now.