Despite Tariffs, Chinese Manufacturing Still the Most Cost-Effective Choice for U.S. Importers
Here's what businesses need to consider when dealing with the uncertain business climate between the United States and China.
The latest escalation in the trade confrontation between the United States and China followed a breakdown in negotiations and saw the United States increase tariffs on Chinese goods and announce restrictions targeting Chinese technology companies. China responded with its own tariff increases on U.S. goods and by placing select U.S. businesses on a new "unreliable entities list." The escalation comes amid a period of ongoing uncertainty and increases pressure on U.S.-China supply chains and business models designed for a world of low-friction goods and capital flows.
These recent developments raise four major questions for businesses to consider when dealing with the uncertain environment.
Question #1: How significant are the developments and what industries or businesses are most vulnerable?
Answer: Unexpected changes, whether economic, political or regulatory, are always a test and will expose companies that have inflexible business models or funding vulnerabilities. The hike in U.S. tariffs from 10 percent to 25 percent and the proposed expansion to new categories of goods puts significant pressure on Chinese manufacturers of tariffed goods that have concentrated U.S. sales.
Similarly, for U.S. companies sourcing a large share of goods from China that fall under tariffed categories, the recent increases are a direct blow. The difference between 10 and 25 percent is critical in some cases, because it takes the option of a negotiated absorption of the tariff increase (by sacrificing profit margins) off the table. For many affected business relationships, handling the initial 10 percent hike was a challenge last year, and there may not be enough room to handle an additional 15 percent. To complete the list of vulnerable companies, it is also important to mention logistics and service providers that facilitate the flow of goods between China and the United States — to the extent the tariffs curtail volumes, they may also be affected.
Question #2: How can companies and their stakeholders caught in the trade war respond?
Answer: In acute situations on the Chinese supplier side, tariffs at 25 percent can be an existential risk; depending on a given business’s liquidity and cash flow, there may be little time to act. This is particularly true for suppliers exporting to the United States under DDP trade terms, where the burden to pay duties in the destination country remains with the seller. For company management, just keeping up with changes in tariff categories and rates can be a challenge amid day-to-day operational responsibilities, not to mention the additional time required to assess their impact on the business and consider strategic changes. For capital providers with stakes in affected businesses, the situation is often opaque — it can be difficult to get information to assess the situation, and yet timelines for making investment decisions in critical situations are often tight, with large sums at stake.
How many of the Chinese manufacturer’s customer relationships are at risk? What are the contract terms and how soon might customers try to switch to an alternate supplier? Can the business find a manufacturing partner outside of China and maintain its existing U.S. customer relationships as a sourcing agent? If so, will the manufacturing quality meet specifications? If losing clients is unavoidable, what alternative customers can the business target?
Knowing the right questions to ask and crafting a viable response requires a mix of deep financial and industry expertise. The goals are to manage short-term cash flow needs, stabilize longer-term business prospects, and protect stakeholders’ interests. In many cases, the best solution will draw on several strategies to balance these objectives.
Question #3: What does the trade war mean for supply chains and sourcing strategies going forward — are we going to see a manufacturing exodus from China?
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Answer: Despite tariffs and trade war uncertainty, companies around the world need Chinese suppliers as much as ever. There is simply no one country or group of countries that has the manufacturing breadth and depth to match China, whose advantage is based on a mix of infrastructure and human capital and is the product of decades of compound growth. While certain countries, like Vietnam in footwear and apparel, and Malaysia in small electronics, have developed niche expertise, there is no credible alternative in terms of capability and price to match China’s offering on a global scale.
Data from the World Bank that aggregates manufacturing value added by country underscores the magnitude of China’s existing capabilities compared to other countries. China was responsible for over $3.5 trillion of manufacturing value added in 2017, far exceeding second-place United States and dwarfing the contributions of countries such as India, Indonesia, Thailand, Malaysia and Vietnam, which are often mentioned as alternative sourcing countries. Given the stark differences in current capabilities, for just 25 percent of China’s manufacturing value added to shift to these other countries, the capacity in all of them combined would have to more than double. It would be difficult for such a shift to happen quickly.
Even tariffs of 25 percent do not change this basic calculus — while it will meaningfully affect certain businesses (like the acute cases mentioned above), China’s cost and capability margin broadly remains strong despite the tariff increases. A recent survey by AmCham Shanghai and AmCham China found that despite the recent trade war escalation, roughly 60 percent of U.S. firms sourcing manufactured goods from China were not even considering relocating outside of the country. For the remaining 40 percent, their exploration of alternate countries will likely prove difficult.
Question #4: What are the key elements of a strategic sourcing strategy and how does the trade war impact the approach?
Answer: Good sourcing requires navigating dynamic and diverse markets and cultures, many of which are unfamiliar to Western executives. Not all manufacturers are created equal, and finding a dependable, qualified supplier at the right price can be very challenging. The process generally works best when a local market insider with a detailed understanding of the sourcing company’s needs and a rigorous screening process for suppliers bridges the two cultures. Robust due diligence of potential manufacturing partners, quality assessment backed by trial runs, and a running competitive bidding process among vetted, capable suppliers are critical elements of a good sourcing strategy.
The trade war is a hurdle that can be accounted for in a broader sourcing strategy. Increased uncertainty makes intelligent and efficient sourcing as important as ever. The first step is for a business to objectively evaluate its current sourcing process. This can range from a holistic look at its global sourcing strategy to a more tactical analysis of the impacts of recent tariff changes. While company circumstances vary, a few general responses to the immediate challenges posed by tariffs are worth mentioning. In some cases, for companies that have diversified global manufacturing and sales bases, it is possible to rebalance internal supply chains to reduce the flow of China-U.S. goods at a cost that is lower than the U.S. tariff rates.
For other companies, a careful analysis of their products alongside the U.S. Harmonized Tariff Schedule can highlight opportunities to reclassify goods into non-tariffed categories. A similar product-by-product review can also be critical for intermediate distributors importing tariffed goods to justify (and in some cases, contractually validate) tariff-driven cost increases to their customers.
© Copyright 2019. The views expressed herein are those of the authors and do not necessarily represent the views of FTI Consulting, Inc. or its other professionals.
Senior Managing Director, Leader of Asia Business Transformation
Senior Managing Director