The China Dilemma: Stay or Leave?

In these unstable times, keeping most of your sourcing eggs in the China basket has become inadvisable, and companies appear to be putting a lot more energy and resources into finding alternatives to the world’s workshop.

In a survey of the US-China Business Council’s member companies, 28% expressed pessimism about the outlook in China, up from 21% last year. The number of optimistic companies fell to a record low of 49%. More than one-third of respondents said they have reduced or paused planned investments in China over the past year.

As I described in my 2020 post Moving Out of China? Not Really establishing relatively small-scale operations elsewhere as a hedge against over-dependency on Chinese manufacturing is commonly called the ‘China + 1’ strategy. Is this strategy no longer tenable as companies strive to withdraw most, or even all, of their operations from China?

Doubts on many fronts

It seems that hardly a day goes by without a story about some plan to lessen the West’s reliance on China. There are various reasons for these moves to cold-shoulder the country.

Enterprises are reevaluating their presence in light of China’s deteriorating economic outlook. A slew of international investment firms have downgraded 2023 GDP growth forecasts for China from around 5.5% to 5%. Weak domestic demand, stalled real estate markets, and high youth unemployment are among the problems that have taken the shine off China’s reputation for consistently delivering high growth rates. There is concern that it will take years to rebalance the country’s faltering growth engine.

These economic woes are unfolding against heightened geopolitical tensions, especially between China and the United States. Anxiety over the West’s dependence on China for strategically vital materials and components such as microchips has grown markedly in this post-pandemic period. The country’s recent announcement that it is curbing exports of gallium and germanium, minerals used in semiconductor manufacturing, is a reminder of its willingness to exert control over critical markets. The Biden administration recently issued rules designed to prevent billions of dollars in federal grants to US chipmakers from being used to expand manufacturing in “foreign countries of concern,” including China. The concept of “friend-shoring,” reorienting international supply chains towards countries deemed friendly, has become fashionable.

The Covid-19 pandemic has also left a mark on China’s reputation for efficiently managing its economy and society. If there is one lesson that stands out from the crisis, it is that assuring sources of supply is one of the most critical supply chain challenges faced by companies in today’s volatile business environment. ?During the outbreak, the Chinese government implemented its “zero-covid” policy to stamp out resurging infections. The draconian measures closed production lines and disrupted supply chains, casting a shadow over the country’s reputation as a reliable supply source. Pandemic-weary companies were already engaged in efforts to de-risk their global supply chains by, for example, expanding their supply bases internationally. The disruptions in China provided another reason for reassessing relationships with suppliers there.

The changing world order is another reason for reviewing China’s standing on the world stage. India’s rise as an economic power and the fallout from Russia’s brutal invasion of Ukraine are among the forces redrawing the global geopolitical map.

On the upside

However, as I explained in my 2020 post cited above, companies have spent hugely building elaborate supply chains in China over recent decades. They are loathe to simply abandon this infrastructure – even assuming they can find reliable alternatives. China still offers manufacturing expertise and capacity that is difficult to match elsewhere.

Although the country’s traditionally high annual growth rate is now moderating due to structural problems, China still represents a significant market with the world’s second-largest GDP. The country’s largest province, Guangdong, is estimated to have a nominal GDP larger than Canada’s.

It is also essential to keep in mind that for decades, China has been investing in technology to move up the value chain. This ambition is undiminished today and has yielded leading positions in future-shaping markets such as batteries, EVs, and solar energy technology.

?Spread the risk

There are good reasons to stay in China as a buyer of its materials and components and as a competitor in the country’s vast consumer markets. On the other hand, sound reasons exist for diversifying supply chains away from the country.

Given these tensions, the ‘China + 1’ strategy needs a makeover – but still has merit. Companies should maintain a significant presence in China while pursuing other options elsewhere. Maybe today’s approach could be called the “China + Others” strategy, reflecting a world without sure bets.?