Ukraine war, 1 year on: are China's supply chains headed toward upheaval, or can it stem the tide?

In the 12 months since Russia evoked the ire of the West by invading Ukraine, the subsequent and unprecedented sanctions against Moscow continue to send ripples through global supply chains, spanning several industries.

Meanwhile, Beijing's choice not to condemn the aggression of its northern neighbour - while simultaneously bolstering trade and strengthening its alliance with the pariah of the West - has served as further impetus for some businesses to diversify away from China, even as they are well aware that such a move could come at a heavy price.

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Compounding the situation is the fact that tensions between Beijing and Washington have been ratcheted up on multiple fronts, from relations with Taiwan to a suspected Chinese spy balloon in US airspace.

In trade, the administration of US President Joe Biden has introduced measures to strengthen the competitiveness of its industries as China strives to retain its crown as the world's manufacturing powerhouse.

Matthew Fass, president of Virginia-based Maritime Products International, also acknowledged that diversification away from China became more necessary during the coronavirus pandemic, which resulted in mass lockdowns and business disruptions in the country for nearly three years. But he, like many others, is struggling to discern the best way forward.

"We are in the food industry - seafood in particular. China has developed both very strong production with its own aquaculture over the past 30 plus years and also real expertise and efficiency in further processing globally harvested seafood for many export markets," Fass said.

"I would note that our company and industry are quite reliant on the principles of relatively free trade of goods and services, and this also feels under assault right now in many places - certainly including Sino-US relations. This is very troubling to us."

China's exports to the US have remained relatively steady, with shipments valued at US$581.78 billion for 2022, a rise of just 0.9 per cent from 2021.

But China's exports to the European Union grew by 8.4 per cent to US$561.97 billion for 2022 over 2021, according to China's customs data.

Since Russia's invasion of Ukraine, politicians in the EU have stepped up calls to reduce reliance on China by diversifying supply chains for technologies and critical raw materials while avoiding new vulnerabilities.

Peter Bogh Hansen, China political director at the Confederation of Danish Industry, said that the pandemic and Ukraine war have exposed vulnerabilities of being too dependent on specific supply-chain locations.

"China has been the go-to offshoring hub for European manufacturers for decades, and both sides have benefited significantly from the relationship," Hansen said. "But in light of the growing geopolitical tensions involving China, manufacturers are becoming more concerned about overreliance in China."

Joerg Wuttke, president of the EU Chamber of Commerce in China, said it could be very difficult for certain industries - such as chemicals, auto and machinery - to completely move away from China.

"In chemicals, half of the global market is in China; in the car industry, it's one-third," Wuttke said. "If you are developing electric-vehicle batteries, you have to be in China. The machinery market in China is as big as Europe, the US and Japan put together."

According to the German Chamber's latest Business Confidence Survey, released late last year, 87 per cent of respondents said they were feeling the impact of economic and technological decoupling tendencies.

Jens Hildebrandt, executive director and board member of the German Chamber of Commerce in China for North China, said that German companies were trying to mitigate the risks by localising or diversifying their operations, or they were doing both.

"Localisation means pulling closer supply chains, production and research and development capacities and engaging more with local partners inside China," Hildebrandt said.

"Diversification mainly entails building parallel supply-chain structures throughout the Asia-Pacific region. Localisation and diversification strategies are adopted across all industries. Larger companies tend to diversify more outside China than smaller companies because of the cost associated with building up parallel structures."

The difficulties of moving away from "made in China" are demonstrated by China's rising exports in alternative energy products, which have climbed since last year amid efforts from some European countries to reduce dependence on oil and gas from Russia.

"To get to the scale of China in batteries, it's going to be very difficult and very expensive," Wuttke said.

Last year, China surpassed Germany to become the world's second-largest car exporter, trailing only Japan, after mainland exports jumped 54.4 per cent, year on year, to 3.11 million vehicles in 2022, according to the China Association of Automobile Manufacturers (CAAM).

Electric vehicles became a significant factor in China's buoyant car exports, with electric-vehicle shipments surging 120 per cent, year on year, to 679,000 in 2022, the CAAM data showed.

Another area in which China dominates is battery separators - key components of lithium-ion batteries that separate positively charged anodes from negatively charged cathodes. These are widely used in electronics.

China's shipments of battery separators rose 55 per cent to 13.3 billion square metres in 2022, accounting for more than 80 per cent of the global market, according to a report by Fitch Ratings on February 14.

"We're seeing more double- or even multi-sourcing arrangements to cover and diversify risks. This will have an impact on the prices customers will have to pay, but it also requires a lot more effort to manage, monitor and control the more diverse supply chains," said Florian von Baum, global head of technology, science and industry at Pinsent Masons, a multinational law firm.

The bipartisan Chips and Science Act of 2022 and the Inflation Reduction Act legislation in the US are expected to have a profound impact on advanced semiconductor chips, chip-making software and tech talent. The battery supply chain may also be affected.

Last year also saw the introduction of the European Commission's European Chips Act, which aims to reinforce the EU's chip industry and reduce its dependence on supplies from both the US and Asia.

Choi Jae-duk, the head of the Korean-Chinese Relations Institute at Wonkwang University, said that China-US tensions, as well as the supply-chain changes resulting from the war in Ukraine, have made it more difficult for South Korea and China to maintain and develop economic relations.

"South Korea's high economic dependence on China has always been pointed out as the Korean economy's vulnerability. Considering various recent issues, such as the economic retaliation for the deployment of the Terminal High Altitude Area Defence [anti-missile system], China's zero-Covid policy and the opacity of the Chinese system, reducing Korea's economic dependence on China could make the Korean economy healthier," Choi said.

China is South Korea's biggest trading partner, accounting for 22.8 per cent of South Korea's total exports in 2022.

The world's second-biggest economy is especially critical for South Korea when it comes to semiconductor chips - the biggest export item for the country, making up 18.9 per cent of its total export value in 2022. And 40.3 per cent of its semiconductors were exported to China.

South Korea's biggest semiconductor chip manufacturers, Samsung and SK Hynix, have multiple factories in China, but future production there has become unclear.

In October, the companies were granted a year-long exemption from the US Chips and Science Act banning of the entry of various semiconductor manufacturing equipment into China.

"If the Chips act makes it impossible for Korean semiconductor companies to make additional investments and import new equipment into their Chinese factories, it will ultimately lead to factories having to shut down, as it would be difficult to maintain the machines and supply flexibly to the Chinese market," said Lee Hyun-tae, a professor at Incheon University who specialises in the economic relations of Korea and China.

On the other hand, South Korea is also seeing new investment. Dutch semiconductor group ASML is investing US$189 million to build a new office and a remanufacturing facility in the country, marking the Dutch firm's first construction of a remanufacturing facility in a foreign country.

"It is very difficult to quantitatively calculate whether the loss or the gain is bigger [for South Korea]. It will require sophisticated designs at the individual corporate level to make the most out of the advantages and overcome the disadvantages," Lee said.

Apple, for example, appears to be pursuing a strategy to cut its dependence on China - a country that has powered much of its growth over the years.

India's minister of commerce and industry, Piyush Goyal, said last month that Apple was already making between 5 and 7 per cent of its products in India.

"If I am not mistaken, they are targeting to go up to 25 per cent of their manufacturing [in India]," he said at the Business 20 India inception meeting.

Georg Riekeles, associate director at the European Policy Centre, said some companies have clear goals to move specific supply chains to not only Vietnam and India, but also to Europe and the US. However, others remain on the fence about such moves.

"In overall trade figures, I don't expect you will see decoupling to any significant degree. It's about diversification and risk management," Riekeles said.

Hansen, with the Confederation of Danish Industry, said China has "some formidable industry clusters" that would be hard for other countries to replicate.

"Top infrastructure and logistics, affordable labour, skilled management and smooth operational processes - that is difficult for any nation to compete with. China's comparative advantage applies to most industries, but probably more so in commodity-based industries with relatively low profit margins," Hansen said.

Yao Yang, a professor and dean at the National School of Development and director of Peking University's China Centre for Economic Research, said that a total "decoupling" between the West and China would be highly unlikely.

Yao highlighted China's investments in upgrading its industries, the size of its market, and its manufacturing capabilities as the key reasons that foreign companies will not completely exit the world's second-largest economy.

But Yao said that China should be careful in drafting its foreign policy and not signal something that it does not wish for.

"Especially if we don't want to decouple, deep down, but we express it poorly," Yao wrote in his latest book, released in October, about China's economy.

Yao said one of the biggest risks facing China in terms of innovation is that it's often driven by the state, thus diminishing the role that the free market has to play.

"Independent innovation in key areas must be necessary, but it is also necessary to distinguish what must be done by the government and what can be completely left to the market," Yao wrote.

This article originally appeared in the South China Morning Post (SCMP), the most authoritative voice reporting on China and Asia for more than a century. For more SCMP stories, please explore the SCMP app or visit the SCMP's Facebook and Twitter pages. Copyright © 2023 South China Morning Post Publishers Ltd. All rights reserved.

Copyright (c) 2023. South China Morning Post Publishers Ltd. All rights reserved.