Xi Jinping has become the ultimate authority on business operations and politics in China. This has led to concerns among companies and states dealing with China, concerns that Beijing’s lack of transparency with regards to the true extent of the Covid-19 outbreak have only augmented. Investors active across the country have therefore increasingly been looking for alternatives. 

An early mover was South Korean conglomerate Lotte, which moved its supply chain subtly and imperceptibly out of China after being forcefully sanctioned by the Beijing government as the corporation sold a piece of land to the South Korean government, which was eventually used by the US to counter threats from North Korea. 

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Samsung started downsizing its manufacturing units in Shenzhen and Tianjin and also began shifting production to Vietnam because of the volatility of the Chinese government and tariffs. 

Meanwhile, its market share in the Chinese market has shrunk because of competition from domestic rivals. This shift that started with Lotte and Samsung has recently accelerated with the Covid-19 crisis and Japan and China’s conflictual attitude. However, it’s not only the Japanese and the Americans who are leaving mainland China and setting up shop elsewhere. Chinese business owners are also doing the same. 

Fundamentally, the Xi Jinping regime now faces its biggest challenge as the ‘middle-income trap’ looms large in the horizon. This term refers to those countries which have experienced rapid growth and reached the status of middle-income country in a very short period of time, but then fail to catch up with the higher income economies and hence get trapped. 

Foreign companies not only contribute to China’s economic growth, but also provide exports and employment. All of these factors are important if China wants to leave the vicious middle-income trap. If foreign companies continue to leave, then new investment may stagnate,  which will negatively affect all the factors required for China to ascend to the status of a high-income economy.

If foreign companies continue to leave, then new investment may stagnate,  which will negatively affect all the factors required for China to ascend to the status of a high-income economy.

The Chinese exodus

As many as 50 companies moved production out of China or left altogether because of the trade war with the US, according to data from Nikkei Asian Review. The main reason for this exodus is for investors to avoid the punitive tariff introduced by the US government. Manufacturers like Apple have therefore started shifting their production, though on a trial scale, to India and Vietnam. 

A survey among 250 company members of the American Chamber of Commerce in Shanghai found in May 2019 that “approximately 40% of the respondents are considering or have relocated their manufacturing facilities outside of China”. 

Another 2019 survey by supply chain advisory QIMA recorded that 80% of the US companies and 67% of the EU companies are considering leaving China. Uniqlo, the largest Japanese fashion chain, increased its base of suppliers in Vietnam by 40% due to rising wages and workforce shortages in China. On the same grounds, Adidas and Nike have also withdrawn their units from China. This trend is accelerating more among small scale manufacturers. 

Covid-19 will escalate the trade feud between Washington and the US.  The US government will change the incentive structure for private investors with operations in China, which will eventually force many corporations to move their production out of the country. As stated by Patrick Van den Bossche in Kearney’s seventh annual reshoring index, “three decades ago, US producers began manufacturing and sourcing in China for one reason: costs. The trade war brought a second dimension more fully into the equation – risk – as tariffs and the threat of disrupted China imports prompted companies to weigh surety of supply more fully alongside costs. Covid-19 brings a third dimension more fully into the mix­, and arguably to the fore: resilience – the ability to foresee and adapt to unforeseen systemic shocks.” 

‘Economic distancing’ a new normal

Japan’s latest economic stimulus earmarked $2.2bn to help its manufacturers shift their production out of China, to mitigate supply chain disruptions moving forward. In this budget, approximately $2bn are reserved for companies shifting their production back to Japan and $215m for those seeking to move production to other countries. It is a wise decision to reserve funds in the budget as it will work as a catalyst in this process. This step may bring the affable relations between the two states to an end, as well as reduce the reliance of Japan on China. 

The US has imposed tariffs on Chinese imports worth $550bn, to which China retaliated by imposing tariffs on US imports for $185bn. But this is not enough if the White House wants its companies to move out of China. If the US government wants this process to be successful, then it must pay companies' moving costs.

This can also be referred to as ‘economic distancing’. One of the important questions in this difficult situation is whether China could challenge Japan or US measures before WTO or ISDS. The answer is clear, ‘very likely no’. If we look at the WTO statistics, over the last 16 years, there have been 23 cases between the US and China. The US won 20 cases, and the remaining three cases are still pending. So, the odds are pretty clear.

In addition, this ‘economic distancing’ might be further strengthened as the Phase 1 trade deal stands still because of Covid-19. This deal had the potential to stop the economic conflict between the two superpowers. The first part of the deal requires China to purchase $50bn of US energy products in the next two years. The impact of the novel coronavirus on the Chinese economy raises serious questions about whether the energy component of the trade agreement is already doomed to failure. 

Even if this part gets executed, thousands of jobs needed to build new energy facilities would not materialise, depriving the US of one of the key benefits of the trade agreement. The coronavirus has restricted the movement of people and the flow of goods, thereby negatively impacting economic growth in China and around the world. 

The resulting decrease in energy demand will make a $50bn purchase in the short-term even more challenging. Some have suggested that China could be backed into a corner where it needs to declare force majeure – an excuse for not satisfying a contractual obligation because of certain unforeseen events that are beyond the party’s control – from its obligation to purchase $50bn of energy products over the next two years. All this will lead to the non-implementation of this agreement and so the possibility of seeing Phase 2 is not clear. 

China may not escape middle-income trap

The decline in Chinese economic activity increases its financial instability and slows the much needed reorientation of the Chinese economy. It is a risk that is amplified by the fact that China’s historic development process is navigating the trickiest of all transitions where it faces the ‘middle-income trap’, in which a country’s economy becomes stuck and never shifts into higher gear.

Over the past decade, the world has grown more authoritarian, nationalistic, xenophobic, unilateralist, anti-establishment, and anti-expertise. The current state of politics and geopolitics has exacerbated, rather than stabilised, the crisis. Due to lack of strong diplomatic actions at this time, all this will lead us back to unilateralism in international trade and investment. Even if companies leave, China is hard to replace. For many components, it is the only game in town.

The colossal Chinese economy is currently bleeding and the more it will bleed, the more opportunity will be there for other nations. So the question is, who will benefit from the wounds of China?

The potential beneficiaries are the ‘Mighty Five’ nations, led by Vietnam (the others being Malaysia, India, Thailand and Indonesia). Mexico has also become a major dot for outsourcing because of the new US-Mexico-Canada Agreement. In 2019, Vietnam exported $47bn more than it imported from the US. Companies like Samsung, Nike and Adidas have shifted production to Vietnam. The US-China Trade dispute has opened the pores for other nations and their profits will be mainly in those products which have been hit by the tariffs. The golden days of the dragon as the go-to hub manufacturing for the west seem to be over for good. 

Julien Chaisse is professor of law, City University of Hong Kong and advisory board member of the Asian Academy of International Law. Arjun Solanki is an associate, World Trade Advisors.