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With 25 years in finance, Martin has raised ~$500 million in capital and managed real asset portfolios from $50 million to $10+ billion.
China’s position on the world stage is changing rapidly as it moves to become a strategic competitor to incumbent economic powerhouses. Not least because of the recent trade conflict between the US and China and its long-term fallout as well as the COVID-19 outbreak, it is imperative for companies to recalibrate their manufacturing relationships with the Chinese market.
While many manufacturers started to deploy a China +1 policy in the past, I believe an approach involving further diversification (China +x) yields multiple opportunities and advantages. I will analyze various countries and regions around the world in terms of suitability to replace manufacturing capabilities currently maintained in China.
For each alternative location, I will analyze a) pros and cons, b) current state, and c) outlook for each major market. I will focus on the following parameters: workforce, productivity, infrastructure, utilities, taxation, free trade agreements (FTAs), political stability, rule of law, and perceived corruption.
China’s export-oriented manufacturing industries are mainly concentrated in labor-intensive and technology-driven industries, according to the McKinsey Global Institute. Accordingly, textiles/apparel (40% of global exports), as well as computers/electronics (28%) and electrical equipment (27%), are leading the pack in terms of market importance of China-based manufacturers.
Labor costs in China’s manufacturing sector have seen a steady rise over the last two decades, which is driven by a number of factors:
While the labor cost impact of the first two drivers is rather difficult to quantify, the rise in minimum wages is well-documented. While still at a modest level, since 2006, minimum wages in China nearly quadrupled while they remained almost flat in most OECD countries.
While a number of manufacturing sectors in China have adapted by automating production and shifting the focus to domestic consumer markets, the impact on the competitiveness of China’s manufacturing sector is no longer negligible. More significant, however, is the already visible impact of China’s trade and non-trade relationship with its major trade partners. Additionally, the recent COVID-19 outbreak and its disruptive impact on the supply chains of companies with production facilities in China has led to considerable soul-searching in a number of boardrooms to recalibrate global sourcing and supply chain strategies.
As such, manufacturing outside China locations will need to be evaluated in order to reduce the dependency on China-based outsourced manufacturing and/or China-based plants to supply global markets.
Since the availability of a qualified and low-cost global workforce proved to be a major draw for China’s rise, alternative locations will need to be evaluated on that particular criterion. However, other parameters are of similar importance. Hence the discussion of relocation opportunities will also focus on political stability, availability of utilities and transport infrastructure, availability of financing, taxation, and the regulatory framework (ease of doing business) as well as the freedom of capital flows.
More than half of the world’s workforce is located in Asia and the Pacific, according to the International Labor Organization (ILO), a UN agency. Another 14% are located in African countries, in particular Sub-Saharan Africa.
While there is certainly potential to bring back manufacturing capacities to western economies in Europe and North America using automation as well as cost advantages due to trade corridors and lower transport costs, the focus of this analysis will be on labor substitution.
The Eastern Asia region makes up 27% of the global labor force, consisting of China, Hong Kong, North Korea, the Republic of (South) Korea, Macau, Mongolia, and Taiwan. With relatively small and/or rather expensive workforces, Hong Kong, Macau, Mongolia, and Taiwan do not really have potential for manufacturing shifts from China.
North Korea, with a workforce of 14 million people, would have the potential for a partial manufacturing relocation. However, apart from approximately 100,000 North Koreans working more or less openly in various international markets as part of government-sponsored labor export programs, the country is largely shut out from international manufacturing due to the UN and other sanctions imposed.
South Korea, on the other hand, with its 28 million-strong workforce, is well-placed to capture a portion of the impending China replacement manufacturing capacity.
Workforce | 28-million-strong labor force with high productivity (graph below), converging unit labor costs; >90% tertiary educational enrollment; flexible labor laws |
Productivity | Approximately 10% higher than major OECD economies (see graph below) but similar unit labor cost (see 2nd graph below) |
Infrastructure | Well-developed road, airport, and rail network; strong port/container port infrastructure (Busan in the southeast and Incheon in the west) with easy access to China and Japan |
Utilities | Electricity - self-sufficient but high fossil fuel dependency (70%) Crude Oil - 100% import-dependent (fifth largest importer globally) Natural gas/LNG - almost 100% import-dependent (ninth largest importer) |
Competitiveness (a) | 79.6 (max 100) |
FDI confidence (b) | 1.54 (max 3) |
Source: WEF, UNESCO, AT Kearney
(a) WEF rating entails 12 pillars of competitiveness: Institutions, Infrastructure, ICT adoption, Macroeconomic stability, Health, Skills, Product market, Labor market, Financial system, Market size, Business dynamism, and Innovation capability.
(b) AT Kearney rating; survey-based, high/medium/low rating the 3-year forward-looking FDI likeliness in the particular market
Bottom Line (Eastern Asia)
With its highly qualified and efficient labor force, productivity, and infrastructure, South Korea provides replacement opportunities to diversify some of the high-complexity manufacturing currently handled out of China. Given its already strong trade relationships with the Chinese economy as well as geographic proximity, manufacturing shifts, and supply chain, rerouting should be considered.
The southern Asia region is defined as an area consisting of Afghanistan, Bangladesh, Bhutan, India, the Maldives, Nepal, Pakistan, and Sri Lanka.
Both Bhutan and the Maldives have a labor force of less than 1 million and will therefore be disregarded. Despite a labor force of more than 14 million, Afghanistan has also been disregarded due to its volatile security situation.
Apart from India, which is a major potential labor market, this section will also discuss Bangladesh, Nepal, Pakistan, and Sri Lanka in terms of their manufacturing relocation potential.
So let’s start by taking a look at India, one of the more obvious choices to diversify manufacturing capacity away from China.
Workforce | 520-million-strong workforce with a 75% literacy rate, 75% secondary school enrollment, and 28% tertiary education (university & similar) enrollment |
Productivity | $9 USD GDP/hour worked (i.e., less than 10% of the OECD average) |
Infrastructure | Rail network and container port infrastructure on par with China in terms of quality, but only 7% of China’s overall container terminal capacity; medium-quality air and road transport infrastructure (on par with China) |
Energy | Electricity: 100% self-sufficient, >70% fossil dependency Crude oil: top five global crude importer Natural gas/ LNG: top 20 global gas importer |
Competitiveness (a) | 61.4 (max 100) |
FDI confidence (b) | 1.54 (max 3), down from a 1,85 rating in 2012 |
Source: WEF, UNESCO, AT Kearney
(a) WEF rating entails 12 pillars of competitiveness: Institutions, Infrastructure, ICT adoption, Macroeconomic stability, Health, Skills, Product market, Labor market, Financial system, Market size, Business dynamism, and Innovation capability.
(b) AT Kearney rating; survey-based, high/medium/low rating the 3-year forward-looking FDI likeliness in the particular market
So, India has a large, well-educated workforce and is poised to take over from China to become the world’s next workbench, right? Well, before drawing a conclusion on India’s suitability and readiness to take over, it is worthwhile to look at a few more fiscal and economic parameters, starting with FX rates and inflation.
Driven by uncertainty surrounding the lack of market reforms as well as political risk, interest rates steadily rose prior to 2014. However, this perception changed with the Modi Government implementing further market reforms along with fiscal discipline following its 2014 election.
However, this momentum came to a halt after 2016, when government policies like “demonetization” (canceling of large banknote denominations) and the introduction of the Goods and Services Tax stifled domestic consumption. With the continued stellar recovery trajectory of western markets, FDI investors decided to leave or pass on investments in India.
Bottom Line (India)
India provides significant replacement opportunities for manufacturing capabilities and to repeat the success demonstrated by its outsourcing and IT sector over the past two decades. However, significant issues remain—notably, enhancements and privatization of the bloated government sector, gender issues, lack of suitable infrastructure, and bureaucratic hurdles.
Despite all these, I believe that, as opposed to China, the comparably lesser frictional potential between India and the western world will refocus the West’s attention toward the Indian economy and as such provide significant opportunities for investors.
Pakistan | Bangladesh | Nepal | Sri Lanka | |
Workforce | 75 million | 70 million | 17 million | 9 million |
Literacy rate | 60% | 75% | 68% | 92% |
Secondary school enrollment | 43% | 73% | 74% | 98% |
Tertiary education (uni etc.) enrollment | 9% | 21% | 12% | 20% |
Source: World Bank, UNESCO (2017/2018)
Country | Pakistan | Bangladesh | Nepal | Sri Lanka |
GDP/capita (PPP) | $4,940 | $3,880 | $2,741 | $11,955 |
Labor productivity | ~$8/hr | $4/hr | ~$3/hr (*) | $19/hr |
Infrastructure | Underdeveloped | Underdeveloped | Underdeveloped landlocked | Underdeveloped, but improving |
Energy | Electricity: self-sufficient; Top 30 O&G importer | Electricity: self-sufficient, large parts w/o access; Moderate O&G imports | Electricity: self-sufficient | Electricity: self-sufficient; Moderate O&G importer |
Competitiveness (a) | 51.4 | 52.1 | 51.6 | 57.1 |
FDI Trajectory 2020-23 (b) | negative | slightly positive | slightly positive | slightly positive |
Source: World Bank, CIA World Factbook
(*) extrapolated
(a) WEF rating (max score 100) entails 12 pillars of competitiveness: Institutions, Infrastructure, ICT adoption, Macroeconomic stability, Health, Skills, Product market, Labor market, Financial system, Market size, Business dynamism, and Innovation capability.
(b) AT Kearney FDI confidence rating unavailable, hence use of FDI trajectory.
Bottom Line (Southern Asia ex India)
South Asian countries outside of India provide a young and plentiful workforce which opens up opportunities for investors to expand the manufacturing opportunities. However, political instability and the lack of infrastructure represent significant investment hurdles.
Bangladesh and Sri Lanka, however, show signs of economic improvement driven in both cases by the garment industry and improved trade liberalization. The comparatively high educational achievements in Sri Lanka should allow expansion into the service sector or higher-value manufacturing. The same applies partially to Bangladesh.
Nepal has become a major labor exporter to traditional target markets like the Middle East, but increasingly also to European markets easing their lack of qualified labor. Once the country manages to reverse this trend, local manufacturing hubs would certainly profit. Pakistan, as the biggest labor market in the region, together with China, enacted the China-Pakistan Economic Corridor (CPEC) to invest $60 billion in energy generation and infrastructure projects and the declared goal to achieve growth rates in excess of 6% per annum. It remains to be seen how these projects will materialize and allow manufacturing (and service) investors to tap the significant expansion potential the market has to offer.
Major SEA labor markets with manufacturing relocation potential include the following:
Indonesia | Vietnam | Philippines | Thailand | Malaysia | |
Workforce | 134 M | 57 M | 45 M | 39 M | 16 M |
Literacy rate | 96% | 95% | 98% | 93% | 94% |
Secondary school enrollm. | 89% | No data | 86% | 82% | 82% |
Tertiary education enrollm. | 36% | 29% | 36% | 49% | 45% |
GDP/capita (PPP) | $11,605 | $6,609 | $7,942 | $16,905 | $28,201 |
Labor productivity | $11/hr | $5/hr | $10/hr | $13/hr | $22/hr |
Energy | ~ 100% elec- tricity self-suff, Major gas producer and crude importer | ~100% elec- tricity self-suff. O&G self-sufficient | 100% electr. self- sufficient, Major crude importer, gas self-sufficient | ~90% electricity self-sufficient, Top20 O&G importer | ~100% Electricity self-sufficient, Top40 crude importer |
Competitiveness (a) | 64,9 | 58,1 | 62,1 | 67,5 | 74,4 |
FDI Trajectory 2020-23 (b) | positive | positive | positive | flat | positive |
Source: World Bank, ILO, UNESCO, CIA World Factbook
(a) WEF rating (max score 100) entails 12 pillars of competitiveness: Institutions, Infrastructure, ICT adoption, Macroeconomic stability, Health, Skills, Product market, Labor market, Financial system, Market size, Business dynamism, and Innovation capability.
(b) AT Kearney FDI confidence rating unavailable, hence use of FDI trajectory.
Bottom Line (Southeast Asia and the Pacific)
Given their proximity to existing manufacturing hubs in Southern China, Southeast Asian countries are natural candidates for companies looking to diversify their China-only supply chains. Initially driven by the US-China trade animosities, the post-COVID-19 world will see increased soul-searching and action to diversify exposure.
In particular, Vietnam has seen tremendous advancements in its GDP growth rate during recent years, exceeding 7% in 2018. Samsung, for instance, has poured more than US$ 17 billion of FDI into R&D and manufacturing facilities in Vietnam, making it its major cell phone production hub worldwide. Total South Korean investments are exceeding US$ 60 billion, closely followed by Japan and Singapore-based investors. There is also an increased interest by Chinese investors to shift production to Vietnam in order to hedge against tariffs imposed by the US.
Nevertheless, common obstacles like insufficient infrastructure, energy shortfalls, corruption, and a difficult-to-navigate tax and regulatory framework provide significant hurdles for expansion of both domestic entrepreneurs and foreign investors. Regional instability like the ongoing dispute between China and Vietnam/the Philippines about territorial claims in the South China Sea, impacting access to natural resources and international shipping routes, adds additional layers of complexity. However, the impressive progress countries like Vietnam and Indonesia have made recently look promising. Given the combination of a young and available workforce along with a solid educational framework should definitely put them on the radar for international investors seeking to diversify their supply chains.
While the world’s eyes have been trained on Asian manufacturing markets over the past, going forward, another particular region stands out with significant potential to become an alternative manufacturing hub.
Sub-Saharan African countries represented approximately 12% of the global labor force in 2018, according to the ILO. However, the next 10 years and beyond are poised for significant structural changes in the availability of global labor, which is primarily driven by demographic disparities between Western and Asian countries on the one hand, and sub-Saharan countries on the other. This medium- to long-term trend is reflected in the following three simple graphs.
Bottom Line (Sub-Saharan Africa)
While significant obstacles remain for sub-Saharan Africa to cash in on its demographic dividend, success stories like those of Rwanda, Ethiopia, Kenya, and Tanzania are encouraging and should definitely put these and other regional markets on the menu for manufacturers looking to diversify and de-risk their supply chains.
A particularly interesting industrial cluster is evolving around the Red Sea combining various KSA-based industrial cities (KAEC, Jazan, etc.) with access to cost-effective energy sources and extensive labor markets in North and East African countries.
That’s the end of our “Phileas Fogg - around the world” search of alternatives to diversify China-only supply chains. As the world is emerging from its COVID-19 standstill and facing an increasingly hostile relationship between the US and China, it is high time to future-proof businesses for a much more volatile economic and geopolitical future.
As we have seen over the past couple of months, well-diversified and redundant supply chain structures are, and will remain, crucial to weather future storms and as such should move to the top of senior executives’ to-do list.
Given the recent political turmoil and the COVID-19 pandemic, many companies have been increasingly evaluating alternative manufacturing sources outside of China.
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