Is it a good idea for governments to interfere with supply chains? Multiple parts of the U.S. government certainly believe so and are seeking to expand the current trade dispute with China. While it’s wise to be skeptical of government intervention, there are sound reasons why some supply chains that include America should not include China. And even if ongoing bilateral talks achieve limited success, Washington is likely to continue in some form to try to displace certain supply chains.

There are two rationales supporting this course of action. The first is financial and the second technological.

On the financial front, from spring 2014 to fall 2019, China earned approximately $1.6 trillion net from goods and services trade with the United States. While not all of that came through supply chains, the biggest component in bilateral trade is consumer electronics, which is dominated by trans-Pacific supply chains (there are others as well). Despite this, official Chinese foreign exchange reserves fell by $850 billion during the period. The United States is thereby providing the hard currency necessary to fund Chinese initiatives ranging from Belt and Road construction in strategic locations to acquisition of major foreign assets. Without the United States, China does not have the money.

America benefits from bilateral trade but pushing supply chains out of China would remove all the associated gains for China with much milder American losses. Production would shift to slightly or somewhat higher-cost producers considerably friendlier to American interests. While it would not be cost-effective to try to micro-manage the relocation, the prime outlets are Mexico, India, Vietnam, Indonesia, and the Philippines, none of which pose anything like the economic or military threat China does.

On the technological front, it is well known that a major aspect of Beijing’s leverage over American technology companies is the size of its domestic market. Market size is primarily determined by Chinese policy. There is, however, another element: the location of the assembly end of very large-scale supply chains that ultimately sell back to the United States. If the latter were to shift, outright Chinese pressure on American firms to transfer dual-use technology in exchange for the privilege of operating in China would be considerably less effective. Physical relocation would also impinge on more subtle methods of acquiring sensitive technology, such as offers to form joint ventures outside supply chain cooperation and extensive contact among technical personnel.

In this light, American policy on supply chains running through China requires multiple changes — more clearly articulated objectives, consistent treatment of specific chains (currently lacking), the augmentation or replacement of tariffs with other policy tools, and the fostering of supply chains elsewhere. The value of these changes can be seen by documenting the minor extent of decoupling to date, identifying major problems with Chinese-U.S. integration from the American perspective, and recommending corrective actions.

State of Play

It’s still too early for definitive conclusions about how much supply chain movement has occurred due to trade conflict. Some observers saw writing on the wall as early as President Donald Trump’s election campaign, the launch of the Section 301 investigation into China’s coercion and theft of intellectual property (IP), or the June 2018 initial application of tariffs. Nonetheless, sufficient steps to alter supply chains were not taken until May 2019, when 25-percent tariffs were applied to $200 billion in imports. There’s been little time for American action to have a serious impact, so the impact to date has been limited.

Source: National Bureau of Statistics of China

Analysis is further hampered because Chinese land and labor costs likely caused production to relocate prior to and independent of U.S. policy. Left entirely to their own devices, rising Chinese labor and land costs displace output and can cause supply chain shifts. In particular, with China’s labor force expected to shrink indefinitely, it is natural to expect that the long-time consumer mainstays of simple consumer electronics and apparel chains will leave the country. Movement of production could therefore be unfolding but in the same way as it did in 2016, when it was not so closely scrutinized. Or it could be a reaction to recent U.S. policies, but one that will quickly unwind if policies are reversed after the 2020 election.

Source: U.S. Census

The obvious place to start assessing if chains have moved is where Trump started, with the single biggest component of the economic relationship: merchandise trade. There are a few early warning signs: American goods exports peaked in the fourth quarter of 2017 and bilateral services trade volume peaked in the first quarter of 2018, although the changes were small. But the outright decline of goods import started only in the fourth quarter of 2018. Bilateral trade volume in the first three quarters of 2019 was then 17 percent lower than it was during the first three quarters of 2018, even though heavy tariffs did not appear until midway through the second quarter of 2019. If a bilateral deal does not unwind tariffs, more declines in direct trade are certain.

This is complemented by an on-year decline in direct investment from the United States to China. In the first half of 2018, American direct investments in the mainland and Hong Kong (a transit point for money entering the mainland) were each over $6 billion. In the first half of 2019, the numbers were $3 billion and $2 billion, respectively. At the same time, investment into Indonesia reversed a decline, that into Singapore reversed a large decline, and investment in India doubled. Some American capital sought greener pastures.

Source: Bureau of Economic Analysis

But only some. Portfolio investment — for ownership of securities only, not physical assets — does not itself finance production, as direct investment does, but it supports production by enriching the recipient firms. From the end of 2016 through June 2019, American portfolio investment into China nearly doubled, rising $100 billion in total. It rose substantially in the first half of 2019. This has been encouraged by Beijing granting greater financial market access to foreign firms. Portfolio investment can be far more easily withdrawn than direct investment, so its flows can quickly reverse. But the magnitude of the portfolio gain for China over the past few years has been larger than the direct investment loss. On net, there has not been financial decoupling.

Source: Treasury Department

American companies operating in China are the most likely to ship back to the United States and thus are forced to contemplate the higher tariffs. Information regarding other firms which might export from China to the United States is less helpful. E.U. data, like its decisions, are hopelessly slow to appear and do not yet touch the period where supply chains might have moved.

Chinese investment data are difficult to read because Hong Kong is given as both the primary source and the primary outlet — the central government does not track investment that is routed through Hong Kong. Aggregative inward investment slowed sharply in November 2018 but has held at roughly three-percent annualized growth since. However, the number of new contracts dropped by one-third, year-on-year in the first three quarters of 2019. Some multinationals remain quite optimistic about China’s prospects, but there seem to be fewer of them.

Beyond the scattered numbers there are plenty of stories. A September 2019 survey of American firms in China showed more cancellation plans, though this was attributed more to domestic conditions than the bilateral dispute. There are recent reports of Japanese and Taiwanese firms leaving China. Even a handful of Chinese firms admit to relocation.

It’s nonetheless too early to say whether relocation has accelerated due to existing or threatened American action. Any supply chain changes are recent enough and the magnitudes small enough that they could be quickly reversed through either negotiation or the 2020 election. But if American pressure is maintained or increased over the next few years, supply chain shifts will intensify beyond what has been observable to now.

Reasons to Act

In principle, at least, pressure is justified. Some chains running through China pose sharp risks to the United States, others have already been harmful. The consensus starting point is technology, especially that having dual commercial and military uses. The consensus stems first from an obvious change over time: Both the foreign knowledge China is targeting and its ability to acquire that knowledge have become much more advanced. This is indirectly reflected in American imports of communication equipment from China, which from 2002 to 2018 rose by a factor of 17.

Source: U.S. Department of Commerce

The second factor has remained constant from the onset of bilateral negotiations over accession to the World Trade Organization to the present: systematic Chinese infringement or outright theft of foreign IP. The two factors combined mean curbing IP coercion and theft lies at the intersection of high-value American commercial and military interests. It was thus chosen as the Trump administration’s opening salvo against China in the Section 301 investigation. But the focus shifted quickly to conventional trade balances and tariffs, leaving IP protection and technology chains unchanged.

Action against Huawei was initially motivated by Iran sanctions. Moreover, the addition of Huawei to the Department of Commerce’s list of unreliable partners still allows firms to shift operations out of the United States, then do business with Huawei freely. New export controls could be more comprehensive but mandated changes are late. Commerce has not yet published draft regulations, much less acted on tasks such as enforcing bans on deemed exports (where foreign nationals participate in U.S. research and development). The United States has identified reasons for robust steps on technology chains, but has done very little.

There are no conventional supply chains in finance. But all supply chains need money, making finance vital in moving them out of China. If the United States does eventually maintain coherent policies to shift technology chains, for example, these policies will require a financial component to be effective.

Here, rather than doing little or nothing, American policy is internally contradictory. It is counter-productive to separate the American and Chinese technology sectors, yet continue to finance Chinese technology. Similarly, current American tariffs are overly broad. But any final, smaller set of tariffs should come with financial restrictions. It makes no sense to inhibit market access for China-based exporters at the end of supply chains while simultaneously providing them American funding.

Perhaps unsurprising, U.S. policy presently makes no sense. Chinese firms, including technology firms that have long benefited from IP coercion and theft and others recently hit by tariffs, can freely raise money on American capital markets. Moreover, they can do so despite consciously violating disclosure requirements. Not content with this, the Trump administration is actively seeking rights to invest more in China, with provisions to prevent undermining its own tariffs, pending export controls, or any potential action to shift supply chains.

Finance and technology are very broad; there also are specific problems with supply chains in other sectors. China is said to be the dominant global producer of active pharmaceutical ingredients (API), a British government report assigned a 40-percent share. The original source of these and related numbers, however, is unclear. And a key reason to pull supply chains out of China is the Communist Party’s steadfast opposition to any inconvenient transparency that might make for a clearer picture. The preference for opacity runs directly counter to desired benefits of globalization and is especially troubling in products such as API (versus, say, shoes).

Among the results of lack of transparency are repeated and serious quality control failures within China’s own pharmaceutical sector which have primarily harmed China, have also harmed the United States, and could do so again. The most famous case is dozens of deaths caused by adulterated heparin in 2008. While that was more than a decade ago, the quality of Chinese clinical trials remains extremely poor. In 2019, major drugmakers have lied about their data and their finances. Finally, there is an entirely non-market motive for limiting dependence of the U.S. military on Chinese API.

Parallel arguments to API apply to a handful of other components of ordinary merchandise trade, for example any device which might be used to conduct surveillance from phones to drones. Here as well Chinese producers are global leaders and the corresponding threat is data “accidentally” being rerouted (again). Rare earth supply chains have also been seized upon as dangerous, but evidence of a threat remains weak. A purported Chinese embargo against Japan in 2010 had little impact due to ease of substitution and the volume of American rare earth imports in 2018 was only $160 million.

Partial Solutions

Instead of evaluating supply chains, U.S. policy has chiefly used tariffs to coerce export access. Non-tariff options such as barring all business contacts or fining Chinese entities have been largely ignored. To the extent supply chains are being targeted, results will still fall short unless goals go beyond trade balancing. American goals are presently unclear or unstable but can include relocating production, to the United States if possible, but also inhibiting technology transfer, countering Chinese industrial policy, and even combating human rights violations.

If goals are fixed and specific supply chains identified, three features needed for effective policy are depth, durability, and discrimination. The need for durability is plain — supply chain shifts beyond what is evident thus far cannot be accomplished by transient measures. Discrimination refers to treating China appreciably worse than other producers, so firms have incentive to relocate. Depth refers to moving beyond tariffs.

China’s merchandise shipments to the United States are the bulk of the economic relationship. It’s impossible to consider all the chains involved but China reports exports are led by consumer/business electronics such as computers and phones, broadcast equipment for television and radio, electrical equipment and machinery such as power plants, textiles, and steel. These are reflected in disproportionate increases in American goods imports since 2002, the first year of China’s membership in the World Trade Organization.

Consumer electronics — computers, phones, display screens and accessories — include the best-known supply chains. They also comprise the largest component of the bilateral deficit, making depth fairly easy. If China-based electronics firms selling to the United States anticipate high tariffs and little trans-shipment through third parties, they will want to move. Durability follows from a protectionist president such as Trump or Sen. Elizabeth Warren. But conventional protectionism calls for targeting all low-wage countries that run bilateral surpluses.

The key to success is discrimination. More companies will move if they have alternative sites from which they can supply the United States. Mexico is obvious but more output would leave China if there were also attractive East Asian suppliers to the United States, such as Vietnam or the Philippines. For large chunks of electronics supply chains to leave China, the United States ought to treat production and export from other partners clearly better than that from China, ignoring probably rising bilateral imbalances with the new sources.

For API, it’s necessary to relocate some production specifically to the United States, as a form of insurance. The risk comes from quality control in mass-use drugs and possible Chinese attempts to coerce the United States by targeting the military. The American defense establishment will likely mandate reliable suppliers for pharmaceutical products that cannot be stockpiled. Relocating chains serving ordinary consumers is cost-sensitive. Efforts should be concentrated on improving alternatives to Chinese supply for the most (health-) vulnerable sections of the population. Non-tariff tools, starting with research, are vital and discrimination against China is needed.

Technology chains differ from others because of the combination of military use and rapid shifts in product performance. Semiconductors are the core. A proxy for important technology chains can be found in American firms with high revenue dependence on China, most connected to chips, such as Qualcomm, NVIDIA, Texas Instruments, and Intel. Supplementing that, the Commerce Department’s overdue export controls regulations are supposed to identify “emerging” technologies, for instance expert systems, biomaterials, or anything with the word quantum in front of it.

To shield advanced technology, coordinating with top alternative suppliers Japan and Germany has some value. But the United States is the runaway leader in dual-use development and discriminatory treatment is a minor factor. In terms of depth, properly constructed and implemented export controls would be sufficient. If export controls are flawed and China acquires vital IP, tariffs and other steps cannot shape technology supply chains, given the Communist Party’s intense commitment to technology development.

Genuine durability is the key to success in technology chains. It is simple in concept, difficult in practice: The determination of high-value technology supply chains to return to or remain under American control ought to be regularly updated, a time-consuming and expensive process if done well. The alternative — outdated restrictions — would strangle older, harmless activity and ignore newer and more harmful technological diffusion.

Financial action is a necessary part of most steps to shift supply chains. It is perverse for the United States to negotiate to reduce the distortions caused by Chinese industrial policies while American money helps support those policies. Beijing is opening its financial services sector because national finances are far more strained than commonly thought, with official foreign reserves dropping $900 billion since spring 2014 and, more important, soaring internal debt.

This strain is ongoing, so American financial actions do not need to be durable to be effective. For the same reason, however, discrimination is a challenge. As with supply chains themselves, the United States wants capital to find other pastures greener than China. Beijing, however, is already claiming improvements to its investment environment and Washington may need to work with partners to increase their appeal.

The key to financial support in moving supply chains is depth. The Department of the Treasury recently published draft regulations tightening foreign investment screening but Chinese direct investment in the United States has previously fallen sharply. There are currently only a few billion dollars in annual direct investment, so the new rules are precautionary.

More important actions are just now being explored: formal restrictions on outbound investment. As noted, larger flows are found in portfolio rather than direct investment. Two measures to restrict portfolio investment are in play, starting with delisting the Chinese companies that ignore U.S. disclosure requirements. While justified by rule of law, this has little bearing on supply chains. The second measure is much narrower for now but easily expanded: preventing a U.S. government financial institution from portfolio investing in China.

The justification is preventing U.S. government support for Chinese development of dual-use technology, which is directly linked to supply chains. The scope can easily be broadened. Most important, restrictions can be applied to private investors. They can be applied to direct investment as well as portfolio. Targets can be expanded to firms that have benefited from coerced or stolen IP or participate in violations of human rights or other undesirable behavior. When finance is included, the American ability to shift high-priority supply chains jumps.

In sum, if there are any goals other than cost minimization, the United States should not rely on certain supply chains running through China. Goals should be public and persist beyond contemporary rounds of bilateral negotiations. Only the most important chains should be targeted by government intervention, tariffs should not be the only or even the principal tool, and alternative chains through third countries should be cultivated or at least accepted.

Derek Scissors is resident scholar at the American Enterprise Institute, studying the Chinese and Indian economies and US economic relations with Asia. He created the China Global Investment Tracker. He is also chief economist at China Beige Book. Dr. Scissors has a bachelor’s degree from the University of Michigan, a master’s degree from the University of Chicago, and a doctorate from Stanford University.

Image: Wiki Commons (Photo by Robert Scoble)