U.S. Supply Chain Strategy Needs a Globalization Rethink to Beat China | #espionage | #surveillance | #ceo | #businesssecurity | #

The coronavirus crisis has brought home the dangers of losing sufficient domestic manufacturing capacity to meet the needs of a mass medical emergency—especially when the foreign supply comes from a potentially hostile power like China. Efforts by U.S. companies to expand production of ventilators have been complicated by difficulties in obtaining essential parts from Chinese and other sources. Thanks to export restrictions imposed by Beijing, health care staff around the world face a severe shortage of masks and respirators, the majority of which are made in China. The fact that some of these desperately needed items are manufactured at American-owned plants, by comparatively low-wage Chinese workers, is a painful reminder of globalization’s potential downsides.

As bad as things are, they could still get worse. The capacity to manufacture drugs and active pharmaceutical ingredients has moved from the United States and Europe to developing countries in Asia where costs are lower and environmental regulations more relaxed. According to some widely cited estimates, the United States now imports virtually all of certain common antibiotics and over-the-counter pain medications from China, along with a high percentage of generic drugs used to treat HIV, depression, Alzheimer’s, and other ailments, and many of the active pharmaceutical ingredients used to make other medicines. Constriction of supply chains due to coronavirus-related shutdowns in China, further disruptions in global transportation networks, and a spike in worldwide demand for essential drugs could endanger the health of American citizens. And there is always the possibility of cutoffs imposed for political reasons—a tactic not yet used but increasingly threatened of late by China. An article on the website of China’s official Xinhua news agency provides a not-so-friendly reminder: If China were to retaliate for U.S. statements blaming it for the spread of the coronavirus by cutting pharmaceutical exports, “the United States would sink into the hell of a novel coronavirus epidemic.”

These potential geopolitical as opposed to market or logistical factors point to a larger problem that extends well beyond medical supply chains. The ongoing erosion of domestic manufacturing capacity in certain industries in the United States and the accompanying increase in dependence on Chinese imports could greatly complicate any future attempt at defense mobilization. If trade were suspended due to a tense confrontation or an actual armed conflict, the United States might find it difficult, and perhaps impossible, to ramp up and sustain production of arms, munitions, weapons platforms, communications equipment, and other military systems. In addition to a direct loss of Chinese exports, an actual shooting war in the Western Pacific could also disrupt U.S. access to alternative sources of supply from other regional trading partners, including Japan, South Korea, and Taiwan. Although such concerns have started to receive more attention from defense planners in recent years, the last several months have cast them into sharp relief.

A man in a face mask works at a production facility of the pharmaceutical company Escom, which manufactures saline solution, glucose solution, and other infusion and injection solutions in Stavropol, Russia, on May 6. The factory has moved to round-the-clock production during the pandemic.Alexander Pogozhev/TASS via Getty Images

Even before the current crisis, many companies had begun to diversify production away from China, shifting a portion of their manufacturing capacity to other countries. This movement was driven by the need to avoid U.S. tariffs, but also by longer-term trends, including rising Chinese wages and technological developments that are making it both desirable and cost-effective to shorten some supply chains, bringing producers closer to final consumers.

Once the coronavirus pandemic begins to recede, greater awareness of the potential impact of natural as well as man-made shocks will accelerate tendencies not toward deglobalization but rather toward reglobalization: a reshuffling of supply chains and at least a partial reduction in the concentration of capacity inside China. In the words of one recent survey of global manufacturing trends: “While the trade war triggered some notable tinkering, the massive operational disruption wrought by the coronavirus pandemic will compel companies to fundamentally rethink their sourcing strategies. At minimum … they will be increasingly inclined to spread their risks rather than put all their eggs in the lowest cost basket, as many long did in China.”

As was true during its early stages, so too will the next phase of globalization be driven by thousands of discrete corporate decisions about profit and loss. But, as in the past, those calculations will also be shaped by government policies. The disruption caused by the pandemic creates an opportunity for U.S. policymakers to reassess and recalibrate their generally laissez-faire approach to globalization.

There are four distinct but overlapping reasons why U.S. strategists should seek to encourage at least a partial restructuring of global supply chains.

1. Reducing vulnerability to disruption or coercion

Under normal conditions, there may be no obvious problem in depending on imports rather than domestic suppliers for medicines or materials used in arms production.

In a crisis, however, as demand rises and imports are insufficient or unavailable, the absence of adequate domestic capacity could prove disastrous. In order to identify potential gaps and shortfalls, planners would need to consider a range of plausible scenarios, estimating emergency requirements, comparing them to readily available resources, and pinpointing instances in which the United States might find itself excessively dependent on imports from China. In such cases, the federal government would then have to contemplate ways of inducing U.S. or foreign companies to build or expand production facilities on American soil, to diversify foreign sources of supply, and perhaps to do both simultaneously.

2. Reducing vulnerability to sabotage or surveillance

The prominent role of Chinese-based companies in IT manufacturing, including everything from parts to finished products such as phones, drones, and network switching equipment, and the ability of the Communist Party to exert control over even nominally private Chinese entities create numerous potential vulnerabilities for their foreign customers.

This is why the U.S. federal government has banned Huawei and ZTE from the American telecommunications system. The Defense Department and other agencies are also developing techniques for peering more deeply into supply chains, tracing the sources of parts and subassemblies that go into the equipment they procure. To mitigate risk, when links to potential “threat actors” are identified, alternative, trustworthy suppliers must also be found.

U.S. President Donald Trump participates in a tour of a Honeywell International plant that manufactures personal protective equipment in Phoenix, Arizona, on May 5.

U.S. President Donald Trump participates in a tour of a Honeywell International plant that manufactures personal protective equipment in Phoenix on May 5. BRENDAN SMIALOWSKI/AFP via Getty Images

3. Preserving/expanding domestic manufacturing capacity

Another reason for attempting to shift existing supply chains and, in particular, for trying to preserve and expand domestic manufacturing capacity is that doing so could help boost the overall productivity, international competitiveness, and long-term growth prospects of the U.S. economy. That, in turn, would generate more of the aggregate resources necessary to sustain a protracted strategic competition with China, while at the same time enhancing the well-being of many American workers.

The loss of manufacturing jobs that followed, and was in part caused by, China’s entry into the World Trade Organization appears to have contributed to rising income inequality, hurting the middle class and damaging the fabric of American society. A revitalization of U.S. manufacturing industries could help to reverse this by creating more higher-wage jobs, especially for workers who lack college degrees. The United States needs at least a portion of the manufacturing capacity in existing industries that it would need to meet the requirements of a near-term crisis. In the longer run it must also have vibrant, home-based companies to develop and produce the next generation of advanced materials, semiconductors, and automated systems that will provide the basis for both new weapons systems and novel consumer products.

4. Imposing costs on China

Just as it could provide benefits to the United States, shifting supply chains would also impose costs on China. As economist Derek Scissors has pointed out, earnings from the final assembly and export of consumer electronics to the United States are a major source of hard currency for Beijing. In Scissors’s words, “pushing supply chains out of China” would constrict its export earnings while helping other countries “considerably friendlier to American interests.” Even if the value-added from the final assembly of consumer goods is relatively small, from a strategic standpoint it would be preferable if the resulting gains accrued to the economies of U.S. friends and allies rather than to China. The physical relocation of some portion of existing supply chains could also help slow China’s efforts to extract sensitive technology through industrial espionage or coerced joint ventures.

U.S. policymakers have an array of instruments with which to further encourage the partial exodus of productivity capacity from China. Especially if it becomes clear that they will not be lifted anytime soon, tariffs such as those the Trump administration imposed in 2018 and 2019 will continue to help drive this process.

If the purpose of U.S. policy is to enhance its own security and prosperity rather than simply to impose economic pain on China, import taxes on many consumer products could be lifted while those on a narrower list of intermediate goods (including some electronic components and chemicals) are retained. These targeted tariffs, many of which were initially levied in retaliation for China’s alleged theft of intellectual property, could be supplemented by a set of financial sanctions against specific companies that have engaged in IP theft and other unfair trading practices. As Scissors suggests, “it makes no sense to inhibit market access for China-based exporters at the end of supply chains while simultaneously providing them American funding.”

Even a largely market-driven dispersion of supply chains and a lesser degree of concentration in China should help to reduce risks and increase resilience. While Washington lacks sufficient leverage to orchestrate or fine-tune this process, it can enhance the appeal of some locations over others. As analyst Robert Atkinson has pointed out, in combination with the new U.S.-Mexico-Canada trade deal, eventual U.S. entry into some version of the Trans-Pacific Partnership “would make it clear to global companies that if they move production out of China to one of these partner nations, they will not be subject to punitive tariffs in the future.” Free trade agreements with Taiwan, the Philippines, and perhaps eventually Indonesia and India could have similar strategic as well as economic benefits. There may be other attractive alternative sites in Eastern Europe and possibly Turkey. To the extent feasible, the United States should seek to source imports of critical goods from a trusted production network of facilities in friendly or allied countries, at least some of them located far from China.

Washington also has a variety of tools with which to encourage the location, or promote the expansion, of industrial capacity on American soil. During World War II and the opening stages of the Cold War, the federal government used the tax code in a focused fashion, extending the so-called rapid tax amortization privilege to promote expansion in sectors where resource requirement calculations revealed gaps that could stall defense mobilization. In the 1950s, federal agencies also used procurement guarantees to encourage the maintenance of capacity above anticipated market demand for certain minerals and machine tools by promising to buy a portion of the resulting output. Some of these were then placed in stockpiles for possible future use.

The U.S. government could use similar tools today if, for example, it wanted to expand the nation’s ability to manufacture personal protective equipment and ventilators, items that might be needed to combat the next pandemic. Tightening the interpretation of “buy American” provisions in government procurement regulations has been proposed as a way of providing an additional incentive for domestic manufacturing. Finally, in order to cultivate domestic capacity in some key sectors, the government may have to offer subsidies, loans, or loan guarantees. This is especially likely to be the case in industries such as semiconductors, rare earth minerals, and pharmaceuticals where the costs of building, enlarging, or reopening facilities on U.S. soil might otherwise be prohibitively high.

Globalization is not an unstoppable natural force, propelled solely by technological progress and autonomous market forces; instead it is a man-made phenomenon with contours shaped by the choices of states as well as firms. China’s emergence as an irresistibly attractive manufacturing platform was partly due to the sheer size of its working-age population and the falling costs of communication and transportation, but also due to deliberate government policies designed to aid in the acquisition of foreign intellectual property while keeping the cost of land, labor, and capital low and exchange rates favorable. Conversely, the migration of manufacturing capacity from the advanced industrial countries reflected not only the profit and loss calculations of individual companies but also the permissive policies of Western governments that concluded in effect (in the U.S. case) that what was good for Apple or 3M was good for the United States.

Even as some of China’s earlier advantages have started to wane, firms and now states have begun to recognize that, if it results in excessive dependence, an addiction to low costs can create serious commercial and strategic risks. In responding to this reality, corporate executives can be expected to do what is best for their companies and their shareholders. Governments, meanwhile, will have to make judgments about what is in the best interests of their countries and their citizens. In keeping with long-standing American traditions, rather than dictate to the private sector or attempt to do its job directly, the U.S. government should create incentives that bring corporate interests and the national interest more closely into alignment.

There are obvious dangers here. Sharpened tools of trade and industrial policy can be abused by irresponsible leaders seeking to pander to voters and pay off supporters, or they may be captured and exploited by special interests. An effective strategy for reforging supply chains and strengthening domestic manufacturing will have costs and it will require mechanisms for assessing requirements, making decisions, and implementing policies that are at least partially insulated from day-to-day political pressures.

All of this would be a tall order under the best of circumstances. Still, the experience of finding themselves dependent in a dire emergency on an irresponsible, opportunistic, and potentially hostile power has clearly left an impression on democratic publics and politicians that will not soon fade. There will never be a better time for the United States and its partners to reconsider, and begin to reshape, their economic relations with China. The current crisis is a terrible thing, but it would also be a terrible thing to waste.

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