The drivers and winners of supply chain diversification away from China

While economic factors have led to supply chain reshuffling for at least a decade, the US-China Trade War in 2018, the COVID pandemic in 2020 and the Russia-Ukraine war in 2022 have accelerated the trend with a complicated layer of geopolitics and competition, pushing production diversifying from China. In this note, we analyze the economic and geopolitical drivers behind such policy drifts and identify the winners by country and sector.

The three drivers of supply chain diversification include geopolitics, industrial policies and economic reasons of labour costs and demographics. While the geopolitical dynamics is apparent under the narratives of strategic competition and supply chain security, there is clearly a stronger push to compete through industrial policies. In the US, the government introduced the CHIPS Act to incentivize domestic semiconductor production. Subsequently, the Inflation Reduction Act aims at subsiding green related manufacturing in the US with friend-shoring, which is followed by the EU. Trade liberalization is also under ways to favor non-China countries in Asia with the EU, and the US IRA has clauses that help FTA countries to qualify exemptions to get subsidies. Economic factors, including wages and demographics, favor most ASEAN countries and India with population growth, especially as more countries carry out labour market reform.

On a country level, the winners specialize in different segments and tech levels of the supply chain. At the top end of the supply chain, Japan and South Korea stand out to benefit as investors look to non-China alternatives. At the medium-tech level, Malaysia already has an existing semiconductor packaging supply chain and Thailand has well-built automobile facilities. In labor-intensive manufacturing, India has reduced import tariffs and is beefing up investment with tax cuts and subsidies, while Vietnam has decent infrastructure, incentives, and aggressive trade liberalization. At the commodity level, Indonesia is a crucial nickel producer, with a worldwide market share of 48% in 2022, and Australia also benefits as it has high production and/or reserves in a range of critical materials, especially lithium.

While it is unsure whether the visible hand and the friend-shoring trends will lead to a desirable economic outcome in the long run, there can also be winners in sectors and corporates because of the more powerful policy-driven forces for change. APAC is well-positioned to capture the opportunities in green, critical materials and tech sectors. With a US-led multi-country chip ban, a direct consequence is it will drive production in non-China markets as long as there is demand for chips globally. Chipmakers may lose access the Chinese market, but the shock will be smaller than it looks on the surface as some production and demand may shift to other locations.

All in all, geopolitics and industrial policies may have complicated the market forces, but it is also about the economic drivers, including changing demographics and wages. With the tensions between China and the world, the current trends in supply chain diversification will likely continue. It will disrupt the existing production set-up with higher costs, but it will also bring winners in APAC countries and sectors.

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