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Out of Asia: Promise from Pandemic of a Manufacturing Renaissance in North America (Part 3)

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Free Trade Agreements, Global Trade Daily, International Trade

Out of Asia: Promise from Pandemic of a Manufacturing Renaissance in North America (Part 3)

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In their first two installments (which you can view here and here), George Y. Gonzalez and Jesus Alcocer respond to the gaps exposed in the supply chain by the pandemic by proposing a shift away from overreliance on China and a shift towards reshoring manufacturing closer to home. In their final installment, they will explore how the potential cost of reshoring out of Asia to North America could be lessened if capacity is relocated to Mexico, a natural alternative. Wrapping up their discussion, they will also examine how Houston may serve as a central hub for cross-national manufacturing and trade.

Mexico Has Also Been a Beneficiary of This Shift Out of China

Mexico has benefited from this rearrangement almost as much as Vietnam. According to A.T. Kearney, manufacturing imports from Mexico rose $13 billion to $20 billion in 2019. Thanks to this climb, the U.S. now imports 42 cents from Mexico for every dollar it purchased from LCAs, up from 37 cents during the past seven years. This pattern has also extended into 2020. In the first quarter of this year, imports in maintenance and repair, construction, and insurance sectors all grew in the triple digits, while imports of information and communications technology products (“ICT”) grew 20% year-on-year.

The trade relationship between the two North American countries has developed in spite of political obstacles. The Trump Administration imposed tariffs on Mexico-produced steel in 2018 but removed those barriers in May 2019. Likewise, Andres Manuel Lopez Obrador, Mexico’s president since 2018, was widely regarded as a nationalist suspicious of international trade. According to the Congressional Research Service, “in the area of foreign policy, President-elect López Obrador generally has maintained that the best foreign policy is a strong domestic policy.… Some observers feared that López Obrador might roll back Mexico’s market-friendly reforms and adopt a more isolationist foreign policy.” Against these inauspicious circumstances, bilateral trade has grown steadily since 2016. Mexico surpassed Canada as the U.S.’s largest trade partner in 2019. In 2013, Canada exported 8.3% more to the United States than Mexico. Now the order has reversed, with Mexico exporting .5% more than Canada into the U.S.

Growing imports can be partly explained by a hike in U.S. FDI in Mexico, which grew approximately 5.2% between 2018 and 2019 to $100.89 billion. Investment in primary and prefabricated metals manufacturing close to doubled from 2015 to 2019 to close to $2.27 billion, while FDI in machinery manufacturing grew about 25% during that same period. These are some of the industries where U.S. FDI in China has dropped most sharply, as explained above. Rising FDI stock was driven by waves of U.S. companies establishing a base or increasing their footprint in Mexico, following the market-oriented reforms in that country in the last decade. According to A.T. Kearney, by 2016 more than half of U.S. companies with manufacturing operations in Mexico had relocated production therefrom places such as China to supply the U.S. market.

Moreover, according to the Boston Consulting Group, some major Chinese consumer electronics manufactures have been adding capacity in Mexico to serve demand in Latin America. This broadly corresponds to the Chamber survey referenced above, which indicates that while LACs are still the top relocation choice for U.S. firms, North America is an increasingly popular option. Close to 17% of the firms dislocating their operations from China in 2020 indicated they would move that capacity to Mexico or Canada, up from 10% in 2019. An additional 22% reported they would move it to the U.S., up from 17% in 2019.

Mexico as a Natural Alternative

Mexico is already the U.S.’s largest trading partner, as well as the manufacturing base for a substantial part of its products. Last year, Mexico traded $614 billion with the U.S. – surpassing Canada ($612 billion) and China ($558 billion). “Merchandise trade between the two countries in 2018 was six times higher (in nominal terms) than in 1993, the year NAFTA entered into force,” according to the Congressional Research Service. Among the leading U.S. exports to Mexico are “petroleum and coal products ($28.8 billion or 11% of exports to Mexico), motor vehicle parts ($20.2 billion or 8% of exports), computer equipment ($17.4 billion or 7% of exports), and semiconductors and other electronic components ($13.1 billion or 5% of exports).” On the other hand, the top U.S. imports from Mexico in 2018 included “motor vehicles ($64.5 billion or 19% of imports from Mexico), motor vehicle parts ($49.8 billion or 14% of imports), computer equipment ($26.6 billion or 8% of imports), oil and gas ($14.5 billion or 4% of imports), and electrical equipment ($11.9 billion or 3% of imports).”

Increasing the cross-border manufacturing prompted by NAFTA may be the most practical way for the U.S. to eliminate its cost gap with China. “Many economists credit NAFTA with helping U.S. manufacturing industries, especially the U.S. auto industry, become more globally competitive through the development of supply chains in North America. A significant portion of merchandise trade between the U.S. and Mexico occurs in the context of production sharing as manufacturers in each country work together to create goods.” Mexico’s wage growth is on par with Vietnam’s, but Mexico’s productivity is about 5.2 times higher. Mexico’s combination of low labor costs and relatively high productivity result in production costs that are 20-30% lower than in the U.S. (including transportation and associated fees).

Mexico also has an important advantage vis-à-vis China with respect to transportation costs, which account for a significant portion of costs in industries like metals and automotive parts. Shipping a 40-foot container loaded with automotive parts from Shanghai to Los Angeles cost an average of $1,374.03 – $1,518.66 (before taxes and duties) in July 2020. Shipping that same container from Veracruz, in the Gulf of Mexico, to New York, cost $1,102.24 – $1,218.27. Sending that same container by truck from northern Tamaulipas, where a large portion of the country’s manufacturing base is located, to Houston cost an average of $304.11 – $336.12 – four to five times less than shipping it from China. Mexico also maintains a clear edge in delivery time. It takes 75% less time to transport goods to the customer from Mexico than from Asia. Proximity is an essential advantage in industries that are shifting towards highly personalized products, including electronics, automotive, and clothing. The short distance can also be exploited to combine the countries’ supply chains across the border, one of the main drivers of economic growth under NAFTA.

According to the Center for Car Research, between 80 and 90% of U.S. automotive trade is intra-industry, and parts produced in Mexico and the U.S. cross the border up to eight times along the manufacturing process before they are delivered to consumers. In fact, on average, close to 40% of the content of a vehicle produced in Mexico was initially imported from the United States. This tight integration was only achieved after the NAFTA, which allowed producers to spread their supply chain across the border. Before 1993, for example, the vehicles produced in Mexico contained only 5% of parts produced in the U.S

The Effect of the USMCA

NAFTA completely changed the landscape of North America by driving unprecedented integration in the region and generating a dramatic increase in trade and cross-border investment. NAFTA also had an essential role in promoting Mexico’s privatization, where state-owned enterprises represented a substantial part of production until at least 1988. Between 1988 and 1994, 390 Mexican businesses were privatized – close to 63% of large corporations in the country. Telling of Mexico’s explosive development in this era is that before 1988 there was only one billionaire family in Mexico: Monterrey’s Garza Sada, who made their fortune selling beer and steel. In 1994, however, Forbes’s ranks included 24 Mexican billionaires. Between 1993 and 1994 alone, the number of multimillionaires in the country rose by 85%.

The USMCA, which consists of 34 chapters, four annexes, and 14 side letters, will further encourage growth by maintaining the most important aspects of NAFTA: a legal framework with protections for foreign investors and a free-market zone between the three nations. It will also maintain investor-state dispute settlement (ISDS) “between the United States and Mexico for claimants regarding government contracts in the oil, natural gas, power generation, infrastructure, and telecommunications sectors; and maintains U.S.-Mexico ISDS in other sectors provided the claimant exhausts national remedies first.” According to the Congressional Research Service, ratification of the treaty was expected to remove some investors’ unease about domestic policy uncertainty and the international economy. “Longer-term prospects for export-oriented manufacturing, as well as oil production, appear positive,” according to that report. After the elimination of steel tariffs on Mexico and Canada in May of last year,  the International Monetary Fund (IMF) estimates that the USMCA will increase trade between the three North American countries by approximately $15 billion.

Among the most significant achievements of the USMCA is that it will accelerate the integration of energy [utilization] on both sides of the U.S.-Mexico border. The treaty maintains NAFTA’s zero tariffs for energy products,   which have made Mexico “the No. 1 export market for U.S. natural gas and refined products and the No. 4 export market for upstream oil and gas equipment.” It also locked in Mexico’s historic 2013 energy reform, which allowed foreign investment in oil and gas.  Previously, state-owned Pemex was the only company allowed to invest in Mexico’s energy sector, a state of affairs that NAFTA explicitly acknowledged. The USMCA also facilitates the transport of energy products. For example, it allows “hydrocarbons transported through pipelines to qualify as originating, provided that any diluent, regardless of origin, does not constitute more than 40% of the volume of the good.”  Lastly, it maintains the automatic export approvals for U.S. liquified natural gas (LNG) that is exported to Mexico or Canada.

Another key feature of the treaty is the customs administration chapter. This section mandates streamlined procedures that lower the time, complexity, and cost of exporting and importing many goods. According to the IMG, “most of the benefits of USMCA would come from trade facilitation measures that modernize and integrate customs procedures to reduce trade costs and border inefficiencies further.” The international organizations indicate these new procedures could lead to “one-tenth of a percent reduction in regional merchandise trade cost.” This section will also boost the trade of low-value products because it raises the value-thresholds for products eligible for tax-free, duty-free, streamlined customs, treatment. Mexico’s $50 limit for tax-free entry has remained the same, but products up to US $117 can now enter duty-free entry through a simplified customs processes. The IMF expects these modifications to benefit small and medium businesses, as well as online retailers.  They may also have an impact on manufacturing processes where the value of parts that cross the border is low.

The treaty also strengthens IP protections. Intellectual property is one of the U.S.’s most significant exports, and IP-intensive industries generate 45 million jobs in the U.S., as well as close to $6 trillion dollars per year (38% of the GDP). This is also one of the sectors where the U.S. has enjoyed a significant and consistent trade surplus. According to the Congressional Research Service, “IP-intensive goods and services are an important part of U.S. trade with Canada and Mexico.” Chapter 20 of the USMCA established a committee on IP rights, which will deal with concerns related to trade secrets and patent litigation, as well as a mediator in some IP disputes. The USMCA also extended minimum copyright protection to 70 years, up from 50 years under NAFTA, and retains a minimum of 20 years for patent protections. Moreover, it empowers copyright possessors to “expeditiously” enforce their rights in online settings. Law enforcement officers are also entitled  to “stop suspected counterfeit or pirated goods at every phase of entering, exiting, and transiting through the territory of any Party.” Lastly, many violations of copyright and trade secrets, now carry criminal sanctions under the treaty, including cyber theft — even if the perpetrator is a state-owned entity.

The USMCA’s strong IP protection contrasts with the perceived weaknesses of China’s IP regime. In 2018, a U.S. Trade Representative’s investigation indicated that the U.S. government would take actions to curve China’s “forced technology transfer requirements, cyber-theft of U.S. trade secrets, discriminatory licensing requirements, and attempts to acquire U.S. technology to advance its industrial policies.”  For instance, U.S. Customs and Border Protection reported stopped $1.2 billion of IP-infringing goods at coming into the U.S., with China being the largest source.

The onset of the COVID-19 pandemic has revamped reported IP violations of Chinese entities in the pharmaceutical industry. The Wuhan Institute of Virology recently applied for a patent of a compound based on Gilead Sciences -produced Remdesivir, which has been hailed as a potential medication for COVID-19 patients. China-based BrightGene Bio-Medical Technology Co. is also in the process of manufacturing a Remdesivir generic. It is worth noting “that Gilead’s patent application in China for Remdesivir use in coronaviruses has been pending since 2016.” The Chinese government has also found a potent tool to promote technology transfer through its antitrust law. “China has required technology transfer in antitrust reviews of foreign firms in China 2025 sectors,” according to the Congressional Research Service.

Finally, the treaty includes new rules that will require Mexico to increase the wages of some of its workers in the automotive industry and to source a larger part of its manufacturing materials within North America. Vehicles must now contain at least 75% of content sourced in North America to be eligible for tariff exemptions. Likewise, it dictates that at least 70% of a producer’s steel and aluminum purchases must originate in North America to be eligible for exemptions and eliminates several loopholes that allowed for transshipments under NAFTA. These sections were aimed in part at encouraging member states to displace Asia as the source of steel, aluminum, and electronic components, according to a professor at the business school of the Tecnológico de Monterrey.

The Mexican government has been in talks with a host of Asian steel producers, including South Korea’s POSCO, Japan’s Nippon Steel Corp, and Mitsubishi Corp, about the possibility of manufacturing steel for the auto sector in Mexico, in order to take advantage of the local content rule, according to Reuters. The news agency also reported that Andres Manuel Lopez Obrador’s administration is enticing Apple to set up manufacturing bases in the country. “These phones don’t have to be produced in China … there is an enormous opportunity to produce them” in Mexico, Economy Minister Graciela Marquez told Reuters.

The  Mexico Texas Relationship

The relationship of Mexico with Texas is historical and current. The Lone Star State was part of Mexico until 1836. Today, people of Mexican ancestry account for close to 36.6% of Texas’s residents, and Spanish is spoken in the homes of close to 30% of Texans, according to data from the U.S. Census Bureau. Their economic ties are as strong as their cultural and ethnic ones. Texas accounts for 44.41% of the U.S.’s trade with Mexico, followed by California – which accounts for 11.6%. Mexico is also Texas’s largest foreign trading partner, representing 43.79% of its exports and 35.15% of its imports. China, in contrast, makes up for 8.7% of Texas’s exports, and 14.6% of its imports  Texas also carries approximately 72% of all imports by value coming from Mexico to the U.S. Laredo, which received $132 billion in imports from Mexico by truck last year, itself accounts for about 40% of all truck cargo from Mexico into the U.S., according to data from the Department of Transportation.

Mexico and Texas’s heavy trade in oil products and vehicles underscore the robustness of their trade relationship. Oil and bitumen substances corresponded to 21.8% of Texas’s total exports to Mexico in 2017. Texas also accounted for 61.5% of propane and 40.9% natural gas Mexico purchased from the U.S. Likewise, oil represented close to 10% of Mexico’s exports to Texas, which is about 69% of all oil Mexico exports to the U.S. The USMCA, by maintaining zero tariffs in energy products and reinforcing Mexico’s energy reform, will potentiate trade in this area. Mexico exported approximately $5.3 billion worth of vehicles to Texas in 2018, close to 23% of the total value of the vehicles it exported to the U.S. that year. An important part of this trade takes place within the automotive manufacturing process, where energy cost is a critical component.

Can Houston Become North America’s Hong Kong?

Houston is well-positioned to serve as a hub for the growing trade cross-national manufacturing base in the U.S.-Mexico border. Houston serves as a gateway for a substantial portion of foreign trade in the U.S. and is ranked as one of the easiest places to do business in North America. Texas’s ports receive more cargo than any other state at 573 million tons – which accounted for approximately 23% of all waterborne cargo in the U.S. in 2018. Neighboring Louisiana is the second largest with 569 million tons. California, in contrast, carried 249 million tonnes – less than half of Texas’s amount, according to data from the U.S. Army Corps of Engineers.

Houston itself was the largest carrier of international cargo in 2018, at 191 million tons (up 10% year on year). The port of Houston, however, is not the only one in the metropolitan area. The ports of Texas City, Beaumont, Port Artur, and Lake Charles (Louisiana) together account for approximately 508 million tons of water cargo, including 336 million in foreign cargo. This is equivalent to about 20% of the total tonnage of the largest 150 ports of the U.S., as well as 22% of foreign cargo.

In terms of shipping, the city of Houston plays a similar role as Hong Kong does within the China ecosystem. Hong Kong’s port handled 19.6 million TEU in 2018, while China processed approximately 245.6 million TEU, according to the World Bank. Based on this data, Hong Kong accounted for about 8% of container shipping by TEU in China, while the port of Houston accounted for about 10% of U.S. sea cargo by weight. Similarly, when conflated with the nearby ports of Shenzhen and Guangzhou, Hong Kong constitutes about 28% of container trade in China. Houston, along with nearby ports and the Port of Southern Louisiana, accounted for close to 31% of the total cargo by weight in the U.S.

Houston’s role in the U.S.’s overall economy is also similar to Hong Kong’s role in China. The Houston metro area generated approximately $478 billion in 2018 or close to 2.2% of the country’s total. This is analogous to the proportion that Hong Kong contributed to China in 2019. Last year, China’s GDP by purchasing power parity (PPP) was approximately $21.4 trillion ($14.3 trillion in current dollars), while Hong Kong’s stood at $467 billion that same year  ($366 billion in current dollars). Hong Kong, therefore, accounted for approximately 2.5% of China’s GDP.

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Out of Asia: Promise from Pandemic of a Manufacturing Renaissance in North America (Part 2)

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In their first installment (which you can view here), George Gonzalez and Jesus Alcocer examined the current supply chain against the backdrop of the COVID-19 pandemic, highlighting the need for restructuring and underscoring the challenges presented by our overreliance on Chinese manufacturing. The following will focus on how to reshore manufacturing in North America through domestic policy and government support.

Potential Governmental Role in Accelerating Reshoring

Some U.S. firms are already reshoring without any government support. A large-scale reshoring, however, may require the government to subsidize part of the capital expenditure (“capex”) of relocating, as well as the higher cost of manufacturing in the U.S. Other nations have put in place efforts to reshore and reduce their reliance on China for strategically important products. Japan provides a recent example.

Earlier this year, Prime Minister Shinzo Abe announced a ¥240 billion yen ($2.2 billion) plan to help companies reshore to Japan. The subsidies cover up to two-thirds of investments for major companies, and three quarters for small and medium-sized companies, according to the Economy, Trade and Industry Ministry. Abe stated that the plan is targeted at high value-added products for which Japan relies heavily on a single country. The government will also encourage firms to diversify their low value-added production bases to Southeast Asia. The government set apart an additional ¥23.5 billion ($220 million) for this last initiative, as well as ¥3 billion to repatriate active pharmaceutical ingredients. As of early June, only one company, consumer products manufacturer Iris Ohyama, announced it was taking advantage of the program. The company expects the government to supply 75% of its ¥3 billion ($28 million)investment in a factory that will drastically ramp up its production of protective masks in Japan. Once the project is complete, Iris Ohyama calculates its output will increase from 60 to 150 million masks.

Japan has attempted to reduce its dependence on China for close to a decade. Since the early 2000s, Japanese companies have been implementing a “China plus one strategy,” through which they aim to establish manufacturing bases in at least one location outside of China. The supply chain vulnerabilities exposed by the COVID-19 pandemic, however, have made officials more explicit advocates of reshoring. Japanese Economy Minister Yasutoshi Nishimura, for example, told reporters in June that the country had become too reliant on China, after Japanese factories in the auto sectors were forced to temporarily suspend operations in February, following the closure of a substantial portion of Chinese suppliers. Imports into Japan from China nearly halved in February, resulting in a supply shock that affected everything from personal computers to the handover of homes — which were left without toilets and bathtubs.

According to Nikkei, Japan relies on China for about 20% of its parts and materials needs. In 2018, 80% of face masks in Japan were imported, mainly from China, according to the Japan Hygiene Products Industry Association. Likewise, “car parts from China accounted for 36.9% of Japan’s total imports in 2019, while phone handsets from the Asian neighbor accounted for 85.5% of the total import value,” according to the Japanese Finance Ministry. However, data from the World Bank, indicate that Japan may be less vulnerable than the U.S. to a supply shock, especially in regard to electronic products and industrial machinery. In 2018, the U.S. maintained a more significant trade deficit than Japan with China in all sectors, except raw materials, fuels, vegetables, food, minerals, and animal products.

U.S. Reshoring Policy in Process

Similar federal support for U.S. reshoring out of China has been discussed in Washington D.C., but legislation has yet to be drafted. Among the most widely reported ideas is a $25 billion reshoring fund similar to the Japan initiative above. On relative terms, the U.S. initiative would be 10 times larger than the Japanese plan, even though the U.S.’s FDI stock in China is slightly lower than Japan’s ($116.5 billion, and $126 billion,  respectively).

The Wall Street Journal and Reuters reported earlier this month that there was “widespread discussion underway”  for a reshoring fund aimed to “drastically revamp their [(the U.S.’s)] relationship with China,” according to two anonymous administration officials cited by Reuters. The details of the plan are not public yet, but these officials indicated states could be in charge of managing the funds.

While several congressional aides have acknowledged the existence of this plan, no U.S. lawmaker embraced it publicly. In particular, Reuters indicated the issue is unlikely to be addressed in the next COVID-19 fiscal stimulus. Still, other sources suggested that lawmakers hope to include reshoring provisions in the National Defense Authorization Act (“NDAA”) – a $740 billion bill setting policy for the Pentagon that Congress passes every year. The plan reportedly faces stiff opposition within the administration. One of the sources cited mentioned that pure subsidies are not an option. “Internally, some are questioning why we should be providing funds to companies that have left [the U.S.] in recent years,” the source indicated.

Even if the reported fund does not come to fruition, the government is already taking some steps to promote reshoring. For example, President Donald Trump signed an executive order that gave the U.S.  overseas investment agency new powers to help manufacturers in the U. S. The president indicated the order would help “produce everything America needs for ourselves and then export to the world, and that includes medicines.” Others within the administration are considering attracting investment to the U.S. through tax incentives. Larry Kudlow, the Director of the United States National Economic Council, has publicly spoken about using such incentives. Several members of Congress have backed similar proposals. Senator Marco Rubio (R-FL) introduced a bill on May 10 that would “bar the sale of some sensitive goods to China, and raise taxes on U.S. companies’ income from China.”

Other plans have focused on the healthcare sector. Peter Navarro, the NDAA policy coordinator, indicated an order would soon require federal agencies to purchase U.S.-made medical products, and the administration would work to make it easier for pharmaceuticals to operate in the U.S. by deregulating the industry. Similar recommendations have been put forward by lawmakers. Senator Josh Hawley (R-MO) proposed stringent local content rules for medical products, and subsidies to encourage domestic production of related components. Senator Tom Cotton (R-AR) and Congressman Mike Gallagher (R-WI) also introduced legislation calculated to decrease the U.S. dependence on Chinese pharmaceuticals.

Surveys suggest that the public may be more receptive to measures like this in the wake of the pandemic. An analogy may be drawn to the public’s reaction to the recent $32 billion rescue deal for the airline industry. The bailout initially faced stiff opposition because the airline industry experienced unusually high profits over the five years leading to 2020 but failed to build a war chest to confront eventualities. Voters, however, became increasingly supportive of the measure as the effects of the pandemic propagated. For example, in a poll conducted by Morning Consult between March 17-20, only 31% of people surveyed approved of the bailout, but close to 51% did so during a poll conducted on March 27-29. Moreover, closer to 86% of voters approved of the $2 trillion COVID-19 rescue package in late March.

Why is Government Support Critical?

The U.S. should consider seeking to reshore critical and advanced manufacturing in the short term for at least four reasons. First, China will likely retain a labor cost advantage for many years. According to Goldman Sachs, the average manufacturing wage in China was close to $750 per month in 2015, while that in the U.S. was slightly higher than $4,000 per month. This computes to a six-seven-fold differential. Wages are not an accurate metric of labor cost, however. How much a worker produces in an hour is as important as how much he or she gets paid during that time. The productivity adjusted wage of a U.S. worker (and a Japanese worker) is close to $40 per hour, while that of a Chinese worker is closer to $20. This gap has been declining at about 1% per year since 2012, driven not by increasing U.S. productivity, but by an upsurge of wages in China.

However, relying on further wage Chinese growth to reduce this labor cost gap is not likely to be a successful strategy. Additionally, the U.S. is also losing ground against other countries, including France and Germany, which reduced their labor cost by 5% and 4% per year with respect to the U.S. Second, while wages are rising in the affluent areas of coastal China, labor is cheaper in the inner provinces. Manufacturers, faced with high costs in Guangzhou and Shanghai, can shift inland to retain a competitive edge.

Third, maintaining manufacturing capacity abroad may prevent the U.S. from developing a robust base of skilled labor. China employed about 113 million people in manufacturing in 2013, while the U.S. employed only 12 million in manufacturing. In addition, China purchased about three times as many robots for production as the U.S. in 2015, further deepening this productive capacity gap. These differences may keep growing, as manufacturing processes become more skill-intensive. Chinese universities have awarded close to 1.2 million engineering degrees per year since 2013, and the number is steadily growing. The U.S., in contrast, has awarded close to 180,000 per year since 2013. Without an appropriate pool of trained workers, lower production costs will not necessarily improve the U.S. productive capacity.

According to consulting and accounting firm Deloitte, 50% of open positions for skilled workers in the U.S. manufacturing industry were unfilled due to a skills gap in 2018. These positions include skilled production workers, supply chain talent, digital talent, engineers, researchers, scientists, software engineers, and operational managers. This shortage is expected to widen from 488,000 jobs left open today to up to 2.4 million in 2028, resulting in a potential opportunity loss of $2.5 trillion in the next 10 years.

Fourth, the longer the U.S. takes to reshore, the more challenging it will be to match China’s manufacturing. A student who practices math problems every day will become more efficient at solving them relative to a student who only practices once a week. If their studying rates remain constant, the gap between them may become so wide that it will be nearly impossible for the second student to catch up. The same concept applies to manufacturing. Because Chinese producers are manufacturing at a higher rate than their U.S. counterparts, they have more opportunities to identify cost-cutting measures and revenue-generating innovations. China’s manufacturing prowess is already hard to replace. It is the sole producer of many electronic components and sits at the center of the supply chain for many others. Moreover, China is becoming a more integral part of the world’s manufacturing machinery, as rising foreign investments in R&D and advanced manufacturing make it difficult for companies to exit the country altogether.

In a now-classic paper, Bruce Henderson described this phenomenon as the experience curve. Based on company data, Henderson concluded that every time a company’s accumulated production doubles, its production cost drops by 20% to 30%. The manufacturer with the highest share, therefore, should be expected to increase its productivity at a faster pace. In the long term, he predicted, only the competitors with the three highest market shares can survive.

If Henderson is correct, then the U.S. should focus on industries where it still retains the upper hand. In particular, the U.S. retains three key potentially durable competitive advantages: the potential to stay at the cutting edge of automation, low energy cost, and the capacity to innovate. Additionally, as explained below, the U.S. also has nearly unfettered access to the manufacturing base of Mexico, where wages are already lower than in China. McKinsey predicts automation will decrease global trade of goods by 10% in 2030. According to McKinsey, only about 18% of global goods trade is now driven by labor-cost differences – a number the firm expects to decrease further since half of the tasks that workers are paid to complete across industries could technically be automated. The company predicts automation will decrease global trade of goods by 10% in 2030. Amid Abe’s reshoring program, some Japanese firms are predicting they could relocate home thanks to shifts in automation.

The U.S. has a sizable advantage with respect to energy costs. The price of natural gas dramatically dropped in North America following an explosion of shale gas production in 2004. Thanks to “hydraulic fracturing and horizontal drilling…imports of crude oil by the U.S. decreased from 9,213 barrels per day (Kb/d) in 2010 to 7,969 Kb/d in 2017. By 2012, natural gas in North America was six times cheaper than in Asia and three-four times cheaper than in Europe. Continuing to develop North America’s durable competitive advantage with respect to energy cost may be a more efficient and realistic way for the U.S. to bridge its manufacturing cost with China. The contribution of gas and electricity cost to overall cost is 60% as large as the contribution of labor cost to overall cost across industries in China, based on data compiled by BCG. In other words, the U.S. may be able to offset a 10% decline in labor costs in China by decreasing energy prices by less than 20%.

Lastly, the U.S. might seek to enlist its capacity for innovation, ingrained in its world-leading universities, and top-notch corporate research departments. Clay Christiansen, former dean of Harvard Business School, observed that the top companies of one generation rarely retain their leading role in the next generation. His theory of radical innovation explains that newcomers can capture market share in one of two ways. First, they might start by focusing on the needs of less profitable consumers, who are ignored by large players, and use that capital to eventually challenge the incumbent’s dominance of the high-end market. Secondly, companies can aim to focus on markets that are currently not on the radars of incumbents, who are focused on serving and predicting the needs of their current markets. In the same manner, the U.S. can focus on manufacturing emerging technologies, where it can build an advantage from early on while others focus on serving current needs.

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Out of Asia: Promise from Pandemic of a Manufacturing Renaissance in North America (Part 1)

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The COVID-19 pandemic has exposed the weaknesses of supply chains on which nearly half of the population relies on for life-saving medication. Countries have enforced restrictions on the flow of essential medical supplies in a bid to save their own populations. States competed with the Federal government for ventilators in the market, paying multiples of the devices’ usual prices. Doctors, working in painfully under-supplied hospitals, folded plastic sheets to make their own protective masks. Many U.S. hospitals have had to connect multiple patients to devices meant to sustain the life of one. Hospital doctors and administrators have already been asked to decide who should live and who should die.

Understanding the need to transform the current supply chain, the following is the first part in a three-part series that examines how the promise from the COVID-19 pandemic is a manufacturing renaissance in North America. This first installment will lay the groundwork for understanding the current deficiencies within the supply chain and then pivot to explore the dangers of over-reliance on foreign exporters and what challenges U.S. companies are continuing to face in China.

The Current State of the Pandemic Supply Chain

It is late March 2020. In New York’s Presbyterian hospital, doctors are wrangling to accomplish something that “hasn’t really ever been done before,” at least not according to Dr. Jeremy Beitler, a pulmonary disease specialist. The hospital, one of the world’s largest, is affiliated with two Ivy League institutions and routinely ranks as one of the top five health centers in the U.S. Inside its contemporary art-clad walls doctors are connecting two people to a ventilator designed to sustain a single set of lungs. The process, which had been only tested in animals before, carries with it a host of risks because sharing does not double ventilator access, and many victims need their own device. Moreover, the two patients need different volume and pressure levels, – which means that often one or both cases are kept in sub-optimal settings.

Professionals, including the editor in chief of the journal Respiratory Care, have warned against ventilator sharing, arguing that “the time to try an untested treatment not previously used in humans is not amid a pandemic.” For the doctors in charge of triage at New York’s Presbyterian, however, the other option was death. As Dr. Charlene Babcock, an emergency doctor in Detroit puts it: “If it was me, and I had four patients, and they all need intubation, and I only had one ventilator, I would simply have a shared discussion meeting with all four families and say, ‘I can pick one to live, or we can try to have all four live.’”

This technique has now expanded across the country, as state governments fought to outbid each other to purchase one of the few ventilators left in the market. The machines went to the highest bidder. It has been four months since that day in March, but the situation that led doctors to attempt an untested off-label procedure in one of New York’s top hospitals stems from issues that run much deeper.

Foreign companies made close to 50% of the intensive-care ventilators in the U.S., where at the time, there were fewer than 12 manufacturers with the capabilities to produce them. As the COVID-19 pandemic advanced, even these U.S. manufacturers found it impossible to sharply increase their supply since the hundreds of parts that make up these complex devices were sold by companies across the world. It would take at least eight months for St. Louis-based Allied Healthcare Products to revamp its supply chain and meet the rising demand, according to the New York Times. In less than seven months, there have been close to 150,000 reported COVID-19 deaths in the United States.

This fragile state of U.S. healthcare supply was exposed by an inadequate manufacturing base that had been deteriorating for years. The toll of COVID-19 has revived efforts to overhaul the capabilities of manufacturers in the U.S. – an issue that had been dormant for decades, as manufacturers moved to jurisdictions outside the U.S., principally to Asian countries in pursuit of lower costs. Just last week, newspapers heralded the “end of an era” in U.S. manufacturing as Intel, the largest chipmaker in the country, announced it was finally considering outsourcing its production to Taiwan and South Korea. This policy was embraced by Intel’s competitors but shunned by the Silicon Valley giant for decades.

The COVID-19 pandemic has triggered an unprecedented new consciousness among the U.S. business elite of the potential risk of over-reliance on a supply chain substantially based in Asia. This new consciousness, in the midst of the pressure of COVID-19 on supply chains, the rising public support for economic rescue measures, and the recent signing of the United States–Mexico–Canada Agreement (USMCA) can collectively act to usher in an era of renewed manufacturing in North America.

The USMCA buttresses the free market access among the three North American economies and ensures U.S. producers access to low-cost labor in Mexico. Importantly, it locks in Mexico’s 2013 energy reform, which allows foreign companies to invest in the country’s energy sector and eliminates barriers to trade in energy commodities. Together, these provisions pave the way for more fully integrating the cost­-competitive production base in Mexico with the technical know-how of U.S. manufacturers – a combination with the potential to shift the manufacturing center of gravity out of Asia.

Dangers of Overreliance

Heavily relying on a global supply chain for crucial products is costly. COVID-19 has underlined the dangers of relying on China and other foreign nations for essential supplies and compounded the anti-globalist sentiment that had been developing in the U.S. in the last few years. Close to 68% of Americans surveyed by Pew Research Center supported trade and growing business ties with foreign countries in 2014. In contrast, only 47% said globalization was good for the United States in May of this year.

The U.S. imported close to $472 billion from China in 2019, down from $559 billion in 2018, according to the Bureau of Economic Analysis (BEA). In absolute terms, the most significant component of these imports is consumer products, followed by capital and industrial goods. In relative terms, however, electronics and pharmaceuticals are the sectors on which the U.S. is arguably most dependent on China. In 2019, the U.S. imported close to 70% of its consumer electronics from China. Mexico, Korea, and Vietnam: the next three largest contributors, together, accounted for 19%.  The extent of this dependence is underscored by executives in the auto industry, who told The Wall Street Journal that “they could run out of certain parts used in U.S. factories in coming weeks, with particular concern over potential shortages of electronic components,” as the pandemic forced Chinese factories to temporarily close their doors in February.

Emergent consciousness of the U.S.’s lack of self-sufficiency is perhaps most starkly obvious in the healthcare sector. According to consulting firm A.T. Kearney, close to 70% of protective masks in the U.S. are made in China, as well as 80% of the country’s antibiotic supply – including 95% of ibuprofen and 91% of hydrocortisone. Moreover, some widely used blood-pressure medications and antibiotics are no longer produced in the U.S. at all, and experts warn that China is the only known producer of certain key ingredients in antibiotics used to treat diseases like pneumonia. As of April 2020, 79 countries had imposed export bans or restrictions on essential medications and medical supplies to the U.S. market. India alone banned exports of 26 critical active pharmaceutical ingredients. The resulting undersupply in the U.S. may have already endangered national health. In the U.S., roughly half of the population is dependent on prescription drugs, and the majority use over-the-counter medicines on a regular basis.

Building manufacturing expertise in critical sectors such as healthcare as soon as possible should be a strategic policy goal. Unlike other industries, manufacturing pharmaceuticals requires knowledge and capacity that cannot be built in the short term. According to A.T. Kearney, some types of ventilators and antiseptics are among the easiest products to utilize cross-industry capacity to produce. This, of course, contrasts with the critically low supply of ventilators described above, and the government’s unsuccessful 13-year attempt to shore up that supply. Moreover, even if companies could be outfitted to assemble these complicated machines in the short term, replacing the global supply chain of parts may take much longer.

COVID-19 is testing supply chains across the whole economy. According to A.T. Kearney, close to 82% of companies surveyed indicate the pandemic has profoundly disrupted their supply chain. In comparison, only 5% of U.S. manufacturers indicate the disruption has been minimal. Similarly, according to consulting firm McKinsey & Company, material shortages were the top COVID-19 operational challenge for corporations, with close to 45% of respondents agreeing. This option comes ahead of drops in demand (41%) and cash-flow issues (22%). McKinsey indicated advanced industry, including auto-manufacturing, was the sector most affected by the supply shock, “primarily due to interconnected supply chains spanning multiple geographies.”

The U.S.’s reliance on Chinese imports contrasts with China’s self-sufficiency. According to the United Nations Comtrade data compiled by Goldman Sachs, the only segment where China acquires more than 50% of its imports from the U.S. is in aircraft (63%). Moreover, the only sectors where China imports more than a third from the U.S. are seeds and agricultural products.

U.S. Companies in China Face New Challenges

The current crisis brought into public view the dangers of depending on other countries for essential products. Discontent among U.S. companies operating in China, however, had been developing for months. Several companies now indicate they are ready to reshore out of Asia. In the most recent survey by the U.S. Chamber of Commerce in China (“Chamber”), close to 9% of member companies have already started relocating out of China, and an additional 8% are thinking about doing so. In the resource and industrial (R&I) sector, a full quarter of respondents indicated they are already relocating or considering doing so – the highest proportion across industries. For some producers, remaining in China does not make commercial sense anymore. According to Lei Wang et al., for example, it is already cheaper to produce metal and oil products in the U. S. after the U.S. imposed 25% tariffs on Chinese products.

“An uncertain policy environment, rising costs [in China] and U.S. tariffs are the top three factors influencing relocation considerations,” according to AmCham China. Close to 45% of companies relocating or thinking about doing so cited an uncertain policy environment as one of the top three reasons to relocate in 2019 (up from 9% in 2018). Similarly, 40% cited rising costs, including labor costs (up from 17% in 2018), while 38% pointed to U.S. tariffs on products exported from China.

Companies that are delaying or canceling investments in China cite similar worries. About 37% of firms surveyed by the Chamber, the largest proportion since 2013, indicate they are delaying additional investments in 2020 or looking to reduce their footprint in China. This trend is even more pronounced in the R&I sector, where 43% indicate they will not invest further in the country in 2020. This group of companies also point to the tense U.S.-China bilateral relationships as the most significant barrier to investment, followed by expectations of a slowing Chinese market, rising labor costs,  and uncertain local regulations.

Among the most longstanding concerns of U.S. firms in China are intellectual property (IP) protection and technological sharing. AmCham China suggests this is a lesser concern among firms than it was in past years, and that protections are improving. Close to 69% of U.S. firms surveyed indicated in 2019 that IP enforcement had improved over the past five years – with only 2% reporting that it has deteriorated. Similarly, the percentage of firms that indicated the risk of IP/data security leakage is higher in China dropped 10 percentile points year-on-year to 44% in 2019.

Despite the reported improvements, a significant portion of U.S. companies are still dissatisfied with the state of IP protection. Intellectual property and data leakages are still the second most cited barrier to increasing investment in China (38% of respondents), behind transparency and fairness of the regulatory environment. It is important to note, however, that industries differ widely about their uneasiness with IP protections. Within the technology sector, 49% of companies indicated that IP protections remain an obstacle to additional investment. R&I corporations are not far behind, with 48% reporting IP as a hurdle to investment.

Few empirical studies have examined China’s IP litigation outcomes, in part because the relevant data became available only after 2014. The longstanding notion among U.S. commentators is that the Chinese system systemically discriminates against foreign patent plaintiffs and that this phenomenon is more pronounced outside of large coastal cities. Gaétan Rassenfosse et al. supports this thesis in a paper that looks at how foreign IP litigants are treated by the China National Intellectual Property Administration (CNIPA) in the context of patent applications declared as standard essential to 3G and 4G LTE technology. Based on this subset of cases, the study finds that foreign applicants’ patents are granted between 8.8-9.3% less often than Chinese applicants’ patents and that it takes between 8.5 to 12.6 months longer for foreign applicants to obtain patents than for their Chinese counterparts. Some other scholars, however, have recently challenged the discrimination hypothesis advanced by Rassenfosse.

Regardless of their reasons for discontent, one thing is clear: U.S. firms are making less in China – a trend many industry leaders expect to continue. More than a fifth of respondents indicated that they experienced yearly revenue drops in 2019, up from only 12% in 2017. This drop was even more striking within the R&I group – in which 30% experienced sales declines, and an additional 36% remained flat. Companies in this sector were also the least optimistic about 2020, with close to 40% of firms surveyed not expecting their market to grow this year. Profitability across industries has also plunged to historic lows, with 38% of companies indicating they recorded losses or broke even.

U.S. Investment in China has Steadily Declined

Foreign direct investment (“FDI”) and bilateral trade data also support this reshoring narrative. According to research provider Rhodium Group, U.S. foreign direct investment in China rose to $14 billion in 2019, up from $13 billion in 2018. This number, however, does not tell the whole story. The uptick in investment was mostly driven by projects that had been in the works since at least 2018, including Tesla’s Gigafactory in Shanghai. In contrast, the value of newly commenced (greenfield) projects declined from $2.4 billion in 2018 to $1.4 billion in 2019,  supported by an expansion of GM’s Chinese joint venture. U.S. FDI in China has been falling since approximately 2012 in many industries. For instance, between 2005 and 2011, U.S. firms channeled roughly $1.27 billion per year into machinery. In contrast, they only invested $104 million per year on average in that sector between 2018 and 2019. Likewise, investment in basic materials was $1.84 billion per year on average between 2005 and 2011, but only $321 million between 2018 and 2019.

As U.S. companies have moderated their investments in China, the U.S. has also reduced its imports form the Asian nation, partly as a response to new U.S. tariffs on Chinese goods. Imports of manufactured goods from low-cost Asian countries (“LCA”) into the U. S. dropped for the first time since 2016 in 2019– recording a decline of 7.2% to $757 billion. Last year also marks the first-time imports from LCAs fell as a percentage of domestic manufacturing output since 2011. This contraction has mainly concentrated in China, where exports to the U.S. slid 17% between 2018 and 2019 to $90 billion. This trend has continued into the first few months of 2020. Imports of goods from China fell 29% year-on-year in the first quarter of this year, according to the BEA. Imports of consumer goods from that country shrank by close to 30%, while those of vehicles and automotive components, industrial supplies, and other capital goods diminished between 20% and 30%. This decline has been partially offset by a $31 billion expansion in imports from other LCAs. In particular, 46% of this amount was absorbed by Vietnam, which is also a popular choice for Chinese businesses looking to cut costs. After this shift, China accounted for 56% of U.S. manufacturing imports from LCA’s, down from 67% in 2013.