Out of Asia: Promise from Pandemic of a Manufacturing Renaissance in North America (Part 2)
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.
Click here to view original web page at Out of Asia: Promise from Pandemic of a Manufacturing Renaissance in North America (Part 2)