by Todd R. Vollmers, Macaluso LLP
Are You Standing on Quicksand?
Companies that do business internationally or rely on a global supply chain (either directly or indirectly), should continue to expect and be prepared for far-reaching and unique challenges arising out of the global pandemic caused by Severe Acute Respiratory Syndrome Coronavirus 2 (SARS-CoV-2), which causes the respiratory illness known as COVID-19.
Everything from A to Z including automobile parts, medical equipment, and solar energy components have been affected. As Chief Economist of Grant Thornton Diane Swonk put it, shipment delays and product shortages are, and will be, “consequential,” with a wider economic impact resembling “standing on quicksand. At least for now there is no clear end in sight as to when containment measures in various countries might end or in what manner, or what may lay in store for one or more waves of recurrence in the future, which makes planning for the current global business situation more about scenario and survival planning than typical business planning in more stable times. Understanding events in China, however, in particular can be helpful since China was the initial epicenter of the pandemic and the first to implement and then start emerging from society-wide containment measures. At the same time China is a primary location for international manufacturing for many industries virtually all of which experienced significant disruption. Lastly, it is the world’s second largest economy.
New Challenges to an International Supply Chain
Automobile Parts
China is a key, large-scale manufacturer and supplier of automobile parts. According to the UN’s Comtrade database, China exported approximately $34.8 billion of motor vehicle parts and accessories in 2018, with the US car industry by far the most reliant on Chinese exports of auto parts, alone accounting for $11.7 billion of that amount.[i] There have been reports of GM factories in Flint, Michigan and Arlington, Texas facing shortages of parts sourced from China that could affect production of certain GM truck and SUV models, and even of GM arranging for shipment from China by chartered jet when parts are available. To illustrate the scope of this issue and its effect on companies beyond just manufacturing in the U.S., it should be noted that in 2019 GM produced almost 640,000 cars in China, approximately 40% of its Chinese production, in Hubei province where Wuhan, the original ground zero of the pandemic, is located.[ii] Furthermore, unsurprisingly GM is not the only carmaker dealing with a lack of Chinese-made auto parts: Fiat Chrysler Automobiles NV announced in February that it would temporarily halt production at a car factory in Serbia; Hyundai Motor Co. and France’s Renault SA temporarily stopped assembly lines in South Korea; and Nissan Motor Co. shifted production to factories in Japan, all because of supply chain issues with parts from China.[iii] Going forward the automobile industry’s cost-saving reliance on global just-in-time supply chains for automobile parts will surely be scrutinized by the auto industry and governments in light of the post COVID-19 importance of supply-chain continuity and security.
Medical Equipment
China is also a considerable manufacturer of various types of medical equipment, exporting CNY 10.2 billion ($1.45 billion) in medical gear between March 1 and April 4 of this year, and with Chinese manufacturers in contracts in early 2020 to ship medical products to more than 50 countries and three international organizations.[iv] Again, highlighting the interdependence of countries due to the global scale of many supply chains, China’s Foreign Minister Wang Yi recently asked his Swiss counterpart for assistance in securing greater numbers of Swiss-made components so that Chinese manufacturers could meet the increased demand for ventilators.[v] But despite the many cases of cooperation and mutual reliance of companies and countries, high demand and competition for medical equipment has generated several notable examples where national interest, policy, or some other atypical circumstance influenced the normal operation of international supply chains. Two high profile examples include: U.S.-based manufacturer of Personal Protective Equipment (PPE) 3M stating that it was directed by the US government to stop exporting N95 respirators to Canada and Latin America so that they would instead meet demand in the U.S.; and the Berlin city government asking the German military for transportation security assistance after initially alleging that 200,000 respirators produced by 3M in China had been “confiscated” by the U.S. in transit to Berlin “in an act of modern piracy.[vi] Furthermore, in addition to supply chain issues caused by the location of the headquarters of a manufacturer, or location of the manufactured goods themselves, the location of the factory producing the goods has also been a factor. After being shut down by the Governor of Baja California for not selling locally, US-based Smiths Medical’s Tijuana factory was only allowed to resume producing ventilators after agreeing to reserve some of the finished goods for facilities in Baja California.[vii] However, since the Tijuana factory operates under the IMMEX program, which requires that 100% of finished goods are exported, presumably Baja California will have to wait to purchase the Tijuana-manufactured ventilators until after they have been exported from Mexico.[viii]
Although the present coronavirus pandemic created an extreme situation, policymakers from various countries will certainly debate measures to address the national security implications of overseas supply chains for medical supplies (along with other products deemed critical). China, for instance, is one of the largest suppliers of Active Pharmaceutical Ingredients (APIs), which are the basic components for antibiotics and other prescription drugs. US dependence on Chinese pharmaceutical companies that provide 95% of U.S. imports of ibuprofen, 91% of US imports of hydrocortisone, 70% of US imports of acetaminophen, 40 to 45% of U.S. imports of penicillin, 40% of U.S. imports of heparin, and 80% of the U.S. supply of antibiotics[ix] is an area that will surely be a focus. Further complicating such issues will be existing geopolitical tension that, in the case of U.S. dependence on Chinese pharmaceuticals, undoubtedly will include points such as Chinese state media outlet Xinhua stating in March 2020 that China has not, but could impose pharmaceutical export controls that would plunge the U.S. “into the hell of a novel coronavirus epidemic.”[x]
Solar Energy Components
Components used for solar energy such as solar cells, modules/ panels, racking systems (that hold the solar modules/ panels) and inverters (that convert the variable Direct Current (DC) into Alternating Current (AC)) are largely manufactured in Asia, and primarily China. Through acquisitions and extensive government support, solar manufacturing in China became part of a “strategic industry” that benefited from various loans and tax incentives under China’s 5-year plans. Of the top 10 solar module suppliers with the largest global market share based upon 2018 sales, seven are based in China (including one in Hong Kong).[xi] With the world’s largest solar manufacturing industry, China became a price leader, and beginning with inexpensive solar modules helped create a global surplus that resulted in world prices dropping by 80% between 2008 and 2013.[xii] As previously noted though, Asia in general has become a center of manufacturing for solar energy components, and while China was the largest source of solar products to the US in 2016, more recently it has been surpassed by Korea and Malaysia.[xiii]
Due to the threat to domestic solar manufacturing, two U.S. solar manufacturers filed a petition for import relief for domestic industries under Section 201 of the Trade Act of 1974,[xiv] resulting in tariffs being placed on imported solar cells and modules beginning in February 2018. Although the Section 201 tariffs did have some of the intended benefit to US manufacturing, according to the Solar Energy Industries Association the U.S. has continued to import 80%-90% of solar cells and modules.[xv] Early in the COVID-19 crisis when its impact was mostly being felt in Asia, solar equipment installers in the U.S. were initially concerned about foreign manufacturing and disruptions to the supply chain for imported solar equipment. While that has also proven to be a valid concern, another perhaps more important issue is the decrease in U.S. demand as COVID-19 containment measures have been enacted in the U.S. and much of the rest of the world. Residential solar customers in the US are delaying or canceling home renovations and research firm Wood Mackenzie, which had before projected 10% residential growth in the U.S. this year, is now estimating that the market could decline up to 34% from 2019.[xvi] In the words of Gordon Johnson, an analyst at GLJ Research, “[p]eople are not going to sign up for a 20-year lease or pay $20,000 for a rooftop system if they don’t know whether they’re going to be able to pay their mortgages in two or three months.”[xvii]
Planning for the Next Normal
After being the initial epicenter of the virus that causes COVID-19, and the first to implement containment measures in response, China has been loosening those measures and allowing businesses to reopen. An estimate from the Trivium National Business Activity Index found that 82.8% of economic capacity in China is currently being used when compared to pre COVID-19 levels.[xviii] Although by that measure almost one-fifth of the Chinese economy remains closed, relatively speaking China is further along in emerging from the pandemic and its economic repercussions than the U.S. and other nations, which at the time of writing in many cases are still in the process of determining when and how to reopen their economies. Indications thus far of the economic damage in China caused by COVID-19 and its containment are sobering, and at least to some extent provide a warning of new challenges to doing business in China, as well as what may occur right here in the U.S., and elsewhere. Some examples of the extent of the damage include the fact that China’s economy shrank by 6.8% in the first quarter of 2020, the first contraction since the end of the Cultural Revolution in 1976, and the first quarterly contraction since those records started being kept in 1992.[xix] According to a study by Tsinghua University’s PBC School of Finance, revenues for Small and Medium-sized Enterprises (SMEs) at the end of March 2020 dropped 69.5% from the same period last year.[xx] In addition, more than 460,000 Chinese firms permanently closed in the first quarter of 2020, and the rate of new businesses being established during that same time period dropped 29% from a year earlier.[xxi] While larger companies and State Owned Enterprises (SOEs) in China tend to get the most attention, these last statistics are particularly concerning since the SME sector in China generates an estimated 90% of employment, 80% of exports, and accounts for 70% of GDP.[xxii]
What exactly the “next normal” will look like in the age of COVID-19, and what should be done to adapt to this new and developing reality, depends on the specific circumstances of each business. Companies that do business internationally should be prepared for a significantly changed business environment as countries and governments cope with the fallout of the pandemic, its economic consequences, and seek to enact new policy accordingly (whether such policy in reality is prudent or not). Doing business in or with China will especially provide new challenges as the “decoupling” between the U.S. and China that began with the trade war could well accelerate in the wake of the pandemic.
For companies that rely on international supply chains it will make sense to consider: 1) whether they are overly dependent on any one country or region for all or any significant part of that supply chain; 2) what alternatives may exist; and 3) to the greatest extent possible, what can be done to plan for future contingencies. Second time around, particularly in the U.S., the potential legal liabilities associated with such over-reliance may be more difficult to navigate if there is no mitigation in the interim. As the ground continues to shift in this evolving situation, businesses have every reason to plan now in order to protect themselves legally and mitigate risk going forward.
In this dynamic and evolving business environment, the companies that survive, and thrive will be those who plan and adapt to ensure that they are not left standing on that proverbial “quicksand.”
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Michael Macaluso, JD, MBA 
Posted on May 5, 2020
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