De-risking China – international companies respond to pressure to diversify supply chains
The world relies heavily on China for its supply chains and access to strategic resources. Whilst the geopolitical risk may be increasing, a complete decoupling is still undesirable for most companies. Faced with mounting pressure to diversify out of China, many foreign companies are therefore exploring alternative de-risking strategies to help with effective supply chain diversification and key-asset distribution.
Over the past two years, foreign companies have experienced increasing difficulties in doing business in China due to stringent policies, such as the zero tolerance on COVID and China’s stronger inwards focus and push for self-sufficiency. Asset exposure, supply chain disruption and logistics are among the most critical areas impacted by a changing political and business environment.
These factors, and the perception that geopolitical risk has increased in general, have hastened many foreign businesses to re-assess the scale and nature of their China operations and to consider options for diversification away from China. To face the increasing risk and to find the right position in the Chinese economic eco-system, it is key for international players to understand the underlying political and economic drivers.
De-risking rather than decoupling
The EU still relies heavily on China for strategic resources that will be crucial for the shift to net zero carbon emissions. Therefore, a decoupling approach would be unlikely to work, and the EU is aware that a slow and structural de-risking process is preferable. As stated by EU Commission President Ursula von der Leyen on 17 January 2023 at Davos, the EU should de-risk rather than decouple its trade ties with China and that the EU should use its foreign subsidies to do so.
Many company executives are tasked with developing strategies for “de-risking China” to prepare their companies for the future of doing business in China as well as seizing growth opportunities in a risk-reduced manner.
Whilst it is impossible to avoid policy and geopolitical risks altogether, it can be significantly reduced with sound strategies of supply chain diversification and key-asset distribution.
The "In China, for China" strategy
Securing supply chain stability in China has become increasingly challenging in recent years. Companies are being confronted with unprecedented risks and are forced to approach risk mitigation from a new perspective.
One popular concept that has arisen out of this is the “In China, For China” strategy, meaning that foreign investors are re-orienting their China investments to serve Chinese consumers rather than international ones. Rather than relying on China as a production base for their global export manufacturing and to produce goods that are sold elsewhere, foreign investors are producing their goods specifically for local consumption. For some companies, “In China, For China” is merely giving a positive spin on a partial move away from the Chinese market.
De-risking marks a sudden and significant shift in attitudes towards the country that has long been known as “the factory of the world”.
Exit barriers
Foreign investors often encounter issues when they attempt to exit the Chinese market, which might constitute part of the reasoning behind a decision on a partial, rather than a complete, move away from the Chinese market. Some of the most common issues are:
A lengthy and cumbersome tax review and de-registration procedure upon liquidation of the local company entity
Expensive financial severance packages imposed on the company as well as the difficulty to obtain approval and support from local government for significant layoffs
Strict review by local banks of all documentation in respect of any transfer of funds back to foreign investor’s country after de-registration of company
Additional subsidies and incentives may be offered by the local government to retain foreign investments in the region
Even a partial exit can be lengthy and sometimes painful. However, the trend of companies pivoting to lower cost alternatives like India, Indonesia, Thailand and Vietnam for export-driven production is clear and the stringent Chinese Covid-19 restrictions, which made it difficult to enter and leave the country for years, have only served to reinforce this trend.
Samsung, for example, has closed its last smartphone factory in China and began operating the world’s largest mobile phone manufacturing facility in India. Compared to Samsung, whose smartphone production has been completely moved out of China, many other companies are instead adopting a “China plus one” strategy where higher value manufacturing continues to be done in China whilst lower value production is moved to a lower cost country.
Key asset distribution – financial sale and lease back
Regardless of the exact strategy being used, mitigating the risk of supply chain disruption is a complex undertaking. Alongside the approach to diversify and relocate the supply chain out of China, international investors are also conducting careful risk assessments and adopting financial solutions to proactively manage the political risk of staying in China.
One of the efficient tools that has been used is the sale and leaseback of self-owned assets in China, usually seen in the Western market as a tool for freeing up capital. Under a typical sale and leaseback transaction in China, the owner of a property (usually a Chinese subsidiary of a foreign company) enters into a set of agreements simultaneously to sell the property to a buyer and lease the property back from the buyer for a designated period and with agreed conditions.
Depending on the nature of the asset and property, the main categories of buyers are usually government / state-owned enterprises, industrial developers, investment institutions, manufacturing end users and local investors. The procedure for the sale of assets usually varies with the category of buyers. Normally, if the buyer is a government or state-owned enterprise, the process will involve more formal procedures, including a bidding and auction as well as the requirement for an evaluation report issued by a Chinese qualified evaluation agency.
Under a sale and leaseback transaction foreign investors are able to maintain control of property for as long as needed, and are also able to raise capital via non-traditional sources.
In addition to the usual benefits, sale and leaseback transactions in China also serve as a method of making a future exit from China easier to manage, should the need arise. This, alongside other methods of “de-risking”, allow foreign companies the flexibility they need to continue their profitable operations in China while maintaining an eye on the horizon so they can adapt should any of the current risks materialise.