“Made in China” for Ukraine: New Investment Opportunities.
How the COVID-19 pandemic will impact China and Global Supply Chains and the ramifications for Ukraine
The mobile phone in your hands, the television in your living room and the refrigerator in your kitchen, have all become integral parts of our modern life. Will they always be available? That depends on what will happen with Global Supply Chains. This term refers to the entire route goods and services take from production to customer. “Supply chains” are the invisible threads that hold the global economy together. The current COVID-19 pandemic poses a threat to their operations, and, in some cases, has led to their disruption. Theoretically speaking, in the worst-case scenario, this disruption could lead to a complete collapse of the global economy.
Prior to the pandemic, the world seemed to be simultaneously getting smaller and more complex with every passing year. It was getting smaller since we could board an airplane and fly wherever we wanted, or have access year-round to exotic fruits that do not grow on our local farms. In Kyiv, for example, you can buy strawberries in January, even though twenty years ago, they were considered a seasonal berry. Now, it’s only a matter of price.
Meanwhile, the world also became more complex. We drive cars whose production is scattered among numerous autonomous manufacturers. One factory makes the electronic components, another makes engines, and they’re assembled in a third. Every one of these factories can be situated in a different country. These processes are the result of globalization, institutionalized in the creation of the World Trade Organization (WTO) in 19951. This organization came to replace the General Agreement on Tariffs and Trade (GATT). The primary difference of the WTO was that this agreement addresses not only goods, but also trade in services and intellectual property. The world always traded “things,” but now absolutely everything is on the market. Goods, services, labour force, intellectual property — literally everything “moves” across the planet. This is why the need arose to institutionalize these processes in the form of the WTO. Like it or not, the fact is national economies are interwoven and integrated with each another.
The COVID-19 pandemic poses a threat to the world’s established way of life. The global lockdown struck a mighty blow to the supply chains that connected the globalized world. David Dodwell, executive director of the Hong Kong-APEC Trade Policy Study Group noted “My school was a 10-minute bike ride away. Most of our food was grown on my father’s plot of land, half a mile up the hill. For those lucky enough to afford them, cars were built in the British Midlands 50 miles away.” 2 It is unlikely the world will ever revert back to that level of atomization. Globalization has its profound causes and substantial advantages, but the political reaction to the pandemic will fundamentally change the nature of globalization. The primary challenge is the maintenance of existing supply chains, as well as the creation of new supply chains of goods being produced in new locations.
The COVID-19 pandemic has exposed the dangers of existing supply chains in the healthcare and defense sectors. In early March 2020, the US Department of Health and Human Services (ННS) estimated that in order to combat COVID-19, US medical professionals will require 3.5 billion N95 masks, while only 12 million were stockpiled. Moreover, according to the World Health Organization’s calculations, the manufacturing of this kind of medical equipment will need to grow by 40% to satisfy the global demand 3.
The avalanche-like growth of the medical sector’s demands presents a challenge to politicians across the world. No country wants to be dependent on the manufacture of surgical masks beyond their borders. China, and several other countries, even sought to take advantage of this dependence to obtain geopolitical dividends. This has been referred to as the “mask diplomacy” phenomenon. In practice, this means that in exchange for political support, the manufacturing country provides medical equipment or personal protective equipment as humanitarian aid 4. As a result, the recipient state ends up being dependent on the country providing the “favour”. No government wants to be kept on the hook of “mask diplomacy”. Therefore, it is necessary to either diversify suppliers, or establish local manufacturing, or amass the requisite stockpiles. Each of these options has their pros and cons.
The diversification of suppliers may not completely satisfy demand and hinges on global prices. In the event of another lockdown, countries must be prepared to pay more. Establishing local manufacturing may ensure that local demand will be met, but this can also lead to the monopolization of the domestic market, higher prices and market stagnation. Stockpiling supplies for emergencies requires significant investments, and not everything can be stockpiled. While medical masks and protective suits are straightforward, stockpiling ventilators, for example, can prove costly. Then there is the issue of the expediency of stockpiling.
Something similar to the situation with medical procurement has occurred in the US defense sector. Take the example of the F-35 combat aircraft. The F-35 is comprised of 300,000 different parts that are manufactured in 48 states, Puerto Rico and 7 partner countries. In order to maintain production, the US Department of Defense issued special orders to support the critical infrastructure of production and supply. Still, some suppliers were forced to temporarily halt manufacturing, as their workers were afraid of going to work, while others had workers who became sick. The government stimulated production through additional payments: $3 billion was allocated to manufacturers and suppliers. But in Mexico, for example, defense industry companies were not exempted from quarantine measures, resulting in delays to items contracted by US aerospace programs 5. The US Department of Defense resorted to diplomatic channels to request the reopening of important suppliers, and US and Mexican politicians came to an agreement on resuming production. But this evoked push-back on the part of some Mexican workers, because they were afraid of being infected by the virus and infecting their families and friends. Some of them claimed that trade exports are more important for the government than their lives and health 6.
The pandemic presented a serious threat to supply chains, even in such vital sectors as medicine and defense. These challenges were overcome with the help of administrative and financial instruments. Supply chains will inevitably be reviewed, and special measures will be developed to protect the most susceptible links in those chains.
China holds an important place in the global economy due to the volume of its participation and the role it plays. China became “the world’s factory”, a place where companies move their manufacturing in order to lower the price of the final product for consumers. Consider, for example, the manufacturing cluster in Zhuji, which accounts for 30% of the global production of socks 7. The entire supply chain for sock production is concentrated in this cluster. The most vulnerable component is fully dependent on the local economic and epidemiological situations and the actions of the Chinese Communist Party.
The spread of the SARS-CoV-2 virus has shown that China is an unreliable partner. The US Department of Homeland Security (DHS) found that Beijing concealed the truth about the virus in order to accumulate supplies of essential medical equipment. The Chinese government was aware of the real state of affairs at the same time it purposefully limited exports and stimulated imports of medical equipment. Beijing withheld information about trade contracts, lied to the WHO, and forced doctors who tried to speak out about the danger of the virus to keep quiet. Meanwhile, personal protective equipment (masks, gowns and gloves) was being earnestly imported 8. The Human Rights Foundation, an organization that fights against tyranny, held an online event called COVIDCon in April 2020, during which experts (journalists, civic activists, political dissidents) spoke about the human rights violations and increasing authoritarianism resulting from the outbreak of the disease caused by the novel virus. Most of what was presented dealt with China, where the Communist Party threatened local doctors who spoke the truth about the outbreak and its scope. This had global ramifications: while China suppressed the truth, the international community was disinformed and, consequently unprepared for the challenges that subsequently arose 9.
The New York Times reported that high-ranking EU officials, under pressure from China, rewrote a report on Chinese disinformation during the novel virus outbreak. Diplomats and officials, who had seen a preliminary draft of the report, said that the Chinese Communist Party pressured European officials to soften the report’s rhetoric. Because the German automotive industry and many European farmers rely on Chinese manufacturing, Brussels resorted to self-censorship 10. If true, this information is a glaring example of how China’s control over manufacturing and supply chains allows Beijing to keep European political elites on the hook.
Canada provided another interesting example. In that country, the Communist Party resorted to including the Chinese Diaspora in the supply chain, by calling on Chinese Canadians to purchase medical equipment and send it back to China. That effort was coordinated by the United Front Work Department, that is directly controlled by Beijing. Consulates and chambers of commerce participated in the effort. Overseas, nearly every Chinese person became an agent of their state.
Another example of this was Mexico, that eagerly sold its supply of masks to China in January and February of 2020; but in March, Mexico was buying them back at prices that exceeded their own sale by 20-30 times 11.
It’s unlikely Beijing will be able to wash its hands of such manipulations and affairs. In the British parliament, the Chairman of the Foreign Affairs Committee Tom Tugendhat, together with several of his fellow Tory MPs, formed the China Research Group to examine China’s economic and diplomatic initiatives in response to Chinese disinformation regarding the virus and its efforts to use the pandemic to increase its influence in the world. Tugendhat criticized his leader Boris Johnson for taking too soft a stance on China 12.
Meanwhile, the White House is stepping up the development of measures which will push companies to move their manufacturing out of China, something President Trump promised on the campaign trail. The problems of doing business with China have been made crystal clear by the pandemic. According toKeith Krach , the Undersecretary for Economic Growth, Energy and the Environment at the State Department, US officials are “turbo-charging” initiatives to diversify supply chains in order to reduce dependency on China 13.
The last few years of trade wars between the US and China have resulted in manufacturing leaving China. Vietnam and Mexico have benefited the most from the current situation. These countries have seen an increase in their trade volumes with the USA. In 2016, trade between the US and Vietnam totaled nearly $54 billion, and grew to nearly $61 billion in 2018. US-Mexico trade in 2016 totaled $526 billion, and grew to $614 in 2018. 14 Despite higher manufacturing costs and constant drug cartel wars, Mexico has become a more attractive destination for US companies 15.
In the new conditions created by the pandemic, the US is trying to create an alliance of trusted partners, which Secretary of State Mike Pompeo called the Economic Prosperity Network. Talks are underway with Australia, India, New Zealand, Japan, South Korea and Vietnam. Latin America is also expected to play an important role. The Columbian ambassador, for example, has spoken publicly about his nation’s talks with US officials about shifting supply chains 16.
It remains to be seen if manufacturing will “exit” China and that supply chains will be changed forever. The pandemic is not eternal, and neither is Trump, who can be replaced by someone Beijing deems more “friendly”.
China is banking on the theory that the Communist Party’s deceit will be forgotten, and the profit motive will take the upper hand. However, the general macroeconomic trends in the Chinese economy suggest that this will not be the case. Economic growth based on inexpensive manufacturing is a thing of the past. China is falling into the “middle income trap” wherein rising wages nullify the advantages of inexpensive production. The increase in wages can be seen in the change of the average annual meat consumption per person in China (actual consumption will be higher, as this statistic does not include seafood and small farm production). In 2017, each Chinese citizen consumed nearly 60 kg of meat, compared to 44 kg in 2000 and 24 kg in 1990 17. Rising wages lead to slower economic growth, which is further compounded in China by the negative demographic trend of declining working-age population. The growth of the population older than 65 in the ten years between 2005 (101.7 million) and 2015 (135.18) totaled 34 million, i.e. the number of seniors grew by approximately a third. At the same time, the population younger than 15 fell between 2005 (262.89 million) and 2015 (247.07 million)18. Although this latter decrease is not as significant, the trend clearly shows that this age group is not growing quickly enough. The demographic trend forecast indicates that China will reach peak population between 2027 and 2030, followed by decline 19. This means that the working-age population will continue to shrink, while the number of seniors who require social services and pensions will continue to grow. And this will put a strain on China’s economy.
The Communist Party of China knows and understands these trends, and believes the solution is the transition to the production of high value-added goods and services. The primary tactic to attain this goal is “investment injections” followed by technology transfer back to the homeland. Initially, Chinese investors acquire shares in a high value-added company abroad, then open a branch back home, or simply duplicate it. This is what happened with the California company ATop Tech. A Delaware court sold it through a bankruptcy proceeding to a company called Avatar, whose ultimate beneficiary owner is a metallurgical magnate from Hong Kong. The primary problem is that ATop Tech’s product can be used to manufacture microchips which can be used in mobile phones or high-tech weaponry. Such products are considered part of US critical defense infrastructure. 20 The Chinese are essentially domesticating technologies. When it can’t accomplish this through economic means, the Communist Party has no qualms about resorting to outright theft. The growing role of high value-added products in the Chinese economy makes Beijing and Washington competitors, not partners. And this trend is more stable than any of the pandemic’s effects. 21 In 2018, US direct investments into the Chinese economy totaled $117 billion 22. All in all, US companies have invested more than $6 trillion outside their country’s borders. Obviously, these funds were not invested in a single day; repatriating them would be a complex undertaking and the relocation of manufacturing operations requires significant financial inputs 23.
The COVID-19 pandemic has shown that businesses and governments need to think about protecting supply chains and having reliable partners. Thus, the process of redistributing investments has begun, as has the competition for them. That is why the pandemic, and the economic crisis it has caused, can become an economic leap forward for some countries.
Ukraine and the competition for foreign investments
According to an IMF forecast from April of this year, Ukraine’s GDP is expected to shrink by 7.7% in 2020 24. However, crises such as the pandemic are temporary and they often present an opportunity for innovative economic policies. In order to evaluate Ukraine’s investment attractiveness, let’s compare it to those countries already identified by the US as potential partners: Australia, India, New Zealand, Japan, North Korea and Vietnam, Mexico, and Columbia. As benchmarks, we suggest using the average wages of skilled and unskilled labor and corporate tax rates as the primary factors that have an impact on a product’s final price:
Data from https://tradingeconomics.com/.
For South Korea, there is only one data point for average monthly wage. For New Zealand, an hourly wage is provided; the monthly average wage is calculated at a rate of 160 hours a month (hourly wage is provided in USDs in brackets). Data for 2018.
This comparison shows that Ukraine has a competitive advantage over all the counties in this particular list. Wages and the corporate tax rate are lower in Ukraine. While this comparison does not include other benchmarks, such as social payments for every worker, Ukraine nevertheless remains competitive in comparison to the other countries being considered by US investors and officials as partners.
With these conditions, Ukraine should have already seen a steady stream of investments, but that is not the case. In 2018, Foreign Direct Investment (FDI) into Ukraine amounted to approximately $2.5 billion, at a time when $11.5 billion was invested in Columbia and $15.5 billion in Vietnam 25. Moreover, since 2015, foreign investment in Ukraine has stayed at roughly the same level, between $2.5 to 3 billion. This amount appears miserly compared to the $12 billion that Ukrainian workers abroad remitted in 2019. 26
Thus, there must be other factors that are holding back the investment stream into Ukraine. The first that comes to mind is the Russian-Ukrainian war. The current armed conflict and Russian aggression could be a serious factor that is seen as increasing risk for large businesses and discourages capital investments. Numerous studies have shown that military conflicts really do have an impact on FDI. This is typically the case for large scale projects with long-term periods of return. Mid-sized and smaller projects are not as susceptible.
The sphere of investments and their revenue-generating potential are also important. For example, mineral resource extraction is considered a reliable economic sphere, and investments are welcome even in crisis conditions (p.14). Generally speaking, FDI typically returns to countries about 3 years after the conclusion of large-scale conflict (with more than 1,000 fatalities). It is noteworthy, however, that, according to one survey, only 15% of investors identified “war” as posing a danger to their capital, and terrorism is even lower at 4%. Instead, the primary risks are so-called “regulatory changes”, corruption, and the absence of trust in the judicial system 27.
Corruption is likely the real obstacle to foreign investment in Ukraine. Moreover, as of 2017, 33% of accumulated foreign investments were monies from offshore zones, such as Cyprus or the British Virgin Islands 28. In other words, this is the reinvestment of domestic capital or hidden investments of Russian capital making its way into the Ukrainian economy. This is money belonging to oligarchs who know how to do business in a country with corrupt courts. This is further evidence that war is not the primary obstacle to foreign investments.
In fact, the decline of foreign direct investments began in 2013 (2012 — $8.1 billion, 2013 — $4.5 billion). FDI began falling before the conflict with the Russian Federation began. This is further proof that the primary problems are the absence of a transparent judicial system and corruption as the obstacles that thwart Ukraine’s economic development.
COVID – 19 presents Ukraine with economic opportunity
Despite the financial hardships they impose, crises provide opportunities for restructuring and rapid development. Many reputable companies were founded during recessions. For example, General Electric, IBM, Disney, Microsoft and Adobe were founded during times of crisis. When Steve Jobs returned to Apple in 1997, he was faced with the task of reducing the company’s product line by 70% 29. This may be a better example of an individual company’s crisis than it is of a global crisis, but it shows how difficult moments create opportunities for reinvention, and can even result in the creation of a masterpiece product. Those who can make the most of a bad situation always will. Ukraine, unfortunately, has shown that it was unprepared, not only for the pandemic, but also for the opportunities that have arisen as a result. For now.
Political and business elites in the US and EU are concerned with protecting their supply chains and where to move them. They are currently looking, in real time, for trustworthy countries who can, even in dire conditions, deliver the final product. Ukraine has relatively low wages and a low corporate tax rate. It has enough skilled workers, and the enormous European market is next door. The military conflict with the Russian Federation can even be viewed as an advantage in this case. Washington and Moscow traditionally view one another as competitors, and Ukraine could position itself as an important and reliable partner that never gives in to its enemies.
Alas, Ukraine is not on the radar of political elites in Washington and business elites of New York. The likely reasons for this are the absence of a transparent judicial system, corruption of the political and economic systems, and lack of rule of law. Another reason is local Ukrainian political ambitions, such as cases like the “Derkach tapes,” rendering Ukraine toxic for US investors 30.
The global pandemic has given rise to more than medical and economic crises. It has also become a crisis of trust. So while the search for someone trustworthy in Washington continues, we, here in Ukraine, need to ask ourselves whether we can trust one another.
Brief developed by: Oleksandr Kiriakov, Marko Suprun, Stanislav Hreshchyshyn, Diana Rusnak
Translated by: Stephen Bandera, Ulana Suprun
21 Sagatom Saha,Ashley Feng. Global Supply Chains, Economic Decoupling, and U.S.-China Relations, Part 2: The View from the People’s Republic of China. [The Jamestown Foundation] [https://bit.ly/2Y2hp0g]
Drawing of the MAERSK cargo ship is a rendition of an image by Kees Torn at posted to Flickr [https://bit.ly/3dyjCVz]
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