The Rise of China
China’s initial rise to become the global manufacturing hub was triggered by joining the WTO in 2001 but up until that date, it had already developed a raft of export-friendly policies to encourage manufacturing, including VAT exemption on most exported products, as well as having a permissive regulatory environment.
This was coupled with the key advantage that it had a vast pool of low-cost labor and the ability to develop infrastructure and supply chains rapidly, given its positioning as a command economy. The Chinese government also orchestrated a marked 33% devaluation of the currency in 1994, from RMB5.5 to the USD to RMB8.7. This move was an earlier trigger, giving it an immediate competitive advantage.
China then rapidly developed its supply chains and productivity to produce increasingly value-added products at a relatively low cost of production. As labor costs have risen, increased productivity has also become increasingly important. Higher labor costs started to drive more labor-intensive industries, such as textiles, to other countries in the mid-2010s.
The Shift Has Begun
More recently, supply chains have been shifting from China to Southeast Asia for a diverse range of reasons including geopolitical, economic, as well as commercial considerations.
There is increasing evidence of the shift in supply chains from China to Southeast Asia.
Pandemic Induced Shift
Key actors reflecting this shift range from Chinese corporations seeking to circumvent tariffs, notably from the US, to foreign multinationals looking to diversify their manufacturing bases outside China. The latter have experienced significant delays and bottlenecks during the COVID-19 pandemic.
There have also been increasing accusations of violation of intellectual property rights in China, which presents risks of copycat-type products.
Brands diversifying sourcing
Manufacturing Costs In China Have Increased
The costs of production, especially labor costs, have risen significantly in China, leading companies to relocate to lower-cost manufacturing locations for more labor-intensive goods, including Vietnam, Thailand, and Indonesia.
There has also been an increasing emphasis on US security concerns regarding Chinese-manufactured electronics products, especially from firms such as Huawei. This extends to companies in the tech space with shareholdings by Chinese corporations.
China’s complete shutdown during the COVID-19 pandemic impacted supply chains in a meaningful way and provided further impetus to shift to Southeast Asia for industries from auto manufacturing to pharmaceuticals. Over-reliance on Chinese production, especially given the Sino-US trade war, has led companies to diversify production to other countries, including Thailand, Malaysia, the Philippines, Indonesia, and Vietnam, covering several sectors.
Issues with Chinese labor disputes and legacy political issues have led Japanese manufacturers to seek out alternative manufacturing bases in Southeast Asia, especially in Vietnam, Thailand and Indonesia.
The Sino US Trade War Exposed Vulnerabilities
The Sino-US trade war has necessitated a move to produce outside China for exports to the US to avoid punitive tariffs. Chinese EV manufacturer BYD has announced it will invest US$1.3bn in Indonesia including building a manufacturing facility for EVs in Thailand and recently announced the intention to do the same in Indonesia. More recently, Vinfast has also committed to invest US$1.2bn in Indonesia to build its supply chain there, underlining the attractiveness of Indonesia as a manufacturing base.
Chinese companies are also investing in Southeast Asia as part of the Belt & Road Initiative in a wide range of industries including cement, steel, solar panels, and commodity-related industries including the processing of nickel and copper with smelter investments with the eventual aim of supporting EV battery production.
Southeast Asia Has Become A More Attractive Destination
Increasing investments have been made into infrastructure to encourage FDI, especially in Indonesia, as the emphasis on manufacturing shifts to Central and East Java to take advantage of lower costs. This has been driven by new toll roads, new ports, and railways connectivity.
The Patimban Port in Central Java is specifically designed as an auto-export hub, which will help to attract auto companies seeking to export from Indonesia, potentially for 4W EVs.
The passing of the Omnibus Law in Indonesia makes it easier to apply for licenses, given that it centralizes and relaxes employment law to encourage foreign investment in building supply chains in the country. The complexity of setting up a business in Indonesia in terms of licensing and employment laws has historically been a barrier to investment, given the difficulties of making retrenchments of full-time staff.
The EV battery supply chain has shifted to Indonesia given its rich nickel deposits and the requirement to process nickel onshore. This has encouraged companies involved in the EV battery supply chain to build smelters in Indonesia, attracting large amounts of FDI from mining to processing and battery production, with EV production as the next stage.
There is a practical element in Indonesia, given the abundance of raw materials required to produce EV batteries and the fact that it is a huge domestic market. Furthermore, it has the potential to become an export manufacturing hub for EVs.
The increasing investment in sustainable power generation has also given rise to investments in solar panel manufacturing in Indonesia by Chinese producers aiming to get closer to the market. There are also plans to build “green” industrial estates that supply sustainable energy to tenants from hydro to solar and biomass. The Adaro-owned Green Industrial estate in Kalimantan is one such estate, with a large-scale hydro project set to provide power for the estate. This is helping to attract manufacturers with a greater focus on sustainable production, with the earliest commitment from an aluminum producer for EVs.
Supply Shifts Improve The Quality Of Economic Growth
The shift in supply chains to Southeast Asia is helping increase the value-added manufacturing component to GDP rather than focusing on commodity-driven industries which are more prone to cyclical downturns. Already the shift in processing nickel in Indonesia has created a positive tailwind for the economy and a significant trade surplus, which in turn has meant a stable IDR.
The rapid pickup in FDI to Southeast Asia as a result of the transfer of supply chains is leading to strong demand for industrial estates providing the right kind of infrastructure and connectivity. The JIIPE industrial estate in Gresik, owned by AKR Corporindo, close to Surabaya is a good example of such an estate.
A growing share of FDI to ASEAN is now directed towards the manufacturing sector, which increases employment on the ground, which means greater training helping to improve the region’s human capital. Increased investment should also improve the quality of the workforce through training over time, especially given young populations, especially in the Philippines, Indonesia, and Vietnam. This will in turn attract further investment in those industries given there is a growing pool of skilled workers.
China-related supply chain issues have prompted Southeast Asian countries to shift the sourcing of key components to neighboring nations within Southeast Asia. This trend is particularly notable in areas such as medical equipment and pharmaceuticals, with companies like Kalbe Farma (KLBF IJ) transitioning their sourcing of basic raw materials onshore from China.
Thailand has already established itself as an auto manufacturing hub for exports and Indonesia has the opportunity to do the same in the EV space given the abundance of raw materials for EV batteries. Chinese investment in the supply chain has already started to happen.
Vietnam has already taken the lead in electronics manufacturing, even producing earphones for Apple, and has experienced growth in other sectors such as footwear and apparel. This shift from China is attributed to escalating costs and geopolitical issues, reflecting the growing ‘China plus one’ approach adopted by multinational companies.
Supply chain shifts of this size take long periods to complete, often years but the shift has started already, especially in areas such as the auto industry and electronics, with ASEAN’s share of intermediate goods on any increasing trend but there is still a long way to go before this reaches an equilibrium.
Politics And Regulations Represent Risks
There are of course risks to the continuing momentum behind this shift, not least from changes in political regimes, which may bring about more nationalistic policies. There may also be unexpected changes in regulations, especially in Indonesia, making those locations less attractive to manufacture goods.
Additionally, there may be changes to foreign ownership regulations, potentially forcing a stake sale to domestic third parties. The recent elections in Thailand have seen some changes in policy and Indonesia’s next President may take a different view of the world from the current one.
Exciting Prospects for Southeast Asia
The costs of production in Southeast are low but there is still a productivity gap with China which needs to be closed with an ongoing need to improve production efficiency. There are also sustainability goals that need to be met with certification of green standards sometimes taking time to achieve.
There is also a need to move towards low carbon emissions to satisfy the investment criteria of multinational companies, especially those from Europe, and in segments such as EV production, these sensitivities are significantly higher.
Overall, a combination of the disruption caused by the COVID-19 pandemic combined with cost considerations and improving infrastructure have accelerated the shift of supply chains from China to Southeast Asia. That momentum is set to continue but it still has a long way to go, making the prospects for Southeast Asia all the more exciting.
Author: Angus Mackintosh | He is the founder of CrossASEAN Research, an independent research firm that actively publishes differentiated SEA-focused insights on SmartKarma. He has over 30 years of experience covering Asian Markets, with in-depth knowledge of companies, economies, and markets based in ASEAN