CUHK Business School Research Looks at Why Global Efforts to Move Production Away from China May Not Mitigate Supply Chain Risks

The unprecedented COVID-19 pandemic has posed severe challenges for the global economy and supply chains have been in the eye of the storm. Amid heightened geopolitical tensions, some countries are considering moving supply chains out of China. However, as a recent research study by The Chinese University of Hong Kong (CUHK) reveals, cutting ties with China might not help firms to mitigate risks.

“In many parts of the world, there’s been concern that global supply chains were over-reliant on China, now widely regarded as ‘the world’s factory'”, says Jing Wu, Assistant Professor of Department of Decision Sciences and Managerial Economics at CUHK Business School and one of the authors for a new study.

Such efforts include reported talks in August between Japan, India and Australia to establish a trilateral effort, named the Supply Chain Resilience Initiative, to build stronger supply chains and to reduce dependence on China. Earlier in the year, Japan also earmarked US$2 billion to help its companies shift production out of China and back onto its shores. Across the Pacific, both the Trump administration as well as Democratic Presidential nominee Joe Biden have signaled that post-election they would seek to end the U.S.’ reliance on Chinese manufacturing.

“We live in an increasingly interconnected world, so much so that having supply chain relations with other regions when the pandemic hit China didn’t mitigate credit risk at a time when credit risk for firms with ties to Chinese supply chain partners was increasing,” says Prof. Wu in discussing the results of his latest study The Impact of COVID-19 on Supply Chain Credit Risk.

“When the pandemic spread to the rest of the world and recovery started in China, having supply chain linkages to China was beneficial for the companies as the rest of the world was going through economic shutdowns or slowdowns,” he says.

The research was conducted by Prof. Wu in collaboration with Prof. Senay Agca at George Washington University, Prof. John Birge at University of Chicago and CUHK Business School Ph.D. student Zi’ang Wang. The researchers examined how supply chain activity reflects into credit risk during different phases of the COVID-19 pandemic.

They specifically looked into spreads on credit default swaps, or CDS — a type of financial instruments which allows credit risks to be hedged, and its relation to U.S.-China supply chain links. The study mainly reviewed CDS data in two phases of COVID-19: when the Chinese economy shut down between January 31 to February 29 and when the Chinese economy reopened between March 1 to April 6.

“By exploring two phases of the pandemic, we find that supply chain disruptions and resumptions substantially affected the credit risk of U.S. firms during the pandemic. Credit risk increases with supply chain disruptions due to economic shutdowns and decreases when supply chain activity resumes when the economy opens,” says Prof. Wu. The effects were economically significant, increasing CDS spreads by around 6 percent to 7 percent during disruptions and improving credit risk by 16 percent 29 percent when supply chain activity resumes during the reopening of the economy.

The study also points out that the resumption of supply chain activity in China seems to have a more pronounced effect on improving credit risk than during supply chain disruptions when the pandemic spread in China.

Household Demand Factor

Prof. Wu and his collaborators then looked into specific industries to find out which sectors were more vulnerable to supply chain disruptions. They found that sectors that are more closely related to household demand, such as electronics and consumer goods, did not benefit as much as other sectors when supply chain activity was improved during phase two of COVID-19 in China. The resumption of supply chain activity in China did not reduce the credit risk for these sectors due to low household demand in the U.S.

According to the study, sectors such as oil and gas and manufacturing were more directly affected by disruptions and the resumption of supply chain activity. The CDS spreads for these sectors increased during periods of disruptions and decreased with resumptions.

However, it was a different picture for the U.S. companies that had Chinese customers. When the Chinese economy re-opened in phase two, increasing household demand in China, the CDS spreads of the consumer goods sector reduced considerably for the U.S. firms with links to Chinese customers.

“Since this is the period when the U.S. economy shut down, having access to Chinese markets was beneficial for U.S. firms with Chinese customers, particularly for those in the consumer goods sector,” Prof. Wu explains. Among other sectors, firms in the oil and gas industry that work with Chinese customers also have reduced credit risk when the Chinese economy reopened.

Firm and Supply Chain Characteristics

In terms of firm characteristics, the researchers found that firms that were investment-grade, with more cash and more growth opportunities were less affected by supply chain disruptions during the pandemic. In addition, firms with high leverage were more vulnerable to supply chain disruptions but also benefited more when activity resumed.

“Investment-grade firms are further away from the default boundary and therefore have the ability to withstand adverse developments. Firms with more cash holdings also have more buffer in such situations. In addition, growth opportunities appear to allow firms to shift to other businesses when production or customer demand changes during the pandemic,” Prof. Wu explains.

Firms that operate in highly concentrated industries, where a small number of firms made up for a high proportion of production, were affected more by supplier disruption but less from customer disruption, as these firms have a lower risk of losing market share. This contrasted with firms in sectors where products were similar and competition fierce. As firms were more substitutable, they were more vulnerable to supply chain dynamics. Firms with more capital could also better adjust to supply chain driven changes and thus they were less affected during supply chain disruptions.

Furthermore, companies with longer supply chains suffered from amplified credit risk as these relations are harder to substitute. Upstream sectors were less affected from reduced demand in China as it might be easier for these firms to find substitute markets. According to the study, these firms also recovered faster when supply chain activity resumed. On the other hand, when firms were more central in the supply chain network, their credit risk was less affected by disruptions in any particular individual supply chains.

The study complements the current discussion about the impact of COVID-19 supply chain disruption on firm credit risk and it is also the first to consider supply chain disruptions with household demand within the context of supply chains.

“We bring evidence of how supply chain disruptions affect firms as economies move to different phases of the pandemic. These results have implications for other forms of regional production or consumption disruptions and the impact of global supply chains on propagating or mitigating such shocks.”