Blindsided on the supply side

On Feb 27, Apple CEO Tim Cook announced that the tech giant would be reopening its factories in China, which had been an early victim of the coronavirus. Like Apple, companies around the world are discovering that their China-linked supply chains bring not only financial advantages but risks, too. And COVID-19 won't be the last such risk. While everyone should spare a thought for COVID-19's victims, they also ought to learn lessons from the bug's disruption of the unsexy but vital supply chain.

At the end of January, when COVID-19's destruction in China was becoming apparent, US Commerce Secretary Wilbur Ross told Fox Business that "I think it will help to accelerate the return of jobs to North America." Coming at a moment when some 8,100 Chinese had been infected with the virus, it was an extraordinarily callous comment, but the line was consistent with the so-called decoupling from China the administration of US President Donald Trump advocates.

It was also incorrect. In the short term, the virus won't help bring jobs back to the United States. On the contrary, it's likely to cause reduced manufacturing in North America and other Western countries as failing arrivals of Chinese-made components cause production delays.

That's exactly what happened in 2011, when a devastating tsunami and earthquake hit Japan's Fukushima region. Japanese high-tech firms are part of many companies' global supply chains—and executives soon discovered just how vital that Japanese cog was.

Before the earthquake, the Fukushima region produced, among other things, some 22 percent of the world's 300-millimeter silicon wafers, which are used in semiconductors; 60 percent of critical auto parts; and a large share of lithium battery chemicals and the conductive film used in flat-panel liquid-crystal displays. Indeed, the Japanese suppliers did such a good job that countless global manufacturers had gone single-source—that is, they were only using the Japanese firms. That's fine most of the time, but not when an earthquake strikes and renders factories unusable.

COVID-19's brutal world tour is not over yet, nor are the resulting supply-chain disruptions. The trouble is no CEO actually knows his or her companies' complete supply chain. As I pointed out in an article last year, suppliers are just the first tier of the supply chain. The suppliers have suppliers of their own, who may, in turn, even have a third layer of suppliers. Michael Essig, a professor of supply management at the Bundeswehr University in Munich, calculated that a multinational company such as Volkswagen has 5,000 suppliers (the so-called tier-one suppliers), each with an average of some 250 tier-two suppliers. That means that the company actually has 1.25 million suppliers—the vast majority of whom it doesn't know.

Even if a company tried to keep track of all of its tier-two suppliers, it would struggle to do so. "COVID-19 can become a wakeup call for both businesses and government authorities," Daniel Jonsson, deputy head of the Department of Social Security and Safety at the Swedish Defence Research Agency, told me. "Here's a very real opportunity to study which operations fare reasonably well during disruptions and which ones succumb. The latter may need government contingency incentives."

In fact, supply-chain vulnerabilities may only become apparent when there's a crisis. A new report by corporate data analytics firm Dun & Bradstreet calculates that some 51,000 companies around the world have one or more direct suppliers in Wuhan and at least 5 million companies around the world have one or more tier-two suppliers in the Wuhan region, COVID-19's epicenter. Fully 938 of the Fortune 1000 companies have tier-one or tier-two suppliers in the Wuhan region, Dun & Bradsteet reports. When a crisis strikes it is, of course, extremely difficult to fix the problem because companies are all looking for substitutes at the same time—and the market doesn't simply have lots of specialized companies able to spring into action if there's trouble elsewhere.

Indeed, even though the US pharmaceutical giant Merck and some other companies affected by the Fukushima earthquake responded by creating large inventories of critical components, many multinationals appear to have forgotten the lessons learned from Fukushima. Indeed, when COVID-19 hit China, Apple was stuck. So were other companies. Microsoft—hardly a risk-seeking company—announced that its quarterly sales would be lower than expected as a result of the virus's impact on its supply chains.

Such reports have caused stock markets to plummet. The last week of February was one of the worst since the 2008 financial crisis for both the Dow Jones Industrial Average and the London Stock Exchange.

Why didn't executives learn from the Fukushima disaster? Many probably did but failed to take action, though some firms—including Levi's—have cut their Chinese suppliers for fear they'll be harmed in a US-Chinese trade war. "And many companies have built supply chain risk management in order to identify problems and take action at an early stage," Essig told me. "The coronavirus is showing whether such systems work."

Creating inventories, or moving to dual-source, is expensive, and natural disasters are relatively rare. According to the US Geological Survey, most years there's only one major earthquake worldwide. What's more, CEOs are judged on their companies' quarterly results. Why spend money on resilience, so the thinking goes, for a contingency that's highly unlikely to occur?

But the world is changing. Severe-weather events are increasing. Like earthquakes, flooding can cause factories to temporarily close. Equally troubling, nation-state aggression is shifting its focus to the private sector. China is emerging as an extremely skilled practitioner in using its companies to weaken other countries through means including intellectual property theft, cyber aggression, and predatory takeovers of cutting-edge firms—so skilled that the US government has made the issue a priority.
Long international supply chains, then, pose an enormous vulnerability, not just to the companies relying on them but to the countries where those companies are based and where their products are delivered. Consumers are, of course, ultimately affected, too. That makes it extraordinarily tempting for one country wishing to harm another to do so by disrupting the supply chains of companies seen as representing that country.

Last year, long before the coronavirus paralyzed markets, German-based Adidas's sales growth declined when the company's suppliers—nearly all of whom are based outside Germany—failed to keep up with customer demand. Imagine the effects if the Chinese government, or any other government with lots of companies supplying Western conglomerates, decided it wanted to harm another country.

For example, what if the Chinese government instructed Chinese companies to delay or halt deliveries to Swedish companies in order to punish Sweden for standing up for Gui Minhai, a Hong Kong-based bookseller who has just been sentenced to 10 years in prison? Two years ago Gui, a Chinese-born Swedish citizen who had published books critical of Chinese leaders, was abducted by Chinese agents while traveling in China with two Swedish diplomats. Gui received his sentence in February, following an apparently coerced confession and forced return to Chinese citizenship. Delaying or halting Swedish firms' supply chains would cause a great deal of harm—and it would be virtually impossible to prove that the disruption had been instigated by the Chinese government.

Ross's comment about the virus helping bring US jobs back was nasty and inaccurate in the short term, but it did point to a larger reality: In the longer run, it's safer for companies to have their production closer to home. Such localism also benefits the national security of the businesses' home countries. Given the low cost of shipping and developing-country wages, it's unfortunately also much more expensive, and thus unlikely to happen.

Instead, businesses should make a concerted move to diversification. To be sure, having additional suppliers in other countries would cost more, as would maintaining large inventories, but it would also guarantee a modicum of stability in case of crises—whatever those crises might be. The businesses currently slumping on Wall Street and other stock exchanges are surely now wishing they had done so.

After all, a string of fine quarterly results doesn't matter much when supply-chain disruptions—whether caused by animal-triggered viruses, Mother Nature, or hostile governments—can wipe away months of gains or billions of dollars in market value in a matter of days.