Decoupling and De-Risking: A Guide to Managing Global Supply Chain Risks

Decoupling and de-risking are essential strategies for managing global supply chain risks. By reducing dependence on a single supplier or market, businesses can minimize the impact of disruptions and maintain a stable supply of goods and services.

Decoupling involves diversifying suppliers, sourcing materials from multiple locations, and investing in backup systems. This approach can help mitigate the effects of supply chain disruptions, such as natural disasters or trade wars, which can significantly impact a single supplier or market.

Businesses can also de-risk their supply chains by implementing risk management strategies, including scenario planning, supply chain mapping, and supplier evaluation. By understanding potential risks and vulnerabilities, companies can take proactive steps to mitigate them and ensure business continuity.

Decoupling and de-risking are not one-time fixes, but ongoing processes that require continuous monitoring and adaptation. By staying vigilant and responsive to changing market conditions, businesses can maintain a resilient supply chain that can adapt to unexpected disruptions.

De-risking semiconductor supply chains is crucial, as seen in the EU's response to Russia's invasion of Ukraine. The EU reduced its reliance on Russian gas from 40% to 12% in just a few months.

The EU's de-risking exercise involved diversifying gas pipelines from other sources, such as the Trans Adriatic Pipeline, and investing in renewable energy resources like wind and solar power. This strategy helped reduce the EU's reliance on Russian gas.

The US, on the other hand, has no intention of decoupling its economy from China, despite concerns about strategic technologies being traded. The value of daily goods and services traded between the US and China is approximately $1.26 billion.

Stratified global value chains can make it difficult to suddenly stop commerce, as seen in the US-China trade relationship. This can disrupt trade, derail investment, and cripple supply chains.

Addressing security risks does not necessarily address macroeconomic and political exposures, such as strong dependencies that can lead to substantial costs in the event of political confrontations.

Germany has a significant economic presence in China, with around 5,000 German companies conducting business there.

A substantial portion of Germany's economy relies on exports to China, with 2.7% of the country's total economic value-added and 2.4% of total employment dependent on these exports.

However, China is not Germany's most important trading partner, with EU neighboring countries, such as the Visegrád countries, accounting for almost 40% more in trade.

Germany's large firms are particularly involved in China, and political economy risks exist, but the EU Commission's proposals to address these risks are unclear and may not be effective.

Germany stands out in China exposure, with around 5,000 German companies conducting business in China. This is a significant presence, considering the economic risks that come with it.

A substantial portion of Germany's economy depends on exports to China, with 2.7 percent of its total economic value-added and 2.4 percent of total employment at stake. That's a notable chunk of the country's economic pie.

Germany's largest trading partner for trade in goods is China, accounting for 9.5 percent of Germany's trade in goods. However, EU neighboring countries are much more important, with the four Visegrád countries in 2021 accounting for almost 40 percent more in trade.

Addressing security risks doesn't automatically address the macroeconomic and political exposures that can put a country in a vulnerable position.

The German chancellor's call for diversification highlights a crucial point: strong dependencies can lead to substantial costs in the event of political confrontations.

In the context of China exposure and risks, understanding the difference between security risks and macroeconomic and political exposures is essential.

A number of alternative policies can be considered to mitigate these dependencies, but they require careful analysis and planning.

Germany's China strategy needs to be part of a larger EU strategy, but it's currently lacking. The European Council is scheduled to meet in June to discuss what "de-risking" means, and Germany must have a clearly formulated strategy by then.

A leaked draft of the Federal Ministry for Economic Affairs and Climate Action (BMWK) guidelines suggests excluding Chinese firms from investing in German critical infrastructure, but these documents are not yet official policy. The BMWK guidelines also recommend ending development aid to China and forcing German firms exposed to China to regularly report on their activities.

Concrete policy proposals are needed to address the complexity of risks and the lack of clarity on what a risk is. The term "de-risking" needs a clear definition and operational ways to implement it, as the German chancellor's statement that it doesn't mean decoupling but rather increasing trade relations with other countries is unclear.

Germany's China strategy needs to be part of a larger EU strategy. Germany currently doesn't have a China strategy, which is a problem since many aspects of a China strategy, such as trade and technology policies, fall under EU competence.

The European Council is scheduled to meet in June to discuss what "de-risking" means, and it's crucial that Germany has a clearly formulated strategy by then. Germany's Federal Ministry for Economic Affairs and Climate Action drafted China guidelines that were leaked in late 2022, but these are not yet official policy.

According to the leaked draft, Chinese firms should be excluded from investments into German critical infrastructure. The draft also recommends that China should no longer be considered a developing country, and development aid should be ended.

German firms exposed to China should be forced to regularly report on their activities. The draft also proposes that new investment guarantees should direct German FDI to markets other than China. The draft even suggests proposals for outbound investment screening, primarily targeted at tech sectors critical for military use.

However, these leaked documents are not yet official policy, and actual decisions, such as allowing Cosco to buy part of the port of Hamburg, seem to contradict the BMWK draft's intention. The German government still needs to adopt concrete policies to address the problem of China risk.

The German chancellor insisted that "de-risking" doesn't mean decoupling, but rather increasing the number of trade, supply, and investment relations with countries other than China.

Setting targets and limits on China relations is a crucial aspect of the Critical Raw Materials Act. The Commission's proposals aim to ensure no single third-country supplier has a share of above 65 percent of the EU's total consumption of each strategic raw material.

This threshold is not clearly justified, leaving many questions unanswered. The proposed administrative approach may not effectively incentivize diversification, as it's unclear whether it would be implemented at a firm level or a national level.

Firms drive relations, so they require precise guidance, not broadly stipulated guidelines. The lack of clear direction may lead to confusion and hinder efforts to diversify supply chains.

Germany should take the lead in defining security risks and acting on them in Europe. This involves clearly spelling out hard security risks and applying policies to mitigate them, such as export controls on high-tech goods with military and civilian applications.

The Dutch government has already implemented export controls on lithography machines, which are needed to produce advanced chips. This is a good example of how a single country can take action to address security risks.

Germany can also play a key role in coordinating security assessments at the EU level to avoid fragmentation of the single market. This would ensure that critical components of export-restricted goods, such as Zeiss optics, are equally under export limits.

Germany's role in European security is closely tied to its semiconductor supply chains. The EU's de-risking of Russian energy supply chains is a relevant example of how countries can diversify their supply chains to reduce reliance on a single source.

The EU's reliance on Russian gas fell significantly after it increased imports of liquefied natural gas from countries like the US, Qatar, and Norway. This shows that diversifying supply chains can be an effective way to reduce dependence on a single source.

Senior US officials have made it clear that they have no intention of decoupling the American economy from China, despite concerns about the trading of strategic US technologies. This suggests that the US is committed to maintaining its global supply chains, including those with China.

The value of daily goods and services traded between the US and China in 2023 is approximately $1.26 billion. This highlights the complexity and scale of global supply chains, which can be difficult to disrupt or decouple.

Germany should take the lead in European security efforts by clearly defining and addressing security risks. This can be achieved through coordinated policies, such as export controls on high-tech goods with military and civilian applications.

The Dutch government has already implemented export controls on lithography machines, which are needed to produce advanced chips. Similarly, Germany should scrutinize inbound investments into security-sensitive industries to avoid fragmentation of the single market.

A European Economic Security Council could be formed to provide a shared risk assessment and roadmap for addressing security risks. This council would include five security representatives appointed by EU member states, along with relevant European Commissioners, to deliberate delicate security concerns.

Germany should also consider subsidizing European firms that diversify and move business away from China, regardless of the location they choose. This approach would remove any implicit subsidy for production in China and provide a more cost-effective solution than a national subsidization scheme.

A tax on companies operating in China with excessive exposure risks could be a negative incentive to nudge companies to move to other locations. However, several practical questions remain for implementing such a tax regime, including how to define such a tax and how to apply it.

Defining a tax on excessive exposure risks in China is a complex task. It's unclear how to measure exposure risks and determine what constitutes excessive exposure.

Implementing a tax regime in China could be incompatible with WTO rules. This raises concerns about the feasibility and effectiveness of such a tax.

The Ukraine war is reshaping climate and energy policy, but let's dive into how it's affecting global supply chains. Given the realities of the US-China geopolitical rivalry, global supply chains have divided into three layers.

Strategic goods make up about 20% of trade between the US and China, including critical technologies like semiconductors, supercomputers, and artificial intelligence. These strategic technologies are being placed inside a "small yard with a high fence" by Washington, with the goal of decoupling them from Chinese state-controlled manufacturing and assembly.

Dual-use goods, which make up the next stratum of global supply chains, present a de-risking dilemma to multinational enterprises. These goods have potential military utility, and their status can change quickly in the event of an unforeseen geopolitical event.

New export licensing requirements or prohibitions can be imposed by Washington or Beijing based on spontaneous events, making it difficult for companies to navigate. This is reflected in the de-risking actions taken by companies like Dell and Foxconn, who are pre-emptively preparing for potential geopolitical scenarios.

The US-China trade relationship is complex and multifaceted, with a history of trade tensions and disputes. The two nations have a significant trade imbalance, with the US importing over $452 billion worth of goods from China in 2020.

China is the US's largest trading partner, accounting for over 21% of US trade. The US exports to China have been declining in recent years, with a 12% drop in 2020 compared to the previous year.

The US has imposed tariffs on Chinese goods, with over 50% of Chinese exports to the US facing tariffs. These tariffs have led to a significant increase in the cost of goods for US consumers.

In 2020, the US imposed tariffs on $360 billion worth of Chinese goods, with the average tariff rate on Chinese imports increasing by 10% compared to 2018 levels.

German companies have a significant presence in China, with DAX companies generating 230 billion euros in turnover in 2021, which is 16 percent of their total turnover. This level of dependence on China is evident in companies like Volkswagen, where one out of every six employees is based in China.

Volkswagen sells around 38 percent of its new cars in China and makes more than one third of its turnover there. Infineon, Germany's largest semiconductor manufacturer, generates 37.8 percent of its turnover in China.

However, despite this dependence, Chinese investments in German industry are relatively small.

Foxconn, a major electronics manufacturer, is quietly redistributing its manufacturing to countries like Vietnam, Mexico, and India, while its operations in China decline. This shift marks a significant move towards de-risking, a gradual approach to mitigating specific risks associated with economic engagement with a particular country.

De-risking involves diversifying supply chains, identifying alternative sources of goods and services, and implementing measures to reduce exposure to potential disruptions. Unlike decoupling, which involves a complete separation of ties between two or more economies, de-risking seeks to continue basic trade and investment activities once the risks have been dealt with.

Dell and Foxconn's behavior in China is often described as China de-risking, a nuanced and gradual approach to reducing reliance on a single supplier or protecting against potential economic or geopolitical events.

Around 5,000 German companies conduct business in China, with 2.7 percent of Germany’s total economic value-added and 2.4 percent of total employment dependent on exports to China.

Germany's largest trading partner for trade in goods is China, accounting for 9.5 percent of Germany’s trade in goods, although EU neighboring countries are much more important.

The German government's implicit insurance creates a moral hazard that makes it difficult for companies to take losses if relations with China deteriorate, as large companies may perceive themselves as systemically relevant and anticipate the government will change course during crises.

Firms rationally provide insufficient insurance to cover their exposure to risk due to this political economy problem.

Thirty-six percent of SME CEOs declared that their company supply chains are dependent on China, with the electronics and chemical industries being particularly dependent.

Large SMEs with annual sales of over 50 million euros are more likely to want to withdraw from China, with 33 percent of SMEs wanting to strengthen their supply chains in Western Europe.

Almost two thirds of SMEs surveyed want to expand their supplier network to avoid being severely affected by possible shortages of goods in a particular region.

DAX companies have significant dependencies on China, with 230 billion euros of turnover generated in China in 2021, accounting for 16 percent of DAX turnovers on average.

One out of every six Volkswagen employees are based in China, and Volkswagen sells around 38 percent of its new cars in China, making more than one third of its turnover there.

Export restrictions can have a significant impact on businesses.

Meetings like the one mentioned in the article can affect how aggressively government policy makers pursue decoupling in strategic sectors.

Decoupling and de-risking are likely to continue to be an uncertain and messy enterprise.

Michael Dell has stated that customers are demanding less reliance on China.

Dell is planning to phase out 'made in China' chips by 2024.

Companies like Foxconn are investing heavily in alternative locations, such as India and Mexico.

Foxconn is building a $1.5 billion plant in India to boost iPhone output.

This investment is a clear sign that companies are taking steps to de-risk their supply chains.

Decoupling and de-risking are complex issues that require a thoughtful approach. The European Union's experience with security risks highlights the importance of clear policy levers.

To address security risks, EU countries must come to a shared understanding and definition of these risks. This will help avoid undermining security measures by a well-functioning single market. The European Commission should play a crucial role in defining which security risks to act on, in conjunction with selected representatives of member states through a newly established European Economic Security Committee.

Institutional arrangements are key to addressing broader supply chain and macroeconomic risks. The European Commission is best equipped to use detailed empirical models to establish where production is excessively concentrated in one country. This systematic and data-driven approach will help identify areas where de-risking is necessary.

Evidence-based decision-making is essential to avoid becoming too broad in risk definition. A broad risk definition can lead to a call for decoupling, which is not the goal. Germany, as the EU's most exposed country, should lead the debate on China de-risking.