HOW THE WAR IN UKRAINE IS FURTHER DISRUPTING GLOBAL SUPPLY CHAIN (by David Simchi-Levi and Pierre Haren)
Russia’s invasion of Ukraine is adding to the woes of global supply chains. It is affecting industries ranging from semiconductors to cars to food. It almost certainly will accelerate the shift from global to regional sourcing.
The invasion of Ukraine by Russia and sanctions imposed on it for doing so and new pandemic-related shutdowns in China are the latest events to rock global supply chains. Combined with the China-U.S. trade war and other pandemic- and climate-related disruptions, it is certain to accelerate the movement by Western companies to reduce their dependency on China for components and finished goods and on Russia for transportation and raw materials and to lead to more localized, or regional, sourcing strategies. If China decides to back Russia in the Ukraine conflict, it would only fuel that movement.
In the 1990s, companies pursued strategies such as outsourcing, offshoring, and lean manufacturing to cut costs, retain market position, or gain competitive advantage. China emerged as a major manufacturing hub to serve global markets, including many Asian economies that were opening up.
Things started to change after the financial crisis of 2008. With a significant increase in oil price in 2008 and a variety of natural disasters, from the SARS epidemic of 2003 to the 2011 tsunami in Japan and flooding in Thailand, industry leaders recognized that the strategies adopted in 1990s could increase their exposure to operational problems and compromise their ability to respond effectively to natural disasters. This led many companies to increase local manufacturing in order to reduce their exposure to global risks and to be able to respond much faster to local demand.
Yet, given the benefits of relying on China and other Asian countries for manufacturing and the growing Asian markets, the change was not radical. Indeed, between 2014 and 2018, China’s manufacturing output grew up by 21% while that of the United States rose by 13%. In 2019, just before the pandemic, China accounted for 28.7% of global manufacturing output while the United States accounted for 16.8%
In the last four years, however, the China-U.S. trade war and the supply chain disruptions generated by the pandemic and climate-related events have caused the pace of supply-chain localization to rise significantly. In fact, a January 2020 survey of 3,000 firms, motivated by the China-U.S. trade war, found that companies in a variety of industries — including semiconductors, autos, and medical equipment — had shifted, or planned to shift, at least part off their supply chains from current locations. Companies in about half of all global sectors in North America declared an intent to “reshore.”
This is already happening. Consider the recent decision by Schneider Electric to build three new manufacturing facilities in North America, one of which will be in El Paso, Texas, and the plan by automakers and battery manufacturers to establish 13 new electric vehicle battery factories in the United States within the next five years. Similar announcements have been made recently in the solar, semiconductor and the biotech industries. The Ukraine war and closer alignment of China and Russia will modify profoundly the exchange of energy, raw materials, industrial parts, and goods between the Western world, China, and Russia and promise to accelerate the reshoring trend.
With oil and gas prices soaring due to the war, transportation costs will follow suit. What is less obvious but equally important is that the war-imposed constraints on the ability to use Russian transportation infrastructure to support manufacturing in Asia. Indeed, many companies have been building components and finished goods in China and using the Russian railway to move these items to Eastern and Western Europe. Of course, it is possible to ship some of these items by air, but that is significantly more expensive, especially now that airlines need to bypass Russia.
Equally important, Ukraine supplies about 50% of the world’s neon gas, which is used to produce semiconductor chips. Governments and large corporations are now scrambling to obtain alternative supplies, but the supply is tightening and prices have dramatically increased. Russia and Ukraine are also big exporters of grains such as corn, barley, and wheat as well as fertilizer. While the war’s full impact on global food supplies is not yet clear, prices are already skyrocketing.
These factors are boosting interest in local supply chain strategies. The recent agreement by Électricité de France (EDF) to purchase part of GE’s nuclear power business, which GE had bought from Alstom in 2015, exemplifies this swing from globalization to localization. France is increasing its dependence on nuclear power plants, which already generate 70% of its electricity. It decided that to do so it needed to better control the whole supply chain for such plants. Another example is semiconductor manufacturing equipment. The U.S. and Dutch governments have blocked ASML, the world’s largest producer of lithography equipment used to make computer chips, from selling its most advanced machines to China.
Finally, the Ukraine war’s surprisingly large impact on European car manufacturing has highlighted the risk associated with the current global supply chain. For example, Volkswagen and BMW have been closing assembly lines in Germany due to the shortage of wiring harnesses manufactured in Ukraine by the German company Leoni. And tire manufacturer Michelin has recently announced it could close some plants in Europe due to logistics issue created by Russia’s invasion of Ukraine. There is no doubt that the European car companies will take a hard look at the risks associated with international suppliers and consider buying more locally, even if this requires additional price increases. This could provide an opportunity for Europe to strengthen its internal manufacturing sector.
But as one of us (David Simchi-Levi) and others have observed, the localization approach is no panacea. Since China is now a dominant, if not sole, source of thousands of components, reducing dependence on it in many instances will take considerable investment and time. A case in point is Intel’s recently announced plan to spend $20 billion to build two semiconductor factories in Ohio. The first plant won’t begin production until 2025.
What is more, industry alone will not be able to address many of today’s supply-chain challenges. Governments will have to be involved. In the United States, federal and state governments are increasing investments in ports, airports, and other infrastructure. The U.S. CHIPS Act (which Congress has yet to fund) and the European Chips Act are examples of government efforts to reduce dependence on Taiwan and South Korea for semiconductor. The Ukraine conflict is also likely to give a boost to the European Battery Alliance, which the European Union formed in 2017 to make Europe a leader in advanced battery industry.
Until infrastructure investments in local regions happen, companies should stress test their supply chains and pursue strategies to make them more resilient to risks. About the only thing certain right now is the challenges to global supply chains are going to increase for the foreseeable future.
About writer : 1. David Simchi-Levi is a professor of engineering systems at Massachusetts Institute of Technology and the head of the MIT Data Science Lab. 2. Pierre Haren is the CEO of the fintech start-up Causality Link. He cofounded ILOG, a leading provider of optimization engines and business rules, which was bought by IBM in 2008.