China’s Zero Covid Exit and Potential for 2023 Supply Chain Outages

China is rapidly reshaping its Zero Covid policy, putting an end to its brutal strategies of mass testing, quarantine and lockdown, at least for now. In the first two years of the pandemic, Zero-Covid worked pretty well. While other countries struggled to keep factories running, China’s main problem was dealing with congested logistics on its main trade routes to North America and Europe as its exports boomed. But with the more contagious omicron variant, all this flew out the window. To understand the potential impacts of 2023 on global supply chains, we first need to understand the implications of this Zero-Covid outbreak on the country’s “factory city” production model.

Chinese high-volume production model

One of the reasons why Chinese manufacturing is so efficient is the preponderance of “factory cities” – self-contained campuses that contain factories, warehouses, office space, and residences within a fenced perimeter. These campuses emerged in the 1990s in coastal provinces such as Guangdong, Zhejiang, and Jiangsu, with workers recruited from inland provinces such as Shanxi, Henan, Hubei, and others. Coastal provinces made heavy early investments in infrastructure that supported exports, including road and container ports. All this helped China become the workshop of the world.

A typical campus may have 10,000 workers living in apartment towers and separate administration pods, often referred to as dormitories. Large campuses, such as Foxconn’s Longhua Science and Technology Park in Shenzhen, at times employed 270,000 workers on a one-square-mile campus. It was not uncommon to see more than 50,000 people on a single campus. Driving through Dongguan, a city adjacent to Shenzhen, in the early 2000s, I found the 10-15000-person campus to be ordinary. You could see them for miles. Where one ends, the next begins.

There was a very high concentration of workers in the factories. Six years ago, I took a course to visit a mobile phone assembly plant in Dongguan. 15,000 workers shoulder to shoulder assembling 100,000 smartphones a day. On these campuses, workers often eat in company-run canteens, and the proximity of living quarters means shift changes are crowded with people walking across campus. Huge parking lots and no traffic like you might find in US factories.

High population density was also a feature of the dormitories. Not so long ago you could find 12 people per room with four triple bunk beds and a shared bathroom. While many factory cities go to four people per room, companies often don’t share this information or let you see the rooms. Six or more per room is apparently still common.

Zero-Covid worked well with this model until it didn’t work

When Covid-19 first surfaced in Wuhan, China at the end of 2019, every factory manager in China knew the consequences of a highly contagious respiratory infection that had hit their factory – they could have instantly hosted a superspreading event. They had experienced this before with SARS and H1N1 in 2009, so they quickly implemented masking and temperature controls at their entrance. If you were a factory manager living in the midst of high population density, you would jump to these measures.

Now let’s add the impact of one of the largest seasonal migrations of people in the world: Lunar New Year in China. Most migrant workers staying in dormitories go home only once a year at this special time. Factories officially closed for seven days, but often for two weeks or more, and millions of workers took trains and long-distance buses to go home to see their families. Often this is to see children being raised at home by grandparents or families supported by remittances of factory earnings. It is the most important holiday of the year for them.

I was in China and South Asia for the first two weeks of the year in 2020 and the Covid issue had already come to the fore. Lunar New Year began on January 21 that year, and with the quarantines and transportation shutdowns that began in February, it was clear that many workers would have a hard time getting back to their factories and jobs. I was trying to explain why I thought Covid would have a huge impact as the New York Stock Exchange reached new heights. It was good. Initially, this was because workers could not return to the factories, so the factories had trouble starting over. This has led to numerous parts shortages in their supply chains.

Factories eventually resumed work when global demand collapsed, and then demand changed as work from home took root. At this point, however, China has managed to break the contagion and keep its economy and factories running. It has even become reliable exporters as other countries such as China, Vietnam, Malaysia and India are suffering from waves of infections. Throughout all the geopolitical turmoil and trade wars of the Trump administration and then Covid, many Western companies have kept their faith in China.

April 2022 was a turning point

The lockdown in Shanghai in April of this year was a turning point. The extensive and extreme measures taken by local authorities to maintain the zero Covid policy have had a huge impact on companies in the tech sector. From Shanghai to Kunshan and west to Suzhou, there is a huge production base for IT equipment, critical components and sub-assemblies. The harshness and unpredictability of government policies has led to a loss of confidence in the manufacturing sector in China. Add to Apple
recent troubles at supplier Foxconn’s factory complex in Zhengzhou. If you weren’t serious about diversifying your supply base away from China before, these events changed everything.

Looking ahead at the calendar

While the accuracy of China’s reporting of omicron infection rates will likely decline, there is little doubt that this highly contagious variant will spread rapidly among the country’s population as authorities essentially abandon Zero-Covid. It is the calendar we have to look at.

The Lunar New Year begins on January 22, 2023. If Omicron infection rates start to rise just before that, China will be in big trouble. It seems to be in the process of lifting many travel restrictions, but with more than 100 million people traveling at the height of a pandemic, it won’t be a pretty sight. Chinese workers left a few years ago, when many New Year’s trips are forgotten, so there must be a huge pent-up demand. We can expect many excursions.

The biggest problem will be when these workers try to come back. Localized deadlocks can come back and hinder travel. Or if workers are sick, there won’t be enough space to quarantine them. China is entering unknown territory. It worked until Zero-Covid didn’t. We’ve reached the stage of not doing it anymore, and the potential to cause more supply chain pain is huge.

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