China’s Zero-Covid Exit And The Potential For 2023 Supply Chain Disruptions

China has been rapidly refashioning its Zero-Covid policy, ending its draconian mass testing, quarantine, and lock-down strategies, at least for now. During the first two years of the pandemic, Zero-Covid worked pretty well. While other countries struggled to keep factories running, China’s main challenge was coping with clogged logistics on the main trade lanes to North America and Europe as its exports boomed. But with the more contagious omicron variant, all this went out the window. To understand the potential 2023 impacts on global supply chains, we first need to understand the implications of this Zero-Covid exit for the country’s “factory city” manufacturing model.

The Chinese high-volume manufacturing model

One of the reasons Chinese manufacturing is so efficient is the preponderance of “factory cities” – self-contained campuses that include factories, warehouses, office spaces, and housing within a fenced perimeter. These campuses sprang up in the 1990s in coastal provinces like Guangdong, Zhejiang, and Jiangsu, with workers recruited from inland provinces like Shanxi, Henan, Hubei, and others. The coastal provinces made early heavy investments in infrastructure that supported the export trade, including roads and container ports. All this helped make China the workshop of the world.

A typical campus might have 10,000 workers living in apartment towers, often referred to as dormitories, along with separate management quarters. Large campuses like Foxconn’s Longhua Science and Technology Park in Shenzhen at times had 270,000 workers on a one square mile campus. It was not unusual to see 50,000 plus at a single campus. Driving through Dongguan in the early 2000s, a city adjacent to Shenzhen, I saw that the 10–15,000 person campus was commonplace. You could see them mile after mile. Where one ended, the next began.

Factories had a very high density of workers. Six years ago I took a class to visit a mobile phone assembly facility in Dongguan. 15,000 workers stood shoulder to shoulder assembling 100,000 smartphones a day. On these campuses, workers generally take their meals in company run canteens, and the proximity of their living quarters meant shift changes are crowds of people walking across the campus. No giant parking lots and traffic, as you might find at U.S. factories.

High population density was also a feature of the dormitories. Not that long ago you might find 12 people per room, with four triple bunk beds and a shared bathroom. While many factory cities have gone to four people per room, companies generally 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

When Covid-19 first turned up in Wuhan, China at the end of 2019, every factory manager in China knew the implications of a highly contagious respiratory infection hitting their factory – they could instantly become the host of a super-spreader event. They had been through this before with SARS and H1N1 in 2009, so they quickly implemented masking and temperature checks at their entrances. If you were a factory manager living amidst a high population density, you would jump on these measures.

Now let’s add the impact of one of the great seasonal migrations of people in the world: the Lunar New Year in China. Most of the migrant workers living in dormitories only go home once a year during this special time. Factories shut down, officially for seven days but often for two weeks or longer, and millions of workers crowd on to trains and long-distance busses to make the trip home to see their families. Often this is to see the children being raised at home by grandparents, or the families they support with remittances of their factory earnings. For them it’s the most important holiday of the year.

Back in 2020 I was in China and South Asia for the first two weeks of the year, and the Covid problem had already risen to prominence. The Lunar New Year started on January 21 that year, and with quarantines and transport shutdowns beginning in February, it was clear that many workers would have trouble getting back to their factories and jobs. While the New York Stock Exchange was hitting new highs, I was trying to explain why I thought Covid was going to have a huge impact. Well it did. Initially it was because workers couldn’t get back to factories, so the factories had trouble restarting. That led to numerous parts shortages across supply chains.

Eventually the factories got going again, just as global demand cratered, and then demand shifted as work from home took root. But by this point, China was able to break the contagion and keep its economy going and its factories humming. If anything, China became the reliable exporter as other countries like Vietnam, Malaysia, and India suffered through waves of infections. Through all the geopolitical turmoil and trade wars of the Trump administration and then Covid, many Western companies kept their faith in China.

April 2022 was a turning point

The Shanghai lockdown in April of this year was a turning point. The breadth and the extreme measures taken by local authorities to maintain the Zero-Covid policy had a huge impact on companies in the tech sector. Between Shanghai, Kunshan, and west to Suzhou are a huge manufacturing base for IT equipment, critical components, and subassemblies. The heavy-handedness and unpredictability of government policies caused a loss of confidence in manufacturing in China. Add to that Apple’sAAPL
recent woes at supplier Foxconn’s factory complex in Zhengzhou. If you hadn’t been serious about diversifying your supply base away from China before, these events changed everything.

Looking ahead at the calendar

While the accuracy of reporting of China’s omicron infection rates is likely to decline, there is little doubt that this highly contagious variant will spread quickly among the country’s population as the authorities essentially abandon Zero-Covid. We should be looking at is the calendar.

The Lunar New year starts on January 22 in 2023. If omicron infection rates start spiking right before then, China will have a big problem on its hands. It seems to be in the process of lifting a lot of travel restrictions, but having over 100 million people traveling at the height of a pandemic is not going to be a pretty scene. Chinese workers have already gone several years where many New Year trips home have been forgone, so there must be enormous pent-up demand. We can expect a lot of trips to be made.

The big problem will be when those workers try to come back. Localized lockdowns might come back, impeding travel. Or if workers are sick, there won’t be enough space to quarantine them. China is going into uncharted territory. Zero-Covid worked until it didn’t. Now we are into the didn’t stage, and the potential for causing more supply chain pain is huge.