Impact winter

The full toll of the economic crisis is still unknown. What was once a problem of bad mortgages and poorly managed banks has spread far wider, devouring the global economy at a pace that has surpassed most predictions.

China has not been immune. The announcement that the country’s exports fell by 17.5% year-on-year in January, the sharpest decline in a decade, was a sobering reminder that not only are financial markets linked, but global supply chains are as well. The even more dramatic import contraction of 43.1% – which can be linked to a fall in industrial demand for raw materials – suggests the export shock will remain for the time being.

These difficulties come despite government efforts to support manufacturers through monetary and fiscal policies. Beijing wants to stabilize businesses and keep workers employed, but the apparent failure of its rescue measures only serves to emphasize China’s dependence on external demand.

Bad dreams come true

For foreign buyers, a major concern is that they can no longer rely on the underlying financial stability and integrity of many supply chains. Worst-case scenarios that were once merely the stuff of nightmares suddenly seem more real.

It could be as quick as a supplier, already teetering on the brink, losing a major contract and being forced to close, leaving a string of orders unfulfilled. It could be as simple as an operations manager, under pressure to cut costs in a deteriorating business climate, using cheaper grades of alloys, plastics or paints in a product destined for the shop shelves. No one wants to revisit the unhappy memories of summer 2007, of toymakers and product safety scandals.

Manufacturers are being affected in almost every industry. This can be seen in the closure of supply chains related to retail firms like Restoration Hardware and Design Center. In addition, global auto giants such as GM and Delphi – an auto maker and an auto parts manufacturer, respectively – are forcing suppliers to take extended vacations.

Toys, textiles, auto parts and furniture are the industries at greatest risk. Firms operating in these industries exhibit the classic dangerous characteristics: low margins, little product differentiation, high labor content and rising material costs.

Where industries are regionally clustered – entire towns living off the value chain for a single product, from assembly to packaging and promotion – the potential fallout becomes so much greater. Foshan in Guangdong province, for example, has become home to thousands of firms in the ceramic tile industry. But in becoming wedded to one business stream, in a sense the local economy has become about as shatter- proof as its core product.

Buyers who worked hard to create a stable and longstanding China supply chain structure are beginning to see their relationships change as suppliers buckle under the weight of the downturn.

Firms that are facing financial pressures have often taken drastic steps to avoid difficulties. Many have changed the pricing and delivery terms of contracts in order to shore up their cash positions. The appearance of solvency is crucial, given that a letter of credit may not be honored by a bank on the verge of bankruptcy.

This is not just an issue for small-scale buyers dealing with a handful of suppliers. Even the biggest beasts, the likes of Wal-Mart, which have ties to hundreds of factories and spend millions of dollars each year on supply chain management, are finding themselves dragged into the maelstrom.

As consumer demand in the West continues to decline, the severity of these disruptions will likely increase.

What is plan B?

To navigate the current landscape, and to minimize supply disruptions, buyers must take the time to understand fully how their supply chains are being affected in China. Flexibility has become a critical factor. Companies need to work with their suppliers to assess the risks, and identify back-up sources in order to avoid unpleasant surprises. Increased investment in their quality systems will also be necessary to ensure that product quality and reputations are protected.

A failure to take necessary steps now suggests a naïveté about the magnitude of the situation. A failure to deliver on commitments made to retailers due to a breakdown in the supply chain could have much more serious commercial consequences.