Through the lens of the pandemic, the economic outlook for Southeast Asia continues to brighten. To be sure, COVID continues to weigh on the economies of the region and is likely to do so for the foreseeable future. Fortunately, trade in goods has done well so far this year due to the strength of the region as a global manufacturing center.

COVID vs. the Trade War

But the biggest factor affecting trade and supply chains in Southeast Asia is not COVID. It’s the U.S.-China trade war, which is having a far greater impact on supply chains and, therefore, the regional economy than the pandemic. The reason is because of the power of discriminatory tariffs. Even a small tariff on Chinese goods has a large impact on the regional economy.

The U.S. tariffs on Chinese goods are powerful because they create significant incentives to relocate supply chains. The current tariffs are applied on 100% of the value of the landed product, although only a small part of the product’s cost is the value-added share coming from China. If, for example, a product has 0.1 or 10% value added in it from China, the 25% tariff actually becomes a 250% (25/0.1) tariff on the China-added portion. Based on 2018 data, the actual value added in China for so-called China exports to the U.S. was 30.9%. So less than one-third of the value of Chinese exports was actually made in China.

That one-third figure for value added is representative of most countries heavily engaged in supply chains because there is much division of labor across borders. That means that a 25% tariff is more than tripled to become an 81% tax on producing in China. Which means that any country competing with China for supply chain activities is in a favorable position if it can perform those functions for less than 81% of the higher cost. A 25% U.S. tariff, in other words, gives competitors an 81% advantage or buffer to attract supply chains out of China into their country. This is why we have seen so much relocation to Vietnam, Thailand, and Malaysia.

Beyond Tariffs

But tariffs by themselves are not the whole story. Much depends on how long you believe the trade war will last. If you believe it is a symptom rather than a cause of a long-term underlying competition for hegemony, then it is not likely to go away anytime soon.

There are many reasons to believe that U.S.-China competition is not going away. We have already seen that the Biden administration has not changed anything significant regarding the trade war. The phase-two deal is still very much on the back burner. If anything, we may see tensions escalate.

Adjusting Supply Chains

Adjusting supply chains to this reality may be difficult due to the varying shares of fixed versus sunk costs across different industries. In industries including machinery, electrical equipment, and transport equipment, for example, value added is very high, but fixed costs are also quite high, which means they are difficult to move because costs are sunk and cannot be retrieved. But in clothing, textiles, footwear, and similar industries, where sunk costs are low and the value-added shares are important, movement is often quick and easy. And we have seen that happening, with lots of movement in these industries into Vietnam and Bangladesh from China.

Transferring an entire production ecosystem — not just manufacturing capability but relationships with governments and labor unions, for example — is not easy, but it can be done, especially when the economics heavily weigh in favor. If the trade war continues, economics may precipitate greater movement. If there is a revival of multilateralism, with greater support for global institutions and their processes, which the Trump administration was not very keen on, we may see less movement. But so far, that doesn’t seem likely. The signs so far is that the Biden administration will reengage the region through security or other avenues rather than through trade deals. Domestic politics and rising anti-globalization sentiment is preventing it from resuming a leadership role in setting trade rules.

If we proceed along the path to a bifurcated world with two supply chains, one with and one without China, we probably are locking ourselves into an era of higher costs and greater tensions. In fact, a trade war doesn’t really help anyone, and while it punishes the direct participants most, the world as a whole loses.

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About Jayant Menon

Jayant Menon is Senior Visiting Fellow at the Institute of Southeast Asian Studies (ISEAS-Yusof Ishak Institute) in Singapore. Earlier, he served as Lead Economist at Asian Development Bank, where he worked for 21 years. He also has held positions at American University and Monash University. Jayant holds a PhD in international economics and a master’s degree in commerce from the University of Melbourne, and a bachelor’s degree in economics with honours (first class) from La Trobe University.

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This article on the Southeast Asian economy is adapted from the GLG Roundtable “SEA Macroeconomy: Between Covid-19 and Trade War Part II.” If you would like access to events like this or would like to speak with expert economists like Jayant Menon or any of our approximately 1 million industry experts, please contact us.