The world’s second-largest economy is embroiled in a trade war. That could change the calculus for firms doing business there.

Why Firms Are Souring on China

The United States and China remain locked in a scrum over trade, present truce notwithstanding. Beijing is grappling for leverage while struggling to keep its own side intact. One of its greatest risks: Some of the biggest exporters in China could simply decide they want no part of this game, take their ball and go, if not home, to some other low-cost manufacturing hub.

According to a Peterson Institute for International Economics study, the first two rounds of U.S. tariffs disproportionately affected U.S. imports from China-based affiliates of multinational firms, rather than Chinese-owned firms.

According to an October study conducted by the American Chamber of Commerce in South China – China’s most export-heavy region – around 85% of U.S. companies in the region said they were suffering from the new tariffs, compared to around 70% of their Chinese counterparts. In other words, the firms in China hurt most by the trade war are the ones most capable of leaving. More than 70% of U.S. firms with operations in China surveyed said they were mulling whether to delay or cancel new investments in China or considering leaving for greener, cheaper pastures altogether. (Just 1% of the firms said they were planning on moving operations back to the U.S.)

There have been growing hints that a nascent exodus is underway. Samsung, the world’s largest smartphone maker, which has been increasingly relying on factories in Vietnam and India, announced last week it would end production at its factory in Tianjin.

On December 5, Pegatron, a key supplier of components for Apple products, announced it’s moving some production to a new factory in Indonesia. Over the past year, Japan’s Panasonic, Suzuki and Nikon all announced closures in China in favour of Southeast Asian hotspots, including Thailand and Singapore, as well as Mexico. Even Foxconn – the paragon of efficient manufacturing at a staggering scale in China – is reportedly eyeing a move to Vietnam.

But there’s a big difference between “considering relocation” and packing up the moving vans, and that difference will define how bad things get for China. This Deep Dive examines China’s vulnerability as the trade war accelerates the rerouting of global supply chains. It looks at what advantages China’s neighbours can dangle in front of firms eager to avoid U.S. tariffs and rising labor and land costs in China, but also considers the reasons why many firms will opt to keep some of their operations in the Middle Kingdom.

Multinational firms were eyeing the exits in China long before the election of U.S. President Donald Trump, who rode to office threatening a trade war with Beijing. This happens when a country starts to get rich. As China has become wealthier, the increase in living standards has pushed labour and land costs ever higher and driven political demand for costly environmental regulations. And so Chinese exports have become less competitive, giving foreign firms cause to look to more affordable alternatives. The challenge for China intensified as its neighbours in South and Southeast Asia, in particular, began investing heavily in manufacturing and export infrastructure (particularly since they put the regionwide Cold War chaos largely behind them). In northern Vietnam, for example, wages are little more than half those in the manufacturing heartland of southeastern China. As a result, foreign investment has surged in Vietnam, rising nearly 8.5% in the first half of 2018 over the same period in 2017 – itself a record year. Across Southeast Asia, net foreign direct investment inflows jumped 18% year on year during the first half of 2018 to $73 bln, according to United Nations figures.

This ordinarily wouldn’t be all bad news for a country like China. Rising wages generally lead to a more upwardly mobile and less restive populace, and greater consumer power makes a country less vulnerable to a sharp downturn in exports. But the trade war threatens to magnify at least three problems particular to China.

First, the Communist Party of China deeply fears social unrest and thus cannot tolerate the kind of spike in unemployment that would accompany short-term periods of economic disruption. More than 200 million Chinese people work in manufacturing. It’s bad for China if firms hit by tariffs have to start downsizing. It’s a whole lot worse if firms begin abandoning the country altogether and new foreign investment simply dries up.

Second, there are effectively two Chinas. Though the coasts have become wealthy and are scrambling up the manufacturing value chain, like Japan and South Korea did before them, vast swaths of the country – home to hundreds of millions of people – have been left behind, meaning low-skill, labour-intensive manufacturing sectors like apparel are necessary to meet China’s employment needs. (China accounted for just over 30% of global apparel exports last year, but this is down from 40% eight years ago.) Most of these industries have thus far been spared from U.S. tariffs, but if Trump ever follows through on his repeated threats to effectively tax all imports from China, such operations would be the easiest to move to countries like Bangladesh, Vietnam and Cambodia.

Third, high-value exports like electronics, metals and auto parts – sectors critical to China’s efforts to escape the middle-income trap – are the main focus of the U.S. trade offensive. Exporters in China facing 10% tariffs have largely been able to weather the added costs due to a weaker yuan, tax and regulatory changes and the fact that U.S. consumers are absorbing some of the costs. But the tariffs will