U.S.-China relations have not been so tense since before President Jimmy Carter and Chinese leader Deng Xiaoping agreed to exchange ambassadors in 1979. Attitudes have hardened especially in the last two months, in part because of the Covid-19 pandemic, and in part because of the troubling developments in Hong Kong. Some voices in the Washington establishment are even advocating a “decoupling” of the deep, complex business connections between the two countries that have been built up over decades.

Because many U.S. companies give their China operations a large measure of autonomy, top management and boards often do not have a good grasp of the risks they face. Based on a review of 75 confidential board assessments conducted over the past 15 years, we can report that almost no board possesses a complete picture of its company’s operations in Greater China, including Hong Kong. Management may make presentations about international sales in general, but very few details about China surface at the board level.

When business was prospering in China, boards could afford to turn a blind eye to the details. But that’s a mistake now, given the impending storm clouds. Disruptions in their access to the Chinese market or in their supply chains and procurement channels would spell disaster for many companies, including household names such as General Motors, Apple, and Intel.

To understand their China risks, U.S. executives and boards need to start a discussion. As we see it, the agenda should include the following five questions:

Are we too dependent on Chinese supply chains?

There has been a great deal of talk about reducing U.S. dependence on China That’s why some companies have moved some of their production to Vietnam or Mexico. But these have been relatively small in scale and significant moves to “re-shore” manufacturing from China to the United States would be expensive and difficult, partly because of a shortage of skilled manufacturing workers in the United States. Any such move also would risk backlash from Chinese authorities.

What’s more, China has cornered the market in many critical components. As New York Gov. Andrew Cuomo found in seeking to respond to the Covid-19 pandemic, crucial reagents for testing kits come from only one place: China. Certain kinds of masks and protective gear come from only one place: China. Nearly every computer and smart phone in use in the United States comes from China or at least has some component in it that is manufactured in China.

Perhaps even more seriously, China dominates production of many of the critical raw materials that go into the products of the new economy – from smartphones to wind turbines. These include critical “rare earth minerals” like yttrium (used for charging electronic devices like smartphones), cerium and lanthanum (used for touch screens), and neodymium (used in electric car batteries).

Are we too dependent on sales to China?

If a company has a significant percentage of its sales in China, say 10–20%, it obviously is going to fight, on all levels, to maintain those sales. In many cases that will mean the company cannot maintain critical distance from the Chinese government.

But closeness to the Chinese government could create problems elsewhere, including the domestic U.S. market. “Do CEOs and boards really want to help the Chinese smother Hong Kong, erase Xinjiang and Tibet and sink all the non-Chinese fishermen in the South China Sea?” asks Clyde Prestowitz, author of the forthcoming book, The World Turned Upside Down: China, America and the Struggle for Global Leadership. “At some point, it seems to me, that kind of acquiescence is bound to look pretty bad.”

The risk is especially serious for companies like American semiconductor manufacturer Nvidia, which provides products used in facial recognition technology that could be used by the Chinese government to enable human rights violations.

China is signaling that it intends to introduce its own version of justice in the former British colony, which hosts the Asian regional headquarters for many American companies. Tens of thousands of Americans live there. Hong Kong is critically important for many U.S. companies because of their partnerships and relationships with Hong Kong Chinese players, who help them navigate their way in China itself. Some companies have located IP and other sensitive financial and legal functions in Hong Kong, in large part because Hong Kong law affords businesses stronger legal protection and property rights, which could be compromised.

If the legal system in Hong Kong deteriorates, as seems inevitable, a financial analyst working in Hong Kong for a Wall Street firm might come under pressure from mainland authorities for writing a negative research report about a Chinese state-owned enterprise. International companies could also be pressured to make management changes, of the sort already imposed on some Hong Kong corporations; last year the Chinese government forced the ousting of two senior executives of Cathay Pacific airlines for issues related to support of the pro-democracy movement by Cathay employees.

The possibility also looms that Hong Kong Chinese, Chinese, or even Chinese Americans working for U.S. companies in Hong Kong could be detained or arrested. “The people of Hong Kong should prepare to cope with the varieties of arbitrary detention that have been inflicted on compatriots elsewhere in China,” Jerome Cohen, director of the U.S.-Asia Law Institute at New York University, recently wrote.

Finally, if the Trump administration concludes, as the president has announced, that Hong Kong no longer has a high degree of autonomy from China, then the U.S. Congress may withdraw the island’s current special status as a privileged trading partner. This would mean, amongst many other things, that tech exports from the United States, which now flow freely to Hong Kong, would be subjected to the same export controls as on goods shipped to China and the Hong Kong dollar would no longer be pegged to the U.S. dollar. Depending on the details of what Congress and the Administration enact, U.S. travelers to Hong Kong might also require visas, which they currently do not.

How much should we collaborate with Chinese companies?

In the open international research environment that American scientists cherish, U.S.-based researchers often collaborate remotely with Chinese counterparts. That could prove problematic, because the findings and insights they share may go further than their research partners in view of the Chinese government’s civil-military “fusion.”

“Should American researchers be working with Chinese researchers on such technologies as facial recognition technology in low-light environments?” Samm Sacks, a senior fellow at Yale Law School’s Paul Tsai China Center and a cybersecurity policy fellow at New America, asked on a recent Zoom call sponsored by the U.S.-Asia Law Institute. “I think probably not … How do you know that your technology is not being used, even indirectly, to incarcerate hundreds of thousands of Uighurs?”

China also has a track record of research espionage: the Ministry of State Security is known to have targeted Chinese and Chinese-American employees at U.S. companies to obtain access to their technology or to penetrate their companies’ decision-making process. American law obviously prevents companies from discriminating against people on the basis of their ethnicity, but there are policies and procedures that can be put in place to better safeguard IP and key decisions. One practical but costly step would be asking all employees to disclose international travel, disclose other sources of income and reveal contacts with foreign governments.

How secure are our company’s IT systems?

It’s not just approaches to their people that companies have to watch for. In 2018, Bloomberg Businessweek published an article revealing that China’s People’s Liberation Army had covertly installed  microchips in components that had been sourced from China for use in IT products used by many companies internally, including Apple, which vehemently disputed the report.

China’s software hacking capabilities are also highly sophisticated, as evidenced by the work of the state-sponsored APT10 group in Tianjin (APT stands for Advanced Persistent Threat), which was able to penetrate American cloud computing systems and remain inside them for four years, as disclosed by the Department of Justice in December 2018.

APT10, which federal officials said was acting in concert with the Chinese government, was able to penetrate the systems of dozens of companies and government agencies in at least 12 countries, as documented in a book recently published by one of us (Holstein), The New Art of War: China’s Deep Strategy Inside the United States. Other recent disclosures suggest that government-affiliated groups in China have developed malware that can be attached to Microsoft Word documents and is virtually undetectable.

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Responding to these issues will require sustained, structured discussions between entire boards and top managements. No single board committee can carry the full load. The issues extend beyond the ability of an audit committee, whose job is to focus on the numbers, which is only one part of the overall challenge. Human resource committees also need to be part of the equation to respond to the espionage risk. Compensation committees need to find creative ways of retaining top managers if quarterly and annual earnings begin to suffer. The discussions will also need to be held under the tightest security. Zoom calls are not a good idea. The goal should be to identify and manage issues before they explode into the public domain.

America’s (and other developed nations’) relationship with the two most populous countries in the world, China and India, is undergoing a stark, rapid and perhaps permanent transformation.

In April, a Pew Center survey found that two-thirds of Americans say they have an “unfavorable” view of China; according to Pew it was “the most negative rating for the country since the Center began asking the question in 2005.” But if China is falling in attractiveness, what is filling its place?

The answer, it seems, is India, where on the same day the Pew survey was released, Facebook, Inc. announced that it invested $5.7 billion into India’s largest telecom company, Reliance Jio, instantly valuing Jio to being among the top five companies in India, were it an independent entity.

While the Facebook-Jio deal is largely digitally driven, we believe that 2020 could mark an inflection point in the bilateral trade of goods between the United States and India. The shift can be attributed — at least in part — to the stresses from Covid-19 and the tariffs imposed on Chinese goods by the Trump administration. Following our article on India as an attractive manufacturing destination, we look at India as a sourcing partner for goods, becoming a partial replacement for imports from China.

Exodus From China

Companies in the United States, Canada, Europe, and Australia have been hit with supply chain shocks as the flow of materials from China was disrupted by the pandemic. CEOs are confidentially asking their supply chain teams to develop additional sources that are completely independent of China. In addition, in the United States there is pressure from employees who are wary of traveling to China, from customers who are concerned (rationally or not) about the safety of foods and other items from the country, from investors who worry greatly about over-dependence on any one country, and increasingly from politicians as well as State Department leaders who want companies to rapidly decouple from China.

More than 20 years ago, electronics companies from Taiwan led the way into mainland China, but now in the wake of Covid-19 as Bloomberg reported in March 2020, “electronics makers are past the point of no return in their gradual migration from China.” Chinese billionaire Cao Dewang, of Fuyao Glass Industry echoed a similar thought in response to the pandemic, saying that “the global industrial chain will reduce its dependence on China.”

Why India?

In 2019, the United Stated imported a staggering $452 billion of goods from China. Only five low-cost countries have GDPs larger than that: India, Mexico, Indonesia, Brazil, and Thailand. India is the biggest economy among these candidates and has the largest untapped potential for filling part of the supply chain vacuum that is created by exodus from China.

In a recent virtual meeting with the American Chamber of Commerce in India, Thomas Vajda, deputy assistant secretary for South Asia was quite blunt. “India can quickly become a favorable jurisdiction for more of the industrial activities that are happening currently in China,” he told them according to The Economic Times.

Dr. Mukesh Aghi, CEO of the trade group, U.S.-India Strategic Partnership Forum, declares “While U.S. companies are looking for alternatives to China, India becomes a natural destination. You have an English speaking workforce, highly skilled, the cost of labor is cheap and more important it is a growing market of 1.3 billion people whose disposable income is growing.”

Already, “The United States is India’s top trading partner, ahead of China today,” adds Nisha Biswal, President of the U.S. India Business Council (USIBC), which is part of the U.S. Chamber of Commerce in Washington. Indeed, she says, a lot of top American companies have their biggest or second biggest bases in India.

Traditionally American executives have thought of India as a source of spices, textiles, apparel, jewelry and handicrafts.

While India does export billions of dollars of these products to the United States, India has moved much further up in the value chain. The cabin of Marine One, the presidential helicopter is fabricated for Lockheed Martin’s Sikorsky unit in India, according to Aghi and he goes on to add “The Ford EcoSport is manufactured in Chennai, India for the U.S market.” NASA’s Jet Propulsion Laboratory in Pasadena, California is collaborating with the Indian Space Research Organization on the most expensive imaging satellite ever to be launched, NISAR. This probe will be built and launched in India and will study hazards and global environmental change more accurately than ever before.

India exports shrimp, processed foods, and agricultural products to the United States. Aghi says that 3.2 million Apple iPhones built in India will be exported from the country. Biswal of USIBC asserts that India can supply medical devices, energy efficient green transportation, power semiconductors, switches, and rectifiers for American needs. India already provides almost 40 percent of the generic drugs sold in the United States, produced at factories inspected and approved by the U.S. Food and Drug Administration.

We call this phenomenon “India Inside,” where much of what is imported from India goes unnoticed by both American consumers and the media, but is nonetheless crucial to the fabric of the U.S economy. In particular we are confident that factories in India can scale up volume production to meet the domestic Indian, American, and global demand for devices, disposable and drugs to diagnose, treat and vaccinate against Covid-19.

Unlike export-driven China, India’s companies grew rapidly by serving pent-up domestic demand since the economy liberalized in 1991. In the process, Indian managers and entrepreneurs acquired the management skills and quality standards to expand globally, but they first turned to markets in the Middle East, ASEAN, Africa and Eastern Europe.

According to detailed current data from India’s Ministry of Commerce, Indian companies export billions of dollars each in categories as diverse as: furniture, medical and surgical instruments, electrical machinery, ships and boats, vehicles, boilers, parts made of plastic, steel and aluminum, organic and inorganic chemicals and more. We believe that many of these Indian suppliers are ready for first world markets. American companies can source these and other goods from their Indian corporate counterparts; unlike in China, these suppliers are not affiliated with the government.

China Plus One

How do you go about sourcing from India? We recommend an incremental approach in bringing on Indian suppliers; we call this “China Plus One.” Carefully select some low-risk or high-reward programs to try out in India, while maintaining your Chinese base. Work with multiple Indian partners as you get started. Very soon you can fine tune and amplify your successes.

What you learned in order to succeed in China may not serve you well in India, so it is important initially to approach India with humility and curiosity. Indians love America and American culture but react strongly to what they perceive as American arrogance. Despite Prime Minister Narendra Modi’s efforts to improve the ease of doing business, India still poses obstacles due to practices relating to both land and labor. Foreign companies wishing to build their own factories occasionally feel discouraged by these factors. But here are some ways that most American companies can overcome these challenges:

First, in order to leverage India as a source of supply, most American companies don’t need to invest in land and buildings, and they don’t need to hire employees in India. In our experience it is often best to start our as a buyer than as an investor. This gives more flexibility, reduces overhead, and limits initial risk.

Second, keep in mind that India is a diverse country with a federal structure. Many rules that affect industry vary from state to state. Some of India’s 28 states are more eager to help local and global entrepreneurs than others. The states of Andhra Pradesh, Gujarat, Karnataka, Maharashtra, Tamil Nadu, and Telangana are generally reputed to be friendlier toward local and global companies. But for specific industries and sectors, it is fine to do business in other states, as long as you do your due diligence. One of us (Bagla) has successfully taken clients to Uttar Pradesh for high-end floor coverings, such as rugs, and to Himachal Pradesh and Uttarakhand in the Himalayan foothills for personal care and consumer health products.

Third, when you do business in China, you know you need a language translator. While Indians do speak English, you still need a cultural interpreter and business guide helping you. While the U.S. Department of Commerce helps American companies to sell to India, they are not set up to guide companies who want to source from India. Someone inside your company who has current experience in doing business with today’s India is ideal (and not just any employee who just happens to be of Indian origin). Alternatively you can turn to external trusted advisors who specialize in U.S.-India business.

Finally, accept that India is a messy democracy and that the flow of goods can still be a challenge. Success in sourcing from India takes time and patience. Mukesh Aghi of USISPF is optimistic: “As new roads are built, harbors are expanded, and airports are enlarged, logistics will get more efficient.” In the meantime you may find that Indian companies are quite enterprising and can often encapsulate these complexities from their overseas customers.

Today, India permits 100% foreign direct investment in most sectors, so you don’t have to share your intellectual property or trade secrets with a local partner. Many American companies have had factories in India for decades and some have invested recently, such as Amway’s $100 million plant in Tamil Nadu.

As one of the top Asia-facing executives at a major American retailer put it to us, “Given amount of dependence on China, the only alternative country that can have the scale, the skills and the space to service American demand effectively is India.”

An article in the Harvard Business Review by Philipp Carlsson-Szlezak, Martin Reeves and Paul Swartz follows – the bulk that I think I understood makes interesting reading – maybe the rest does too!

As the coronavirus continues its march around the world, governments have turned to proven public health measures, such as social distancing, to physically disrupt the contagion. Yet, doing so has severed the flow of goods and people, stalled economies, and is in the process of delivering a global recession. Economic contagion is now spreading as fast as the disease itself.

This didn’t look plausible even a few weeks ago. As the virus began to spread, politicians, policy makers, and markets, informed by the pattern of historical outbreaks, looked on while the early (and thus more effective and less costly) window for social distancing closed. Now, much further along the disease trajectory, the economic costs are much higher, and predicting the path ahead has become nearly impossible, as multiple dimensions of the crisis are unprecedented and unknowable.

In this uncharted territory, naming a global recession adds little clarity beyond setting the expectation of negative growth. Pressing questions include the path of the shock and recovery, whether economies will be able to return to their pre-shock output levels and growth rates, and whether there will be any structural legacy from the coronavirus crisis.

Darker outlook, less visibility

The window for social distancing — the only known approach to effectively address the disease — is short. In Hubei province it was missed, but the rest of China made sure not to miss it. In Italy the window was missed, and then the rest of Europe missed it too. In the U.S., still constrained by insufficient testing, the early window was also missed. As the disease proliferates, social-distancing measures will have to be enacted more broadly and for longer to achieve the same effect, choking economic activity in the process.

Another wave of infections remains a real possibility, meaning that even countries that acted relatively quickly are still at risk every time they nudge their economies back to work. Indeed, we have seen some resurgence of the virus in Singapore and Hong Kong. In that sense, only history will tell if their early and aggressive responses paid off.

At present, the economic outlook for late actors looks bleak, having caught politicians, policy makers, and financial markets off guard. What happened in the last four weeks was not part of the risk calculation. Forecasts won’t help much here. For example, consensus estimates for initial unemployment claims in the U.S. were around 1.6 million this week, but the figure came in at 3.28 million — an historically unprecedented figure, about five times greater than the largest weekly increase in the global financial crisis. Notoriously unreliable at the best of times, forecasts look especially dubious now as there are simply too many unknowable aspects:

• The virus’ properties are not fully understood and could change.
• The role of asymptomatic patients is still imperfectly understood.
• The true rates of infection and immunity are therefore uncertain, especially where testing is limited.
• Policy responses will be uneven, often delayed, and there will be missteps.
• The reactions of firms and households are uncertain.

Perhaps the only certainty is that any attempt at a definitive forecast will fail. However, we think examining various scenarios still adds value in this environment of limited visibility.

Examining the shape of the shock

The concept of a recession is binary and blunt. All it says is that expectations have flipped from positive to negative growth, at least for two consecutive quarters.

We think the bigger scenario question revolves around the shape of the shock — what we call “shock geometry” — and its structural legacy. What drives the economic impact path of a shock, and where does Covid-19 fit in?

To illustrate, consider how the same shock —the 2008 global financial crisis — led to recessions with vastly different progressions and recoveries in three sample countries:

• • • V-shape. In 2008, Canada avoided a banking crisis: Credit continued to flow, and capital formation was not as significantly disrupted. Avoiding a deeper collapse helped keep labor in place and prevented skill atrophy. GDP dropped but substantially climbed back to its pre-growth path. This is typical of a classic “V-shape” shock, where output is displaced but growth eventually rebounds to its old path.
    • U-shape. The Unites States had a markedly different path. Growth dropped precipitously and never rebounded to its pre-crisis path. Note that the growth rate recovered (the slopes are the same), but the gap between the old and new path remains large, representing a one-off damage to the economy’s supply side, and indefinitely lost output. This was driven by a deep banking crisis that disrupted credit intermediation. As the recession dragged on, it did more damage to the labor supply and productivity. The U.S. in 2008 is a classic “U-shape” — a much more costly version than Canada’s V-shape.
    • L-shape. Greece is the third example and by far the worst shape — not only has the country never recovered its prior output path, but also its growth rate has declined. The distance between old and new path is widening, with lost output continuously growing. This means the crisis has left lasting structural damage to the economy’s supply side. Capital inputs, labor inputs, and productivity are repeatedly damaged. Greece can be seen as an example of L-shape, by far the most pernicious shape.

So, what drives “shock geometry” as shown above? The key determinant is the shock’s ability to damage an economy’s supply side, and more specifically, capital formation. When credit intermediation is disrupted and the capital stock doesn’t grow, recovery is slow, workers exit the workforce, skills are lost, productivity is down. The shock becomes structural.

V, U, L shocks can come in different intensities. A V-shaped path may be shallow or deep. A U-shape may come with a deep drop to a new growth path or a small one.

Where does the coronavirus shock fit in so far? The intensity of the shock will be determined by the underlying virus properties, policy responses, as well as consumer and corporate behavior in the face of adversity. But the shape of the shock is determined by the virus’ capacity to damage economies’ supply side, particularly capital formation. At this point, both a deep V-shape and a U are plausible. The battle ahead is to prevent a clear U trajectory.

Understand the damage mechanisms

Keeping the geometries above in mind, this leads to two questions about the Covid-19 shock:

• What is the mechanism for damage to the supply side?
• What is the policy response to prevent such damage?

Classically, financial crises cripple an economy’s supply side. There is a long history of such crisis, and policy makers have learned much about dealing with them. But coronavirus extends liquidity and capital problems to the real economy — and does so at unprecedented scale. As though the twin risk of financial and real liquidity shocks were not enough, they are also interrelated, raising the stakes.

Let’s look in more detail at the two paths for Covid-19 to deliver structural damage in a U-shaped scenario:

• Financial system risks. The unprecedented Covid-19 shock has already generated stress in capital markets, triggering a forceful response from central banks. If liquidity problems persist and real economy problems lead to write-downs, capital problems can arise. While from a policy perspective we may know the solutions, bailouts and recapitalization of banks are politically controversial. In the case of a financial crisis, capital formation would take a huge hit, driving a prolonged slump with damage to labor and productivity as well.
• Extended real economy “freeze.” The truly unprecedented possibility. Months of social distancing could disrupt capital formation and ultimately labor participation and productivity growth. Unlike financial crises, an extended freeze of this magnitude damaging the supply side would be new territory for policy makers.

The financial and real economy risks are interrelated in two ways: First, a prolonged Covid-19 crisis could drive up the number of real economy bankruptcies, which makes it even harder for the financial system to manage. Meanwhile, a financial crisis would starve the real economy of credit.

It is fair to say the risk profile of the Covid-19 crisis is particularly threatening. While there is a policy playbook for dealing with financial crises, no such thing exists for a large-scale real economy freeze. There is no off-the-shelf cure for liquidity problems of entire real economies.

It is important to recognise that none of the shock scenarios outlined above will be inevitable, linear, or uniform across geographies. Countries will have considerably different experiences for two reasons: the structural resilience of economies to absorb such shocks — call it destiny — and the capacity of medical researchers and policy makers to respond in new ways to an unprecedented challenge — call it innovation. Can they create novel interventions, at unprecedented speed, that will break the intractable and unattractive trade-off between lost lives and creating economic misery?

On the medical side: It’s clear that a vaccine would reduce the need for social distancing and thus relax the policy’s choke-hold on the global economy. But timelines are likely long, and so the focus may well have to be on incremental innovation within the confines of existing solutions.

Examples of such innovation may be found across the entire medical spectrum: on the therapeutic end, existing treatments may prove effective in fighting the disease. Several dozen existing treatments are currently being evaluated. On the other end of the spectrum, organisational innovation will be needed to free up capacity to meet the demand for resources, such as the optimal mobilisation of medical professionals, repurposing of spaces for treatment, and changes to triaging medical care to prioritize the Covid-19 crisis.

On the economic side: In the U.S., politicians have passed a $2 trillion stimulus package to soften the blow of the coronavirus crisis. But policy innovation also will have to occur. For example, central banks operate so-called “discount windows” that provide unlimited short-term finance to ensure liquidity problems don’t break the banking system. What is needed now, today, is a “real economy discount window” that can also deliver unlimited liquidity to sound households and firms.

The emerging policy landscape includes many worthwhile ideas. Among those are “bridge loans” that offer zero-interest loans to households and firms for the duration of the crisis and a generous repayment period; a moratorium on mortgage payments for residential and commercial borrowers; or using bank regulators to lean on banks to provide finance and to rework terms on existing loans. Such policy innovation could have meaningful impact in softening the virus’ impact on economies’ supply side. Yet it also needs agile and efficient execution.

We think there is a chance for innovation to prevent a full-blown U-shape, keeping the shock’s path closer to a deep V-shape than would otherwise be possible. But the battle is underway, and without innovation the odds are not in favor of the less damaging V-shaped scenario.