A Diversification Framework for China

Western policymakers and business leaders are rethinking over-reliance on China as a global manufacturing and sourcing hub. The first question is whether diversification from China is even possible, given the economies of scale and scope China’s huge size has permitted. We find that, properly defined, diversification is already taking place to a limited but important degree. Shocks from the US-China “trade war,” COVID, Russia’s war on Ukraine, and other events have made the risks of hyper-globalized value chains clear, altering the valuation of those risks in business and policy planning. And tensions with China continue to rise as a function of technological change, even as political authorities seek stabilization. Yet China’s market size, four-decade manufacturing investment boom, and geopolitical clout also present major hurdles to diversification. Even when other economies enjoy the same attributes that made China attractive and have better security alignment with the United States, diversification can be difficult.

In this report, we assess the potential for diversification of manufacturing and sourcing from China to other economies, whether that potential is being realized, and the reasons why or why not. We come to several working conclusions on these questions:

• In the aggregate, diversification from China is underway, as evidenced by China’s decreasing share of US imports and foreign direct investment (FDI) over the past seven years.
• Diversification has so far centered on just a few countries (Mexico and Vietnam in particular), presenting a risk of capacity constraints and rising costs, hence slowing diversification.
• Diversification is concentrated in a few sectors, too (textiles, electronics, and autos), and in the assembly segment rather than upstream supply chains. In short, firms on the move are still relying on their China-based manufacturing or sourcing for inputs, and broader migration will only happen in stages over a longer period.
• US trade diversification and investment diversification often don’t match: the change in the composition of US imports is often not driven by US FDI but by non-US firms, not least of which—ironically—are Chinese and Taiwanese.
• Beyond Mexico and Vietnam, like-minded nations can be diversification winners despite higher-cost structures: Canada, Taiwan, Germany, and South Korea are picking up trade and FDI shares. Yet many other security-aligned nations are not: Japan, Australia, and the Philippines are notably absent from the list of hotspots.
• The gap between diversification potential and outcomes has many causes, but two factors stand out: availability of workforces with basic-to-advanced skills and the role of high-quality, cross-border economic agreements. These assets are essential both to China’s success over the past two decades and to understanding where activity is shifting today. For instance, the US-Mexico-Canada Agreement (USMCA) is key to why Mexico is picking up so much diversification, while China’s agreements within members of the Association of Southeast Asian Nations (ASEAN) are central to the rise of its neighbors, particularly Vietnam, as US trading partners.
• In the potential/realized diversification gaps we identify, there are opportunities to drive diversification to core US partners, broaden the scope of supply chain movement (beyond assembly), and align trade and FDI patterns. These opportunities require active commercial diplomacy and engagement.
• Reducing over-reliance on China is not impossible, as it was considered until recently. However, the economic costs and risks are real and not all worth incurring. Analysis helps to clarify where it can be viable, even at this early stage, and where policy and government action can help to clear the path.