De-Globalization Is Not a Right Way to Resolve Supply Chain Risk

David Simchi-Levi

（Professor at MIT, Director of MIT Data Science Lab, INFORMS Fellow, the Editor-in-Chief for Management Science and former Editor-in-Chief for Operations Research.）

Lijian Lu

 (Professor at HKUST Business School, winner of INFORMS George Nicholson paper competition, was Vice-President at Goldman Sachs Quantitative Investment Division and co-founder at the UniQuant Capital.)

Assessing impacts of COVID-19 on Supply Chains Scientifically

Lijian：Hi Professor Levi, I am very happy to have this conversation with you via the platform of“Guangming International Forum”. Since the outbreak of COVID-19, it quickly spread over to the whole world, till now, more than 30 million are infected and more than 0.9 million are dead. According to IMF and World Bank’s report on the forecast of the world economics, the outbreak of COVID-19 has severe impacts on world’s economics, even worse than 2008 financial crisis, and the world economics is forecasted to decrease by 3%, its impacts are even bigger on developed countries, which is projected to be more than -6.1% in this year. Based on a report by an international evaluation organization, there are more than 400 mid to large cap corporations filed bankruptcy, more than 30 among them has liability of more than 1 billion US dollars. The pandemic has a bigger impacts on US med to small enterprises, there are more than 80 thousands firms announced closure forever, a new high over last 10 years. As a premier scholar in supply chain and business analytics, could you please share your professional opinions on the impacts of COVID-19 on world as well as US economics?

Levi: COVID-19 pandemic has a profound impacts on global supply chains, especially to the upstream mid to small suppliers, as many of these suppliers are forced out of business due to insufficient capital reserved, causing severe shortage of components across many industries. On February 23, 2020 Pierre Haren, a high-tech executive, and I submitted a paper to Harvard Business Review entitled “How Coronavirus Could Impact the Global Supply Chain by Mid-March.”

The paper appeared online on February 28, where we predicted that “the impact of Covid-19 on global supply chains will occur in mid-March, forcing thousands of companies to throttle down or temporarily shut assembly and manufacturing plants in the U.S. and Europe.” This prediction was highly accurate! Indeed, during the week of March 16 newspapers all over the world reported supply chain shut down in the US and EU. According to recent data, up to July 31st, there are more than 8 million med to small enterprises filed bankruptcy protection, an increase of more than 35% from same period last year, and more than 50% of small companies are concerned that they will be closed forever. If we classify these bankrupt companies by their industries, restaurant has the highest percentage with more than 15%, the second largest one is retailing with 10%. According to a report of the US small enterprise management association, mid to small enterprises account for 44% of the whole US economics, with almost half of employment, therefore, bankruptcy of millions of mid to small companies will definitely have a severe damage on US economics.

Lijian：This is indeed the case, the pandemic spreads quickly, and its impacts on world economics is more than expected. Your prediction accurately forecasts what will happen in the future. What is your prediction method? Did you use mathematical models and big data analytics in the prediction?

Levi：The prediction in the HBR article was based on a model, referred to as the Risk Exposure Method, that I developed in 2014 together with two PhD students. This model, developed after events like the 2011 Tsunami in Japan and flood in Thailand was initially implemented in the automotive industry by the Ford Motor Company. Other companies followed suit and the UN Office of Disaster Risk Reduction applied the Risk Exposure method in developing countries.

A central feature is Time-to-Recover (TTR), the time it would take for a particular node — a supplier facility, a distribution center, or a transportation hub — to be restored to full functionality after a disruption. Another feature is Time-to-Survive (TTS), the maximum duration that the supply chain can match supply with demand after a facility disruption. By quantifying each measure under different scenarios, a business can model its ability to recover from a disaster. For example, if for a specific facility, TTR is greater than TTS, the supply chain will not be able to match supply with demand unless, a backup plan exists.

The upshot of this approach is the ability to financially quantify the cost of disruptions and prepare mitigation plans for the most critical parts of the supply chain. It is also helpful in planning recovery plans after a supply chain disruption has occurred. This approach applies stress-tests to the supply chain akin to a bank stress test which was instituted after the 2008 financial crisis. It is an exercise that helps bank managers and regulators understand a bank’s financial strength.

Lijian：It is very innovative in your methodology and perspective. First, you think about the enhancement of supply chain structure from perspectives of supply chain risk, and propose a way to quantitatively measure risk exposures in each tier of supply chains. The concept of risk exposure is well-known in the area of finance, the risk exposure measures the potential loss without any hedge against particular type of risks. For example, risk exposure to liquidity means potential loss due to liquidity risk that is unhedged, risk exposure to size means potential loss due to unhedged market cap, obviously, there are multi-dimensional risk exposure indexes. The risk exposure indexes you proposed may have an innovative perspective on supply chain robustness.

Levi: You are correct.

Manufacturing Return and Localization May Not Improve Supply Chain

Lijian：The supply chain and globalization are highly correlated in 21 centuries. After the outbreak of COVID-19, some medias propagate “inverse globalization” topics, advocating ceasing globalization and want manufacturing return back to its origin country and localization. Some politicians in some countries even use globalization as political game and bets. Do you think economic globalization will stop?

Levi：It is natural to expect that federal governments will require the same from supply chains of companies in critical industries, for example, healthcare, life science, and food. That is, I believe that in these industries, governments should mandate stress-tests that organizations, such as hospitals, distributers and manufacturers should perform in order to prove that they will be able to respond to a disruption. Time-to-Recover and Time-to-Survive are possible measures that can be applied.

Applying supply chain stress-tests ensures that companies will focus on a new paradigm that balances supply chain resiliency and efficiency. Indeed, much of the global supply chain disruption that we have seen in the last few months, is due to the lean global supply chains that have been deployed widely in order to reduce costs through efficient allocation of production to low-cost regions, in Asia and in particular China. Therefore, industry critics and pundits have been emphasizing restructuring supply chains so they are more resilient by bringing back local manufacturing.

However, reshoring alone does not necessarily create resiliency! To illustrate this point, consider the recent meat shortage in the US. In this industry, the supply chain is entirely domestic but in order to reduce cost, many companies focused on significant consolidation of manufacturing activities where a relatively small number of slaughter plants process much of the beef and pork in the United States. Shutting down one plant, even for a few weeks backs up hog and beef production across the entire country, crushes prices paid to farmers and leads to months of meat shortages. This implies that just moving manufacturing to a single region, be it Asia or North America, does not increase resiliency.

Lijian：Whether localization or globalization requires consideration of a country and industry’s real situations. If a supply chain needs to be localized, it should be localized, and it should be globalized if it should be. De-globalization is not a right way to resolve supply chain risks. The supply chain research and practice ex-pandemic have focused on the operational efficiency perspective to setup supply chain configuration and operational efficiency improvements. For example, to save production cost, many production factories are offshored globally, with majority of productions outsourced to regions with low labor cost and raw materials prices, such as south east Asia, Mexico, and South America. And only a small portion of production are localized, to balance production cost and quick response to demand. There are many researches with massive mathematical modeling and bi data analysis, including myself on the value of globalization on supply chains, results show that properly degree of globalization could add significant value, it may exceed 30% in some business circumstances.

Undoubtedly, there are many problems accompany with globalization, such as risks associated with geo politics, overly globalization will cause dependence on other country or region’s production, and may cause incapability to response to surging demand. For example, the demand for medications such as masks during the pandemic has surged more than 10 times in a very short time period, while the key component of those medications largely depend on developing countries, however, these demand can not be fulfilled in a timely manner due to problems such as the long delivery time as well as surging local demand. I highly agree with your points that de-globalization is not the key to resolve supply chain development post pandemic, the key is to enforce supply chain stress test system and find a good balance between operational efficiency and supply chain risks.

Levi：You are right.

Improving Supply Chain Resilience should be Case by Case

Lijian：There is scientific evidence that it will be normal that the virus will always be with human. Facing such situation, from both macro and micro perspectives, how should a supply chain designed?

Levi：The way to achieve supply chain resiliency is through mapping the layers of suppliers, manufacturing plants, distributors, etc. and stress testing to evaluate the ability to recover from disruption. Once there is an understanding of where bottlenecks are located, various mitigation strategies can be considered including adding local manufacturing capabilities or suppliers. Given the size of the Chinese market, most global companies will need to keep a presence there to serve that market and may even need to diversify inside China in order to create a more resilient supply chain.

The implications are clear! The need to find the right balance between resiliency and efficiency will force companies to restructure their supply chains to increase resiliency. This already started due to the US-China trade war and will accelerate in the near future as a result of COVID-19. But, reshoring is not necessarily the solution. The specifics will vary from industry to industry. For example, in the apparel industry, the move is likely to be to South East Asia and India. The High-tech industry is likely to move closer to market demand. That is, in this industry, manufacturing is likely to diversify to regions such as Brazil and Mexico to serve North America market and Eastern Europe for the European market, while China manufacturing is likely to focus on China.

The challenge is in pharmaceutical industry. Today, most chemicals used to make drugs sold in Europe and North America now originate from China and India but chemical production is environmentally damaging. So, increasing resiliency of drug supply chains by investing in local manufacturing activities in North America and Europe requires the development of clean technology and this may take 5 to 10 years and will require a significant financial investment.

To summarize, increasing resiliency through stress-testing and supply chain restructuring is accelerating. But in certain industries, for example the pharmaceutical industry, this is not necessarily a cheap or simple matter.

Lijian：You have talked about how to configure a supply chain globally, and advocate improving supply chain resilience considering specific situation within each industry. I think such global configuration complies with the basic rule of economic development in each country, and will be logic way to reduce cost and improve supply chain competitiveness. The recovery of world economics after pandemic requires governments to forfeit different political philosophies, to corporate, to stay together, and work together for the fully recovery and sustainable development of world economics. World economics and politics are complicated and with uncertainty, on one point, governments should stimulate and enlarge internal consumption via macro policies, and encourage and support mid to small enterprises; on the other side, governments should encourage international communication and collaboration, with the objectives of achieving synergy of resources, mutual beneficial, development and win-win healthy society.

As for the importance of technologies in supply chain transformation in each country, the recent development in high tech such as blockchain, big data, AI are widely adopted in all fields. I know that you have also co-founded business that focuses on application of smart supply chain and big data operations analytics, you have applied latest research in big data and AI to the real business cases of supply chain enhancement. Looking back the history of human development, along with each technology innovation and advancement, the society and economics are hugely advanced to next level. For example, the great England is greatly developed from the steaming technology in the first industrial revolution gaining the monopoly power worldwide; The electricity technology in the second industrial innovation has flourish and civilized Europe; The computer science and internet in the third industrial revolution has greatly benefit the US that becomes the new worldwide giant. The development of a sustainable economics highly relies on the technology advancement and application. Along with recent advancement in storage technology and data processing capability, majority of firms are benefited from the automation and smart of whole operations process due to the application of big data AI and blockchain. Taking Amazon as an example, it started using massive mathematical models and big data technologies to manage its global supply chain, and within 20 years, it becomes the most premier ecommerce platform today.

In the post epic of pandemic, technologies such as big data and AI will play even more important roles in the supply chain. On one hand, technology tends to be more mature and smart, it has developed adaptive evolution to various different environments. On the other hand, big accumulation becomes more and more easy, covering more and more aspects, the data has no boundary, thus, fruitful data will in turn advance artificial evolution of technologies. This has provided great convenience for enterprise development and supply chain communication, providing powerful technology backups for the globalization.

I also would like to discuss how to improve supply chain resilience and competitiveness, which is very important for the industrial development post pandemic.

Levi：First, we should think about supply chain rebuilt from perspectives of supply chain risk, to improve supply chains capability to resolve risk. For example, the risk exposure model has provided us a good risk perspective to assess the supply chain resilience. The government and regulation should make standards of stress testing, and enforcing periodic assessment of supply chain evaluation of their risks to make sure these standards are complied. Second, supply chains should balance well between resilience and operational efficiency, production and manufacturing return to local region does not necessary improve supply chain resilience. Supply chain designs should be case by case depending on the specific attributions within each industry. For some special industries such as pharmaceutical industry, it may not be economic and effective to satisfy local customers via local production. To summarize, increasing resiliency through stress-testing and supply chain restructuring is accelerating. But in certain industries, for example the pharmaceutical industry, this is not necessarily a cheap or simple matter.

Lijian：There is a concept called mechanism design in the supply chain management. This concept works similar to the options hedging in the capital market. It selects a diversified portfolio of global suppliers across different regions, signing contracts that specifies the rights and responsibilities, this is similar to option contract, so that the supply chain capacity are effectively diversified and risk hedged with safety guarantees of production capacity. In the supply chain disaster management practice, safety stock is another commonly used tool to secure capacity. The safety stocks refers to advance production and storing inventory to satisfy unpredictable situations such as natural disasters, the safety stocks has played important roles in 2011 Tsunami in Japan and flood in Thailand.

As for the supply chain competitiveness, I believe supply chain should encourage more innovation and industrial enhancement, further advancing the supply chain digital, information, smartness process, achieving supply chain integration and coordination via blockchain and big data AI technologies, improve supply chain operational efficiency and smartness. Also, more efforts should be made to develop the key and critical bottleneck technology, so that the bottleneck technology and key components are self-controllable. Finally, more regulation on supply chain risk, implementing stress testing in critical industries, improve supply chain resilience and stability. From perspective of supply chains, I also would like to forecast the recovery of world economics post pandemic. First, the pandemic has been well controlled in China, the upstream, midstream, and downstream production activities within each supply chain has been gradually reopened and recovered. According to statistics, the GDP in the second quarter increases 3.2%, while the GDP in the first half year decreases 1.6%, and the national economics is predicted to be fully recovered by the fourth quarter of this year to the level before pandemic. Second, pandemic has not been well controlled in other developed countries such as US, the GDP in the second quarter has decreased as high as 9.6% and decreases by 4.6% over the first half of year. Millions of upstream mid to small sized enterprises are bankrupted and there is no evidence of re-open and recovery in short period, this together with challenges of manufacturing returning advocated by politicians, its economics is predicted to recovered after two years when pandemic is controlled. To sum up, the supply chain development post pandemic should leverage and learn from various aspects including supply chain risk exposure, contract mechanism design, safety stock, technology advancement and application of operational efficiency, to improve supply chain stability and key competitiveness, with a mutual benefit and developing structure, guarantee sustainable development of economics. Thanks again for Professor Levi’s excellent opinions.