The rhetoric hurled across the Pacific by the US and China has reached fever pitch. In the weeks after the US military shot down an alleged spy balloon in February, Democrats and Republicans in Washington reached a rare consensus: China is a threat that must be contained. China, meanwhile, has warned that the US risks “conflict and confrontation” if it doesn’t change tack, and has repeatedly flexed its military muscles in the waters around Taiwan.

Yet while political animosity has grown, the US and China appear more closely intertwined than ever: Trade in goods between the two reached an unprecedented $690.6 billion in 2022. “The record figures are ostensibly an indication that geopolitical tensions have not harmed business relationships between the two countries,” says Andrew Cainey, founding director of the UK National Committee on China (UKNCC) and co-author of Xiconomics: What China’s Dual Circulation Strategy Means for Global Business.

Even so, Cainey believes the record trade figures are misleading. While US agricultural commodities exports have grown, manufacturing exports are stagnant in aggregate, and technology-intensive exports have fallen. “The outlook for trade and investment flows between the US and China is poor,” he says. It is hard to imagine these two giants could completely disentangle their economies. How far—and how fast—will they separate? And how can global companies successfully navigate the shifting dynamics?

Upping The Ante

Much of the tension between the US and China arose from the speed and scale of China’s growth and the increasing diplomatic might that came with economic power. At first, US businesses welcomed the opening of China’s economy and its promises of cheap labor and new markets. But while China became the world’s largest manufacturing exporter, imports grew more slowly, creating a large trade deficit with the US.

Deborah Elms, executive director of the Asian Trade Centre, argues it was in part China’s objective of greater self-reliance—signaled in the Made in China 2025 strategy—that triggered US tariffs. Announced in 2015, Made in China sought to accelerate the development of technologies such as semiconductors, electric vehicles and biotech to increase the country’s self-reliance. But as China moved up the value chain, many US political and business figures also came to view it more as a competitor than ally, and grew wary of China’s growing assertiveness in global affairs.

In 2018, such concerns led the Trump administration to impose a series of tariffs, specifically protesting China’s alleged lax intellectual property protection and failure to tackle the trade deficit. The unstated, but no less real, goal was to spur US firms to redirect their supply chains away from China, says Elms. China retaliated with tariffs—but also with restraint—targeting goods worth roughly a third of the value of those hit by the US measures.

At first, the US measures had little impact on supply chains, because most firms assumed the tariffs would end under a new administration, says Elms. But the Biden administration retained almost all the Trump tariffs—and added new measures. “With the CHIPS Act, there was a greater emphasis on national security over economic issues,” she says. “The government wants US companies not to rely on China—and to stop China accessing US semiconductors.” The Inflation Reduction Act echoes this strategy: US companies must create domestic green technology supply chains—by implication cutting out China, the world’s leading source of green tech—to access its nearly $400 billion in subsidies.

This mindset is also informing the international engagement of the US, according to Earl Carr, CEO of New York–based CJPA Global Advisors, a global strategy firm which, among other advisory services, helps raise funds for large-scale emerging markets infrastructure projects. “A key requirement from US development-financing institutions is that solar panels must be US-produced, and producers cannot be involved in China’s Belt and Road Initiative,” he says. “That would never have been the case five years ago.”

Meanwhile, such measures prompted Beijing to double down on efforts to reduce China’s dependence, says Elms. The result was the “dual circulation” policy, announced by Xi Jinping in 2020, which marks out a clear distinction between the internal economy (“internal circulation”) and the rest of the world (“external circulation”). “Following an era of ‘opening up’ and integration into the world economy, China now sees greater opportunity at home,” Cainey explains.

Such a shift is both natural and inevitable, given China’s growth—more-mature large economies (like the US) tend to focus more internally. The domestic economy is also where the Chinese Communist Party (CCP) has the most control.

But dual circulation’s focus on national security and self-reliance inevitably plays into the narrative of a more adversarial relationship with the US. Moreover, dual circulation has a second objective. “Xi would like to increase the rest of the world’s dependence on China, both—he says—as a deterrent to economic aggression from the US and—others fear—to increase China’s coercive economic diplomatic power,” explains Cainey. Either way, it signals a clear shift in the way Chinese leaders view their country’s role in global trade.

What Can Companies Do?

For corporates, interpreting a rapidly evolving set of rules—and the words and actions of political leaders—into reworked supply chains and trading relationships is tricky. Corporates in strategic sectors, such as artificial intelligence, quantum computing, biotechnology, advanced semiconductors and anything that could have a dual military/civilian use, are already decoupling, according to Carr at CJPA. “There has been a significant decline in both inbound and outbound investment between the US and China [in these sectors],” he says. “While it’s still continuing in solar and environmental technologies, it is declining.”

US companies in nonstrategic sectors, as part of a broader risk reassessment, appear to be preparing for a future where China plays a less important role, according to Cainey: “They are shifting where they manufacture and source components and intermediate products, based on changing tariffs and trade frictions—and to build in resilience against geopolitical risk.” Part of this is customer driven: Michael Dell, CEO of the eponymous computer group, recently said buyers are pushing Dell Technologies to source components from outside China.

US firms’ major suppliers are also seeking to diversify their supply chains, in consideration of risk management and their buyers’ concerns. For instance, Taiwan’s Foxconn, a major supply partner for Apple, is building out its supply chain in Vietnam, India and elsewhere. “Manufacturers can no longer afford to be motivated solely by short-term costs and just-in-time efficiencies,” says Cainey. “In effect, they are taking out insurance against the increased risks—and insurance costs money.”

Nevertheless, the expense and difficulty of reworking supply chains will limit the scale of change in the near term. “Firms are not going to diversify out of China unless they absolutely have to, because the alternatives are not great,” says the Asian Trade Centre’s Elms. “They might move 5% of their production, but ultimately things are going to be made where they can be done at the right price, to the right quality and according to the right timescale. And at the moment, that’s still China.”

Chinese companies are also on the move, shifting production of solar panels to Vietnam and Malaysia so as to be less vulnerable to trade restrictions, for instance. Indeed, many began to move manufacturing outside China even before the trade conflict with the US, concerned by increasing labor costs and the need to diversify risk. But just as US firms find it tough to match China’s scale advantages when seeking alternative locations, China can offshore only part of its production. “There is a limit to how many suitably skilled managers there are in Vietnam, or the capacity of ports, for instance,” Elms says.

While risk management is the name of the game when it comes to supply chains, the allure of China to US firms remains strong. Tesla, Starbucks and Goldman Sachs all have ambitious expansion plans in the country, for example.

In many sectors, the Chinese government has committed to continue to open up the economy and ensure international firms compete on the same basis as Chinese firms. But equal treatment with Chinese companies may not always be what foreign companies really want. “Under dual circulation, foreign companies need to build up the whole value chain in China, including R&D and manufacturing, and ensure Chinese data is kept in China,” says Cainey at the UKNCC. “It can mean accepting Communist Party organizations within the firm and being responsive to ‘guidance’ from local government and party officials.”

Ram Charan, business consultant to some of the world’s largest corporations, puts it more forcefully. “Every CEO needs to look at the facts, which are observable and verifiable, and be honest about what it means to do business in China,” he says. “You must follow China’s rules and demands, which are in the interests of the CCP and China and require, for example, companies to give up their technology. Every CEO knows this is the case—and if they don’t, all they have to do is call their people in the country and ask.”

Chris Pereira, CEO of the North American Ecosystem Institute, which advises Chinese companies on international expansion, says the US remains a prime market for Chinese companies, despite what he describes as “unfair scrutiny and criticism of Chinese companies by American media and politicians.” He adds, “There is no significant evidence of consumer backlash against Chinese companies.” Indeed, despite the views of US politicians, he says, Chinese firms TikTok and fast-fashion giant Shein remain preferred brands among Generation Z consumers.

But to succeed, Chinese companies need to focus on local compliance, talent and investment—and “de-China” themselves, says Pereira. “There isn’t anything sinister about this—it’s just good business practice,” he says. “The sometimes-awkward attempts at localization by Chinese companies in the US should be encouraged: Companies making these efforts are trying to build bridges across cultures and see the value in diversity.”

Ultimately, Chinese companies operating in the US need to prepare for stormier political weather, however. “The US administration has implemented policies that restrict some exports to China,” notes Charan. “Affected companies need to think about why these rules are being put in place, whether additional restrictions will be implemented and whether a different administration might enact different policies. They need to reevaluate whether their activity in the US continues to create shareholder value. There are no generalities: Every company must look at this for itself and confront the reality.”

A Tightrope Walk

Clearly, the positions adopted by both the US and China will result in less trade and investment between the two countries—that’s part of the objective. Yet, as US Treasury Secretary Janet Yellen recently noted, “A full separation of [the world’s two most important economies] would be disastrous for both countries,” adding that, “It would be destabilizing for the rest of the world.” Keeping the two economies sufficiently connected to avoid harm while satisfying bellicose politicians in both countries is going to be a tightrope walk.

A breakdown in trade relations would not only impact the US and China but also damage the rest of the global economy. The International Monetary Fund estimates that the fragmentation of the world economy into US- and China-centered blocs could reduce global output by as much as 2%, while the president of the European Central Bank, Christine Lagarde, told the Council on Foreign Relations in April that it could hike inflation by “around 5% in the short run and roughly 1% in the long run.”

If Yellen’s worst fears are realized and the global economy divides into polarized camps, the size of the US domestic economy would protect it from the worst of the turmoil. But it’s unclear that the US would emerge as the victor. “With an increasingly closed-off market and heavy restrictions on trade, the US is at risk of isolating itself,” says Pereira. France’s President Emmanuel Macron recently traveled to China with a delegation of 50 business leaders that included the CEOs of Airbus, Alstom and EDF, touting trade. Other erstwhile US allies such as Germany and Saudi Arabia remain keen to forge deeper trade and investment links with China.

At the same time, the US enacted a new forced-labor rule banning the import of cotton from China’s Xinjiang region, where it is alleged that Uyghur people are being subjected to forced labor. This could push Asian companies—many of which currently trade heavily with both China and the US—more firmly into China’s orbit. “As the rules require companies to prove that they are innocent, they are extremely hard to comply with,” says Elms. “If that approach is adopted more widely, and exporters to the US are required to prove that no components come from a blacklisted company, it could force many to reconsider their business model.”

The implementation and ramifications of these new policies will emerge over time, creating new economic structures and dynamics. UKNCC’s Cainey “‘Decoupling’ is a slippery, hard-to-define word,” says UKNCC’s Cainey. “But the weakening and change in commercial relationships is real.”

Global Finance: How has the supply chain crisis impacted your company?

Fergus King: While in recent years TomTom has pivoted to software, maps and location technology, it continues to manufacture and sell personal navigation devices—although in much smaller volumes than in the past. These devices are manufactured in China by a Taiwanese company.

The shortages in consumer electronics are a result of Covid-19 kicking in, factories shutting down and then reopening with significantly increased demand. That sequence highlighted capacity limitation in semiconductor manufacturing. In October, for example, we are likely to receive just 30% of the components we need to meet our inventory requirements.

GF: What measures has the company taken to address these challenges?

King: One strategy we have adopted to maintain activity is to buy common components on the gray market. But for unique components such as semiconductors there is no alternative. Semiconductor manufacture is the critical bottleneck: There are only a few companies in the market, and you just wait for your turn. That turn may not necessarily be determined by when you place your order. Any manufacturer wants to serve its biggest and most profitable customers first, although longevity of relationship is also important. Everyone is paying more; but even if you offered double or treble the price, you wouldn’t necessarily get further up the queue.

GF: What other factors determine when, or whether, semiconductor orders are met?

King: The technology being deployed matters in semiconductors. Manufacturers obviously want to squeeze as much profit as possible out of production. It might be possible to get 200 chips out of a single wafer with a 5-year-old design. But it might be possible to get 400 chips of a brand-new design out of that same wafer. The manufacturing time is the same in both cases; but the new chip sells for a higher price, and they can make more of them. Customers needing older chip designs are inevitably less of a priority. Smaller brands tend to suffer most.

GF: How have pricing and lead times changed?

King: Some semiconductors have doubled in price, but overall costs are up by 15%-20% over the past year. Semiconductor manufacturers are trying to limit price increases; but wafer prices are going up, and they cannot absorb it all. To date, we’ve not passed on these price rises to customers; but our margins have been squeezed dramatically, and we will not be able to maintain this forever.

In the past, the longest lead time we had was 12-16 weeks for central processing units and glass; now it is up to 52 weeks. One manufacturer of chips is unable to tell us when we can have our order. As a result, our engineers are likely to have to redesign circuitry so we can substitute an alternative chip.

GF: Have current logistics problems affected TomTom?

King: As we manufacture in China, we face reduced freight capacity and increased costs. As our products are high value, we airfreight most of them. Airfreight used to have a three- or four-day lead time. Because of Covid, we now assume 10 days for airfreight and sometimes can’t get on a flight. So far, our road distribution in Europe has not experienced any major disruption, although prices are going up as fuel costs increase.

GF: Has TomTom considered reshoring?

King: Five years ago, we felt too reliant on China and investigated moving production to elsewhere in Asia or to Eastern Europe. Our analysis showed that labor costs were broadly similar in Eastern Europe, for example; and there were savings on logistics. But crucially, most of the electronic components would still have come from Asia; and therefore overall, a shift was not viable. In the longer term, the US and the EU should be trying to build semiconductor fabrication plants so that they’re not reliant on Asia. The US now recognizes this; the EU also needs to do so.

When the hundredth cargo ship joined the unprecedented line outside the Los Angeles-Long Beach port complex in October the supply chain crisis that had simmered for months looked to have boiled over. Parents began to worry about the availability of Baby Yoda toys in stores for the holidays. Economists’ warnings of soaring demand, supply shocks, ongoing Covid-19 disruption and potential runaway inflation reached a deafening pitch. Then in late November the Covid omicron variant emerged, threateninig another round of lockdowns and disruptions.

Certainly, the statistics look worrying. Supply chain problems pushed US industrial production 1.3% lower in September, the biggest drop in seven months. While wage rises of 1.5% from the second to the third quarter—the fastest pace since 2001—may seem like great news for workers, their pay bump will be eaten up by October’s year-on-year consumer price growth of 6.2%, a 31-year high. Meanwhile, IHS Markit’s Purchasing Managers’ Index, published in the third week of October, showed that eurozone business activity is weakening. The index fell to a six-month low “amid increasing supply bottlenecks.”

For months, corporates have sought to lower expectations and warn of worse to come. Procter & Gamble announced price increases for nine of its 10 product categories, in the mid-to-high single-digit percentages across most of its portfolio. Nike lowered its sales forecast, with production and shipping delays hampering its ability to meet demand; while home appliance firm Whirlpool said supply chain blockages and the increased price of materials would add almost $1 billion to costs this year. And Amazon predicted that “labor inflation” would add $2 billion to its cost base in the fourth quarter.

What’s Going On?

In order to understand how and when the supply chain crisis might resolve itself, it’s important to understand how we got here. According to Gregory Daco, chief US economist at Oxford Economics, the current supply chain crisis has two unique characteristics that differentiate it from those of the past. “First, we live in a highly globalized environment where supply chains span the entire world, and there are an incredible number of financial and capital-based interactions between economies,” he notes. “Second, the Covid-19 crisis, unlike any previous crisis, affected every country in the world.”

While the pandemic affected everyone, supply in different countries is coming back online at different times, leading to pockets of disruption that have cascading effects on downstream industries and have created a “desynchronized global recovery,” according to Daco. This challenge is being exacerbated by the ongoing distortion of the global economy, says Ben Laidler, global markets strategist at investment platform eToro.

In most of the biggest 10 economies, government lockdown actions and restrictions as gauged by Oxford University’s Covid-19 Stringency Index peaked at over 80 (on a scale of 0 to 100) between the beginning of March 2020 and the end of March 2021. Yet restrictions linger and return. “Even in October 2021, it was still around 60,” says Laidler. “Many supply chain distortions are ultimately driven by the fact that we are still, to some extent, locked down.” For instance, there is a labor shortage due to problems in matching laid-off workers to vacancies.

Trade’s complexity and scale means that, “like a supertanker, it takes a long time to turn around,” says Rebecca Harding, trade economist and CEO at data provider Coriolis Technologies. The world is dependent on a limited number of shipping lanes from Asia to Europe and the US, and they can easily get clogged up. As the Suez blockage showed, a single problem can have significant consequences. “The ships that were delayed [then] are still displaced [seven months later], causing knock-on effects for future traffic.”

In other words, many of today’s problems—while serious—are largely short term in nature; the backlog of ships outside the Los Angeles-Long Beach port complex will eventually be cleared, more truckers will enter the workforce and the disruptive impact of the Covid-19 Delta and Omicron variant will (hopefully) dissipate.  Equally, it’s important to note that the current supply chain challenges are not universal, according to Madhur Jha, head of thematic research at Standard Chartered. “In Asia, the manufacturing hub of the world, supply remains available,” she says. While pandemic-related shutdowns in Vietnam and China led to some delays in production, restrictions have now been lifted. “Supplier delivery times in the US and Europe are elevated by as much as 17 points; in China, they have risen by perhaps two.”

Uncovering Underlying Problems

Even the best prepared companies might have struggled in recent months, given the pace and nature of the global recovery. But according to Anastasia Kouvela, partner at Boston Consulting Group (BCG), many firms have also found it hard to address underlying or long-term supply chain challenges.

“Transparency across the extended supply chain is critical,” explains Kouvela.  Most companies found it difficult to act quickly during the pandemic, as they did not know where their stock was or how resilient their tier-two and -three suppliers were. In addition, many companies had become complacent and failed to proactively manage risk by devising backup plans and strategizing “what if” and “then what” scenarios. Many companies had also concentrated production in a limited number of locations far from their main market of sale, she adds.

Kouvela says that companies are addressing all of these challenges: “In the short term, [they are] relocating inventory and creating buffers. Much of this work [began] during Covid.” Corporations are also “collaborating more extensively with suppliers, including providing training, to improve resilience” and trying to diversify their supplier base, she notes: such efforts will necessarily only bear fruit in the longer term.

The supply chain challenges described above were clearly magnified by the short-term shock of the pandemic. But they have also been steadily intensifying as a result of longer-term political and technological shifts, according to Coriolis Technologies’ Harding.

“Today’s semiconductor crisis, for example, is really the result of the Trump tariffs imposed on semiconductors in 2017,” she explains. “Since then, China has developed its supply chain and focused on domestic production and consumption as part of the Made in China 2025 initiative.” Meanwhile, in the West, there’s been an increased emphasis on nearshoring in order to build resilience. “As a result, global trade in semiconductors has declined and the industry has become less able to respond to the problems we see today,” Harding adds.

Higher energy prices, eToro’s Laidler adds, are largely a result of the breakdown in the relationship between prices and investment (i.e., higher prices usually prompt investment) as the global economy has begun to transition to a low-carbon future.

How Long Will Recovery Take?

Policymakers have limited options available to alleviate current pressures on supply chains. Governments could seek to increase economic capacity through a greater focus on infrastructure investment, capital investment or the labor force. But that will take time. Certainly, today’s problems are outside the scope of monetary policy. “In the current environment, [inflationary] pressure is coming from the supply side, which central banks can do nothing about,” says Oxford Economics’ Daco. “If they tighten monetary policy, that will impact demand and limit growth but do little to increase capacity at ports, bring people into the labor force or alleviate other supply side problems.”

But while today’s problems are significant, it’s helpful to keep a sense of perspective. Many current challenges ultimately reflect good news. Record fiscal stimulus has lessened the blow from the pandemic and spurred a boom in global trade, notes Laidler. “Chinese exports are up 26% year-on-year, Europe 11% and the US 19%. The World Trade Organization says global trade will be up 11% on the year—the best performance in recent memory.” It’s hardly surprising that the world is struggling to meet demand.

Similarly, Daco points out that “the second quarter was the best ever for company profit margins, at around 13% in the US and 11% in Europe.” This is despite the gap between the producer price index (the cost to a company of making something) and consumer prices (which can be seen as a proxy for what can be passed onto the consumer) being enormous by historical standards: at 3% in the US, 9% in China and 10% in Europe, according to Daco. Companies’ strong performance against such an unpromising backdrop is testament to extremely strong demand, which is more than offsetting margin pressure.

Given that the supply chain problems in the West are localized, they are likely to be relatively short term in nature, according to Standard Chartered’s Jha. “The last-mile logistics issues will be sorted out. Clearly there are exceptions, such as chip manufacture. But even here, Taiwan [chip] supplier delivery times are starting to fall. [Likewise,] the Federal Reserve’s recent survey of suppliers in New York, Texas and Philadelphia anticipates an improvement in the next six months.” An absence of Baby Yoda toys on store shelves this Christmas might prompt anguish among parents, but the outlook is bright. Jha believes inflation is temporary and unlikely to become entrenched. Overall, she remains optimistic: “We anticipate GDP growth of 5.8% this year, and we have not revised that downward.”

Visibility, forward to customers and backward to suppliers and logistics, is critical, says Evan Quasney, global vice president of supply chain solutions at planning and budgeting software firm Anaplan. Companies also need improved agility and collaboration. “Just seeing [problems] coming isn’t enough: Companies need to be able to understand the business implications and act,” he says. “Together, visibility and agility produce resilience.” While all companies have some visibility, a lag of over a week is typical. “Nowadays, they need daily or even intraday visibility,” says Quasney. Equally, the scope of visibility in the past was one-to-one; now, companies want to see further into the supply chain. The extra time created by improved visibility allows companies to better understand risks, potentially source alternative supplies or make other arrangements.

Many companies were already on a journey to digitalize their supply chain, and this is now being accelerated. BCG’s recent global survey of the consumer goods industry showed that a quarter of firms digitalized their supply chain operations and use artificial intelligence (AI) at scale in their supply chains, and 80% plan to do so in the next 18-24 months, notes Anastasia Kouvela, partner at BCG. She says that addressing supply chain problems is less about striving for perfection and more about creating structures that are fit for their purpose. “Companies need to ensure there is the right balance between human capabilities and digital infrastructure, so that the two are more than the sum of their parts.” In the short term, building new digital infrastructure will require investment. “But ultimately, the efficiencies generated can mitigate some of these costs,” she says. “Moreover, by being better able to sense demand, [there is] an opportunity to capture new growth.”

“We’ve managed to avoid gaps on shelves, because our planning strategy is always to have inventory in the supply chain at various points,” explains Fergus King, vice president of global supply chain, consumer products, at mapping- and geolocation-technology firm TomTom, which is now focused on software but continues to produce personal navigation devices. King says just-in-time supply chains are largely a myth outside the auto sector: The consumer electronics sector has lead times of 12-30 weeks; some components now require a commitment 52 weeks in advance, and there will be buffer stocks of at least a month. “We typically keep four to six weeks of inventory in our warehouses. Our partners, distributors and retailers keep eight to 14 weeks of inventory,” he adds.

“Companies need to improve demand-and-supply planning so that they have a tighter “handshake” between the commercial and supply sides of a business, according to BCG’s  Kouvela. “Sales and marketing need to be more proactive in communicating what is happening in the market, so that the supply chain is given more time to prepare,” she says. “The entire organization needs to focus on what is feasible given inventory, and design promotions and discounts accordingly.”

Many companies, especially in sectors deemed critical by their governments, are seeking to build a more diverse portfolio of suppliers in order to de-risk the supply chain or even reshore production. The latter is not a panacea for all companies, however. Madhur Jha, head of thematic research at Standard Chartered, says that while AI and robotics could facilitate reshoring by lowering costs, her research shows that most firms still prefer China and Asia as their production base. “China and Asean countries [members of the Association of Southeast Asian Nations] have an infrastructure, regulatory and institutional setup that is hard to replicate elsewhere,” she notes.

“Suppliers are proactively seeking alternative ways to access financing outside of traditional bank lending or factoring, [and some are] encouraging their customers to launch early payment options such as supplier finance and dynamic discounting,” says Matthew Fraser, working capital solutions head at Citi Commercial Bank. Buyers can respond by providing critical vendors with liquidity that—by leveraging the buyer’s credit rating—is offered at a lower cost than a supplier could usually achieve. As a result, explains Fraser, supplier finance can facilitate the production of goods during times of uncertainty and safeguard the overall sustainability of supply chains.

“Innovation played a role in vaccine development; but even though some vaccines utilize new technology such as mRNA, they didn’t come out of nowhere,” says SUNY’s Russell. “They depend on decades of public investment, standardized trial structures, existing vaccine manufacturing capabilities and established cold-storage supply chains. Adaptations were necessary, given the volume required and urgency of the task; but much of what was needed was already there.”

“The pandemic has shown that companies are more innovative than they thought. They can act quickly, in fundamentally new ways, in uncertain environments and with true decisiveness,” says New Markets’ Wunker. “During the pandemic, there was not time for most companies to innovate the product. Instead, they had to focus on the business system and the services that surround the product, such as channels or customer experience. Restaurants, for instance, did this effectively by creating remote experiences, such as [delivery of] frozen cocktails, that reflected the new environment. Thinking beyond the product opens up new avenues of innovation and creates flexibility at a low cost, because nonproduct offerings are easier to adjust.”

“Despite scientists warning for years about the risk of a pandemic, very few companies had it on their list of risks at the end of 2019. Predicting Covid-19 was tricky, but other future disruptions seem highly probable,” says Wunker. “Covid-19 taught firms that they need to embrace uncertainty and think through the implications of potential actions. This takes rigor and humility but opens up a realm of possibilities that you foreclose if you presume omniscience.”

“Covid-19 showed that government support can be critical, especially in commercially unattractive markets such as vaccines,” says How Innovation Works author Ridley. “But we should not infer that mission-oriented funding is the right choice: It prevents the trial and error and serendipity that are a crucial part of innovation. There are ways of publicly funding the private sector to achieve public goals, such as prizes, that don’t require the state to pick winners in advance.”

“Covid-19 has [highlighted] the importance of the distinction between simple and complex contagions,” says U Penn’s Centola. “While Covid-19 is a simple contagion—one sick person can transmit the disease to many—prevention measures like wearing a face mask are complex contagions. If your friends are not wearing face masks, you are unlikely to be the only one who does. When it comes to spreading public health behaviors, nonadopters exert countervailing influences that increase a person’s resistance to behavior change. Leaders need to be attentive to countervailing influences. They challenge the legitimacy of an innovation and prevent people from accepting it.”

Defining something as pivotal to modern life as innovation is surprisingly difficult. We can be certain that the groundbreaking mRNA technology that helped create a whole new class of vaccines, including ones that protect against Covid-19, is innovative. But what about a phone with a screen that folds but that otherwise works just like other phones? That gets called innovative too.

“A lot of the problem associated with innovation—within both society and companies—is the use of language,” says Andrew Russell, dean of the College of Arts and Sciences at SUNY Polytechnic Institute and co-author of The Innovation Delusion: How Our Obsession with the New Has Disrupted the Work That Matters Most. “Innovation is too blunt a word to describe what actually happens.”

Matt Ridley, author of How Innovation Works: And Why It Flourishes in Freedom, draws a distinction between invention (which he says involves new prototypes) and innovation (which consists of incremental improvements that make products or services more affordable, available or reliable). He offers a well-known example: lighting. Based on the average wage now, it takes a third of a second of work to pay for an hour of lighting, compared to eight seconds in 1950, 15 minutes in 1880 (for a kerosene lamp) and six hours in 1800 (for a tallow candle). “Now energy is a given, not a luxury,” says Ridley. “That’s as a result of innovation.”

Russell agrees that most innovation is not a spark of genius, but comes about through successive iterations. “In our own time, we think of the iPhone as a pivotal, even iconic innovation,” he notes. But it wasn’t invented from scratch. “Its success came because Apple recombined existing technology and packaged it with excellent marketing and a keen understanding of the sensibility of users,” he adds.

How Innovation Took Over the World

The fetishization of innovation started after World War II, when economists were trying to explain economic growth: A perception was formed that technological change—dubbed innovation—was associated with increased productivity. Given the era’s geopolitics, the arms race and the space race also came to be described in the same terms. “That language of innovation has altered our expectations of what change looks like,” says Russell. “As postwar consumer culture took hold, it hijacked the concept of innovation, which subsequently came to dominate business schools, consultancies and many businesses.”

In recent years—the dawn of the Digital Age—digital technology’s transformative power has turbocharged the cult of innovation. “There is disruption in almost every industry—and it’s not just from big tech companies like Amazon,” says Stephen Wunker, managing director at consultancy New Markets Advisors. He notes that even in seemingly staid industries like household durable goods manufacturing, new business models are emerging, new technologies are facilitating product substitution and regulations are changing how markets function. In the air conditioning business, for example, climate change regulations and the Internet of Things have significant implications.

In today’s world of accelerating disruption, innovation has come to be perceived as central to corporate survival and success. “Change doesn’t occur in just a linear way anymore but increasingly as a series of discontinuities,” says Wunker. “People realize that while they need to keep the lights on in the core business, they also have to innovate in fundamentally different ways.”

Companies’ recent experience of business disruption due to Covid-19 only increased expectations of innovation. “The pandemic caused a heightened sense of urgency for how companies innovate,” says Francesco Fazio, principal at Doblin, Deloitte’s innovation strategy unit. “That requires a much more agile and experimental approach.”

The Wrong Type of Innovation

Agile and experimental, yes, but too many corporates go about it in the wrong way.

With tech and software firms widely celebrated as exemplars of innovation, companies in other sectors have, predictably, tried to emulate them. But while software firms may live or die by the latest version of their product, which often accounts for most or all of their revenue, the majority of businesses don’t. “Most companies’ customers neither want nor need the product or service they buy to be transformed on a regular basis,” Russell explains. Software’s “move fast and break things” philosophy is not a good template for most other businesses.

In reality—as both lighting and iPhones show—business success most often comes from incremental improvements to existing lines rather than a single breakthrough new product. But today, our understanding of innovation as well as our expectations for returns have been skewed by tech companies that are capable of perpetually reinventing themselves in a way that regular companies cannot. Many corporates that try—such as GE, which sought to digitally transform itself into “a 124-year-old startup”—fail.

In their quest to match the success of the tech sector, some companies lacking innovation capacity have instead resorted to “innovation speak,” deploying the language of innovation without delivering real progress, explains Russell. Ridley agrees: Companies talk the talk of innovation, but don’t make the incremental improvements needed to stay the course.

Other signposts suggest innovation has lost steam. He notes that the turnover of companies—how quickly they die and are replaced by new entrants—has slowed down, entrepreneurs’ average age is increasing and nondigital industries such as manufacturing or transport lack dynamism. “We’ve been fooled by the huge rate of innovation in the software industry into thinking that we are in an era of incessant advances,” says Ridley. “In reality, we are suffering a drought of innovation.”

How to Deliver Real Innovation

Creating appropriate structures for innovation to flourish is fiendishly difficult. The high-level goal should be to encourage trial and error, says Ridley. That means allowing for error. “More experimentation inevitably means more chances for failure, yet incumbent organizations are not built to reward risk-taking,” says Patrick Kuehnle, senior manager at US grocery delivery firm DoorDash, noting that big companies in particular struggle with new ideas. “What they don’t realize is that the risk of not experimenting can easily outweigh the risk of doing so.”

While copying big tech verbatim doesn’t make sense, Ridley identifies a number of potential innovation models that large incumbent companies might consider. One strategy is to give up trying to invent in-house, and instead commission research globally, he says. P&G moved to an open innovation model, giving up their own R&D; and it worked well for them. The strategy makes it easier for a company to cut its losses when things don’t work out, overcoming a common problem for internally developed projects.

A second approach—Amazon’s method—is to treat a big company as a series of city states, where people are empowered to try different things. “At Amazon, even a junior employee’s idea—provided it is championed by someone else—cannot be vetoed by the majority and must be presented to a senior management committee,” Ridley says. “That means Jeff Bezos continues to hear about radical ideas, as does his successor [Andrew Jassy, set to take the CEO seat in Q3 2021], and they are not shut down by the natural conservatism of company bureaucracy.”

A third option, designed to escape that natural conservatism, is to build an isolated facility for blue-sky thinking. The Lockheed Martin Skunk Works model, also pursued by X Development (formerly Google X), gives researchers complete freedom to consider “mad” ideas, explains Ridley. Innovators need to be protected, argues Damon Centola, professor in the Annenberg School for Communication at the University of Pennsylvania, and author of Change: How to Make Big Things Happen, against influences from elsewhere in the organization that nudge them toward strategies that resonate or mesh with the status quo. Separation enables innovators to “develop new ideas without being pressured to conform,” he says.

Getting the Details Right

The nascent scientific discipline of social networks is bringing new understanding of innovation’s two components—fostering new ideas and diffusing them—according to Centola. He says the field’s key insight is that networks behave counterintuitively.

“We might assume that networks with access to more information are better for innovation,” he explains. “But if people constantly have high levels of information, it’s easy for them to default back to everyone else’s ideas.”

Centola ran eight competition experiments, giving one problem-solving team “fireworks” networks, in which they can easily access broad but limited information regarding the activities of others. The second team, on the other hand, worked with “fishing net” networks, which offered more-limited access to the same information.

“The fishing net teams always found the best solution,” Centola says.

Once an innovation is conceived, the next step—getting it to take hold within an organization or to change—also happens through a social network; and some ideas are more “contagious” than others. A “simple” contagion is just a new way of doing the same old thing, Centola explains; while a “complex” contagion challenges basic assumptions about what good solutions look like or how a business operates. “This may entail significant risk,” he says, “because the real value of innovation is often unknown at first.”

For the latter, the solution lies in what Centola calls “wide-bridge” communication, which runs through multiple overlapping social connections rather than narrow, liaison-driven collaboration that relies on broker relationships. Centola cites the Human Genome Project: Each of more than a dozen labs had its own established norms and practices; but via multiple overlapping information- and discovery-sharing practices, each retained freedom to adapt its problem-solving approaches as deemed fit without ideas being funneled through a centralized authority or a handful of key brokers.

Centola’s findings emphasize the importance of clearly delineated strategies when it comes to innovation, not only on the front end of creation but also on the back end of implementation.

There appears to be a financial incentive. Consultancy Stryber recently analyzed 1,838 listed US and European companies from 2010-2019. The analysis indicates that 68% were not major innovators and also did not deliver big shareholder gains. Stryber also found that the firms that most diversified their revenue segments—which Stryber believes is a reasonable proxy for innovation—delivered shareholder returns 54% higher than those that didn’t diversify at all.

There’s more than one way to innovate; but regardless of the model, companies must trust their innovation teams enough to free them from conventional thinking and recognize that for new thinking to take hold requires every employee to be an innovator.

“More than ever now, the innovation engine needs to produce results in weeks or months,” says Deloitte’s Fazio. “Gone are the days or months, or years, to develop, validate and launch new concepts.”

Global Finance: Soft power is in part a country’s impact on others via culture. Why is it important?

Stuart Wood: When it comes to global leadership, facts and figures tell only part of the story. While the US was the undoubted economic powerhouse of the past century, it was as much its cultural cachet that rooted it in the world’s collective memory. Hollywood, US pop music (from Elvis to hip-hop), fashion, literature and brands such as Ford, Nike, Microsoft, Coca-Cola and McDonald’s—for better or worse—signposted America’s role in the world. The American Dream is not a replacement for US military or economic power but an addition to it. The ability to make friends and influence people can be a valuable strategic tool in achieving prosperity and security. Culture, brands, reputation and values are all crucial parts of that.

GF: Is Asia poised to play a similar cultural and creative role?

Wood: It’s important to recognize that Asia includes multiple cultures and countries at different stages of development. For instance, Japan emerged initially as a producer of generic, cheap manufactured goods before becoming admired worldwide for innovations such as the Walkman in the late 1970s. Now it is as much known for its culture and creative brands, such as Issey Miyake, as for the electronics that made its name.

Other countries will follow a similar pattern to Japan. In China, perfection is deemed to come from the ability to copy perfectly. That strategy has served the country well, enabling it to produce smartphones, TVs and electric cars that rival some of the best in the world. Now China is at a tipping point in terms of creativity. There is a critical mass of young, creative, domestically educated Chinese who, leveraging China’s ability to produce cheaply and rapidly, are potentially world beating. Digitization can act as a powerful catalyst of this process: China’s TikTok launched globally only in 2017 but by 2020 had 800 million users worldwide, including 90 million in the US. China recognizes at an official level the value of soft power: That’s why it supports Mandarin language learning programs at schools worldwide, for example.

GF: Which country is leading Asia’s soft power charge?

Wood: Korea is important. Just two decades ago, the idea that it would be a major global force in pop music, could win a Best Film Oscar (for Parasite) or be among the biggest innovators in consumer products was unlikely. But Korea’s success highlights two seemingly contradictory forces. The first is that today’s younger consumers have a borderless attitude: They don’t see K-pop—or China’s TikTok for that matter—as Asian. The second is that there is a strong global demand to tap into what is perceived as an Eastern culture of wellness, health and beauty, as the huge international success of Korean cosmetics brands shows.

GF: Asia’s economic growth is likely to continue to outpace Europe and the US. So why are Asian companies looking overseas?

Wood: China’s economy may soon match the US in size, but the people’s spending is just a third as large. It could take another half-century to reach equal spending [per capita]: The US and Europe remain lucrative markets. At the same time, brands—and the countries they come from—want acceptance, validation and the soft power that comes from being a big name on the world stage.

The moment when global leadership passes from one place to another often becomes clear only in hindsight. Did the US become preeminent in 1917 when it entered World War I? Or during the roaring 1920s, when its exports (including Hollywood’s) led the world and one in five Americans became rich enough to buy a car? In reality, the transition of economic, political and cultural power is incremental.

Pinpointing the shift in power from the US to Asia is no easier. Some claim it has already happened, highlighting the great financial crisis that left Asia relatively unscathed and positioned China as the savior of the global economy, boosting its prosperity and standing. Others point to former US President Donald Trump’s abandonment of the post-World War II rules-based order or his withdrawal from the Trans-Pacific Partnership trade pact as turning points: A geopolitical vacuum tends to be filled.

Most likely, the transition is ongoing. But it is clear that Asia—more than just a one-country story despite China’s superpower scale—is gaining ground on the West. The region’s growing wealth, farsighted decision-making, increasing commercial creativity and cultural visibility underpin its inevitable ascendancy. Asia’s capable management of Covid-19 and its swift economic recovery from the crisis are just the icing on the cake.

Making the Leap

To be a world power takes wealth. According to the World Bank, the East Asia and Pacific economy will continue to outperform in the near term, with growth accelerating to 7.4% in 2021, led by a rebound in China. In contrast, the eurozone will expand 3.6% and the US just 3.5%. To a large extent, this outperformance is business as usual: Asia’s growth in recent decades is unparalleled in history and unmatched by other emerging market (EM) regions.

However, to dominate the century, Asia needs to make a leap. Historically, escaping the middle-income trap—continuing to grow after the advantages of low wages diminish—is tricky. “Emerging markets in Asia have a better chance of escaping the middle-income trap than do countries in other EM regions such as Latin America,” says Tommy Wu, lead economist at Oxford Economics in Hong Kong. “In particular, China will continue to grow at a fast rate for some decades, enabling it to become a high-income country.”

What’s Asia’s secret? Wu says many Asian countries have opened up their economies and developed an export-oriented growth strategy that upgraded their industrial know-how, skills and manufacturing base. But crucially, as they have moved up the value-added chain, they have continued to invest in infrastructure and learn from the outside world, attracting foreign direct investment, developing human capital and raising productivity.

Meanwhile, Asia’s demographics are helping its economies to reconfigure, boosting their ability to escape the middle-income trap. “Alongside productivity gains, growth in the size of the working population is an important determinant of economic growth,” says Viswanathan Parameswar, head of Investments Asia at private equity asset manager Schroder Adveq in Zurich, Switzerland. “Globally, the working population is falling,” he says. “In Asia, it’s still rising.” Both Indonesia, the world’s fourth most populous country, and India, the second most populous, have a median age of around 29—almost two decades lower than Germany, for instance.

Asia does face pockets of demographic challenge. “Japan’s retirees account for a similar proportion of the population as in Europe,” explains Parameswar. “But China is in a roughly similar position to Japan 30 years ago, while India is where China was 30 years ago.” In other words, with 1.1 billion millennials across the region, according to UN data—compared to 76 million in the US and roughly 150 million each in the EU and Latin America—Asia will enjoy a demographic dividend for years to come.

Asia’s demographic advantages are amplified by its burgeoning middle classes, notes Parameswar. The Brookings Institution estimates that 2 billion Asians are already middle class; by 2030, the number could rise to 3.5 billion. The middle classes spend more on consumer products and services. About 50% of the growth in consumer demand over the next decade will come from the region, and 44% of international students are Asian. “A virtuous circle is underway,” says Parameswar.

The expanding middle class is turning domestic demand into an important growth driver and helping the region to become more self-sufficient, believes Wu. While the private sector’s dynamism can take much of the credit, government actions including directing resources, devising farsighted policies and taking a conservative approach to borrowing also increase the likelihood of escaping the middle-income trap. “This differs from other parts of the developing world, where high fiscal debt could pose [problems] and, in some cases, government policies are too often focused on the short term,” notes Wu.

Trusting in Trade

Asia has been a crucial part of global supply chains for decades. Indeed, exports to the US and Europe have driven its dramatic economic development. But intra-Asian trade has been meager in comparison, focused largely on raw materials or components. Trade in final products and services has been too costly (because of tariffs) or complicated (because of nontariff barriers), holding Asia back. “The Regional Comprehensive Economic Partnership [RCEP] will start to change this dynamic and make trade within Asia easier,” says Deborah Elms, founder and executive director of the Asian Trade Centre in Singapore.

RCEP, which was signed in November 2020, is not the first major multicountry Asian trade agreement. The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), concluded in 2018, has some membership overlap with RCEP, including Japan and Australia. CPTPP is a broader and deeper agreement than RCEP, aiming to eliminate all tariffs on almost every product (soft cheese imported to Japan is one of a handful of exceptions). In contrast, RCEP covers fewer products and doesn’t seek to cut tariffs to zero. Moreover, its timeline extends to 20 years.

The strength of RCEP, however, is its scale. It covers 15 countries (China, Japan, South Korea, Australia and New Zealand, plus the 10 Asean countries) that account for almost a third of the world’s population and of global GDP. That makes RCEP the world’s largest free trade agreement—bigger than US-Mexico-Canada or the EU. RCEP began as an effort by the Asean countries to simplify trading standards—their exporters had to contend with five different agreements. But it snowballed to add more countries and broader goals. That 15 countries decided to reject protectionism and open markets at a time of tensions in the global trading system is significant, says Elms.

RCEP’s impact in terms of boosting GDP growth looks underwhelming in the short term: The Peterson Institute for International Economics estimates it will boost global GDP by less than 0.6% of 2019 GDP based on World Bank figures. However, such projections are based on the benefits to trade if tariffs are reduced; and RCEP has modest tariff-reduction goals. Elms believes the agreement might ultimately have a profound impact. “Firstly, RCEP covers services, which account for half the global economy,” she says. “Secondly, it enables companies whose ambitions might have previously been limited by the size of their domestic markets to think of Asia as their marketplace, creating enormous new opportunities.”

Perhaps most important, RCEP lays the foundation for future advances. “RCEP will have a secretariat and regularly scheduled meetings, including an annual summit of leaders. Consequently, it has the potential to become a forum where officials talk about new rules,” says Elms. “It’s not going to become an Asian version of the European Union, but it could result in greater interoperability. For instance, it could eventually result in standardized rules on food safety, energy exports or the Internet of Things.” RCEP’s common rules of origin for the entire block will accelerate intraregional integration—companies will create supply chains that no longer involve Europe or the US. “That will accelerate economic growth and expand the middle class,” says Elms, helping to create the Asian Century.

Every so often, history presents an opportunity for countries or regions to rise to the occasion. Covid-19 is one such event. While success is relative, given the global tragedy of the pandemic, Asia has undoubtedly fared better than much of the West. Eight of the top 15 countries in Bloomberg’s January Covid Resilience Ranking, which provides a snapshot of government effectiveness and social and economic resilience, are in Asia. Neighboring New Zealand and Australia also feature in the top 15. Europe, in contrast, occupies just two top 15 spots. The US languishes in 35th position.

Asia’s Covid-19 performance matters for two reasons. First, the ability of countries such as Korea and China to deal with the pandemic has economic benefits. “They are outperforming on a relative basis,” notes David Rees, senior emerging markets economist at Schroders in London. That means Asia’s economies will be less scarred by Covid-19. Moreover, their resilience will attract businesses seeking stable supply chains. At the same time, according to Oxford Economics’ Wu, Asian government debt-to-GDP ratios—already lower than in Europe—leapt by around 10 percentage points during the Covid-19 crisis, while those in Europe grew by 20 to 30 percentage points. That should give Asia greater flexibility in the future.

The UK-based Centre for Economics and Business Research consultancy recently said China will overtake the US to become the world’s largest economy by 2028, five years earlier than previously forecast, as a result of this divergence of growth and debt.

Second, Asia’s Covid-19 competence reinforces the perception, growing since the financial crisis, that the region is no longer outshone by the West. Cultural factors explain some of Asia’s Covid-19 outperformance—citizens are more willing than Westerners to accept restrictions for the common good. But Asian governments were also more willing to act boldly than the West, shutting down borders quickly to prevent imported cases while introducing strong domestic controls and successful contact tracing, says Wu. China has subsequently bolstered its reputation—and relations with key developing countries such as Brazil, Indonesia and Turkey—by signing distribution deals for its domestically developed Covid-19 vaccines. Indeed, for many EM countries, China—rather than the US—is now the exemplar for governance, economic expertise and technological know-how.

Combined, these developments will—over time—boost Asia’s geopolitical influence at the expense of Europe and the US, which were already losing power. “Before the crisis, part of the global economic and political challenge was accommodating a fast-rising Asia (even beyond China),” says Robert Kahn, director for global strategy and global macro at the Eurasia Group. “Covid-19 gave additional impetus to this.” Change will not occur overnight. “The pandemic is not the triggering event that leapfrogs Asia into preeminence,” he says, “but it is an accelerant of the pressures that will lead to its preeminence.”

To be powerful, scale is important. “Four out of every seven people on Earth are in Asia,” notes Schroder Adveq’s Parameswar. But size alone doesn’t confer success. Asia’s ascent is also driven by thriving entrepreneurship, a critical mass of manufacturing and services, and robust demographics. Indonesia is widely seen as the next hot spot for tech growth: the likes of Facebook, Google and Microsoft have recently made sizable investments in Gojek, Indonesia’s largest tech company, and e-commerce platforms Tokopedia and Bukalapak.

Other countries in southeast Asia, most notably Vietnam, have rapidly achieved critical mass in manufacturing, as businesses move out of China in search of lower costs and to avoid US trade sanctions. Meanwhile, the region can call on worldleading financial centers in Shanghai and Singapore and the information technology prowess of India, which—among much else—has given the country a powerful diaspora in Silicon Valley. This economic diversity gives Asia real strength. History is also on the region’s side. “We shouldn’t forget that Europe came to dominate the world only from the 1700s—and the US much later,” says Parameswar. “Now the pendulum of history has swung back.”

What might upset this trajectory? Despite recent antagonism with the US, the greatest threat to Asia’s primacy is likely to come from within the region. Politically, Asia runs the gamut from fully-fledged democracies to totalitarian states. Unsurprisingly, tensions can run high. Recently, China has taken to flexing its diplomatic and military muscles with economic sanctions against Australia and border skirmishes with India, China’s greatest long-term rival in the region given its scale and potential. But it’s important to remember that the Asia story is much bigger than China alone: Measured by purchasing power parity, India is the third economy in the world, while Asean is fourth. Moreover, as large and mature economies, Korea and Japan will continue to act as valuable counterbalances to China.

The 19th century French economist Claude-Frédéric Bastiat is widely quoted as having said: “When goods do not cross borders, soldiers will.” The success of trade deals such as RCEP and CPTPP at a time when global trade is floundering indicates that regional powers understand Asia is stronger together. Achieving a shared interest in stability—through deeper supply chains, closer trading relationships and broader cultural interaction (K-pop is popular in China)—looks set to be the making of the Asian Century.

Business headlines in recent months have inevitably focused on the impact of Covid-19 on multinationals such as airlines and oil firms. Household names like Virgin Atlantic have taken a big hit. But small and midsize enterprises (SMEs) are arguably a more important part of the global economy—and the challenges they face may be greater than those of corporate goliaths.

SMEs account for 99% of firms, 70% of jobs and up to 60% of value added among the Organization for Economic Cooperation and Development (OECD) countries. In emerging economies, SMEs contribute up to 40% of GDP, according to the World Bank. They are major innovators in the tech and biotech sectors, accounting for more than 70% of China’s patents for instance, according to the Rand Corporation think tank.

However, SMEs’ relatively small size also makes them vulnerable to external shocks. The concurrent supply chain disruption and collapse in demand that occurred in March and April, when governments reacted to Covid-19 by shutting down swathes of the global economy, dealt a heavy blow to SMEs. Many small companies could not work remotely. The UK’s Office for National Statistics says 24% of firms temporarily closed or stopped trading after lockdown was announced.

Moreover, the crisis has exacerbated existing working capital challenges faced by many SMEs, according to Neil Daswani, global head, Business Banking and Corporate Partnerships at Standard Chartered in Singapore. A survey by Tsinghua University and Peking University estimates that 85% of Chinese SMEs have three months cash. SMEs in other countries face a similar predicament, and some of the worst affected sectors have almost no cash buffer: A JPMorgan Chase Institute report estimates that restaurants have cash reserves of just 16 days on average.

Government to the Rescue?

To stem the impact of the Covid-19 shutdown, governments around the world have enacted emergency measures to provide funding and other support. The programs and their scale are constantly evolving; but the numbers are vast, even compared to post-2008 financial crisis relief, according to Lamia Kamal-Chaoui, director of the OECD Centre for Entrepreneurship, SMEs, Regions and Cities, in Paris.

“The quantum, speed and tenor of the response by governments are impressive; many countries are offering relief for up to six months or even as long as 12,” says Daswani. “There are government guarantees available for 80% or even 100% of lending in some countries. And many banks have also rolled out moratoriums on principal payments, payment holidays, debt restructuring and other measures.” Both the US Federal Reserve and the European Central Bank have taken various steps to ease lending by commercial banks to SMEs.

In addition to direct lending to SMEs through public institutions (underway in Lithuania, Spain and the US), and loan guarantees enabling commercial banks to expand lending to SMEs (in the UK, Switzerland and Latvia), support for SMEs has taken various other forms.

Austria, Germany and the Netherlands, have new measures to shorten working hours, prevent layoffs and relax sick leave rules. Australia, Canada, Japan, South Korea and New Zealand are providing wage and income support. Several countries, such as the Slovak Republic, Argentina and Chile, are offering grants and subsidies to SMEs to bridge the drop in their revenues.

The deepening crisis means governments are continuing to extend and broaden the support available. The US government’s initial $349 billion of PPP (Payroll Protection Program) funding was exhausted in just 13 days (and much of it went to major public companies); a second $320 billion round of funding has been made available. Similarly, at the end of April, the UK reversed itself, joining Switzerland and Germany in guaranteeing 100% of new loans to some small businesses. It is conceivable that other countries could follow Germany in taking equity stakes as part of rescue efforts.

Is the Support Working?

Making money available is quite different from its reaching SMEs. UK banks were criticized for pushing SMEs to borrow on commercial terms or insisting on personal guarantees for 80% government-backed Coronavirus Business Interruption Loans (CBILs), which are interest-free for 12 months.

There are also concerns about delays in approving loans in the UK and other markets. Figures from banking and finance industry association UK Finance show that by the end of April, less than half of the 52,807 applications for CBILs had been approved; anecdotal evidence suggests many times that number have contacted banks but have yet to make a formal application. Similar problems in Germany regarding the complexity and pace of loan-granting administrative procedures led to their easing, according to the OECD’s Kamal-Chaoui.

“The banking and finance sector recognizes the challenging conditions faced by many businesses and the critical role we must play in helping the country get through this crisis,” said Stephen Jones, CEO of UK Finance in London, in an April statement. “Front-line staff in local branches and call centers are working incredibly hard to help firms access finance as quickly as possible amid unprecedented demand.”

Standard Chartered’s Daswani says that on the whole, emergency programs have been smoothly rolled out: “Most countries have accelerated credit checks to ensure help gets to SMEs quickly,” he says. “But at the same time, it’s important to channel support to companies that have a good repayment record rather than to SMEs that may have had chronic problems that predate Covid-19.”

Kamal-Chaoui believes it is too early to assess the effectiveness of these policies and the extent to which they will help businesses survive. “What is clear is that without such measures, there would be a real danger of massive disruption and widespread bankruptcies for SMEs and the self-employed,” she says.

An Uphill Task

Restarting the SME sector will be tough. Jennifer Bouey, an epidemiologist and Tang chair in China policy studies at the Rand Corporation, says SMEs must contend with local quarantine issues, reopening permits and health regulations (carmakers and their SME component suppliers across Europe are struggling to meet social distancing rules as they restart assembly lines, for example).

Bouey adds that SMEs also face challenges associated with broken supply chains. “Upstream SME closures are felt by downstream factories that are relying on the parts they produce,” she testified before the US House of Representatives Small Business Committee in March. “Without the parts and necessary logistics to bring in materials and ship out products, many factories can barely produce or have no place to store the products.” And despite unprecedented support, cash flow will continue to be a big worry for SMEs, given that they are “financially more fragile and cash strapped” than larger corporations, Bouey said.

But while the problems facing SMEs are huge, they are not insurmountable. “It’s not all gloom and doom,” says Daswani. “SMEs not only have a raft of government and bank initiatives to draw on but, in many cases, have been agile in moving into related areas of business that are benefiting from current conditions, such as e commerce. Many will be able to respond quickly to the post-Covid-19 world. SMEs could benefit from shorter supply chains; and many are not that encumbered by bricks and mortar or legacy systems, so they can quickly respond to new demand behaviors.”

The OECD’s Kamal-Chaoui believes the crisis has reinforced the need to accelerate digitization. “Early data suggest that digitally enabled businesses may be weathering the turmoil better,” she says. “Enabling SMEs to come out of the crisis better digitally equipped should be an important ambition for public policy going forward.”

What a difference a word can make. As of January 1, publicly traded US corporations have had to record credit losses when they are “expected” rather than “probable.” That nomenclature shift could be enough to force banks’ reserves up 30%, tightening credit when the next recession comes, says Gregory Norwood, Risk and Financial Advisory managing director at Deloitte & Touche. “Bankers say that increasing reserves decreases their ability to lend in a downturn,” he says.

The villain, or hero, here is the new “current expected credit loss” (CECL) standard devised after long years of deliberation by the US Financial Accounting Standards Board (FASB). It reaches beyond banks to any entity that extends medium- or long-term credit: automakers and dealers, retailers with in-house credit cards or installment plans, and others. In theory, any company with accounts receivable—effectively credit to customers—must apply the new standard; though loss calculations are unlikely to change for terms of a year or less.

Compliance with CECL is enormously complicated by the FASB having framed it as a “principle-based” standard. Companies are free to achieve it as they wish, so long as their methodology is “reasonable and supportable.” That’s set off a scramble among the 600 publicly traded US banks to get their reasonable and supportable methods in place in advance of first-quarter financial statements, where CECL makes its debut. “There’s no checklist,” says Barry Pelagatti, a partner at Lancaster, Pennsylvania-based audit firm RKL. “No one can provide a solution and say, ‘This is CECL compliant.’”

Accounting standards are the supertanker of financial regulation: slow to turn but cutting a wide swath once they pick up steam. The quest for more-stringent loan-loss accounting dates back to the 2008-2009 financial crisis. Until then, lenders and creditors used a 12-to-15-month horizon, provisioning at the beginning of each reporting year for loans that looked likely to become delinquent. That approach proved inadequate, to say the least, in the face of surging defaults on mortgages and other assets that had been counted on to produce income for years into the future.

The grandees who set US accounting principles intended to forge a new global prudential order with the overseers of international financial reporting standards (IFRS). But somewhere along the way, the bodies “agreed to disagree,” says Jonathan Jacobs, global financial services industry leader at advisory firm Duff & Phelps.

With CECL, FASB is requiring US corporations to somehow forecast risk for their entire loan portfolio over the full life of the instruments involved. Guesstimates may really be too weak a term to describe banks’ widely ranging early loss estimates under CECL, Pelagatti says. “You have one institution saying their reserves need to go up 30%,” he relates. “You go down the street 20 feet and another says they may go down because their loans are not risky at all.”

The international standards group opted to slide between that maximalist approach and the old status quo, implementing an “expected credit loss” standard—also known as directive IFRS 9—in 2018. This mandate also requires losses to be provisioned for the length of the loan, but only applies to credits already at risk. That effectively limits the forecasting horizon to two to three years, Jacobs says, and constrains the leeway for judgment calls. “There’s a lot less guesstimating and a lot less volatility in the IFRS approach,” Deloitte’s Norwood affirms.

The divergence between the two is not surprising, considering the scope of the task: projecting risk for a mortgage portfolio decades into the future, for instance. Issuing banks may sell off mortgages after an average of about seven years, Pelagatti says. But that raises another problem. The seven years preceding January 1, 2020, were healthy ones for the US economy, with below-average defaults. Using that record to forecast the next seven could undermine the basic objective of building adequate buffers for the next crisis.

Then there are devilish details of untapped credit lines available through plastic cards or home equity loans, Jacobs adds. Do lenders need to reserve against amounts currently outstanding, or all the extra cash borrowers might draw down if stressed in a weaker economy? “These off-balance-sheet obligations are where you’re going to see the really big swings in reserves,” he says. “Basic corporate and mortgage lending should be more consistent.”

Finding the Right Path

Seen in a more positive light, CECL gives US financial institutions and their shareholders a massive opportunity for what might be called bottom-up regulation. Starting with the Q1 reports this spring, banks and other lenders will be, as it were, throwing their compliance methodologies at the wall and seeing what sticks—with investors looking for the right balance between aggressiveness and prudence, and with an array of regulators who may step in if they choose: the Securities and Exchange Commission, various banking watchdogs or the Public Company Accounting Oversight Board. “You should start to see convergence in CECL approaches as investors, clients and auditors have time to analyze the disclosures,” Jacobs says. “But it’s going to take at least a year.”

Big banks, already subject to Federal Reserve Board “stress tests” under post-2008 legislation, may have capabilities in place to shift to CECL. The mass of smaller institutions will try to keep their own compliance costs down while waiting for industry standards to emerge. “Smaller public banks are caught in the middle here,” Pelagatti says. “They have the same requirements as the money-center banks, but not the money to fund solutions.”

Companies outside the financial sphere might feel the effects of CECL as banks rein in loan books. A 30% jump in reserves requirements sounds like it would leave less capital to lend out. And it might, Deloitte’s Norwood says, but not at this peculiar economic moment, because the US economy is awash with cheap funding and business for most borrowers is solid. “We don’t see the effects in the current benign environment,” he says.

It’s a fair bet the benign environment won’t last forever, though. The next downturn will show not only whether CECL constricts credit, but whether the whole complex CECL game is effective in making banking more stable and avoiding the massive government bailouts of a decade ago. For now, the one sure result is much more work for risk analysts and auditors. “A lot of people find this standard challenging,” Norwood notes. “It will take us a while to figure this out.”