HONG KONG, CHINA - Media OutReach - 29October 2020 - The unprecedented COVID-19 pandemichas posed severe challenges for the global economy and supply chains have beenin the eye of the storm. Amid heightened geopolitical tensions, some countriesare considering moving supply chains out of China. However, as a recentresearch study by The Chinese University of Hong Kong (CUHK) reveals, cuttingties with China might not help firms to mitigate risks.

"In many parts of the world, there's been concern that globalsupply chains were over-reliant on China, now widely regarded as 'theworld's factory'", says Jing Wu,Assistant Professor of Department of Decision Sciences and Managerial Economicsat CUHK Business School and oneof the authors for a new study.

Such efforts include reportedtalks in August between Japan, India and Australia to establish atrilateral effort, named the Supply Chain Resilience Initiative, to buildstronger supply chains and to reduce dependence on China. Earlier in the year,Japan also earmarked US$2 billion to help its companies shift production out ofChina and back onto its shores. Across the Pacific, both the Trump administrationas well as Democratic Presidential nominee Joe Biden have signaledthat post-election they would seek to end the U.S.' reliance on Chinesemanufacturing.

"We live in an increasingly interconnected world, somuch so that having supply chain relations with other regions when the pandemichit China didn't mitigate credit risk at a time when credit risk for firms withties to Chinese supply chain partners was increasing," says Prof. Wu indiscussing the results of his latest study TheImpact of COVID-19 on Supply Chain Credit Risk.

"When the pandemic spread to the rest of the world andrecovery started in China, having supply chain linkages to China was beneficialfor the companies as the rest of the world was going through economic shutdownsor slowdowns," he says.

The research was conducted by Prof. Wu in collaboration withProf. Senay Agca at George Washington University, Prof. John Birge atUniversity of Chicago and CUHK Business School Ph.D. student Zi'ang Wang. Theresearchers examined how supply chain activity reflects into credit risk duringdifferent phases of the COVID-19 pandemic.

They specifically looked into spreads on credit defaultswaps, or CDS -- a type of financial instruments which allows credit risks to behedged, and its relation to U.S.-China supply chain links. The study mainlyreviewed CDS data in two phases of COVID-19: when the Chinese economy shut downbetween January 31 to February 29 and when the Chinese economy reopened betweenMarch 1 to April 6.

"By exploring two phases of the pandemic, we find thatsupply chain disruptions and resumptions substantially affected the credit riskof U.S. firms during the pandemic. Credit risk increases with supply chaindisruptions due to economic shutdowns and decreases when supply chain activityresumes when the economy opens," says Prof. Wu. The effects wereeconomically significant, increasing CDS spreads by around 6 percent to 7percent during disruptions and improving credit risk by 16 percent 29 percentwhen supply chain activity resumes during the reopening of the economy.

The study also points out that the resumption of supplychain activity in China seems to have a more pronounced effect on improvingcredit risk than during supply chain disruptions when the pandemic spread inChina.

HouseholdDemand Factor

Prof. Wu and his collaborators then looked into specificindustries to find out which sectors were more vulnerable to supply chaindisruptions. They found that sectors that are more closely related to householddemand, such as electronics and consumer goods, did not benefit as much asother sectors when supply chain activity was improved during phase two ofCOVID-19 in China. The resumption of supply chain activity in China did notreduce the credit risk for these sectors due to low household demand in the U.S.

According to the study, sectors such as oil and gas andmanufacturing were more directly affected by disruptions and the resumption ofsupply chain activity. The CDS spreads for these sectors increased duringperiods of disruptions and decreased with resumptions.

However, it was a different picture for the U.S. companiesthat had Chinese customers. When the Chinese economy re-opened in phase two,increasing household demand in China, the CDS spreads of the consumer goodssector reduced considerably for the U.S. firms with links to Chinese customers.

"Since this is the period when the U.S. economy shutdown, having access to Chinese markets was beneficial for U.S. firms withChinese customers, particularly for those in the consumer goods sector,"Prof. Wu explains. Among other sectors, firms in the oil and gas industry thatwork with Chinese customers also have reduced credit risk when the Chineseeconomy reopened.

Firmand Supply Chain Characteristics

In terms of firm characteristics, the researchers found thatfirms that were investment-grade, with more cash and more growth opportunitieswere less affected by supply chain disruptions during the pandemic. Inaddition, firms with high leverage were more vulnerable to supply chaindisruptions but also benefited more when activity resumed.

"Investment-grade firms are further away from thedefault boundary and therefore have the ability to withstand adversedevelopments. Firms with more cash holdings also have more buffer in suchsituations. In addition, growth opportunities appear to allow firms to shift toother businesses when production or customer demand changes during thepandemic," Prof. Wu explains.

Firms that operate in highly concentrated industries, wherea small number of firms made up for a high proportion of production, wereaffected more by supplier disruption but less from customer disruption, asthese firms have a lower risk of losing market share. This contrasted withfirms in sectors where products were similar and competition fierce. As firmswere more substitutable, they were more vulnerable to supply chain dynamics.Firms with more capital could also better adjust to supply chain driven changesand thus they were less affected during supply chain disruptions.

Furthermore, companies with longer supply chains sufferedfrom amplified credit risk as these relations are harder to substitute.Upstream sectors were less affected from reduced demand in China as it might beeasier for these firms to find substitute markets. According to the study,these firms also recovered faster when supply chain activity resumed. On theother hand, when firms were more central in the supply chain network, theircredit risk was less affected by disruptions in any particular individual supplychains.

The study complements the current discussion about theimpact of COVID-19 supply chain disruption on firm credit risk and it is alsothe first to consider supply chain disruptions with household demand within thecontext of supply chains.

"We bring evidence of how supply chain disruptionsaffect firms as economies move to different phases of the pandemic. Theseresults have implications for other forms of regional production or consumptiondisruptions and the impact of global supply chains on propagating or mitigatingsuch shocks."

Reference:

Agca,Senay and Birge, John R. and Wang, Zi'ang and Wu, Jing, The Impact of COVID-19on Supply Chain Credit Risk (July 1, 2020). Available at SSRN: https://ssrn.com/abstract=3639735

Thisarticle was first published in the China Business Knowledge (CBK) website byCUHK Business School: https://bit.ly/2IYgSr3.

About CUHK Business School

CUHKBusiness School comprises two schools -- Accountancy and Hotel and Tourism Management -- and fourdepartments -- Decision Sciences andManagerial Economics, Finance,Management and Marketing. Established in Hong Kong in 1963, it is the firstbusiness school to offer BBA, MBA and Executive MBA programmes in the region.Today, the School offers 10 undergraduate programmes and 18 graduate programmes including MBA, EMBA,Master, MSc, MPhil and Ph.D.

In the FinancialTimes Global MBA Ranking 2020, CUHK MBA is ranked 50^th. In FT's 2020 Executive MBA ranking, CUHK EMBA is ranked 15^th in the world.CUHK Business School has the largest number of business alumni (40,000+) amonguniversities/business schools in Hong Kong-- many of whom are key business leaders. The School currently has more than 4,800undergraduate and postgraduate students andProfessor Lin Zhou is the Dean of CUHK Business School.

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