For decades, globalization was a guarantee of success for European industry. German machinery and plant manufacturers in particular have benefited from a high non-European export ratio of 38%. Business with China plays a key role, accounting for one-fifth of sales outside the European Union. And China is more than just a sales market: 14% of direct investments are made there. Hundreds of manufacturers have established their Asian hub in the country as well and put down deep roots via sourcing, logistics, and production.

Now however, the climate for doing business in China is becoming less certain. Companies need answers and alternative strategies as conflict intensifies between China and the United States, the other large non-EU sales market for German industry. The situation is effectively confronting many German industrial companies with a decision: East or West?

Geopolitical developments are eroding the decades-old business basis of German engineering, specifically free trade and the international division of labor. Russia's war with Ukraine, which passed the one-year mark on February 24, shows how abruptly sales markets and access to raw materials and energy can close. Dependency on any individual country becomes problematic when the geopolitical situation is no longer static. Particularly worrying for German companies is a scenario in which China — a much more important end customer and raw material market — were to close suddenly on the back of escalating conflict.

“System competition” between the US and China leads to decoupling risk

The “system competition” between the US and China manifests itself in protectionist measures on both sides, including restrictions on foreign direct investment and export and import controls, which affect German companies. Not only is China progressively sealing itself off from Western companies, but also the US has passed laws such as the Inflation Reduction Act (IRA) that serve as a gigantic subsidy program for parts of US industry. In parallel, the country is trying to weaken China's competitive position through laws such as the CHIPS Act, which provides billions of dollars in funding for domestic semiconductor manufacturing.

Because both opposing blocs are rapidly raising barriers, a so-called decoupling threatens. Politically, for Germany, integration into the Western system seems obvious. But do companies also have to assign themselves to one of the two blocs?

More than 90% of executives at European industrial goods manufacturers consider decoupling to be the defining scenario of the upcoming decade — and the most pressing problem area next to inflation, according to a survey we recently completed at Oliver Wyman. What’s more alarming, the survey finds, is only 40% consider their companies to be strategically equipped to deal with the new geopolitical and trade policy complications.

Reassessment and alignment of own China setup

With the disruption caused by decoupling, adjusting strategy requires maximum risk awareness. Every company needs to find a setup where it would be possible to spin off its China operations without jeopardizing the core business.

There are several strategies to choose from. Companies that have only a small share of business in China, or have strong products that China is dependent on, may be able to stay in the pure export model. An active withdrawal from China currently would not make sense. But they would have to find a way to cope with withdrawing from China in the event they were practically forced to do so by US legislation such as the CHIPS Act. The most prominent examples are the Dutch company ASML and the Japanese company Tokyo Electron, whose governments have given in to US pressure and will pass semiconductor export restrictions based on the American model.

The most common model for German machinery and equipment manufacturers will probably be one in which they produce products locally for the local market in a China-specific setup ("local for local"). Should the technical and data standards between the US and China drift further apart, it could become necessary to develop sphere specific product versions or even completely separate product programs. Smaller companies could find this difficult because of the cost disadvantages resulting from the necessary duplication of structures and know-how.

Companies that have previously used China as a low-wage location should also rethink their strategy. This option no longer appears to have a promising future, if only because of increased costs in China; at best, the location can still be considered as a hub for the "Chinese sphere." Many companies must consider establishing a second pillar for production in Asia. They should also weigh new locations in countries that can be classified as part of the US sphere and that benefit from legislation such as the IRA via free trade agreements. Mexico could be one such option.

US legislation affects German industry

China's role as a supplier of important raw materials poses major problems for unilaterally positioned companies. Those using China today as their sole source for certain raw or primary materials must urgently try to build up other options and accept the additional costs. This task is highly complex because alternatives are often lacking. Another complicating factor is the comparatively weak negotiating position of medium-sized mechanical engineering companies, which are in competition with large companies when it comes to scarce raw materials. The latter use their market power to obtain supplies from Western sources. Volkswagen, for example, has stakes in mines in Canada to gain preferential access as a customer.

The extent to which US legislation also affects German industry was demonstrated in the past, for example, by the Iran sanctions. Complying with them was practically a prerequisite for doing business with the US. The CHIPS Act, which is aimed at China, threatens a similar scenario. The law may mean that European companies can no longer export some products to China. Also, along with rules in other legislation, if their products contain certain Chinese technology or parts or are associated with human rights violations, export routes to the US may be blocked.

Companies must not only understand US legislation in detail, but also analyze their entire product line and supply chains. Only in this way can they understand where they may have potential conflicts. Then, they must devise problem-solving strategies: Can I redesign to avoid the parts? Can I obtain the parts from other sources? Or can I do without certain business in the US or China?

Time for manufacturers to analyze risks and plan for different scenario

The formation of geopolitical camps not only requires positioning with regard to the two major spheres, but also contested neutral markets. It is important to form an opinion on which camp countries are likely to fall into, using detailed analyses. As the intensity of competition increases, special strategies are needed to get customers in contested markets to adopt the standard of the Western sphere. German companies that have setups in both the Chinese and American spheres will face interesting questions: From which setup should they serve individual markets? And how does one manage the emerging intracompany competition. 

One thing is clear: Companies must quickly learn to analyze and manage the risks of the emerging new world order. Because future conditions will evolve dynamically, they must make plans for different scenarios. Failure to do so will not only jeopardize market share, but in extreme cases the company’s very existence.