Managing Supply Chain Disruption in an Era of Geopolitical Risk

19 July 2022 Blog
Author(s): Michael J. Walsh, Jr. David W. Simon
Published To: Manufacturing Industry Advisor Dashboard Insights

Supply Chain Disruption Series: Article 4

Geopolitics have always impacted supply chain logistics, but over the last two years they have played an outsized role that will likely continue for the foreseeable future. While the COVID-19 pandemic demonstrated the risks of just-in-time sourcing strategies and lack of alternate or dual sources in many supply chains, geopolitical risk will remain as a key driver in supply chain decisions going forward. Companies have learned from the response to Russia’s Ukraine invasion that Western democracies will use economic sanctions and export controls to punish nation-state aggression and to promote national security interests. Multinational companies have walked away from billions of dollars in investment in Russia’s economy and the invasion has disrupted the flow of natural gas, oil, and grain, causing governments and companies around the world to reconsider their energy and food supply chains.

It is unlikely that this dynamic will be limited to Russia or to deterring military aggression. We are already seeing economic restrictions between the U.S. and China that would be unfathomable just five years ago. If this trend continues, the potential disruption to the supply chain will far surpass the impact of the Russia sanctions. For example, in a rare bipartisan effort the U.S. Congress passed and the President signed the Uyghur Forced Labor Prevention Act (UFLPA), which establishes a rebuttable presumption that all goods, wares, articles, and merchandise mined, produced, or manufactured wholly or in part in the Xinjiang Uyghur Autonomous Region (XUAR) are made with forced labor and prohibited from entry into the United States. China in turn has enacted “antisanctions” laws that prohibit Chinese companies from taking actions to comply with U.S. sanctions against China.1 While Chinese enforcement of its antisanctions laws has been uneven, the omnipresent threat has acted as a powerful deterrent to multinational companies.

This article focuses on the disruptions to the global supply chain associated with these two events and discusses strategies for companies to mitigate future geopolitical risk.

The “Global” Supply Chain

Since the fall of communism and end of the Cold War, the “global economy” became synonymous with sprawling supply chains, including just-in-time manufacturing enabled by low cost sourcing and sophisticated logistics. This model requires geopolitical stability and low barriers to trade. Starting with the Clinton administration, the U.S. hoped that China’s admittance to the World Trade Organization would enhance geopolitical stability and promote global free trade. But in order for that hope to materialize, countries must be good state actors working toward the global good. The Russian invasion of Ukraine does not further the global good, and Russia’s pursuit of Ukraine has caused it to become isolated from the global economy. Similarly, China’s use of state subsidies and alleged use of forced labor has caused trading partners to impose protective measures (in the form of antidumping and countervailing duties) and outright bans (in the form of the UFLPA) to protect what they perceive to be their national interest and global human rights. Similarly, Russia’s pursuit of Ukraine has caused it to become isolated from the global economy as other countries attempt to use their economic muscle to push Russia to cease its hostilities. As a result of Russia’s and China’s decisions to act contrary to the interests of Western trading partners, the “global economy” as it has been understood for decades may no longer exist. As Black Rock founder Larry Fink recently stated, “the Russian invasion of Ukraine has put an end to the globalization we have experienced over the last three decades."2 The fact that the head of one of the largest asset management companies in the world believes as much demonstrates that companies should prepare to operate in an economy that is less global and more regional.

The Impact of Russia’s Invasion of Ukraine on the Supply Chain

Since Russia invaded Ukraine, the U.S. government — in close coordination with many other like-minded governments, particularly in the U.K.3 and European Union4 — has imposed sweeping sanctions and export controls that target both Russia and Belarus. These measures have been significant in both size and scope.5 They target Russia’s largest financial institutions, prominent Russian individuals in the business world, and in the Politburo.6 The sanctions and export controls restrict access to U.S. capital markets by the Russian government and many key Russian companies, and restrict access to U.S.-origin technology (and, in some cases, even products utilizing U.S.-origin technology). Although the measures taken to date do not amount to a complete embargo, the net result is that Russia has become a country subject to some of the strictest U.S. economic sanctions and export controls in existence, all on a coordinated basis with most other major economies.7

Since the Ukraine invasion, the U.S. has issued additional sanctions, including banning the sale of Russian gold, grounding Russian commercial aircraft, preventing the export of luxury goods to Russia, and cutting off oligarchs and financial institutions from the Society for Worldwide Interbank Financial Telecommunication (SWIFT) messaging system, announced on February 26, 2022. As a result of this unprecedented issuance of U.S. sanctions and export controls, every multinational company that sources from, sells to, or operates in Russia or Belarus, or directly or indirectly sells to Russian or Belarussian entities, has had to dramatically alter its business operations. Many U.S. companies voluntarily walked away from billions of dollars of infrastructure, investment, and sales due to opposition to the Russian invasion, to support the Ukrainian people, and in some instances because political pressure to cease Russian operations became too great to ignore.

The supply chain disruptions are even greater in Europe than the United States. European governments and companies are struggling to replace Russian oil and gas supplies, on which they became heavily reliant.8 European governments now are looking to the U.S., Asia, and the Middle East for fuel supplies they had, until recently, taken largely for granted. By imposing and increasing Russia sanctions, governments have demonstrated a willingness to prioritize national security concerns over economic and supply chain disruption concerns. The U.S. and European response to the Russian invasion will cause companies to re-evaluate existing supply chains and take advantage of opportunities to recalibrate supply chains out of an operational necessity that was not present even one year ago.

The Impact of China and the UFLPA on the Supply Chain

Despite their geopolitical differences, the U.S. and Chinese economies remain inextricably intertwined. U.S. manufacturers rely heavily on materials, including polysilicon, lithium, and other critical minerals mined in China by Chinese-owned companies. U.S. companies further rely on Chinese companies’ ability to manufacture large volumes of lower end products at scale cheaper and faster than anywhere else in the world. And U.S. institutions seek the exponential growth that access to the Chinese consumer market provides. China in turn relies on U.S. technology to advance its own interests. China’s policy of military-civil fusion – that any technological advances with a civil application must be shared with the Chinese military – has allowed China to become a global military power.9 China’s acquisition of data, intellectual property, and intellectual capital has allowed Chinese companies to obtain advantages in the global economy. At bottom, the Chinese government can and will unilaterally take action to obtain goods, services, and technology when doing so is in the interest of the Chinese Communist Party. However, China’s own internal policies are now hampering economic growth. The ramifications of China’s commitment to zero-COVID have created economic losses,10 and the Chinese Communist Party has intervened on more than one occasion to hamper the growth of technology companies seeking to access the public markets.11

China’s policies have further isolated themselves from the U.S. and the West. The U.S. State Department recently issued an advisory recommending that U.S. citizens refrain from traveling to China “due to arbitrary enforcement of local laws and COVID-19-related restrictions."12 And on July 6, 2022, the U.S. and the U.K. gave an unprecedented joint speech warning of the long term risks China poses to the established world order.13 In light of these unmistakable signs of continued economic drift, companies hoping that supply chains will return to business as usual in the near future will not be as well positioned as their competitors who begin planning now for potentially drastic change.

Perhaps the most telling indicator of this drastic change is the passage of the UFLPA in December 2021. The UFLPA, effective as of June 21, 2022, bans the import of goods produced in the XUAR. Under the law, the following goods are presumed to be the product of forced labor and are barred from entering the United States:

  • Goods that are mined, manufactured, or produced in Xinjiang, wholly or in part.
  • Goods produced by entities that work with the Xinjiang regional government to recruit, transport, transfer, harbor, or receive forced labor out of Xinjiang.
  • Export products to the United States that are (i) made wholly or in part in Xinjiang or (ii) made by entities that work with the Xinjiang regional government to recruit, transport, transfer, harbor, or receive forced labor out of Xinjiang.
  • Source material from Xinjiang.
  • Source material from persons working with the Xinjiang regional government or the Xinjiang Production and Construction Corps. (XPCC) in connection with government programs that use forced labor such as the “poverty alleviation” and “pairing-assistance” programs.14

This presumption is not limited to goods produced by companies that are located in Xinjiang. It also applies to products made by companies based outside of XUAR and outside of China that source material from XUAR or produce even a portion of the product inside XUAR. The law is sweeping in its scope and stacked heavily against importers seeking to release seized goods, but it should come as no surprise to companies that have been tracking U.S.-China relations. In 2019, alleged association with forced labor in Xinjiang caused the U.S. Department of Commerce to place prominent Chinese companies on the Bureau of Industry and Security’s Entity List, which prohibits U.S. companies from exporting to entities on the list. Since then, the U.S. government has dramatically expanded the use of the Entity List as a tool to protect U.S. national security.

In connection with its mandate to enforce the UFLPA, Customs and Border Protection (CBP) has begun to inform importers of the level of supply chain due diligence and tracing required to rebut the presumption of forced labor.15 CBP will require importers to demonstrate that they have serious, enforceable, and enforced supply chain due diligence policies and procedures and require their own suppliers to have them as well. CBP requires importers to provide supply chain tracing information in the form of information on producers, suppliers, exporters, purchase orders, invoices, certificates of origin, payment records, and any other documents that allow an importer to trace the supply chain and demonstrate that it is free of forced labor. CBP has also suggested importers can produce a supply chain map that identifies each entity, worker information (including pay), and audit reports regarding working conditions.16 Companies that do not have this information about their Chinese supply chains should begin taking steps to obtain it. CBP has made clear that invoking China’s antisanctions laws to explain lack of supply chain documentation will not be sufficient to rebut the presumption of forced labor.

If enforced to the letter, the UFLPA can lead to broad disruption in the polysilicon supply chain in particular, impacting solar projects and creating uncertainty similar to that created by the U.S. Department of Commerce investigation into alleged solar panel China duty circumvention in Cambodia, Malaysia, Thailand, and Vietnam. There, the solar industry convinced President Biden to issue an emergency declaration directing the Secretary of Commerce to consider waiving or suspending any cash deposits or duties imposed in connection with circumvention. But it is unlikely the administration or U.S. companies will have the political will to seek a similar type of intervention to prevent the enforcement of forced labor laws.

Planning for the Global Supply Chain of the Future

 Checkmark Adapt to and comply with restrictions imposed to achieve geopolitical goals.
 Checkmark Make compliance with sanctions a boardroom level issue.17
 Checkmark Adopt careful scenario planning to evaluate options beyond China.

There are several lessons that U.S. and multinational companies can take from the U.S. response to Russia’s invasion of Ukraine and to further steps toward a U.S.-China decoupling and the ongoing regionalization of the world economy:

First, companies must understand that governments can and will use their power to issue sanctions and export controls to punish or prevent geopolitical behavior they find to be intolerable. Western governments turned Russia into a pariah state in a matter of days. The UFLPA was passed on an overwhelmingly bipartisan basis during one of the most partisan times in the U.S.’s history. And as discussed above, China has taken steps to isolate itself from the U.S., and it still has many more tools at its disposal to further isolate itself and keep the West at bay. This means that governments expect companies to adapt to and comply with restrictions imposed to achieve geopolitical goals. While this has been a given in China and Russia, rarely since the Cold War has corporate America been asked to operate under such conditions.

Second, the U.S. government expects companies to treat compliance with sanctions as a boardroom level issue. The SEC has directed companies to identify by name the board members responsible for Russia sanctions compliance. Congress also has required CBP to publish details of all instances in which importers successfully rebut the presumption of forced labor. This means that Western governments expect to hold individuals and companies accountable for furthering their geopolitical objectives.

Third, China has been seeking to expand its global influence for years. From the Belt & Road Initiative in Africa, Eastern Europe, and Asia, to its pursuit of diplomatic relations with Latin American and Caribbean countries that had been aligned for years with Taiwan, China’s reach can be felt far outside China. Therefore, when companies evaluate their own geopolitical supply chain risks, they must look beyond China to China’s entire sphere of influence. While there is no formula for assessing risks associated with sourcing from allies of an increasingly isolationist power, careful scenario planning should help companies better understand when and how such risks will likely manifest themselves.

Companies that have not begun scenario planning for further global supply chain disruption should start to do so now. They must ensure that senior management understands the existing supply chain in the context of geopolitical risk, and know if they are sourcing materials from XUAR or from other companies that are associated with rights violations in XUAR. Companies should also understand their supply chain exposure to China, generally. Multinational entities should assess the geopolitical risks and exposure of their suppliers and sub-suppliers. If Russia’s sights are set on Eastern Europe, companies with operations in Estonia and Latvia may be at risk. Companies must decide whether to source materials and products from elsewhere, or they may wish to assess the feasibility of assisting with relocation. If the relationship between China and the U.S. deteriorates, either country may impose severe restrictions on commercial relationships with the other. Companies should look to the UFLPA guidance document to ascertain whether they conduct the kind of supply chain tracing and supply chain due diligence that CBP expects. This will help companies better understand their own supply chains even if they do not have exposure to XUAR.

Companies should also consider whether and how to incorporate redundancy into their supply chains. Any organization with heavy reliance on China or Eastern Europe can consider reshoring, nearshoring to Mexico or Latin America, or even far shoring in other countries in Southeast Asia or Northern Europe. Finally, companies should consider gaming out geopolitical conflict scenarios to better grasp whether they have material weaknesses that can be mitigated through early planning.

Conclusion

If you have any questions about scenario planning, please contact the authors, Michael Walsh or David Simon. Mike and David have worked together to design and execute tabletop exercises and scenario plans for companies with varying levels of exposure to Eastern European and Chinese supply chain risk, and they would welcome the opportunity to work with you to discuss your company’s risk profile and scenario planning needs.

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3 Foreign, Commonwealth & Development Office, UK sanctions relating to Russia (Updated June 24, 2022)

4 European Commission, EU Sanctions Map (Updated June 2, 2022)

5 U.S. Department of Commerce, Bureau of Industry and Security, Resources On Export Controls Implements In Response to Russia’s Invasion of Ukraine (Updated June 28, 2022)

6 U.S. Department of the Treasury, Ukraine-/Russia-related Sanctions (Accessed July 11, 2022)

7 Husisian, Gregory et al., Understanding and Coping with the Sweeping New Russian and Belarussian Sanctions & Export Controls, Foley & Lardner LLP (March 14, 2022)

9 U.S. Department of State, Military-Civil Fusion and the People’s Republic of China (May 1, 2020)

10 Campbell, Charlie,The Rising Costs of China’s Zero-COVID Policy, TIME (May 31, 2022)

12 U.S. Department of State, China Travel Advisory (Accessed July 11, 2022)

14 U.S. Customs and Border Protection, Uyghur Forced Labor Prevention Act (Updated June 28, 2022)

15 Husisian, Greg, “Enhanced U.S. Government Scrutiny of Supply Chains Increases Compliance Expectations for U.S. Companies that Source from or Operate Abroad”, Top Legal Issues Facing the Manufacturing Sector in 2022, Foley & Lardner LLP (July 6, 2022)

16 U.S. Customs and Border Protection, Operational Guidance for Importers (June 13, 2022)

17 Simon, David et al., “Human Rights Compliance in Supply Chains”, Top Legal Issues Facing the Manufacturing Sector in 2022, Foley & Lardner LLP (July 6, 2022)

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