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Investment views

From trade war to tech war

3 July 2019
Author: Sahil MahtaniStrategist

Technology is quickly becoming the most significant area of competition in the US-China rivalry. How the tech war interacts with the ongoing trade dispute is the key question. Will a trade deal settle the issue in the near term? Sahil Mahtani and Lindsay Williams discuss.



Lindsay Williams: Let’s talk about the US-China trade war, with a specific reference to the tech aspect of this trade war, which has been rumbling on for months and months and months now. With me is Sahil Mahtani, who is Strategist at Investec’s Investment Institute. Just before we get into your analysis, because you have written a very in-depth piece, how serious is it because, as I said in my introduction, it really is rumbling on?

Sahil Mahtani: Thanks, Lindsay. Well, it looks pretty durable from where I stand. I still think we are headed for a multipolar world in a number of aspects. But, even if you do get some sort of trade deal, it is going to involve a standing task force, perhaps based in Beijing and DC, and so that monitoring mechanism is going to be a source of friction throughout its life. So I think this is the beginning of the skirmish, not the end.

As you mentioned, there are a number of dimensions on this US-China competition, which was preceded by 40 years of convergence and it is now giving way to real rivalry. We have trade, of course. Technology is an important part of that and, if you look back to the Cold War between the USSR and the US, it also involved an ideological and a security component. That has not been as prevalent in this case but, given how quickly this skirmish has evolved in the last year, that is something investors will also have to be mindful of.

Lindsay Williams: Yes, indeed. Would you say that the tech war within the trade war is characterised by the Huawei situation, which I think behind the scenes probably infuriated the Chinese authorities?

Sahil Mahtani: Yes, I think Huawei is one part of it. Certainly in the UK, the big debate is about the extent to which the UK should engage China with Huawei. I think it is partly in the US about Made in China 2025, which we haven’t heard very much about but is still continuing.

If you take a step back, the story here is that China has advanced technologically in the last decade. If you look at Chinese exports’ sophistication, that has been going up. For example, China’s share of high-tech exports in the global market is now 35%, up from 5% in 1995. So that is the context – you have an increasingly sophisticated technological power that is investing in R&D and that is making the established power nervous.

In this short piece that we did, we looked at the ways China would respond to this US technological containment policy and I think our conclusion is that China will respond by doubling down. It will respond by upgrading its R&D. In 2000, Chinese R&D over GDP was just under a percent. Next year they expect it to be at 2.5%. That is already surpassing the European level, which they did in 2014.

I think China will also try to encourage a reverse brain-drain. It makes it easy because the US is actually curtailing knowledge transfer, for example by prosecuting US-based Chinese scientists on spy charges. That makes it easy for China to kind of raise salaries and provide more opportunities. We have seen some recent data that suggests that more grads are returning to China than before. It is actually around 85%, so it is very large.

The third thing we think China will do is they will pivot towards Europe because Europe is weak and divided and we have got the Belt & Road deals that they have signed with Italy and Greece. France hasn’t signed the Belt & Road agreement but it has signed a bunch of multibillion dollar deals which are quite similar to that. I think the Huawei issue is exactly how it is manifesting itself in Europe but necessarily in the US or Australia or Japan, where it is a non-issue really.

Lindsay Williams: One of the things about China to me is that they are very, very nimble. It is a huge economy but they are very nimble and they make decisions very, very quickly indeed. It is not as if they don’t need the United States because everyone needs the United States apparently, as the world’s largest economy, but China is saying okay, well, we are going to do other things to ameliorate the problems that have arisen because of the trade war instigated by the US.

Sahil Mahtani: That is exactly right and I think people underestimate the speed with which the Chinese act. I mean we see this at the company level, where you have a company like Pinduoduo, which has got half a billion users in just over 2 years. WeChat has a new programme called “jump Jump” from a few years ago, from 2 years ago rather, and they had 100 million users in 2 weeks.

Lindsay Williams: Sorry, can you say that again because that has only just sunk in – 100 million users in 2 weeks?

Sahil Mahtani: Yes and I think we all know that China, everything is dealt with in large numbers but I don’t think we know quite the effect that is having on the technological ecosystem because, when you have 100 million users in 2 weeks or 500 million users in 2 years, you can iterate very quickly.

So in Pinduoduo’s case, they managed to create something called group buying, which is a system where people gather together and buy products in groups and, as a result, get discounts and that is something they could do relatively quickly and pioneer that model because of the scale. So I think people underestimate the impact of scale as a handmaiden to – think of it as indigenous innovation in China.

Lindsay Williams: So then why is the next paragraph in the piece that you kindly sent me yesterday entitled “Isn’t China vulnerable?” It seems to me that they have gone from 0.9% R&D up to the current 2.5%. They will soon overtake the United States, which is currently at 2.8% of GDP. Where are the vulnerabilities as you see them?

Sahil Mahtani: I think semiconductors are the biggest vulnerability. Analysts look at China and they say China is 10 years behind in designing high-end chips. It is definitely investing heavily to remedy this. It is also stockpiling on a short-term basis.

If the US curtails semiconductor sales to China in a hard way, that will be problematic for China but keep in mind that 40% of sales for US semiconductor companies go to China. They would be hurting their own companies if they did that so I think there is an incentive for the US to keep sales going in some form.

Our base case is that, despite the recent escalation, tariffs are likely to be in targeted measures, giving China more time to build up its production base. It is not impossible to see China becoming a significant power in semiconductor manufacturing and design. If you look at Samsung, its rise shows that it is possible to achieve tech dominance relatively quickly.

I think another source of vulnerability is telecoms, where (as I mentioned earlier) the US, Australia, Japan and New Zealand have banned Huawei but there is actually very little sign that countries in Africa, emerging Asia and even in Europe are planning to do the same, partly because Huawei is technologically more advanced in some products than their chief two competitors but also because they are very cost-effective. So I think those are the two main vulnerabilities.

Lindsay Williams: Talking about vulnerabilities, the US isn’t immune to them either because, as you say, 57 companies in the S&P 500 get more than 10% of their sales from China. Of course, the one that everybody will know about and everybody will be familiar with and can relate to is Apple.

Sahil Mahtani: Yeah, that is right. I think there is Apple but you also have other companies that we would consider the technological frontier of the US economy. You have got firms like Qualcomm and Texas Instruments and Nvidia and Microsoft and actually there are quite a lot of the quality growth names that have really outperformed over the last decade. These include companies like Tiffany’s and McDonald’s, Starbucks and Nike. I mean these are companies that have made China an important part of their expansion strategy.

To the extent that Chinese consumers and Chinese laws start to move away from products that these companies are making, that will certainly impact the US and US investors but I think look beyond the company level and look at the impact the trade war is having on the Chinese reform agenda because the trade war is actually giving a massive boost to reformers in China and the difficult supply side reforms that were moving a little bit slowly a few years ago are accelerating. You know we look at SOE reform for Chinese companies and we have seen a mixture of mergers and acquisitions, bankruptcies, capacity closures and improving corporate governance and that has boosted profitability within these companies.

On a macro basis, if you look at Chinese credit growth, which has been far ahead of nominal GDP growth in recent years, that number has come down significantly. So that suggests that we are actually getting close to the point where credit growth in China is not contributing significantly to imbalances in the economy and I don’t think we are prepared for a period in which the Chinese economy is performing at speed without generating these imbalances.

Lindsay Williams: You have made the point that you have already made actually in your next paragraph, where you say: “we are still headed for a multipolar world no matter what”, Niall Fergusson being the economic historian that you quoted there. You say: “The US and China competition is broadening out from trade to technology and eventually to ideology and security.” To your last point, you more or less said, which can be paraphrased I suppose by an old English saying, necessity is the mother of invention, and the Chinese are reinventing themselves via the reforms you spoke of.

Sahil Mahtani: Yeah, that is exactly right and I think you should expect to see that going forward. Now, when I typically make this case to investors, they come back to me with a number of problems that they see in the Chinese economy. One of those problems is the huge stock of debt and they wonder whether the tech war and the trade war will be a catalyst for making that a problematic aspect of investments in China.

I look at that and I say look, overall debt to GDP in China is 270% and investors look at that and they have the Japan analogy from the ‘90’s in their mind and we think this is misleading. Much of the debt was actually used quite productively if you think of China’s high-speed rail system, which has a 30,000 km network, lifespan it will have, which is measured in decades.

Of course, there are ghost cities and there has been a diminishing productivity of capital in recent years but, unlike in advanced economies where actually much of the recent debt build-out has been spent on tax cuts and social spending, which, at best, maintain the productive capacity of the economy and, at worst, a pure waste, in China a hefty portion of it has been used on increasing productive capacity. These are things like railroads, bridges, modernised housing, hospitals – all these will serve China for many years to come.

Then if I just compare the capital stock in China per capita to South Korea’s or Japan’s, that figure is still less than half. That suggests that China has actually not overdone its investment build-out.

Finally, one way I think of China’s potential and productive capacity is just looking at how many people are still in rural areas. There are still 580 million people in the Chinese countryside and, if you look at the urbanisation ratio in China, it is still under 60% versus 80-90% in Europe and developed East Asia. That suggests that China has still a lot of potential and it is able to realise that potential, provided that the trade war isn’t as big of a shock. We think it can overcome those shocks at the moment.

Lindsay Williams: Yes, well, let’s hope so. I mean they won’t become an insular, self-sustaining economy like the United States of America because of their fantastic export qualities and export performances over the years but certainly they will adjust their economy (as we have both said earlier on in the interview) quite quickly compared to the western world (if I can put it that way).

Sahil Mahtani: Actually, I disagree with you there, Lindsay. I think China has the potential to be a vast continental economy of the kind that the US is. If you look at the US at the moment, partly because of their scale and partly because the dollar insulates them from foreign trade shocks, it is effectively a vast economy which trades mostly amongst itself and with a low export-to-GDP figure.

We think that is eventually where China is headed. Obviously, it has had an export-led growth model and now it is reaching a point where it is difficult to get the rest of the world to absorb those exports just because China’s sheer scale has made it difficult for the rest of the world to absorb at scale those exports. So, as a result, China will have to develop a vast domestic economy and we see actually that it is going in that direction and the reforms are succeeding. You can see that in SOE reforms. You can see that in reforms within the financial system, for example, where the wealth management products and other shadow banking activity has been curbed in recent years. So they are doing all the right things to get a vast domestic economy going.

Lindsay Williams: Sahil, it is fascinating stuff. Thank you so much for your time. That is Sahil Mahtani, who is Strategist at Investec’s Investment Institute in London.

Sahil Mahtani
Sahil Mahtani Strategist

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