Until April, the question for markets was whether there would be a near-term deal between the US and China. Today, market participants are wondering whether the recent escalation in tensions is a sign that the US-China relationship is changing irrevocably into a permanent rivalry. Are the diplomatic fireworks a harbinger of the end or do they, in fact, herald a never-ending conflict between two superpowers? On closer inspection it turns out that both outcomes may amount to the same thing.
The end of the beginning
Even if the trade negotiations resolve themselves satisfactorily, they will do so with some enforcement mechanism. Perhaps, as some have suggested, this will take the form of a standing task force with headquarters in Beijing and Washington, with frequent reviews. If that is the case, the enforcement mechanism transforms a short-term solution into a long-term one. Any such process will probably be a source of geopolitical friction throughout its existence. As a result, no matter what happens next, 2019 is likely to be the end of the beginning, not the end of US-China competition.
After 40 years of convergence, the US and China are now competing actively in many areas. Trade is just one part of a broader realignment in the US-China relationship — the most consequential bilateral relationship of the 21st century. That competition is likely to take place in four major areas: the economy, defence, technology, and ideology — though whether competition can be contained in these neat categories is a real question.
Let’s say it can.
Of these four areas, it is technology that is likely to be the most contentious over a secular horizon, which we define as the next 5-10 years. Whereas the Cold War dispute between the US and the USSR took place along geographic spheres of influence, that is the wrong model for the US-China dispute, which will instead be focused on technology.
First, there is little ideological competition between the US and China. China has not tried to export its political model around the world in the way the Soviet Union did.
Second, there is substantial defence competition, but for the moment it is playing out primarily in the cyber world rather than in physical war (barring some exceptions like the near collision in October between US and Chinese warships in the South China Sea). The US and China will continue to disagree about Taiwan and China’s various territorial claims, but for the moment that does not look likely as a source of immediate escalation.
Third, there has been substantial economic competition between the US and China, but there is also immense cooperation. The US and China should continue to benefit from each other’s growth. Full economic decoupling still seems unfeasible given the scale of the US and China economic and financial relationship. Niall Ferguson and Moritz Schularick’s 'Chimerica' is still alive.
It is, ultimately, technological decoupling that is much more likely, especially in technologies that influence national security, and here it is not clear whether US and Chinese interests are compatible. Definitions of what constitute matters of national security seem to be broadening.
Already, Beijing’s great firewall has long kept many US internet firms out of China. The world’s ten largest internet companies are all American or Chinese, and all operate largely in different markets.
Meanwhile, the US is starting to act aggressively to constrain the creation of new Chinese technology companies and the Chinese government’s acquisition of new technologies. Both the US and Europe are now scrutinising Chinese FDI. Export controls of US technology to Chinese buyers are being mooted. Visa applications for Chinese students are being denied. Established companies are pursuing new listings in friendlier jurisdictions.
Technology, therefore, is already at the forefront of the US-China trade conflict and is likely to be there for the foreseeable future. The so-called trade war is giving way to a 'tech war.'
The battle for primacy
As we explore in ‘China is no longer a copycat’, China is fast becoming a leader in many areas of scientific research and their commercial applications. That technological progress, according to Chinese observers, is the root cause of the US-China rivalry, even though it may be most immediately expressed in US claims that these firms have facilitated espionage and violated sanctions.
For Chinese analysts, claims like the US Secretary of State’s recent warning that Chinese involvement in building 5G mobile networks will “open doors for Beijing’s spymasters” are purely a smokescreen. From sanctions on ZTE to the arrest of Huawei employees, they regard actions against Chinese firms as salvos in the battle for primacy in the global tech sector.
The release of Made in China 2025 — which named 10 manufacturing and industrial areas that Beijing wants to dominate — led Washington to respond with what some are calling a 'technological containment' policy — aimed particularly at the Chinese semiconductor, telecoms, aerospace and biotech industries.
This containment policy includes: prohibiting US companies from selling core technologies and equipment to China; restricting Chinese investment in US tech firms; limiting sales of Chinese tech products in the US and allied countries; curtailing knowledge-transfer and academic exchanges with China; and prosecuting US-based Chinese scientists and engineers on spy charges.
How will China react to the US technological containment policy?
From the view of our Chinese sources, Beijing will have no choice but to counter these perceived challenges with initiatives to accelerate technological decoupling. The Chinese will likely do so in the following ways:
1. Enhancing IP protections
As China becomes a source of innovation in its own right, it is going to be important to enhance intellectual property (IP) protections. These are being done, for example, by establishing China’s first IP appeals court. Patent law is also being amended to make it easier for patentholders to defend their rights. Although these reforms are partly a response to US complaints about IP theft, they also reflect China’s growing confidence in its own technological achievements. China hopes stronger IP protections will encourage domestic research and development (R&D) spending and attract investment from overseas technology firms.
2. Ramping up R&D expenditure
In 2000, China spent just 0.9% of its GDP on R&D, according to the OECD. By 2017, that figure had swelled to 2.1%. Though Chinese research spending relative to economic output still lags that of Japan (3.2%) and the US (2.8%), it continues to rise and astonishingly is already higher than that of the eurozone (see Figure 1). The country is targeting R&D expenditure of 2.5% of GDP by 2020. In 2018, the US National Science Foundation declared China to be the world’s largest producer of scientific articles.
Beneath the headline numbers, the emphasis is shifting towards cutting-edge research. In 2016, about 85% of R&D expenditure was on ‘development’ (creating new products using existing knowledge and technologies). Now the focus is switching more to ‘research’ (seeking scientific breakthroughs), including in areas like artificial intelligence and neuroscience.
Figure 1: R&D spending/GDP (%)
Source: OECD, May 2019.
3. Improving access to tech funding
China is also seeking to facilitate tech companies’ access to funding. Launched in November 2018 by the Shanghai Stock Exchange, the Science and Technology Innovation Board makes it easier for tech start-ups to list, for example by lowering the profitability hurdle relative to other boards. By mid-April this year, the exchange had received 72 applications for initial public offerings, 16 of which were from biomedical companies (see Figure 2). The recent decision of Chinese chipmaker SMIC, which announced they would delist from the NYSE, as well as Alibaba’s weighing an additional listing in Hong Kong, are other signs of the shifting funding landscape.
Figure 2: IPO applications for the Shanghai Stock Exchange’s Science and Technology Innovation Board
Source: www.iyiou.com, May 2019. This chart has been redrawn by Investec Asset Management.
4. Encouraging a reverse brain drain
China will move up the value chain by attracting good scientists and engineers back from the United States. Already, Chinese institutions are offering higher salaries to retain domestic talent and attract international experts. Chinese institutions commonly now offer postdoc programmes with salaries equivalent to the average earnings of US academics at the same level, according to the China Postdoctoral Science Foundation. The Chinese are encouraging listings on the Shanghai Science and Technology Innovation Board as it tries to replicate the Nasdaq in China. China’s clear goal is to begin exporting intellectual property to the rest of the world.
As our Chinese sources see it, these efforts are being bolstered by US counterintelligence measures. Spying charges against US-based Chinese scientists are reportedly deterring some Chinese experts from working in America. Figures from China’s Ministry of Education indicate that, of the Chinese students who graduated overseas between 1978 to 2018, 85% had returned home by the end of 2018, up from 72% in 2011.
5. Pivoting to Europe
With the US restricting access, China hopes to expand its collaboration with Europe, including its technology links. Although the US is pushing other governments to blacklist Chinese firms from involvement in sensitive tech projects, Beijing believes that US-European ties have been weakened by Washington’s America-first trade policy. In addition, it expects Europe’s sluggish growth prospects to encourage EU members to seek more business with China.
Though some EU member states have voiced national security concerns, Europe as a whole does not appear to be about to close the door on Chinese tech companies. For instance, following a summit this April, the EU and China agreed to cooperate further on developing 5G mobile networks and other joint technology initiatives.
If the US and China are indeed engaged in a tech war, what might this mean?
Consequences for Chinese firms
In the longer-term, the ascendance of China’s tech industries will be difficult to derail. There are important technological gaps, such as in semiconductors. But the rise of large tech platforms in China is a sign that China can already compete with the West at the technological frontier.
It is also possible that deeper trade ties with other developed nations may replace some of the US business lost due to restrictions imposed on national-security grounds.
Chinese analysts are aware that one broad vulnerability for China is that its semiconductor manufacturers do not make high-end chips (for now, it is investing heavily to remedy this). Consequently, many Chinese tech businesses rely on foreign suppliers for crucial components, exposing them to US export bans. However, the expectation is that a total prohibition on chip exports to China would greatly disrupt the supply chains of leading US businesses. Despite the recent escalation, ultimately targeted measures are more likely, giving China time to build up its own production base. Analysts estimate China is 10 years behind in designing the high-end chips of the kind used in Huawei’s switches and routers. However, as the example of South Korea’s Samsung shows, it is possible to achieve technological dominance relatively quickly despite starting from a low base.
US attempts to encourage governments to blacklist Chinese technology firms could hurt China’s telecoms sector, among others. Australia and Japan have effectively banned Huawei from providing 5G mobile technology. As yet, other states appear less inclined to follow suit. For instance, the Malaysian Prime Minister recently said that Malaysia will continue to use Huawei products “as much as possible.”
In recent years, Chinese aerospace companies have been investing in Western companies to acquire technologies. But unless US-China relations improve, future deals may be blocked on national security grounds. Another potential obstacle for Chinese aerospace manufacturers is that they need to obtain international safety certifications to enter global markets. That process is controlled by US and European agencies.
China’s biotech and pharma industries could be hampered in three ways: by US restrictions on working visas and academic exchanges; by limits on the ability of Chinese companies to outsource biotech research to the US; and by the withholding of US regulatory approvals, which are regarded as the global benchmark.
Potential consequences for US businesses
There is little chance that a prolonged tech war between the US and China would not leave American business unscathed. Of course, some large-cap US tech companies do very little business in China. Facebook, Google, and Twitter’s market share in China are all close to zero.
But for most large US companies, China has been an important part of their expansion strategy. For example, China is the largest automobile market in the world and US firms have been doing less well there recently. Sales of American cars in China fell 25% between January to May 2019 compared to the same period the preceding year. This was ten percentage points more than the overall decline in passenger cars1.
Meanwhile, the most exposed target is Huawei’s smartphone rival Apple, which gets about a fifth of its revenue from China in addition to manufacturing its iPhones there. An Apple ban in China would scythe earnings by up to 30%, by some estimates2.
It’s not just the odd American company. Fifty-seven companies in the S&P 500 get more than 10% of their sales from China, and the list is dominated by the technological frontier of the US economy, including firms like Qualcomm, Texas Instruments, Nvidia, Apple, and Microsoft. In semiconductors, the average figure is closer to 40%.
They also include consumer companies that have made a big bet on China as well, such as Tiffany’s, McDonalds, Starbucks, and Nike — all stalwarts of the quality growth firms that have dominated indices in the post-crash period.
Irrespective of how a tech war with China may or may not unfold, the backdrop is becoming much less favourable for the companies that have dominated US stock-market leaderboards in recent years.
Perhaps the biggest risk of a US-China dispute is the long-term evolution of Chinese firms and the possibility that they will eclipse US firms. The trade dispute has finally given Chinese reformers the cudgel they need to persuade vested interests to reform. Somewhat ironically, China may finally put in place institutional reforms like IP protection and boosting private sector funding that will give its firms an edge.
Moreover, the US business community may simply be underestimating the size and scale of the domestic market in China as an endogenous source for iterative innovation. The consensus view until just a few years ago is that authoritarian systems and high-level innovation were mutually incompatible, but the rise of China’s tech giants is an obvious rejoinder.
Figure 3: Exposure to China of MSCI US corporations by industry
Source: MSCI, Factset, Bloomberg, JPMorgan Quant. Universe: Global listed stocks > $100mcap and covered by at least 2 brokers. As at 02.05.19.
Are we seeing the unwind of globalisation?
Ultimately, it is clear that technology is quickly becoming the most significant area of competition between the US and China. There are other dimensions, including the economy, ideology and security, but technology is the key battleground.
How the tech war interacts with the ongoing trade dispute is the key question. Many still expect President Trump to relax tariffs on China but maintain technological controls over the long haul. One caution is that this kind of an outcome is unlikely to prove very stable. More likely, it will be a source of friction in the years ahead because it will be seen in China as a hostile act.
Unfortunately, the status quo — of restriction-free trade — is also unstable, because US Republicans have already declared it as untenable, and with contentious US elections looming in 2020, there has so far been little sign of the Democrats taking a conciliatory line. Markets will likely have to navigate technology and trade disputes for many years, because what the US and China want — technology supremacy — may prove to be fundamentally incompatible. Given the twists and turns that await the US-China relationship, active managers will have to be nimble, and be mindful of political risk.
Ultimately, 2019 may be seen in the future as the year in which the global economy began to unwind the globalisation of the last 30 years, at great expense. This will certainly be challenging for shareholder returns as high margins come under pressure from the trade dispute. To the extent that the current dispute forces China to carry out long-planned institutional reforms and boost its own technology sector, 2019 may be seen as the beginning of a long term decoupling: a two-sided global economy, each bloc viable without the other, and each increasingly spinning in their own orbits.
General risks: The value of investments, and any income generated from them, can fall as well as rise.