US-China relations are as precarious as ever: during his State of the Union address last week, US President Donald Trump took aim at China, vowing to end what he described as China’s “theft” of American jobs. He added that a trade deal with China would require “structural changes to end unfair trade practices”1.
This week US negotiators are in Beijing in attempt to reach an agreement by the 1 March deadline set by Trump. Failure to reach a deal could raise the stakes in the global trade dispute.
But what is the sticking point in this costly trade war?
The ‘Made in China 2025’ (MIC2025) policy – a plan to upgrade the country’s manufacturing capability to mirror its world-class physical infrastructure.
China intends to ensure its competitiveness through adopting advanced technology in manufacturing, using robotics, 5G, artificial intelligence, and the internet of things. This strategy sits at the top of President Xi Jinping’s economic agenda, part and parcel of his strategy to create a sustainable economic model.
Unfortunately for China, the Trump administration has put the industries and products associated with this plan at the very heart of the trade dispute.
Beijing has dropped references to MIC2025, an initiative it has promoted aggressively since 2015, since the trade war erupted and the country’s official media has toned down its blaring patriotic praise of the strategy too. But there is scant chance that Beijing will really back away from the most important industrial upgrade in China’s history.
On the contrary, external pressure – especially the threat of sanctions from the US on key technologies and industrial products – will push Beijing to pour more capital and administrative resources into boosting technological upgrades and self-sufficiency across the most strategic industries.
Beyond shrinking the trade deficit, the Trump administration’s agenda is really aimed at preventing China’s rise as a rival power and thus US-China policy is starting to bear a striking resemblance to economic warfare.
Trump is demanding stronger Chinese protections for US intellectual property, an end to forced technology transfers and greater market access to China for US companies. To force these developments, the US government has imposed 10-25% tariffs on $250bn worth of Chinese imports, tightened controls over China’s investment in US tech companies, and set export sanctions on several Chinese tech companies.
The trade war has already begun to lead multinational companies to relocate, threatening China’s current economy and its plans to upgrade its technology. If the dispute escalates further, however, China can lower the temperature by scaling back self-sufficiency targets, improving protection for intellectual property, and tilting the playing field back a little to help foreign and domestic private companies versus state-owned enterprises (SOEs).
But we see little chance of MIC2025 being abandoned; instead, it is likely that Beijing will publish a new national strategy for technology development under a new name. Unfortunately for China, this and other initial adjustments to the MIC2025 plan are not likely to appease US hawks. Tighter restrictions on access to US technology are already being strengthened and will likely remain in place over the long term.
The potential damage to China’s industrial future is hard to quantify but important for investors to consider. If the US government sets more restrictions on Chinese students and researchers studying in US universities, or blocks the acquisition of Silicon Valley start-ups by China’s venture-capital funds and tech giants, the pace of knowledge acquisition in China may slow appreciably.
Of course, the US will suffer as well. Removing Huawei from the list of potential suppliers of 5G technology, an essential building block of the digital economy, leaves the US exposed to a duopoly.
A ‘Made in China’ Plan B is thus likely to disguise its ambitious import replacement/copyright control objectives and concentrate overwhelmingly on industrial upgrading and the development of specific technologies. The self-sufficiency targets may become 'internal' objectives known only to industry regulators and key domestic players, and will be diluted to reflect a more long-term roadmap of technological development. The highest priority for self-sufficiency will remain semiconductors – though the deadline will likely slip – given their increasingly central role in the rest of industry and China’s now obvious vulnerability to foreign restrictions in this area.
An additional American demand is for reduced levels of state support for SOEs. These adjustments may already be underway on the Chinese side. Amid the escalation of the US-China trade war, Premier Li Keqiang, Vice Premier Liu He, Minister of Industry and Information Technology Miao Wei and other senior government officials promised to offer "fair treatment” to all types of enterprises – including foreign firms – in the execution of the MIC2025 plan2. This fair treatment would include equal access to government auctions, subsidies and information resources.
Although some scepticism of Beijing’s promises is usually advisable, the need to prevent the US-China trade war from destroying China’s supply chain has led Beijing to take these particular commitments seriously this time. As one of the key steps towards 'fairer treatment' Beijing has eased ownership restrictions on foreign firms’ investment in China, for example by allowing Tesla, BASF and Exxon Mobil to build new, wholly-owned plants, and letting BMW buy a majority stake in its China JV Brilliance Automotive. Increased ownership of their Chinese subsidiaries will alleviate some of the forced technology transfer concerns. The authorities have proposed a ban on "forced technology transfer" in the recent draft of the Foreign Investment Law, published by the National People’s Congress, which could then be approved over the next 15 months or so3.
And reaching agreement on reforming China’s SOE subsidies could prove much harder; existing government support is huge. Total government subsidies reached an estimated Rmb800bn in 20174, accounting for 4% of total government spending and 1% of GDP. Further complicating matters is the fact that a large proportion of local government subsidies are issued with the primary goal of keeping local enterprises operating (along with their employment and tax payments). If the primary purpose of the subsidies had been R&D or innovation, cuts would have been easier to achieve.
Quite apart from the US demand for removing subsidies, China may be considering taking the initiative itself in this area. High levels of local-government debt and excess capacity make large subsidies increasingly unaffordable and therefore it would make sense to cut them. Limited fiscal resources would become concentrated on the most important industries such as semiconductors, robotics and pharmaceuticals, and government subsidies to less strategic industries would shrink.
The ongoing US-China trade war and the spotlight it has shone on the MIC2025 strategy is merely a symptom of the rising strategic competition between the two nations.
China cannot and will not make the wholesale changes in its political economy that the US is demanding, but the political desire from both Xi and Trump to achieve a 'deal' is high.
Thus, chances are that concessions will be made and trade pressures will gradually ease over the near term. The superpower rivalry, however, is here to stay.
1 “State of the Union: Trump vows to end China's job 'theft',” published by the BBC on 6 February 2019.
2 “China drafts law to ban forced tech transfer from foreign partners," published by the Financial Times on 24 December 2018.
3 “Plan B: Reshaping made in China 2025,” published by CLSA on 16 January 2019.
The views and opinions contained herein are those of Gary Greenberg, Head of Global Emerging Markets, and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products. This commentary is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments.