Source: MERICS

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Critics, in particular, pointed out that China’s setting of quotas for self-sufficiency constitutes a violation of WTO rules against technology substitution. The supply chains for hi-tech products usually span across many borders, with highly specialized components often produced in one country and modified or assembled somewhere else. Rather than abiding by the free market and rule-based trade, China is intent on subsuming the entire global hi-tech supply chain through subsidizing domestic industry and mercantilist industrial policies. Semi-official documents lay out even more specific quotas for Chinese manufacturers. In its defence, China's Ministry of Industry and Information Technology (MIIT) insists these targets are not official policy. A report from the Mercator Institute for Chinese Studies, however, argues that officials are using internal or semi-official documents to communicate targets to Chinese enterprises in order not to openly violate WTO rules.[5]

 

Increasingly, foreign governments are viewing Chinese investments, especially those intent on taking over firms with proprietary technologies, as challenges and threats. By itself, merger and acquisitions activities between companies are common and are therefore neither surprising nor objectionable. In the case of China, however, critics are quick to point out that technology acquisitions are partly supported and guided by the state through highly opaque investor networks. This explains why the recent $146-billion (€122-billion) bid by Singapore-controlled Broadcom to take over US chip giant Qualcomm was blocked by US President Donald Trump on the ground that US national security interests would be threatened by such a large scale technology transfer to Asia even though Broadcom, on the book, is not China-owned.

 

Because of Beijing’s involvements, Chinese high-tech investments are regarded as not purely business transaction. The crux of the issue is not whether the state involvement undermines the principles of fair competition. Rather, the fear of foreign governments is that China’s state-led economic system is exploiting the openness of market economies in Europe and the US to systematically acquire cutting-edge technology and generate large-scale technology transfer.

 

In April 2018, the Germany’s head of domestic intelligence urged vigilance about increased moves by Chinese companies investing in and acquiring high-technology German companies, warning the loss of key technologies could harm the German economy. He said intelligence officials had been initially puzzled by a sharp drop in Chinese cyber espionage activities about two years ago, but then realised that Beijing was simply exploiting the openness of market economies in Europe and the US to gain access to German know-how legally.[6]

 

The warning came amid German economy ministry review of a Chinese bid for aerospace supplier Cotesa, a move which could lead to Berlin blocking the sale. Early in 2016, concerns were raised over possible loss of sensitive technology when Chinese household appliance manufacturer Midea acquired a 76.4% stake in KUKA, a German industrial robot powerhouse. The sale went through on the agreement that KUKA would not have to share any of its intellectual property or sensitive customer data with Midea and that KUKA’s leadership would run independent without interference from the Chinese side. Moreover, the company’s headquarter would remain in Germany and all of its 12,300 jobs are guaranteed to be preserved. However, the agreement would stand only until 2023.[7]

 

To protect sensitive technologies from falling into “wrong” hands, the European Union is reportedly working to complete a new screening mechanism to better control Chinese and other foreign takeovers of sensitive technologies by the end of the year.

 

In the US, the Obama administration had spent years pressuring Beijing to rein in illegal commercial cyber espionage. It is only now that the US is beginning to grapple with the repercussions of Chinese investment and technology transfer agreements which are legal. Because the U.S. economy is open, foreign investors, including those from China, are able to invest in the newest and most relevant technologies gaining experience with those technologies at the same rate as the US does.

 

Currently, the primary tool the government has to block or mitigate foreign investment is the Committee on Foreign Investment in the United States (CFIUS). However, since CFIUS reviews specific deals on a case-by-case basis, rather than systematic assessments of acquisitions or acquirers, it will only look into deals that involve a controlling interest by foreign investors. CFIUS is only partially effective in protecting national security since its jurisdiction is limited.

 

China invested some $64 billion in the US between 1990 and 2015 but in 2016 alone, Chinese foreign direct investments (FDI) amounted to $45.6 billion, triple that of 2015. As of end of 2016, the majority of the cumulative Chinese FDI of $109 billion went to real estate and hospitality industries, information and communications technology, as well as entertainment and financial services.[8] One area that has got alarm bells ringing in recent years though is Chinese venture capital funding in new US startups working on early-stage technologies that would be foundational to future innovations: artificial intelligence, autonomous vehicles, augmented/virtual reality, robotics and blockchain technology. Between 2015 and 2017, Chinese participation in venture-backed startups reached a record level of 10-16% of all venture deals, up from 6% during 2010-2015. Potentially such investments could lead to transfer of new technologies that could, over the long term, accelerate growth of the Chinese economy at the expense of the US’.

 

Moreover, some of these dual-use technologies are of interest to the US Defense Department to create the Third Offset strategy. Losing them to China would constitute a serious threat to national security. This has struck the raw nerve of American policymakers who were alarmed by how quickly China has managed to modernize its military in recent years, supposedly by stealing technologies from the US, including through cyber theft and industrial espionage. According to the US Defense Innovation Unit Experimental (DIUx), cost of intellectual property stolen by China has been estimated at $300 billion per year.[9]

 

[What is Third Offset Strategy? US military superiority since World War II has relied on both US economic scale and technological superiority. US technological pre-eminence enabled the series of offset strategies which included being first with nuclear weapons (the First Offset) and the electronics-enabled weapons of night vision, laser-guided bombs, stealth and jamming technologies as well as spaced-based military communications and navigation enabling the U.S. to dominate the battlefield (the Second Offset). Countries like Russia and China have caught up with US in terms of military technology to nullify advantages the US military has based on the two offset strategies. US is currently working on its Third Offset strategy which would be built on the early-stage technologies China is reportedly eyeing via their VC funding in the US startups.]

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The Sino-US Trade War: More about Technology than about Trade

 

The US has left little doubt that the ongoing trade war is really more about technology than about trade.[10] The USTR Section 301 report released in March 2018 cites MIC2025 a full 116 times. In contrast, China's Cybersecurity Law, which has been a perennial headache for many U.S. multinationals, is only mentioned 13 times. Of course the report also presents a searing indictment of China’s disregard for intellectual property, discrimination against foreign firms, and use of preferential industrial policies to unfairly bolster Chinese firms but the real beef was about MIC2025. Testifying before the Senate Committee on Finance, US Trade Representative Robert Lighthizer wanted all the 10 high-tech industries listed in MIC2025 to be targeted for possible tariffs, asserting that “These are things that if China dominates the world, it's bad for America.”[11]

 

Trump objective for the Sino-US trade war is therefore more about maintaining the US long-term technological edge (i.e. preventing China from unfairly acquiring core US technologies) than about addressing the trade imbalance (i.e. having China buy more US goods).[12] The US is not alone in wanting to face up to China. Many countries actually share Trump's desire to combat Chinese hi-tech mercantilism even though they were furious with Trump blanket tariffs against them.

 

European countries, for example, are quietly hoping to benefit indirectly from the Trump’s protectionist agenda. A severely strained trade relation between US and China, for example, will not only potentially improve Europe’s negotiation position with China but also result in diversion of China’s trade and investments from the US to the Europe.[13]

 

The Trump administration is not just imposing tariffs on Chinese exports to the US. It is also targeting Chinese tech companies. In April 2018, the US slapped a seven-year ban on ZTE Corp.’s purchase of components from American suppliers on the ground that ZTE ignored its pledges to resolve a sanctions dispute. The ban threatened the survival of China’s No. 2 telecommunications gear-maker. Besides ZTE, the US Justice Department is also said to be investigating whether another Chinese tech giant, Huawei Technologies Co., violated sanctions.

 

However, despite Washington's attempt to disrupt China’s effort, experts say in the long run it would be difficult to stop Beijing from emerging as a leader in a number of key industrial sectors.

 

In the short term, though, there is no question that Trump’s actions are causing pain and have injected uncertainty into the Chinese economy. Imposition of tariffs on Chinese exports to the US may induce some MNCs to relocate their manufacturing operations out of China but at the same time, Chinese retaliatory measures on US made products may attract investments to China. It is unclear what the net effect would be over the longer term for China. What can be certain is that the trade war will in the end result in rearrangements in the international value chains of MNCs, accelerating a process which in any case was already underway for some industries because of China’s rising costs.

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In response to Trump’s charges, President Xi Jinping vows a 'new phase' of opening China's economy. At the Boao Forum for Asia (博鳌亚洲论坛) in April 2018 he announced that China would raise foreign equity limits in securities, insurers and banks; ease restrictions on foreign ownership in manufacturing (ships, aircraft and autos); lower tariffs for autos and other products; and empower a new state agency to enforce the legal intellectual property of foreign firms.[14]

 

However, hoping that China will drop its MIC2025 agenda is probably more of a long shot. China will adjust some of its unfair practices but not change its course to upgrade update its industries. In the long run it will still be difficult to stop China from emerging as a leader in a number of key industrial sectors given China’s fundamental strengths, including its deep pocket, first-rate physical infrastructure, huge domestic market, and a pool of hardworking and increasingly well-educated work force. Most of all, China has an exceeding tight-knitted governance structure highly effective in moving Chinese companies in a concerted manner based on state guidance once a direction is set for the overall economy.

 

For the US, the benefits of the trade war, if it persists, are also not clear cut, not to mention also the collateral damage on the international free trade regime and the global economy. To begin with, it has been pointed out that raising tariffs risks undermining, rather than boosting, US manufacturing. In the aircraft industry, for example, the US imports parts to manufacture aircraft which are then exported to China and other foreign buyers. A proposed 25% tariff on “high-tech” imports from China, including aircraft and parts, will harm the US aircraft industry by increasing the cost of inputs and making Boeing’s products less competitive compared to its European rival, Airbus. The same story goes for US manufacturers across a range of high-tech sectors. And if China slaps retaliatory tariffs on US goods, U.S. manufacturers face the double-whammy of increased costs alongside reduced access to the Chinese market — the largest market for many US exporters. Moreover, it has been pointed out that Trump may have overestimated China’s dependence on the US market. The US market currently accounts for just 18% of China’s exports. More than 80% percent of China’s exports go elsewhere. The US no longer has the leverage to dictate trade terms to China.[15]

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Trump is acting not only on China. Claiming that the US has not benefited from free trade and has been taken advantage of by its trading partners, Trump is basically trying to dismantle the global free trade regime by disregarding WTO; walking away from new trade agreements such as the Trans-Pacific Partnership (TPP); putting on hold the US-EU Transatlantic Trade & Investment Partnership (TTIP); and reneging on existing agreements such as the North America Free Trade Area (NAFTA). Noting that “the US is one of the primary beneficiaries of the global economy” and that “the WTO and its predecessor GATT have been fundamental in ensuring open trade rules”, Professor Sharyn O’halloran of Columbia University regards Trump’s claim that the global free trade regime “has been unfair to the US and that the US has not benefited whatsoever” as one that is hard to support.

 

Trump’s rascally protectionist behaviours have prompted the rest of the world, led by EU, to act in unison to protect the global free trade regime. In July 2018, for example, EU and Japan signed the EU-Japan Economic Partnership Agreement (EPA) after nearly five years of negotiation. The agreement is reportedly the largest bilateral trade deal ever, encompassing a population of about 600 million people in 29 countries and accounting for roughly 30% of the world's GDP.[16] As for its concerns over China’s unfair trade and investment practices, EU adopted a non-confrontation approach of conducting talks with China within the framework of WTO. At the same time, EU is stepping up efforts to renew or conclude new trade agreements with Canada, Mexico, Australia, Vietnam, Singapore, Chile, Indonesia, New Zealand, Tunisia, India, and Mercosur.[17] Japan, on its part, has provided the leadership to conclude the 11-country Comprehensive and Progressive TTP without the participation of the US. Meanwhile, ASEAN is leading the way to conclude the Regional Comprehensive Economic Partnership (RCEP) involving the 10 ASEAN members and six other Asia Pacific countries namely, China, Japan, South Korea, India, Australia and New Zealand. Even though the idea was first introduced during the 19th ASEAN Summit in 2011, it was not until Trump's withdrawal from TPP in January 2017 that its chance of success became likely.

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Instead of waging a high profile and impact Sino-US trade war, critics say that Trump’s efforts could have been better used to put its house in order to meet the emerging challenges from a China on the rise. Among other things, the US can review the working of the CFIUS to better vet Chinese investment into hi-tech sectors; uphold the existing international free trade regime by using WTO to present a case against Chinese industrial policies; rejoin the Trans-Pacific Partnership, which set high bars for intellectual property protection, labour standards, and safeguards against unfair competition from state-owned enterprises; and invest in education, infrastructure, and basic science to ensure the US maintains its competitive edge.[18]

 

As Joseph Stiglitz posits in his writing “The US is at Risk of Losing a Trade War with China”, the US has a problem but it is more to do with too little saving at home than with China. Unless consumption levels and behaviours change, what the US will not buy from China has to be imported from somewhere else. Resorting to a trade war to solve an imbalance caused by bad spending habits at home may be good for political campaigning but makes poor economic sense.

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China's Responses to the Trade War​

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At a 2017 Politburo meeting to discuss economic plans for 2018, the Chinese top leaders oozed confidence then that China, as the world’s economic engine, had the power to deal with its impending trade war with the US.

 

As events unfolded in 2018, however, Trump's full-frontal assaults on China's trade with the US is slowly but surely inflicting a toll on the Chinese economy which is on track to expand in 2018 at the slowest pace in almost three decades. The slowing economic activities are in part caused by declining investments attributable to the government's deleveraging efforts since 2016.  

 

Without resorting to a big fiscal stimulus to prop up growth, optimism that the Chinese government could fight on two fronts — taming its heavy debt burden at the same time as taking on America — appeared to be dissipating.

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In December 2018, both governments announced a 90-day truce during which negotiations will be attempted to arrive at a comprehensive agreement between the two countries. As parts of its peace offering, China not only announced that it would temporarily cancel an extra 25% import tariff on American cars (imposed in retaliation for American tariffs) and resume purchases of American soyabeans, but also indicated willingness to walk away from the “Made in China 2025” blueprint that aims to turn the country into an advanced manufacturing power.  To downplay its significance, Chinese officials described it as a vague, aspirational document. References to it had all but vanished from state media and the government appeared ready to rescind it formally.

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Meanwhile, the Chinese government also wanted to show that foreign companies play on a level field. Vice Premier Liu He was said to have asked the central bank to devise guidelines for how “competitive neutrality” would work in China. The idea, promoted by the OECD rich-country club, is that state-owned companies can form part of a healthy market economy provided they enjoy no special advantages. Even before this, China had already demonstrated its willingness to open its economy to foreign firms by allowing Tesla to be the first foreign carmaker to have a wholly owned manufacturing facility in China; UBS, a Swiss bank, to be the first foreign firm to be allowed a majority stake in a Chinese brokerage; and ExxonMobil to build a wholly owned petrochemical complex, which until recently foreign firms could not do. Moreover, China had also published tougher rules for protecting intellectual property, which foreign companies have long demanded.

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One avenue Xi is pinning his hope on, not only to mitigate the adverse impacts of the trade war but also to lift China out of the middle-income gap, is the push of the private sector which is nimbler and more productive than its state-owned counterpart. China’s private sector today is responsible for 50% of tax revenue, 60% of the nation’s output, 70% of technological innovation, 80% of employment and 90% of new jobs. The sector's well-being will therefore have a great impact on the overall economy.

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However, the government's crackdown on the shadow banking system has inflicted great pain on private businesses which traditionally have depended on the unofficial banking industry to finance their operations and growth.  Lending has effectively dried up as a result of the clampdown causing shadow financing to shrink for an eighth straight month in October 2018 to the lowest since December 2016. At the same time, as the economy slowed, banks in the official sector became more reluctant to lend to smaller, often riskier companies. For rational business reasons, these banks prioritize lower-risk lending to state-owned companies backed by the government and with security of collateral that private companies often lack.

 

With funding drying up, corporate borrowers (almost all privately owned) defaulted on a record $6.6 billion of debt in the third quarter of 2018. The high default rate pushed up interest rates on private company bonds, exacerbating the squeeze. Capping it all are the higher tariffs, and greater uncertainty, caused by the trade war with the US. That’s hitting private, export-dependent companies harder than state enterprises.

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                                         Slowing pace of growth of outstanding loans to small companies

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