The Coming ‘Breaking’ Of The China Supply Chain
The U.S. and China are official at each other’s throats. If there was any doubt that a public health crisis might cause Washington to go a little easier on China, those doubts were cast long ago. China uncertainty is back.
China, from the Trump Administration’s point of view, is to blame for the global pandemic. For punishment, Trump is talking about rolling back his promise not to increase tariffs.
“It would be extremely destabilizing if the president pulled out of the agreement without giving the Chinese a chance to meet their commitments,” says Craig Allen, president of the U.S. China Business Council, an organization representing the interests of large multinationals doing business with China.
On Friday, Trump slapped new, extra-territorial sanctions on China’s telecom systems maker Huawei. The Commerce Department implemented plans to block Huawei from obtaining even foreign-made semiconductors built using U.S. technology, that could put them out of market for Taiwenese, Japanese and South Korean semis.
“There has been a very highly technically loophole through which Huawei has been able, in effect, to use U.S. technology through foreign producers We never intended that loophole to be there,” Commerce Secretary Wilbur Ross told Maria Bartiromo on her show Mornings with Maria on Friday.
Ross also said the government has appropriated $1 billion to get rural telecom towers to remove Huawei equipment.
Is the U.S. weening itself from China? Yes. And if it’s not doing so by government mandate, it’s happening through the private sector.
“More companies are seeing that this pandemic really crippled their business and are thinking they need to diversify their supply chain,” says John Scannapieco, an attorney with Banker Donelson in Nashville.
“Companies are thinking that if this kind of thing happens again, and apparently it will, they want to diversify for that reason,” he says. “Plus it’s getting too bureaucratic now to be a foreigner in China. They are looking to other countries in Asia and Mexico. They reducing their presence and hedging their bets so they don’t get stuck from another pandemic, or politics.”
What Will Leave China First?
The first things to leave China will be anything deemed a national security issue. In the not so recent past, that was steel. In the near future, it’s going to be anything medical related — from an over-reliance on China for pharmaceutical inputs and generic drugs like ibuprofen — to simple things like personal protection equipment required to cover medical stuff from head to toe when dealing with infectious diseases.
During times of geopolitical tension, or in the face of a global pandemic like now, dependency on foreign suppliers can become a threat to national security, says a 52 page study the Henry Jackson Society in London, published this month.
This is particularly true if a major supplier emerges as a geopolitical rival, like China.
Dependency can be even more serious where the opponent has a technological lead in relation to a particular industry, because procurement of the goods elsewhere becomes nearly impossible, report authors wrote.
The U.S. is dependent on China in 16 categories, across five sectors that run the gambit between things that few really ever think of (rare earth materials — 68% from China) to things school nurses and families have at home (Vitamin C and Vitamin D — 75% from China).
You know that little red heart pill that costs a fortune at Duane Reade — CoQ-10? Well 99% of that enzyme is sourced in China, according to the Henry Jackson study.
For the U.S., China has become a tech power faster than Brazil, faster than Russia — which sent a man into space before anyone else. China did it because of intellectual property theft, the story goes in Washington.
For China, their take is that they’re just smart and hard workers and can make things without stealing American computer code.
Like the rest of the world, China is still dependent on American technology — whether its semiconductors or operating systems for its cell phones. Most of this is American IP.
“One paradigm one can cite with a high degree of confidence that will emerge dramatically different post COVID is the fault lines of the global tech cold war,” says Apjit Walia, a managing director for Deutsche Bank. “The acceleration of this 21st century cold war has the potential to split the world into two halves by a ‘Tech Wall’ – two parallel tech regimes – a U.S. centric one and a Chinese centric one, with little or no inter-operability,” he says, forcing partners to pick sides like Apple AAPL or Microsoft MSFT, only trickier because, to put it in simple terms, the Apple device won’t be able to run Word, and the Windows machine won’t be able to download items from a Mac machine.
The impact this could have on every sphere of life globally may last decades, if not generations. It is something every policy maker, institution and corporation has to bear in mind as they plan for life post-pandemic, Walia wrote in a recent report he titled “The Coming Tech Wall”.
In the previous cold war, the U.S. won the innovation race versus the Soviets by outspending them. That primary strategy eventually worked. The Soviet Union had no access to capital markets, either. So they went broke.
China has access to capital markets. In fact, Wall Street loves China. Venture capital loves China tech. Tik-Tok is Chinese. Zoom is the brainchild of a Chinese entrepreneur now living in Silicon Valley.
Thanks to China’s easy access to global capital and its talent pool, China will likely reach tech parity with the U.S. between 2025-2030, based on the data crunchers at Deutsche Bank’s dbDig, a big data platform.
The Trump strategy to slow China down, however, seems to be working.
“This would come as a surprise to several stakeholders who believe Trump’s China policies are flawed,” says Walia. They are not. But nor are they permanent.
Trump could be out of office in 8 short months. Democrats would likely try returning to the late Obama-era strategy of ring fencing China through labor and tech trade agreements like the Trans-Pacific Partnership and hope that American companies will turn to sourcing elsewhere as labor and environmental arbitrage tighten.
“Going after China alone without allies is not the way to handle this and I would assume that (Joe) Biden would go back to that diplomatic approach,” says Nicole Lamb-Hale, a managing director at Kroll, a division of Duff & Phelps in Washington, D.C. She is a former Assistant Secretary for Manufacturing and Services in the U.S. Department of Commerce’s International Trade Administration and served as the Department’s lead on the Committee on Foreign Investment in the United States.
“If we do this alone, we will have no leverage,” she says. “That’s really what TPP was about. You box China in a bit because all of southeast Asia was coming together to set a new standard. That might force China to change its ways. We walked away from that when Trump came in. I could see a Democrat moving back in that direction.”
In the meantime, China will ramp up its home grown technological capabilities.
The Greater Bay Area, their version of Silicon Valley, will be a real rival. Wait until they are able to entice Taiwanese, South Koreans, Singaporeans and Hong Kongers to come in and build a better mouse trip. It’ll happen.
Proponents of a decoupling from China say that the only way to get them to play by the rules would be to punish them financially. Some in the market are worried that financial sanctions on China’s state owned banks, the largest corporations in the world based on the recently released Forbes Global 2000, would be the beginning of the end of the U.S.-China relationship, dividing the world — perhaps — between the Western capitalist democracies, and the top-down managerial style of the Chinese communist party’s state-directed capitalist model.
Alone Or With Partners?
Even Adam Smith – the “father of free trade” – made clear that it was undesirable for a country to become dependent on its neighbors for key products lest it become unable to protect itself in times of crises.
See the Western world’s lack of ventilators and surgical masks as exhibit A.
Still, there is a positive way, and a negative way to work through what appears to be an obvious desire to remove some supply from mainland China.
From the Henry Jackson Society’s report, negative decoupling will happen if the U.S. and its allies decided to:
1. Adopt legislation and establish mechanisms to constrain Chinese entities from gaining control over strategic industries;
2. Act punitively together against Chinese enterprises that have engaged in unfair trading practices, such as joint sanctions. Right now only the U.S. has sanctions on Hikvision, for example, a partially state owned surveillance systems manufacturer whose cameras guard facilities holding Uighur Muslims in Western China.
3. Enact incremental legislation, at national level, to reduce import dependencies on China.
Then there’s what the report authors call a more positive decoupling, one that does not seek to smash China in the mouth.
1.Adopting a national economic strategy to ensure secure access to goods required to meet strategic industrial needs, which includes localizing these items.
2. Develop a national infrastructure strategy to reduce dependencies caused by China’s mercantile market distortions in an effort to strengthen independence from China supply chains in key, high paying job creating areas, namely electronic communications, transportation tech, and building national infrastructure, such as better ports utilizing automation to drive down the costs of trading among countries.
This requires the U.S. to focus on STEM subjects in schools instead of the arts and humanities. We are either going to build the world’s best tech, or a few of us will be lucky enough to be able to sing and dance for their CEOs.
Moreover, government and private sector funding for research and development is needed to uphold and restore technological leadership instead of using the money for share buybacks.
A strategic supply chain shift is in the cards.
The Anglo-American Five Eyes countries — U.S., U.K., Canada, Australia and New Zealand — have long been at the vanguard of global development. They have often stood together to resist challenges to the rules-based international system, a system people like Trump believe has been corrupted, in favor of transnational finance and purposefully homeless corporations with no allegiance to a national commonwealth.
If the system is broken, as Trump and the China hawks will attest, then it sets the table for the U.S. to go it alone.
That puts some of the onus on the other countries to try and woo Washington to the table, especially if Trump is re-elected and the desire to break away from China persists next year. But if they don’t come together, it sends the signal to markets that the world’s No. 1 economy will be taking on the world’s No. 2 by itself.
“Nationalist forces in China and in the United States means that there is likely a 60% chance that China will drop the phase one trade agreement given how egregious it is,” says Sebastien Galy, macro strategist for Nordea Asset Management in Luxembourg.
Viewed from China, the odds of the U.S. taking action against them on trade are even higher.
China understands the risk is due, in part, to the presidential campaign.
Investors are not relearning that China trade uncertainty, put to rest for the most part in December, is now back.