Corporate earnings could face a critical risk if the Trump administration decouples much of the U.S. supply chain from China in response to China’s campaign to challenge U.S. leadership in key industries.
President Donald Trump has been an unabashed trade hawk for decades. He’s called for protectionist measures since at least 1989, when he declared “I’m not afraid of a trade war,” presaging his more recent exhortation that “trade wars are good, and easy to win.”1
Historically, Americans have been very pro-trade. Today, however, a majority of citizens appears to agree with the president’s views, especially when it comes to dealing with its new rival, China—it’s no longer just about jobs. The United States is worried about China’s growing commercial and technological clout, with both sides vying for dominance over new technologies that’ll determine the economic balance of power in the 21st century.
China has changed the terms of engagement since President Xi Jinping’s ascension in 2012. While his predecessors emphasized the slogan “peaceful rise,” President Xi has been a far more assertive Chinese leader than anyone since Mao Zedong. This “new era,” as Chinese officials have taken to calling it, has celebrated and entrenched the state’s leading role in the modern economy. The key reason why tensions have ramped up recently is Made in China 2025—Beijing’s aggressive blueprint for dominating the tech industries of the future, including robotics, biomedicine, renewable energy, aerospace, communications equipment, new materials, and artificial intelligence.
Made in China 2025
U.S. policymakers have been startled by the plan’s focus on indigenous innovation and the Maoist calls for self-reliance, aspiring to achieve self-sufficiency through domestic secure and controllable technology and import substitution. Publicly proclaiming the aim of dominating critical high-tech industries has confirmed suspicions in Washington, D.C. that China isn’t looking for a win-win in trade relations.
It’s difficult to understand why Beijing didn’t foresee how its massive and pivotal state-led program would receive such a hostile reception in America. Made in China 2025 is an ambitious scheme that directs huge state subsidies at key new tech sectors that China wishes to dominate. From America’s perspective, two aspects of the blueprint are particularly worrisome: First, its reaffirmation of the government’s central role in economic planning; and second, its focus on import substitution.
Made in China 2025 expressly calls for China to achieve 70%–80% self-sufficiency in a wide range of critical, tech-heavy industries.2 Achieving such brazen market share targets clearly requires enormous government support, much of which occurs through a web of opaque subsidies. Firms associated with Made in China 2025 are provided with extensive financial assistance through a multitude of state-directed investment funds.
"China's government is aggressively working to undermine America's high-tech industries and our economic leadership through unfair trade practices and industrial policies like Made in China 2025."— U.S. Trade Representative Robert Lighthizer, June 2018
Although it’s challenging to find a comprehensive listing of all sources, it’s possible that total support could exceed an eye-popping $1 trillion. The U.S. Chamber of Commerce estimated that the Chinese government plans to spend $161 billion by 2025 to develop the semiconductor sector.3 That’s a huge sum, and it only refers to one industry.
All ten of the sectors targeted by China 2025 are viewed as key to future economic growth by both China and the United States. However, the truly breathtaking innovations are occurring in fields directly affected by artificial intelligence (AI). To illustrate, in 2017 the consulting firms PwC and McKinsey estimated that by 2030, world GDP could increase by around $15 trillion (or 14%) purely because of AI—with China being the primary beneficiary, receiving about 45% of the total gain.4, 5 This makes AI the biggest commercial opportunity in today’s dynamic economy and means the stakes are unprecedentedly high.
A focus on mercantilism
Mercantilism is a core feature of the Chinese economic system. Imports of manufactured goods from the United States represent less than 1% of GDP. China also imposes severe restrictions on foreign direct investment (FDI). According to the Organization for Economic Cooperation and Development, China maintains one of the most restrictive investment regimes with only a few countries, such as Saudi Arabia, ranking worse.6 Many sectors have rigid foreign equity restrictions or joint venture requirements. These restrictions either block opportunities, or in some cases, create a de facto technology transfer requirement to the Chinese partner as a precondition for market access.
Data compiled by Global Trade Alert, an independent U.K.-based think tank, demonstrates that China has implemented a distressingly large number of mercantilist measures over the last decade.7 While the United States and other countries have also exhibited a proclivity toward protectionism, China is in a league of its own among large economies.
Finally, the United States has unquestionably been the world leader in the commercialization of the internet. However, no U.S. website ranks in the top 20 most visited in China.8 This is a direct result of China having banned, blocked, or placed high restrictions on sites such as Google, YouTube, Facebook, Instagram, WhatsApp, Snapchat, Twitter, Pinterest, Flickr, Tumblr, Dropbox, The New York Times, Bloomberg and The Wall Street Journal.
China’s mercantilist behavior has undermined political support in the United States for free trade and openness. Anti-trade rhetoric has ramped up, the World Trade Organization (WTO) appears increasingly irrelevant, and the United States has withdrawn from the Trans-Pacific Partnership process. If the trend continues, we could end up with a segmented world trading system instead of a global one—an outcome that would be lose-lose.
The U.S. response
During the last couple decades, America’s approach to China has been founded on a belief in political and economic integration and convergence. However, by celebrating and entrenching the state’s leading role in the industries of the future, President Xi and his new era have demonstrated that convergence was never their goal.
The Trump administration has adopted an aggressive stance, demanding three key changes:
1 China must jettison the mercantilist web of rules that have systemically protected and lavishly subsidized companies in numerous sectors throughout the economy.
2 China must cease its chronic practice of purloining U.S. companies’ trade secrets through forced technology transfer, state-sponsored cyber theft, and corporate acquisitions.
3 Beijing must fully embrace the principles of reciprocity and full market access for U.S. businesses operating in or exporting to China.
In October, U.S. Vice President Mike Pence delivered a remarkable, 40-minute broadside against China that justifiably received an enormous amount of attention. In surprisingly blunt and strident terms, Pence accused China of bullying American companies and stealing their technology and intellectual property (IP). He concluded that it’s up to China to avoid a cold war, and he demanded concessions on several issues, including China’s rampant IP theft, forced technology transfer, and restricted access to Chinese markets.
While Pence’s speech received significant attention, the craftsman behind U.S. trade policy and chief China critic is Robert Lighthizer, Trump’s U.S. trade representative. Lighthizer makes a compelling case that China’s economic and political system is fundamentally incompatible with our conception of free trade rules, and has been particularly critical of the systemic noncompliance practiced by China for decades. One doesn’t have to be a trade lawyer to realize how difficult it’ll be to obtain a verifiable agreement that both countries can bring home while declaring victory. Consider the primary sticking points in the ongoing negotiations: forced technology transfer, unfair licensing requirements, corporate acquisitions, and government-backed cyber theft. Effective September 24, 2018, the United States imposed tariffs on $200 billion of Chinese imports. Ongoing negotiations, with a soft deadline of March 1, 2019, will determine whether the tariff rate is raised from 10% to 25% and whether tariffs will be applied to additional imports from China.
The global supply chain unravels
It’s been just over a decade since Thomas Friedman’s book, The World Is Flat, painted globalization as a seemingly unstoppable trend; it may have marked globalization’s peak. Yet during the past few years, global supply chains have begun to buckle, with the world’s two giant economies clearly decoupling. If the global supply chain does bifurcate, with one part centered on the United States and the other on China, which sectors would be most affected? Ground zero is likely to be all ten sectors that are targeted by Made in China 2025, especially where sensitive technologies are involved. Among the hardest-hit industries would be tech hardware—especially semiconductors—with tech software and services being less directly affected. Other exposed industries include capital goods, and possibly automobiles, as well as certain consumer durables and chemical/commodity sectors. Still, a full chasm between the two countries seems improbable, with the possibility that energy and agricultural commodities could even become beneficiaries of the new trade architecture.
As trade tensions mount, what countries are most likely to benefit by stepping into the void left by China? While relatively little would return to the United States, it’s feasible that some high-end manufacturers could move to South Korea, Taiwan, Japan, and Singapore, while the low-end manufacturing could shift to member countries of the Association of Southeast Asian Nations (ASEAN) and possibly Mexico.
Even if a relatively small percentage of existing production were relocated, or if capacity expansions began to favor these destinations, the local impact could be highly significant. FDI has been flowing solidly into the ASEAN region over the last decade, even as FDI into China has started to moderate. This suggests that the marginal relocation process is well under way, with Vietnam, Malaysia, and Thailand appearing best positioned to attract significant FDI inflows.
Manufacturing margins under pressure in 2019
If global supply chains do in fact bifurcate, what’s the likely impact on corporate margins and earnings? One channel that hasn’t received sufficient attention concerns the impact of overcapacity in the sectors that Made in China 2025 targets. Whenever countries undertake overly ambitious central planning exercises, excess capacity inevitability results. This occurred earlier in China’s development when it built out its heavy industry capabilities—steel, cement, petrochemicals. This time around, the impact is likely to prove even more wasteful. Such excess capacity will probably drive down margins and profitability in most Made in China 2025 industries—not just in China, but globally.
Still more worrisome is the prospect that decades of progress toward globalization could be unwound. International trade accelerated from 1990, following the fall of the Berlin Wall, and was then turbocharged at the turn of the century when China entered the WTO. A key part of this acceleration was, over a period of many years, putting in place the complex global supply chains that exist today—a process that helped drive a dramatic increase in manufacturing margins. This suggests the recent turn toward protectionism is likely to be particularly negative for sectors such as tech hardware, semiconductors, industrial capital goods, and some consumer cyclicals.
Moreover, the labor cost savings from locating production abroad (largely in China) are estimated to have accounted for about one-fifth of the increase in manufacturing profit margins since 2000. However, this factor is likely fully played out and will probably be at least partially reversed during the next couple years. A bifurcation that results in a much less efficient global supply chain would cause additional damage to margins. This is why we believe the peak in manufacturing margins is now well behind us.
1 “Trump Forged His Ideas on Trade in the 1980s—and Never Deviated,” Wall Street Journal, 11/15/18. 2 “Made in China 2025,” The State Council, the People’s Republic of China, 2018. 3 “Made in China 2025: Global Ambitions Built on Local Protections,” U.S. Chamber of Commerce, 2017. 4 “Sizing the prize: What’s the real value of AI for your business and how can you capitalise?” PwC, 2017. 5 “Artificial intelligence: implications for China,” McKinsey Global Institute, 2017. 6 “FDI Regulatory Restrictiveness Index,” Organization for Economic Cooperation and Development, 2018. 7 “Brazen Unilateralism: The US-China Tariff War in Perspective,” Global Trade Alert, 2018. 8 http://www.chinawhisper.com/top-20-most-visited-websites-from-china/