u.s.-china phase one trade deal signed: now comes the hard ...€¦ · geopolitical briefing...

Economics and Strategy

Geopolitical Briefing

January 23, 2020

U.S.-China phase one trade deal signed: Now comes the hard part By Angelo Katsoras

Introduction The good news is that phase one of the trade agreement signed between China and the United States should calm the trade waters for at least this year. President Trump’s goal to make this deal a trade policy success in the run-up to the U.S. presidential election in November will likely prevent him from raising tensions. China, for its part, needs a truce in order to be better able to focus on an economy growing at its slowest pace in nearly three decades, to prevent further companies from relocating their supply chains elsewhere and to deal with the unrest in Hong Kong. The potential impact of the flu-like coronavirus virus is yet one more challenge facing China.

The bad news is that this deal could mark the high-water mark of trade negotiations. China and the United States are in the early stages of a long-term geopolitical rivalry. This competition is focused on which economic model performs better and which country will dominate the world’s next generation of technologies.

It is important to note, also, that today’s trade tensions with China are very different from past commercial disputes the United States has had with other countries. Historically, the United States has, up to a certain point, tolerated large trade deficits with Germany, Japan, and South Korea because they are close allies and democratic states. In stark contrast, China is viewed by America as an authoritarian geopolitical rival intent on reducing its global geopolitical and economic influence. The wide philosophical gap between the two countries is best exemplified by China’s attempt to challenge the long-established Western orthodoxy that a country cannot become rich without first becoming democratic and loosening state control over education and business.

Consequently, what the trade deal might have accomplished above all is to buy both sides time to further decouple their economies and to prepare for inevitable future trade tensions.

Phase 1 trade deal Under the deal, the United States will cut tariffs on $120 billion in Chinese goods by half to 7.5% and forgo other planned tariffs and, in return, China will increase imports of U.S. agricultural, industrial and energy products/services by about $200 billion dollars from 2017 levels over the next two years. The agreement also includes Chinese pledges to better protect U.S. intellectual property, curb the forced transfer of technology, and open up its financial services market to U.S. firms.

Source: “U.S., China Sign Deal Easing Trade Tensions”, Wall Street Journal, January 15, 2019

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Implementing deal will not be easy, though

For starters, reaching the targets outlined in the deal entails an increase in exports to a single country without precedent in the history of U.S. trade.1 Though China does have room to buy more U.S. agriculture products owing to the damage wrought by the swine flu disease, increasing imports from $24 billion in 2017 to $40 billion will not be easy. Moreover, to attain the agriculture import targets, China will have to abandon its efforts to build new agricultural supply lines in South America and elsewhere.

As for manufacturing, attaining the target is complicated by the fact that China will want to mostly import the very high-tech goods that in some cases the United States has banned it from purchasing. Finally, the more that China purchases U.S. agriculture, energy and industrial products, the less it will buy similar goods from other countries such as Canada.

Verifying whether China has followed through on its commitment will be another challenge. Instead of deferring to arbitrators and/or the WTO, the two sides will seek to resolve disputes through direct talks. This means that either country will have the right to impose tariffs if it is not satisfied with the outcome. The United States will be able also to consider anonymous complaints by U.S. companies. This might fix the problem of executives staying silent for fear of retaliation, but China could complain that it is being accused of wrongdoing for something it cannot verify.2

Finally, many key issues were deferred to the next phase of trade talks. These include China’s financial subsidies to corporations and the large role of state-owned enterprises in its economy. The importance that China attaches to its economic model will make progress in these areas very difficult. Last year alone, state-owned companies or government-run investment companies acquired 44 high-tech firms with a combined market value of about $36 billion. This highlights the depth of China’s support for a state-led economic model.3

Deal or no deal, the push to partially decouple supply chains will continue

The driving force behind this gradual unwinding is the desire of both countries to become less reliant on the other. To avoid the sting of being repeatedly hit by tariffs and bans on the purchase of U.S. technology, China will double down on efforts to develop its own expertise in key sectors. As for the United States, its ever-tighter rules on Chinese investments in U.S. companies and screening of supply chains for national security vulnerabilities are an attempt to at least partially disentangle itself economically from China. In the near future, the United States will be very tempted also to impose further restrictions on the sale of certain technologies in which it dominates the market. This is because the longer that it waits to act, the greater the risk that China will develop viable alternatives.

Huawei has thus far been able to withstand export restrictions because the U.S. government had indicated its desire to implement sanctions long beforehand. This gave Huawei time to prepare by stockpiling U.S. parts and diversifying its supply chain. The following chart illustrates the steps already taken by Huawei to reduce its reliance on U.S. components:

Huawei rejigs its supply chain away from United States

1 “U.S., China Sign Deal Easing Trade Tensions,” Wall Street Journal, January 15, 2019 2 “The ceasefire in the trade war between America and China is fragile,” The Economist, December 18, 2019 3 “Deal breaker? China nationalizes strategic tech with eye on US,” Nikkei Asian Review, January 16, 2019

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*Pre-ban phones refer to Huawei’s P10 Plus, P30 Pro and Mate 20 phones released before the U.S. ban. †Post-ban phones refer to the Mate 20X 5G, Y9 Prime, and Mate 30 released after the U.S. ban.

Note: HiSilicon is a Huawei subsidiary. Sources: UBS, Fomalhaut Techno Solutions, and iFixit.

Source: “Huawei Manages to Make Smartphones Without American Chips,” Wall Street Journal, December 1, 2019

Can China crack code for memory chips? China’s chip industry is reportedly on track to produce about 5% of the world's memory chips by the end of 2020 from virtually 0% last year. Memory chips serves as tiny sensors and memories for all IT devices. The market is currently dominated by U.S., South Korean and Japanese manufacturers.4 While China has made substantial progress in this field, it is still likely several years away from mastering the design of high-end chips.

Source: “China memory chip output zooms from zero to 5% of world total,” Nikkei Asian Review, November 20, 2019

It will be near impossible for the U.S. to unwind many restrictions placed on China Over the past several years, the United States has with strong bipartisan support implemented a number of regulatory and legal actions against China. Below are recent examples:

Committee on Foreign Investment in the United States (CFIUS). In mid-2018, Congress voted overwhelmingly to broaden the power of the CFIUS to block transactions deemed a threat to national security (both economic and political). These include any foreign investment over 5% in various technologies.

Student visas. In 2018, the United States shortened from five years to one the duration of visas for Chinese graduate students in the fields of aviation, robotics and advanced manufacturing from five years to one year, citing the risk of espionage.5

Surge in FBI investigations against China. In July 2019, FBI Director Christopher Wray stated: “We have probably about 1,000 plus investigations all across the country involving attempted theft of U.S. intellectual property, whether it’s economic espionage or counter proliferation, almost all leading back to China.”6

4 “China memory chip output zooms from zero to 5% of world total,” Nikkei Asian Review, November 20, 2019 5 “Chinese students and US universities become pawns in the trade war,” Nikkei Asian Review, August 7, 2019 6 “FBI’s Wray dodges questions on Mueller report’s findings,” Associated Press, July 23, 2019

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Chinese-made drones. The U.S. Department of the Interior is set to permanently ground about one thousand drones that were manufactured in China or contained Chinese-made parts. Officials are increasingly worried that the data that they collect could be sent back to China. The U.S. Army has already banned drones made by the Chinese company DJI, which is the world’s largest producer of civilian drones, and Congress is debating a bill that would ban the federal government from purchasing further drones made in China.7

Hong Kong Human Rights and Democracy Act. Under the act signed into law last November with overwhelming bipartisan support, the U.S. Secretary of State is required to make an annual determination whether the “one country, two systems” formula that guarantees Hong Kong’s independent legal system is intact. A negative review would revoke its status as an independent member of the World Trade Organization and in turn subject it to the same U.S. tariffs and restrictions currently imposed on China.

TikTok. The U.S. military has banned its members from using TikTok, the social media video app owned by Chinese conglomerate Bytedance, on any government-issued device. Like other apps, TikTok collects information on its users, including data that could be used to track the location of individuals. TikTok was the second most downloaded app in 2019.

Growing number of blacklisted Chinese firms. Washington has so far placed more than 200 Chinese companies and organizations on an entity list. Those on the list must apply for additional licences to purchase products from U.S. suppliers. A loophole that exempts from this restriction some components made by U.S. companies at factories offshore could soon be partially closed. Under current regulations, the United States can require a licence or block the export of many high-tech products shipped to China from other countries if U.S.-made components make up more than 25% of their value. The U.S. government’s proposed rule would reduce this threshold to 10% for Huawei.8

Source: “Trump's blacklist squeezes 200 Chinese companies as net widens,” Nikkei Asian Review, November 19, 2019

7 “US to ground civilian drone programme on concerns over China tech,” Financial Times, January 12, 2020 8 “Trump administration moves toward blocking more sales to Huawei: sources,” Reuters, January 14, 2020

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Made in China 2025 still very much alive While China has gone silent regarding its Made in China 2025 strategy, which entails becoming a global leader in several cutting-edge technologies, the plan is still being pursued. For example, China recently ordered all government offices and public institutions to remove foreign computer equipment and software for domestically made versions within three years. Furthermore, the market for western smartphone brands is rapidly declining. In 2011, 70% of smartphone sales in China were controlled by three foreign brands: Nokia, Samsung Electronics, and Apple. In the first half of 2019, 71% of the market was shared by three Chinese brands: Huawei, Oppo, and Vivo.9

Source: “Washington’s Chinese Tech Conundrum,” Geopolitical Futures, November 15, 2019

Huawei continues to be at centre of battle for control of 5G The United States is maintaining its pressure on Huawei by limiting its access to U.S. markets and technology and mounting an aggressive diplomatic campaign to persuade U.S. allies to block Huawei equipment from new telecommunications networks.

So far only Australia, New Zealand, Japan and Vietnam have decided to ban Huawei from their 5G plans. Other U.S. allies, notably in Europe, are trying to appease both China and the United States by allowing Huawei access only to “non-core” parts of 5G networks.

European Union

There are two main reasons that most European countries have avoided a total ban. First, Huawei equipment tends to be less expensive than the alternatives. Moreover, for some countries, going with another provider would include also the additional costs of ripping out the 4G Huawei technology already in place. Second, banning Huawei formally would likely draw some form of Chinese retaliation.

While a total ban is off the table, increased European suspicions over China’s espionage capabilities and fears that China is trying to buy influence with individual members to disrupt EU unity could lead to surprisingly tight restrictions in certain countries. Another major factor to consider is that two European companies, Nokia and Ericsson, are among the few global players able to compete with 9 “America Is Losing the Chinese Shopper,” Wall Street Journal, October 12, 2019

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Huawei. Even if their costs are higher, there will be significant political pressure exerted to favour these local champions over Huawei as much as possible.

One European country that is particularly torn over Huawei is Germany. Merkel’s plans to allow Huawei to bid for business has been met by a potential revolt by lawmakers who want to effectively ban Huawei equipment. A major investigation of three German nationals accused of spying for China has only added to the pressure. “If Germany were to make a decision that led to Huawei’s exclusion from the German market, there will be consequences,” warned Wu Ken, China’s ambassador to Germany, in December.10 The German automobile sector, which sells millions of cars in China, is particularly vulnerable to retaliation.

Canada

Ottawa is in the midst of conducting a cyber security review that is expected to determine whether Huawei can keep selling its equipment to Canadian carriers. Already, the possibility of restrictions being implemented in the near future combined with the U.S. ban means that some of Canada’s largest wireless service providers are exploring options for new equipment suppliers. Samsung Electronics’ deal to supply equipment to Videotron for the development of its 5G networks is a case in point. Not surprisingly, China has publicly threatened reprisals if Canada does implement a ban on Huawei.

Developing world

In contrast to many developed countries, lower costs and deep trade ties with China are leading many emerging countries to fully embrace Huawei with no restrictions. One major wildcard is India, however. While India has officially given approval for Huawei to bid for a chance to build up its 5G networks, suspicions about security and the geopolitical rivalry between the two countries could prevent Huawei from winning major contracts. As one Indian telecom executive put it last summer: "We don't want to be caught in a situation where we have deployed Huawei and then a ban comes.”11

10 “In Huawei Battle, China Threatens Germany ‘Where It Hurts’: Automakers,” New York Times, January 16, 2020 11 “Will India allow Huawei to sell its 5G networking equipment in the country?” The Economic Times, August 13, 2019

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Decoupling between two countries continues While headlines focus on the signing of the recent trade deal, the two countries continue to decouple their economies. Here are three examples of this:

Splinternet. Decoupling has already occurred between China and the United States in terms of the internet. China’s firewall blocks news stories and sites that it considers suspect. This has in fact banned the likes of Google, Facebook, Twitter, Instagram and thousands of other foreign sites from China. Beijing has also mandated that certain data be stored on internal servers not accessible from abroad.12

GPS. China recently announced that it was nearing completion of its new global positioning system (GPS) network as it prepared to further disengage from America’s GPS network. The last two satellites will be launched in the first half of this year to complete the 35-satellite network. In comparison, America’s GPS network runs on only 30 satellites.13

Source: China Daily, 2018

Financial decoupling. Trade tensions between China and the United States have also led to renewed focus on their long-standing disagreement over audits. The main area of contention is China’s refusal to allow American regulators to examine the audits of Chinese firms whose shares trade on U.S. financial markets. Last June, a bipartisan group of senators introduced legislation to address the issue. Under the bill, companies would have three years to either comply with regulations or withdraw from U.S. financial markets. Given the strong bipartisan support for the bill, it is highly likely to obtain congressional approval. As perhaps a sign of things to come, the total amount that Chinese companies raised by listing in the United States fell from $9.4 billion in 2018 to only $3.6 billion in 2019.14 The Trump administration is also considering barring the Federal Retirement Thrift Investment Board (FRTIB), the retirement savings vehicle for federal government employees, from investing in Chinese capital markets. (Refer to our previous report for further details: “Expect more financial decoupling between China and the United States.”)

Taiwan: caught between a rock and a hard place Perhaps no country in the world more than Taiwan is caught in the crossfire in the struggle for tech supremacy between China and the United. To date, it has managed to navigate this challenge and avoid tariffs by bringing some production back home from mainland China.

One company crucial to the advanced industries of both the United States and China is Taiwan’s Semiconductor Manufacturing Company (TSMC), the world's top producer of leading-edge performance microchips. In addition to being a key supplier to both Apple and Huawei, it

12 “The World-Shaking New That You’re Missing, New York Times, November 26, 2019 13 “China decouples from US in space with 2020 'GPS' completion,” Nikkei Asian Review, December 28, 2019 14 “Hong Kong clings to IPO crown despite protest turmoil,” Nikkei Asian Review, December 16, 2019

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makes microchips for the U.S. military. There are reports that the Pentagon is pressuring TSMC to build new production lines for semiconductors in the United States in order to reduce the risk of Chinese espionage. TSMC has warned that such a move would entail a significant increase in operating costs.

The following quote from The Economist best summarizes the challenges faced by Taiwan and TSMC: “Being the unmatched supplier of a world-shaping technology relied on by two great powers squaring off for a serious fight would be worrying under any circumstances. When one of those countries claims sovereignty over your country and the other is pledged to protect it—and may expect favours in return—the worry is correspondingly greater.”15

Conclusion While the markets may have breathed a sigh of relief over the signing of the recent trade deal, both countries will continue to strive to become less economically reliant on the other. On the one hand, China will keep seeking to take market shares away from American and western companies in strategic sectors like IT and, in the process, try to become less vulnerable to continued U.S. bans on the sale of certain American-made components to Chinese companies. On the other hand, the United States will keep seeking to tighten restrictions on Chinese investment in U.S. companies and respond more vigorously to alleged corporate espionage by China.

This partial economic unwinding is being driven by a great power rivalry, radically different economic/governance models, increasingly separate communications and internet systems, conflicting financial regulations, fraying supply chains and, most importantly, a lack of trust. In this new landscape, market access for companies in sectors deemed strategic by both sides will often depend on whether their business plans, products/services and supply chains are compatible with the geopolitical objectives of either country. Based on these criteria, the company with the best products or services will not always be the one to come out ahead.

The emergence of two major economic models and the mutual desire of the United States and China to rely less on one another’s technology and equipment could lead to the adoption of different technical standards in various sectors. Each side will push for its standards to become the global norm. Two examples of how this competition is playing out are China’s near completion of its very own GPS system to compete with America’s network and China’s proposals for new international standards for facial recognition and video monitoring to the UN International Telecommunication Union (ITU). Historically, technology standards ratified by in the ITU have been adopted by many regions, particularly in the developing world. 16 The chart below also illustrates the massive efforts China is undertaking for its standards to become the global norm.

Source: “Ten charts that tell the story of 2019,” Financial Times, December 28, 2019

15 “A look inside the factory around which the modern world turns,” The Economist, December 18, 2019 16 “Chinese tech groups shaping UN facial recognition standards,” Financial Times, December 1, 2019

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From an investor's perspective, this trend means that, in addition to considering the quality of a company’s products and services, investors must also begin to take into account their compatibility with technical standards of either China or the United States.

Deal or no deal, it seems almost inevitable that American and Chinese companies heavily dependent on one another's markets in sectors deemed strategic will lose market share over the long term. For example, China’s intentions to build up its capacity in the semiconductor sector combined with American restrictions on sales to China make it likely that U.S. semiconductor companies will lose ground in China. The Semiconductor Industry Association estimated that China accounted for about $75 billion, or 36%, of the revenue earned by U.S. semiconductor companies in 2018.

Source: “The outcome of the US, China trade negotiations will make or break these stocks into year-end,” CNBC, Nov. 2, 2019

Finally, regardless of the outcome of the extradition hearing for Huawei CFO Meng Wanzhou, in today’s world of great power politics, Canada’s extensive trade, security, geographic and cultural ties with the United States force it to largely support U.S. positions on China. This means that, as long as relations remain strained between the two superpowers, Canada will face significant barriers to deepening economic ties with China.




Montreal Office Toronto Office 514-879-2529 416-869-8598

Stéfane Marion Matthieu Arseneau Warren Lovely Chief Economist and Strategist Deputy Chief Economist Chief Rate Strategist, Economics and Strategy [email protected] [email protected] [email protected]

Krishen Rangasamy Paul-André Pinsonnault Marc Pinsonneault Taylor Schleich Senior Economist Senior Fixed Income Economist Senior Economist Associate, Rates Strategist, Economics and Strategy [email protected] [email protected] [email protected] [email protected]

Kyle Dahms Jocelyn Paquet Angelo Katsoras Economist Economist Geopolitical Analyst [email protected] [email protected] [email protected]

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u.s.-china phase one trade deal signed: now comes the hard ...€¦ · geopolitical briefing...

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