The US-China economic equilibrium of the past 20 years has gone and as we look into 2019, it is not yet clear when and where a new equilibrium will form. What level of economic separation will develop between the world’s two largest economies? How much will businesses need to change in their business model — from the customers they target, the products and services they offer, their overall supply chain, and even their capital structure and ownership? The next stages of this transition will play out over 2019 in ways that cannot be fully anticipated, but without doubt, uncertainties will lead to lower levels of long-term investment by businesses in 2019 and to greater levels of volatility in market growth and in the valuations of many kinds of assets. It will be a year for prudent conservatism in many areas, combined with a readiness to make big, bold bets if and when one-time opportunities arise.
Impact of US-China ‘economic’ confrontation
The most visible change in US policy toward China is the existing imposition of tariffs and the threat of more to come. Yet this is only one element of many broader changes in the permission granted to Chinese businesses to access US markets, to acquire companies in the United States, to transfer intellectual property (IP) from the United States to China or to conduct research in the United States. While there is the possibility that US and Chinese governments negotiate to a permanent status quo on tariffs, there are no plans for a meaningful rollback of the broader changes. Tariffs affect any company exporting from China, regardless of its ownership nationality, but broader changes specifically restrict Chinese companies and Chinese investors.
A long-term structural trend has been under way over the past decade to shift some manufacturing activities out of China. Samsung moved many tens of thousands of jobs to Vietnam from China years ago. Li & Fung’s textile supply chains have a center in Bangladesh.
Yet China’s domestic market size and the efficiency of its supply chains mean that rarely will all volumes shift. With a declining Chinese currency, increased export-tax rebates, and mix reconfigurations, to date, the pain for exporters arising from US tariffs has been limited.
Contingency plans have been prepared should tariff rates rise to 25 percent across more categories in March, after the current 90-day discussion period expires. How disruptive the change required will be will depend very much on how global the exporter is today. For a globalized consumer-goods company, the United States may represent less than 20 percent of output from China and the company may already have a footprint of manufacturing plants around the world. Putting spare capacity in these plants to work and, for example, swapping production between a plant in Turkey and China — so that the Turkish plant can produce for the United States — would incur additional operating costs but not capital investment. If additional capacity is required, putting it alongside existing facilities is preferred. Eastern Europe, Turkey and even India and the Philippines are destinations seen to have the capacity to provide workers and supply-chain infrastructure. Vietnam is seen by many to be at capacity, and producing in Mexico is stymied for some by high local value-added requirements contained in the United States-Mexico-Canada Agreement. But net uncertainties mean that capital investment anywhere in production capacity is being held back.
On the receiving end in the United States, the bulk of the direct pain will be felt by businesses (Exhibit 1). Close to three-quarters of Chinese exports to the United States are intermediary goods, not direct-to-consumer goods. Consumers will feel price increases largely to the extent that US producers choose to pass through their higher costs.
The narrow short-term GDP impact on China of the tariffs alone is modest, on the order of 0.5 to 0.8 percent of GDP. But if tariffs lead to job losses in China and then a decline in consumer confidence, the medium-term impact will be much, much greater. Then, in combination with the broader set of economic barriers to US-China economic interaction, the impetus for companies to change their core business operations and capital structures is high.
Chinese investment levels into the United States have fallen by more than 70 percent this year and will likely fall further in 2019. No Chinese company wants to be caught up for months in a review process with the Committee on Foreign Investment in the United States (CFIUS), with the high risk of the transaction being turned down. US sellers do not want this uncertainty, either. As a result, many Chinese strategic investors are simply self-censoring and not taking opportunities to make acquisitions in the United States or they are turning to smaller amounts of organic investment. In the US start-up space, this means the loss of investment funds from China that offered enhanced access to the China market in return for investment and also a valuation of up to four to five times what domestic investors offered. In some parts of the US start-up world, valuations could fall substantially as Chinese capital withdraws.
Over the past few years, when many Chinese investments were made in the United States, only a small proportion reported themselves to CFIUS — the cross-ministry committee within the US government tasked with overseeing and clearing international investments into US companies — and received a formal OK. At the time, no one really seemed to mind; the responsibility was with the company to report, and CFIUS lacked the resources to go out and track down nonreporters proactively. But in this new era, it is entirely possible that in 2019, we will see CFIUS move beyond reviewing new transactions. It might also investigate unreported transactions that closed several years ago and impose remedies on them if it finds them noncompliant to new criteria (for example, involving sensitive sectors and technologies or access to US citizen personal data). While such action could potentially be litigated by the company, it could take years to resolve. There will be some quiet divestments of US assets by Chinese companies in 2019 that see this issue coming their way.
Where might Chinese money flow instead? Wang Qishan’s recent visit to Israel highlighted the importance of Israel as a source of investable start-up opportunities, from artificial intelligence to agritech, for Chinese companies. The UK start-up community continues to receive Chinese investment in fintech and healthtech, alongside investment in more mature industrial sectors. Italy’s new government has proactively reached out to China seeking further investment in many areas. And Chinese companies continue to explore acquisition targets, from luxury goods to tech, quietly in Japan.
With much less visibility, Chinese companies are also facing increasing market-access challenges in the United States, especially in B2B markets. While the banning of Huawei Technologies and ZTE from much of the telecom-infrastructure market was announced, more quietly, the federal government is not only restricting its own purchases of goods and services from Chinese companies but also discouraging its core vendors from buying from Chinese companies. The United States has also sought to persuade the European Union and others not to buy from Huawei Technologies. Tech, healthcare, and financial services are all in the line of fire. After the “Supermicro bug” article, an even broader range of companies now see a perception of risk in buying from Chinese suppliers and are making the conservative choice to go with a non-Chinese brand name, even if the product might be produced in the same factory in China or Mexico as the Chinese brand product they rejected.
Opportunities for Chinese researchers to work at leading facilities in the United States are being restricted, highlighted by Johns Hopkins University briefly halting its visiting-scientist program in October to revise its application requirements. Where visas are issued to researchers, they are for shorter periods, leaving researchers uncertain if they will be able to complete their projects. Fewer researchers and students are likely to go the United States; they will head to other countries, although the capacity to take more Chinese students at top universities in other parts of the world is limited — universities in the United Kingdom and Australia in particular are likely to see greater demand. Fewer Chinese megadonors will give funds to build new world-class research facilities on US campuses.
If Chinese researchers are unable to spend time in world-class research teams internationally, the Chinese government will doubtless seek to attract world-class research institutions to set up operation in China. The Oxford Suzhou Centre for Advanced Research — jointly established by the University of Oxford and Suzhou Industrial Park, with a focus on medical research, where the University of Oxford is ranked number one globally — will be followed by many more.
Beyond visas for researchers, Chinese business people have noted that their green-card-to-passport application process has ground to a complete halt.
IP transfer to China
The US government has moved away from exporting semiconductor-production equipment to China.
The US government’s announcement of a ban on the export of US semiconductor-production equipment to Fujian Jin Hua Integrated Circuit in October was a very visible example of limitations on the flow of technology from the United States to China, whether through a commercial deal or intracompany transfer. Transfer of IP, either as a virtual good or embedded in a product or solution, is being subject to deeper US government scrutiny — whether the transfer is as a commercial sale to a third party, to a joint-venture partner, or even to the Chinese branch of an international company’s operations.
During 2019 we may well see international companies needing to defend themselves from US government criticism over their investment levels in China. The impact of this could extend to Hong Kong. Also, in November, the US-China Economic and Security Review Commission recommended reviewing the arrangement to treat Hong Kong and the mainland as separate customs areas in the export of dual-use technology.
Chinese government policies — such as Xi Jinping’s continuing exhortations for China to increase its “self-reliance” (that is, independence from foreign technology and more) — add to the forces for increased separation of the Chinese and US economies and, consequently, for the separation of business activities of businesses that choose to operate in both geographies.
In 2019, expect corporates, Chinese and non Chinese, to start to investigate quietly their options for creating separate corporate structures for their China-focused and US-focused operations. Separate route-to-market partnerships and development centers as well as distinct products and services and maybe even brands, headquarters, and legal entities are entirely possible outcomes of the direction in which government action is moving businesses.
Chinese government is highly active
China has been reducing its exposure to the world while the world has been increasing exposure to China.
Most major leadership moves and ministry reorganizations in the Chinese government were completed in the first half of 2018. New policies, with active follow up to track implementation, were seen through the year, as ministers acted on the agenda set for them by Xi Jinping, who will complete his sixth year as president in March 2019. By the end of this year, businesses could feel the impact of an uptick in policy and regulatory announcements and enforcement actions. Greater levels of intervention by the government into business activity spanned almost all aspects of operations — from online operations through to new subsidies and tax rebates and greater involvement of the Party Committee in private-sector companies. On investments, some businesses were discouraged from making international investments (Exhibit 2); others were strongly encouraged to invest in struggling state-owned enterprises.
Many industries faced discontinuities because of policy changes, one example being private kindergartens, where policy changes effectively locked them out of operating from the majority of residential tower blocks. Multinationals did see follow-through on commitments made to allow them to hold a majority stake in parts of the financial sector and in the automotive sector. Pharmaceutical companies saw further changes to drug-approval and -reimbursement policies, with more than 100 foreign-developed drugs approved into the China market in 2018. Overall across all sectors, a more interventionist government is feeling confident in its ability to shape and control more and more specific details of a business, leading it to intervene through policy, regulation, and arbitrary one-off actions.
Individual consumers saw the impact of active government intervention online, on what content they could see or post and on what games they could play and for how long. They also saw the failure of government regulation over the issue of fake vaccines given to children and the more than 500 peer-to-peer lenders that went out of business, leaving investors out of pocket. These failures are seen by the government as failures of insufficient intervention and will lead to more intervention in the future.
Where might government intervention be most visible in 2019?
Ensuring that manufacturing companies do not implement sudden large-scale layoffs as part of their response to US tariffs will be priority number one. Any company that thinks it can get away with such layoffs should plan on leaving China entirely, as the government reaction will not be mild. Even if layoffs were part of a long-term plan made before tariffs were even thought of, it will be extraordinarily hard to persuade government officials that this is the case. The reality is, they may not even care, if their key performance indicator is to prevent any layoffs. This will be an equal-opportunity policy — applied to all manufacturing companies regardless of nationality or ownership structure.
Navigating a way out of the $1.3 trillion (roughly 10 percent of the total market cap) pledged-share problem on China’s domestic stock markets will be another priority.
Thousands of company owners have borrowed against the value of their shares from brokers, banks, and grey-market financiers. To put it mildly, many of the funds raised were not put into productive investments. With the decline of the stock market, many of these loans are now underwater, a problem for the borrower and (often state-owned) lender.
Frequently, the underlying business is operating just fine; this is purely a crisis of capital structure. Some of the companies will pass into state ownership as state-owned companies step in to assume the loan and wipe out the private-sector owner.
Others will be available for international investors to acquire, if they can persuade current owners to take the valuation discount that is required.