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Prevailing Winds

The China Investment Dilemma – Part II

The Rocky State of the U.S.-China Relationship

Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.

China’s rise as an investment destination has occurred amidst a significant deterioration in the U.S.-China relationship. Broader than a trade war, the two countries are engaged in conflict and competition across a variety of fronts. Nothing illustrates deterioration of the relationship more starkly than the bitter recriminations between the two countries over responsibility for the Covid-19 pandemic. The U.S. and China have experienced many periods of friction over the decades, but the current trajectory of the relationship leaves little room for optimism.

The worsening of bilateral relations can be attributed to three major trends: China’s growing assertiveness on the world stage, China’s failure to enact significant economic and political reforms, and growing support in the U.S. for a more aggressive approach to countering China’s rise.

China’s Growing Assertiveness on the World Stage

China’s ascendance as a global power has been both long-predicted and disconcertingly rapid. Under the Xi Jinping administration, China has become more willing to use its growing economic and military power to advance its interests around the world.

Nothing encapsulates this phenomenon better than China’s Belt and Road Initiative (BRI). Providing economic assistance to and investment in more than 100 countries, the BRI is designed to mark China’s emergence as a major economic power and strengthen its economic and trade relations with the rest of the world. The subtext of much of the activity associated with the BRI is creating closer links between China and strategically important countries. BRI-linked aid and support are also strengthening China’s tight relationship with many authoritarian regimes around the world.

China’s old maxim of “hide your strength, bide your time” (韬光养晦) has given way to sharp assertions of military power and economic influence. In territorial disputes with Southeast Asian countries in the South China Sea over the past several years, China has taken a forceful and uncompromising position. In 2016, when South Korea allowed the deployment of U.S. anti-missile capabilities in its territory, China subjected South Korean companies to an intense, albeit unofficial, campaign of economic sanctions and administrative harassment.1 In 2019, a retweet in support of the Hong Kong protests by the manager of the Houston Rockets led the Chinese government to pull NBA games from state-run television and reportedly demand the firing of the team’s manager.2

In the corporate world, Chinese companies have become global competitors in a variety of sectors, such as e-commerce, digital payments, 5G technology, autonomous vehicles, and facial recognition. Local firms now dominate these areas in China’s domestic market. Abroad, Chinese firms are competing with U.S. companies not only in global markets, such as Europe and Southeast Asia, but also in the U.S.

Chinese firms have also engaged in high-profile overseas investments and acquisitions, and Chinese investors have become a major source of venture capital. Many investments by Chinese venture capitalists have targeted companies developing cutting-edge or strategic technology. Many venture capital groups are controlled by Chinese state-owned enterprises (SOEs) or receive funding from state-owned financial institutions, leading to accusations that their investments are motivated by politics rather than pure business interests.3 These claims are buttressed by the stated goals of the Chinese government to develop or acquire technology in strategic areas and the massive government resources supporting this initiative. China is not unique among developing countries in seeking foreign technology through both legitimate and illegitimate means, but the scope and aggressiveness of its actions are unique.

Adding to frustrations over the emergence of Chinese firms as global competitors is a widespread belief that the Chinese government engages in economic espionage in order to benefit domestic enterprises and advance national political objectives. On several occasions, the U.S. government has brought charges against government-affiliated hacking groups that have targeted U.S. companies, alleging that trade secrets were stolen to benefit domestic firms.45 As a result, many Americans believe that Chinese companies are now not only a competitive threat but also the recipients of unfair support from the Chinese government.

In the economic, political, and security realms, China is vying with the U.S. for power and influence around the world to an unprecedented degree. Many Americans are apprehensive about the ways China will use this new power and influence to advance its interests.

China’s Failure to Enact Significant Economic and Political Reform

The dramatic slowdown in the pace of China’s economic and political reform is a major factor in the deterioration of U.S.-China relations. From the U.S. perspective, the foundations of the bilateral relationship have long rested on the belief that China would gradually reform to embrace a more open political and economic system. Early in the tenure of Xi Jinping, there was widespread hope that he would usher in a new period of significant reforms.6 Since then, progress on the economic front has been limited, and Xi’s efforts to centralize power and decision-making have shattered the notion that China is moving toward a more open political system.

Inadequate Economic Reform

In the economic realm, several major sources of dispute have emerged. They include the failure to reform state-owned enterprises, continued restrictions on foreign investment and the operations of foreign businesses in China, and an increasingly lopsided trading relationship.

The failure of state-owned enterprise reform represents a major setback to the process of creating a more open and market-based economic system in China. Starting in the late 1990s and continuing throughout much of the 2000s, China embarked on a major campaign of SOE reform. With the ascent of new leadership in China in 2012, these reforms abruptly slowed. Instead of shutting down inefficient state-owned enterprises and giving more space to private firms, the Xi Jinping administration sought to merge them into larger and more powerful national champions.7 This approach has been largely a failure. SOEs continue to decline in efficiency and are serving as a major drag on the country’s growth. U.S. businesses operating in China also complain that state-owned enterprises receive subsidies and preferential treatment and therefore do not compete on a level playing field. The lack of progress on SOE reform is evidence that China is not committed to free market principles.

Barriers to foreign companies operating in China are another significant irritant in the bilateral relationship. China maintains restrictions on foreign investment in several areas of the economy, particularly the service sector. It has gradually reduced the number of industries subject to the “negative list,” which prohibits or restricts foreign investment, but the slow pace of progress has frustrated many foreign businesses operating – or seeking to operate – in China. Beyond official restrictions, foreign businesses claim that authorities in China engage in frequent unofficial actions that disadvantage them relative to domestic firms. One major complaint is that foreign firms are pressured to form joint ventures with Chinese companies and to transfer their technology to their Chinese partner.

The lopsided trading relationship between China and the U.S. is a further source of contention. Following China’s accession to the World Trade Organization, in 2001, the bilateral trade deficit between China and the U.S. expanded rapidly, as shown in Figure 1.

Figure 1. U.S. Goods and Services Trade Balance with China
Source: Bureau of Economic Analysis.

China’s management of its currency was a major driver of the trade surplus between the mid-2000s and 2012. During this period, the exchange rate was set at a level that was widely believed to be undervalued, giving Chinese exporters an advantage. The People’s Bank of China subsequently reduced its intervention in the currency market, and the currency now trades at a level largely in line with economic fundamentals.8 Despite this change, U.S. officials continue to cite China’s management of its currency as a key reason for the large bilateral trade deficit and has labeled China a currency manipulator. The more likely contributors to the trade deficits include China’s large role as an assembly point for many products sold to the U.S., persistent low savings rates in the U.S., and nontariff barriers facing U.S. exports to China.

Inadequate Political Reform

Deterioration in the political relationship between the U.S. and China stems primarily from a conclusion among many U.S. policymakers and politicians that China is no longer moving toward a more open and pluralistic political system. The Chinese political system has become more closed and repressive over the past decade. One clear indication of this reversal is the renewed assertion of the primacy of the Communist Party in all aspects of public life. It plays a leading role not only in politics but also in science, the media, culture, and other important aspects of Chinese society. No alternative political groups are permitted to organize, and debate within the Communist Party on many topics is highly circumscribed. China’s turn away from political openness and reform can be linked to the initial coverup of the Covid-19 virus.9 In a system where the flow of information is tightly controlled, officials have both the ability and motivation to hide bad news.

Another major blow to the belief that China was converging toward a more open political system was the elimination of term limits for China’s president. Since the start of the reform era under Deng Xiaoping, the peaceful and regular transition of power between Chinese leadership generations has been the bedrock of China’s political stability. In 2017, this system was cast aside with the removal of term limits for the president. The new system, with no clearly defined limitations on term in office, puts China’s legacy of peaceful political transitions in jeopardy. China may now be entering a period in which a strong leader, such as Xi Jinping, may hold on to power for an extended period, raising the possibility that future leadership successions may be less stable and that competent and honest officials may have fewer opportunities to rise through the system.

Growing Support in U.S. for a More Aggressive Approach toward China

The increasing tension in the relationship between the U.S. and China cannot be attributed solely to actions by China. In the U.S., support for engagement with China has deteriorated rapidly over the past several years in favor of a more hardline approach. This shift is supported by public opinion polling data that show the number of Americans with a somewhat unfavorable or very unfavorable view of China increasing significantly (Figure 2).

Figure 2. Views of U.S. Public Toward China
Source: Pew Research Center.10

The shift in opinion has been influenced by many of the factors mentioned above, including China’s growing assertiveness on the world stage and its failure to pursue key economic and political reforms. But the change also reflects the growing influence of a more hawkish group of academics and policymakers in the U.S. Many former advocates of engagement with China have joined the ranks of this group after being bitterly disappointed with the country’s lack of progress on political and economic reforms over the past decade. The hawks argue that China should be treated as a strategic rival and cooperation between the two countries limited. The failure of China to engage in desired political and economic reforms is used as evidence that the previous U.S. policy of constructively engaging with China failed. Now that China is beginning to compete with the U.S. as a peer in many domains, they argue, disputes and conflicts with it should no longer be ignored or minimized.

The influence of China hawks rapidly expanded with the election of Donald Trump. Having vigorously criticized China during his campaign for president, President Trump staffed his administration with officials sympathetic to these positions and began to implement a more confrontational China policy. Emblematic of this shift was the 2017 National Security Strategy, which declared that China (and Russia) “challenge American power, influence, and interests, attempting to erode America security and prosperity. They are determined to make economies less free and less fair, to grow their militaries, and to control information and data to repress their societies and expand their influence.”11

The headline initiative of this new hard line toward China is the trade war. In early 2018, the U.S. imposed the first round of tariffs on Chinese goods; the U.S. government’s goal was to force concessions by China that would result in a reduction in the bilateral trade deficit. The Chinese quickly responded with matching tariffs on U.S. imports. Over the following months, the U.S. continued to escalate the dispute, and the Chinese responded in kind. As a result, most goods traded between the countries became subject to tariffs.

While an agreement to reduce tensions was signed in January 2020, its success remains to be seen.

In addition to launching a trade war, the U.S. has taken other actions to apply pressure on the economic relationship. U.S. policymakers have taken forceful action against Chinese firms accused of violating sanctions on North Korea and Iran, implemented new rules to limit Chinese investment in the U.S. and reduce the sale of advanced U.S. technology to Chinese firms, and adopted new regulations to prevent Chinese companies from entering the U.S. market. U.S. officials have also put pressure on allies to limit investments by Chinese firms in sensitive areas of their economies. Of particular concern is the possibility of firms (like Huawei) building out the critical communications infrastructure necessary for new technologies, such as 5G. These efforts have met with varying success, with some allies, such as Britain, resisting U.S. pressure to ban companies like Huawei.15 U.S. policymakers want to prevent Chinese companies from becoming entrenched in the global telecommunications system in order to prevent possible spying by the Chinese government. The U.S. secretary of state has described Huawei and other Chinese technology companies as “trojan horses for Chinese intelligence.”16

Part III of this paper examines how this challenged relationship is creating a new set of risks for U.S. investors in China.

Nicholas Borst,
The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
As of March 31, 2020, the Seafarer Funds owned no shares in the entities referenced in this commentary.
  1. Jeongseok Lee, “Back to Normal? The End of the THAAD Dispute between China and South Korea,” China Brief, Jamestown Foundation, 22 November 2017.
  2. Tom Lutz, “Chinese State TV Blacks out NBA Season Opener after Threat of ‘Retribution,’The Guardian, 22 October 2019.
  3. Office of the U.S. Trade Representative and Executive Office of the President, “Update Concerning China’s Acts, Policies and Practices Related to Technology Transfer, Intellectual Property, and Innovation,” 20 November 2018.
  4. U.S. Department of Justice, “U.S. Charges Five Chinese Military Hackers for Cyber Espionage against U.S. Corporations and a Labor Organization for Commercial Advantage,” 19 May 2014.
  5. U.S. Department of Justice, “Chinese Military Personnel Charged with Computer Fraud, Economic Espionage and Wire Fraud for Hacking into Credit Reporting Agency Equifax,” 10 February 2020.
  6. Arthur Kroeber, “Xi Jinping’s Ambitious Agenda for Economic Reform in China,” Brookings Institution, 17 November 2013.
  7. Nicholas Lardy, “The State Strikes Back: The End of Economic Reform in China?” (Washington, D.C.: The Peterson Institute for International Economics, January 2019).
  8. 2019 External Sector Report: The Dynamics of External Adjustment,” International Monetary Fund, July 2019.
  9. Geremie R. Barmé, “China’s Coronavirus Crisis Is Just Beginning,” The New York Times, 3 March 2020.
  10. Spring 2019 Global Attitudes Survey,” Pew Research Center, 30 September 2019.
  11. National Security Strategy of the United States of America,” The White House, December 2017.
  12. Economic and Trade Agreement between the Government of the United States of America and the Government of the People’s Republic of China,” U.S. Trade Representative, 15 January 2020.
  13. Hui Shan, Maggie Wei, Helen Hu, Zhennan Li, Yu Song, and Andrew Tilton, “Purchase Agreement in the US-China Phase 1 Deal: How Might China Spend $200bn,” Goldman Sachs Economic Research, 10 January 2020.
  14. Chad Brown, “Phase One China Deal: Steep Tariffs Are the New Normal,” Peterson Institute for International Economics, 19 December 2019.
  15. Adam Satariano, “Britain Defies Trump Plea to Ban Huawei From 5G Network,” The New York Times, 28 January 2020.
  16. Michael Pompeo, “The West Is Winning,” U.S. Department of State, 15 February 2020.