investment insights
China: Trade, technology and the changing balance of power
Lombard Odier Private Bank
As China manages the transition to a more consumption and service-driven economy, its international relationships are evolving in a struggle over the historic balance of power in trade and technology. China’s economy, which accounts for one-third of the world’s growth, is creating investment opportunities that increasingly need to be understood on China’s terms.
China is going through profound structural changes as its economy shifts away from its historic dependence on exports and manufacturing. We expect gross domestic production to fall from 6.6% last year, its slowest pace since 1990, to 6.3% in 20191. This has short and long-term implications for the rest of the globe because GDP in the US and eurozone is simultaneously set to decelerate or stagnate with attention on the Federal Reserve's response and politically fragile trade relations.
We start by looking at the trade tensions between the US and China. The US answer to its trade deficit is tariffs and trade war. China’s answer to its trade surplus has been to look for ways to invest its foreign reserves in developing companies through the multi-lateral “One Belt, One Road” project which aims to connect Asia to Europe, the Middle East and Africa.
While GDP data may not be as reliable as elsewhere, other indicators such as money supply, electricity production, freight and trade data all support the conclusion that China’s economy has peaked.
Trade and timing
The trade dispute begun last year by Donald Trump looks increasingly like a pistol in the President’s hand pointing at his own foot. Trump has made reversing the US trade deficit with China, which reached a 12-year high in 2018, into a central policy objective2. But his timing is awkward. The US and China’s leadership are locked in a fight that Mr Trump started when his Republican party still had a majority in the House of Representatives. After November’s mid-term elections, he faces opposition in the House, which refuses to finance his promised wall on the border of Mexico, another campaign promise. In an attempt to force Congress’ hand, Trump unilaterally shut down his own government in the longest dispute of its kind in American history. That undermined federal employee pay and pensions at the same time as equity market volatility has been making headlines.
Unfortunately, as we wrote in October, wars of all kinds are easier to start than stop. And in the end, the trial of strength between the US and China isn’t so much a trade issue as a dispute about the future balance of power, and different economic and social visions of what the world should look like.
wars of all kinds are easier to start than stop
A December truce agreed between Chinese President Xi Jinping and Mr Trump ends 2 March. The US is now applying tariffs on Chinese imports worth USD253 billion. China has countered with tariffs on USD110 billion of American imports that target politically sensitive Congressional seats. Without an agreement, the US has threatened to more than double tariffs on a further USD267 billion while China threatens raising tariffs on another USD20 billion.
Our forecasts around the US-China trade dispute centre on three scenarios. Our base case is for some escalation before an eventual compromise, as neither side can hope for short-term improvements in their fundamentals, but the probability of some form of détente has increased.
‘Dark Ages’
The net loser in the threats of tariffs and retaliations has been faith in global free trade. Roberto Azevedo, the head of the World Trade Organisation, said in November that the world is facing its “worst crisis” since the creation of the multilateral trading system in 1947. Last week in Davos he warned, “we’re in for the Dark Ages” if politicians continue to undermine free trade.
Trade tensions aside, and in line with the economy’s shifting focus, China’s government is concentrating on improving the quality of investments, with fiscal and monetary support to counter some of the effects of the US tariffs.
China consumed more concrete in the three years from 2011-2013 (6.6 billion tonnes) than the US in the whole 20th century (4.5 billion tonnes)
The extent of the turnaround that China is going through is hard to exaggerate. China consumed more concrete in the three years from 2011-2013 (6.6 billion tonnes) than the US in the whole 20th century (4.5 billion tonnes), according to calculations by analyst Vaclav Smil. cited by Bill Gates as his favourite scientist, Smil points out that rather trying to cut energy consumption in line with efforts in the rest of the world, China is “trying to out-America America” by consuming more and more.
Nevertheless, an overall slowdown in investments, as capital funds services rather than construction projects, is both welcome and necessary. To put it simply, the simple, spectacular years of China’s growth through booming infrastructure spending are over and won’t return.
Unicorns, Cyberwar and Censorship
While trade between the US and China remains stubbornly one-sided, the intellectual property balance in terms of technology firms between the two countries is shifting. The number of Chinese software companies doubled in the five years following 2009 and China is now home to nine of the world’s 20 largest tech companies,3 including China Mobile Limited, Tencent Holdings, Alibaba Group and Baidu. By some estimates the country is educating 100,000 new software engineers per year.
China is now home to nine of the world’s 20 largest tech companies
A quick look at the evolution of ‘unicorns,’ privately held start-ups with revenue of more than USD1 billion, is instructive. When the term was coined in 2013, three-quarters of these firms were US-based and China was home to none. By 2017, the US’s share of unicorns had fallen to 41% while China’s had grown to 36%. A year ago, four of the top ten unicorns worldwide were Chinese, including three of the five largest; Ant Financial Services Group (an Alibaba spin off), Didi Chuxing Technology Co. (a ride-hailing application) and food-delivery firm Meituan-Dianping. In the list of the top 50 unicorns by value, 26 are Chinese and 16 are American. There are no European firms.
One of the effects at work is surely the “leapfrogging” that happens in any technological innovation. For example steel production advances from 18th century Britain that were then improved by German foundries, or an economy such as Nigeria where the lack of landlines hasn’t prevented mobile phones becoming as common as in the US, according to Pew Research.4
China has clearly signalled its intention to move at its own pace and direction in technology, while limiting access to, and use of, the Internet. It blocked Alphabet’s Google search engine in 2010, banned Microsoft’s Skype calling and messaging service in 2017 and just last week Microsoft’s Bing search platform was shut down. Until now, Bing was the only large, foreign-owned search engine reachable from inside China’s ‘Great Firewall.’ China’s communist partly clearly prefers to limit access to information, even if the limitations are themselves a brake on development as slower internet connections undermine business and waste creative energy looking for ways to circumvent the restrictions.
China’s communist partly clearly prefers to limit access to information, even if the limitations are themselves a brake on development
Another illustration of these competing visions in the field of technology are the allegations of spying which have undermined relations. In early December Canada arrested Meng Wanzhou, the chief financial officer of Huawei, the world’s third-biggest builder of mobile phones as she changed flights in Vancouver. The arrest and potential extradition to the US has triggered a diplomatic crisis, including a Canadian national being sentenced to death in China over drug trafficking charges, and a rash of debate about communications network security among western nations.
A number of governments, including the US, Australia, Japan and New Zealand, have banned Huawei components from strategic communications networks over spying fears while France was last week reported to be considering action and there is debate in the UK and Canada. In particular, they point to concerns over China’s 2017 National Intelligence Law, which says “all national bodies, military forces, political parties, social groups, enterprise and undertaking organisations, as well as citizens, shall support, cooperate with and collaborate in national intelligence work.”
Stable yuan
Investors watching China’s economy, and conditioned to paying most attention to central banks, should remember that the country’s implicit yuan target value, measured against a basket of currencies, is more revealing than the easily-reversed changes to the country’s domestic liquidity or interest rates. China has spent foreign exchange reserves to defend the yuan’s implicit range versus the basket and unlike other currencies, does not trade freely.
While our outlook for the renminbi is short-term neutral, we think that any sign of a lasting solution to the trade dispute would lead to substantial strength. The currency’s recent rally was more a reflection of the USD’s weakness and China continues to keep the yuan trading within a stable range against its official benchmark of currencies.
Overall, relations between China and the US are being painted as antagonistic, when the global economy rather depends on their cooperation and mutual understanding. In the meantime, Chinese technology firms are investing in a China-focused market that is independent of longer-standing businesses in the US and Europe.
Important information
This document is issued by Bank Lombard Odier & Co Ltd or an entity of the Group (hereinafter “Lombard Odier”). It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a document. This document was not prepared by the Financial Research Department of Lombard Odier.
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