How does the tech sector matter for Asian economies? What is the impact of tech competition? And, perhaps most importantly, what are the investment implications?

Over the last two weeks, the center of U.S.-China tensions has moved back to China’s tech sector. On August 6, President Trump issued two executive orders banning any company that falls under U.S. jurisdiction from transactions with Tiktok or WeChat (or their parent companies, Bytedance and Tencent), effective after 45 days. This marks another milestone of the “tech war” between the world’s two largest economies, and a significant escalation from last year, when the U.S. added Chinese tech firms to an “entity list” that restricts the export of U.S. items. The list so far includes Chinese tech giants Huawei, Qihoo 360, Hikvision, and more.

There are various drivers of the current tensions, including national security concerns, election year politics, and ongoing U.S. efforts to “level the playing field”. But fundamentally, almost everyone agrees that tech will largely dominate growth in the coming decades. Therefore, it’s worth looking at what is at stake. In today’s note we will explore a few questions: How does the tech sector matter for Asian economies? What is the impact of tech competition? And, perhaps most importantly, what are the investment implications?

The rise of consumer technology in China has been synonymous with the rise of the tech giants, such as Tencent and Alibaba, over the last decade. Further, it may be underappreciated how deeply integrated these companies are with China’s economy. Their impact stretches far beyond “apps” on phones and laptops—for example, the core functions of WeChat, the most-used messaging app in China, moved beyond messaging a long time ago. The underlying ecosystem, namely its embedded social media platform and the many third party applications that feature some of China’s best-known consumer technology businesses, are instead the real economic value.

Also of significance, these tech giants invest in many new businesses every year that shape the digitalization process in China (similar to how U.S. tech giants do in the U.S.). For instance, earlier this month, Alibaba made a new equity investment and became the second largest shareholder of E-House Holdings, a large real estate transaction and service platform in China, aiming to support its online service development. This marks a new cornerstone in the firm’s investment realm, which covers almost every sub-sector of consumers, brings new digitalization of these areas, leveraging an enormous platform.

By 2017, tech already accounted for as large a share of output in China as it did in Germany. The Chinese digital economy is now estimated at more than $3 trillion, or nearly a third of national output. Anchored by several internet giants, the tech sector was not only counterbalancing the decline in older industries, such as steel and aluminum, but was also largely debt free. To us, it seems that the bigger the digital economy, the greater China’s capacity to manage mounting debts in the old economy and keep growth alive. 

In many ways, the full ramifications of the “tech war” will take years to fully play out. The implications of the choices that each side makes today will impact growth of individual companies, sectors, as well as regional economies. Obviously, the upcoming U.S. elections are also a factor to consider. But an equally important point is how China is viewing this “tech war”. From China’s perspective, the risk of having such a large and important part of its economy choked off by U.S. export bans is too big to ignore. Last year’s ban on Huawei, as well as the latest threatened ban on WeChat, have been big wake-up calls for policymakers and businesses. As a result, the process of improving domestic capabilities in high-end manufacturing as well as innovation, are now of great importance.

One good example is semiconductors. It’s often said that data is the oil of the modern economy, meaning it’s now the world’s most valuable resource. We tend to disagree. Data is not finite, is freely created, and not fungible. If looking for a metaphor to describe the modern economy, there is no better place to look than semiconductors. Advanced microchips are found in almost everything: smartphones, PCs, base stations, and cars; and beyond consumer devices, almost every modern weapon system.

Without a consistent supply of semiconductors, any modern economy or military would cease its ability to function. Furthermore - similar to oil, the vast majority of the world’s supply is produced in just a few economies. Looking to reduce this crucial chokepoint, China has been heavily focused on domestic supply, which has seen production grow at an annualized rate of over 30% since late 2019. The ratio of domestic production to imports is now nearly 50%. This indicates there is an opportunity for China’s domestic production to increasingly replace imports in some areas of semiconductor manufacturing. However, most of the import substitution will be in the lower-end and more basic part of the production process. China is still years, if not a decade away, from cutting-edge semiconductor manufacturing 

It seems to us that the “catch-up” process will continue – and the “tech war” will be an accelerator. From a policymaker’s perspective, there is now even greater need to invest in fundamental research as well as commercial R&D. In many ways, China’s domestic R&D capability has been increasing. It is now the biggest patent-producing economy amongst its emerging market peers – with a general level of innovation that ranks above its income level. But there are still big areas of deficiency, in terms of fundamental research in areas such as life science and specialized engineering. 

While China is focused on reducing its import exposure to semiconductors, two economies stand out as the world’s leading producers. Nearly half of the world’s semiconductor production, especially among the most advanced chips, occurs in Korea and Taiwan across companies such as Samsung, Taiwan Semiconductor Machinery Company (TSMC) and SK Hynix. Continuing along the oil metaphor, together South Korea and Taiwan have as large a share of global semiconductor production as Saudi Arabia does of oil. Controlling advanced chip manufacturing in the 21st century may well prove to be like controlling oil supply in the 20th. The country that controls this manufacturing can directly influence the economic and military capacity of others. The U.S is not attempting to do this via direct control of the supply, but by limiting TSMC’s ability to sell chips to Huawei.

The implications are twofold. First, East Asia semiconductor producers are finding themselves playing an increasingly important role in the global economy. With semiconductors in nearly everything, and demand structurally increasing on the back of rapid digitalization, Taiwan, and to an extent Korea, have outperformed economically. And in the case of Taiwan, equities are among the best performers globally. As more of our lives move online and both work and school are increasingly performed virtually, structural demand is likely to accelerate.

Second, the increasingly fraught U.S.-China relationship centers on controlling the commanding heights of advanced technologies. This puts companies like TSMC in a difficult position. Approximately 60% of the chips they produce are destined for American companies, and the rest are for Chinese companies. U.S. measures to limit the sale of chips to Chinese firms constitutes a serious challenge to China’s high-tech ambitions. While producers like TSMC have been able to navigate tensions so far, the recent decision to end waivers raises the stakes and adds a new overhang of risk.

China’s tech sector looks like it’s only going to grow bigger. Consumer technology has become a deeply integrated part of China’s economy, and digitalization will likely continue to expand in every aspect of people’s lives, despite the significant progress that has already been made. Tech-related service sectors will largely outgrow traditional industries, and continue to be a key bright spot for investors.

China’s domestic semiconductor industry presents an opportunity. Domestic production is rising fast, and in some areas, will soon be able to replace imported chips. Nonetheless, in the cutting edge spaces, this will take many years. To hedge against the risk of having a large part of its economic growth choked off by more U.S. tech bans, Chinese policymakers will likely further incentivize R&D in the coming years.

Economies and firms that play crucial roles in the semiconductor supply chain will continue to benefit. As the digitalization process keeps accelerating, structural demand in semiconductors will likely continue to increase, which will benefit economies and firms dominating the supply chain. However, they are also caught in the crosshairs of geopolitical tensions, which is evidently an important risk to watch. 

All market and economic data as of August 17, 2020 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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