While some companies could be adversely impacted in the short term, the intense competition between both countries could spur an increase in investment and create opportunities.
Following a contentious meeting last week in Anchorage, Alaska, between high-level U.S. and Chinese officials, the current trajectory of heightened tensions between the two countries looks set to continue. Despite optimism that the Biden administration may engage in a reset, the post-meeting statement and actions from both sides seem to reinforce how the two countries’ core interests are increasingly at odds.
Although a different approach and slate of tactics from Washington, this administration’s view of the U.S.-China relationship does not appear to significantly deviate from the previous slate of policymakers. Furthermore, by the looks of the Anchorage meeting, there appears to be little understanding of each other’s core interests.
So what does this mean for investors?
From our point of view, trade and technology are the two key linkages between the economies where shifts in the status quo could impact the macro landscape and markets.
Two weeks ago, we wrote about how we think trade policy will evolve over the next four years. In today’s note, we look at technology—and specifically the implications if the U.S. continues to go down its path of restricting technology exports and the flow of research to China, and if China continues down its path of technology self-sufficiency and import substitution.
Micro vs. Macro: In the short-term, we think technology decoupling would create a bigger problem for U.S. companies
According to a BCG analysis1, U.S. company revenues in China are estimated to be $410bn, nearly three times that of Chinese companies’ sales to the U.S. (just $140bn). The paper estimates that while $410bn is just 5% of total U.S. company revenues, that amounts to 15% of market cap or $2.5tn in market value (assuming 49% gross margin and EV/EBITDA multiples of around 11 to 14). Furthermore, beyond the absolute level of sales, China represents the largest source of growth for many companies.
Technology is by far the most exposed sector, with 14% of U.S. revenues in this sector going to China (and nearly 30% of semiconductor sales going to China). Additionally, subcategories vulnerable from a demand perspective include consumer electronics, auto parts, aerospace, medical equipment, and machinery.
According to the U.S. Chamber of Commerce, the repercussions could be especially severe for the semiconductor industry. Restrictions (from either country) limiting firms’ access to China’s market would mean lower revenues and R&D spending for U.S. companies—and a less centralized role in global technology supply chains. U.S. restriction on the sales of products made using American goods could prompt some foreign firms to “de-Americanize” their semiconductor production.
Whether that’s possible is questionable, but it could push for further self-sufficiency along the semiconductor supply chain. In their estimation, lost access to Chinese customers would cause the U.S. semiconductor industry $54 billion to $124 billion in lost output, risking more than 100,000 jobs, $12 billion in R&D spending, and $13 billion in capital spending 2.
Not to mention that semiconductors have already been losing ground (U.S. semiconductor sales to China are down 3% as a share of total semiconductor sales over the past three years).
While this may not be surprising given restrictions imposed by the U.S. government, this may become the blueprint of the future.
Macro vs micro: Over the longer-term, China could face weaker productivity from technology tensions, but select opportunities for domestic companies could result
From a longer term perspective, in the event two separate ecosystems develop, what are the implications?
Technology tensions that drive China to pursue self-sufficiency and technology autarky, as well as drive the U.S. to reduce commercial and academic ties, have no clear precedent. Beyond the near-term impacts described above, the long-term repercussions must also be considered.
Restrictions on the flow of technology and research can impact long term productivity and growth. This is particularly the case for China. To escape the middle income trap, China will need to achieve reasonably high sustained growth rates. The “middle-income trap” is a theory of economic development in which wages in a country rise to the point that growth potential in export-driven low-skill manufacturing is exhausted before it attains the innovative capability needed to boost productivity and compete with developed countries in higher value-chain industries.
As China’s labor supply declines in line with demographic shifts and investment growth slows following years of extraordinarily high levels of fixed asset investment, future growth must come from higher productivity. However, China has been facing a productivity slowdown over the past decade, making innovation all the more critical.
That begs the question, how might China innovate?
In general, there are three pathways for a state, especially a “catch up” state, to acquire new technology: “making”, “buying”, or “absorbing”4.
- Making entails homegrown innovation, through supporting domestic research and development
- Buying entails foreign acquisitions that result in technology transfer
- Absorbing foreign technology could occur through legal use of openly available research or illicit intellectual property theft.
Developing technology domestically (in the “making” category) tends to take longer and cost more money, while acquiring or “absorbing” tends to be quicker and/or cheaper. Historically, China has used all three pathways to rapidly catch up. However, the risk that rising U.S.-China tensions causes either China to close itself off, or causes the rest of the world to restrict China’s access to its tech would make it difficult to buy or absorb foreign tech and negatively impact China’s ability to innovate and grow.
In some respects, this is already happening—the acquisition channel is already constrained, with Europe and the U.S. turning less welcome to Chinese acquisitions. If, due to restrictions on the flow of research, people, and advanced technology, China’s ability to absorb foreign technology could also be severely restricted.
The importance of technology diffusion
China, along with many developing countries, relies on technology diffusion from advanced economies. It can then apply this research, scale it, and build upon it.
As background, there are broadly three types of R&D: basic, applied, and experimental. According to the National Science Foundation, basic research is theoretical work primarily to acquire new knowledge of the underlying foundations of phenomena and observable facts, without any particular application or use in view. Applied research is directed primarily towards a specific, practical aim or objective, and experimental research is directed to producing new products or processes or to improving existing products or processes.
Currently the focus between the countries is very lopsided; the U.S. spends the majority on basic research to achieve new scientific breakthroughs, and China focuses its efforts overwhelmingly on applied research to develop applications based on breakthroughs achieved elsewhere. This strategy helps explain why China allocates only 6% of its R&D budget to basic research, while the United States allocates 17%. It is also why China spends over 80% of its R&D funds on experimental development, while the U.S. spends only 63%.
Qiaohai Shu of the China Academy of Social Sciences (CASS) explained the logic behind this strategy when he wrote, “Innovation is time-consuming, laborious and risky…but when it comes to applying technology, the opportunity cost to leap ahead is low, (and) the chances of success are high.”5 Understanding that this access to research might shift in line with U.S. policies to limit the flow of research to China, Beijing recently announced plans to scale up basic research to 8% of all R&D spending as part of its 14th Five Year Plan.
Thus, the biggest long-term impact on China from technology tensions could be productivity, which will need to be the engine of future growth. Buying or absorbing research and technology from abroad allows China to expand its own IT production and product development. Technology-using industries will be the drivers of future investment growth and in turn a key factor in lifting labor productivity. If foreign basic research and/or intellectual property are restricted it would force China to pursue the “making” pathway which is slower, more expensive, and less efficient. Broadly speaking, tech decoupling means China’s productivity growth could suffer.
Research by the Rhodium Group helps quantify the impact. For China, the impact of tech self-sufficiency depends on how easily it can substitute foreign tech products with domestic, and how that tradeoff affects long-term productivity. According to their estimations, if China replaced tech imports with domestically produced goods, the resulting productivity loss from inefficiencies would amount to 3% of its productivity growth and it would face an estimated 3.38% reduction in GDP6.
Policy may help offset some of the negative implications
As a final point, the free exchange of goods and ideas represents the most efficient equilibrium from an economic perspective, so understandably, pulling apart that efficient equilibrium implies losses.
For the U.S., tensions could result in lost market share and sales in China. For China, being cut off from advanced products could impede its ability to innovate, reduce productivity, and its long-term growth potential.
However, governments can partially offset the negative impact of tech tensions. The U.S. can look to open new export markets for tech products, and/or the government could subsidize R&D dollars lost from reduced sales to China. China can increase support for innovation through R&D and other incentives for research in science and technology. Although tensions would force China to innovate through the slower and more expensive “making” pathway, large-scale government support could speed the process and absorb the losses.
What does it all mean for investors?
From an investment perspective, we take a simple approach. Technology decoupling, along with an intense interest by both countries to achieve a technological edge means that the technology ecosystem could become bifurcated. Bifurcation, along with large-scale domestic support for innovation, means two global poles of innovation will likely exist and investors will increasingly need access to both for diversification.
In the short term, some companies could be adversely impacted, and in the longer-term, tensions could impact productivity and growth; however, the intense competition between both countries could spur an increase in investment and create opportunities.
For the U.S., the impact is more micro than macro, requiring careful company selection based on which companies are less exposed to tech decoupling. For China, the risks are more macro in terms of the impact on productivity and growth, while opportunities may exist for domestic companies to gain domestic and global market share.
Broadly, investors will need to be more selective in their exposure, weighing the risks that tech decoupling could cause certain foreign firms to lose market share in China. Global investors who have become accustomed to investing in China’s growth through international companies with exposure to China’s market might need to shift as China pursues tech self-sufficiency. Increasingly, global investors who wish to capture China’s growth will need access to fast growing domestic firms that are gaining market share.
For investment in China, investors will also need to be more selective. If our view that tech decoupling presents macro risks, but creates micro opportunities play out, then a bias towards active management could have the advantage over passive index-level exposure.
1 BCG, What’s at stake if the U.S. and China decouple, October 2020 (link)
2 U.S. Chamber of Commerce, Understanding Decoupling: Macro Trends and Industry Impacts, January 2021
3 Phys.org, Biden’s hopes for rare earth independence a decade away, March 2021 (link)
4 Kennedy, A & Lim, D 2018, 'The innovation imperative: technology and US-China rivalry in the twenty-first century', International Affairs, vol. 94, no. 3, pp. 553-572.
5 Military-Civil Fusion: China’s Approach to R&D, Implications for Peacetime Competition, and Crafting a US Strategy.” Horizon Advisory China Standards Series. Horizon Advisory. March 10, 2020.
6 Rhodium Group, Preventing Deglobalization: An Economic and Security Argument for Free Trade and Investment in ICT, 2016
• PHLX Semiconductor Sector Index (SOX) is a capitalization-weighted index composed of 30 semiconductor companies. The companies in the Index have primary business operations that involve the design, distribution, manufacture and sale of semiconductors.
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