Have you wondered why Huawei is always in the news? Wonder no more. We also examine the Great wall of debt, how China is finding its place in the world and look at what is behind China’s trade war with the USA?

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Note: This article was first published in the January 2019 edition of Investing Insights, our 15th publication of Investing Insights.

Key takeaways

  • Debt in state-owned enterprises is biggest economic risk in China
  • An escalation in the US China trade war will slow Chinese, global and Australian economic growth
  • A cessation in the trade war will simply lead to the next issue of conflict between the US and China

Stimulus from the Government ensured growth in China in 2018 (6.6%) fell only slightly from 2017 (6.9%). It was actually higher than the market had expected and slightly above the Government’s own target (6.5%). However, 6.6% growth is the slowest since 1990.

The problem with a seemingly high growth level by Western standards (Australia’s growth is ~2.8%; USA ~3.0%) is the trajectory of the growth. Chinese annual growth averaged 9.6% from 1998 to 2018 and it’s clearly now heading downwards. After seemingly never-ending economic growth, China is now trying to manage this transition in their economy.

Apart from the ongoing trade war, China faces the problems of high debt levels and a slowing property construction industry (residential real estate accounts for most of Chinese construction output).

Great wall of debt

While the debt held directly by the Government is not high, the debt held by state-owned enterprises and local governments increased rapidly in recent years.

These businesses went on a debt-fuelled investment and spending spree which was good for growth at the time but the debt has to be paid back eventually.

Trade war will start to bite

While the impact on Chinese growth from the trade war with the US was muted in 2018, it will increase in 2019 if the trade war continues. The IMF estimates that US tariffs could reduce Chinese growth by 0.6%, which would take Chinese growth below 6% in 2019.

We fear that China may not be able to successfully deal with a trade war and decrease state enterprise debt at the same time without growth falling materially. We expect the Chinese share market to remain incredibly volatile in 2019. We remain underweight in our exposure to China and to the wider emerging markets.

President Xi forever?

“President for life… I think it’s great. Maybe we’ll have to give that a shot some day.” President Trump

Perhaps the biggest piece of news out of China in 2018 was news that the national constitution had been changed to remove the two-term limit on the presidency. President Xi was due to step down in 2023 but instead has consolidated his power to a level not seen since Mao Zedong (Chairman of the Communist Party from 1943 to his death in 1976).

This has shifted power in China from a group of nine old men sitting on the Politburo Standing Committee to one man.

While, technically, President Xi could now rule for the rest of his life (like Mao Zedong), it is more likely that he will give himself another five year term. This will extend his rule to 2028 (he will be aged 75) and allow him to install his protégés. It is hard to see his grip on power being challenged by anyone in the near future.

US China détente?

Détente /deɪˈtɑːnt/ noun / the easing of hostility or strained relations, especially between countries.

In December 2018, Presidents Trump and Xi met face-to-face on the sidelines of the G20 conference in Argentina. The talks were positive and initial reports revealed a trade truce had been reached. In the weeks that followed, confusion set in as both sides argued over what happened and what was agreed.

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It says much about the current state of expectations that, even in this fog of confusion, the fact that they sat down and agreed one or two things was enough to reassure markets. It is in the interests of both leaders to reduce tensions and to avoid pressures on their domestic economies and share markets.

Key to the temporary truce was that the US would not raise tariffs to 25% from 10% on 1 January 2019 and that further talks would take place. They set a 90-day “timetable and road map” but no one was really sure when the 90 days started.

However, the trade war is but one symptom of the ongoing fundamental shift in relations between these two great powers. Even if this current trade war eases off, other conflicts between the two nations will rise and the risk of a conflict increases.

China finding its place in the world

In 1972, US President Richard Nixon embarked on a 7-day visit to China, ending 25 years of no ties or communication between the USA and China. After meeting with Premier Zhou Enlai and Chairman Mao Zedong, President Nixon described his visit as “the week that changed the world.” Today, historians recognise it as the most important visit by a US president anywhere and we still feel the historic reverberations of that meeting.

Since then, every US President (except President Carter) has followed in President Nixon’s footsteps and visited China. Each has followed a bi-partisan policy of constructive engagement with China.

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Aside: President Carter did actually visit China in 1949, well before he was elected President. He visited the port of Tsingtao (now Qingdao) as a submarine officer on the USS Pomfret to support the Nationalist Chinese under Chiang Kai Shek who were using the port to flee to Taiwan from the new Chinese Communist Government. The Nationalists in Taiwan remains a major Chinese issue today.

Aside: In 1972, President Nixon was the actually third senior western politician to visit China. The second was his National Security Adviser, Henry Kissinger, who secretly travelled there to set up Nixon’s trip. But it was the then Australian Opposition Leader, Gough Whitlam, who was the first western politician to travel to China in 1971 to meet with Premier Zhou Enlai. Ridiculed by the Australian press, his ground breaking visit was the first step in establishing Australia’s economic and political relationship with China.

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The US sought to use diplomacy to convince China to open its economy to market forces and to play by the rules America set in the world order. The US view was that if they treated China as an enemy then that would make them an enemy. If, instead, they treated them as a friend, they may make them into a friend.

In late 2001, the policy looked like it was working when China joined the World Trade Organisation, a significant step toward integrating in the US-led world order. The move was fully supported by President Clinton’s administration.

However, since then US China relations have been bumpy. In 2005, President Bush’s Deputy Secretary of State, Robert Zoellick, urged China to become a “responsible stakeholder” in the world economy.

Well before President Trump, successive US Treasury Secretaries urged China to liberalise its financial services industry; to reduce its currency interventions, to reduce foreign ownership restrictions; to remove industrial policies and unfair trade practices that reduce competition (eg subsidies and dumping goods at below-market prices); to lift Chinese bans on certain US imported goods; to remove uneven tariff rates; and to clamp down on intellectual property theft. China just ignored them all.

What is behind the trade war?

To understand what lies behind the trade war, you need to understand global intellectual property.

What is intellectual property (IP)?

According to the World Intellectual Property Organisation, IP refers to creations of the mind, such as inventions, literary and artistic works, and designs, symbols, names and images used in commerce. It is protected in law by patents, copyright and trademarks.

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Patents cover the right to make, use or sell an invention; copyright covers the right to express an idea (eg literary, dramatic, musical, artistic, and other intellectual works); and trademarks cover words, names, symbol or devices used to indicate the source of the goods (eg brand names, logos and slogans).

For example, if you have an iPhone, the brand iPhone is trademarked globally by Apple. As are AirPods (cordless headphones), the brand Apple itself, and the Apple symbol.  Apple also has more than 200 patents relating to the technology inside your iPhone. If you have music, movies, or eBooks on your iPhone, then that content will be covered by copyright. So now you know what patents, copyright and trademarks are; the three types of intellectual property. And IP is at the heart of the dispute between the US and China.

Why is intellectual property theft bad?

Each of the 3 types of IP (patents, copyright and trademarks) enables people to earn recognition or financial benefit from what they invent or create. This fosters creativity and innovation.

If ideas from companies, individuals, government or academic institutions are stolen, products can be manufactured by companies somewhere else (such as in China) without the need to pay any research and development costs. The copying company can then sell the products at a far lower cost and kill off any competition from the company that invented or developed the product in the first place.

If we’re going to be brutally honest, industrial espionage is a fairly normal part of international relations. Yes, China does it, but so too do the United States, France, Russia and Israel. For example, two of the CIA’s four intelligence directorates are involved in scientific, technical and economic espionage.

However, China is now taking industrial espionage to a whole new level. They exert pressure on foreign corporations in China to hand over their IP. They force foreign companies to enter into joint ventures with local domestic enterprises and force them to transfer the IP to these local partners. Many of these local partners are directly or indirectly owned or controlled by the Chinese state. So it’s effectively state-authorised, fully legal (under Chinese law) IP theft on an industrial scale.

As well as forced technology transfers, Chinese firms are also making strategic US technology acquisitions. To top it off, China also resorts to outright cyber theft.

Regardless of all this, US companies still want to invest in China because the opportunities of selling to a market of 1.4 billion people are just so immense. They don’t want to hand over their IP to Chinese companies and they hate the counterfeiting of their brands but they also don’t want to miss out on the massive opportunities for growth.

Please note: If this report is being read in China, please be aware that we completely retract anything we may have said above about Chinese industrial espionage. We are happy to abide by all Chinese laws, regulations and anything you wish us to adhere to. Duì bu qǐ 对不起. We are deeply sorry for spreading fake news. However, if this report isn’t being read in China, then we encourage you, dear reader, to please ignore this paragraph and move on.

What does IP theft cost?

According to estimates from the National Bureau of Asian Research, IP theft costs the US economy US$225 billion to US$600 billion a year. To put that number in perspective, Australia’s entire output (GDP) in a year is US$1,300 billion (or US$1.3 trillion). So the theft of IP equates to between 20% to 46% of Australia’s entire economy for a year.

From constructive engagement to strategic containment

For 46 years from 1972 to 2018, the US stuck to its policy of constructive engagement with China. In 2018, President Trump abruptly ended that policy and shifted the US to a policy of containment of China. Thus began the tit-for-tat tariffs.

This did not come out of the blue from President Trump. Throughout his 2016 campaign, he vilified China and blamed it for the ills of American manufacturing workers. President Trump believes that the US’s efforts to integrate China into the US-led international order has only resulted in creating new threats to US primacy, especially in Asia.

This shift in US policy will have profound impacts on the world and, especially, on Australia. China takes 30% of Australia’s exports and provides 23% of our imports. Any escalation in the trade war between China and the US could potentially wreak havoc on Australia’s economy.

Importantly, it is likely that this strategic shift will likely last well beyond President Trump’s term/s in office.

China’s growing global confidence

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You may have heard of the Chinese slogans ‘Made in China 2025’ and ‘Belt and Road Initiative’ (also known as ‘One Belt One Road’). If you haven’t, then you will increasingly so in the coming years.

‘Made in China 2025’ is a 10 year strategic plan China developed in 2015 to transform China’s economy from being dependant on cheap goods and low quality manufacturing to an economy that develops higher value products and services.

The plan focuses on high-tech industries such as the pharmaceutical industry, the automotive industry, the aerospace industry, telecommunications, semiconductors, IT and robotics. Not coincidentally, all these industries are dominated by US companies (European and Japanese to a lesser extent).

So, instead of China manufacturing cheap plastic McHappy meal toys and cheap tools you buy at Bunnings, China will develop and manufacture its own version of the iPhone.

Of course, the quickest, easiest and cheapest way of undertaking this transformation is to steal the knowledge from Western companies or to force them to hand it over.

The Chinese Government has committed US$300 billion to achieve its ‘Made in China 2025’ goal. A cynic might point out that amount equates to how much Chinese theft of IP costs the US economy each year, but luckily we are not cynics.

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Why are Huawei and ZTE always in the news?

In telecoms, China has two global equipment makers in Huawei and ZTE. As part of its ‘Made in China 2025’ policy, China wants these companies to dominate the shift from 4G to 5G. If you don’t know what 4G is then you won’t know what 5G is and your eyes have probably glazed over. But stick with us – this is important and hopefully we can lift the confusing fog of acronyms. 4G is the fourth generation of mobile phone technology – it’s the technology in your smart phone and behind your mobile network.

We’ve had 4G technology since 2009. Before that, we had 3G technology. You don’t need to understand the technology but you need to know the difference is the speed at which the network can move data.

The faster your mobile phone network can move data, the more services you can use. For instance, you can watch Netflix on your 4G phone but you could never do that on your 3G phone. If you’re wondering, the first 4G iPhone was the iPhone 5 (the iPhone 4 and earlier models were 3G phones).

5G will be up to 50 times faster than 4G so we will get many more services. 5G will also make us all wonder why on earth the Australian government wasted so much money on an antiquated NBN.

China missed out on leading the development of 3G and 4G technology (led by European and US companies) and it doesn’t want to miss out again. It wants Huawei and ZTE to be 5G global champions.  That is why it is so important to China for Huawei and ZTE to dominate 5G technology. And why it is so important to the US and its ally that they don’t.

In 2018 the US, Australia, Japan and New Zealand blocked Huawei and ZTE from supplying their mobile phone carriers with 5G network equipment (that’s the network stuff you don’t see that makes all the smartphone magic happen, not your phone itself). They all deemed Huawei and ZTE unacceptable security risks – for using their equipment to spy on people, government and companies and for stealing IP. In 2019, Germany, France, the UK and Canada are also looking at implementing similar bans.

Not just catch up

China isn’t seeking to catch up to the US, it is seeking to dominate technology and other industries well into the 21st century.

The US think tank Council on Foreign Relations declared in 2018 that ‘Made in China 2025’ is a “real existential threat to US technological leadership.”

‘Made in China 2025’ will undoubtedly harm US companies and it is no coincidence that President Trump’s tariff list mainly focuses on the products included in the ‘Made in China 2025’ plan.

Belt and road initiative across Asia & beyond

By comparison, China’s ‘Belt and Road Initiative’ is a massive investment in infrastructure developments in countries in Europe, Asia and Africa.

‘Belt’ refers to the six land-based corridors for road and rail transport (‘the Silk Road Economic Belt’) to other countries. Confusingly, ‘Road’ refers to the major sea route to other countries.

In history, the ‘Maritime Silk Road’ was the sea route connecting China to SE Asia, Indonesia, India, Arabia and beyond to Egypt and finally Europe (200 BC to 1500 AD).

The ‘Belt and Road Initiative’ strategy was unveiled by Chinese President Xi in 2013. It covers six belt (land) and one road (sea) corridors traversing circa 60 countries (in Asia, Europe, Oceania and East Africa) at an estimated cost of US$4–8 trillion.

China is not undertaking this massive ‘Belt and Road Initiative’ out of the goodness of its heart. It seeks to fundamentally reshape global trade, with China squarely at the centre. It also hopes that the infrastructure corridors will spur growth in China’s underdeveloped hinterland and rustbelt. One concrete result of the ‘Belt and Road Initiative’ is that today, China is home to more than 50% of the world’s total constructed high-speed railways.

US created a void

Perversely, when President Trump was first elected one his first acts was to reject the Trans-Pacific Partnership (TPP). It was a signed, comprehensive trade agreement between Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, Vietnam, and the US. When the US refused to ratify the TPP, this enabled China to more easily sell the economic benefits of its ‘Belt and Road Initiative’ to many of these same countries. President Xi filled the void left by the US and promoted China as the new global champion of free trade