Escalating US-China Tensions: Implications for Investments and Industries in the New Cold War
The intensifying tensions between the United States and China have been evident for a considerable period. The US-China trade war, which emerged in early 2017, serves as a primary manifestation of these tensions. However, recent events such as the US downing a suspected Chinese spy balloon, the escalation of hostile rhetoric between the two countries, and President Biden’s plans to impose additional investment restrictions on China ahead of the G7 summit have once again brought these tensions to the forefront. As a result, the investment and industry implications are a topic of significant concern.
The relationship is currently at its worst since the historic meeting between Henry Kissinger and Zhou Enlai in 1971 that initiated the normalization of US-China relations. Allison argues that the recent rise in tensions was predictable, as historical patterns indicate that such hostilities tend to occur when a rising power, such as China, poses a serious challenge to a major ruling power like the US.
While the expectation is for the relationship to further decline as China challenges the United States’ dominant position in Asia, there remains a belief that war between the two nations can be avoided. However, it is crucial to emphasize the necessity for extraordinary efforts to avert such a situation.
All eyes are currently on President Biden’s forthcoming executive order, which is anticipated to impose additional restrictions on US outbound investments to China, particularly in technology sectors, with advanced semiconductors being the primary focus.
Richard Hill, a veteran in the semiconductor industry, explains that semiconductors have become a significant point of contention due to concerns among US policymakers that Chinese advancements in semiconductor technology could undermine America’s military capabilities. However, Hill believes that such concerns are exaggerated. Furthermore, he argues that the subsidies provided under the US CHIPS and Science Act, aimed at revitalizing US semiconductor manufacturing, are insufficient to meet the scale of domestic industry needs.
Note : China produces more than 95% of the world’s raw gallium, a soft, bluish metal used in making chipsets for generating high frequency radio waves in 5G base stations.
Additionally, a shortage of skilled labor poses a significant challenge. Likewise, China faces limitations in becoming self-sufficient in semiconductors due to equipment and critical materials constraints. Consequently, Hill does not anticipate a substantial reshaping of the global semiconductor supply chain in the near future, despite shifting investment flows within the industry.
Many observers argue that given China’s rapid economic growth and its distinct political system, some level of tension with the United States was inevitable over time. China’s economy, in terms of purchasing power parity (PPP), caught up to the US after the 2008 financial crisis and continues to grow at a faster pace.
The erosion of the US manufacturing base, the rise of Chinese global competitors in key industries, and the persistent US trade deficit have all underscored China’s increasing economic influence. Geopolitically, disputes over Chinese sovereignty periodically surfaced with neighboring countries, and the US often demonstrated its alliances through displays of force, such as military exercises with allies or “freedom of navigation operations” in the South China Sea. However, in recent years, several new factors have strained the US-China relationship:
The US trade war and unresolved bilateral imbalances: President Trump’s initiation of the trade war signaled a significant shift in US economic policy towards China. While tariffs did reduce imports of specific Chinese products to some extent, they did not bring about a substantial shift in the bilateral trade imbalance due to significant differences in saving and investment patterns between the two countries. The conditions set by the Trump Administration for tariff removal, such as purchase targets for US goods, were never met. Chinese policymakers were surprised and disappointed by the Biden Administration’s decision not to lift the tariffs.
Hong Kong protests: Although the UK and US governments recognized Mainland China’s sovereignty over Hong Kong following the 1997 handover, they rhetorically supported pro-democracy protesters in 2019, which angered Beijing. Chinese policymakers attributed the protests to “foreign forces” and imposed a new national security law in Hong Kong, drawing criticism from the US and its allies.
The Covid pandemic: The global pandemic, the most significant in a century, caused immense economic and human suffering. However, even after more than three years, there is no consensus on the origin of Covid. The World Health Organization’s investigation remains incomplete, according to its own assessment, and US policymakers have expressed dissatisfaction with China’s level of cooperation. Both countries took divergent approaches to Covid control, criticized each other’s handling of the crisis, and relied on domestically-developed vaccines. The lack of cross-border travel and face-to-face interactions between US and Chinese citizens and policymakers further exacerbated misunderstandings.
Russia’s invasion of Ukraine: Following Russia’s invasion of Ukraine, China and Russia initially declared a “no-limits” partnership, coinciding with the first land war in Europe since World War II. While Chinese policymakers have refrained from using that phrase since then and likely view the war as complicating their efforts to maintain positive relations with Europe, they have consistently emphasized strategic alignment with Russia. Recent meetings between the presidents and defense ministers of both nations further highlight this alignment. Trade between China and Russia has witnessed a significant increase since the commencement of the war.
In response to Russia’s unexpected invasion, US policymakers have drawn the conclusion that stronger efforts to deter China’s mainland may be necessary to safeguard Taiwan. Ongoing US weapons sales and visits by policymakers to the island have sparked protests and triggered military exercises from China’s mainland.
With the shift in US policy, moving away from tariffs and towards technology…
Amidst worsening relations, tariffs, which were initially intended to be temporary, have remained in effect. However, the focus of bilateral tension has shifted towards technology and investment. National Security Advisor Jake Sullivan has emphasized the US strategy of maintaining a substantial advantage in critical technologies compared to its rivals.
In line with this strategy, US export controls have undergone significant expansion during the Biden Administration. Under President Trump, notable restrictions were imposed on telecommunications companies such as ZTE and Huawei, primarily due to their sales of equipment with embedded US technology to Iran. In the first 1.5 years of the Biden Administration, the US Department of Commerce added various Chinese firms from sectors like supercomputing, surveillance technology, aerospace, drones, and others to its Entity List or subjected them to military-industrial company sanctions. The aim was to prevent the supply of advanced US technology to companies that might be associated with China’s military or surveillance activities, particularly in Xinjiang.
In October 2022, the US took a significant step by announcing a broad ban on the export of advanced semiconductor technology, including chips, equipment, and related software, to all of China. This decision essentially abandoned the attempt to identify sensitive or military end-users, partly due to China’s civil-military fusion policy. While policymakers have mentioned the possibility of imposing controls on other strategic industries like biotech and biomanufacturing, the semiconductor controls are expected to have the most substantial macro impact.
Various potential scenarios have been examined, including a base case that could lead to a cumulative decline of nearly 2% in China’s GDP over the next few years if the competitiveness of specific downstream export sectors is affected. The US has also closely scrutinized Chinese investments in the US through the Committee on Foreign Investment in the United States (CFIUS) process.
China endeavors to uphold connectivity
As tensions between the US and China intensified, and the US implemented restrictions on China in the areas of trade, technology, and investment, Chinese leaders responded with a hardened rhetoric towards the US. President Xi Jinping, in particular, explicitly referred to the US during the annual “Two Sessions” and accused Western countries, led by the US, of implementing containment, encirclement, and suppression against China. In response to US tariffs and controls, Chinese policymakers are seeking to discourage other countries from joining US sanctions efforts and are emphasizing the importance of self-reliance to reduce dependence on foreign economies.
China is heavily investing government resources in the development of cutting-edge technologies. It has established dominance in the electric vehicle (EV) battery supply chain, with global investments in raw materials and leading manufacturing capacity within China. Semiconductor development has become a higher priority following US sanctions, and the government has revitalized the “Big Fund” with new leadership. China could potentially leverage its advantages in sectors such as rare earth production and refining to gain economic or diplomatic concessions, although it has exercised caution in this regard with respect to the US.
To ensure market access, China has pursued its own trade agreements such as the Regional Comprehensive Economic Partnership (RCEP) and has applied to join existing agreements like the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP). China’s diplomatic efforts have been active, including high-level meetings and the recent announcement of a Saudi Arabia-Iran détente. Chinese exports continue to grow in emerging markets and, to a lesser extent, in Europe. Some production capacity targeted at the US market, particularly in later-stage operations like assembly, is shifting to countries and regions not subject to tariffs, such as India and Southeast Asia.
China is making efforts to reduce its dependence on the US dollar and mitigate the impact of US financial sanctions. The use of the Chinese currency, RMB, has increased in Russian firms and bilateral trade. China also aims to expand the use of its currency with other key trading partners in regions like the Middle East and Brazil. Large-scale testing of China’s digital currency, e-CNY, is ongoing, and there has been a slight shift of foreign reserves towards gold in recent months.
Direct retaliation by China has been limited, partly to avoid deterring desired foreign investment. Apart from symbolic tariff retaliation, China has placed two US defense contractors on an “unreliable entities list” for arms sales to Taiwan and has investigated or penalized several foreign firms, including launching a security review of US chipmaker Micron.
A New Cold War: New Strategic Focus in US-China Policy
Tariffs remain in place, but are now of less significance
Initially implemented by the Trump Administration as a means to address economic concerns and reduce the bilateral trade deficit, tariffs on Chinese imports have remained in place under the Biden Administration. Despite facing challenges in court, including recent rulings upholding the Section 301 tariffs on over $300 billion worth of imports from China, there are no immediate indications of significant changes to the tariff policy. In fact, the tariffs have now become a non-controversial aspect of US-China relations, with their removal carrying greater political risks than maintaining them.
While the elimination of tariffs would have a disinflationary effect, it is important to note that the overall impact would be relatively small and diffuse, resulting in a minor decrease of approximately -0.2 percentage points on core Personal Consumption Expenditures (PCE).
Strategic Focus: Shifting Policies Towards China
During the latter stages of the Trump Administration and continuing into the Biden Administration, US policy towards China has undergone a significant shift, moving away from purely economic considerations to a more strategic approach. This change is most evident in the realm of technology. The Biden Administration has transitioned from aiming for a “relative advantage” in key technologies to striving for “as large a lead as possible” over its competitors. This shift has led to two main consequences:
- Expansion and intensification of export controls: Export controls, which began increasing during the Trump Administration (e.g., targeting Huawei), have continued to escalate. Notably, in the fall of 2022, the Department of Commerce implemented stricter export controls on semiconductors, encompassing restrictions on equipment, components, and services. The Entity List has also been expanded, requiring US companies to seek licenses for trade with entities listed under a “policy of denial,” which now includes the Chinese semiconductor company YMTC. The Biden Administration is expected to further expand the scope of technologies subject to export controls under the “emerging and foundational technologies” export control rules, known as “Section 1758” technologies.
- Likely implementation of new restrictions on outbound investment: The Biden Administration has been developing policies for outbound investment, similar to the existing inbound process under the Committee on Foreign Investment in the United States (CFIUS). An executive order is anticipated in the coming weeks to introduce these restrictions. They are expected to apply to US private sector investment in critical sectors such as semiconductors, quantum computing, and AI. These policies are likely to include new reporting and notification requirements. However, there may be important exceptions as the aim is primarily to limit the transfer of US expertise and technology rather than capital itself. The focus of these policies is likely to be on active investments rather than passive portfolio investments.
Limited legislative action despite strong rhetoric in Congress
While Congress has seen a lot of discussion surrounding China-related policies, the actual legislative developments have been relatively modest. In late 2022, a spending bill was passed that included a few amendments with a focus on China. The most notable measures include an accelerated delisting timeline for companies that fail to meet US auditing standards, now reduced to two years instead of three, and a ban on TikTok usage on federal government devices, which carries mostly symbolic weight.
Despite the ongoing hawkish rhetoric coming from Congress, it is expected that headlines emphasizing a tough stance on China will continue. The opening remarks by Rep. Gallagher (R-WI), Chairman of the new House Select Committee on China, during its inaugural hearing reflected a maximalist perspective, characterizing the strategic competition with China as an existential struggle shaping the future of the 21st century.
Although the committee does not possess legislative authority, its initial hearings have not yet put forth specific policy recommendations. However, the Chairman has expressed an interest in examining US investment in China, as well as identifying critical areas where the US relies on China in its supply chain, such as rare earth minerals, pharmaceuticals, and medical goods. Additionally, Senator Schumer has indicated that Senate Democrats are likely to introduce a China bill later this year, potentially during the summer, which could serve as an update to the previously proposed but unpassed “Strategic Competition Act” from 2021. This forthcoming bill is expected to become another central focus for China-related policy discussions within Congress.