Strategic Insights
May 16, 2019

Will U.S.-China Supply Chains Survive Failing Trade Talks?
 

Predictions of near-term bifurcation of global supply chains are overblown, but the business climate between the United States and China will remain difficult for the foreseeable future.

• The breakdown in trade negotiations are proof of growing limits to U.S.-China trade integration—fully 40 percent of the global economy and the world’s two largest individual country consumer markets—but decoupling will be gradual and uneven.
• CSIS’s Will Carter: “Immediate separation is not really possible and would be incredibly damaging to the U.S. … unraveling existing supply chains, shifting fixed capital and building up alternative capacity is not something that can be done overnight.”
• CSIS’s Bonnie Glaser: “For manufacturing companies that produce for export, there is likely to be a shift in assembly lines. Companies that produce for sales in China will remain in the hope that they can take advantage of China’s gradual shift toward a consumption-driven economy.”

Trade negotiations have confirmed that Beijing is unwilling to alter its economic policy—a position it has held since its 2001 WTO accession.

• China is focused on growing its technology and innovation base. China stopped publicly referencing its “Made in China 2025” strategy after growing U.S. criticism but implementation continues.
• The strategy employs heavy state subsidies—and in many cases direction at the national and provincial governmental levels—to grow domestic companies that can dominate the Chinese market and eventually compete globally, all at the expense of foreign competitors.

• The White House has continually escalated its approach to reducing Chinese imports and the U.S. trade deficit, beginning with anti-dumping cases inherited from the previous administration, then section 301 and 232 investigations, and now broad deployment of tariffs.
• The Foreign Investment Risk Review Modernization Act (FIRRMA) and Export Control Reform Act (ECRA) also created new barriers to Chinese and U.S. investment and cooperation in the fastest-growing areas of the trade relationship.
• The U.S. global campaign against Chinese-supplied 5G networks, escalated by yesterday’s executive order to effectively bar Huawei from the U.S. market, is convergent if not strategically integrated with overall Trump administration trade policy objectives.

• Congress authorized FIRRMA and ECRA to reduce transfer of sensitive technology and information to China, strengthening the existing Committee on Foreign Investment in the United States (CFIUS) process. Both houses of Congress continue to hold frequent hearings on China’s economic and technology policies and practices.
• The results are clear: Chinese investment in U.S. companies collapsed from $46 billion in 2016 to $5 billion in 2018.

• A UBS survey found that 37 percent of export-oriented manufacturers in China had moved at least some production (typically accounting for 30% of their exports) out of the country in 2018 with another 33 percent intending to do so in 2019.
• Similarly, an American Chamber of Commerce in Shanghai survey found that tensions have led to 30.2 percent of respondents to adjust their supply chains to source components and/or assembly out of China and 18.3 percent to consider relocating some or all manufacturing out of China.
• And in A.T. Kearney’s 2019 Foreign Direct Investment (FDI) Confidence Index, China moved from the second-ranked FDI destination on the list to seventh—its lowest ranking in the 20 year history of the index.

• CSIS’s Scott Miller: “The most pronounced trend in value chains is that they are becoming more regional and less global… Factory Asia, Factory Europe, and Factory North America are becoming more integrated and less connected with each other.”
• “This process is coincident with (and perhaps caused by) the increasing services content of goods—labor inputs account for less value-added, while embedded services account for more.”

• The decision by the administration to exit the Trans-Pacific Partnership (TPP) was a victory for Beijing; U.S. reengagement in what has emerged as the 11-nation CPTPP would be the quickest way to gain leverage in current negotiations with China.
• As a next step to turn the tables on Beijing, the United States should consider how to reverse course and improve trade relations with Europe, growing a united front against China.

• Will Carter: “I would also recommend companies think about where they sit in the supply chain. A company selling directly to US consumers or enterprise customers from Chinese suppliers or that does final manufacturing or assembly in China might be more likely to find themselves in the political limelight than companies whose China exposure is a few layers down the supply chain.”
• “In general, I would recommend companies look at diversifying their supply chain and market risk. Many companies I have spoken to are heavily concentrated in China, and as the international political and trade climate becomes more tense not being over-exposed to any one country is a good investment.”

• Will Carter: “I’m not expecting additional export control legislation in the immediate term, although the collapse of the trade talks does raise the risk of additional punitive action from both Congress and the White House.”
• “I think the immediate risk is that FIRRMA and ECRA will be implemented very stringently, and that we see more movement on supply chain risk.”
• Scott Miller: “‘Free trade’ will likely continue in its current form, that is relatively complete coverage of industrial goods within the factories—NAFTA/USMCA, the EU Single Market, and ~200 Asian bilateral FTAs, plus the ITA (free trade for electronics).” 
• “Free trade in agriculture is a pipe dream, free trade in services is going nowhere.  But, on the bright side, it’s goods trade that makes the ‘factories [Factory Asia, Factor Europe, and Factory North America] operate.”
• Both sides will be watching economic indicators closely ahead of the meeting between presidents Trump and Xi on the sidelines of the G20 meeting at the end of next month in Osaka, Japan. Who might blink first, or will the head-on impact continue?