Topics:   Corporate Governance,Risk Management,Strategy

Topics:   Corporate Governance,Risk Management,Strategy

January 18, 2019

The Evolving US-China Relationship: What to Pay Attention to In Q1 2019

January 18, 2019

The year 2018 ended with the US-China relationship in a precarious position, leaving many onlookers wondering if this may be another crucial turning point in what’s arguably the most important bilateral relationship in the global economy—a turning point that, this time, is taking a hard turn for the worse.

Sixty-seven percent of respondents to the 2018–2019 NACD Public Company Governance Survey were concerned or very concerned that intensifying global trade conflicts would impact their organizations over the next 12 months, and 38 percent of respondents specifically identified increased competition with China as impactful to their organizations.

A survey of US-China Business Council (USCBC) members in 2018 reiterates these concerns: worsening US-China relations ranked as the number one challenge to US companies doing business in China in 2018—up from being ranked as the eighth biggest challenge in 2017. Seventy-three percent of respondents to the USCBC survey also indicated their business with China had been affected by the current US-China trade tensions.

With the future of US-China relations more uncertain than ever before, here’s what to watch for this quarter.

Prepare for continued volatility in the short term as official talks continue.

The Development: Midlevel officials from the United States and China met in Beijing last week to conduct preliminary negotiations on resolving the trade dispute that erupted during 2018 and resulted in $250 billion in tariffs on US imports of Chinese goods and $110 billion in tariffs on Chinese imports of US goods. US President Donald J. Trump and Chinese President Xi Jinping agreed to a 90-day truce in December to stop increasing or initiating new tariffs—and China has since reduced tariffs on US cars and auto parts and recommenced purchases of US soybeans. The first round of talks also resulted in China’s approval for imports of genetically modified crops and a pledge by the Chinese “to purchase a substantial amount of agricultural, energy, manufactured goods, and other products and services,” according to the Office of the US Trade Representative.

A second round of midlevel talks will take place in Washington next week, with a meeting between cabinet-level officials scheduled for January 30. Ahead of these talks, US officials have discussed removing the import tariffs on Chinese goods as a way to advance the trade talks and extract concessions from the Chinese. However, resolving the underlying issues (aside from the trade deficit) that initiated the trade dispute in the first place—Chinese-government-directed acquisitions and investments, forced technology transfers, biased licensing processes, and cyberattacks targeting US networks—may prove difficult, as China collects foreign intellectual property (IP) through these methods to further its own technological supremacy goals. Made in China 2025 (MIC2025) is China’s plan to become the global leader in high-tech manufacturing by developing 10 sectors—including electric cars, agricultural technology, and aerospace engineering, among others—to become 70 percent self-sufficient in these industries by 2025 and completely self-sufficient by 2049 (the 100-year anniversary of the founding of the People’s Republic of China). For MIC2025 to succeed, China relies on copying and building upon Western technology.

Board Considerations: Boards should expect continued volatility in US-China relations and prepare for tensions to exacerbate further—even if their businesses aren’t currently affected by the trade dispute. “We’re at an inflection point [in the US-China relationship],” said USCBC President Craig Allen. “But like any real inflection point, it’s not safe to say what happens after that inflection point. We are not wise if we discount the trade conflict and if we believe it will stay in narrow, tariff-bound lanes. This has the potential for expanding well beyond that.” The scenario of a prolonged economic and political “cold war” cannot be ruled out.

Allen provides three possible scenarios for how a US-China trade truce may shape up by the March 1 deadline, with all scenarios equally likely:

  1. The Happy Scenario: The United States and China agree to provisions that improve US access to the China market and increase IP protections for US companies—leading the United States to lift the Section 301 tariffs and the Chinese to reciprocate by lifting their own retaliatory tariffs.
  2. The Baseline Scenario: The current arrangement is extended, with the existing tariffs remaining in effect and no agreement being reached by the deadline.
  3. The Unhappy Scenario: President Trump raises tariffs on Chinese goods that are currently at 10 percent to 25 percent, as he has threatened, and begins a process of imposing additional tariffs on the remaining goods imported from China.

Boards should ask management to consider how the company’s value chain can be diversified over the long term to avoid overreliance on a single country. Audit and risk committee members of industries currently unaffected by the tariffs should consider how long-term economic- or security-related tensions between the United States and China could impact future strategy. As the deep-rooted issues fueling US-China trade tensions, such as forced technology transfers, may not be easily overcome in the short term, boards of companies just entering the China market may reconsider entering into joint ventures—especially in light of China loosening its requirement for foreign automakers to enter into joint ventures with Chinese companies. Directors should ensure management is balancing the need to protect IP—upon which long term strategy may be contingent—with the short-term need to capitalize upon the size of the China market.  

In the short term, boards of companies exporting goods to China should question whether the Chinese market still remains profitable given imposed or potential tariffs, and explore alternative growth strategies in other emerging markets. Boards should ensure management is seeking alternate suppliers in the case that production inputs coming from China are, or could be, impacted by escalating tariffs.

China’s government is focused on addressing slowing economic growth, which may lead to downward pressure on its private sector.

The Development: In addition to undergoing negotiations on the trade dispute with the United States, the Chinese government is under pressure to deal with slowing economic growth and a high percentage of leverage in its stock market. China’s economic growth in Q3 2018 was 6.5 percent, which was its slowest growth reported since the days of the global financial crisis, and China’s projected gross domestic product growth for Q1 2019 was also reduced from 6.5 to 6.3 percent. By the end of 2018, the Shanghai Composite was down over 24 percent in comparison to the end of 2017.

Furthermore, over $600 billion worth of Chinese shares, or 11 percent, have been put up as collateral for loans by company founders or major shareholders—which are at risk of margin calls. To reduce the risk of continued selloffs as the market slides, state-owned enterprises (SOEs) purchased $6.2 billion worth of stakes in 39 Chinese private companies from January to October of 2018, and the government introduced a number of economic measures to cut down on “shadow banking” practices from private companies that were cut off from obtaining loans through official channels.

Board Considerations: The following developments may decrease opportunities for foreign firms to compete in the China market: slowing domestic growth; increased dominance by state-owned enterprises; and protection of mission-critical sectors such as technology, specifically artificial intelligence and e-commerce. Chinese SOEs, as well as Chinese private companies, are known to receive preferential treatment in regards to financing opportunities, tax incentives, and policy enforcement, among other areas. Directors are encouraged to discuss how a slowdown of China’s economic growth might impact profits, and how the company strategy could be adjusted to offset these impacts. Boards should question management’s strategy for competing with both Chinese state-owned and private firms, given their preferential treatment. Directors may also discuss at their board meetings what implications about the appetite of Chinese consumers can be taken away from Apple’s slashed sales forecast.

Slowing economic growth in China is also often coupled with increasing signs of nationalism and censorship from the Communist Party as a way to hedge against domestic instability. American companies operating in China, especially technology companies, should constantly re-evaluate requests for product modifications from the Chinese government, and discuss how those limitations might promulgate human rights violations in China. Could your products be used to further restrict freedoms of Chinese citizens or collect data on their activities? Is your company ready to deal with the reputational backlash from its stakeholders?

Look for continued analysis in the NACD BoardTalk blog on the business climate in China as trade negotiations continue to evolve.