Economic Conflict with China

Economic Conflict with China

Meeting the Threat Together

Dr. Shale Horowitz/University of Wisconsin-Milwaukee

China’s economic rise no longer looks like a benign story of inward-looking development and international coexistence. Under General Secretary Xi Jinping in particular, the characteristic Chinese Communist Party (CCP) methods of internal economic and political control have become more centralizing and repressive.  Foreign policies are more overtly aggressive. These policy changes have come as China’s economy moves into a more capital-intensive specialization. This presents other nations — particularly in the Indo-Pacific region — with a raft of major new economic security threats, which often compound worsening military security threats.

How can threatened states best respond? To answer this complex question, it helps to categorize the variety of threats and response capacities. Powerful countries that face economic and military threats from the CCP are likely to form the strongest coalition advancing the most effective responses. These states, in turn, are likely to attract the cooperation of a second important group of states, which face threats that are primarily economic. This is illustrated by examining three threats to infrastructure and supply chain security — in telecommunications, rare earth minerals and semiconductors — and an example of interstate policy coordination — the Supply Chain Resilience Initiative (SCRI) of Australia, India and Japan.

This theory and evidence support the conclusion that China’s threats are calling forth an alternative core group of states. This core has the will and ability to prevent China from using economic leverage to force unwilling states into economic dependence that also may threaten their diplomatic autonomy and military security. The case studies also suggest guidelines for building best responses to China’s threats. These include starting at home with state-level policies; cooperating as closely as possible with like-minded alternative core states; supplementing these foundational policies with efforts to advance and popularize compatible international norms; and avoiding policy errors by focusing on specific threats and working with allies and partners to face them directly and efficiently.

The China Economic Threat: Goals and Strategies

During the Xi period, China’s economic ambitions have changed qualitatively. China no longer seeks to integrate into the international economy merely as part of the “reform and opening up” campaign to modernize its economy. This modernization has now reached a transitional phase, where China has mastered labor-intensive production and is moving into more capital-intensive sectors that compete directly with the world’s advanced economies. Xi aims to vault China into a dominant position across all major high-technology industries, rather than merely allow market forces to direct China into the one-among-many type of division of labor now prevailing among advanced economies.

How is this goal to be achieved? Formally, as with the Made in China 2025 plan and its iterations, the main instruments are to be state subsidies and, in select strategic sectors such as telecommunications, a guaranteed home market. Informally, there are additional powerful instruments. One is a broader discrimination against foreign-owned firms competing in the home market, designed to force transfer of their technology to local partners and then use regulatory discrimination and subsidies to replace them entirely with domestic producers. Simultaneously, an unprecedented campaign of state-sponsored cyber theft is being used to steal foreign technology directly. China’s domestic producers ultimately shift focus to export markets, again supported by direct subsidies and a protected home market. States that openly criticize these efforts or take countermeasures are threatened with accelerated targeting of their remaining markets in China and reduced visits by Chinese tourists and students. The same treatment is meted out to states that disagree with China’s other foreign and domestic policies.

As consolidation of high-tech industries in China takes hold, other nations’ economies will become more dependent and vulnerable. Their economies will be in a subordinate, replaceable position in supply chains, with China having asymmetric leverage. For countries involved in territorial disputes with Beijing, there are even darker prospects. Such threats are credible because of China’s size; and because China can usually compartmentalize such conflicts to the major vulnerabilities of targeted states as these and other states are typically not willing to respond in kind or escalate.

Huawei’s 5G services are displayed at a Beijing expo. THE ASSOCIATED PRESS

Types of Chinese Threats and Target Response Capabilities

Although China’s economic threat has a uniform logic, countries face different threats and possess different response capabilities (Table 1). States facing military as well as economic threats from China have the strongest motivation to respond comprehensively. For example, the member states of the Quadrilateral Security Dialogue (Quad) — Australia, India, Japan and the United States — fit this category. For countries that are only or primarily threatened economically, the threat varies with the level of development. Developed nations face threats to their existing specializations in more capital-intensive goods and services, while middle-income states face threats to their ability to continue moving up the value chain into more capital-intensive specializations. Lower-income countries are least threatened since movement upward into capital-intensive specializations is a longer-term prospect. Such lower-income countries are faced mainly with exclusion from China’s lucrative domestic market if they do not follow Beijing’s lead or at least remain neutral in foreign policy matters.

Nations also have different response capacities, and efforts to craft joint responses to counter China’s threats must account for such differences. Trying to impose excessively uniform responses will produce lowest-common-denominator policies, and even these are unlikely to be reliably implemented. By evaluating responses already taken to meet specific threats to specific states, the type of flexible, cumulative policies likely to be most effective will become apparent.

Lynas Corp.’s rare earth minerals processing plant in Gebeng, Malaysia, is pictured while under construction in 2012. After China imposed export restrictions, Japan’s government invested in rare earth mines outside China, reducing its dependence on Chinese supplies from above 90% in 2010 to under 60% in 2020. THE ASSOCIATED PRESS

Threat Responses Take Shape: Critical Infrastructure and Supply Chains

Responses to China’s economic threats have been most far-reaching where Chinese suppliers have developed the capacity to control or disrupt vital infrastructure and supply chains. The most prominent example of critical infrastructure has been telecommunications network equipment, where Chinese companies led by Huawei have established a dominant global market position on the basis of leading-edge products sold at prices significantly lower than those of the competition — mainly the European companies Ericsson and Nokia and the South Korean company Samsung. Huawei’s dominance has been built largely on technology theft, subsidies and a privileged home market position. But Huawei would pose serious threats even had its position been won fairly. Access to foreign networks would enable the CCP regime to inject malicious software and spy on communications, and to orchestrate large-scale, potentially long-lasting disruptions or outages in network-dependent infrastructure and services.

Such threats loomed large as Huawei looked set to become the major supplier of new 5G networks. The response has been surprisingly effective. Bipartisan consensus in the U.S. Congress led to an early ban on equipment from Huawei, ZTE and other Chinese suppliers in U.S. networks. The U.S. administration under then-President Donald Trump explained the risks publicly, adding that intelligence cooperation with allies would be compromised by Huawei equipment. In addition to advocating outright bans, the Trump administration supported a Clean Network initiative, which, without explicitly mentioning China, sought coordination by governments, organizations and businesses to maintain reliable and secure networks — and related businesses, such as applications, cloud services, and computer and other hardware. The initiative builds on similar, complementary efforts, such as the European Union’s 5G Clean Toolbox.

Governments, fearing CCP economic retaliation, were often publicly resistant to formal bans on Chinese 5G equipment. Yet many already harbored doubts, and the resulting debate raised popular awareness about the risks. The result was a broad array of formal and informal bans on Huawei and other Chinese equipment. The Clean Network initiative is now supported by over 60 countries, including almost all members of NATO, the EU and the Organisation for Economic Co-operation and Development, together accounting for over two-thirds of global gross domestic product, and by hundreds of important private companies providing telecommunications services and related software and hardware.

The pattern of national responses is broadly consistent with the varied pattern of military and economic threats. All states facing significant military threats from China adopted formal or informal bans, as did most states facing significant economic threats. Far fewer states did so where neither type of threat is notable. Nevertheless, significant progress is possible even in the little-or-no-threat category. Here, President Trump’s administration also facilitated decisions of favorably disposed states by setting up the International Development Finance Corp. (DFC) and expanding the authority of the U.S. Export-Import Bank to offset China’s subsidized financing and thus make bids from alternative suppliers more competitive. DFC financing facilitated Ethiopia’s recent choice to use a European-led, “clean” consortium to build its 5G network.

Taiwan’s TSMC, the world’s largest contract producer of semiconductors, has been building its fabrication plants in China in recent years. REUTERS

Rare earth minerals are necessary for industrial processes in important sectors such as electronics, renewable energy and military hardware. Beginning in the 1990s, China assumed a dominant position in production and processing of rare earths. In 2010, China intensified export restrictions, both to punish Japan over an island dispute in the East China Sea and to provide cost advantages to domestic users. China’s exports ramped up again from 2015, but the episode showed the dangers of economic dependence on China.

Japan, given the importance of rare earths to its industries, reacted quickly. Japan’s government invested in rare earth mines outside China, reducing its dependence on Chinese supplies from above 90% in 2010 to under 60% in 2020. The U.S. built on Japan’s work with Australia. Relatively small U.S. government subsidies sufficed to encourage not only rare earth mining in the U.S. but also U.S.-based rare earth processing by the Australian company Lynas and other firms.

The U.S. also signed purchasing agreements to encourage rare earth mining in reliable sources such as Australia and Canada. Technical and market demand considerations should determine the minimum secure scale of such mining and processing facilities, such that production and stockpiles are sufficient to guard against potential disruptions from China under peacetime conditions and plausible conflict scenarios. Such capabilities also provide similar levels of security to vulnerable allies and partners, which might otherwise have little alternative to Chinese supplies. Similar beginnings on building reliable local capacities for rare earth mining and processing, underway in some Southeast Asian countries, also merit support from Australia, Japan, the U.S. and other concerned states.

In recent years, semiconductors have presented an even more important supply chain security problem. Semiconductors perform the control, calculating and storage functions at the core of electronic equipment and almost all other machines. As the capital-intensity of semiconductor fabrication plants (fabs) has ballooned along with the state subsidies used to attract them, U.S. and other companies have focused on chip design while outsourcing production. The U.S. share of global production thus fell from 37% in 1990 to around 12% in 2021. Production has increasingly shifted to the Taiwan producer TSMC and the South Korean producers Samsung and SK hynix. TSMC has become the world’s largest contract producer of semiconductors and in recent years, as more electronics manufacturing has moved to China, has built more of its fabs in mainland China. 

During President Trump’s administration, there was significant progress “reshoring” semiconductor manufacturing in the U.S. Significantly, this was achieved primarily via cooperation with the biggest foreign producers — TSMC and Samsung. TSMC is moving ahead with a huge fab complex in Arizona, while Samsung is developing one in Texas. How were these advances possible? First, the various levels of U.S. government finally began offering the large subsidies provided by other states. Second, once the U.S. government decided that a larger domestic semiconductor production base was necessary for economic and military security, both TSMC and Samsung quickly understood that having such a presence in the U.S. was desirable. If they did not capitalize on the opportunity, their competitors would, placing them at risk of losing market share in the U.S. and elsewhere. Moreover, by diversifying supply chains and limiting dependence on production in China, the firms limit China’s ability to hold their non-Chinese markets hostage to force greater dependence on production in China and technology transfer to Chinese firms. A large U.S. base gives TSMC the option of expanding production beyond the reach of China and hence reduces China’s ability to threaten the company. In effect, TSMC has chosen to remain an independent company by securely diversifying its production base beyond Taiwan and China, rather than allowing itself to be slowly transformed into a Chinese-controlled entity by a combination of incentives and threats. To a lesser extent, the same is true for Samsung.

The decisions by these flagship companies similarly advance the economic and national security interests of Taiwan and South Korea. Notably, both Taiwan, due to the intensifying military and economic absorption threats from China, and South Korea, following China’s economic sanctions imposed in response to South Korea’s missile defense efforts, had already begun diversifying supply chains prior to the worsening of U.S.-China trade relations in 2019. For the U.S., there is a parallel to the vicissitudes of its domestic auto industry in the 1970s and 1980s. Strength is best maintained or rebuilt not by artificially propping up privileged home-market champions but by attracting the most efficient foreign firms to produce locally and thus forcing domestic firms to maintain competitiveness.

A worker stacks buckets at an aluminum factory in Agartala, India. In 2020, the Indian government announced broad subsidies for incremental sales increases from domestic production across 10 major industries. REUTERS

Working Together for Supply Chain Resilience

While  states’ responses to China’s threats necessarily reflect their own vulnerabilities and capacities, they are most effective when regularly and flexibly coordinated in the service of common long-term objectives. An important example of such coordination is the SCRI launched in 2021 by Australia, India and Japan. The initiative is intended to promote supply chain security by sharing best practices and by promoting investment and “buyer-seller matching.” This coordination is facilitated by the way in which each state’s measures to address vulnerabilities inherently tend to complement the others’ efforts.

Japan’s greatest unnecessary dependence on China is in using Chinese suppliers as crucial parts of supply chains for re-export to Japan and foreign markets. Japanese producers do not want to give up on the Chinese market unless forced to do so. But neither do they want China to be able to hold hostage their ability to supply other markets; nor are they interested in basing their highest-end technology and production in China, where it can be most easily appropriated by Chinese competitors. The dangers of excessive dependence on Chinese production bases have been evident for some time. They came into stronger focus with China’s 2010 rare earths embargo, the U.S.-China trade dispute and the COVID-19 disruptions. In 2020, Japan began to subsidize its companies’ transfer of production from China to either Japan or to alternative suppliers with lower labor costs. For Japanese companies, this often means building more secure supply chains outside China to serve non-Chinese markets. Such parallel supply chains need not entirely replace exports from China, but they must be big enough to deter China from holding non-Chinese markets hostage.

Indian supply chains for the domestic and export markets have become highly dependent on Chinese suppliers. “China’s share of imports into India in 2018 (considering the top 20 items supplied by China) stood at 14.5%,” according to The Hindu newspaper. “In areas such as active pharmaceutical ingredients for medicines such as paracetamol, India is fully dependent on China. In electronics, China accounts for 45% of India’s imports.”

While border disputes, memories of China’s 1962 attack on India and China’s long-standing support for India’s rival Pakistan are long-term pressures weighing against excessive dependence on China, Indian policymakers were shocked in 2020 by COVID-19 supply chain disruptions and an India-China border incident that killed 20 Indian Soldiers. The result was a fundamental realignment of Indian economic policy toward China. In addition to excluding Huawei and other Chinese telecom suppliers, India banned many popular Chinese apps to “clean” spying and disruption risks to its critical infrastructure. Given the weakest-link character of much critical infrastructure, restrictions on Chinese suppliers and services must be far-reaching to be effective. Due to the high initial dependence of much of Indian industry on Chinese suppliers, however, the kind of abrupt break that occurred in critical infrastructure is not possible in supply chains.

In 2020, the Indian government announced broad subsidies for incremental sales increases from domestic production across 10 major industries. The subsidies target production in areas of heavy dependence on China where India also has comparative advantage. Such investments not only serve the domestic market but also promise to expand export markets. Such prospects attract investment from both Indian companies and foreign multinationals. Where India is at a comparative disadvantage, suppliers can be diversified to reduce dependence on China.

For many years, Australia’s economic growth has rested largely on supplying China’s voracious demand for food and raw materials. Then, in the COVID-19 era, Australia received a harsh lesson in the perils of excessive economic dependence on China. By calling publicly for an international investigation of the pandemic’s origin, the Australian government touched a nerve. The CCP decided to make Australia an example for the rest of the world of what comes from such public defiance. Chinese diplomats immediately threatened economic sanctions. The editor of China’s state-run Global Times tabloid was more colorful: “Australia is always there, making trouble,” he wrote. “It is a bit like chewing gum stuck on the sole of China’s shoes. Sometimes you have to find a stone to rub it off.” China proceeded to impose tariffs and other restrictions on imports of Australian barley, beef, lamb, sugar, wine, lobsters, cotton, timber and coal.

Yet China was not able to impose a high cost on Australia because food and raw materials exporters usually found other buyers. In 2020, the Australian government responded with a plan to subsidize manufacturing for the defense industrial base and in areas of comparative advantage, and to address supply chain vulnerabilities by increasing domestic production and finding more reliable foreign suppliers.

Zooming back out from these three examples, the advantages to coordinating efforts are not hard to see. India’s population is roughly the same as China’s, and India has the potential to continue growing into an economic and military peer competitor. In narrower economic terms, India has comparative advantage in labor-intensive manufactured goods and in human capital-intensive, high-tech industries such as pharmaceuticals and software. Japan has comparative advantage in a variety of capital-intensive manufacturing sectors, and Australia has comparative advantage in many important foodstuffs and raw materials. Thus, each state has an incentive to reach out to the others for more reliable suppliers and export markets. Thus, each state has an incentive to reach out to the others for more reliable suppliers and export markets. This high economic complementarity takes on an even more reliable prospect in view of the shared military threats from China; and existing ties have enhanced potential to grow due to the strong capacities of the three states. Going forward, it is important for the U.S. and its allies and partners to join these efforts with greater energy. The Quad nations possess a much larger joint market than China’s. Given the interest of important regional actors such as Canada, South Korea, Taiwan and many Southeast Asian countries in establishing supply chains and export markets not subject to pressure or disruption from China, the de facto joint market is potentially far larger. The United Kingdom and most EU states also share such interests.

This joint market offers an alternative core for the world economy that is more hospitable and promising than the one dominated by China. Relative to China, the alternative core states generally forgo leverage by their different normative approaches to international relations, which prevent them from routinely using China-style threats or sanctions against other states. But this restraint carries its own strengths. It makes their larger joint markets a more secure base for supply chains that export to the world market, and it offers more reliable, nondiscriminatory market access and more secure protection of intellectual property.  

Three Principles for Optimizing Threat Responses of Allies and Partners

Principle 1: Building and guarding a country’s own strength is the only realistic and reliable foundation for security.

Each state threatened by China must respond with its own strategy, tailored to its own threats and capacities. States more threatened by China will feel the need to take more far-reaching countermeasures. Those states with limited means will try to avoid becoming the focus of Chinese Communist Party ire and sanctions by speaking softly and acting more informally. Nevertheless, such states are not the same as largely unthreatened, indifferent neutrals and should be assisted by allies and partners in the same soft-spoken and informal manner. 

Principle 2: Work together flexibly to maximize security within or alongside an alternative core group of states. 

The most threatened and capable states, flexibly acting together in pursuit of the common goals of military and economic security, form a natural alternative core in the world economy with the capacity to better protect their joint security and independence, while offering similar benefits to less threatened states. Because of the varied situations of these states, and the fast-changing security issues raised by various sectors and supply chains, different approaches to economic and military security will be necessary. Such a patchwork is complex and hard to manage but necessary.

Principle 3: Calibrate responses to threats, while preserving sound principles of national security and economic development.

The most critical infrastructure and supply chains to be secured in the alternative core will naturally tend to mirror those that the CCP regime most jealously reserves for its own control. The CCP regime, by its increasingly brazen intrusiveness, propels the process of defensive reaction. The dual-use manner in which measures taken by Chinese firms to protect the CCP’s internal political control and national security are seamlessly used abroad to control and threaten other states almost necessitates excluding or limiting the presence of such firms in any state that feels threatened. 

Threatened states should focus on effectively working together to minimize such Chinese threats, without departing from traditional sound principles of national security and economic development. States must protect critical infrastructure and supply chains, using an inner circle of more secure supply for emergency use in wartime, along with an outer circle where a broader, freer division of labor develops among mutually trustworthy partners.