The US-China Trade War Touches the Defense Industrial Base
The White House’s announcement on August 1st of its intent to impose new 10% tariffs on over $300 billion in Chinese goods imports to the United States opened a new skirmish in the US-China “trade war,” which has stewed since last year. The trade war looms over the U.S. defense industrial base, which faces cost increases and lost export demand as China reciprocates. The trade war has evolved to involve more than a dispute over the bilateral trade imbalance. Rather, technology now defines the central front of the conflict. Defense suppliers already feel the impact of the “tech war” in the form of new policies that restrict supply chain partnerships. As policymakers decide on the future of U.S.-China trade, defense suppliers should adapt their businesses to this contentious and uncertain business environment.
The new era of trade tensions increases the economic and political risk to the defense sector. Deloitte’s 2019 outlook for the global aerospace and defense sector highlighted import tariffs as a significant threat to future profitability, particularly for defense manufacturers with large export sales. Already, tariffs imposed by the President on steel and aluminum imports from Europe, Canada, and Mexico in 2018 exposed the defense sector to higher costs, potential lost sales, and supply chain disruption in the near-future. Notwithstanding increases in defense spending in FY 2018 and 2019, including a 12% increase in revenue for the “Big Six” top US defense companies, the defense sector also face major second-order geopolitical risks to profits as a result of the trade conflict. For example, in a side-effect of current trade tensions, China recently sanctioned American defense companies involved in the sale of $2.2 billion in defense weapons platforms to the government of Taiwan, which China considers under its sovereignty.
The U.S.-China trade dispute has evolved to focus increasingly on control of intellectual property. Released in April 2019, the U.S. Trade Representative’s annual “Section 301” report criticized China for perpetuating a business environment that endangers intellectual property (IP) rights by encouraging IP theft, forcing transfer of proprietary technologies, conducting economic espionage, and engaging in predatory strategic foreign investment. The report highlighted new concerns stoked by China’s new cybersecurity laws, which appear to serve as a “pretext to force U.S. IP-intensive industries to disclose sensitive IP to the government, transfer it to a Chinese entity, or both.” These measures seem to retaliate against tight controls placed on US exports to Chinese global telecommunications technology giant Huawei, and a forthcoming ban on US federal agencies from procuring Huawei products and services. Fearing China’s early dominance of the highly-anticipated “5G” digital networking technology and its potential to compromise US national security, some members of congress have promoted legislation to ban U.S. companies from using equipment manufactured by Huawei, or Chinese electronics multinational ZTE to build 5G networks in the United States. In another gesture of retaliation, in June 2019 China warned US defense companies they face growing risk of having their access to “rare earths,” hard-to-find metals and minerals heavily used by defense manufacturers to produce advanced weapons systems and other technology-intensive military equipment.
The controversy over Huawei shows how technological competition between the two countries and the trade dispute intersect. Huawei and other Chinese multinationals have been great beneficiaries of the US-China trade relationship, allowing China to become a near-peer technology and competitor to the United States in a relatively short period of time. However, the U.S.-China trade relationship has created dependencies and vulnerabilities for both countries that each would like to see end. China’s industrial policies, such as its sweeping China 2025 roadmap, aim to achieve independence and global preeminence in the industries and technologies that will be key drivers of national economic and strategic power. For the United States, China’s ambitious technology industrial policies trigger a national security concern given how much future technologies will affect the future global balance of economic and military power.
In technology war, the United States faces a strategic dilemma: to pursue an economics-driven negotiated solution, or technological superiority. A negotiated solution would involve working with allies to find a path to new understanding on trade and IP rights with China. By contrast, a technological superiority strategy would embrace the trade rivalry by pushing for domestic investment, mobilization, and economic decoupling. In technological terms, both options seem likely to lead to some form of “managed interdependence.” On the other hand, it could also lead to a “global technology split” that would force countries to choose sides, encouraging a “tech cold war,” that could reduce the reach of American economic and military power.
At a July 2019 Brookings Institution panel discussion, Information Technology and Innovation Foundation President Rob Atkinson, Brookings Senior Fellow Cheng Li, and American Enterprise Institute Senior Fellow Derek Scissors, confirmed the increasingly technological nature of the trade war, framing the future of the US-China economic relationship as a choice between “normalcy and negotiation and decoupling.” Views diverged on whether ‘normalcy’ or ‘decoupling’ would prevail. Atkinson argued to expect normalcy’s return because decoupling would have significant economic and technological downsides for China, whose economic exchange with the United States is critical to its long-term technology strategy. However, as Cheng Li noted, China would easily survive an economic decoupling, although it would be unlikely to out-compete the United States technologically. For the United States, economic decoupling may instill less concern than if China continues to engage in exploitative trade practices that openly violate international rules without sanction, as Derek Scissors explained. The U.S. may actually find in its interest to embrace a version of the Administration’s unilateralist approach, using the tools of trade to sanction against bad Chinese practices, while aggressively competing against China on technology.
Recent policy announcements targeting defense companies indicate the manner of strategic response industry can expect. To help American technology startups decouple from Chinese state-linked funding, the Department of Defense’s has announced plans to launch the “Trusted Capital Marketplace,” a service to help match young companies specializing in defense technologies with vetted sources of private capital. Defense suppliers very soon will face stricter requirements to include “American-made” materials in their products, as mandated by an Executive Order recently issued by President Trump.
Defense industrial base companies will not be able to avoid the effects of the U.S.-China trade war or the technology war. Planning for resiliency should begin now. The Boston Consulting Group advises CEOs to develop strategies for adapting to the new global trade environment, which they expect to affect every company with a significant technology line of business based in the United States or in China, for years to come. Their trade war outcome scenario framework, shown below, offers a useful guide for devising business strategies.