The scene was chilling and highly unusual for seasoned Asia watchers. A frail 79-year old man was being moved against his will in a major political voting arena but this time there was no need for a Therese Coffey headlock or expletives hurled at Jacob Rees-Mogg. President Xi Jinping’s bodyguards were quick to usher the man out of the closing ceremony of the 20th Chinese Communist Party Congress; but this was no ordinary shut-down of a potential protest. The protestor-in-waiting had been seated right beside President Xi in the vast Beijing conference hall and had been Xi’s immediate all-powerful predecessor before handing over power in 2012. Of course, we were never meant to see the video footage of the humiliation of Hu Jintao which cannot be found anywhere on the Chinese internet. It was bad enough that the famed Chinese respect for one’s elders was trashed in public, but there’s another awkward truth which the Xi regime is keen to bury. Comrade Hu was a superior manager of the Middle Kingdom’s economy. The data doesn’t lie.
The headlines this week have linked Xi’s tightening of the reins of power to the double-digit percentage declines of multiple Chinese technology share prices immediately after the Congress ended. However, the longer-term picture of wealth destruction is even more damning. At one point this week the Nasdaq Golden Dragon China Index which tracks Chinese companies(mainly tech) listed in the US had dived 22% in just a few trading sessions back to levels last seen in 2012 when Xi came to power. Ten years of tech progress and gains made by the likes of Tencent, Alibaba, Baidu etc have been wiped out. However, the story is even worse if you’d invested in Hong Kong-listed shares to track the enormous growth of the Chinese economy. The island’s Hang Seng index this week re-visited levels not seen since 2006. That’s more than three Chinese presidential cycles ago for a zero return! The US, despite enduring 4 years of the only business “genius” ever to lose the house in the casino industry, has seen the S&P 500 in the same period return 175%. The news from the Chinese property markets is possibly worse, and potentially fatal for comrade Xi.
Property sales have fallen for 14 straight months in China. Unlike stocks and shares, almost every Chinese household is “all in” on property. The home ownership rate is a whopping 89% in China and it is no exaggeration to share Goldman Sachs’s view that Chinese residential is probably the largest asset class in the world with an estimated total value of more than $50 trillion. So, when a Chinese mainstream newspaper warns of “revaluation” in property prices and the bonds of property developers are in distress it might seem sensible to beef up the financial expertise of the Beijing administration. Hu Jintao might have done it, but not Xi.
The Xi playbook is all about power. The elderly Hu was not the only senior Politburo figure to be squeezed out of the inner circle of influence. Hu’s proteges Li Keqiang and Wang Yang would be well known to western analysts of Beijing politics but have also been removed from the Politburo. In fact, the more alarming development is that the new Xi cabinet contains no recognized financial market expertise. There are also no women members in the Politburo for the first time in 25 years. However, the key to understanding Xi’s current focus is to note the explicit positioning of men who are trusted for their loyalty to the leader and have weapons, miltary, surveillance and aerospace expertise. Not surprisingly, it has been referred to by analysts as a “war cabinet”. Yes, the game theorists will be busy working out potential timelines to an invasion of Taiwan but perhaps that assumption of inevitable conflict in the South China Sea is premature? Arguably, war has already started but in a very different place…Ohio.
In September semiconductor manufacturing giant, Intel, broke ground on a $20 billion project to build a semiconductor factory(known as a fab) in Columbus, Ohio. This is a reversal by the industry of decades of offshoring production to Asia and is a direct result of the Biden administration’s Chips & Science Act which has just been signed into law. The Ohio project is the largest industrial construction seen in years but there will be many more thanks to $52 billion of government incentives to bring semiconductor (chips) manufacturing home. Micron are about to plough $15 billion into Idaho on a similar facility and Taiwan SemiConductors (TSMC) are going for a $12 billion investment in Arizona. Unusually for US politics, this initiative has received bipartisan support across the aisle on Capitol Hill. The reason is simple. Post Covid-19 and supply chain chaos, the chip industry is deemed vital to US economic and national security. So is energy or food you might argue; but there’s a bit more to chips. At the low-tech end of the spectrum semiconductors might be perceived as commodities like oil and wheat but at the hi-tech end this is about the most advanced technology industry on the planet. More on that later but what about the war? Consider the following:
- In probably the most aggressive act by a US administration in decades a White House executive order has crippled the Chinese chips industry by banning US citizens/engineers from working on high end R&D projects with immediate effect. Vital staff were lost overnight and returned to the US.
- The US Justice Department this week announced it had indicted two Chinese intelligence officials who are believed to have unsuccessfully tried to obtain inside information about a federal investigation into Huawei.
- Washington is also targeting the export of latest generation chips and manufacturing equipment used by dozens of Chinese firms. As the New York Times put it: “The rules appear to establish a more comprehensive policy that will stop cutting-edge exports to a range of Chinese technology companies and cut off China’s nascent ability to produce advanced chips itself”.
The cutting-edge descriptor is critical. The Biden executive order is explicitly focused on advanced logic and memory chips. These are the next-generation chips which will power artificial intelligence (AI) applications. The words of National Security Advisor, Jake Sullivan, in August are worth noting – “we have to revisit the longstanding premise of maintaining “relative” advantages over competitors in certain key technologies…. we must maintain as large of a lead as possible.” Now recall those new Beijing Politburo members’ areas of expertise and know that AI is absolutely critical in the development of next-generation aerospace, weaponry and surveillance technologies. Perhaps this “war cabinet” is being tasked to fight a very different war? Who knows what the Chinese will do in retaliation for these recent tech provocations but it still feels a bit early for a Taiwan invasion. Given the concentration of global chip manufacturing/supply based on the island nation there’s too much of a whiff of mutually assured economic destruction to divine any invasion logic right now. However, the following developments are worth watching to understand how this intertwining of economic interests might change:
- Less than 5% of Apple’s products are currently made outside China. That figure will be 25% by 2025. The rush to de-risk China production bases by consumer multi-national corporations is one to watch. Clearly, China is being viewed as an adversary. Any tech company with business in China would do well to note the US is deliberately freezing Chinese domestic chip manufacturing above a certain level. AI might be a small percentage of chip production today but the US views AI as the future, and the means to secure a generational “relative” competitive advantage.
- China’s efforts to catch up starts with one huge disadvantage. Chip manufacturing is all about carving nanometer-small shapes on silicon wafers. The machines that do this shine exceptionally narrow beams of light onto “photoresist” chemicals on the wafer in a process known as lithography. The machines – extreme ultraviolet lithography machines – or EUVs are worth $120 million each, have 100,000 components per machine and take 4 jumbo jets to ship. Oh, and only one company in the world, ASML in Holland, makes and sells these huge pieces of equipment. China will need to build its own ASML to manufacture powerful AI chips but that will take years.
The chip arms race has begun. For Taiwan’s sake, the longer it takes for China to catch up the better. Conversely, there must be a calculation made by China at some point that Taiwan is no longer a sufficient technology risk to deter attack ie China forced to go solo in developing chip self-sufficiency has less and less to lose. It is also a delicate calculation for the White House. The pain inflicted by the latest moves are relatively contained but as AI grows in influence the technology gap between the US and China could grow dramatically in a matter of years. Certainly, if you’ve read Peter Diamandis’ excellent “The Future Is faster Than You Think”, technology convergence is accelerating innovation at warp speed compared to previous economic or industrial cycles. A rapid widening of a technology gap may not be good news. This writer’s fear is an act of desperation by Xi.
A combination of slower GDP growth(2-3%), collapsing demographics and Japan-style property debt stagnation will apply their own political pressures but if the AI future presents a structural threat to Chinese economic competitiveness then the Beijing leadership could see chaos as a means to disguise decline. I’ve often thought Putin was more scared of the structural decline of oil and gas in an ESG world than the prospect of Ukraine joining the EU. We shall see, but recent weeks feel like the geopolitical risk gauge has jumped a few notches. The Great Firewall has already shifted the web into “splinternet” territory but that was a Chinese initiative to control and censor content. This US move to control technology itself is vastly more significant across the entire global economy. Indeed, Ben Thompson in his Stratchery newsletter captures the scale of intent rather well:
“…..the free trade globalized world that China grew up in is gone, and the US is determined to maintain the advantages it has for as long as possible.”
Arguably, Hu Jintao was not the only former leader being pushed around last week. However, only one of the aggressors was showing true strength…. Like always, follow the money. As Chinese and Hong Kong stocks imploded in recent weeks the benchmark US index S&P 500 has been on track for its best October performance in history, up over 10%.