Economy, Economy, Economy

August 22, 2023

August 22, 2023

This week in The Red Report

  1. Economy, Economy, Economy

  2. Taiwan Trade and a Transiting VP

  3. Semiconductor Redux

  4. New Rules for Generative AI

  5. Heightening Competition over Low Earth Orbit

  6. China Considered the Number One Threat to the US, Especially Among Conservatives

From Zhongnanhai: This week in Chinese Politics

Economy, Economy, Economy

China continues attempts to revive declining economic performance through cuts in interest rates, targeted stimulus, and reassurances to foreign firms operating in the country.

China’s post-pandemic economic performance continues to stall as the retail, property, and other sectors dependent on consumer spending fail to rebound to pre-pandemic levels. In response, the People’s Bank of China cut interest rates to their lowest since 2014 to try to boost consumer spending and prevent deflation. Targeted stimulus, such as reduced rates for business and household borrowing, are expected in the near future, although a major stimulus package seems unlikely.  

The State Council, China’s highest governing authority, also announced attempts to improve the business environment for foreign firms investing and operating in China. These measures come as the Biden Administration expands restrictions on investments in high tech sectors in China–namely on Chinese companies with at least half of their revenue coming from quantum computing, AI related to military uses, and advanced semiconductors–on national security grounds.

Analysis

One indication as to how nervous the Chinese Communist Party (CCP) is about the economy is its decision to stop reporting youth unemployment data and to emphasize new guidance on patriotic education as a way to encourage nationalism among China’s youth. Youth unemployment in China is suspected to be extremely high, although the actual level is impossible to determine because of variations in reporting methodologies. If China enters a recession, it will have major implications not just for the CCP and China but also for the global economy. Unlike in 2008 when China relied on large-scale public investments that insulated the country from the US recession, the CCP currently does not have the same borrowing or public spending capabilities.  A recession will increase the price of Chinese exports and threaten to elevate already-high inflation levels around the world. A shrinking Chinese economy also means shrinking opportunities for the Chinese people, which translates into declining popular support for the CCP, and possibly weakening support for Xi Jinping within the CCP. One consequence of Xi’s concentration of power in his own hands is that he has no one else to blame when things go badly. A decline in popular support will force the CCP and Xi to rely more heavily on nationalism, which could increase pressure on the leadership to take military action against Taiwan. 

Attempts to clarify protections for foreign firms investing in China suggest that the CCP is trying to mitigate the bad publicity from its recent heightened national security regulations. Despite assurances to the contrary, however, foreign firms–particularly from the US–should be increasingly nervous about maintaining significant exposure to Chinese markets (see “Business Matters” below) and should aim to isolate their China operations from global operations. At the same time, the Biden Administration’s restrictions reveal tensions within the US government between minimizing China’s threat to US national security while not kneecapping US businesses that want to sustain operations in China. The restrictions will likely have questionable effects against the CCP, as Chinese companies will quickly find workarounds, and the restrictions will not enter into force for several months.

On the Hill: Developments in US China policy

Taiwan Trade and a Transiting VP

The US implements the first part of a trade agreement with Taiwan–while restricting investments to China–in show of bipartisan support.

While the US increased restrictions on investments in and exports to China, Washington simultaneously implemented the first part of a trade agreement with Taiwan announced earlier this year by the Biden Administration. While the agreement does not provide major new market access, it does clarify a number of cooperation and regulatory practice issues to help facilitate increased US-Taiwan trade. The agreement emphasizes the tension between the executive and legislative branches: despite the White House arguing to the contrary, the Ways and Means Committee underscored that authority for trade agreements rests with Congress and not the president. Despite this, Congress passed the agreement, and the president signed it into law, showing that support for Taiwan is a rare case of broad bipartisan support. 

News of the agreement’s implementation coincided with a visit to the US by Taiwan’s current Vice President Lai Ching-te (William Lai). Officially, Lai “transited” the US, because senior Taiwanese officials are not permitted formal visits to the US under current diplomatic protocols. Lai was en route to a presidential inauguration in Paraguay, one of the few states that maintains formal diplomatic relations with Taiwan. 

Lai is the incumbent Democratic Progressive Party (DPP) nominee and current frontrunner in Taiwan’s upcoming presidential election in January 2024, and he embarked on a media blitz during his stopover in the US to try to ensure support for Taiwan in the US court of public opinion.

Analysis

Support for Taiwan, even if it is on the basis of being “anti-China” rather than “pro-Taiwan,” is one of the few issues to receive broad bipartisan support in Congress. It is a policy outcome that plays well domestically: the Biden Administration can herald the signing of a trade agreement and elected officials in the Capitol can tout their China-bashing credentials. Meanwhile in Taiwan, clear signs of US support are welcomed by supporters of Lai’s DPP as evidence that his actions will boost security and ensure US assistance in case of a Chinese invasion, although opposition KMT supporters argue that his actions provoke Beijing. 

Closer ties between the US and Taiwan also come amid improving ties between the US and its Indopacific allies, as well as worsening ties between China and its neighbors. Notably, Tokyo and Seoul have agreed to the Biden Administration’s calls for closer relations between Japan and South Korea–a historically fraught relationship–largely because of the perceived increased threat from China. Japan also recently announced a cyberdefense network among Pacific Island states that explicitly addresses Chinese and Russian cyberattacks. Conversely, China and India failed to resolve major issues about their disputed borders ahead of an upcoming BRICS summit, and the Philippines summoned the Chinese ambassador over an incident between Philippine fishing vessels and the Chinese coast guard. The Biden Administration should continue to capitalize on its current relative strength, and China’s relative weakness in the Indopacific, particularly with India and the Philippines, to minimize the threat of Chinese military action against Taiwan.

Business Matters

Semiconductor Redux

China’s blocking of Intel’s recent merger gives the CCP an effective veto over global companies’ ability to make major business decisions free from Chinese interference.

Intel and Israeli chip manufacturer Tower Semiconductor agreed to end a proposed merger after China’s State Administration for Market Regulation (SAMR) failed to approve the acquisition. China reserves the right to evaluate all mergers for companies earning over a certain threshold inside China; Intel met this threshold by earning USD$17B in China last year, accounting for approximately 27 percent of its global earnings. Originally proposed in February 2022, the merger’s failure will cost Intel $353M in payouts to Tower. 

The scuttling of the merger comes just a week after the Taiwan Semiconductor Manufacturing Company (TSMC) announced the construction of a new manufacturing plant in Berlin, committing USD$3.8B to the project. This project takes advantage of the EU’s European Chips Act, which aims to double European chip-making capacities by 2030. This will be TSMC’s fourth plant outside of Taiwan and China, with two located in the US (Washington and Arizona) and a third joint venture with Sony under construction in Japan with plans for an additional plant in Japan. In the US, the Arizona plant recently delayed its opening. TSMC says that the US lacks the necessary skilled laborers to build the factory, and has requested expedited visa approval for Taiwanese workers, while local unions have pressured the Biden administration to favor US technicians.

Analysis

SAMR’s lack of ruling–rather than outright ban–on Intel’s merger is likely to have a chilling effect on companies looking to do or continue business in China. If the Intel case becomes standard, then the Chinese Communist Party will have an effective veto over major decisions by global companies, and those companies with a significant footprint in China will have to choose between their Chinese markets and desired mergers and acquisitions.

The (lack of) action is likely retaliation for President Biden’s recent ban on sales of key technologies to China, which adds to China’s earlier retaliatory limits on the export of gallium and germanium. As China’s economy continues to decline, protectionist and retaliatory measures are likely to increase, as will requirements that foreign companies work with Chinese partners as a condition of participation in the Chinese market.

Conversely, while the Biden administration’s growing semiconductor alliance hinders China’s access to key technologies, it also threatens the collateral damage of significant losses for businesses in the short term by depriving them of access to Chinese markets, as in the case of Intel’s proposed merger. Moreover, as TSMC’s semiconductor production continues to grow in US-allied countries, China is likely to continue to retaliate against concerned parties. The Biden administration should therefore find ways of compensating companies for losses incurred by the US’s own protectionist measures or risk alienating these major engines of the US economy.

Tech Futures

New Rules for Generative AI

China gains first-mover advantage in establishing standards for AI governance, which facilitates Beijing’s export of its own governance model and weaponization of economic interdependence at the expense of US data security and technology leadership.

China’s new laws regulating AI make it the first state to introduce comprehensive AI regulations. The regulations require AI-generated content to, among other restrictions, regulate recommendation algorithms, contain clear labels to indicate that it is AI generated, and “Uphold the Core Socialist Values” that align with the CCP’s values and message. The law, initially released in July by China’s Office of the Central Cyberspace Affairs Commission, covers AI-generated text, images, and audio and visual content, and is part of the CCP’s recent ambitions to more broadly and comprehensively regulate cyber security and national security. These new standards provide an important guide for how the CCP will likely encourage development in the AI sector and enforce its standards through the rollout of Chinese-manufactured devices and technologies across the globe. 

As Chinese-manufactured technology components continue to proliferate overseas, notably through component parts in smart devices, updates to how China monitors and regulates AI and cybersecurity have increasingly global ramifications. Notably, Chinese technology and communications manufacturers are increasingly competing in global markets. Huawei’s release of its HarmonyOS 4.0 operating system, for example, highlights its bid to compete worldwide with Apple’s iphone and Google’s Android. HarmonyOS will now have Celia, a Siri-like voice assistant, trained on the company’s Pangu AI model, with other Chinese-trained language models, voice assistants, and chatbots likely to enter the market soon now that state regulators have had the opportunity to enforce their compliance with AI, cyber, and national security regulations.

Analysis

The regulations underscore how the CCP is trying to balance promoting innovation in new technologies with continued party control over information. Generative AI in the public and information sectors is a threat to the CCP’s monopoly on information. On the one hand, the CCP promulgates regulations on generative AI to protect its producers of original content from competition from AI, which could destroy jobs. This is no different from concerns expressed in the West, most notably in the labor conflict in the entertainment industry in the US. However, the CCP also fears the ability of AI to produce and disseminate information that counters official Party narratives. As users around the world increasingly use Chinese-trained AI, the CCP will therefore expand its capability to control speech, privilege access to information, and monitor its citizens–particularly minority citizens–both at home and abroad. 

As China’s tech giants establish a growing footprint outside of China, the CCP is increasingly in a position to set global industry standards that undermine US technology leadership. China’s exports of AI technology, particularly surveillance AI like facial recognition software, also emphasizes how increasing integration with global markets has not only failed to liberalize autocratic states like China, but rather is helping China export its own governance model and weaponize economic interdependence at the expense of liberal democracies. The US should consider how it might release its own standards for AI governance so as to counter China’s encroachment in this sector. 

Espionage Alert

Heightening Competition over Low Earth Orbit

Private companies are mostly unaware of the threat of Chinese espionage to their intellectual property. In the case of companies in some sectors, such as space, that threat quickly becomes a question of national security.

2430 Group’s Glenn Chafetz and Xavier Ortiz argue in The Diplomat that China’s People’s Liberation Army (PLA) aims to jump ahead of the US and Europe in the development of low earth orbit (LEO) mega-constellations. The PLA uses predatory investment and lawfare to acquire coveted orbital planes and telecommunication spectrum, which in turn could provide rapid advances in military capabilities in surveillance, communication, and command and control. China's effort in the LEO industry is exemplified by Shanghai Spacecom Satellite Technologies and Shanghai Engineering Center for Microsatellites, which targeted a German/Liechtensteinian company, KLEO AG, that held high-priority filings with the International Telecommunications Union. These efforts involved an initial investment in a joint venture, followed by an effort to seize full control of the entity and then to transfer spectrum rights to China for military purposes.

Analysis

China's advantage in this sector stems from how it combines the financial resources and intelligence machinery of the state with the access of the private sector to acquire foreign intellectual property. China then uses its state sovereignty to shield itself from redress. Western democracies need to provide legal support, funding, training, and sanctions to help their own companies resist and deter such attacks. The case of LEOs is just one example of China's strategy, highlighting the need for democratic governments to take a larger role in safeguarding the private sector from state-sponsored predation and lawfare.

One more thing…

China Considered the Number One Threat to the US, Especially Among Conservatives

China beats out Russia as the new top security threat in a recent survey, which means that China bashing is likely good politics for political candidates, especially Republicans.

In a recent Pew survey, half of US respondents named China as the number one foreign threat to the country, far exceeding the fifth of respondents who named Russia. This marks a sharp increase since 2019 when Russia was top of the list, and in particular since 2007, when it was Iran. Conservative Republicans are more likely to name China, while liberal Democrats are more likely to name Russia as the number one threat to the US. This alignment correlates with how 2024 presidential candidates are positioning themselves on foreign policy. Ron DeSantis is reportedly looking to make a major speech on China in the coming days to help boost his recent slide in polls. China bashing therefore looks likely to be good politics for political candidates in the lead up to the 2024 election. The challenge for the eventual victor in 2024 will be that while China bashing clearly generates benefits for campaigning, it creates a number of complications for actually governing.

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