Whether it is decoupling or derisking, there are big implications for asia

It was nice to see US Secretary of State Blinken visit Beijing and hold substantive talks with President Xi Jinping and other top leaders in China. But, relations between the two have deteriorated so badly that the most that can be achieved will be guard rails that prevent the two powers’ tussles from escalating into outright clashes. In the meantime, there will be spillovers into the global economy. One fear is that we get two separate economic blocs that only weakly interact with each other. Even if that can be avoided, the potential economic losses for the world economy from two blocs going separate ways could be considerable.

To understand where we are headed in terms of this “decoupling” risk, we first need to look at the evolving geo-political context, and work out what shape it might take. We also need to study recent policies and corporate responses. Only then can we work out how much decoupling there might be and the impact it might have on Asian economies. Our conclusion is that extreme outcomes can be ruled out for now, that the economic losses will be contained and that the Asian region can weather these stresses.

China and the US: expect a long period of contention – but within limits

Nothing is ever simple in politics and so it is with the issue of where US-China relations are heading. But we can say the following.

First, even with the best efforts, the relationship between the two nations will be marked by a long period of contestation, tensions, disagreements and perhaps even occasional crises. The breakdown of trust between the two nations in the last few years is deep and difficult to reverse. The US sees China as a force that is hostile to its fundamental values and which intends to disrupt the international arrangements that have delivered decades of relative peace. The Chinese believe that the US will never accept that a rising China deserves its legitimate place in the international order and is scheming to undermine it.

The problem goes beyond just perceptions. The rising power that is China cannot feel secure so long as the western Pacific region is dominated by the US and its allies. Just take a look at the map –China’s entire coast where its political, military, production and financial resources are concentrated is entirely exposed to potential foreign attack with US allies such as South Korea, Japan, the Philippines and Taiwan straddling the seas around it. But the incumbent power that is the US is not going to simply cede its position in the western Pacific to China – it has vast investments, major security commitments and other economic interests in the region. It has been involved in the region since 1853 when, it sent a fleet into Yokohama Bay to force Japan to open up its economy. If it were committed to the region when it was just a tiny power, how much more so today when it is a super-power?

Second, while no one should complacently belittle the risks, the facts point to tensions being contained. Both countries are run by tough-minded but rational leaderships, not wild folks who take irrational risks or who allow their passions to rule their decision-making. These leaders know the risks and understand that nuclear-armed nations can tip into wars that they do not seek through errors of judgement. They may still undertake risky gambits in order to intimidate the other side but they will do so in a calculated fashion and will be ready to change tack if the gambit goes awry. In other words, the adults are in charge. That is why, for all the heated rhetoric, American and Chinese officials sat down with each other in Beijing last week and held serious negotiations. It is also shown in how US House Speaker Kevin McCarthy decided against keeping his promise to visit Taipei, knowing it would only infuriate China and lead to more tensions as well as more dangers for Taiwan.

Third, both sets of leaders have to deal with interest groups and allies whose views they cannot dismiss and who are likely to resist a trend towards greater conflict. It is very clear, for instance, that business groups in the US, Japan and Europe are against extreme measures to restrict trade and investment. They have large investments in China, and there are many corporate giants who rely on the China market for a large share of their profits. While Chinese business groups are not as vocal as those in the western alliance, we can surmise that they, too, would be gently telling their leaders not to aggravate tensions.

For the US, it is also evident that it cannot lord over Europe or Japan or South Korea. That the latter’s views are taken into account is seen in how the initial American talk about “de-coupling” which hinted at substantial economic disengagement has now morphed into the more benign “de-risking”. This followed a speech made by the European Union President Ursula von der Leyen in March where she warned against pursuing overly harsh measures against China.

Thus, the US and China are engaged in meaningful negotiations. Knowing the risks, both sides want to ensure mechanisms such as hot lines are put in place to ensure that small incidents do not flare up into outright fighting. Also, President Xi Jinping and President Biden know that their economies are intertwined and that the costs of significant disengagement will be so painful that the backlash from their constituents and business interests would be very strong.

To cut a long story short then, this is why the most likely scenario is of “de-risking” or a selective distancing between the two blocs in areas where there are direct strategic implications such as semiconductors. A complete de-coupling of their economies is unlikely and would only materialise in extreme circumstances.

What do recent trends tell us about the likely pattern of de-risking?

If we look at the trade and investment data and what government regulators and companies have been doing in recent months, we can get a sense of how much disengagement the global economy will see between the two blocs:

  • Trade patterns are changing: Not surprisingly, for the US, there is trade diversion from China. China’s share of US imports in the period 2018–2022 fell more than 4 percentage points while Vietnam, Thailand and Indonesia enjoyed an increase in their share of the US market. Similarly, the US share of Chinese imports has fallen by around 2 percentage points with Taiwan and Vietnam gaining share in China’s market. While the 2022 data for global flows of direct investment is not available yet, it is likely that foreign investment patterns are also shifting – less flowing into China and more into other Asian and emerging economies which could benefit from the political tensions.
  • However, things are complicated where foreign investment and global supply chains are concerned. There is certainly a push to reduce dependence on areas at risk of conflict. Thus, we see companies diversifying away from not just China but even Taiwan. Even Taiwanese companies are stepping up construction of semiconductor and other plants in the US and elsewhere. But, because the Chinese market remains so attractive and because China’s position is so dominant in some industries, global firms will continue to invest in China on a large scale. For example, BASF is investigating USD10 billion in a chemicals project in southern China. China is so efficient and dominating in global chemicals that large firms may have little choice but to continue investing there. Or take Micron’s plans to invest USD602 million in its Chinese semiconductor-packaging plant in Xi’an even after being the target of Chinese restrictions on its sales in China.
  • Some companies are separating out their Chinese businesses from the rest of their global operations, leaving them with one stand-alone China business and another company with the rest of the world. Look at how the global pharmaceutical giant AstraZeneca is reported to be planning to separate its China business and list it in Hong Kong as a self-contained firm. Another example is Sequoia Capital which will take out its Chinese business from the rest of the company and let it run independently. This process of separating out the China business from the global one is likely to spread. The pressure being placed by Chinese shareholders on HSBC to divide itself into an Asian business (mostly China/Hong Kong) and the rest of the world (mainly US and Europe) could also reflect geo-political factors and not just a desire to improve returns.
  • In Italy, government regulators have used their powers to deny China’s Sinochem the power to appoint the CEO in the tyre manufacturer Pirelli or set the firm’s overall strategy – even though it is the largest shareholder. This was done with the explicit reason to address fears of interference by the Chinese state in the firm.
  • The media has reported how foreign financial institutions’ involvement in initial public offerings in China has fallen to its lowest level in more than a decade. These institutions have won just 1.2% of the total new listings in the market.

So, what is the bottom line?

First, quite apart from the accelerated pace of reconfiguration in global supply chains we discussed in our previous column, there are other economic and financial repercussions from the geo-political contestation. This will probably produce some degree of distancing but not outright disengagement between the US and China. The facts on the ground do not support the thesis of the world being divided into two separate and competing economic blocs.

Second, there will be a reallocation of capital and restructuring of business operations. Global corporations will review their portfolio of production locations and will probably conclude that they need to reduce their allocation to China and increase it elsewhere – probably to India and Southeast Asia. Just as western firms are separating out their Chinese businesses, Chinese firms are likely to establish entities in friendly locations such as Singapore or Dubai to reduce their likelihood of American restrictions on their operations. Chinese firms will step up the pace of delisting from New York’s equity markets and re-listing in either Shanghai or Hong Kong.

Third, this distancing will come with costs. If trade and capital are not flowing in the most optimal ways but are distorted by political factors, there will be some loss of efficiency. That will translate into higher costs of production, lower profitability and thus slower economic growth.

So, for Asia, assuming that our scenario of distancing rather than outright de-coupling materialises, the outcome is not optimal but neither is it likely to cause significant damage to economic prospects. A lot will depend on how the region’s policy makers respond. Where a country’s diplomats are deft enough, that economy could straddle both the US and Chinese blocs are benefit by being a bridge between the two. Where good incentives and improvements to fundamentals such as infrastructure can be implemented, more foreign investment can be attracted as production relocates out of China.

In other words, whether a country benefits or loses from the structural shifts induced by these geo-political forces is not set in stone. Skilful policy making and smart political leadership can make all the difference.