Friday, November 4, 2016

China: The Pentagon’s Great Industrial Challenge


Entering the White House on January 20, 2017, the next President will confront a daunting challenge: ensuring continued US preeminence in military capacity. That edge, which America has enjoyed for a quarter century, is being systematically blunted by competitors. The roots of American advantage lie in an interlinked set of social, political, economic and technological factors. In particular, the United States has exploited the self-reinforcing benefits of being both economically dominant and technologically advanced. Now, however, globalization is driving countertrends in the diffusion of knowledge and wealth. The eroding American techno-economic lead is a chronic risk to US power that will require enormous national effort to overcome.

In articulating their Third Offset Strategy, US defense and security officials are signaling an awareness of this problem. They should understand that the nation’s techno-economic position is underpinned by the remarkable dynamism of its private business sector. US corporations are the world’s most valuable by far, because they are the most profitable, the most productive and innovative, and highly globalized. Almost two-thirds of the world’s most valuable firms are American. They rule over many strategic industries. This position has been achieved with the considerable support of other US institutions: the American workforce foremost, but also the government, universities, research organizations, capital markets, and the military. Recognizing the continuing importance of nurturing this symbiotic ecosystem, the Pentagon has long funded organizations like DARPA, and now is reaching out to the private sector in new initiatives such as DIUx.

There is a general consensus that key technologies addressing both civil and military needs increasingly are merging. A good example is machine autonomy enabled by artificial intelligence, which is a clear dual-use application. “Civil-military integration” is not new, of course, but what is different now is the sheer sophistication and resources of the private sector relative to the government. American firms are independently capable of extraordinary feats of initiative: sparking the shale fracking revolution, for instance, and launching rockets into space. This is welcome testimony to the nation’s model of capitalism. But it should give pause to policymakers, because there are reasons to believe that the motivations of the private and public sectors are diverging. What’s good for big business may not necessarily be good for America.

Reaping globalization’s harvest

Modern globalization, pioneered by Washington’s own institutions, has both raised millions out of poverty and spurred a worrying leap in inequality between rich and poor, skilled and unskilled, and some economic sectors and others. The US as a whole may have prospered for a generation on this unprecedented expansion of international commercial integration, but the plight of the American worker is plenty visible in 2016’s election campaign. Globalization has also seen an epochal shift in the relative balance of power between countries, and between governments and companies.

The archetypical US economic success story today is the multinational corporation, culturally American but spreading far across the planet. The allegiance of such firms is not to Washington but to their shareholders. Half of their profits come from overseas. They deploy sophisticated strategies to minimize their tax burdens stateside. They may exploit regulatory arbitrage too. They build their factories and laboratories overseas — to tap local talent, get closer to markets, exploit financial inducements, and meet countries’ “localization” requirements which are rising by the day. These multinationals often outsource wherever they can. Their supply chains are complex, disintegrated and fragmented, and growing less American. In short, they have intelligently embraced a model of worldwide commerce enabled by a relatively benign era of liberal American economic hegemony.

That era may be ending. The geopolitical environment is becoming more conflictual as new powers, enriched by trade, assert their own interests. The financial crisis that started rumbling in the United States a decade ago still reverberates. Much of the world faces lower growth or outright stagnation, inequality, deflation and low interest rates. The domestic discourse in many of the world’s democracies has grown febrile. Against a darkening security backdrop and rising nationalism and protectionism, America paradoxically is wealthier but less secure, ever indispensable and interconnected yet also more vulnerable.

Along came China

If the world were becoming merely more equal or less unipolar, that would be one thing, for the US would still enjoy relative pre-eminence. Assuming it remained competent as an alliance sponsor, it could be confident of organizing a prevailing coalition in all circumstances. But the rise of China, a highly disciplined rival with vast economic potential and commercial ambition, is of greater concern to US long-term strategists. To understand why, we need to look again through the prism of business. As strategically nettlesome as the Kremlin or Teheran may be to Washington, the US can badly damage them with sanctions. Russian hackers are superb but Russian technology companies make little the world wants. American companies hardly tremble in fear at the Iranian Revolutionary Guard’s business acumen and reputation. China is another matter altogether.

Like America, China is a multi-dimensional power. Today it is China’s economic dynamism that is most startling but, as American twentieth century history shows, techno-economic ascendancy could eventually translate into political, military and cultural leadership as well. China’s economy is remarkable for its sheer size (larger than the US by some measures) but especially its savings and investment rates, among the highest ever seen. Because it owns and controls its domestic financial system, Beijing can channel some of this $5 trillion of annual savings into practically any endeavor it wants (by comparison, US gross national saving is about $3.5 trillion). Much of China’s savings will be misallocated, but this can still do great harm to others. For example, energy and capital subsidies to metal smelters result in Chinese overcapacity spilling out and destroying profitability worldwide. Yet if Beijing’s omnipotent bureaucrats are occasionally misguided, Americans shouldn’t doubt the dynamism of Chinese commerce.

The Chinese have cultivated a market that may prove to be fatally alluring to multinational companies. Beijing constantly tips the playing field with technology-for-access deals, ensuring that intellectual property flows in one direction: to China. If foreign companies now find it a less friendly place to do business, that is intentional. After all, China is still a more open market than Japan and Korea were at a similar stage of development. As the welcome mats for foreigners are withdrawn, Chinese firms are becoming stronger. Though often highly indebted, they remain well funded by state banks and are encouraged to pursue overseas acquisitions for advanced technology. Europe is a principal target. Owners and managers there often are eager cash sellers. European governments like those in Berlin and London are puzzlingly acquiescent in approving sensitive sales without demanding reciprocal investment access to China.

No other large country has thrown itself on China’s financial mercy like America has. One is the world’s greatest saver and the other the world’s largest debtor — an incongruity solved by their huge and mounting bilateral trade imbalance. This in turn has led to Beijing’s accumulation of trillions of dollars of official reserves, much of which are direct claims on Washington. Whether such interdependence stabilizes their political ties is questionable, but ironically it ensconces the greenback as the world’s main reserve currency, however much Beijing resents that. Beyond the headlines of US foreign indebtedness are more profound shifts in the relationship. Chinese firms do not yet threaten America’s high-technology bastions like aerospace, semiconductors and healthcare — but they plan to. Helped in part by US trade policies, universities and corporations, China is moving up the value chain, making lavishly funded state-led breakthroughs in new areas of science. 

The future can be glimpsed in mid-tech industries like solar panels and lithium batteries, where western producers are steadily being edged out. China already produces about seventy percent of the world's electronics. Upstream, it accounts for more than half of world metals demand, and much of its supply as well. First in obscure rare-earth metals, then in steel and now in aluminium, when China moves in, once-proud American mills fall silent. The question is not just whether such industries are “good” for the country, but also whether they are strategically essential. Will the next US warfleet head into combat built on recycled soda cans, Chinese chips, and the forbearance of overseas creditors?

Solving different problems

America's strategic planners must seek a clear-eyed assessment of US weaknesses and strengths. They need to understand where, when and how their networks could be placed at risk; they need to understand the exposures of potential adversaries too. They will be well served by following the money, by watching some of the world's most powerful actors — multinational corporations — and by considering several crucial issues.

First is the obvious acknowledgment that the civilian and military sectors, though interacting and overlapping extensively, are tasked with solving very different problems. Put bluntly, peacetime accumulates capital, and war destroys it. There must be no conflation between the ideas of commercial rivalry and military warfare. Although they may both be elements of a broader strategic competition, they are entirely distinct. Certain activities — codebreaking, stealth, directed energy and nuclear weapons — should never fall within the civil sector's ambit. It is vital that US public agencies maintain research leadership in these fields. As private industry makes increasingly impressive progress in fields like genetics, those agencies must continue to support them in basic research. Where the state does not lead the private sector in knowledge, then at least it must not fall behind.

Second is the recognition of divergent interests, even where civil-military integration makes sense. Silicon Valley, Manhattan and the Beltway are separate worlds with deep cultural differences. Many businesses do not welcome interaction with the US government and especially with its security agencies. Some don't wish to collaborate on principle. Others can’t be bothered; Uncle Sam is a highly demanding customer. To be sure, adversarial public-private tension is natural, even healthy. More problematic would be if global multinationals defy Washington's entreaties in order to comply with Beijing’s. That day may not be far off. To multinationals, the dragon's wrath is a fearsome threat to which the US must be sensitive.

Third, because its development model appears successful and institutionally coherent, China finds itself compared in ideological terms with the United States. Policymakers in DC must ask whether Beijing’s governance model might indeed provide a mobilization advantage over America, both in peacetime and in a security competition. The US once was a much more interventionist state; there is no golden rule preventing the next President from reversing liberalization in order to assert more control over the economy. There is one aspect in which China is disadvantaged, however, and the next US administration would do well to heed it: because its ruling Party is embedded everywhere, domestically and abroad, Chinese firms may never be considered multinational. They will be distrusted in many jurisdictions. Their “corporate power” deficit derives directly from the high level of state influence in China's “mono-national” networks.

Fourth, although prudent US planners must assume that China will be a viable long-term competitor, they should also recognize its other difficulties. Their counterparts in Beijing fret about their own industrial vulnerabilities — specifically oil, which is hard to substitute and for which Chinese import dependence is rising as America's falls. Beijing has also linked its currency to the dollar, making it highly exposed to US monetary policy and to Washington’s power over global financial affairs. The easy money the Federal Reserve issued to repair the American housing sector has been kryptonite to China, where debt is growing radically. China is a monumental experiment to smash through the middle income barrier with brute monetary force. For all its tremendous progress, huge socio-demographic, financial and ecological hurdles await. Both America and China are flawed giants.

Finally, a review of US trade, investment, innovation and infrastructure policy is overdue. Globalization has served both America and China well — but not symmetrically, nor has it benefited everyone in either country. Multinational firms and financiers have prospered, but American workers have struggled. The US now finds itself strategically vulnerable, dependent on China for capital and goods, and tangled in an embrace which is assuredly undermining its innovation lead. Diversifying global networks is a priority for both countries. Yet this must be a subtle exercise. Preferential trade policies alone are an imperfect tool. The proposed Trans-Pacific Partnership is criticized (within the US and other signatories) as blatant advocacy for corporate interests. Likewise, China will face resistance to its “One Belt, One Road” if it is a mercantilist scheme to clear the pathway for its bulging business ambition.

The next President’s inbox will be a formidable array of urgent and important national challenges. The tyranny of the urgent will, as usual, prevail. Yet whatever emergent crises come and go in the Situation Room, there, on the Oval Office desk, will be the great task of sustaining American techno-economic leadership especially vis-à-vis China. It demands an intentional, comprehensive strategic-industrial policy. This is one problem that isn’t going away.

Julian Snelder is a New Zealand-Netherlands dual national, resident in Asia for more than 25 years. He worked for the management consultancy McKinsey & Company for eight years, then for Morgan Stanley for eight years, the latter role as head of technology investment banking for Asia. Since 2005 he has been director and partner in an emerging market investment fund. Mr. Snelder has worked extensively in China, India, Japan, Korea and Taiwan. He has advised corporate and government clients on mergers and acquisitions, fundraising and capital investment, business planning and budget planning, privatization, and industrial policy. His particular interest is the broad application of commercial information and manufacturing technologies to matters of national security. He writes regularly on this topic and has contributed to publications of the United States Naval War College.

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