Will the U.S. and China decouple?

The rise of China is considered a serious threat, or even an existential one by some. Many in the US believe that globalization gives more advantages to China and therefore it is necessary to decouple China from the U.S. not only economically, but technologically and financially. The global industrial supply chain will be torn up and a world split into dollar and yuan economic blocs if it happens. With the new U.S. president and China launching its 14th Five-Year Plan, this complex and dynamic geopolitical game will enter a new stage. The fallout will be extremely consequential. We will examine whether the decoupling will happen and to what extent (if any), and how it will impact the laser and photonics industry.

America will face many challenges in 2021—dealing with the rise of China will certainly be one of them. Sino-U.S. relations are at a turning point in world history, so what happens in the next few years will be scrutinized by historians a century from now.

Many in the U.S. believe that the toughening of U.S.-China relations is inevitable since China has changed in multiple adverse ways. Unpredictable and sometimes-petty U.S. policy towards China in the past four years offered nothing but uncertainty for the business world. As China is on its way to become the world’s largest economy, the U.S. is still searching for its long-term counter-strategy. For many laser and photonics companies, China represents one of the largest markets and growth opportunities.

With the election of a new U.S. president, the Sino-U.S. relationship has been offered a reset button—but the underlying fundamentals remain unchanged. As Ray Dalio, founder of Bridgewater Associates, pointed out in his recent book,¹ “China’s economic aggregate is close to that of the United States, and it is expanding at a faster rate. If its per-capita income reaches half that of the United States in 25 years, its economic aggregate will be twice that of the United States.”  And further, “In the long run, it is certainly eternal and universal truths that determine the success or failure of a country.”

One of the most influential baseline views of the U.S.-China relationship is the Thucydides trap. From the time of ancient Greece to World War II, the way a country became a great power was to use its military to grab pieces of its neighbors. That process resulted in wars between rising powers and, historically, established powers about three times out of four in history. However, two critical things have changed in today’s world. First, human society learned how to grow the economy much faster, thus making economics much more decisive for international influence. Second, military technologies including nuclear weapons have become more destructive, so both conflicting sides will lose if direct military conflict is pursued.

Now, the path to becoming or remaining a great power remains primarily economic. The country still needs a powerful military, but it only protects its economic strategy. This is a fundamental change in the way the world works—to miss that is like an economist missing the industrial revolution. If the U.S. and China compete for leadership by predominantly economic strategies, both can win. That is a vital aspect of U.S.-China rivalry. Of course, if the U.S. or China behaves like a pre-World War II power, it can make the Thucydides trap a self-fulfilling prediction. Graham Allison's book Destined for War: Can America and China Escape Thucydides’s Trap? provides a brilliant exposition of the consequences.²

Some argue that the economic engagement with China since Nixon was a total failure because it did not produce the expected result—turning China into a western-style democracy. However, this was never the goal of the Nixon administration or the subsequent U.S. administrations. Nixon re-opened the door to China to simply counter the then-Soviet Union. Later, the U.S. needed China on many fronts, including peacekeeping in Korea, nuclear nonproliferation, antiterrorism, piracy, and environmental cooperation. This engagement has provided the world with more than a half-century of big-power peace and the most extraordinary increase in prosperity. No doubt that there are many issues in the U.S. relationship with China and firm actions are required, but American's future is not improved by a false ideological revision of history to justify a Cold War mentality that would guarantee a lose-lose outcome.

The escalating tension between the U.S. and China has accelerated the collapse of globalization—faster than many people predicted. This trend is unlikely to reverse; at its core, the agendas of the U.S. and China are at odds. The U.S. hopes to create a level playing field for American companies, to bring jobs back to the country, and balance the trade deficit. China hopes to maintain its economic growth and ensure a secure and controllable technology supply chain by building thriving indigenous technology sectors, an aspiration growing stronger after recent sanctions by the U.S.

In the long term, the U.S. hopes to maintain its technological leadership position and super power status, while China is trying to rise to that level. The U.S. believes that globalization gives more advantages to China and therefore it is necessary to decouple China from the U.S. to stop or slow down its growth.

The recent political maneuvering and growing momentum toward decoupling are pushing companies around the world to reevaluate their global strategies because this new reality has serious implications for their businesses. The global ecosystems are torn up, reversing years of mostly open, global trade. Decoupling could be very disruptive over the near- and medium-terms and damaging both sides from an economic point of view. However, given the intensifying strategic competition between the two countries, national security concerns could supersede economic logic.

This deteriorating relationship will have the most potential impact on companies that are at high risk in terms of demand and supply. If the relationship between the two countries deteriorates to the point that American companies cannot sell in China or become targets of consumer boycotts, the loss of revenue for American companies will far exceed that of their Chinese counterparts, as U.S. companies currently have $410 billion in direct sales revenue in China—three times that of Chinese companies in the U.S.³

China presents a major revenue and profit contributor for many U.S. laser and photonics companies while their Chinese counterparts have little exposure to the U.S. market. American companies will suffer much greater losses if decoupled. In many cases, companies are also closely connected through industrial supply chains. Dissolving commercial relationships that took decades to establish is costly and poses a major risk to American companies.

More than half of the 16 manufacturing sectors in the U.S., especially engineering-intensive industries such as aerospace and telecommunications equipment, rely on China for critical components or raw materials. Meanwhile, China depends on the U.S. for semiconductors, airplanes, and software. The Chinese laser/photonics industry is, however, relatively self-sufficient after more than 40 years of development. Moreover, China's consumption accounts for 25% of global demand that has grown at least twice the global average—for example, China is the largest industrial laser market in the world. Many studies have indicated that a complete decoupling either is impossible or has dire consequences—a lose-lose scenario.^4-7

It is quite possible that the two countries will intensify friction and competition in commercial and technological fields, and decouple in fields related to national security while moving in the direction of two economic blocs: one with China and the other with the U.S. and its allies. Such a scenario is called “Slowbalization,” a term proposed by Dutch trend observer Adjiedj Bakas in 2015 and promoted by The Economist in 2019.⁸ In fact, the world economy has been developing in this direction for some time prior to the COVID-19 crisis. Companies were increasingly worried about the resilience of global supply chains that were heavily dependent on a few countries. It has been accelerated unexpectedly by COVID-19, which will cause significantly higher barriers for companies to do business across the two ecosystems (see table). China has put forward a new economic policy called “Dual Circulation,” which refers broadly to two circles of economic activity—internal and external—with greater emphasis on the domestic market (see Figs. 1 and 2).

Decoupling will force corporate executives to make difficult decisions about the future of their supply chain, products, customers, employees, and even organizational boundaries. Companies in both countries must now be prepared to build agility and resilience in manufacturing and supply networks and to explore for new markets. Some of the impacts are highlighted below.

Export control. Among recent U.S. policy changes are export control provisions further limiting the export of certain technology to China. Many believe that a “high fence, small yard” export control policy would be much more effective and productive. On October 17, 2020, China passed its first “Export Control Law.” On the “export control list” by the Chinese Ministry of Commerce, laser crystals and integrated metal 3D printing were included for the first time.

Supply chain. Many companies in the U.S.  or China rely on imports of critical components and raw materials from the other side. Even though accounting for only a small portion of the total production costs, they are a key element in the early stages of the manufacturing value chain, especially for highly engineered products such as lasers and laser systems. Given the stricter export controls, supply chain transformation becomes more urgent.

Products/markets. U.S. companies have wrestled with the question of localization of products for years. As the two countries increase their restrictions, this becomes a necessity. An increasing number of U.S. laser products are designed specifically for the Chinese market. Many leading laser companies including TRUMPF, Han’s Laser, and HG Laser are developing and implementing Industry 4.0 smart manufacturing. This will ultimately enhance enterprises’ agility and efficiency supported by real-time data, artificial intelligence (AI), and industrial internet.

Organization/talents. Many U.S. photonics and laser companies already have regional entities in China. To ensure continued access to the local market and tap into the local talents, international companies are increasingly making their factories in China serve its markets and neighboring countries, while factories in North America and Europe are focusing on their own regions. More and more Chinese companies are establishing service/product centers in the U.S., while contemplating how they can expand globally.

Impact of immigration policy. The U.S. has made a policy change to freeze new H-1B visas and restrict student visas, especially to Chinese students. This will certainly hit hard on the high-tech industry, including the laser/photonics industry in which U.S.-educated Chinese scientists and engineers play an important role. A recent congressional report noted that a quarter of all new businesses in America is founded by immigrants. Even as the pandemic forces us to stay indoors, we are leaning on technologies by immigrants’ innovation. Whether you order food from Doordash, Google the nearest testing site, message your coworkers on Slack, or connect with your friends on Zoom, you are using a technology created by immigrants—many of them are China-born.

A new study from MacroPolo, a think tank run by the Paulson Institute,⁹ showed that Chinese-educated researchers comprised nearly one-third of the authors of the papers accepted at a prestigious AI conference last year—more than from any other country. It also found that most of them lived in the U.S. and worked for American companies and universities. China stands out as the largest global source for the top-tier AI talent pool, with nearly one-third of these researchers globally completing their undergraduate education in China. Following undergraduate education, China experiences a brain drain of this talent pool. Only 34% of these Chinese researchers are currently in China, while approximately 56% are in the U.S. After completing graduate studies in the U.S., a full 88% of those Chinese researchers chose to stay and work in the U.S., while only 10% headed back to China. These China-born researchers help American firms and schools dominate the cutting-edge field—now, industry leaders worry that worsening political tensions will blunt that edge.          

Find the balance. As the decoupling process continues, more technology companies will re-examine their strategies in the U.S. and China. How do they balance the desire to sell products to the U.S. and China, protect intellectual property rights, and outgrow competitors? For companies in each market, there are several key strategies to consider.

For American companies trying to maintain businesses in China, they should formulate a multi-year strategy for product localization based on the company’s competitive advantage over local alternative products and the “good enough” of the target market segment. If necessary, acquire local assets where China has the strength that the U.S. lacks. In general, all companies should consider problems holistically and adopting the “China plus one” supply chain model to increase agility and resilience.

For Chinese companies looking to expand globally, they should first focus on maximizing the growth of the domestic market so that they have a solid business foundation to withstand global headwinds. Geographic diversification can help mitigate geopolitical risks when investing outside of China. They should also establish partnerships through equity investments and other types of transactions, establish regional entities and businesses, and implement mechanisms that separate their local organizations and data platforms. Finally, they should prepare a contingency exit strategy.

For companies headquartered elsewhere, tensions in U.S.-China relations may not hinder the development of these companies in the short-term. Companies based in Europe, Japan, and other regions could find new opportunities in the U.S. and China as a result of the withdrawal of U.S. or Chinese competitors from the markets, but in the long run, the process of either decoupling or “Slowbalization” will affect every company. So, these companies should begin now to lay the groundwork for the localization in both blocs by adjusting their supply chains, products, customer base, and organizations. Compared with their counterparts in the U.S. and China, this group has more degree of freedom, but their choices also come with more uncertainty at this point.

Ultimately, the right solution depends on the individual company and its strategic goals, and must be rated according to standards that the U.S. and Chinese governments may allow. The deep and complex linkages between the markets and industries in the U.S. and China took decades to establish. These ties will be costly and disruptive to transform, even in a gradual and phased manner. However, companies that are adapting now will mitigate risks and be in the most advantageous position to gain a competitive edge, no matter how the U.S.-China relationship plays out. Although the complexities are high and the challenges huge, it is too big to ignore the prize—the two largest laser and photonics markets and the two largest economies in the world.

REFERENCES

1. R. Dalio, Principles for Navigating Big Debt Crises; principles.com/big-debt-crises.

2. G. Allison, Destined for War: Can America and China Escape Thucydides’s Trap?, Houghton Mifflin Harcourt (2017).

3. Data from Boston Consulting Group and The American Chamber of Commerce in China.

4. H. Farrell and A. Newman, “The folly of decoupling from China, it isn’t just perilous: it’s impossible,” Foreign Affairs (Jun. 3, 2020).

5. R. Flannery, “U.S. China Decoupling ‘Unthinkable’,” Forbes China Forum (Aug. 26, 2020).

6. J. Crabtree, “US-China decoupling is much harder than Donald Trump thinks,” NIKKEI Asia (May 20, 2020).

7. Y. Liang, “The US, China, and the Perils of Post-COVID Decoupling,” The Diplomat (May 8, 2020).

8. “Slowbalisation: The steam has gone out of globalisation,” The Economist (Jan. 24, 2019).

9. See macropolo.org/digital-projects/the-global-ai-talent-tracker.