In this must-read piece from Andy Gilholm, principal and director of Analysis at Control Risks considers the outlook beyond the G20 talks and considers some specific escalation risks including China’s planned “unreliable entities list”.

The leaders of the G20 Group of the world’s largest economies met in Osaka on 28-29 June. By tradition, the culminating Joint Communique has been an expression of solidarity – outwardly at least. That has notably frayed recently, particularly since the arrival of the Trump administration in the US. Osaka was no different, with climate change and trade being the bone of contention between Washington and many of the other members.

But that was predictable. The other, far more interesting, break with G20 tradition was the scheduling of an ad hoc bilateral meeting between US President Donald Trump and Chinese President Xi Jinping. In that meeting, Xi and Trump chose to call a temporary de-escalation of their bilateral trade war. Trump postponed the implementation of additional trade tariffs on Chinese imports and said the US would not yet fully enforce a ban on sales of US technology to China’s leading telecommunications equipment maker, Huawei. “Neither side appears to have made concessions on the fundamental differences that caused talks to stall in May. Trump might be willing to accept a symbolic deal that alleviates economic risks going into the 2020 US election, but also wants to avoid being outflanked by Democratic challengers as “tougher on China”. US officials have indicated that any relaxation of the export restrictions could be reversed. Prospects for a trade deal remain unclear, and US-China tensions are likely to persist and could escalate again at short notice.” says Cory Davie, Partner at Control Risks.

This article below written by Andy Gilholm, Principal and Director of Analysis at Control Risks considers the outlook beyond the G20 talks and considers some specific escalation risks including China’s planned “unreliable entities list”, and some broader recommendations for companies trying to make practical preparations in a highly uncertain, disrupted environment. The bottom line is that despite the talks in Osaka, companies must continue to plan based on the assumption that US-China tensions are both a long-term trend and a problem that could escalate at short notice.

Miscalculation and retaliation

After months of tortuous US-China negotiations and with both their economies feeling the strain, neither Xi nor Trump want to decisively abandon talks and enter unrestrained escalation. But hardening attitudes on both sides mean prospects for a deal have dimmed since April. Washington’s moves against Huawei in May further reinforced Beijing’s belief that US trade complaints are the pretext for an assault on China’s economic rise. Beijing plays up sovereignty concerns to try and establish red lines, but there is a real, historically emotive narrative in China that this is 21st century “gunboat diplomacy”.

Events since April have also heightened Chinese leaders’ skepticism that a deal will really prevent more tariffs or moves against Chinese companies. Beijing’s motivation to pursue a deal is thus weakening just as pressure to retaliate is rising, and room for more concessions is narrowing. Xi is probably close to the point where he would rather accept the economic costs of escalation, rather than risk the domestic political costs of making major new concessions under intense US pressure.

We did, of course, see some concessions made in Osaka, however, they have not settled the multiple fundamental disagreements over a final deal, so what we have is a vague agreement that revives talks and delays escalation. This truce, and any subsequent deal, are then very vulnerable to breakdown amid domestic criticism and disputes over implementation.

Companies, unlike financial markets at times, cannot swing between optimism and pessimism with every trade war twist and turn. They can hope for a trade deal to limit the pace and scope of escalation, but must expect the trend of deepening competition – and the disruption that brings to the trade and investment environment – to play out over years, not months. They should also anticipate the very credible risk of short-term escalation. If talks deteriorate again, Trump could impose tariffs on another USD 300bn worth of Chinese imports within a few days. Expanded export controls and more regulatory or legal actions against Chinese companies are among several other US moves already in the pipeline.

If China sees no short-term prospect of the US softening its position, it is much more likely to retaliate than capitulate. This is contrary to the reported view inside the White House that China is bluffing – a view that suggests miscalculation risks are high. China has continued to hold back on retaliation despite the US decision on 21 June to add more Chinese firms to the Department of Commerce’s Entities List (now put on hold). However, beyond the G20, escalatory US actions are more likely than ever to trigger Chinese retaliation against US companies. Many in Beijing understand that attacking MNCs risks playing into the hands of China “hawks” in the US, by forcing MNCs to greatly reduce China’s role in their global supply chains and strategies. This logic is a restraining factor but could soon be overtaken by the need to hit back harder.

List looms

China’s long-debated retaliation options range from restricting rare earths exports to allowing greater currency depreciation. While more tariffs and supply chain disruption will have global implications, for US companies (and others) in China, potential regulatory retaliation is an equally pressing threat. Long before the trade war, this was a growing concern across regulatory enforcement areas including cyber security and antitrust. In the trade war so far, clear cases of China “punishing” US companies in these areas have been rare, but the latest and largest concern is the Chinese Ministry of Commerce (MOFCOM) plan to release an “unreliable entities list” (UEL).

The UEL is clearly a response to the US putting Huawei and others on the Commerce Department’s long-standing Entities List. It is also the first real warning that China will directly target foreign companies that cut ties with Chinese firms to comply with US restrictions. MOFCOM signaled its UEL plan on 31 May but has still not released the list or said what the consequences will be for companies that appear on it. The pause may be due to the bureaucratic practicalities of preparing and approving details of such a contentious measure. But it probably also reflects that China is still holding back – hoping for leverage in talks, and in no rush to go through with actions that it knows will further unnerve foreign investors.

As long as those hopes persist, China is likely to delay implementing the UEL, or implement it only very selectively at first. We can only speculate for now, but initially, it might only list a small number of companies, focusing on those Beijing deems to have taken some particularly harmful action or to have particular symbolic significance. It might list many firms but apply only limited, deferred or vague consequences. For example, it could warn Chinese companies about certain relationships with listed entities without enforcing any broad ban. It is unclear whether penalties will focus on “reliability” by requiring Chinese firms in some industries to reduce their use of listed suppliers, or if they might mirror US rules by also restricting Chinese companies’ sales to the listed entities.

Given the scope for self-inflicted damage, China is unlikely to totally cut off market access or aggressively target every company that complies with the US Entities List requirements (which can also affect non-US firms providing partly US-made products to China). But it would be a mistake to think Beijing is bluffing. It is preparing to take retaliation to a new level, and companies should take this very seriously.

Targets sighted

MOFCOM says firms or individuals can be listed for withholding supplies or failing to honour contracts for “non-commercial” reasons, harming the “legitimate rights and interests” of Chinese companies or posing unspecified threats to national security. This could be interpreted as applying to any company that terminates transactions or relationships with Chinese firms in response to US government actions. It also ties in with other recent regulatory developments suggesting increased scrutiny of foreign firms on the grounds of “reliability” and national security concerns. Such developments include:

  • The Cyberspace Administration of China (CAC) issued draft guidance on cybersecurity reviews. The draft states that reviews will consider whether operators of China’s critical information infrastructure are vulnerable to supply disruptions due to “political, diplomatic and trade” reasons. This could presumably be used to bar the use of US firms as suppliers in relevant infrastructure.
  • Soon after the CAC announcement, and a day before MOFCOM’s “list” announcement, the Ministry of Industry and Information Technology (MIIT) said it was launching a cyber security inspection campaign in the telecommunications and internet industries.
  • The National Development and Reform Commission (NDRC) in April was given responsibility for leading national security reviews of foreign investment. China has had national security review procedures for many years and the NDRC has long been heavily involved. However, officials are increasingly critical of the US citing national security grounds to target China, and a very vague article in China’s new Foreign Investment Law (FIL) suggests Beijing might respond on this front.
  • State media reported the NDRC’s plan for a “national technology security management list system” on 8 June, but there has still been no explanation of what it will involve, besides the vague intention to “more effectively prevent and handle national security risks”. The basic concept seems to be technology export controls – another counterpoint to US actions.

This situation is concerning for almost any foreign investor in China, especially US multinationals and “core suppliers” to Huawei that are affected by the US Entities List. However, targeting of regulatory retaliation is likely to be heavily influenced by several factors including the following:

  • In the battle of the entity lists, foreign firms in China are probably more vulnerable if their actions are perceived to be particularly harmful to a Chinese company or industry, break specific Chinese laws or are deemed particularly egregious in some way. Whether Beijing can punish the foreign company without exacerbating China’s supply stability problems is another factor.
  • Beijing will consider the symbolic or economic effectiveness of its actions in pressuring the White House. Regulators are unlikely to take totally arbitrary or baseless actions but may focus disproportionately on high-profile US brands, or on cases where China can inflict substantial economic damage on a company or industry that is visible or politically significant in the US.
  • There may be a preference for actions that correspond to US actions against China. MOFCOM and NDRC lists, cybersecurity and national security reviews all suit this purpose. Sectors which have been a focus of US scrutiny – particularly technology – are a likely focus of Chinese attention.
  • In regulatory actions beyond the unreliable entities list, there may be a preference for moves that fit established regulatory enforcement priorities and can be presented as normal activity. A good example is antitrust and competition enforcement, ranging from M&A reviews to abuse of dominance investigations, especially in areas of pre-existing scrutiny such as chips and pharma.

Approaching uncertainty

The Chinese government response could soon intensify, but companies also need to consider the public and media response, as well as their other Chinese clients, suppliers or partners. The US’s Huawei ban is the latest of several subjects of anger expressed in Chinese official and unofficial media; this has included calls for retaliation against US firms. Business risks stemming from negative public sentiment towards the US in China are currently manifested mainly in media, social media and consumer criticism rather than physical security threats, but companies should consider the latter in their contingency planning. Non-US companies could also be affected by the trade war fallout, including any rise in general “anti-Western” or “anti-foreign” sentiment.

Besides the Chinese firms recently targeted by the Department of Commerce, there are signs that some other Chinese firms – presumably alarmed by the Huawei case and unclear on some of the issues – are seeking assurances from US firms regarding the stable supply of goods and services. One large Chinese manufacturer reportedly asked a US supplier to provide formal written assurances guaranteeing supplies – a reminder that recent events are a major concern for a wide range of stakeholders in China.

With so many of the key trade war variables being unpredictable and uncontrollable, many firms have an understandable sense of helplessness and confusion. This is particularly true on issues where companies may face a choice between terrible options, such as either risking non-compliance with US law or “unreliable” status in China. Clearly there are no easy solutions to these problems, but some best practice considerations can help you “future-proof” your China strategy and operations and help ensure a more coherent, less reactive approach:

  • Hope alone won’t help: Doom forecasts and panic are not useful, but companies must assume that heightened geopolitical friction and volatility are a long-term trend. Waiting and hoping for a trade deal or the US elections to bring a return to business-as-usual may dull the sense of urgency needed to face a rapidly evolving environment, and plan for some daunting scenarios.
  • Update understanding: Specific issues such as tariffs and the UEL can demand immediate focus, but it is also essential to have a broad, systematic view of how trade war-related events may impact a business. For example, antitrust and cybersecurity regulation have made fewer headlines than rare earths and tariffs but may pose a greater risk for certain firms. If your company’s China risk assessment is more than two years old, it should be updated as a priority. You need to know where threats may come from, your specific vulnerabilities to those threats, and what you can do to reduce risks and effectively respond to them if they arise.
  • Compliance and communications: Given the targeting factors outlined above, compliance is the first line of defence in China (albeit a difficult one, given uncertainties about some regulations and enforcement). It is also critical to be aware of how various stakeholders in China are likely to perceive your company and its actions in the current context, and communicate accordingly.
  • Monitor more: Understanding of all these risks, regulations, perceptions and stakeholders needs to keep up with rapid change. Some companies suffer information overload, in terms of general trade war news and noise, but lack more targeted information in China and a system for using it. If ever there was a time to review and improve risk monitoring and reporting systems, it is now.
  • Tackle tough questions: It is hard to respond to specific issues and situations unless your company has a wider strategy, guiding principles and priorities for navigating this tougher political and business landscape. These can only be developed by tackling some fundamental scenarios – often deeply uncomfortable and complex ones that involve examining your overall objectives and prospects in China, how the market will figure in your global business, and potential risk-opportunity trade-offs. Though less likely, such scenarios are critical for management teams to describe and address now, in order to avoid a scramble when a rapid response is necessary.