Deflating Ties: China’s Balloon Fiasco Spells Trouble for US Relations

In spite of Joe Biden’s assurance on Thursday to communicate with Xi Jinping, it may be too late in Washington to rely on balloon diplomacy. The bipartisan rage regarding the alleged spy platform that drifted over the central United States may provide momentum to impose new economic sanctions on China.

One notable measure to look out for is a unique framework that limits outward US investment. Lawmakers have been discussing this proposal for some time, and with various other anti-China measures already in effect – including import taxes, export controls, and import restrictions from the Xinjiang area – preventing US companies from investing in China presents a significant untapped leverage point.

Last month, Congress established a new panel dedicated to opposing China’s Communist Party, which is likely to create new pressure for specific actions against Beijing. Morgan Stanley analysts have informed their clients that an investment ban on outward investment is a “key final ‘defensive’ policy tool to safeguard areas of technological superiority” for the United States.

Despite China’s highly publicized loss of face, Biden may want to be generous with Xi in the short term, but it is unlikely that he will retreat from his strong economic and trade stance against China.

Activating this lever will be a significant milestone, as the new structure would increase the stress for the separation of the US and China, at least in the advanced technology industry. Although trade relations between the two largest economies in the world are still soaring, the ongoing establishment of trade barriers would ultimately become noticeable.

The aftermath of this policy change is yet to be seen, and the Treasury Department is expected to present a report to Congress this month on how the outbound investment review process would function. If the report is deemed insignificant by the Congress hawks, they would most likely express their opposition.

According to Grace Fan, an analyst at independent research group TS Lombard, the Biden administration’s primary objective is to initiate targeted executive action on US investment in particular sectors such as artificial intelligence. Subsequently, comprehensive legislation would be passed by the end of the year.

It is still undecided whether the White House would concentrate on a review process or an absolute ban on investing in specific types of projects. Further revelations related to the policy change could exacerbate the situation. Any new evidence that emerges from examining the payload, such as evidence that Western or US companies were involved in making some of the components, would undoubtedly trigger additional controls on exports and investment.

The new congressional committee focused on China, led by Republican Mike Gallagher of Wisconsin, is expected to use the traditional “name and shame” approach to demand corporate executives’ attendance at hearings, where their companies’ actions are publicly scrutinized.

According to Morgan Stanley analysts in a February 6 report, US foreign direct investment in China’s technology sector has been decreasing since the turn of the century and accounted for about 0.5% of China’s total inbound FDI over the 2018-21 period.

“However, American investments, or the refusal to invest, can have an impact on China in ways beyond just monetary value. Emily Weinstein and Ngor Luong at the Center for Security and Emerging Technology stated in their recent analysis that early-stage venture capital investments have intangible benefits, such as mentorship, coaching, and networking opportunities, that go beyond just providing capital. If the US imposes restrictions, it could eventually affect China’s productivity growth, as noted by the Morgan Stanley team who emphasized the need for China to upgrade its own tech sector.

Another aspect to observe is whether or not there will be any cooperation between the US and Europe with regard to foreign investments. This newsletter recently pointed out that the US and Europe have established a new coordination mechanism and are working on coordinating export controls, a field closely related to this topic. If limits on foreign direct investment in China start to spread throughout advanced economies, it could have a more significant impact on Beijing.

Moreover, the imposition of foreign direct investment restrictions could lead to another area of escalation: portfolio investment. In a recent note, Gavekal Dragonomics analysts Arthur Kroeber and Dan Wang warned that “financial markets could be heading into choppy waters” and that any move by Washington to impose sanctions on Chinese companies that are seen as aiding Russia’s war efforts in Ukraine or a stringent new review system “could make international portfolio investors hesitant to invest further in Chinese equities or bonds.”