China's Tech Sector Likely to Suffer Asymmetric Losses in US Rivalry

As US-China relations deteriorate, the ongoing tech trade war will disproportionately weigh on Sino-based tech equity indices.

*The following does not constitute financial advice.

China’s tech sector will likely continue to underperform versus its US-based counterpart as Washington tightens the screws on Beijing, with geopolitics playing a notable role in driving that return differential.

The Biden Administration recently announced an executive order restricting the amount of outbound investment from private equity and venture capital into Chinese technology firms.

A statement from the White House outlined that the:

“Rapid advancement in semiconductors and microelectronics, quantum information technologies, and artificial intelligence capabilities by these countries significantly enhances their ability to conduct activities that threaten the national security of the United States. Advancements in sensitive technologies and products in these sectors will accelerate the development of advanced computational capabilities that will enable new applications that pose significant national security risks, such as the development of more sophisticated weapons systems, breaking of cryptographic codes, and other applications that could provide these countries with military advantages.”

In other words, these restrictions will apply to firms researching and developing sensitive technologies that “pose a risk to US national security”. These include AI, quantum computing, and advanced semiconductors.

According to Elena McGovern, Head of Capstone’s Private Markets Group and Co-Head of the National Security Practice, she was quoted as saying that “this is the first time that the U.S. government is imposing restrictions on how U.S. capital flows out of the country, how U.S. investors are making investment decisions. So that is a new era.”

The measure is intended to be narrow but surgical, in line with Treasury Secretary Janet Yellen’s idea of a “narrow but tall fence” around their rival’s strategic technologies.

But this policy is not being implemented in a vacuum. Rather, it is part of a growing number of restrictions Washington is placing on Beijing as diplomacy takes a backseat - and markets are noticing.

Shanghai’s STAR index - widely recognized as the equivalent to America's Nasdaq - has been deep in the red, and continues to decline as US-China relations wilt. The KraneShares SSE STAR Market 50 Index ETF (which tracks the “index of the top 50 companies by market-cap that are listed on the Shanghai Stock Exchange (SSE) Science and Technology Innovation Board”), is down almost 50% between its launch in January 2021 and August 18, 2023 from $24.36 a share to $12.93.

The technological competition between the US and China will remain a macro-fundamental headwind for both countrys’ tech sectors - but mostly the latter’s. The US continues to dominate the chip industry when it comes to advanced semiconductors, particularly those used to power AI technologies.

When it comes chips, China needs the US more than the latter needs the former.

The US has been surgically removing China’s access to these high-powered chips to hinder their rival’s technological development amid heightened geopolitical competition. The cumulative effect of the restrictions is already creating a chilling effect whereby investing in China is becoming too costly in both regulations and poor returns to be worth exploring.

This marks a trend-defining change relative to the pre-2018 environment, when investors were actively seeking investment opportunities in China. According to PitchBook data, the amount of US-based investors “participating in China-based VC deals fell from 262 in 2018 to 179 by 2022”.

Sequoia Capital already split its international business to account for this growing US-China technological rift, so this is not something new but rather marks an escalation. The other peripheral effects of the US’ restrictive measures according to the White House’s announcement is to also reduce “the peripheral benefits that come with that including: capital, managerial assistance, talent networks, and market access”.

Allies are expected to follow suit. This is not surprising, considering the mass-coordination we are already seeing between the US and Western partners on containing China. These include Dutch ASML limiting the export of advanced equipment, US semiconductor restrictions, Europe-US Anything But China (ABC) policies, de-risking from the Asian giant in the area of critical minerals, etc.

Looking ahead, Chinese tech equities will likely also be pressured by wider risks the country is facing vis-a-vis declining demographics and the precarious housing sector. Geopolitics, however, will continue to play an outsized role in the performance of China’s tech sector, making it more vulnerable to policy-driven volatility.