Eurasia Group/Vontobel study: US-China battle for digital supremacy can create a dilemma for Europe

The conflict between the US and China is only superficially about trade. According to a study by the independent think tank Eurasia Group and Vontobel, the tensions between the two nations are really about supremacy in the digital age. Emerging as a leader in the field of dual-use technologies such as 5G is of particular importance. The nation that has a head start will gain the advantage. Viewed from this perspective, the current dispute over tariffs and trade barriers appears to be merely a means to an end or simply an overture, according to the experts.

The authors of the study set out three scenarios for how the battle for digital supremacy could develop and they outline the impacts that they would have on the global economy. In the most likely scenario involving a protracted and escalating conflict between the US and China, Europe is more likely to end up on the losing side. Since the US and China will avoid a direct confrontation, Europe is likely to serve as one of the ‘proxy’ markets where the future contest between the two countries will be played out. Among the world’s three major economic regions, Europe is, however, also particularly exposed to any cooling of the global economic climate. The European Central Bank appears to have already used most of the tools at its disposal, and Europe’s strongest economies are dependent on export surpluses. Furthermore, cohesion within the EU is fragile when it comes to the question of Europe‘s relationship with China and increasingly also with the US, according to the study. Individual countries go it alone – and always will do – if they expect to gain their own advantages from this approach.

In this future scenario, China will seek to strengthen its economic ties with Europe or individual states. For example, it could give western companies access to previously closed Chinese sectors or grant lower tariffs on goods and services from non-US firms. On the other hand, China will seek to maintain openings for its own foreign investment in Europe, especially if it becomes more difficult for it to access US markets and technology. Europe will find it far from easy to reach decisions on this topic.

The authors of the study believe that the US will not allow Europe to remain neutral and seek to derive its own advantages from the situation. Pressure on Europe will increase if the US seeks solidarity. The economic consequences for individual European states and for the EU as a whole would be too great for them to be able to ignore the interests of the US in favor of China. However, it seems unlikely that Europe will be able to comply fully with the wishes of the US, as Chinese products already play too vital a role in Europe’s infrastructure. Without technology from China, for example, G5 would be practically impossible to implement in Europe.

The winners will be Vietnam, Indonesia, Thailand, Bangladesh, Taiwan, Malaysia and Mexico – at least in the early stages of the trade tensions. Chile, Argentina and Brazil could also benefit from the fact that the US is withdrawing from the race to supply China with goods and services as a result of its own trade sanctions. At the same time, it is likely that the US will see a renewed increase in its importance as a production hub. The climate debate and logistics costs are arguments against long transport routes. New technologies such as 3D printing are lowering production costs to a competitive level, even in high-wage countries. Over the long term, Latin America will also benefit from these trends, given its proximity to the US – as will China’s neighbors in South and Southeast Asia.

According to the authors of the study, these shifts in global value chains will create massive challenges for investors. The study reaches the conclusion that the US equity market is likely to suffer in both the ‘battleground clash’ and the ‘West ascendant’ scenarios. One reason for concern is that more than a third of sales generated by companies listed in the S&P 500 come from foreign markets. These companies would clearly suffer if they were to lose market access abroad. It is only in the relatively unlikely ‘De-escalation’ scenario that US companies could gain better access to Chinese markets, which would strengthen their profit base.

Furthermore, the outlook for higher inflation in the ‘battleground clash’ and ‘West ascendant’ scenarios will have negative consequences for bonds. Investors will demand higher yields to offset returns that are eroded by higher inflation. This will depress prices for both government and corporate bonds.

The shift from a hegemonic to a bipolar world order would also affect currency markets. In this scenario, the proportion of globally traded government bonds denominated in US dollars will decrease, with the US dollar subsequently experiencing a decline in market share.

The influence of the renminbi will probably not increase significantly on the global stage in this scenario. It is more likely that it will become a dominant currency in the Asia-Pacific region. The US dollar’s lost market share is likely to be supplanted by baskets of currency similar to the IMF’s special drawing rights (SDR). It is only in the ‘De-escalation’ scenario that the experts see a clear tailwind for the renminbi, as the economic integration of China in the world economy would probably accelerate, increasing global demand for the Chinese currency.

As a final point, the authors describe measures to counter the negative macroeconomic impacts at a national level. The battle with China over the key technologies of the future – which is regarded as a national challenge – could lead to programmatic initiatives to invest in research, development and training. Combined with the deregulation of markets and further tax reductions, this could prevent negative impacts from occurring. The story behind the birth of Silicon Valley serves as an impressive example in this context.

‘The Next Digital Superpower’ is the title of the latest position paper published by the Eurasia Group and Vontobel, in which they jointly set out different scenarios for the US-China conflict and their implications for the global economy.

The study can be downloaded from the Vontobel website at: vontobel.com/digitalsuperpower

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