Even as the United States and China are set to formally sign a “phase one” trade agreement this week, the perception in Washington of the bilateral relationship has deteriorated to the point where US policymakers now openly assert that the two countries are engaged in a “new Cold War.” This more confrontational approach by US policymakers is driven by an overarching view that China represents a long-term economic and military competitor.

As US policymakers seek to address the perceived national security challenges, US companies, and their ties with China, will come under increased scrutiny for their potential involvement in aiding China’s military advancement, whether intended or not.

 

Civil-military integration blurs boundaries.

At the crux of the issue are concerns in Washington that US companies’ cooperation with China on dual-use technologies will assist China’s military modernization. Known as civil-military integration (CMI), Beijing’s strategy seeks to enlist civilian organizations—companies, universities, and research institutes, to name a few—to design and produce technologies for the People’s Liberation Army (PLA). Tech giants, such as Baidu and Alibaba, are getting involved, and although it is difficult to gauge the number of Chinese companies involved in the CMI program, US officials believe it is ubiquitous.

Beijing is promoting CMI alongside a long-standing policy that encourages domestic companies to innovate by acquiring foreign technologies.

US companies in China may become increasingly hard-pressed to insulate themselves from the CMI apparatus.

Combined with China’s national security laws, which require companies to hand over trade secrets to Beijing when called upon, US companies in China may become increasingly hard-pressed to insulate themselves from the CMI apparatus. So the thinking goes in Washington.

The concerns are not unprecedented

Indeed, China’s CMI program has netted sensitive foreign technology in the past. In 2018, the PLA Navy launched a so-called “supergun,” which was reportedly based on British semiconductor technology. According to a report by C4ADS, CSR Corporation’s (now China Railway Rolling Stock Corporation, or CRRC) acquisition of UK-based Dynex Semiconductor facilitated the technology transfer. As part of the deal, CSR Corp. and Dynex jointly developed a localized high-voltage semiconductor, which China needed for its high-speed trains. In subsequent years, as CMI accelerated, CSR became a supplier to the PLA and incorporated the semiconductors into advanced equipment for Chinese warships.

 

The US government is exploring incremental options.

US officials are hoping to avoid another Dynex, and in 2018, passed legislation to strengthen export controls vis-à-vis China and other countries. Despite the expansion of US export controls, American companies are still able to sell certain dual-use technologies to Chinese companies suspected of supplying the PLA, such as Huawei.

That may be about to change.

In late November, Reuters reported the US Department of Commerce is considering lowering so-called de minimis thresholds from 25 to 10 percent.  If implemented, products that incorporate 10 percent or more US-origin, dual-use content would require an export license from Commerce to be legally sold to Chinese customers.

Further, reports indicate Commerce has been flexing its so-called “is informed” authority, which allows US officials to require an export license on any item, even those not officially controlled. This is significant because it technically gives US officials latitude to block specific transactions on an ad hoc basis. In recent months, Commerce exercised this authority to prevent the sale of an advanced artificial intelligence technology system to a “country of concern,” possibly China.

Scrutiny could extend to MIC 2025, BRI-affiliated projects

Broadly speaking, the US national security community, particularly the Department of Defense (DoD), sees the United States as being engaged in “great power” competition with China over emerging technologies. In its annual report to Congress on US industrial capabilities, DoD described technology transfer to China as a primary threat to US national security, and outlined critical new technological areas in  which China may be gaining strategic advantage, such as AI, quantum science, and robotics. Meanwhile, US military leaders have expressed concern about the alleged role US companies play in willingly transferring technology to the Chinese military.

Considering the scope of both projects, subjects of DoD’s assessment are likely to include companies with US partners.

In response, the US government has been actively studying additional measures to prevent US companies from transferring dual-use technology to CMI-affiliated companies. According to the National Defense Authorization Act for 2020, officials are drawing up assessments of Chinese companies and investment projects that could be converted into military assets. The assessments will cover both private and state-owned companies and projects related to Made in China 2025 (MIC 2025) and the Belt and Road Initiative (BRI). Considering the scope of both projects, subjects of DoD’s assessment are likely to include companies with US partners.

In addition, beginning in 2020, Commerce will produce a semi-annual report on Chinese investment in the United States in sectors that fall within MIC 2025, and submit the report to the Committee on Foreign Investment in the United States (CFIUS). The intent of the assessments is, in part, to inform decisions about export controls, entity list entries, and possibly, retroactive CFIUS reviews and investigations.

 

Increased scrutiny poses compliance and reputational risk.

As a result of the heightened attention on CMI, US companies may encounter pointed US government inquiries about their commercial partnerships in China. In particular, certain types of transactions or relationships could increase compliance risk. Those include:

  • Direct sales or licensing of dual-use technologies to state-owned enterprises (SOEs), research institutions, universities, and even private companies;
  • Investment from CMI-related or industry investment funds in exchange for access to dual-use technology;
  • Joint research projects with CMI-related companies, universities, or research institutions; and
  • Joint business development programs with Chinese SOEs or CMI-affiliated companies in third markets, such as in Latin America and Africa.

Similarly, intense media scrutiny of US-China tensions has put US companies’ activities in China under the spotlight. In June 2019, the Wall Street Journal reported Advanced Micro Devices (AMD) had transferred highly sensitive x86 processors to its JV partner, Tianjin Haiguang, and deliberately formed a convoluted joint venture structure to evade US rules.

China hawks ate up the story and pointed to it as an example of US companies seeking profits over country. AMD denied the allegations and stated it had complied with US regulations, while industry insiders concluded sensitive technology probably did not change hands. In the meantime, Commerce banned AMD from licensing the technology to its Chinese partner. Irrespective of the report’s accuracy, the AMD debacle left a sour taste in Washington, and US companies are likely to face more hawkish sentiment in the media and deeper investigative reporting.

 

What can businesses do now? Take preventive action.

Rather than imposing broad policy constraints, US officials are likely to evaluate transactions on an individual basis and intervene in those that pose a specific national security threat. This can cause uncertainty for companies, and lead to delayed investment and lost sales to Chinese customers.

To offset uncertainty, companies should consider preventive measures. This entails, among other steps, conducting reputational due diligence and risk assessments into business partners to identify latent threats. A robust due diligence program should include checks into the following:

  • Official or private relationships between business partners’ executive leadership teams and the PRC military, the Ministry of State Security, senior Communist Party officials, and other sensitive state organizations;
  • Beneficial ownership, which refers to anyone who has equity in a company or voting rights but is not listed on the record as an owner;
  • Formal supply contracts with China’s defense industry as indicated by the presence of GJB (国际标准) code listings;
  • Sanctions and watch lists; and
  • Public records such as corporate registration and affiliations.

National security concerns—perceived and real—will define the US-China relationship for the foreseeable future, even as “phase one” and subsequent rounds of trade agreements may yield new market openings in China. How well US companies manage the tension between opportunity and risk in the era of great power competition will largely depend on the extent to which they can address problems before they occur.

 

Kyle Sullivan is the China Practice Lead at Crumpton Group, a risk intelligence advisory firm based in Arlington, VA. Kyle previously worked in China for 12 years, including at the US-China Business Council and APCO Worldwide.  

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Posted by Kyle Sullivan