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Who has the bigger button?

While rising geopolitical risks can create headaches for investors, mounting geopolitical challenges present a silver lining to the defence industry and military planners asking for larger budgets. The post-Cold War era has largely been defined by leaner defence budgets and a focus on fighting smaller, asymmetric wars. This increased focus on counter-terrorism led to shifting defence budgets that downplayed the risk of great power conflicts. However, a shift is emerging; following Russian actions in Crimea, Chinese expansion in the South China Sea, and a growing acknowledgement in Washington that the largest global challenge now stems from “revisionist powers”, global defence spending is set to rise to post-Cold War highs. According to the annual forecast produced by IHS Jane’s, worldwide defence spending this year could be approximately US$1.67 trillion, exceeding the previous post-Cold War record set in 2010. The amount would be a 3.3% increase over 2017, representing the highest year-on-year growth in over a decade. The biggest driver of the increase comes from the US. The recently approved military budget is hailed by the administration as the largest in US history, representing a 4.8% increase over last year.

However, the rise in headline spending presents only part of the picture, demonstrating how defence spending is as much an economic issue as one driven by security policy. The increase in defence spending largely reflects improving economic conditions, highlighted by the fact that as a percent of GDP, global defence spending is actually forecast to be the lowest at any point over the past decade. While the broader increase in spending is primarily a factor of economics, within regions there is a clear difference in spending based on perceived instability (see Chart). Perhaps unsurprisingly, spending in Eastern Europe and Baltic states is set to increase substantially in 2018, with eight NATO countries (not including the US) meeting the alliance guidelines calling for members to spend 2% of their GDPs on defence. Spending is set to grow in Asia as well. Economic growth will continue to be a factor in overall military spending but, with many risks on the horizon, it’s no surprise spending is on the rise.

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Tensions building

We continue to see escalating trade tensions as we move through 2018. The year started with US tariff announcements for washing machines and solar panels, before a broader levy was placed on steel and aluminium imports (albeit with a number of exemptions). In March, China came directly into the firing line, with a Section 301 investigation regarding their industrial policies. In response, the US administration announced its intention to levy tariffs on $50 billion of Chinese imports (see Chart 2). We have since seen tit-for-tat threats of escalation, with Chinese promises to reciprocate met with warnings of additional US tariffs on $100 billion of Chinese imports. This rhetoric is clearly alarming, with markets watching the underlying discussions between the two economic superpowers for signs that tensions are being defused.

Sectors in the cross hairs A small but growing share

However, tariffs are not the only aspect of this confrontation. Last week, the US Commerce Department announced a ban on US firms selling components and equipment to the Chinese state-owned telecoms giant ZTE. This stems from a long-running case against ZTE for shipping equipment to Iran and North Korea, false statements and misleading/obstructive disclosure. However, the timing of this move, which has severe consequences for a company highly dependent on US parts, will certainly ruffle feathers – especially given chatter around further non-tariff measures to restrict trade and investment. We have already seen the Committee of Foreign Investment in the US (CFIUS) stop a string of foreign acquisitions of American firms by Chinese Investors over the past 18 months. Congress is considering legislation which would expand CFIUS’s remit to cover outbound investments and joint ventures in China and other countries. Separately, the Treasury is considering using the International Emergency Economic Powers Act to create further restrictions on investment in sensitive sectors such as semiconductors and robotics. Chinese FDI in the US had increased rapidly over recent years, having quadrupled over the past five years, although this growth slowed sharply in 2017 and may continue to slow in the current environment (see Chart 3). China has levers it can pull outside of tariffs, where it is limited by the relative small scale of its imports from the US. In particular, it can make life difficult for US companies looking to operate in its huge domestic market, weighing on overseas profits. Both countries have a great deal to lose from a significant escalation in this conflict.

While the direction of travel is clearly worrying, we are not yet in a full-blown trade war. The scale of tariff measures initiated thus far is small and there is still time for negotiations to find some agreement, with consultation ongoing around tariffs meaning that these will not come into force until at least late May. However, there is clearly a shift in approach taking place. While the US has traditionally led efforts towards trade liberalisation and broader globalisation, its policy approach is clearly shifting towards a more protectionist tilt. Moreover, it seems likely that China-US tensions in particular will persist. Tariffs and deficits will probably garner most attention, but we are seeing shifts in other aspects of this relationship including reciprocal investments and treatment of multinationals which could be equally, if not more, economically important.

James McCann, Senior Global Economist

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On target but under pressure

The rising tension between the West and Russia is acute in the UK. The recent poisoning of an ex-Russian spy on British soil caused a breakdown in diplomacy, as the UK expelled 23 Russian diplomats. This was supported by its allies, who followed suit, expelling more than 100 diplomats in total. In light of this, assessing the defensive capabilities of the UK and the strategy for defence going forward is timely. The share of UK spending on defence has been steadily declining, with spending on other key policy areas like healthcare and social security now overshadowing this (see Chart 4). Despite this, the UK narrowly meets the NATO target of 2%, with defence spending at 1.9% of GDP. Generally, public opinion as measured by the British Attitudes Survey points to a far greater desire for increased spending on policy areas such as healthcare and education than on defence matters.

Bottom of the pecking order Skills gaps emerging

The government recently published an update to its national security capability review, with six key challenges for future national security considered. These ranged from the threat of terrorism, extremism and instability, to the impact of technology and cyber threats. The emergence of non-conventional forms of warfare such as cyber-attacks adds to the need for ever more sophisticated intelligence and surveillance methods. This was particularly clear with the unprecedented joint security announcement last week between the US and UK intelligence services warning of Russian cyber threats, with an extensive document advising businesses and households on how to best protect themselves from such attacks. There is a growing need for coordination between intergovernmental departments, with the need for information sharing between military, security services and intelligence agencies increasingly apparent. The proposal of combining national security responsibilities into one budget could be one way to facilitate this, with aspects of Home Office security, intelligence gathering, and the military combining into one budget. However, this risks causing controversy as it could be seen as a way of manipulating the data to continue to meet the NATO target (estimates put the combined budget at around 2.7% of GDP).

In its current state, the UK’s defence department faces issues around funding sustainability and the recruitment and retention of personnel. Although the UK still meets the 20% equipment spending target of NATO, a recent inquiry into the Ministry of Defence’s 10-year equipment plan highlighted major flaws, with the affordability gap of planned spending ranging from £4.9-£20.8 billion over the 10-year period. There are also growing concerns over the recruitment and retention of skilled personnel, as the number of full-time military personnel is currently 5.7% below existing staffing requirements. The National Audit Office has identified 102 key ‘pinch-points’ with engineering, intelligence and logistics being particularly stretched (see Chart 5). A ‘pinch-point’ is defined as an area where there is not enough trained regulars to perform operational tasks without taking action to mitigate the shortfalls. The areas in which these skills shortages are concentrated are likely to be those where the future demands on the national security are borne. To meet its broader national security agenda, the UK will need consistency in funding for defence and to close the skills gaps that are crucial for the functioning of the UK’s defensive efforts.

Abigail Watt, Senior Analyst

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Strength in numbers

The European Union (EU) comes under frequent criticism for its inefficient and incomplete infrastructure across economic, political and market cooperation. President Macron’s attempts to thrust the EU and Eurozone into the next phase of integration have met significant resistance due to concerns about risk sharing and redistribution across European partners. As the French president has learned the limitations of fiscal and political evolution, he has found support on issues of security and defence where the prospects for cooperation look more promising (see Chart 6). Alongside the introduction of Permanent Structured Cooperation (PESCO) for joined-up military operations across the 25 member state signatories, the EU launched the European defence fund in 2017 to foster collaboration across member states in research and development. The fund includes a grant system that rewards research collaboration across a minimum of three companies from at least two member states into strategic warfare technology, as well as co-financing on joint defence equipment and technology development projects. Funding will be earmarked within the grant programme to support SMEs collaborating across borders in defence technology.

Support from voters... But governments not spending

In terms of the actual numbers, the EU forecasts the fund will initially provide €90 million (m) in direct research funding and up to €500m in co-financing (assuming member states raise €2 billion (bn) for these projects). After 2020, these figures are set to jump to €500m in direct funding and €5bn in co-financing – again, split 80-20 between members and EU. This project has a number of benefits beyond fostering cooperation and furthering the broader integration agenda. Firstly, it has the potential to generate cost savings across states and firms working in defence and security research by pooling procurement. Eighty percent of procurement is run on a national basis, as is more than 90% of research and technology; the annual cost of these inefficiencies is estimated at between €25bn and €100bn. The European Commission estimates that up to 30% of annual defence expenditures could be saved through pooling of procurement. This collaboration also reduces duplication, increases standardisation of equipment and improves the outlook for interoperability between European armed forces.

However, there is a degree of scepticism regarding the Commission’s enthusiastic €5.5bn annual funding estimate. Firstly, the latter part of the programme will come in the new EU budget in 2020, which is subject to ongoing debate around funding levels following the UK’s departure. Additionally, the bulk of the funding is expected to come from member states, with only €500m guaranteed for grants independent of the bulkier co-financing portion of the fund. The backdrop of national defence spending does suggest that every little helps; defence spending as a percentage of GDP declined from a high of 1.54% in 2009 through to a low of 1.33% in 2014 (see Chart 7). Since then, spending has risen but only in line with nominal GDP, leaving defence spending as proportion of GDP largely unchanged and well below the NATO target of 2%. Unsurprisingly, Macron wants to push further, arguing for a common intervention force, a common defence budget and a common doctrine for action. This is where he may feel déjà vu; a common budget for any cause in the EU is likely to be complex to negotiate and limited in size.

Stephanie Kelly, Political Economist

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A victim of Kim’s chicanery?

Rising defence spending in Japan and developed Asia reflects two key threats to the region. Firstly, the acceleration of North Korea’s nuclear weapons programme and increase in ballistic missile testing. Secondly, the strengthening of China’s military capabilities and its more forceful actions in the East and South China Sea. How is the nature of these threats changing, and what will be the impact on the region? Let us start with North Korea. The week ahead promises to be an intriguing one, with the commencement of joint command-post military exercises between South Korea and the US coinciding with a meeting between South Korea president Moon Jae-in and North Korean counterpart Kim Jong-un. The first inter-Korea talks since 2007 have already been heralded as a success following reports of North Korea’s willingness to suspend nuclear and missile tests, as well as to enter discussions with South Korea on a formal peace treaty. However, the fact that the inter-Korean summit may occur amid pre-announced military drills highlights the lingering ambiguity regarding de-escalation on the peninsula.

Frosty relations Keeping powder dry

So what to expect from the diplomatic interventions in the coming months? North Korea has pursued a strategy to ensure regime survival through a nuclear deterrent while seeking to decouple South Korea and other regional powers from the US. In our view, the question of regime survival is driving the shift in engagement from North Korea. Unfortunately, it is not clear whether this is from a position of weakness, driven by a ‘maximum pressure’ approach from China, or from one of strength, as Kim switches strategy having achieved his initial objective of establishing supremacy at home while boosting his negotiating hand overseas. The evidence, although patchy, is more supportive of the view that China has become more assertive in pressuring its neighbour in spite of its much-vaunted non-intervention policy. After targeting coal imports from North Korea last year, exports from China of refined petroleum and steel have declined substantially in 2018. There has been a similar diplomatic hardening with the average annual frequency of high-level exchanges declining under the current leadership (see Chart 8). China has also taken a more aggressive view of counter proliferation policing, with Beijing recently setting up monitoring stations close to the border. Unfortunately, this does not fully convince. Furthermore, a diplomatic solution may benefit the US and the South equally as much, with China to appear on the periphery during the historic US-North Korean summit in May/June. We will be looking for more clues this week.

For the region’s powers, a more assertive China in North Korea is not the only concern. Disputes over the fortification of island chains in the South China Sea and maritime territorial disputes have brought increased spending and the threat of military action closer to international borders. This has prompted Japan to recently set up the so-called Amphibious Rapid Deployment Brigade, a Japanese version of the Marine Corps, while South Korea is looking into the feasibility of domestic production of a nuclear-powered submarine. However, despite these dynamics, defence spending has remained rather modest as a share of GDP across most economies (see Chart 9). While regional politics are far from stable, talk about an arms race seems premature.

Govinda Finn, Japan and Developed Asia Economist

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ZTE, arms embargo, and tech

At the risk of hyperbole, the US embargo on ZTE may turn out to be a highly consequential turning point in US-China relations and Chinese industrial policy. Irrespective of the fact that ZTE was guilty of evading sanctions, and the ban ostensibly having nothing to do with the current trade spat, at a minimum it confirms Chinese suspicions that the US isn’t serious about resolving the current trade dispute. It also further raises suspicions that trade is not the primary factor; rather, US intent is to contain China’s technological advances. Going back as far as 2010, Chinese officials and state media have contended that if the US were to lift export controls on high-tech items it could be a simple win-win solution for reducing the US trade deficit. Now with the US further banning exports in the tech sector, in this case on items not even controlled by export controls, it gives the appearance that either the US is not ready to engage in serious negotiations on trade, or that trade may not even be the main focus of US policy. Furthermore, it reinforces the view that the US is hypocritical in denying China's plans to invest in US technology, while conversely complaining about China not having a level playing field. While US objectives vis-à-vis China are still emerging, they are likely one or any combination of a) reducing the bilateral trade deficit, b) expanding market access, and/or c) changing Chinese industrial policy and slowing advances in tech. We always contended that if (a) or (b), the current dispute is negotiable and stands a higher chance of being resolved without resorting to a trade war; however, if (c) is the primary US objective, then negotiations are unlikely to resolve the current stand-off and tensions will persist. The self-imposed export reduction will surely make it harder to reduce the deficit, and will likely give the impression US intentions are to contain China’s tech rise.

Slowing, maybeDomestic priorities

The other impact will be felt through increased Chinese support for its domestic tech sector and resurrection of the phrase ‘indigenous innovation’, as China seeks to replace foreign tech reliance with domestic production. In this respect, China’s defence industry could provide interesting context for how China’s tech sector might evolve over coming years. The Chinese defence industry has been under a Western arms embargo since 1989, meaning its ability to import defence equipment and technology has been severely limited by export controls. Despite this, China has actually emerged as a leader in defence technology and one of the world’s largest exporters of advanced systems, pointing to its improved technological capabilities. China’s technological gains were confirmed in the latest Pentagon defence strategy, which highlighted China’s rapid advances. These advances were achieved through world-leading growth in defence spending (see Chart 10), which supported innovation efforts (among other efforts). Furthermore, as is often cited, China spends more on domestic security than on military spending; not only is the total quantity larger but the growth rate in recent years has far surpassed military expenditure (see Chart 11). So why does this matter? Historically, many innovations have come from the commercial applications of defence research and development, and China is proving no different with recent advances in facial recognition and A.I. driven in part by domestic security demands. The ban could be a negotiating strategy and may be lifted; nevertheless, it will push Beijing harder in its efforts to reduce its reliance on foreign technology. If Chinese tech catches up as defence has, the world could be in for a few surprises.

Alex Wolf, Senior EM Economist

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