After a period of some improvement in US-China relations since the Xi-Biden meeting in November, the relationship took yet another turn for the worse following the shoot-down of a Chinese ‘spy balloon’ over the Atlantic. Below is a short Q&A on what happened and how we see the implications.
What actually happened?
On Friday last week a large balloon flying over the US started to get media attention. It was suspected to be a Chinese ‘spy balloon’ as it was detected over Montana, a state where the US has nuclear missile sites. US defence officials highlighted though, that it did not present an added intelligence gathering risk relative to what China would be able to gather with low-orbit satellites. According to the US Department of Defence, the balloon had been monitored for some time as it entered over Alaska and Canada before reaching Montana at the border to Canada.
On Friday, China’s Foreign Ministry said the balloon was a Chinese civilian airship used for research, mainly meteorological purposes and that it had deviated from its planned course due to the Westerlies and limited self-steering capability. It stated that “The Chinese side regrets the unintended entry of the airship into US airspace due to force majeure“.
On Sunday, when the balloon had moved over the Atlantic, the US shot it down and divers are currently gathering its debris for further investigation. US Secretary of Defence Lloyd Austin stated that the balloon was being used by China to surveil strategic sites and was brought down above US territorial waters. The shoot-down triggered a sharper response from China, saying it was a “clear overreaction” and that “China will resolutely safeguard the legitimate rights and interests of the company concerned, and reserves to make further responses if necessary”
Is China spying?
Whether the balloon was indeed intentionally flying over the US is hard to tell and experts differ in their views on the matter. On the one hand, it seems like a strange gamble at a time when China seems to have moved to a softer foreign policy stance and is trying to get the US-China relationship on a more calm footing. One expert believes technical problems may have caused the termination mechanism to fail, while one meteorologist claimed the wind explanation was plausible and that since it is hard to aim at targets with a balloon, it is less efficient than low-orbit satellites for gathering intelligence. On the other hand, balloons only used for meteorological purposes tend to be smaller suggesting that it had a broader scope for intelligence gathering.
Regardless of the above, the balloon was in US airspace without permission and it would have been easy for China to notify the US that a balloon had gone astray. The fact that they did not do so undermines their credibility. It is also no secret that both the US and China spy on each other using other means such as satellites. The US is also flying lots of spy planes in the South China Sea and has moved closer to the Chinese shore in recent years, something that has increasingly angered China. They have also been accused of tampering with air codesthat are used to identify individual aircrafts.
What are the implications for US-China relations?
In the short term, there is no doubt that tensions will run high again between the US and China. The visit in Beijing by Secretary of State Anthony Blinken scheduled for yesterday and today has been postponed, a meeting where he was also set to meet Xi Jinping in a sign of some thawing in diplomatic relations. However, the State Department stated that Blinken “would plan to travel to the PRC at the earliest opportunity when conditions allow”, indicating that the trip had not been cancelled completely and that the US administration will aim to get diplomatic relations back on track when the time allows. However, in the short-term, domestic politics will not allow Blinken to go. Republicans have used the incident to attack Bidenfor being too soft in his response. Depending on what the investigations of the balloon debris show, the White House will come with a response against China and China will likely retaliate in some way. But after a while things should calm down again.
In the long term, we think this is part of a new normal with a very strained relationship and rivalry between the US and China, that will last for years, if not decades. Over the next year, more incidents are likely to happen. First and foremost, it seems very likely that the new US speaker of the House, Kevin McCarthy, will follow in the footsteps of Nancy Pelosi and visit Taiwan later this year. China’s response will likely be similar to last time, with extensive military exercises around the island and heightened tensions. Early next year (before 20 April), Taiwan goes to the polls and frictions could flare up again around this time. The ruling DPP elected a new leader in January, William Lai, who is a self-described “political worker for Taiwanese independence”. He is DPP’s candidate for President .
What are the market implications?
Chinese offshore stocks declined 2.7% overnight and the CNH weakened somewhat with USD/CNH rising to 6.79 from 6.74. Most likely the market reaction will calm down again from here, though. The incident should not have an impact on the Chinese recovery and as such the underpinning for Chinese stocks, where we still see upside potential.
However, the incident is yet another issue that has damaged China’s image in the West and illustrates the hesitancy by foreign investors to move money into China. Hence, we think risk premia in the offshore markets are likely to stay higher than before China’s image in the West started to deteriorate starting with Covid in 2020 and since then increased with Russian aggression against Ukraine and ongoing human rights issues in Xinjiang. The higher long-term risk premium implies that we do not see Chinese stocks rallying back to previous highs. But given the low levels, Chinese stocks are still cheap in a historical perspective, and we still see room for higher stock prices from here.
