The U.S. military is getting ready to leave Iraq and Afghanistan. The next threat is much bigger.Even the most casual observer seems to know that China’s economy has been growing at a roughly 10% annual rate for much of the past decade. Less recognized and arguably more important to the state of the world is the fact that China’s defense spending rose even faster than that — 12% or more a year between 2000 and 2009.
“The accelerating pace of China’s defense budget increases is driving countries in the region, as well as the U.S., to react to preserve a balance of power and stability,” says Jacqueline Newmyer, head of Long-Term Strategy Group, a Cambridge, Mass.-based defense consultant. “There is a real potential for arms races to emerge,” she adds. “While once we assumed we’d have access to areas to conduct anti-terrorism or anti-insurgency operations, now we’re compelled to think about preserving our ability to gain access to East Asia.”
Stephen Rosen, Harvard’s Beton Michael Kaneb professor of national security and military affairs, agrees. “All of us are clearly moving in that direction: We, the Japanese, the Indians. The only thing stalling it now are fiscal problems in Japan and the United States,” says the former advisor to one-time presidential hopeful Rudy Giuliani.
An Asian arms race is getting under way, driven by China.
The investment implications for China’s military modernization are only starting to take shape. But some U.S. companies like Lockheed Martin and United Technologies, facing big budget cuts as President Obama withdraws the U.S. from wars in Afghanistan and Iraq, should get some offset from a new spending cycle worldwide. Like it or not, U.S. investors also are likely to hear more about Chinese companies such as Xi’an Aero-Engine (600893.China) and China Shipbuilding Industrial (601989.China) that are helping arm the country.
There’s likely to be a steady stream of new IPOs for Chinese defense companies that some Western investors may choose to avoid. The effects go beyond equities. The sounds of new sabers rattling will stir both the bond and currency markets.
THREE DECADES AFTER Vietnamese forces defeated China’s People’s Liberation Army in a border fight, Beijing’s military has the potential to rearrange geopolitical relationships — and military needs. In October, China conducted a joint air exercise with Turkey, its first with a NATO member. En route, its fighters refueled in Iran, the first time Iran allowed a foreign military to refill at its airfields since the Shah departed. Though they don’t constitute a far-flung naval power, China’s ships increasingly sail the world. In February, Beijing dispatched a frigate to Libya to evacuate 12,000 Chinese workers; it was able to arrive quickly because it was conducting antipiracy patrols off the Horn of Africa.
These exercises seem benign, but they haven’t escaped the notice of China’s regional foes, particularly in Taiwan. China has about 1,500 ballistic missiles, many of them trained at Taiwan. Indeed, incoming Defense Secretary Leon Panetta told the Senate this month that China “appears to be preparing for potential contingencies involving Taiwan, including possible U.S. military intervention.”
China contests its border with India, part of which analysts refer to as “Southern Tibet.” It also claims sovereignty over spits of land in the East China Sea, including the Senkaku islands between Taiwan and Japan. When Japan detained a Chinese trawler there last year, China banned rare-earth exports critical to high-tech manufacturing; Japan backed down. It also asserts authority over the Spratlys and Paracels — largely uninhabited atolls in the South China Sea that sit on the oil-rich continental shelf. Those claims are variously disputed by Vietnam, the Philippines, Indonesia and Taiwan.
China’s claims have raised tensions. As a result, Vietnam held live-fire naval training earlier this month in the South China Sea. Meanwhile, the Philippines renamed the South China Sea the “West Philippine Sea,” and Taiwan said it would dispatch missile boats and tanks to the Spratlys. Most worrying, of course, is control of the sea lanes, through which valuable merchandise and energy shipments pass.
China maintains there’s no ill intent. “We do not want to use our money to buy equipment or advanced weapons to challenge the United States,” People’s Liberation Army Chief of Staff Chen Bingde said in a visit to Washington, D.C., last month. He noted the “gaping gap” between Chinese and U.S. military capability.
Many analysts are skeptical. Bradley Kaplan, a consultant to U.S. Pacific Command, says “Sun-tzu taught that the weaker power never demonstrates its intent or capability.”
Barron‘s has interviewed about two dozen experts on China’s arms buildup; they date its modernization to Desert Storm, when Chinese generals saw how quickly the U.S. and its allies vanquished Iraq. Then came the election of Lee Teng-hui, the first native Taiwanese to become the island nation’s president, which triggered the third Taiwan Strait crisis. The first Bush administration sold Taiwan 115 F-16 fighters. “In 1993, the PLA air force was in such poor shape that the F-16s made a difference,” says David Finkelstein, director of China Studies at Center for Naval Analyses.
China’s increasing wealth pays for a big budget. Following its decade of spending increases, China’s defense outlays are scheduled to rise another 12.7% in 2011 to 601 billion yuan (nearly $100 billion). That’s far less than the U.S.’s $708 billion defense budget — but the two are headed in opposite directions.
Early in its buildup, the mainland bought most of its armaments from Russia. In a move familiar to U.S. technology executives, it then began copying them, infuriating Moscow. Now it’s on the brink of creating indigenous combat vehicles and weapons. The J-20 stealth fighter, which is expected to be ready in 2018, appears to combine both advanced Russian and U.S. designs, says Roger Cliff, China expert at Rand Corp. This week, the 90th anniversary of the Communist Party, China is slated to float its first aircraft carrier, a Soviet design. Ukraine originally sold the ship to China to serve as a casino.
The biggest gains have been in China’s navy and in its strategic missile forces, called the Chinese Second Artillery Corps. Most of its arsenal is short- and medium-range missiles that can fly up to 1,500 kilometers (930 miles), within easy distance of U.S. bases in the Pacific. Increasingly, though, they are longer range, and the military’s new anti-ship missile would severely curtail the ability of U.S. carriers to deliver military aid to Asian allies.
China has more warships than its neighbors and as many attack submarines as the U.S. Aircraft carriers will allow China to use them as floating military bases, cheaper to move wherever and whenever it needs them.
The arms race could produce a mini-boom in Chinese equity offerings. At present, most of the biggest defense contractors are unlisted state-owned companies, but China wants to take them public. “The defense industry’s footprint in the broader capital markets — bond issues, bank loans, non-listed share transfers — is also growing,” says Tai Ming Cheung, a China expert at the University of California Institute on Global Conflict and Cooperation and author of “Fortifying China: The Struggle to Build a Modern Defense Economy.”
Taking companies public “is a clear strategic priority” that also “promotes development of a dual-use economy” that serves military and civilian needs, says Cheung. Already, there are scores of dual-use firms listed just the way Boeing (BA) is in the U.S. Most of them are on the A-share market open to domestic investors and to qualified foreign institutions. Over the past five years, military stocks have far outgained the Shanghai Composite, though they have deflated this year. Right now, the group trades at price-earnings multiples of 25 to 30, low by historical standards for the sector. That’s still too high for Samantha Ho, investment director of Invesco Hong Kong and manager of the Invesco China Fund (AACFX), even though she believes China will spend much more on military and national defense.
“It’s certain military assets will be listed,” says Wang Tianyi, a defense analyst at Shanghai’s Orient Securities. Among the beneficiaries of the modernization, according to Wang: Xi’an Aero-engine, the only listed flagship company to produce engines for China’s fighter jets, and AVIC Heavy Machinery (600765.China), one of the listed arms of a state-run defense contractor.
Yang Liu, manager of the Atlantis China Fund, owns China Shipbuilding Industrial (601989.China), the country’s largest shipbuilder, which makes submarines and torpedoes and supplies the navy. “It’s the No. 1 navy-equipment marine maker,” says Liu. “One day China will build its own aircraft carrier. This company is very likely to produce one.”
Such sentiments have reset spending priorities among China’s neighbors. The Sendai earthquake temporarily silenced Japan, a harsh critic of China’s buildup.
Japanese self-defense forces “are clearly reoriented to China as opposed to Russia,” says Dean Cheng of the Heritage Foundation. Japan plans to add submarines and warships.
India is holding a competition for a supplier of 126 mid-range combat aircraft, its biggest defense deal. The short list includes the Eurofighter Typhoon, made by European Aeronautic Defence & Space (EAD.France); Alenia Aeronautica, a unit of Finmeccanica (FNC.Italy), and BAE Systems (BA.UK). Also contending is the Dassault Rafale, made by Dassault Aviation (AM.France). The fighters will be manufactured with the country’s Hindustan Aeronautics, the state-owned defense contractor that plans to go public this year. India also plans a three-carrier fleet.
Australia is having its largest military expansion since World War II, spending $275 billion over the next 20 years for submarines, frigates, destroyers and the F-35 joint strike fighter. Singapore, South Korea and Vietnam all plan to buy submarines.
OF COURSE, THE U.S. must respond as well. Incoming Defense Secretary Panetta has stressed that the U.S. “must be prepared” for adversaries armed with air-defense systems, long-range ballistic missiles, and anti-ship cruise missiles. That means it needs to modernize long-range strike and surveillance capabilities.
Expect to hear the term “AirSea Battle” more often. It’s a concept promoted by the independent think tank Center for Strategic & Budgetary Assessments. This strategy would integrate U.S. air and naval forces to defeat enemies with sophisticated abilities to deny them access. The idea would be to develop ways to blind satellites and defend against or attack with long-range strikes. It’s a defense against both China and Iran.
“This will shift demand from counterinsurgency warfare toward more traditional systems like long-range strike aircraft and missiles, high-end naval forces and robust space and cyber capabilities,” says Jeffrey Roncka, managing partner at defense consultant Renaissance Strategic Advisors.
Thus, Panetta supports the F-35 Joint Strike Fighter program, with fighters capable of vertical takeoff and landing. To date the program has been plagued by delays and cost overruns. One big beneficiary is Lockheed Martin, although it’s also been blamed for the delays. Lockheed also produces the Aegis combat system. There also is support for a new, long-range bomber. Likely winners in this area include Northrop Grumman (NOC), which makes the B-2 bomber, and United Technologies, which owns Pratt & Whitney, whose PW9000 engine is a strong contender for the new bomber.
Long-range aircraft need air-to-air refueling; the Air Force has just awarded Boeing a $35 billion contract for air tankers. Another area of focus for is cyber-warfare.
China isn’t about to supplant U.S. military primacy. Its own estimate is that military modernization will take many years. One example of the gap: China has 71 submarines, yet fewer than a dozen are nuclear-powered, so the rest must resurface periodically; all of the U.S.’s 71 are nuclear-powered, with reactor fuel that lasts 20 years. That’s a big difference, but not an insurmountable one.
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