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Keeping watch on overseas M&A by Chinese state companies

Greater awareness of role in military modernization plans critical

| China
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Military aircraft manufacturer Aviation Industry Corp. of China has been allowed to buy several U.S. companies despite Congressional concerns.   © Reuters

Beijing's military modernization policies are blurring boundaries between defense initiatives and the overseas commercial activities of Chinese state-owned enterprises. This presents new challenges for foreign policymakers evaluating the impact of Chinese investment in their countries. Foreign companies, unaware of China's military modernization plans and the role SOEs play in state defense initiatives, may be supporting the advancement of the country's military hardware, including fighter aircraft and naval ships.

Since taking the helm as China's paramount leader in 2012, President Xi Jinping has rolled out a national strategy known internally as military-civil fusion, or in Chinese, junmin ronghe. The strategy aims to meld the country's defense and civilian industrial bases to develop a technologically advanced, self-reliant and internationally relevant defense industrial complex.

Xi's vision for MCF underpins Beijing's growing emphasis on technological and industrial development controlled and directed by the state. At a meeting of military delegates to the National People's Congress in 2013, Xi declared, "We should further the great integration of military and civilian development, and work to achieve in-depth integration of the use of infrastructure and other key facilities based on demands and led by the government."

This past Sunday, the Chinese Communist Party's Central Committee Political Bureau announced the creation of a new central commission to oversee MCF development. To be headed by Xi, the commission will oversee "decision-making, deliberation and coordination of major issues regarding integrated military and civilian development."

China's official techno-nationalist approach emphasizes indigenous development, the restriction of foreign direct investment in key sectors and the importation and absorption of foreign technologies and know-how. MCF policy thus in part appears to be driving the international acquisition of dual-use technologies and resources to fill domestic science and technology gaps.

While China had faced challenges implementing such policies before, Xi's consolidation of power, along with a growing base of defense industry stakeholders, appears to be driving rapid adoption of military-civil fusion. This in turn is helping to lay the foundation for a more capable Chinese defense industry.

Achieving fusion

The State Administration of Science, Technology and Industry for National Defense, the sector's regulator, says China has made significant progress in just the last two years in supporting private-sector participation in defense procurement. It also claims success in facilitating innovative strategic alliances between the defense industry and other civilian enterprises, including direct investment in MCF industry research and development programs and joint ventures.

According to the agency, China has inked more than 10 strategic cooperation framework agreements in the last two years with central and local government departments and industry associations to promote MCF initiatives, such as the streamlining of military and civilian production standards. In addition, the agency has helped establish 34 MCF industry demonstration bases around the country.

These demonstration bases are receiving significant central and local government investment, including funding for MCF research and development projects. Many of these zones are already home to foreign companies and are offering preferential tax and investment incentives for overseas entities to establish R&D centers and joint ventures.

The demonstration bases illustrate Beijing's keenness to weave MCF into national economic and industrial development initiatives. Chinese officials are even branding this as a new path for economic development. Priority sectors include aviation, new materials and advanced manufacturing, which mirror China's broader high-tech industry development plans, particularly the official "Made in China 2025" strategy.

Chinese companies, particularly state-owned defense groups, are incorporating MCF into their global corporate strategy. This is blurring the line between state-directed defense activity and the ostensibly commercial pursuits of state-owned companies. With growing Chinese investment abroad, concerns over the potential for technology diffusion are pushing Western governments to carefully consider whether to block the acquisition of high-tech companies by Chinese buyers.

Open doors

Consider the example of state-owned Aviation Industry Corp. of China, the country's sole supplier of military aircraft. Unsurprisingly, AVIC receives government financial support to execute its overseas mergers and acquisitions and industrial development activity.

In 2010, AVIC and China Construction Bank established a $3 billion private equity fund to acquire dual-use technology companies and invest in defense research and development projects to support the restructuring and development of China's aviation industry. As a strategic partner, the Tianjin municipal government pledged an initial $75 million to support the fund.

Since then, AVIC has gone on a multibillion-dollar international buying spree. In the U.S., its portfolio now includes Continental Motors, Cirrus Aircraft and Nexteer Automotive. Despite congressional concerns regarding AVIC's military ties and the potential for technology diversion, the Obama administration approved all of the company's U.S. acquisitions.

Last year, the state of Tennessee offered funds and access to Oak Ridge National Laboratories to Cirrus, then already under AVIC ownership, as part of an incentive package for the aircraft manufacturer to move jobs to the state. Oak Ridge is no ordinary laboratory but rather one of the world's foremost advanced materials, supercomputing, and additive manufacturing research and development centers.

Additive manufacturing, more commonly known as 3-D printing, is a top priority for China's defense industry. It is also an important technology for advancing China's space and aviation programs. AVIC is reportedly using 3-D printing for its J-20 stealth fighter jet program and other military programs.

While Cirrus reportedly has not yet gotten access to Oak Ridge, Tennessee's offer highlights the potential national security risks involved in Chinese state-owned defense enterprises acquiring foreign technologies under commercial arrangements and the potential for diversion.

Under the MCF umbrella, AVIC, alongside other state-owned enterprises such as China Shipbuilding Industry and CNOOC, is being deployed by Beijing to assert territorial claims in the South China Sea. Last October, President Xi declared that SOEs should "become important forces to implement decisions [and] ... major strategies to enhance overall national power, economic and social development and people's wellbeing."

Beijing's use of commercial entities as extensions of the party-state is only generating greater suspicion of Chinese overseas investment. In the U.S., policymakers are now responding to Beijing's use of commercial entities to advance national strategies and objectives. In its annual report to Congress in November, the U.S.-China Economic and Security Review Commission recommended that lawmakers bar Chinese SOEs from acquiring or gaining effective control of U.S. companies. The following month, U.S. Senator Marco Rubio introduced a bill calling for the imposition of sanctions on Chinese companies and individuals participating in "Beijing's illegitimate operations in the South China Sea and East China Sea."

While these actions are helpful at shining a spotlight on SOE activities in the U.S., lawmakers must do more to counter Beijing's misuse of commercial entities. Government reviews of Chinese transactions must consider MCF's dual-use focus, even for technologies not considered cutting-edge. A new monitoring system should be established for periodic reviews of the activities of the acquired companies. This would provide a much-needed backstop to identify and respond to evolving national security risks posed by MCF policies.

Beijing will surely call foul on such measures. But actions like these should make clear that Chinese leaders would be better served reassessing MCF-style tactics and encouraging animal spirits, rather than political dictates, to drive corporate behavior.

Greg Levesque is managing director at Pointe Bello, a research company in Washington. Mark Stokes is executive director of Project 2049 Institute, an Asia-focused security think tank in Arlington, Virginia.

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