China's Military Race With the U.S.

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Stephen Leeb
Thursday, August 13, 2015

Much attention is being paid to the economic race between China and America. But far less has been given to a military race, probably because America’s seeming military dominance has led to widespread complacency here.

That’s a dangerous mistake. Just as the economic gap between China and the U.S. is narrowing – and according to some measures, such as purchasing power parity (PPP), already has swung in China’s favor—the military gap is rapidly narrowing as well. In fact, when it comes to China, there are no areas where we can afford to be complacent. The implications for investors are profound.

A 21st century Cold War pitting China against the U.S., if it does come to that, promises to be far more difficult than the Cold War with the Soviets. The former Soviet Union (FSU) lost that earlier contest because it was forced to spend 20 percent or more of its GDP to match U.S. military spending, which never exceeded 8 percent of our GDP. China, however, unlike the FSU, is driven largely by private enterprise, where the profit motive reigns supreme. As a result its economy is far more efficient than the FSU’s was in the 1980s and far larger relative to the U.S. economy.

Still, most data would seem to suggest that the U.S. spends a larger portion of a larger economy (as measured by market-determined relationships among currencies) on defense. The general assessment is that China’s defense spending is a mere one-fifth of U.S. defense spending.  Several factors, however, suggest these figures may be highly misleading. If so, it means that to maintain global military hegemony, the U.S. will need both to step up its military spending and to reorient where it puts many of its military dollars.

One of those factors relates to how our relative military spending should best be measured. There are two competing methods: PPP and market exchange rates. The Australian economist Peter Robertson and Harvard economist Jeffrey Frankel have made salient observations about when it makes sense to rely on each of these approaches. PPP is a better measure when it comes to looking at a country’s living standards, which depend on goods and services that are acquired inside that country. Market exchange rates are probably better when considering and comparing countries’ ability to export. Thus for tradable goods, market exchange rates work better, but for operational and personnel costs, PPP is a better measurement. Moreover, on many scores, such as personnel costs, which constitute a major chunk of China’s military budget, PPP actually understates China’s relative advantage.

The bottom line is that if China raised its military expenditures to about 5 percent of its GDP—only half a percent higher than what the U.S. plans to spend this year—its military expenditures would roughly equal ours. Moreover, current U.S. plans call for the U.S. defense budget to fall to less than 2.5 percent of GDP by the mid 2020s. It is hardly farfetched to imagine that China will outspend us in the not-too-distant future.         

The comparison becomes even more frightening when you home in on specific military areas. Clearly, in terms of personnel—numbers of people in the armed forces—the Chinese have a major advantage. But an edge in man-to-man combat is far less worrisome than an edge in areas dependent on technological superiority. And here there are several technologies where China appears to have seized a frightening lead, one that no doubt is—or should be—causing American military planners many nights of lost sleep.

One such area is hypersonic missiles. Unlike ballistic missiles, which follow a particular path, hypersonic missiles—capable of flying up to 7,500 miles per hour—can be maneuvered so as to be undetectable by radar. China has successfully tested these missiles, which can carry either a conventional or nuclear payload. While the U.S. has a more comprehensive military program overall, especially in defensive capabilities, it appears to be behind in offensive weapons. The next scheduled U.S. offensive tests are in 2017 and 2020. According to the respected magazine Popular Science, the Chinese hypersonic missile installed on a ballistic missile would give the Chinese the power to strike any target in the world within an hour.

China’s successful test of these missiles, though unlikely to threaten our well-defended homeland, could nullify one of America’s major military advantages, our huge edge in aircraft carriers. Hypersonic missiles armed even with conventional payloads have the potential to destroy aircraft carriers, which could dash any American hope of establishing an important military presence in the Pacific.

Perhaps even more surprising is China’s rapid development of stealth fighters. While it has been generally assumed that China couldn’t produce a stealth fighter until 2020 or later, the recently introduced J-20 and its likely successors appear at least a match for the F-35, nearly ensuring the Chinese will be able to prevent American incursions into the Pacific.

The rapid and surprising development of the J-20 is thought to come from the preternaturally talented Yang Wei, who until very recently worked under the radar. The rapid rise of Yang to the head of Chengdu Aircraft Design Institute goes hand in hand with China’s focus on finding the best minds for the most critical positions. In this regard China’s edge in personnel costs for its army may carry over to higher technology as well. Defense technology in America does not dole out the kind of salaries that regularly attract the best and brightest. But that is not true in China, where prestige and well-above-average salaries and luxury living easily entice the best.

Whether China learned from Israel or the other way around, both have a winning technique for leading the best and brightest into areas where they can serve their countries. In Israeli grammar schools, students are exposed to cyber techniques and related skills. The best are selected for cyber duty when drafted into the army. And those that excel and become part of the most elite units are rewarded with exceptional prestige. Whether it is aircraft design, computer skills, or even chess, similar techniques are used in China. While little is known about China’s individual technology leaders, in less than a decade, China has become arguably the No. 1 country in the world.

In cyber warfare, though hard data is hard to come by, one can make a strong case that China is at the very least our equal and likely ahead of us. China, after all, was able to spend more than a year infiltrating servers that host personnel records of all U.S. government employees, and walked away with massive amounts of information including on employees with past and present security clearance. That’s as close as you come to stealing the family jewels.

To sum up: if China still trails the U.S. by a fairly wide margin when it comes to overall military capabilities, our lead isn’t guaranteed to last–and in some critical areas, China already equals or even surpasses us. If the U.S. wants to have any say in the Eastern part of the world, it must sharply improve its act.

For investors we review a major defense contractors in the latest issue of The Complete Investor. And stay tuned to the September issue of The Complete Investor for more investment advice regarding the defense arena.