China’s Spy Balloon Could Bring Down Investors. Here’s How.

The U.S. shot down a Chinese surveillance balloon over the coast of South Carolina on Feb. 4 and three other unidentified airborne objects over North America last weekend. In response, the U.S. blacklisted six Chinese government-owned defense and contracting firms that the U.S. said were involved in Beijing’s surveillance balloon program.

While U.S. investors aren’t likely to find these companies in their portfolios, the move illustrates the growing escalation between the two countries and requires investors to monitor the geopolitical tit for tat, even as sentiment about China’s economic recovery woos investors back to the market. The iShares MSCI China exchange-traded fund (ticker: MCHI) is up 8% so far this year and is little changed from where it was before the discovery of the first spy balloon.

That first detection led to Secretary of State Antony Blinken postponing a meeting with Chinese counterparts aimed at stabilizing the U.S.-China relationship. Blinken, however, is reportedly weighing a meeting with Chinese Foreign Minister Wang Yi in Munich this weekend, a sign of how much the two countries are still trying to keep the relationship from a free fall.

While it isn’t unusual for advanced countries to spy on each other, rarely are their maneuvers thrust “suddenly and with only minimal context” into the public eye, writes Anna Ashton, Eurasia Group director of China corporate affairs and US-China, in a note to clients. If the still unidentified airborne objects the U.S. military shot down over last weekend end up being linked to the Chinese, Ashton cautions it could ratchet tensions higher.

The latest developments only strengthen the bipartisan chorus in Washington looking to take a tougher stance against America’s geopolitical rival. The balloons could pressure the administration to move more quickly on economic issues, such as an executive order that creates restrictions on investments into China by U.S. firms, says Derek Scissors, senior fellow at the American Enterprise Institute.

While the drumbeat over the threat posed by China will grow louder with Congress holding more hearings and proposing more bills, Scissors is skeptical any laws will pass and says the Commerce Department’s entity list isn’t truly a blacklist since companies are allowed licenses to get around it.

The potential measures investors should keep close watch on are related to investment restrictions. For now, most analysts expect a relatively narrow scope for measures that would limit U.S. investment, with the administration likely focusing on advanced chip companies and those doing artificial intelligence that could have military applications. Those restrictions could target joint ventures, direct investments, and other pacts that allow technology transfers, says Owen Tedford, analyst at Beacon Policy Advisors.

The biggest hit to investors would be if the administration takes a much broader approach and prohibits U.S. investments in certain companies, similar to its moves in 2021 related to businesses linked to China’s military. Though not getting as much attention, these types of restrictions could force U.S. investors to sell stock in any company—not just state-owned enterprises—doing work in sectors ruled off limits, such as those doing advanced semiconductor work or pursuing artificial intelligence that has military potential or supercomputing, Tedford says.

While
Baidu
(BIDU) or
Alibaba Group
(BABA) both have AI-related businesses, Tedford doesn’t expect them to be caught up in such restrictions because linking their work to military applications requires more of a stretch and the administration appears to be taking efforts to not ensnare commercial applications in such measures, he adds.

For some investors, though, the risk that lingers is enough to keep them from making a big bet on China, even as Beijing’s zero-tolerance Covid restrictions are lifted and policy makers roll out stimulus to help revive the economy.

Another risk is the possibility of a conflict related to Taiwan, the self-ruled island Beijing claims as its own.

While Eurasia Group puts very low odds on that, the “currently-low” odds of a significant crisis short of military conflict could increase in response to recent developments, Ashton and team warn in a note to clients.

That is one reason investors will have to keep an eye on how the balloon saga unfolds—and how each side responds.

Write to Reshma Kapadia at reshma.kapadia@barrons.com