China, Leverage, and Values

Tim Culpan declared at Bloomberg that The Tech Cold War Has Begun after the Trump administration barred companies viewed as national security threats from selling to the U.S., and blocked U.S. companies from selling to Huawei specifically without explicit permission. Culpan writes:

The prospect that the U.S. government would cut off the supply of components to Huawei was precisely what management had been anticipating for close to a year, Bloomberg News reported Friday. Huawei has at least three months of supplies stockpiled. That’s not a lot, but it speaks to the seriousness with which the Shenzhen-based company took the threat.

There’s hope that this latest escalation is just part of the U.S.’s trade-war posturing and will be resolved as part of broader negotiations. Huawei, or Chinese leaders, are unlikely to be so naive as to share that. Even the briefest of bans will be proof to them that China can no long rely on outsiders.

We can now expect China to redouble efforts to roll out a homegrown smartphone operating system, design its own chips, develop its own semiconductor technology (including design tools and manufacturing equipment), and implement its own technology standards. This can only accelerate the process of creating a digital iron curtain that separates the world into two distinct, mutually exclusive technological spheres.

I agree with Culpan’s overall conclusions, and dived into some of the short and medium-term implications of the Trump administration’s action in yesterday’s Daily Update. However, to the extent that a “tech Cold War has begun”, that is only because a war takes two.

The ZTE Ban

Huawei’s preparation for this moment likely started last year when a similar ban was placed on the sale of American components to ZTE; as I explained at the time:

Obviously the United States government cannot tell a Chinese company what to do. However, the U.S. government can tell American companies what to do, and that includes determining what technology can be exported, and to whom. To that end, countries like Iran and North Korea have long been subject to U.S. sanctions, which means that it is illegal for U.S. companies in many sectors, particularly technology-related ones, to export products to those countries (including digital products like licensed software). And, by extension, U.S. companies cannot knowingly export embargoed products to companies that then sell those products to countries covered by those sanctions.

That ZTE was flouting those sanctions was well-known, and the company settled with the U.S. government in 2017. The action last year, then, was in response to ZTE allegedly violating that settlement; at the same time, it was hard not to wonder if there was any relation to the ongoing trade dispute with China?

Similar questions surround this Huawei action: the Trump administration ultimately made a deal to spare ZTE, and a waiver has already been granted allowing Huawei to service existing networks and phones in the U.S.

Still, if you’re looking for the start of this “tech cold war”, the move against ZTE was arguably the bigger deal: for the first time the extreme vulnerability China’s tech giants have to U.S. action was laid bare.

The U.S. Advantage

While tech devices like iPhones are “Made in China”, it is important to note that little of the technology originates there — less than $10 worth, in fact. Much more goes to component suppliers in the United States, South Korea, Taiwan, and Japan1 (and obviously, even more goes to Apple itself).

The reality is that China is still relatively far behind when it comes to the manufacture of most advanced components, and very far behind when it comes to both advanced processing chips and also the equipment that goes into designing and fabricating them. Yes, Huawei has its own system-on-a-chip, but it is a relatively bog-standard ARM design that even then relies heavily on U.S. software. China may very well be committed to becoming technologically independent, but that is an effort that will take years.

That is why the best that Huawei could do over the last year was stockpile supplies: the U.S. retains a significant upper-hand in this “war”. At the same time, cutting off Chinese customers like Huawei will cost U.S. suppliers dearly: high-value components by definition entail very large research and development costs and significant capital outlays for their manufacture; that means that profit comes from volume, and losing a massive customer like Huawei would be costly.

China has one other card to play: rare earth elements. These 17 elements2 are essential for electronic components, and China dominates their production, accounting for over 90% of the world’s supply. The country flexed its power in 2010, imposing export quotas (which were later ruled illegal by the WTO) that caused prices to skyrocket, at least for non-Chinese companies, giving Chinese companies an advantage. To that end, it is certainly not a coincidence that Chinese President Xi Jinping toured a rare earth mining and processing center yesterday, accompanied by China’s top trade negotiator.

China’s Protectionism

China’s 2010 rare earth export reduction wasn’t the only shot the country has taken: in January of that year Google announced that its network had been hacked by China, resulting in the theft of intellectual property, and that the company was reevaluating its approach to the Chinese market. Soon after Google closed down its China operations and directed users to its Hong Kong site, which was summarily blocked by the Great Firewall.

Google was hardly alone in this regard: YouTube, Twitter, and Facebook were all blocked in 2009, and since Google’s block sites like Instagram, Dropbox, Pinterest, Reddit, and Discord have been as well, along with a whole host of media sites like the Wall Street Journal, New York Times, and Wikipedia.

Indeed, this is where I take the biggest issue with labeling this past week’s actions as the start of a tech cold war: China took the first shots, and they took them a long time ago. For over a decade U.S. services companies have been unilaterally shut out of the China market, even as Chinese alternatives had full reign, running on servers built with U.S. components (and likely using U.S. intellectual property).3

To be sure, China’s motivation was not necessarily protectionism, at least in the economic sense: what mattered most to the country’s ruling Communist Party was control of the flow of information. At the same time, from a narrow economic perspective, the truth is that China has been limiting the economic upside of U.S. companies far longer than the U.S. has tried to limit China’s.

Not that the U.S. investor class cared: for U.S. component suppliers China provided not only revenue but scale; for hardware manufacturers like Apple China provided low labor costs and an increasingly sophisticated base of manufacturing expertise, and full-on design services for more commoditized OEM’s like PC makers. And while U.S. services may not have been allowed in China, U.S. venture capital money was certainly allowed to invest in Chinese startups.

The truth is that the U.S. China relationship has been extremely one-sided for a very long time now: China buys the hardware it needs, and keeps all of the software opportunities for itself — and, of course, pursues software opportunities abroad. At the same time, U.S. acquiescence to this state of affairs has denied China the necessary motivation to actually make the investments necessary to replace U.S. hardware completely, leading to this specific moment in time.

A Question of Leverage

To that end, and leaving aside broader questions about the Trump administration’s approach to trade with China, when it comes to a “tech cold war” I think the U.S. has the most leverage it ever will have: the U.S. advantage in advanced components, particularly processors and their fabrication, is massive, and will only grow if the U.S. is able to gain the support of countries like South Korea, Japan, and Taiwan. Yes, China will spend whatever is necessary to catch up, but it will take a lot of time.

The primary potential pain points for the U.S., meanwhile, are those same component manufacturers that China needs, whose revenue and profits will be hurt, rare earths, and Apple. The latter is more exposed to China than anyone, on two fronts: first, the company’s massive manufacturing facilities in China, and second, the importance of the Chinese consumer market to the iPhone in particular.

This does not guarantee that Apple will be retaliated against: Apple employs millions of Chinese, both directly in manufacturing and also component suppliers, and the Chinese leadership will be loath to leave any of them unemployed. And, on the flipside, Chinese consumers, particularly those in influential first-tier cities, like Apple products. I do think the latter is more likely to be impacted than the former: China can do a lot to disrupt Apple’s consumer-facing operations in China, as they already have in both services and iPhone sales.

The other big question is if the Trump administration will levy tariffs on iPhones for U.S. consumers: to date Apple has been largely spared, but the U.S. is running out of goods to slap tariffs on; again the company benefits from its popularity with end users, who would be much more sensitive to a rise in iPhone prices than just about anything else.

A Question of Values

For obvious reasons, I think most people in tech are opposed to the Trump administration’s approach: not only is Trump unpopular in Silicon Valley generally (which means his policies are), but the near-term damage to U.S. tech companies could be significant.

At the same time, as someone who has argued that technology is an amoral force, China gives me significant pause. On one hand, while the shift of manufacturing to China has hurt the industrial heartlands of both the U.S. and Europe, nothing in history has had a greater impact on the alleviation of poverty and suffering of humanity generally than China’s embrace of capitalism and globalization, protectionist though it may have been. Technology, particularly improvements in global communication and transportation capabilities, played a major role in that.

On the other hand, for all of the praise that is heaped on Chinese service companies like Tencent for their innovation, the fact that everything on Tencent is monitored and censored is chilling, particularly when people disappear. The possibilities of a central government creating the conditions for, say, self-driving cars or some other top-down application of technology is appealing, but turning a city into a prison through surveillance is terrifying. And while it is tempting to fantasize about removing “fake news” and hateful content with an iron fist, it is a step down the road to removing everything that is objectionable to an unaccountable authority with little more than an adjustment to a configuration file.

This is the true war when it comes to technology: censorship versus openness, control versus creativity, and centralization versus competition. These are, of course, connected: China’s censorship is about control facilitated by centralization. That, though, should not only give Western tech companies and investors pause about China generally, but should also lead to serious introspection about the appropriate policies towards our own tech industry. Openness, creativity, and competition are just as related as their counterparts, and infringement on any one of them should be taken as a threat to all three.

I wrote a follow-up to this article in this Daily Update.

  1. The relative order varies based on the iPhone model; the iPhones XS, for example, gets its very expensive OLED screen from Samsung in South Korea, and its processor from TSMC in Taiwan. Previous iPhone models sources screens from Japan and processors from Samsung. 

  2. The elements are cerium (Ce), dysprosium (Dy), erbium (Er), europium (Eu), gadolinium (Gd), holmium (Ho), lanthanum (La), lutetium (Lu), neodymium (Nd), praseodymium (Pr), promethium (Pm), samarium (Sm), scandium (Sc), terbium (Tb), thulium (Tm), ytterbium (Yb), and yttrium (Y)  

  3. This doesn’t even address rampant piracy in China: the country was one of Microsoft’s largest markets by usage, but drove revenue equivalent to the Netherlands.