On China and Huawei: A Level Playing Field Is Required if Authorities Are Not to Fiddle with Markets

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3Q 2019 | IN-5564

The U.S. administration issued an executive order on May 15 to add Huawei to its so-called “entity list,” in effect preventing Huawei from buying equipment from American suppliers. An offshoot of the executive order is that it can potentially preclude the Chinese vendor from selling its products and services in numerous lucrative markets overseas. Huawei has since announced layoffs in its American arm, FutureWei, which is now a separate company with no ties to Huawei HQ. Discussions about whether or not Huawei will remain on the entity list are still ongoing, given that several U.S. companies will be adversely affected if they cannot sell to Huawei. ABI Research analyzes this complex situation through an economics lens and from a technological perspective. There are three key strands to consider: one, the broad economic reality between the U.S. and Chinese markets; two, the impact that the current economic situation between the two countries has on the technological landscape; and three, the effect this conundrum has on Huawei and its addition to the entity list.

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A Tough Rhetoric on Huawei

NEWS


The U.S. administration issued an executive order on May 15 to add Huawei to its so-called “entity list,” in effect preventing Huawei from buying equipment from American suppliers. An offshoot of the executive order is that it can potentially preclude the Chinese vendor from selling its products and services in numerous lucrative markets overseas. Huawei has since announced layoffs in its American arm, FutureWei, which is now a separate company with no ties to Huawei HQ. Discussions about whether or not Huawei will remain on the entity list are still ongoing, given that several U.S. companies will be adversely affected if they cannot sell to Huawei. ABI Research analyzes this complex situation through an economics lens and from a technological perspective. There are three key strands to consider: one, the broad economic reality between the U.S. and Chinese markets; two, the impact that the current economic situation between the two countries has on the technological landscape; and three, the effect this conundrum has on Huawei and its addition to the entity list.

It is very likely that a “trade war,” heavily linked to economic policy, can potentially extend to technology and eventually translate to a scenario where an invisible digital divide splits the global markets into two separate, mutually exclusive technological circles. For example, Huawei is rumored to be preparing its own mobile device operating system, called HongMeng OS, in case it is barred from dealing with Google for Android. Huawei remains a significant supplier of telecoms equipment and is aggressively pursuing market dominance for 5G core networks. The vendor is a key part of the “Made in China 2025” initiative, a plan that aims to transition the Chinese economy from the world’s “factory” to producing knowledge-based and high-value products and services. The Chinese economy remains superior in manufacturing and assembling “cheap” industrial components, and therefore it enjoys an all-encompassing supply chain. For example, China’s industrial output during the first decade of the century (2000 to 2009) increased by 22% every year on average. [1] But, while China has bolstered its manufacturing prowess, for over a decade U.S. services and technology companies have been unilaterally shut out of the Chinese domestic market. As argued in this ABI Insight, Huawei benefits from that situation.


[1] How to Speak Money: What the Money People Say-and What it Really Means by John Lanchaster

Weighing U.S. and Chinese Innovation

IMPACT


In broad economic terms, the United States is currently running a current account deficit. One of the countries that funds that economic shortfall is China. A great deal of what China produces is exported to the United States. It has been noted that so far, the U.S. economy owes China about a trillion dollars. [2] This is an economic imbalance that lacks a self-correcting mechanism. Additionally, the developed nations have been on a trajectory where knowledge-based services have replaced manufacturing as the engine of growth. Manufacturing has, therefore, become a low-grade activity that developing countries perform. China, for example, has capitalized on this dilution of manufacturing in the West by creating a very successful economic strategy built upon export-centric growth. The result is a success story that has used manufactured things (exports) as a launching pad for growth. This, in ABI Research’s view, is the fundamental causal mechanism behind China’s ongoing economic success. This has created the circumstances for the economy to become an innovation powerhouse for high-grade activities, such as strategic decision making and Research and Development (R&D), all of which spur commercial success stories like Alibaba and the example in point, Huawei.  

The American economy has long been recognized as the hotbed for technology and innovation, but China’s rapid ascent constitutes a serious competitor. The Economist reports that China submitted 53,345 patent applications in 2018 whereas America’s innovation might was marginally higher, with 56,142 patents. [3] The U.S. firms enjoy unparalleled advantage in advanced components, particularly chips and the equipment required to produce them. The Chinese competitors have the capital to build a similar ecosystem of their own, but it will take time and it will not be easy. From a narrow economic perspective, the relationship between the United States and China to date has been extremely one sided. China has been limiting the commercial opportunities of U.S. services (software) companies for longer than the United States has tried to limit China’s with the Huawei saga. China buys all the hardware (i.e., chipsets) it needs from abroad while it keeps the software opportunities for itself, and, of course, pursues software opportunities overseas. An example that illustrates that point is Alibaba, a services conglomerate that obtains approximately 90% of its revenue from the domestic market. [4] However, Alibaba’s tech infrastructure includes 11 data centers and approximately 200 network nodes located overseas, all of which form the basis of its Alibaba Cloud Content Delivery Network (CDN). In other words, Albaba, just like Huawei, has the freedom to pursue services opportunities outside of China. Unlike Alibaba, however, Huawei sits at the heart of what can be regarded as a critical piece of global connectivity infrastructure in general, and impending 5G networks in particular.

Huawei’s unprecedented growth within a short timescale can be attributed to three main imperatives. Firstly, a vast home market enables Huawei to take advantage of volume production and, by extension, competitive prices. Secondly, though main competitors (Nokia and Ericsson) can compete in China, the domestic market remains closed unless specific provisions are met. Thirdly, and equally importantly, Huawei benefits hugely from China’s sophisticated base of manufacturing expertise because the price of manufactured goods, relative to those of services, fall on a consistent basis. This is due to manufacturing industries having faster productivity growth than services. In other words, as manufacturing output surpasses services output, the prices of the former relative to those of the latter fall. It is easier to alter the scale of output by means of automation, mechanization, and chemical processes. In contrast, by their nature, many knowledge-based services are inherently impervious to productivity increases without diluting the quality of the product. Huawei has successfully exploited this low-cost, manufacturing-oriented model by exporting it abroad.


[2] Naked Economics: Undressing the Dismal Science by Charles Wheelan

[4] Statista

Even the Commercial Playing Field

RECOMMENDATIONS


Regarding trade economics between the United States and China, the relationship between the two global powers rests on a significant imbalance that cannot go on indefinitely. The way this imbalance ends is what matters. Whether it is a sudden or a gradual end, and whether that finale comes about in a predictable fashion or from uncontrollable events, is key for the two respective economies over the next few years, to say nothing of European and other economies. This imbalance requires a self-correcting mechanism that, broadly speaking, will be predicated on the following: one, the U.S. economy retains the same gross domestic product (GDP) but consumes less; two, it consumes the same but raises the GDP; and three, favorable trade concessions are sought. The ongoing discussion between the United States and China centers on coming to an agreement about trade concessions. Though talks are still ongoing, it is important to avoid the quest for perfection, which could block the way to minor improvement.

For U.S. component suppliers, Huawei provides not only revenue but also scale. There are three ways the current situation can unravel. First, if Huawei remains in the entity list, a lack of business with the vendor would be costly for U.S. and other affiliated companies. Further, this may be detrimental for Huawei given that there are no viable replacements in China for the components it buys from U.S. component suppliers. A second, alternative scenario is if Huawei remains in the entity list, but specific concessions are agreed so that it can trade with key vendors. This may work in the interim given that Huawei still sources components and technology from the West, whereas Western companies rely on Chinese manufacturing output. A long-term alternative must be considered and that is Huawei being removed from the entity list. This will enable sales to Huawei to resume in the short term, but authorities need to consider the long term by preventing high market concentration.

To avoid a situation where any given telecoms vendor becomes highly entrenched, particularly for 5G networks, Mobile Service Providers (MSPs) should deploy equipment from numerous rival vendors. This will certainly limit the extensive reach of any given vendor, but it will also shield MSPs’ operations so that a bug from rival supplier does not adversely impact the entire network. Going forward, the two economies discussed in this insight do not have to agree about everything in order to agree that they should live by some global commercial and economic rules. This is particularly important for an increasingly interconnected global economic ecosystem predicated on technological infrastructure that knows no borders. These days, business is transacted atop planet-spanning supply chains that blur the lines between geography-specific companies and jurisdictions. What is required is trust and a governance system that allows strong firms to thrive. However, and this is important, the playing field should be level, and, as argued in this ABI Insight,at present it is not.

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