When the chips are down

The last time that ZTE Corporation had a run-in with regulators in the United States its response was relentlessly positive, with claims that the row had helped to boost awareness of the Shenzhen-based tech firm.

“So far, the report really has no negative impact on our business in the US… it actually helps us build the brand,” Cheng Lixin, the head of ZTE’s US operations, said of the network security review in 2012. “It was such high profile news and everyone was talking about ZTE.”

This time around it’s going to be harder to spin the benefits of the blow-up with Washington, following the announcement of a complete ban on the sale of American components to the Chinese firm.

Trading in ZTE’s shares in Shenzhen and Hong Kong were suspended last week after the US Department of Commerce imposed sanctions forbidding American companies from supplying parts to ZTE without formal approval.

Foreign firms whose goods incorporate US-made components are also prohibited from trading with the Shenzhen-based telecom giant.

The restrictions look likely to have a paralysing effect on ZTE’s “ACW” (‘America, then China, and then worldwide’) strategy, which has prioritised sales to American customers, as well as product innovation with American partners.

The American probe, which began four years ago after allegations that the Chinese firm had sold millions of dollars of US tech hardware to Iranian customers, culminated in findings that ZTE had “planned and organised a scheme to establish, control and use a series of ‘detached’ [i.e. shell] companies to illicitly re-export controlled items to Iran in violation of US export control laws.”

Significantly, ZTE hasn’t denied the charges, although it seems to have been surprised by the severity of the penalty imposed.

American investigators have also released documents in which ZTE officials discussed how a network of shell companies might reduce the risks of exporting to the blacklisted “Z Group” of countries. Titled ‘Top Secret, Highly Confidential’, the outline avoids direct mention of Iran by name except for one of the flow charts, where it is clearly labelled. “If our company exports goods containing US technologies and products directly to the countries of the ‘Z Group’, it’ll be inevitable to violate the relevant import and export controls of the US government; thus, [we will] face enormous legal risk,” the report’s authors also predict.

Evidence like this is probably why ZTE has been contrite in its response to the ruling, releasing a short statement saying it will work with the US authorities to resolve the case.

There was greater sign of frustration from the Chinese authorities, however, with the Ministry of Commerce expressing its “resolute opposition” to the move and warning that it would “severely” impact ZTE’s operations.

“China is opposed to the US citing domestic laws to place sanctions on Chinese enterprises,” said Foreign Ministry Spokesperson Hong Lei. “We hope the US stops this erroneous action and avoids damaging Sino-US trade cooperation and bilateral relations.”

In the local media there was also a strong sense that the Chinese telecom equipment makers are being targeted again, following the earlier instance in which the House Intelligence Committee identified ZTE and Huawei as security threats in 2012 (see WiC168). Neither company could be trusted to be “free of foreign and state influence”, the committee claimed.

“As the bellwethers with the highest technical content in China’s information technology industry, Huawei and ZTE have been shut out by the US government many times before,” the Securities Daily complained, before highlighting other cases in which Chinese bids for American tech firms have been dropped because of uncertainty about whether they would be approved by regulators.

Following the warnings from Washington four years ago ZTE switched tack to focus on smartphones and it doubled its share to more than 8% of the US market over the last year and a half, making it the fourth-largest vendor.

The latest restrictions will blow a gigantic hole in that strategy, however, because ZTE is said to source as many as 40% of its parts for its smartphones from American suppliers. Its higher-end brands like the Axon phone are more reliant on US-made components too, including processors from Qualcomm and scratch-resistant glass from Corning. Under the terms of the embargo, none of these parts can be sold to ZTE without the appropriate permits.

Aside from the disruption to ZTE’s production plans, the ban is also raising concerns about losses for some of its US suppliers. Although the larger partners like Qualcomm won’t feel too much impact, smaller vendors to ZTE’s telecom and data networking divisions are more likely to bear the brunt of the directive, including optical-parts maker Oclaro, which saw its shares fall 15% after the action against ZTE was announced.

Dan Panzica, an analyst at IHS, also wonders whether component makers like Oclaro should be concerned about the second-order effects of the ban, especially if Chinese telecom firms start to turn away from American suppliers.

“China is not going to be happy, and they are going to retort,” he predicts. “They are going to circle the wagons. Huawei, ZTE – they are all kind of in bed together even though they are competitors.”

In the longer term the action against ZTE is only going to hasten the Chinese push for self-sufficiency in component technology (for more on China’s advance into the semiconductor sector, see WiC270). Although Chinese firms are the dominant producers and assemblers of mobile phones, they are still heavily dependent on imports from the US, Japan, South Korea and Taiwan for many of the parts. Policymakers have tried for years to reduce this reliance and they now seem to be focusing on support for a limited group of national champions. SMIC of Shanghai is set to be China’s champion “foundry” (the main manufacturer of chips designed by others), while HiSilicon, a Huawei subsidiary, is one of the champions in chip design. The Ministry of Industry and Information Technology has allocated $153 billion to support the growth of the local semiconductor sector over the next 10 years – the bulk of which will be spent on buying expertise from foreign competitors – and Tsinghua Unigroup is leading the charge, making a flurry of bids for overseas technology firms. The goal is to catch up in the design, fabrication and packaging of chips of all types by 2030 and stop being dependent on foreign supplies. Last year the government added another target: within 10 years it wants 70% of the chips consumed by Chinese industries to be made at home.

More immediately, the speculation is that ZTE is considering an appeal against this month’s ruling. It isn’t clear how long the appeal process might last or how long it would take for the export curbs to be removed. But the news from Reuters this week was that dialogue between ZTE and commerce department officials is ongoing. “These discussions have been constructive, and we will continue to seek a resolution,” a senior US official told the press.

 

 

Keeping track: A few days after the publication of this article Washington said it was ready to soften its stance and provide “temporary relief from some licensing requirements”. In exchange ZTE has been given until the end of June to fully disclose its former sales to blacklisted markets like Iran and North Korea, the media has reported.

---

© ChinTell Ltd. All rights reserved.

Sponsored by HSBC.

The Week in China website and the weekly magazine publications are owned and maintained by ChinTell Limited, Hong Kong. Neither HSBC nor any member of the HSBC group of companies ("HSBC") endorses the contents and/or is involved in selecting, creating or editing the contents of the Week in China website or the Week in China magazine. The views expressed in these publications are solely the views of ChinTell Limited and do not necessarily reflect the views or investment ideas of HSBC. No responsibility will therefore be assumed by HSBC for the contents of these publications or for the errors or omissions therein.