Just fine

“If people know you have the big bazooka, you probably don’t have to use it,” Wilbur Ross, Secretary of Commerce in the Trump administration, told Bloomberg last week.

Ross was talking about how to win trade wars without firing a shot. But just two days earlier the 79 year-old billionaire had pulled the trigger on one of the most significant punishments ever of a Chinese company by the United States government.

ZTE, China’s second largest telecom equipment firm behind Huawei, has been zapped with a record fine of almost $1.2 billion, by three government agencies in Washington.

“With this action, we are putting the world on notice. Improper trade games are over with,” Ross warned, condemning the Chinese firm for a “brazen disregard of our laws as insulting as it was dangerous”.

After weeks of testy relations since Donald Trump took office, the announcement seemed likely to trigger another round of Chinese protests. Yet the response was subdued and ZTE accepted its punishment meekly. What is the background to the case?

What is ZTE admitting to?

The Shenzhen-based manufacturer has accepted the main charge that it conspired to evade an embargo against supplying, building and operating large-scale telecommunications networks in Iran using equipment and technology originating in the US.

It was also involved in a further 283 shipments of controlled items to North Korea with knowledge that the shipments violated American export laws.

As part of the settlement, ZTE will also plead guilty to two other charges of obstruction of justice and making false statements to federal investigators, according to a plea agreement released by the US Justice Department.

In response the company has agreed to pay the largest ever fine levied against a non-financial institution.

Apart from $892 million in immediate penalties, the Chinese telecom giant is on the hook for another $300 million, suspended over seven years, during which it must host an independent compliance monitor.

How has the fine been accepted in China?

When we wrote about the imposition of sanctions last year – which prevented American companies from trading with the Shenzhen-based firm (see WiC317) – we reported on the frustration of the Chinese authorities, including comments from a foreign ministry spokesperson, that Beijing was “opposed to the US citing domestic laws to place sanctions on Chinese enterprises”. There were warnings too that the case was likely to damage Sino-US relations, although senior government officials have said little in public about the resolution of the situation last week.

Wang Yi, the minister of foreign affairs, did refer to it in response to a question about American protectionism by reporters at the National People’s Congress this month, but only in a relatively neutral manner.

“Are you referring to the news about ZTE today?” he queried. “I want to tell you that the Chinese government has always opposed unilateral sanctions. But we always ask Chinese companies to obey the laws of the countries they are doing business in.”

Otherwise not much was said and it was the same in the Chinese newspapers, suggesting that the media has been instructed to steer clear.

In the past the press has described the treatment of ZTE as part of a long-running attempt to prevent China’s firms from getting a more commanding grip of the American telecom market.

One reason for the recent reticence is that ZTE was caught red-handed and it couldn’t deny that it didn’t know that it was breaching American export controls. It started shipping routers, microprocessors and servers to Iran in 2010 but called a halt when Reuters published an article in 2012 about violations of the trade embargo. Incredibly, sales were restarted the following year, despite assurances to law enforcement officials that the company was no longer in breach of the ban. At the same time ZTE was hiding documents from the forensic accounting firm that it had hired to conduct an external investigation, and as late as last year it was running a special team to destroy evidence of its activities wherever it could.

With the US government on the verge of punitive action last year, Zhao Xianming was appointed as ZTE’s chairman and president (equivalent to chief executive) with a mandate to reach a settlement. Last week Zhao put out a conciliatory statement on confirmation of the fine, acknowledging that the company had been at fault but pointing out that it had learned from the experience by creating a compliance committee and putting thousands of staff though export-controls training.

Zhao also highlighted “significant personnel changes” since the investigation began and this week there was another reshuffle when the chairman and chief executive roles were separated for the first time. Zhao has resigned as ZTE’s chairman so as to focus on the other role as president. Yin Yimin, who served as ZTE’s president before the allegations of the illegal trading with Iran and North Korea were first reported, has become chairman.

ZTE also announced last month that Shi Lirong, a non-executive director and ZTE’s boss in the period in which the illegal sales were made, had retired. Shi was demoted last year when Zhao took over.

Beijing wants to focus on the bigger picture?

The muted response in China so far was a contrast to the tougher talk in Washington, where Ross seemed to relish his role as the new sheriff in town, despite the origins of the ZTE investigation in the Obama era.

“Those who flout our economic sanctions and export control laws will not go unpunished – they will suffer the harshest of consequences,” he insisted.

Then he laid down the gauntlet, saying that he couldn’t imagine that the Chinese government was unaware of what was going on at ZTE. But China’s leaders have chosen not to respond, holding fire perhaps as they prepare for the first round of formal meetings with their American counterparts.

Xi Jinping, the Chinese president, is reported to be travelling to the US in the first week of April to meet Trump for the first time, when he will be hosted at the tycoon’s Mar-a-Lago estate. Secretary of State Rex Tillerson is due to visit China even earlier, arriving in Beijing tomorrow.

There was a rocky start to the Trump administration’s relations with Beijing after the new president seemed to be contemplating a change to Washington’s longstanding commitment to the ‘One China’ policy (see WiC349).

The mood has improved since Trump affirmed his commitment to the status quo in a telephone conversation with Xi last month. Soon afterwards Chinese Foreign Minister Wang Yi met Tillerson at a G20 gathering in Germany, praising him as “a good listener and communicator”. Wang also spoke pragmatically about ties between the two superpowers last week, when he said that he believed they “could rise above old ideas, open new horizons and build a more robust and mature relationship”.

Indeed, the speedy approval of 38 new trademarks requested by Trump’s business interests in China have been identified in some quarters as evidence of a Beijing charm offensive, after Trump spent years trying (and failing) to grab back the rights from earlier claimants of his famous name.

“For this many marks to all sail through to preliminary approval this quickly, with nary an issue in sight, that is unheard of to me and I have been doing this for 16 years,” Dan Plane, a director at Simone IP Services, a Hong Kong intellectual property firm, told the South China Morning Post. “I wish my clients’ applications would be dealt with half as expeditiously and graciously.”

Of course, there was a more pragmatic spirit in some of the handling of Washington’s case against ZTE as well, including the five reprieves on the implementation of the embargo after it was first announced last year.

Beijing may also have chosen to steer clear of commenting further on the case because of the clear evidence of law breaking. Nonetheless, the Chinese are unsettled by what they see as American efforts to enforce their laws outside its own borders. It’s also the case that the Chinese may not be quite as acquiescent if there is a repeat performance for Huawei – the world’s biggest telecommunications equipment maker – which was also subpoenaed by officials from Washington last summer for documents covering the export of American tech to Iran, North Korea, Sudan, Syria, and Cuba. The findings of this investigation are yet to be announced.

How hard will the fine hit ZTE?

It more than wiped out last year’s profits when ZTE took a provision on the potential fine, booking a loss of $342 million for the year. But investors seem relieved that the situation has finally been resolved. The company’s shares have risen more than 15% since the settlement, surging enough on the Shenzhen bourse on the day the penalty was announced to cancel out 80% of its cost, Bloomberg has reported.

But its corporate customers may have been concerned by the threat facing ZTE and the uncertainty seems to have slowed the company’s push into overseas markets. Two years ago its international revenues were more than half of sales but they declined during the investigation, falling to 44% last year.

Hence the intent on clearing the air in Washington at a time in which ZTE wants to focus on selling more of its networks to companies and governments outside China. It also wants to make headway towards becoming the number three seller of smartphones worldwide, after selling nearly 62 million handsets last year.

As we reported in WiC317, ZTE had pivoted away from sales of routers and switches towards phones in the American market, where it has been frozen out of the more lucrative networking business since 2012. The threat of retaliatory action seemed to have blown a hole in its strategy of prioritising new phone launches to American customers. All the same, ZTE has managed to get to number four in smartphone sales in the US, Sohu reports, despite the investigation slowing its progress in key areas like product development, where the temporary purchase permits have prevented it from making long-term investments in innovation.

The Economic Observer went further in arguing that ZTE would have been forced to give up on most of the mobile phone market without a settlement, because it depends on its American partners for most of its core processors. Its recently released flagship phone, the Axon 7, is a case in point – it’s powered by a Qualcomm Snapdragon chip.

Other analysts have said the same about the dependencies in ZTE’s wider business, estimating that American parts accounted for as much as 15% of its bill of materials last year. The share will be greater for 5G technology, where phones will be faster and more sophisticated than 4G standards. ZTE has just showcased what it is describing as an industry-first smartphone that taps into this ultrafast connectivity, allowing for speeds 50 times faster and enabling new features like panoramic video quality, fast-caching of music and movies, and ‘instant apps’ that won’t even need to be installed.

Of course, Qualcomm is a key player in the same revolution and ZTE’s prototype phone is reliant on another of its newest Snapdragon processors.

The San Diego chipmaker is a key partner with ZTE in the rollout of China Mobile’s testing programme for 5G networks in five Chinese cities, which was announced last month. And ZTE has just announced a new partnership to use Intel’s baseband equipment that powers the same 5G networks. None of these collaborations would have a future without the settlement with the US authorities this month.

This is just the kind of situation that is spurring the Chinese to develop more sophisticated chip-making capacity of their own (see WiC357) in the hope that it will reduce their reliance on overseas producers. But right now their leverage is limited, as ZTE is discovering to its considerable cost.

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