Talking Point

Phoney war hots up

America launches a full-frontal assault on China’s tech champion Huawei

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Shorn in the USA: Washington blacklisted Huawei last Thursday as it escalated its tech war against China

One of the most potent symbols of President Richard Nixon’s groundbreaking trip to China in 1972 was Beijing’s gift to Washington of two pandas: Ling Ling and Hsing Hsing. The bears’ arrival on US territory marked a new diplomatic era in which China ‘opened’ to America and the West after two decades of conflict and ‘cold war’.

So it was an equally potent symbol last Thursday when two pandas were recalled to China from the US. This time Bai Yun and Xiao Liwu were the bears in question and were removed from San Diego – after the Chinese scrapped a loan agreement with the city’s famed zoo. This act of reverse panda diplomacy (i.e. not lending the iconic Chinese animals) comes at a point at which Sino-US relations have soured to levels not seen in decades.

Tellingly The Economist magazine ran a 16-page special report last Friday on the worsening ties which it titled: “A new kind of cold war”.

Indeed, on the same day that the pandas arrived back in China the Trump administration considerably escalated the conflict with Beijing. Last Thursday it added Chinese tech giant Huawei to an export blacklist that would deny it access to key components like chips made by American firms.

The aggressive move was designed to contain a Chinese national champion that the trio of the White House, Capitol Hill and the Pentagon have come to view as a technological and military threat – especially because of Huawei’s leadership position in 5G networks.

Then on Monday, after US tech stocks tumbled on Wall Street, the Trump administration backtracked a bit. The US Commerce Department issued a 90-day ‘temporary general licence’ that permitted Huawei to continue to use American suppliers to maintain existing networks and provide software updates to existing phones.

So how bad have things become and how might Beijing retaliate with a ‘proportionate response’ should the Huawei ban be more fully enforced in three months time?

Going after Huawei

The Chinese telecoms and technology behemoth is no stranger to being in the headlines (it’s a rare day when it is not in the news). Last year we first broached our view that the company’s data networks had become so polarising that the world was likely to decouple into countries that are prepared to use Huawei (i.e. those more aligned with China’s Belt and Road Initiative) and those that will not permit its 5G infrastructure equipment (i.e. those aligned with the Pentagon). Secretary of State Mike Pompeo, for instance, has spent months chiding America’s allies in Europe and Australasia over the dangers to their national security should they allow Huawei into their forthcoming 5G networks (see WiC442).

Another point of friction: in December Huawei’s CFO Meng Wanzhou was arrested in Vancouver at the request of the US authorities, which are demanding her extradition to America. Meng is the daughter of Huawei founder Ren Zhengfei. In a signal of how political the process has become, her extradition hearing has been pushed back by the Canadians to an unspecified date as the government in Ottawa seeks to avoid fresh economic pain from Beijing (the Chinese government’s wrath over the arrest has led to export items like Canadian canola being banned).

But Thursday’s news marked a considerable deterioration: a full frontal assault on Huawei’s business operations – and one seemingly timed to coincide with the falling apart of a deal to end the year-long trade war. “This represents a material escalation in tensions with the Chinese government. We have truly crossed the Rubicon,” Chris Krueger, an analyst at Cowen Washington Research Group, told the Financial Times following the Huawei announcement. “The Kissinger consensus is dead and China is a strategic rival. Full stop.”

The Economist concurred that a new tech cold war is underway, with Huawei in the front line. Its vulnerability: about a third of its 90 core suppliers are American firms. Semiconductors are a key part of this, owing to the dominance in the sector of US firms. James Mulvenon, an expert on Chinese cyber-security, explained to The Economist that “the Pentagon has decided that semiconductors is the hill that they are willing to die on. Semiconductors is the last industry in which the US is ahead, and it is the one on which everything else is built.”

Of course, that Pentagon ‘chip denial’ strategy poses a commercial threat to US firms too, given that Huawei is such a big buyer of their products. Qualcomm sells 5-10% of its products to the Shenzhen-based giant and half of them in China as a whole. The most immediate impact of the blacklist announcement was on chipmakers such as Qualcomm, Broadcom and Intel. Qualcomm, for example, has seen its share price falling nearly 20% in the past week.

The single most exposed US player? California-based Neophotonics gets almost half its revenues from selling Huawei its high-speed data transmitters. Its share price fell almost 20% in one single session last Thursday.

Trump, as president, has always been extremely sensitive to the stock market – correlating his own performance in office with its record highs. However, that also makes him jittery when Wall Street plunges. The sell-off in the tech sector seems to have hit home, leading Trump to order that short-term reprieve of 90-days, in a move NPR described as “easing up” the restrictions.

The South China Morning Post, however, pointed out that the reprieve is not total and that Huawei is still prohibited from buying US components to manufacture new products (such as 5G smartphones) unless it gets “licence approval”.

Some suggest that the move against Huawei was always a tactical play by Trump to try and put more pressure on his counterpart President Xi Jinping to make concessions when they are likely to meet in Japan next month to discuss a trade deal. In fact, there are still prominent US business and political figures who continue to play down the idea that the Huawei move is part of a broader decoupling strategy and new cold war. Michael Bloomberg, for one. This week he announced that the Chinese government had invited his New Economy Forum to relocate from Singapore to Beijing, bringing 400 global tech executives to the Chinese capital in November; he told the FT that in his view trade tensions were “short term stuff”.

Was it about more than hardware for Huawei?

Reuters was told on Sunday by a Google official that the US tech giant was “complying with the order”. That was interpreted in the media as having big implications for Huawei’s fast-growing smartphone business – given all its handsets run on Google’s Android operating system.

“The move could hobble Huawei’s smartphone business outside China as the tech giant will immediately lose access to updates to Google’s Android operating system. Future versions of Huawei smartphones that run on Android will also lose access to popular services including the Google Play Store and Gmail and YouTube apps,” assessed Reuters. Google Maps is another key app set to be affected.

Huawei shipped 200 million smartphones last year – overtaking Apple as the world’s number two after Samsung – and this week it was set to launch its newest flagship Honor handset in London. “Huawei seemed to have unstoppable momentum but with one single blow this could undermine the ambition to become the world’s largest smartphone maker,” Ben Wood of CCS Insight told the FT last week.

After Monday’s announcement NPR subsequently spoke to Google officials who confirmed that Huawei will continue to be able to use its services during the 90-day ‘reprieve’. However, this will apply only to existing Huawei handsets. New smartphones will no longer be able to run Google services – which analysts see as a direct threat to future sales in Huawei’s overseas markets. In 2018 almost 100 million Huawei handsets were sold outside China.

In sum, the quickfire announcements by the US Commerce Department last Thursday and Monday have a double-edge. Current customers need not immediately panic: all existing Huawei products will be untouched by the US ban for 90-days. But its smartphone division will now find it tougher in foreign markets. That’s because its newly manufactured products will hit the market minus Google services like Gmail and Google Maps, a situation that will put off some buyers – who might opt instead for an Android-based Samsung or Xiaomi device.

How did Huawei react to last Thursday’s ban?

Around 13 months ago Huawei’s cross-town rival ZTE – which is seven-times smaller – faced a similar US sanction, and its production ground to a halt. It was a cautionary experience for Huawei’s top executives who responded by ploughing more money into R&D and finding alternatives to US suppliers. Sources told Nihon Keizai Shimbun that Huawei took the decision to amass an inventory of between 6-12 months of US semiconductors, meaning production would not be dramatically disrupted – at least in the short term – should Washington unleash an export ban on it too.

On May 16 the company’s revolving CEO Hu Houkun struck a defiant tone in an open letter to staff: “It is the latest step in the US government’s continued suppression of Huawei for political purposes. The company has seen this coming for many years and a lot of investment and adequate preparation have been made in research and development, business continuity that can guarantee that in extreme cases, the company’s operations are not affected.”

Earlier in the year his predecessor in the revolving CEO role had also told the company’s annual work conference that Huawei had more than 8,000 teams working on the same critical issue of ensuring business continuity “day and night, no holidays”.

Founder Ren was also defiant. He was interviewed by state broadcaster CCTV on Tuesday and declared “Huawei is ready”, although he admitted that the US moves could see the company’s growth rate decline, but revenues would not shrink. In a feisty remark he declared “no company can reach Huawei in 5G, which will not be affected by this war” before noting, “I don’t blame the US enterprises, they are helpful – I blame the US politicians”.

Autarky ahead?

Ren also described the 90-day reprieve as “meaningless”, suggesting he and his top management are digging in for a longer battle – and recognise there will be more immediate impacts (for instance, to new smartphone launches).

The broader question Washington’s sanctions has raised is how easily Huawei can pivot from a reliance on US hardware and software.

At the end of 2018 Huawei announced it had 92 core suppliers of which 33 were located in the US, 25 on the Chinese mainland, 11 in Japan, 10 in Taiwan and 13 in other regions. It said its US suppliers were primarily semiconductor and software companies.

A long article published by news portal Huxiu sought to assess the technical damage a US ban will wreak on Huawei’s various business lines. Some of these segments, it noted, do not depend on US components at all. It gave as an example the photovoltaic inverters used in the solar industry (where Huawei is a world leader). At the other end of the scale is Huawei’s notebook computer business (which saw 400% growth in sales last year). Huxiu concluded that “inevitably it will be greatly affected” as these laptops mostly rely on an Intel CPU and run Microsoft Windows.

On the smartphone side, the messages are more mixed. Huxiu said Huawei has a permanent licence for the ARM V8 architecture, which it regarded as a positive. That situation looked to be muddied by news on Wednesday that UK-based ARM would comply with the US blacklist. But WiC’s understanding is that the ban won’t stop Huawei using the V8 technology it has already licenced. What the latest ARM announcement means is that any new technology ARM creates in the UK will no longer be shared with Huawei. (Complicating matters for ARM is a JV it set up in China in which the Cambridge firm owns 49% and 51% is controlled by a Chinese consortium called the Hopu-ARM Innovation Fund. ARM mini China, the JV, has access to ARM’s patents – see WiC410 for more on this entity.)

Not surprisingly Huawei has forged partnerships with other mainland firms. Local foundry SMIC has been rapidly ramping up its production and is working with Huawei’s fabless semiconductor unit HiSilicon on making the tech giant’s self-developed Kirin 960 chip, which is already used in its mid-end smartphones like the Mate 9.

However, Huxiu says the bigger question is Huawei’s reliance on Taiwanese giant TSMC, since SMIC doesn’t yet have the ability to make the 7nm processor chip used in Huawei’s flagship P30 series. TMSC does, but should it cease to work with Huawei “under pressure from the US… Huawei’s flagship machine may not be able to continue production after the inventory is exhausted,” reckons Huxiu.

On May 17 TSMC said it would continue shipping to Huawei. However, if the US ban is more fully enforced in August that uncertainty may resurface – causing enormous political tensions across the Taiwan Strait.

In China the island of Taiwan is regarded as a province and by extension TSMC is therefore viewed as a ‘Chinese’ company. Were a ‘Chinese’ company to stop supplying another Chinese company at the behest of the US, this would quickly spiral into an issue over American interference in Chinese sovereignty and would unquestionably unleash more nationalism on the mainland. This could spiral out of control very quickly – in the worst case scenario providing a casus belli for a conflict with Taipei.

Another issue is the handset operating system. Huawei has been working feverishly on a Linux-based alternative to Android called Hongmeng. Huawei’s VP for Western Europe Tim Watkins has said the Hongmeng OS has been trialled and can “kick in very quickly” . That would likely solve the OS problem in its domestic market – where Google services aren’t available anyway – but analysts think Hongmeng would likely be less popular internationally as it would lack an ecosystem to rival the 2.5 million apps in the Google Play Store.

Consumer products have become increasingly important to a company that started out relying on sales of routers and such like to telecoms operators. Last year Huawei generated 48% of its revenues from smartphones, tablets and laptops. And international markets have been significant: according to Canalys, one in four phones bought in Europe in the fourth quarter were made by Huawei.

Retaliation ahead?

There will be some in Washington who view the Huawei ban as part of a long-term strategy to keep the US ahead in the tech race (Oracle’s Larry Ellison would be in that camp; see WiC452). The notion there’s a China threat has become largely bipartisan on Capitol Hill (and that’s in an era where almost nothing is bipartisan in Washington). Senator Chris Coons, a Democrat, recently said that being a hawk on China in today’s Congress is “comparable to the 1950s when there was no downside, politically, to being anti-Soviet”.

That said, it’s a dangerous game to deny even a rival a vital raw material. Japan’s decision to enter the Second World War had an economic imperative after the US embargoed oil sales (around 80% of Japan’s oil needs were imported from America). A not dissimilar ratio applies to US semiconductors and China today. As an equity analyst from Morningstar told The Economist: “In a worst case scenario where the US wants to completely stranglehold China, it could, but what kind of escalation would that lead to from Beijing?”

As we pointed out last August, state media in China has dropped broad hints that the American firm most vulnerable to retaliation is Apple (see WiC420). And Tim Cook must have got a bit more nervous after the Huawei blacklisting that his firm might be the prime candidate in a tit-for-tat.

Let’s assume the tech hawks in Team Trump get the upper hand in three months time and the full weight of the ban comes into force. President Xi – who cannot afford to appear weak (see WiC452) – will have a menu of ‘proportionate responses’.

One possible scenario was heavily hinted at this week as Xi made a highly publicised visit to a rare earths magnet maker in Jiangxi province. China dominates the global supply in rare earths and their processing into complex components like magnets, sensors and instrument panels. As they are vital to manufacturing tech products this is a source of great leverage. And there is a precedent: in 2010 China embargoed sales of its rare earths to Japan to punish Tokyo for a maritime dispute.

“China has a strong hand in this battle. They know the supply chains better than we do, and how these materials power our smartphones, Teslas and fighter planes,” David Abrahams, author of a book on rare earths, told the FT. Similarly, Ryan Castilloux with rare earths consultancy Adamas Intelligence told the same paper: “The optics are as they appear. The fact it’s a magnet plant is not a coincidence. It’s signalling they know it’s important not only to US high-tech industries – electric vehicles, wind – but also defence. That’s the message they’re trying to get out.” (For WiC’s first reference to the strategic importance of China’s rare earths see issue 13.) A ban on the sale of these components to US firms would throttle supply chains.

A second scenario: Beijing could target one company – as the US has with Huawei – and ban iPhone sales in China (Apple’s second biggest market). This would likely cause a double-digit fall in Apple’s stock price. Aside from dragging down US indices, the Apple news would trigger a sell-off in other US blue-chips that are heavily exposed to Chinese sales – the fear being, which firm might be next. A crash on Wall Street would undo one of Trump’s key arguments for economic competence ¬– just as his 2020 re-election bid enters a higher gear and he starts to face more criticism from Democrat opponents like Joe Biden.

Of course, there would be fallout for China too. Foxconn assembles Apple phones in its factories in Zhengzhou and Shenzhen and would need to lay off local workers as Chinese sales volumes plunged. The Chinese government is particularly sensitive to rising unemployment.

Given this cost, Beijing would no doubt couch any such ban in terms of ‘national security’. Indeed, while the US has repeated (ad infinitum) the dangers posed by Huawei’s networks it has relied more on stoking suspicions of the potential risk of malicious ‘backdoors’ than actually proving any spying has happened. Conversely after Edward Snowden’s revelations about the NSA and its Prism programme, the Chinese could claim that iPhones might be vulnerable to American spies (Snowden’s lawyer specifically told media that his client never used an iPhone on security grounds). The absence of concrete proof would hardly matter so long as the Chinese public were told it’s ‘conceivably possible’ the NSA could harvest data from the US-designed phones.

Unexpectedly, Cook has an unlikely ally in Ren. During his CCTV interview this week the Huawei founder made an incredible revelation: “My family are using Apple, because we think the Apple ecosystem is very good.” That is quite an endorsement, though not one that will likely stop Beijing banning iPhones if it deems it the most effective form of retaliation…

Thinking the unthinkable

The panda recall; the cold war hysteria on The Economist’s last cover; the move to blacklist one of the world’s biggest tech companies. Only a few years ago such things would have been unthinkable.

What is clear is that the Sino-US trade and tech war has brought even the most irrational of scenarios into the mainstream.

Take, as an example, a new primetime drama that aired on the BBC last week and featured top actress Emma Thompson. Years and Years is set in 2024 and offers a ghastly prediction of what might happen in the last year of a second Trump presidency. As the first episode draws to a close US tensions with China worsen. The cause: an artificial island Beijing has built near Vietnam called Hong Sha Dao. The response: Trump destroys it with a nuclear weapon…


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