13 12 2018

Can the US prevent China from developing?

The spectacular arrest in Canada of the chief financial officer from Chinese telecom giant Huawei follows on the heels of the US punishing another Chinese telecom company, ZTE, earlier this year. The argument is that these companies have violated the US sanctions against Iran. But this is a much deeper conflict and of existential importance for both the US and China and the consequences are far-reaching. How far is the US willing to go to prevent China from becoming a technological great power?

The impressive rise of China as an economic power is well-known. China is now in purchasing power terms the biggest economy in the world, a stunning change from just a couple of decades ago. 1

The rise of China’s as an economic powerhouse has caused worries among the developed countries, and in particular in the world’s only superpower, the US. At first the reaction was condescending: no reason to worry, China was just assembling goods for Western companies and had no own capacity. When it started producing home-grown goods of decent quality, the reaction was that they were only copying, unable to create something original on their own. But that was then.

Now the reaction is different, actually close to panic. China is taking steps to becoming a competitor in high-tech areas considered the realm of leading US and – to a lesser degree – European and Japanese companies. Huawei, now the world’s biggest producer of telecom equipment and the second biggest mobile phone producer, embodies all the worst of US’ fears. It employs 80,000 people in Research and Development (R&D) and has an R&D budget of an estimated 15 billion USD in 2018, still below US giants as Amazon and Alphabet (Google parent company) but close on their heels. Huawei has actively participated in the standard setting committees for the new 5G phone network and owns an important part of the patents (together with companies as Qualcomm, Samsung, Nokia and Ericson). Three of the members of the “five eyes” intelligence alliance have implemented a ban on Huawei equipment for their telecom systems (US, New Zealand and Australia), citing security concerns over the use of Chinese equipment. The last two members of “five eyes”, UK and Canada, are under hard pressure from the US to cancel their contracts with Huawei (and get rid of equipment they have already installed). The US government has strong armed the US phone service provider ATT to pull out of a deal to sell Huawei handsets to its customers. Even so, Huawei has just surpassed Apple to become the second largest smartphone vendor in the world (after Samsung).

The US worry is not limited to Huawei. They fear losing the technological leadership in several areas, such as artificial intelligence, semi-conductors, non-volatile memory, robotics, aerospace etc.

What has particularly caused the ire of the US is the ambitious Chinese policy “China 2025”, which aims to shift the economy away from low value–added, low wage manufacturing to a high-tech, high-productivity economy. This is a natural step given the level of maturity that the Chinese economy has achieved and the rising level of labour costs. Failure to move into up-market products would get China stuck in a situation, where it is too expensive for production of standard goods but unable to compete in more advanced products. “China 2025” mimics what countries as Japan, Singapore and South Korea have done in past decades, and is actually not that different from the German “Industry 4.0” policy. However, the big difference is that China is not an ally, it is big and it is seen as a dangerous competitor. So Washington seems to be willing to go very far to quell China’s aspirations, using all the means at its disposal.

One way of doing so is to refuse to buy Chinese high-tech goods and convince or force the EU and Japan to follow suit. To do this they will argue that the products are a threat to national security, that Chinese firms do not follow US sanctions policy against other countries (Iran, Russia etc.), that the products are based on violations of US Intellectual Property (IP) rights and that Chinese firms have advantages from open or hidden subsidies from the Chinese Government thus distorting the competition for US firms (Google, Qualcom, Amazon, Boeing etc.).

Another, more aggressive and disrupting way, is to deny Chinese companies access to US produced components, extending this ban to products from other countries, if these products include US produced components or patents. This was what was done to ZTE, and it may be used to try to subdue Huawei as well. This is an extreme measure because it threatens the whole idea of global supply chains on which most of modern industry is based, as companies have moved away from vertical integration, outsourcing component production. This can only work, if there is trust that the supplies are stable and in-time. When this trust is not there any longer, the global supply chains become meaningless.

The ban on ZTE using US made components was a shock for China. Without access to US made components the company would be forced to shut down and lay off 75,000 workers. They finally were allowed conditioned access again to US components after paying a heavy fine. The ZTE affair made it clear to the Chinese, just how dependent they are on foreign components, and how easily the US can put even big Chinese companies out of business, if they want to. The success of the sanctions against ZTE (no counter measures from China, ZTE rapidly complying) seems to have made the US establishment smell blood. They now reckon that they have apparently underestimated their power and bolstered by this new discovery they are shifting into a much more aggressive policy to reign in the Chinese. According to Trump, trade wars are good and easy to win.

However, this aggressive stance will necessarily back-fire. The use of technological leadership to deny other countries and companies access to key components will necessarily mean that countries that are not US allies will do their outmost to avoid being dependent on these components. So it is a double-edged sword as it also scares their customers away. The same is the case when denying access to doing transactions in US dollar is used as a weapon. Countries and companies that fear they may be targeted, will for obvious reasons try to avoid doing transactions in US dollars, a trend that is slowly catching up.

We have yet to see how the US-Huawei stand-off ends. My guess is that China will go very far to comply with whatever the US is demanding, and without backing from the Chinese Government Huawei can’t do much. The reason is that China is not yet in a situation where it can afford an outright trade ware in this field, and according to the classic Chinese strategist Sun Tzu, when you are weak you should build up your power while continue to appear weak. But the longer term consequences will be profound. The actions against Huawei will not make China abandon its policy to support its companies in moving into high-tech sectors. On the contrary, they have rather underlined the urgency for China to do so.

The outcome of this stand-off between the US and China will define the relations for many decades to come. The US can try to go the whole way through to prevent China from becoming a developed country based on the production of high-end goods, and thus preserve the US virtual monopoly of key high-tech industries. China is big and powerful, but if the US can force a coalition together which cuts China off from key components and key research, it will be extremely expensive, perhaps prohibitively so, for China to duplicate the R&D carried out by a US-EU-Japanese coalition. This strategy, combined with the high cost of the arms race, worked against the Soviet Union, which was unable to keep up technologically and finally disintegrated. But it will also be quite costly for the US and its partners, as goods become more expensive and companies lose access to the Chinese market, even if China will suffer more. Globalisation and the establishment of global supply chains made production cheaper - a disruption of the global supply chains and return to vertical integration will undo much of that.

With the threat of disruptions of the global supply chains, one of the weakest point of Chinese industry is its reliance on imported semi-conductors. It presently imports 84% of the semi-conductors it needs, and it spends more on this than on importing oil and gas. China will no doubt speed up the development of own production in this area, even if its capacity to do so is put into doubt. We shall take a closer look at China 2025 in our next article.

Footnotes:

1. The 2000 data for Brazil and Indonesia are not available so they are from 2010 and 2011. The 2016 data for France and UK are from 2015.

 To read the following araticle on this theme, click here.

 

 

 

 

 

 

 

 

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Thorbjorn Waagstein

Thorbjørn Waagstein, Economist, PhD, since 1999 working as international Development Consultant in Latin America, Africa and Asia.

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