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Japan’s Economic Death Spiral Continues

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The Sun Also Sets

I used to be a Japan hand. I spent my junior year in college in 1985 as an exchange student at Kansai Gaidai in Osaka. Upon graduating college in 1986, I worked for JETRO (Japan External Trade Organization), the Japanese government’s trade group. I then spent two years working in the Kagoshima State government’s international division. After this, I spent a year as a Research Fellow studying consumer trends at Kyoto University’s Economic Research Institute.

Japan was in its prime in the 1980s, and I was there. I ended my five-year focus on Japan when I read 1989’s The Sun Also Sets: The Limits To Japan’s Economic Power by Bill Emmott, editor of The Economist. The book lays out several points, among them was that Japan’s advantages were not sustainable and were easily copied. In fact, Japan was following a very basic mercantilist approach to becoming a major exporter. They made high-quality products, manipulated the currency to fuel exports and erode competition, and maintained a positive trade balance by blocking imports through trade barriers. Emmott predicted an end to each of these advantages, and he was right.

Once the cheap yen advantage was removed, Japan began a downward spiral from which it has not recovered, and I don’t think they ever will. Japan has the UK disease; a once great island empire fighting to stay relevant on the economic stage.

Japan won’t recover from its downward spiral.

Japan: A Bystander on the Digital Highway

In the world of bytes and bits, Japan has become a bit-player.

Japan’s fading economic might can be summed up in its share of global semiconductor sales, which has collapsed from 40%+ to barely double digits.

Japan Share Global Semiconductor

At the same time – and very much related – Japan’s share of Global GDP (per the OECD) has fallen from 10% in 1990, to 7% in 2004 and 5% today.

As the Semiconductor market has marched up an impressive 9.2% CAGR, Japan has actually shrunk.

Japan and Global Semiconductor

The latest smartphones come from Korea (Samsung) and America (Apple) and are manufactured in Korea, Taiwan and China. The software comes from America. The latest camera, the GoPro, is American. The electric car that everyone wants is American (Tesla). The consumer electronics that everyone buys come from Korea. Telecommunications and computer products come from American or elsewhere, but definitely not Japan.

A simple snapshot of Japan’s fading importance is evident in US imports as seen below:

US Imports Through August ($B):

                        2013     2014     Gain/Loss     

China            $281     $294     +$13

Germany      $74       $81       $+7

Korea            $42       $45       +3

Japan            $93       $89      -$4B

Other Countries See Exports to the US Growing while Japan’s are Shrinking

Participation in the Digital Economy Matters

Japanese companies have lost the lead in their traditional markets because they don’t make products for the 21st Century digital economy.

In 2013, out of $2.3T in imported goods, the top US imports were:

  • Oil $390B
  • Machinery $311B
  • Electronic and Medical Equipment (ex Smartphones) $300B
  • Vehicles $253B
  • Smartphones $100B
  • Pharmaceuticals $63B

Of the $2T non-oil imports, Japan’s share was $142B (7%).

China’s electronic equipment exports to the US ($120B) almost equaled Japan’s total exports to the US.

Production is Contracting

Semiconductors reflect the shift in Japan’s economic relevance. When Japan led the consumer electronics world, semiconductor sales led industrial production:

Industrial Production

Today semiconductors lag overall industrial production.

Make Stuff People Want, Make It Cheaper

The central problem, as noted above, is that Japan doesn’t really make stuff people want. That’s a long-term problem without an easy solution.

In the short-term, the only means to boost exports will be for major monetary stimulus to crush the yen, and not a little bit. It needs to contract at least 15%. That would boost exports.Going back to semiconductors, a lot of production would shift to Japan if the yen drops.

Yen Devaluation

Back in November 2012, I predicted that Japan would have to go nuclear on the yen; drive it to 100. The BOJ did exactly this, forcing the yen up from ¥80 to ¥100. It worked as production surged, but it has run its course.

More Yen Devaluation Please, Mr. Abe

In early August of this year, I called for yet another gutting of the yen, and of sizable degree. I estimated at least 10% or companies won’t change their behaviors.

A cheap yen only goes so far. It works in commodity products where price is the issue (consumer electronics, cars, etc.). The long-term problem is that the products desired by global consumers are not the products Japan makes, which means exports will slow and production will contract. Eventually the yen will reach 140 yen/dollar.

¥115 is coming, but it still won’t stop Japan’s death spiral. Japan’s economy continues to shrink and the game plan is boost exports by crushing the Yen, but don’t expect it to work.

Why Europe is Recession-Bound

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Europe is Already Rolling Over

The Association of European Automobile Manufacturers just reported that new car registrations (a proxy for auto sales) are up 6% over last year. Echoing that report, Ford just announced that 3rd quarter unit sales in Europe jumped 6%. After six years of contraction, European car registrations clocked their 13th month of growth.

Sounds great, until you look closely.

It’s a 1.2M unit market. 6% growth is 70,000 vehicles and getting there took a lot of incentives. Of the 70K in extra cars, 20%+ were in Spain (the highest performing market with a 26% jump in sales). Borrowing an idea from the US, the Spanish government introduced a cash-for-clunkers scheme which is turbo-charging sales (Spain is one of Europe’s major auto producing centers). As for the rest of the jump in sales, producers are offering ever-higher discounts; an average 12% (14% in France!) versus 8% last year.

Plus, the pace of registrations is slowing. It was up 13% year-over-year in March. Now it’s half of that.

In reality, European auto sales are bouncing along the bottom. The market has shrunk every year until this year, tumbling from ~16M in 2007 to 12.3M today.

Europe’s auto market is simply a microcosm of the entire EU economy. Many look at the recent growth in the auto industry as a sign that things are improving and can only get better. Unfortunately that is not the case. Europe is sliding into a recession

Stagnating Now, Rolling Over Tomorrow

The EU economy is more manufacturing-driven than the US (US GDP is 80% service vs. 67% for the EU).

Tracking goods shipments to predict the economy makes more sense for the EU, and not just any shipments. The SouthBay Index tracks a specific subset of shipping that is particularly sensitive to shifts in the economic winds. It reflects those changes quickly and early.

At the moment, the the SouthBay EU Shipping Index shows contraction has begun. This will be reflected in the broader economy by the 1st quarter of 2015.

Shipping Index

Cheaper Euro, Stronger Dollar

Looking again at autos as a proxy for broader economics, at the recent Paris Auto Show, the President of Renault reiterated the desirability of more stimulus. Or, as Peugeot’s President Carlos Tavares pointedly said, “The weaker the euro will be, the more profitable we can be.”

A stronger dollar is actually a mixed bag for the US stock markets. It reduces US exports and cuts the value of European profits. Most big US companies are vulnerable and would see a hit to profits.

At the same time, a stronger dollar brings the good kind of deflation. Cheaper imports expand US consumer discretionary income. Restaurant chains would be the big winners here, especially ones concentrated in North America because they get the benefits of lower food costs without the risk of overseas sales exposure.

Are Central Banks Already Coordinating Their Moves?

With regional economies slowing again, Central Banks must surely be thinking stimulus, but are they going to take unilateral action or will they coordinate? Consider the following:

  • Japan’s (-6.8%) GDP and an export sector that has yet to enjoy the benefits of a weak yen
  • EU is suffering from Russia/Ukarine sanctions at a time when things are slowing down (latest PMI is 52.8)
  • China PMI is barely above 50

The temptation must be strong to cut rates or to take further action. Is another round of currency skirmishes about to take place?

Strong Dollar and Low Yields

Overt moves may not be necessary.

Supply is tapering and driving down rates due to bond scarcity. Demand is rising as the relative strength of the US is driving up treasury demand (the “cleanest shirt syndrome”). The dollar has been firming up and there’s more to come. The yen at 120 and a Euro at 1.20 is inevitable within a year.

As you may know by now, Moneyball Economics doesn’t just take the global economy at its surface. When you really delve in and listen to what the data is telling you, it’s clear that the European Union has punched their ticket to Recession. Knowing what that means to the rest of the world could make a huge difference to your own bottom line.

Why Consensus Is Wrong About 2015

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US GDP Forecasts: Mainstream Economists Will Be Wrong Again

You can’t fault positive thinking, but in economic and investment terms realistic expectations are the most valuable.

Back in January, I estimated that 2014 US GDP would be ~2.2%, far below Consensus which was thinking 3%+. Consensus has caught up and is now predicting 2.2% (down from 2.5% in May).

Turning to 2015, Consensus is again pie-in-the-sky hopeful at 3%.

Sluggish Inflation Today, Sluggish Inflation Tomorrow

The traditional and conventional view is that inflation drives economic growth by forcing producers to buy today before prices get more expensive. Inventory stockpiling boosts the economy.

Looking around, is there inflation and are producers stockpiling? The answer to both is a whopping no.

Some amount of wage inflation is creeping in as minimum wages grow and as labor continues to tighten. Businesses will sometimes bump prices opportunistically. Paul Krugman recently pointed out something that is actually useful and relevant to the 21st century economy. He said businesses that are local and don’t face competitive pressures are raising prices, like airlines and restaurants.

However most producers do face competition and they are not raising prices. Producer Price Inflation (PPI) for goods has been negative two months in a row. On a year-over-year basis, PPI is up a tepid 1.6%. What little inflation we’ve seen comes from food price hikes in the face of drought.

Low inflation has been the trend for over a year, stemming from less pressure to raise prices because margin pressures have eased in the face of low energy prices (thank you cheaper oil) and a stronger dollar. The strong dollar is lowering inflation expectations since the US has emerged at the cleanest shirt in the global economy.

Global Oversupply: The Real Reasons for Low Inflation

Producers are struggling for pricing power. The economy may be on better feet than at any time since the recession ended, but there is still a major supply glut. Chinese supply has overwhelmed demand, leading producers like Alcoa to close factories and steel makers to walk away from purchases. Many commodity prices are in free fall. So much for the super-cycle in commodities.

Manufacturing Capacity Utilization is a great way to evaluate slack on the production side of life. The Federal Reserve Board measures capacity utilization by considering how much production is possible and sustainable and how much is actually being utilized. It considers available labor and equipment, among other things.

Supply constraints point to inflationary pressures as well as demand trends. Buyers bid up prices when supplies are tight.

Capacity Utilization

The good news is that capacity utilization is at a cyclical high, indicating solid demand and some price strength.

The bad news is that capacity utilization remains below the peaks of the previous cycles. We are almost four months into the sixth year of recovery and still lagging the previous cycle.

This business cycle is continuing for a while and with it capacity will get tighter, which is good for producers. Although the primary reason for higher capacity utilization is that producers are expanding slower than the pace of demand growth.

This undermines the entire conventional expectation that inventory stockpiling should be happening – right now – and pulling GDP up with it. Listen to earnings calls and you’ll hear producers in the supply-chain complaining that their customers’ inventories are too lean.

It’s not true that inventories are lean, though. They are leaner than the 1990s but right about where they were in the previous cycle and higher than ever this cycle. Business inventory-to-sales are actually rising.

Business Inventory to Sales

If anything, inventories have grown too much. They have grown while sales have been flat. Some form of inventory cutbacks is likely in the 4Q as businesses right-size their capital.

Business Inventory to Sales Year to Year

The key point in all of this? Producers have sufficient capacity to meet end-user demand, which itself looks likely to soften a bit. Against this background, prices are not likely to rise much and growth will probably weaken a bit.

Semiconductor Sales: The Crystal Ball for 2015 Growth

Consider semiconductor equipment spending. Everything being manufactured either includes semiconductor chips or uses machines that require semiconductor chips. As such, expansion in production of any kind automatically translates into more semiconductor chips.

Semiconductor sales today are tomorrow’s industrial production. Right now, semiconductor producers are looking out and expecting minimal increase in demand.

Look at semiconductor factory expansion. While they are spending more on re-tooling capacity expansion is barely above 0%, about the same as this year.

Fab Equipment Spending vs Change of Installed Capacity

Semiconductor makers are migrating to a new technology and that’s causing massive spending. Despite significant growth in the auto and mobility (smartphone) spaces as well as general global demand for stuff, semiconductor companies see no reason to greatly expand supply.

All that follows other fundamental data points. Consumer spending is steady but relatively mild. Most new jobs in 2013 and 2014 have gone to secretaries and bartenders. Retailers expect organic growth only, and without Y/Y increases.

With demand cruising along at organic levels (low single digits), of course producers will expand cautiously.

Fed Actions Will Slow Growth

Retailers and producers are positioning for low growth in 2015. Earlier this year there was talk about an escape velocity, meaning weather had caused some near-term sluggishness from which the economy was poised to surge and get back to some higher level of growth.

This idea of some mean reversion to higher growth made no sense. Growth is mild because demand is mild. US consumers spend what they earn, and no more. The wage picture doesn’t reflect a surge. Global demand is slowing. Producers expect prolonged subdued demand and are keeping a lid on expansion plans.

Into a low-growth environment, now add in rate hikes. David Shulman, Senior Economist at UCLA’s Anderson School, recently reflected the consensus view when he said that rates will go up for good reasons; because of a strong economy.

That’s not exactly true. One could argue that a stronger economy is what’s enabling both the end of QE and the reduction in treasury borrowing. The absence of pressure to keep rates low is far from being the presence of pressure to boost rates.

It’s an important distinction. If the economy is actually poised to slow and real interest rates rise, GDP will drop fast.

Household Wealth Will be Hit

The first blow will be felt in the housing market. Housing has already entered a slower stage. July home sales fell 4.3% Y/Y. During the most recent earnings calls, homebuilders reported a drop in unit sales and banks aren’t stepping in to chase the marginal buyer and create some type of escape velocity. Wells Fargo CEO John Stumpf recently said, regarding loans to low-income borrowers and poor credit holders, “We’re just not going to make those loans.”

Prices will come under some pressure as inventory grows. More owners are above water and can sell. Into this slower growth market, add higher mortgage rates.

Beyond the housing market, the stock market won’t like the impact of higher rates on leverage. A hit to stock prices is a hit to household wealth, contributing to further slowdown in spending.

We are likely entering a period of disinflation where prices don’t rise. That’s great for consumers; not so great for producers.

Prologue to Recession

Without inflation and pricing power, without growth in demand, companies stop hiring and start firing. A rate hike hastens the advent of a recession.

Right now, jobless claims are at 14-year lows. That’s actually a sign that a recession is coming within 12 months because once claims hit bottom, they can only rise. A rise in claims is the turn in the wheel for the economic cycle as it begins to slow and then contract.

So take economic indicators, conventional wisdom and consensus estimates with a grain of salt. Realistic expectations are far more valuable than overly positive ones.

East Meets West: How the Valley Effects China

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iPhone Sales: Evidence of Online Spending

Moneyball Economics visited a few local stores selling iPhones for the big, long-awaited iPhone 6 release. There were lines but not that deep and none reaching outside the store.  Wait times were no more than two hours. Photos of lines going around the block – like in NYC – reflect unusual circumstances, far from the norm elsewhere.

Apple Store Line

(photo source unknown)

The evidence was certainly not enough to drive the 6.5M figure being whispered for in-store sales. In this case, online sales become much more significant.

Apple hit the whispered 10M unit sales, about $5B worth. It’s hard to find any company that can expect $5B in sales for a week, much less $5B a year, and that’s just a kickoff for the smartphone holiday spending. This promises to be a $60B+ global event over the next few months.

It’s quite possible. A real iPhone release has been two years in the making (the iPhone 5 was a placeholder). A massive and loyal user base is waiting to upgrade.

China’s Struggle for Growth

The Chinese economy is in trouble. The domestic consumer economy is a pale shadow of the export economy, and exports are sluggish and slowing. According to the Port of Hong Kong, total exports grew 2% Y/Y on a rolling average basis, but August contracted (-3%) Y/Y.

Hong Kong Exports

The smartphone will push up the figures in the next few months, but not for long.

It’s hard to be positive about China’s prospects for growth over the next year. As an export-dependent economy, China has no reason to feel positive. The EU is tipping back into Recession. US demand for Chinese goods has matured. None of these things will be countered by growth in the emerging economies.

Surveys of China’s producers (Markit’s Purchasing Managers Index or PMI) indicate production is one cold breeze away from contraction. (Markit surveys 420 manufacturing companies each month.) Production is 50%+ of the economy.

Additionally, new products simply aren’t appearing fast enough. It’s a post-smartphone world. US and EU markets are saturated. The Chinese domestic market has a lot of growth potential, but the total global growth that Chinese manufacturers have been serving is slowing down. Replacing the production is critical to maintaining growth.

The promise of the next high-volume consumer product is centered on connected devices. The idea is that every smartphone owner will want at least two or more peripheral gadgets; glasses and a watch, at the very least.  These devices aren’t taking off though. Instead of a few billion smartphone users and billions of connected devices, we’re seeing a few million connected devices. Apple had to delay the release of their watches into 2015, causing some delay in pick-up. Samsung has theirs ready but sales have been puny at best.

Desperation and Distribution Channels

If Chinese companies can’t grow out of the slowdown, then they can expand out of it. Instead of manufacturing for other companies, many Chinese companies are looking to sell under their own labels and some are looking to move into local markets and participate in the distribution channel. This requires massive infrastructure investment and the payoff is not happening anytime soon.

Chinese manufacturers are starting to seek growth outside of their traditional areas of expertise. High tech companies now entering the ice cream space, for example.

Predicting this slowdown back in 1Q, SouthBay Research said that – despite official Chinese government assertions – some stimulus would be needed by Summer 2015. Indeed, the PBOC just stepped in with some big monetary help and it won’t be the last.

There’s a reason why Caterpillar expects sales to China to collapse (-10%). Global demand is slowing. At the same time, domestic demand has relied on the property bubble, and we all know how spectacularly it burst.

Capital Flight From China to the US

Faced with slowing global demand, a sluggish domestic economy, a collapsing real estate market and a seriously under-performing stock market, Chinese investors are looking for better performance. The US stock market is calling like an oasis in the desert.

While investments in gold have more downside risk and US real estate seems to be peaking, the US equity markets are liquid and seem to have gas left.

Alibaba is a juicy example of capital flight in action. The #1 company in China had the biggest IPO of all time. However Alibaba did not IPO in China and that’s serious loss of face. The likely reason is that important Chinese investors (insiders including government officials) could maximize their returns and, more importantly, keep the money outside of the reach of the Chinese government.

It will be interesting to watch the carrots and sticks the Chinese government puts up to slow capital flight.

Expect Stimulus to Combat Slow Growth

The housing market is crashing, pulling down domestic consumption. Look for some action here in the form of lower down payments or moves to lower interest rates.

Expect monetary stimulus in the form of extra lending.

With slower global demand, China’s consumers are the key going forward. The Chinese government will attempt to keep the yuan flat. A cheaper yuan helps exports but hurts consumers.

This is all good for US equities. A boon in Chinese demand will lead to greater US company sales and a flat yuan keeps the dollar-denominated profits stable (most US companies price in dollars to avoid the yuan trap but there is still exposure to a falling yuan and the erosion of dollar-denominated profits).

Normally a strong dollar is bad for the stock market as it reduces value of offshore profits, slows exports and moves money into alternative investments like bonds. However trends like a Chinese capital flight into the US equity markets will add some tailwind.

This all leads back to our anecdote about iPhone 6 sales. Growth in the mobile phone market is stagnant and other mobile device growth sluggish. The strongest company in China had the largest IPO of all time, but in the US equity market. The Chinese economy is in major need of a kick-start if it wants to keep up with the world.

Smartphone Riches: Silicon Valley vs. China

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The Chinese Government Attacks

In the Digital Age, the Internet is the key indicator of the economy. Countries which have fallen behind on the technological scale are now scrambling to catch up, which inevitably leads to intellectual property theft. When you mix intellectual theft with the Internet, you get computer hackers.

Map

The above image comes from Norse Security. It’s a snapshot of global hacking attacks in real time (the complete version is here).

A list of hacking countries is in the chart’s left-hand corner. China and the US lead the hacking attempts, but the similarities end there.

US hacking is uncoordinated and unspecific. The lines depicting hacks emanate from the US and go everywhere. Plus the timing varies. In essence, US hackers target anybody and everybody, like opportunistic college kids fooling around.

Chinese hackers, on the other hand, are single-minded and directed. They almost exclusively target the US. In fact the scale, timing and coordination of Chinese hacking indicate a single entity is behind them – the Chinese government.

China and Intellectual Property Theft

Cheap labor and materials only go so far before economies of scale run out. At that point, economies either stall or they increase their technical capabilities in order to move up the value-add chain since higher-priced, higher-margin goods and services typically depend on greater technical proficiency.

When countries enter this catch-up phase, they often steal intellectual property.

Britain dominated the Industrial Revolution (1780s~1840s). Iron manufacturing, steam-powered industrialization, and textile manufacturing enriched the country. United States companies had no problem stealing the technology and producing at cheaper prices. The Soviets worked hard to steal nuclear and other industrial secrets. Likewise, Japanese companies stole from US firms in the 1970s and 1980s.

China is merely joining a tried-and-true club of countries that have attempted to level the playing field by stealing industrial secrets. Yet there are two things set apart the Chinese approach:

  1. Breathtaking scale and scope. The Internet enables unlimited reach and access.
  2. The extreme to which the Chinese government has taken spying as industrial policy.

Governments spy for national security reasons. Companies spy for financial reasons. Sometimes the two motivations overlap and sometimes governments encourage or sanction industrial espionage. Although, never have we seen governments coordinate, fund and direct whole scale intellectual property theft.

Battlefield Smartphone

The smartphone and underlying technologies are huge engines of wealth. They are also incredibly disruptive to national security.

Social messaging (like Twitter) propelled the Arab Spring and the Syrian and Iranian uprisings. International spying fears are raised to an entire new level thanks to revelations about NSA spying. Countries like China that control and censor information flow are right to be worried that their system is under threat. Central Bankers are scared of digital currencies emerging through the Cloud.

The immense smartphone/tablet wealth is evident in Silicon Valley. Consider the basic aspects of work and living space availability:

  • Office space unavailable: Google is snapping up properties all around their Mountain View headquarters and they are not alone. According to Cushman & Wake (real estate agents), office space in the area is almost completely leased up for the next two years. Buildings under construction are pre-leased.
  • Company housing necessary: The high cost of living and limited housing is driving Google to build housing for employees.

The stakes are huge. In 1H 2014 alone, the US imported $45B worth of smartphones (smartphones are on track to be 20% of all consumer products imported into the US). Chinese companies will spend upwards of $15B on a new mobile telephony infrastructure roll-out. Semiconductor CAPEX is forecast to hit $62B in 2014 and $68B in 2015 (per Gartner).

Software wealth is also quite impressive. Facebook bought WhatsApp – a company with 55 engineers – for $19B.

Finance is also subject to technology as mobile payments are disrupting commerce. Also Bitcoin has emerged as a viable form of currency firmly outside the hands of Central Bankers. (Bitcoin may not be smartphone dependent, but it operates in the Cloud and enjoys the same technological infrastructure.)

Not to mention, along with wealth comes the debauchery. A Google executive recently died from a heroin overdose.

US cell phone imports…

US Cell Phone Numbers

is driving spending in the semiconductor space…

Global Semiconductor

Chinese Cyberwar: Industrial Espionage With a Hint of National Security

The economics of the smartphone is a huge thorn in China’s side. Most of the employment benefits have gone to China, but most of the profits go to Western companies. It’s one of the few products (airplanes are another) where China isn’t competitive, and they consume a lot of them. China has 35% of the world’s smartphone sales (by units) and 600M Internet users.

What it doesn’t have is a correspondingly large share in the lucrative hardware and software components. Chinese companies assemble the phones but the profitable bits are designed by Western companies. In classic catch-up mode, they have exhausted the benefits of a cheap workforce and must move up the value-add chain in order to grow.

Imagine 600M Chinese consumers buying one tablet and phone each. That’s $1.5T spent on hardware and software operating systems revenue, and only a portion going to the domestic economy, all happening in under four years. That’s a likely scenario and it presents massive capital outflow problems.

It’s also hugely problematic for Chinese government spying. Windows and Android may enable other governments to spy on China. More critically, it prevents the Chinese government from censoring and spying on its own citizens.

Faced with both economic and political vulnerabilities, the government response is to go on the attack:

  1. Attack Apple: The Chinese government has called Apple a national security problem.
  2. Attack Microsoft: Windows 8 is banned from Government computers and Microsoft is the subject of an anti-trust probe which included raids on the company in Shanghai and Beijing.
  3. Attack Google: They are supporting alternatives to Android and developing one via the Chinese Academy of Engineering. It’s a rip-off of Android but good luck suing them, Google. ZTE has tried to use Mozilla instead of Android.
  4. Attack cloud services not based in China: Support phones that offer China-based cloud services. Xiaomi phones – the largest vendor in China – was recently discovered to be collecting and sending data to a non-Xiaomi server (i.e. Chinese government). Google doesn’t even bother offering its Cloud services due to governmental requests for censorship and access.
  5. Attack hardware component makers: China launched an anti-trust probe against Qualcomm, the engine of smartphones. The whispered fine was $1B.

China’s Three-Pronged Attack

The goals are to soften the economic blow of capital outflow and to ensure State control of information. Stealing the technology works only up to the point when high-tech changes rapidly and Chinese companies would be blocked from exporting theft-based products.

These strong-arm tactics are working for now. Market access is muzzling protests.

  • Get component prices down: Qualcomm chips cost ~$15 per phone, depending on the platform. Android software is free but Google charges ~$50 license fees for the bundled applications (navigation, YouTube, etc.) and for patent royalties to non-Google companies. Cutting $25~$50 per phone is meaningful for 600M consumers.
  • Get more vertically integrated: Move up the value-chain by boosting domestic efforts. Force companies like Qualcomm to share technology.
  • Ensure control of the domestic Internet: Western applications and services have been cloned and customized to the Chinese market, but they operate under Chinese government scrutiny.

There is also an interesting upside to all this. Exports to emerging countries is booming.

The US and EU won’t buy Chinese phones for a while as there are too many technical and regulatory hurdles. Using Chinese cloud services presents far too many security concerns for Western consumers. However emerging economies are more open. African countries, for example, has a larger middle class than India and are happy to buy Chinese telecom equipment from Huawei. Nearly every country in Africa is now buying aggressively priced Huawei equipment and phones. Half of Kenya’s phones are produced by Huawei. Namibia and Angola use Huawei as their telecom backbone.

Africa wants the low-priced Chinese phones that are emerging.

Key Takeaways

The Chinese Government wants to limit how much of the domestic market is in play and it doesn’t want to be a bystander in the global market. The goal of achieving this proficiently has forced both the government to steal intellectual property, disrupt the profitable efforts of Western companies and seek business opportunities in emerging markets.

When China catches up to the Western world in terms of smartphone manufacturing and technology, the most important thing will be to determine what the next driver of global economics will be and to get ahead of the curve.