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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.