The ecosystem and supply chain that developed in China in the field of telecoms allowed, through a very strong integration of the various players, a massive reduction in production costs and an increase in the efficiency of R&D processes. As a result, the development cycles of new products was almost halved between 2000 and 2010 (the development time of a new mobile phone typically goes from 18-20 months to 9-10 months).

The emergence of mobile internet markets.

Eventually, new entrants also benefited from the extraordinary development of the Internet in China, and the massive adoption by consumers of the mobile digital economy.

Between 2008 and 2018, China has reached a smartphone equipment rate of 55% (more than 720 million users), going up to even 90% for the 18-35 age group. Said differently, China is now the world’s largest market, representing about 30% of the global market in volume terms.

The very dynamic Chinese market, driven by very demanding consumers, is, therefore, becoming extremely competitive, forcing manufacturers to be ever more innovative. This competitiveness imperative translates in a constant pressure on costs and on employee productivity. R&D engineers are naturally pushed to work harder, as with the Xiaomi’s famous 996 rule (working from 9am to 9pm, over a minimum of 6 days). Said differently, white-collar workers in the technology industry have become the new “working masses”.

All these factors explain the rise of Chinese brands, which have in practice progressively replaced the European brands at the top of the world ranking. On the network side, in fact, the leading global manufacturers in 2018 are now Huawei, ZTE, Nokia and Ericsson. As for smartphones, Apple, Samsung, Huawei, Oppo, Vivo, Xiaomi and Huawei represent nearly 70% of the market (note that Oppo and Vivo, still little-known in Europe, are controlled by the same shareholder BBK, making this group the number two worldwide).

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A globalized industry and a new geopolitical situation favoring protectionism.

The Chinese telecom industry has, therefore, become global. Huawei is ahead of all its competitors in 5G networks, and, for terminals (smartphones), new companies such as Xiaomi, Oppo or Vivo have been expanding very rapidly, driven by their success in China and by the necessity to go beyond their borders to continue their growth.

Interestingly, however, this globalization trend has over the years created a very strong interdependence between the major technological players in the sector. For instance:

• The leader in smartphone processors (“chipsets”) is the American manufacturer Qualcomm, the main supplier to most of the major Chinese companies in the sector, which outsources the production of its processors to Taiwanese factories (the leader being TSMC).
• Qualcomm itself is dependent on the British company ARM based in Cambridge (UK) which provides the technology to define mobile phone processors (even Apple depends on ARM). ARM is now controlled by the Japanese SoftBank.
• The leader in high-density memory, an essential component of all smartphones, is Korean Samsung.
• All Chinese smartphone manufacturers use Android and are therefore dependent on Google.
• The new generation displays (AMOLED and P-OLED) are manufactured by Samsung and LG, which retain strong leadership in these technologies, which are also used for TV sets but are gradually being transferred to China.

This interdependence is the consequence of the structuring of this industry into highly specialized technological sectors, built around massive economies of scale.

For example, an AMOLED display or semiconductor factory requires an investment in the billions of euros and is only profitable if the production volume is sufficient, i.e. if several smartphone manufacturers use the same component. Similarly, Google can only support the investments necessary for the development of Android and related services through the monetization of user data.

This business model not only makes it possible to make services and innovations accessible to categories of users who would otherwise not be able to afford them. Market globalization has also become a form of investment pooling that has allowed mobile Internet and mobile communications to develop with unprecedented speed while lowering costs for users (today the cheapest smartphone costs less than 50 EUR, and allows Internet access equivalent to the most expensive iPhones).

In other words, the telecom industry has therefore benefited greatly from globalization (one could also say that it has contributed to this globalization), but it is now caught up in a new geopolitical situation that encourages protectionism. And, in this new context, this interdependence is suddenly seen by China as a risk to its economy and in a way to its sovereignty.

A concrete risk.

This risk materialized dramatically in April of this year (2018) when ZTE was banned from using components or services incorporating US technology.

This ban was imposed by the US Department of Commerce, due to ZTE’s failure to comply with its obligations regarding the embargo on Iran and North Korea. Suddenly, ZTE had to stop its operations completely, as it could not continue to develop and manufacture its equipment and smartphones without Qualcomm components or Google’s operating system, to name just two.

To make matters worse, ZTE found itself having to negotiate with the US Department of Commerce in the midst of a trade war between the two countries and was inadvertently the subject of President Trump’s morning tweets. The case was recently resolved in exchange for a fine of approximately USD 1.4 billion and the obligation to change the entire management of the company.

But this situation of dependence also exists in the other direction. In response to the ZTE case, China for example blocked Qualcomm’s absorption of NXP by refusing to give its consent to the acquisition. Another example is Apple, which makes nearly a quarter of its sales in China, where it produces almost all its iPhones. Paradoxically, Apple could be impacted both by the American escalation (which could tax smartphones made in China) and by Chinese retaliation (which could impose more constraints on American companies operating in China). It seems that for the time being, Apple has managed to negotiate to be kept out of the trade war between the two countries.

“Made in China 2025” and the challenges of the Chinese telecom industry.

In retrospect, it seems that the trade war initiated by President Trump has triggered an alarm and has made people aware of the risk associated with this dependence. Paradoxically, in fact, this trade war has had the effect of increasing China’s and its companies’ determination to develop the “Made in China 2025” plan and use it to reduce this technological dependence as quickly as possible.

The Made in China 2025 plan aims to accelerate China’s rise to power in advanced technological fields, such as 5G, artificial intelligence and robots. One of the motivations is the up-scaling of Chinese industry to anticipate the loss of the country’s attractiveness as a “world factory”. In a way, this plan must enable China to follow in Japan’s footsteps, then Korea’s, and move from a low-cost subcontracting or production economy to a strong creative and value-added economy, supported by a high-tech industry, which implies an increase in the quality of production and R&D.

The point is worth emphasizing, if only because the R&D investment of Chinese companies in telecoms is already one of the highest in the world. Huawei’s annual R&D budget for example amounts to more than USD 12 billion, compared to just one third for the Nokia Group. This makes Huawei one of the largest patent generators, with approximately 4,000 applications filed in 2016 (compared to 2,500 for Qualcomm).

The impact of dependency reduction?

The rapid reduction of dependency gives a new dimension to the Made in China 2025 plan. In the telecom sector, in particular, it means that China must quickly acquire its own solutions in two fundamental areas:

• that of chipsets, now dominated by American companies;
• that of the operating system, now in the hands of Apple (iPhone) and Google (Android).

The first challenge is probably being met, as several companies have already invested in the field for several years with good results. We can mention the semiconductor company Spreadtrum, which, in partnership with Intel, is one of the first to offer a 5G solution, and also, of course, Huawei, the world leader in telecommunications equipment, which has developed its own processor (Hi-Silicon, and whose technological level is probably now very close to that of Qualcomm).

The second challenge is probably more complex for several reasons. First of all, for an operating system (OS) to be adopted by consumers, it must not only offer clear benefits in terms of use but also have a significant and complete ecosystem. Microsoft failed to impose Windows on smartphones because it failed to develop an application ecosystem fast enough. The same reason explains the failure of the BB10, the BlackBerry OS, or Symbian, the Nokia OS.

In this respect, the “winner takes it all” rule applies 100%. Once the leader’s ecosystem is sufficiently developed, it is difficult to convince consumers to switch to a competing system, which will necessarily be less efficient – which explains the domination of the two main current systems: iOS (exclusively Apple) and Android.

Market reactions.

Several Chinese initiatives are already attempting to overcome this problem, nonetheless.

The main attempt is to develop a variant of Android, which will now be compatible with existing applications – a direction Alibaba is taking with its AliOS. Tencent is rather focusing on integrating applications into its messaging (WeChat), gradually replacing Android.

Another direction is to focus on a future revolution, linked to Artificial Intelligence (AI), that will make it possible to rethink the user interface. Coupled with the arrival of new types of smartphones (thanks to flexible screens), this could create the conditions for a new OS. The Chinese government has clearly determined that AI must be a national priority and has established a program to encourage R&D in this field and the creation of a “National AI team”, including Tencent, Alibaba, iFlytek, etc.

User data control: the ultimate challenge facing company models.

But the real challenge is not necessarily technical.

One of the key conditions for any intelligent operating system that aims to become global is to be able to access user data, both because of what is necessary to provide the service (Google Maps needs to know the precise location, or Google Assistant systematically listens to what is said in order to be able to eventually recognize and execute an order), but also because it is the way to create value and therefore to make the corresponding technological investment profitable.

This need to access private data is however confronted with increasingly stringent regulations (Europe being the leader in this field with the GDPR), which respond to the greater sensitivity of users and public authorities. The Facebook case highlighted the power of influence that large social networks can have – a phenomenon that China understood very quickly, deciding very early on to prevent Google, Facebook, and in general any Western Internet company from operating in China (which probably makes this country the one where the “fake news” problem is the least widespread…). In terms of privacy, two very different conceptions clash, corresponding to sometimes opposing models of society.

Until now, the expansion and globalization of large telecom companies has been based on exporting the Western model, putting the user’s benefit above political interest – the extreme example being Apple, which has even refused to assist the FBI in unblocking one of its phones.

One of the major obstacles to the expansion and emergence of a truly global and iconic Chinese brand (including in the West) in the telecoms sector is undoubtedly the confidence of users in the respect of private data. This problem does not arise in China, as state control is an established fact and companies’ collaboration with the government is total – to the point that the country is in the process of establishing a social rating of individuals based on their behavior on Chinese courier and Internet services.

Huawei and ZTE are already victims of this barrier in the United States, Australia and probably soon in the United Kingdom. Beyond the political and strategic aspects motivating the governments of these countries, the question of the use of private data by companies very close to the Chinese state is clearly raised. The answer will remain complex, as it is a confrontation between different societal models.

This insight was originally published in French as part of the Lettre de la Chine hors les murs – n°25 – septembre 2018 (spécial 120 ans), by the French External Trade Advisors (Comite National des Conseillers du Commerce Exterieur).