U.S. - China trade wars escalate for the IT sector

Tuesday, October 10 2018

Phase two of the trade war between the United States and China came into effect on 24 September, with 10% tariffs applied to China to U.S. imports totaling US$200 billion. This will rise to 25% in January. Phase one was implemented in July and August, which targeted imports worth US$50 billion. The latest round will directly impact the networking and PC technology segments, as well as add further duties on components required for semiconductor manufacturing. The United States Trade Representative (USTR) went ahead with the levies in spite of lobbying from the leading U.S. based networking vendors and semiconductor trade associations, which highlighted potential economic implications and disruption. Order delays and cancellations are anticipated, especially when the 25% tariff comes into effect, as vendors will inevitably pass rising costs to customers. Increased prices may not only be limited to the U.S. if supply chains are disrupted long term. Vendors have made contingency measures, but workarounds will be slow to scale given the cost and complexity of shifting assembly plants across borders. The situation will worsen if China retaliates, as the U.S. has threatened to impose a third phase of tariffs on the rest of its imports worth US$267 billion. This will include a broader range of technologies, such as smartphones, servers and other areas currently excluded.

President Trump responds to Chinese policies and practices against U.S. firms

China is one of 12 countries currently on the USTR’s Priority Watch List, with a further 24 on its lower level Watch List, which is published annually as part of its Special 301 Report. These countries have been identified as having inadequate intellectual property (IP) protection for U.S. companies, requiring bilateral engagement to resolve. Tensions between the two have escalated since President Trump’s memorandum to the USTR in August 2017. It stated China operates policies and practices designed to transfer U.S. IP and technology to Chinese enterprises, which negatively affects U.S. economic interests and contributes to the growing trade deficit. The USTR subsequently published a report in March 2018 detailing the findings of its investigations based on feedback from U.S. companies. It accused the Chinese government of using tools, such as opaque and discretionary administrative approval processes, joint venture requirements, foreign equity limitations, ambiguous licensing processes and other mechanisms to limit the operations of U.S. companies in China. It also raised suspicions of the use of cyber attacks to gain IP. China has repeatedly refuted these allegations.

Protecting IP is a priority for the U.S. government, as technology and innovation developed domestically is viewed as critical in maintaining its competitiveness. The USTR estimates IP-intensive industries supports 30% of employment in the country. China’s long-term ambition is to transform from being a low-cost manufacturing hub to a leader in science and technology. The development of Chinese companies, and reducing dependence on foreign firms, are crucial for its plans to dominate domestically and challenge internationally. These ambitions are manifested in the series of five-year development plans implemented by the government dating back to 2005. Its latest initiative, Made in China 2025, targets 10 industries where it aims to be 40% self-sufficient by 2020 and 70% by 2025. This includes IT, robotics, new energy vehicles, electrical generation and transmission, pharmaceuticals, new materials, maritime, rail, aerospace and agriculture. Other initiatives such as the US$22 billion National Integrated Circuit Industry Development Fund for semiconductor R&D; Internet Plus for cloud and IoT; and Broadband China for network buildout are also driving significant Chinese investment.

The USTR’s report accuses the Chinese government of using these initiatives to systematically transfer IP from U.S. companies to state owned enterprises to accelerate its progress. This is being used as the basis for its trade negotiations, as the United States tries to address its growing trade deficit. It wants to remove technology transfer requirements. Tariffs are being used to ensure bilateral engagements takes place and pressure China to agree to the United States’ demands. Other countries on the Watch Lists could be threatened with similar tariffs, as part of future trade negotiations.

Cloud computing and networking a case in point

Cloud computing was highlighted by the UTSR as an example of China prioritizing the development of indigenous companies to dominate domestically, with a view of competing internationally. It accused the Chinese government of systematically allowing U.S. cloud service providers to gain access to China by partnering with licensed indigenous companies to adhere to the China Telecommunication Regulation, before tightening regulations to force transfer of IP. In 2017, AWS sold local infrastructure assets to its Chinese partner, Beijing Sinnet, in order to continue operations. Partnerships were later formed between Oracle and Tencent, and IBM and Wanda. Microsoft extended its partnership with 21Vianet later in 2018. Google Cloud does not have a region in mainland China, but operates data centers in Hong Kong. Alibaba Cloud now dominates in China, accounting for more than 40%, followed by Tencent and China Telecom, with other local players including Ksyun, 163Yun and Qiniu also growing fast. Both Alibaba Cloud and Tencent are expanding internationally.  

Similarly, U.S. networking vendors found operating in China challenging over the last five years. Declining sales and political pressure on state owned enterprises to buy from domestic vendors forced many to restructure operations and take a different approach in China. Cisco and Inspur formed a joint venture, which was officially inaugurated in November 2016, with Inspur holding 51% ownership. Its stated aim was to invest in R&D centers and develop new networking products for the domestic market. This follows HP’s (HPE at the time of closing) sale of a 51% stake in its HC3 business unit to Unisplendour Corp, a subsidiary of Tsinghua Holdings. H3C was established in 2003, as part of the joint venture between Huawei and 3Com. HP acquired 3Com in 2010, which included H3C. Other partnerships included Juniper Networks and Guomai Technologies, and Brocade and Guiyang High Tech Industrial Investment Group. Huawei and H3C now dominate switching and enterprise router shipments in China, with Huawei and ZTE leading in service providers. On an international basis, Huawei is expanding in EMEA and Latin America.

Tariffs applied to finished networking products as well as components

According to U.S. Census Bureau data, total imports of products under the HTS (Harmonized Trade Scheme) Code 85176200 (including routers and switches subject to tariffs) totaled US$47 billion in 2017. Imports from China accounted for 48%, followed by Mexico with 20%. In contrast, U.S. exports in this category totaled US$18 billion, with Mexico the largest recipient and China only representing US$500 million. The sector is representative of the large trade deficit between the two countries. However, U.S. headquartered vendors dominated shipments in 2017, accounting for more than 97% of switches, 89% of enterprise routers and 79% of service provider routers. Chinese vendors have limited presence, after being effectively banned when U.S. security agencies publicly recommended against using Huawei and ZTE in 2012. Tariffs are being used to encourage vendors to relocate assembling plants to the United States, as they are being applied to finished products. However, shifting to and scaling capacity in the United States will be costly and a multi-year process. Vendors will also have to invest in establishing an ecosystem of local component suppliers to drive efficiencies. In 2016, for example, Cisco announced a US$4 billion investment over a two-year period to modernize and expand existing manufacturing facilities in Mexico, which also included the development of local component suppliers. Higher labor costs in the United States will make it significantly costlier.

The precedent of shifting capacity to the United States has been set by Arista Networks, albeit at a smaller scale. It managed to work around an import ban imposed by the U.S. International Trade Commission in 2016, after it ruled in favor of Cisco’s patent infringement suit. It hired Flextronics to provide logistics and final configuration services in the United States. Arista’s operations were impacted as lead times increased due to component shortages. Gross margins were also hit as costs increased. The ban was eventually overturned and it returned to its previous contractor, Foxconn. The key challenge this time is that some components needed for assembly lines in the United States are also subject to tariffs. In addition, local contract manufacturers will be challenged to scale quickly enough to meet vendor demand, if they all switch at the same time. This will force some vendors to utilize capacity in Mexico and other parts of Asia first. 

The direct impact on networking will be to add costs to U.S. vendor’s operations, which will then be passed onto service providers as well as customers in the private and government sectors. This comes at a critical time, as service providers begin to deploy infrastructure to support 5G rollout. Campus and data center refresh is also underway, as enterprises invest in new network solutions to support more devices and new workloads. Cloud service providers will be impacted, with capacity expansion likely to slow as network costs rise. Delays are expected as higher prices force customers to re-assess and re-size projects, or cancel altogether. Vendors are likely to protect prices on existing quotes made before the tariffs came into effect. Customers have become accustomed to price increases over the last two years, with rising DRAM costs contributing. It will be difficult for customers to absorb further increases. Price increases will vary by vendor based on their dependence on Chinese factories. Early Canalys forecasts expect a moderate decline in shipments in Q4, with larger contractions anticipated in 2019. Results in Q4 will be mixed, with some customers pushing through projects before the 25% tariff comes into effect. The router segment has already seen strong declines in the first half of 2018. However, investment in network software and professional services, not subjected to tariffs, could benefit as customers look to optimize existing assets and defocus on upgrading hardware.

Semiconductor tariffs will add cost to Chinese technology vendors

The ban on ZTE from buying U.S. origin components by the U.S. Commerce Department earlier in April demonstrated the current dependence of Chinese vendors on U.S. semiconductors. ZTE had to cease operations for three months until it met stringent requirements, including paying a US$1 billion fine and putting another US$400 million in escrow, as well as retaining a compliance team. Tariffs on wafer fabrication have been included in both phases. The U.S. retains a large wafer fabrication capacity, especially in high-end silicon, with Apple, GlobalFoundries, Intel, NXP and Texas Instruments among others having factories in the country. Wafer fabrication capacity in China is growing fast, primarily in the low-end. Overall, China has a significant trade deficit in this area, with semiconductor imports totaling US$260 billion in 2017 compared to exports of US$60 billion. Chinese semiconductor development is being funded by the National Integrated Circuit Industry Development, which received new funding worth US$47 billion earlier this year. It tried to reduce the gap through acquisitions, but the U.S. blocked attempts to purchase Xcerra and Lattice Semiconductor. Higher semiconductor fabrication costs in the U.S. will ultimately be passed to Chinese vendors, adding pressure to their margins. However, Chinese vendors are expected to switch to other suppliers in Taiwan, South Korea and Japan. The risk of U.S. vendors becoming less competitive is high.

Tariffs on PCs and accessories are far more selective

Imports covering HTS code 8471, which includes PCs, servers and accessories totaled US$84 billion in 2017, with China representing 60%. Unlike networking, tariffs applied to this segment is more selective, specifically targeting desktop PCs and accessories including keyboards and mice. HP, Dell and Lenovo will be the most impacted. They collectively accounted for 87% of desktop PC shipments in the United States last year. All three use assemblers in China, as part of a global mix. Desktop PCs only accounted for 14% of PC units shipped in 2017. Nonetheless, increased costs will be highly disruptive. Local PC assemblers will also be hit due to tariffs on components such as CPU fans, motherboards and power supplies. It remains unclear why notebooks and tablets were excluded alongside smartphones. One reason could be the potential impact on consumers at a critical time before the upcoming U.S. mid-term elections. Notebooks and tablets are far more popular. Any price increase before important buying events, such as back to school, Black Friday and Cyber Monday, would be viewed unfavorably. In contrast, networking is primarily purchased by large businesses. Another reason could be that PC vendors were more effective at lobbying the USTR to get exemptions than networking vendors.

Tariffs will promote rising Chinese champions, but hamper U.S vendors

Affected vendors will have to adjust supply chains. The risk to their business of not doing so is high, as some vendors will be less exposed than others based on country mix, and so, potentially, will have price advantages. The desired outcome is to bring more manufacturing to the United States as part of President Trump’s America First policy. However, tariffs on components will create barriers, making the United States even less competitive for assemblers. Technology vendors will favor cheaper and more established manufacturing hubs such as Mexico, Taiwan and Vietnam, which stand to prosper the most from the trade war between the United States and China. Vendors and contract manufacturers may have to set up identical supply chains in both countries given their importance, as relocating supply chains to any of the other countries on the USTR’s Watch List carries a risk under the current administration. Even if assembly lines relocate to the U.S., investment in automation may negate the need for a human workforce. The main risk to the U.S. is the trade tariffs only serve to hamper its technology vendors by raising prices and creating product shortages, while providing a stimulus for the rising Chinese champions like Huawei, Inspur and ZTE to continue to expand.   

 

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