China.......just to be aware
U.S. Tech Companies And The Chinese Indigenous Innovation Policy
Aug. 6, 2015 3:30 PM ET | 7 comments | Includes: AAPL, CSCO, FB, GOOG, GOOGL, INTC, MU
Disclosure: I am/we are long MU, INTC. (More...)
Summary
•China's Indigenous Innovation Policy represents a significant threat to the Chinese earnings of US tech companies.
•The acquisition of US companies' intellectual property is to be the quid pro quo for access to the Chinese market.
•China's policing and repression of the Internet within China poses a threat to the worldwide Internet system that's the basis of the new economy.
•Investors should carefully assess risks to medium- and long-term profits for companies that operate in China.
"Indigenous innovation is a massive and complicated plan to turn the Chinese economy into a technology powerhouse by 2020 and a global leader by 2050. (…) the plan is considered by many international technology companies to be a blueprint for technology theft on a scale the world has never seen before. " China's Drive for "Indigenous Innovation," James McGregor, APCO
Presumably by the time this piece sees the light of day, the fever will have broken surrounding the mythical Tsinghua Unigroup "offer" for Micron (NASDAQ:MU) that was first reported some two odd weeks ago in the WSJ. To be fair, WSJ played it straight, reported it "as Tsinghua Unigroup prepping a $23B ($21/share) bid" but once picked up by other outlets the story quickly escalated into a click-bait feeding frenzy that left many followers of Micron reaching for brown paper bags to breathe into. Leaving all that commentary sound and fury aside for the moment, there are some very serious issues that this tempest in a teapot stirred up that should be considered in the sober light of a new day. This article will attempt to do that.
Any attempt to assess the desirability or the likelihood of US technology companies being acquired by Chinese state/business entities must start with a general understanding of the fundamental conflict that exists between the interests of the developing Chinese economy and those of the already developed world. At the heart of much of the conflict rhetoric that pervades the China/US relationship is the Chinese feeling of victimization and paranoia that has been fostered by the Chinese Communist Party itself as a means of maintaining its control. Listen to Evan Osnos in his recent book on China:
"To prevent a reoccurrence of Tiananmen, the Party had redoubled its commitment to Thought Work directed at China's young people. (…) President Jiang Zemin (… called for) a new approach to explaining China's history 'even to the kids in kindergarten,' (…). The new approach emphasized 'bainian guochi' - the 'century of national humiliation' (…) Students were taught 'never to forget national humiliation.' (…) The National People's Congress approved a holiday called National Humiliation Day, and textbooks were rewritten." p. 140, Age of Ambition - Evan Osnos
The party, having pushed this version of Chinese history as a problem for the new China of today, can hardly be expected to forgo offering its solution to the problem.
Only a resurgent, powerful and self-sufficient China can withstand foreign attempts at domination. As McGregor reports in this monograph:
"The holy grail of science and technology is considered the key to China finally breaking free from its embattled past. Premier Wen expressed this "never again" view in November 2009 when key indigenous innovation regulations were unveiled: "Only by using the power of science and technology will China, this massive ark, be able to produce the immeasurable ability to allow nobody to stop our advance forward."
Broadly speaking, from an intellectual property (IP) perspective, the US and developed world have the IP that drives the modern Internet-powered economy. China doesn't have it. As China sees it, the US and the developed world use their dominant position in IP to take unfair advantage of the largest market in the world. This has to be remedied. The Indigenous Innovation Policy is that remedy, and it has far-reaching implications for the future for all foreign companies, especially the information technology companies that wish to operate in the Chinese market.
This is especially true in the case of companies like Micron and Intel (NASDAQ:INTC) that design and produce the integrated circuit and its many derivatives of which semiconductor memory like DRAM, NAND and 3D XPoint are examples. So where does this leave us? Proceeding further will require us to carefully establish some empathy with the Chinese reality and perspective. Let's take a closer look.
The Chinese economy today is the second largest in the world, having grown at more than a 10% a year rate for the last 30 years, an achievement that is unprecedented in human history. The model that has been used to obtain these results is straightforward and easy to understand. Under the command of the Communist Party of China, the economy is organized around so called State Owned Enterprises (SOEs) whose role it is to manufacture goods that are then exported in order to obtain valuable dollar denominated reserves that are used to fund further investment in increasingly higher value exports. In addition to capturing and monetizing the value of the highly productive labor of the Chinese worker, Chinese exports also benefit from an under-valued Renminbi that has the effect of artificially underpricing Chinese exports.
The value of this model to the party is two-fold. First and foremost the model produces industrial jobs on an immense scale that the Party uses to lift the overall standard of living of Chinese society. The second benefit of this model is its undoubted financial success. China today has a $4 trillion dollar-plus treasury account. Together these two factors support infrastructure development in China and increased levels of social investment that serve to keep the party's grip on Chinese society and polity secure.
While this growth has been overwhelmingly good for the party and the Chinese people, it has engendered some severe problems that, if they were to go unresolved, would threaten the party's grip on power. The first problem is the environment. In this area the impact of unrestrained growth of the high carbon economy have produced pollution on an unimaginable scale. The second major problem is a direct outcome of the success of the model in that, because export growth has taken priority over growth of the domestic market, any global slowdown in overall demand will take a big toll on China's dominant export sector, thus reducing growth below the party's goal
A third major problem that has developed over the last half-decade has been the state-owned enterprise debt crisis that has resulted from the party's efforts to prime the pump after the 2008 worldwide financial crisis. With total debt now at 280% (McKinsey Global Initiative 2014) of GDP, China finds itself on the precarious knife-edge of financial crisis with any unforeseen financial shock to the world system. Total Chinese debt in 2014 was over $28T, up more that $20T in the past seven years. Enterprise debt (almost all of which belongs to SOEs) is by itself 125% of GDP, with financial and banking sector debt coming in at two-thirds of GDP. Real estate debt in particular has reached alarming levels, comprising nearly half of all corporate debt. While there's no reason to conclude that this debt crisis is existential, it certainly comprises a major risk that will be difficult to resolve in such a way that a "soft-landing" can be engineered.
The broader point to be made here is that China is in the midst of a risk-laden transition in its economy and society. As McKinsey puts it:
"A rapidly aging population, increasing debt, and declining returns on fixed asset investment place new burdens on the economy. Because of aging, the labor force is expected to peak this year and begin a long decline that could reduce its size by 16 percent by 2050. By 2030, China's dependency ratio - the percentage of the population that is not in the labor force (mostly the elderly and children) - will reach 47 percent. This is far sooner, in terms of GDP per capita, than in countries such as Japan or the United States. (…) At the same time, debt-financed investment is approaching a level of diminishing returns. (…) The incremental capital-output ratio (ICOR), which shows how much capital is needed to generate a unit of GDP, was 3.4 on average from 1990 to 2010, but it has since risen to 5.4, meaning that it takes 60 percent more capital to generate a unit of GDP.
The China Effect on Global Innovation - McKinsey White Paper - 2014
The bottom line - China urgently needs to innovate in order to assure long-term sustainable growth. The party's ability to retain power ultimately depends on this initiative being successful. But can China do this? One noted observer of China doesn't think so:
"Even the most exuberant analyses of China's economic prospects recognize that China suffers from other institutional, legal, and normative hurdles to becoming a global leader. Innovation is one of those areas of weakness. Corruption, the lack of independent and private academic research institutions, and the lack of intellectual property rights protection all hinder China's development in a global marketplace that rewards innovation. (There are no Chinese universities in the global top twenty.) (…) Chinese academic culture (…) has neither well-developed professional norms nor regulatory oversight to prevent fraud, plagiarism, or other forms of intellectual property theft. Without such institutions, China is unlikely to produce top universities soon." P. 73, The China Challenge, Thomas J. Christensen
Notwithstanding all of the very serious issues presented above, China is no paper tiger. The party and indeed the Chinese people are convinced that China in time will be the strongest economic power on earth, with political and military strength commensurate with that ranking. US government policy has been and remains a mix of peaceful cooperation and hard-nosed competition with this rising power, and there can be little doubt that this relationship will be fraught with flashpoints for some time to come. The Indigenous Innovation Policy, launched in 2006 by Premier Wen Jiabao and President Hu Jintao, is one of these areas.
The Policy is implemented by a document called the "MLP," which is a contraction of its bureaucratic title "The National Medium- and Long-Term Plan for the Development of Science and Technology (2006-2020)." As McGregor of APCO puts it:
"The MLP blueprint is full of grand visions, good intentions and gilded rhetoric about international cooperation and friendship. (…) But it is also steeped in suspicion of outsiders. The MLP explicitly states that a key tool for China to create its own intellectual property and proprietary product lines will be through tweaking foreign technology. Indeed, the MLP defines indigenous innovation as "enhancing original innovation through co-innovation and re-innovation based on the assimilation of imported technologies." It also warns against blindly importing foreign technology without plans to transform it into Chinese technology. The report states: "One should be clearly aware that the importation of technologies without emphasizing the assimilation, absorption and re-innovation is bound to weaken the nation's indigenous research and development capacity." (emphasis added)
The MLP could hardly be clearer about what China expects to be done with regard to foreign intellectual property. The question for the US and the developed world in general is what are we going to do about it? For individual US companies the choices on offer are stark and excruciating: write off the Chinese market or write off your IP and see it coming back at you encased in competitive products that serve to reduce your global market share both in China and in the world as a whole.
Yesterday's Wall Street Journal explores just one of the areas where China is mounting a direct challenge:
No country has gone as far as China in its effort to fracture the international system that makes the Internet basically the same everywhere. The country is trying to influence every part of its digital world, from semiconductors to social media. Laws under consideration encourage Chinese companies to find local replacements for technology equipment purchased abroad and force foreign vendors to give local authorities encryption keys that would let them control the equipment.
In fact, these laws are "no longer under consideration" - they are in the new implementation rules of the MLP. What's under consideration, according to Bloomberg Business, is the posting of cyber cops within internet-related firms such as Alibaba (NYSE:BABA), Tencent Holdings (OTCPK:TCEHY) and Baidu (NASDAQ:BIDU). In language that could have been lifted from Orwell's "1984", Bloomberg quotes the following:
"President Xi Jinping designated "representatives of new media" as a key focus for the ruling party's outreach in May, according to Xinhua. China had 668 million Internet users at the end of June, according to a government research institute.
Technology leaders should "demonstrate positive energy in purifying cyberspace," Xi said at the end of the party's first national United Front conference, Xinhua reported. He called for regular contact with representatives of new media to build support for the party's agenda."
What does this mean for our tech titans like Apple (AAPL, Intel, Micron, Facebook (NASDAQ:FB) and Cisco (NASDAQ:CSCO), to name just a few? Google (NASDAQ:GOOG) (NASDAQ:GOOGL) wrote off the Chinese market, Apple didn't. Is there any reason to believe that China Inc. won't inevitably play hardball with Apple, for example, and thereby threaten its ability to maintain outsized profits on its products? Tech sector investors need to be keenly aware of the potential threat in order to assess the safety of their investments over time. There's no reason whatsoever to think that this issue will go away or become less urgent.
One thing for sure, any prospective Chinese acquisition of an American company with significant IP assets will be difficult if not impossible over the course of (at the very least) the balance of this decade. More broadly, American tech companies who derive substantial revenue and profit from their Chinese operations are going to be under increasing pressure from the Chinese government to hand over IP assets as a quid pro quo for market growth in China. When considering investment risks over the medium and long term, investors would be wise to consider the appropriate discount on China market earnings for US companies in their portfolio.
Seeking Alpha
U.S. Tech Companies And The Chinese Indigenous Innovation Policy
Aug. 6, 2015 3:30 PM ET | 7 comments | Includes: AAPL, CSCO, FB, GOOG, GOOGL, INTC, MU
Disclosure: I am/we are long MU, INTC. (More...)
Summary
•China's Indigenous Innovation Policy represents a significant threat to the Chinese earnings of US tech companies.
•The acquisition of US companies' intellectual property is to be the quid pro quo for access to the Chinese market.
•China's policing and repression of the Internet within China poses a threat to the worldwide Internet system that's the basis of the new economy.
•Investors should carefully assess risks to medium- and long-term profits for companies that operate in China.
"Indigenous innovation is a massive and complicated plan to turn the Chinese economy into a technology powerhouse by 2020 and a global leader by 2050. (…) the plan is considered by many international technology companies to be a blueprint for technology theft on a scale the world has never seen before. " China's Drive for "Indigenous Innovation," James McGregor, APCO
Presumably by the time this piece sees the light of day, the fever will have broken surrounding the mythical Tsinghua Unigroup "offer" for Micron (NASDAQ:MU) that was first reported some two odd weeks ago in the WSJ. To be fair, WSJ played it straight, reported it "as Tsinghua Unigroup prepping a $23B ($21/share) bid" but once picked up by other outlets the story quickly escalated into a click-bait feeding frenzy that left many followers of Micron reaching for brown paper bags to breathe into. Leaving all that commentary sound and fury aside for the moment, there are some very serious issues that this tempest in a teapot stirred up that should be considered in the sober light of a new day. This article will attempt to do that.
Any attempt to assess the desirability or the likelihood of US technology companies being acquired by Chinese state/business entities must start with a general understanding of the fundamental conflict that exists between the interests of the developing Chinese economy and those of the already developed world. At the heart of much of the conflict rhetoric that pervades the China/US relationship is the Chinese feeling of victimization and paranoia that has been fostered by the Chinese Communist Party itself as a means of maintaining its control. Listen to Evan Osnos in his recent book on China:
"To prevent a reoccurrence of Tiananmen, the Party had redoubled its commitment to Thought Work directed at China's young people. (…) President Jiang Zemin (… called for) a new approach to explaining China's history 'even to the kids in kindergarten,' (…). The new approach emphasized 'bainian guochi' - the 'century of national humiliation' (…) Students were taught 'never to forget national humiliation.' (…) The National People's Congress approved a holiday called National Humiliation Day, and textbooks were rewritten." p. 140, Age of Ambition - Evan Osnos
The party, having pushed this version of Chinese history as a problem for the new China of today, can hardly be expected to forgo offering its solution to the problem.
Only a resurgent, powerful and self-sufficient China can withstand foreign attempts at domination. As McGregor reports in this monograph:
"The holy grail of science and technology is considered the key to China finally breaking free from its embattled past. Premier Wen expressed this "never again" view in November 2009 when key indigenous innovation regulations were unveiled: "Only by using the power of science and technology will China, this massive ark, be able to produce the immeasurable ability to allow nobody to stop our advance forward."
Broadly speaking, from an intellectual property (IP) perspective, the US and developed world have the IP that drives the modern Internet-powered economy. China doesn't have it. As China sees it, the US and the developed world use their dominant position in IP to take unfair advantage of the largest market in the world. This has to be remedied. The Indigenous Innovation Policy is that remedy, and it has far-reaching implications for the future for all foreign companies, especially the information technology companies that wish to operate in the Chinese market.
This is especially true in the case of companies like Micron and Intel (NASDAQ:INTC) that design and produce the integrated circuit and its many derivatives of which semiconductor memory like DRAM, NAND and 3D XPoint are examples. So where does this leave us? Proceeding further will require us to carefully establish some empathy with the Chinese reality and perspective. Let's take a closer look.
The Chinese economy today is the second largest in the world, having grown at more than a 10% a year rate for the last 30 years, an achievement that is unprecedented in human history. The model that has been used to obtain these results is straightforward and easy to understand. Under the command of the Communist Party of China, the economy is organized around so called State Owned Enterprises (SOEs) whose role it is to manufacture goods that are then exported in order to obtain valuable dollar denominated reserves that are used to fund further investment in increasingly higher value exports. In addition to capturing and monetizing the value of the highly productive labor of the Chinese worker, Chinese exports also benefit from an under-valued Renminbi that has the effect of artificially underpricing Chinese exports.
The value of this model to the party is two-fold. First and foremost the model produces industrial jobs on an immense scale that the Party uses to lift the overall standard of living of Chinese society. The second benefit of this model is its undoubted financial success. China today has a $4 trillion dollar-plus treasury account. Together these two factors support infrastructure development in China and increased levels of social investment that serve to keep the party's grip on Chinese society and polity secure.
While this growth has been overwhelmingly good for the party and the Chinese people, it has engendered some severe problems that, if they were to go unresolved, would threaten the party's grip on power. The first problem is the environment. In this area the impact of unrestrained growth of the high carbon economy have produced pollution on an unimaginable scale. The second major problem is a direct outcome of the success of the model in that, because export growth has taken priority over growth of the domestic market, any global slowdown in overall demand will take a big toll on China's dominant export sector, thus reducing growth below the party's goal
A third major problem that has developed over the last half-decade has been the state-owned enterprise debt crisis that has resulted from the party's efforts to prime the pump after the 2008 worldwide financial crisis. With total debt now at 280% (McKinsey Global Initiative 2014) of GDP, China finds itself on the precarious knife-edge of financial crisis with any unforeseen financial shock to the world system. Total Chinese debt in 2014 was over $28T, up more that $20T in the past seven years. Enterprise debt (almost all of which belongs to SOEs) is by itself 125% of GDP, with financial and banking sector debt coming in at two-thirds of GDP. Real estate debt in particular has reached alarming levels, comprising nearly half of all corporate debt. While there's no reason to conclude that this debt crisis is existential, it certainly comprises a major risk that will be difficult to resolve in such a way that a "soft-landing" can be engineered.
The broader point to be made here is that China is in the midst of a risk-laden transition in its economy and society. As McKinsey puts it:
"A rapidly aging population, increasing debt, and declining returns on fixed asset investment place new burdens on the economy. Because of aging, the labor force is expected to peak this year and begin a long decline that could reduce its size by 16 percent by 2050. By 2030, China's dependency ratio - the percentage of the population that is not in the labor force (mostly the elderly and children) - will reach 47 percent. This is far sooner, in terms of GDP per capita, than in countries such as Japan or the United States. (…) At the same time, debt-financed investment is approaching a level of diminishing returns. (…) The incremental capital-output ratio (ICOR), which shows how much capital is needed to generate a unit of GDP, was 3.4 on average from 1990 to 2010, but it has since risen to 5.4, meaning that it takes 60 percent more capital to generate a unit of GDP.
The China Effect on Global Innovation - McKinsey White Paper - 2014
The bottom line - China urgently needs to innovate in order to assure long-term sustainable growth. The party's ability to retain power ultimately depends on this initiative being successful. But can China do this? One noted observer of China doesn't think so:
"Even the most exuberant analyses of China's economic prospects recognize that China suffers from other institutional, legal, and normative hurdles to becoming a global leader. Innovation is one of those areas of weakness. Corruption, the lack of independent and private academic research institutions, and the lack of intellectual property rights protection all hinder China's development in a global marketplace that rewards innovation. (There are no Chinese universities in the global top twenty.) (…) Chinese academic culture (…) has neither well-developed professional norms nor regulatory oversight to prevent fraud, plagiarism, or other forms of intellectual property theft. Without such institutions, China is unlikely to produce top universities soon." P. 73, The China Challenge, Thomas J. Christensen
Notwithstanding all of the very serious issues presented above, China is no paper tiger. The party and indeed the Chinese people are convinced that China in time will be the strongest economic power on earth, with political and military strength commensurate with that ranking. US government policy has been and remains a mix of peaceful cooperation and hard-nosed competition with this rising power, and there can be little doubt that this relationship will be fraught with flashpoints for some time to come. The Indigenous Innovation Policy, launched in 2006 by Premier Wen Jiabao and President Hu Jintao, is one of these areas.
The Policy is implemented by a document called the "MLP," which is a contraction of its bureaucratic title "The National Medium- and Long-Term Plan for the Development of Science and Technology (2006-2020)." As McGregor of APCO puts it:
"The MLP blueprint is full of grand visions, good intentions and gilded rhetoric about international cooperation and friendship. (…) But it is also steeped in suspicion of outsiders. The MLP explicitly states that a key tool for China to create its own intellectual property and proprietary product lines will be through tweaking foreign technology. Indeed, the MLP defines indigenous innovation as "enhancing original innovation through co-innovation and re-innovation based on the assimilation of imported technologies." It also warns against blindly importing foreign technology without plans to transform it into Chinese technology. The report states: "One should be clearly aware that the importation of technologies without emphasizing the assimilation, absorption and re-innovation is bound to weaken the nation's indigenous research and development capacity." (emphasis added)
The MLP could hardly be clearer about what China expects to be done with regard to foreign intellectual property. The question for the US and the developed world in general is what are we going to do about it? For individual US companies the choices on offer are stark and excruciating: write off the Chinese market or write off your IP and see it coming back at you encased in competitive products that serve to reduce your global market share both in China and in the world as a whole.
Yesterday's Wall Street Journal explores just one of the areas where China is mounting a direct challenge:
No country has gone as far as China in its effort to fracture the international system that makes the Internet basically the same everywhere. The country is trying to influence every part of its digital world, from semiconductors to social media. Laws under consideration encourage Chinese companies to find local replacements for technology equipment purchased abroad and force foreign vendors to give local authorities encryption keys that would let them control the equipment.
In fact, these laws are "no longer under consideration" - they are in the new implementation rules of the MLP. What's under consideration, according to Bloomberg Business, is the posting of cyber cops within internet-related firms such as Alibaba (NYSE:BABA), Tencent Holdings (OTCPK:TCEHY) and Baidu (NASDAQ:BIDU). In language that could have been lifted from Orwell's "1984", Bloomberg quotes the following:
"President Xi Jinping designated "representatives of new media" as a key focus for the ruling party's outreach in May, according to Xinhua. China had 668 million Internet users at the end of June, according to a government research institute.
Technology leaders should "demonstrate positive energy in purifying cyberspace," Xi said at the end of the party's first national United Front conference, Xinhua reported. He called for regular contact with representatives of new media to build support for the party's agenda."
What does this mean for our tech titans like Apple (AAPL, Intel, Micron, Facebook (NASDAQ:FB) and Cisco (NASDAQ:CSCO), to name just a few? Google (NASDAQ:GOOG) (NASDAQ:GOOGL) wrote off the Chinese market, Apple didn't. Is there any reason to believe that China Inc. won't inevitably play hardball with Apple, for example, and thereby threaten its ability to maintain outsized profits on its products? Tech sector investors need to be keenly aware of the potential threat in order to assess the safety of their investments over time. There's no reason whatsoever to think that this issue will go away or become less urgent.
One thing for sure, any prospective Chinese acquisition of an American company with significant IP assets will be difficult if not impossible over the course of (at the very least) the balance of this decade. More broadly, American tech companies who derive substantial revenue and profit from their Chinese operations are going to be under increasing pressure from the Chinese government to hand over IP assets as a quid pro quo for market growth in China. When considering investment risks over the medium and long term, investors would be wise to consider the appropriate discount on China market earnings for US companies in their portfolio.
Seeking Alpha
