ZTE Settlement: One Hit for the US, but More Battlegrounds Ahead?
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By Elizabeth Freund Larus and Ross Darrell Feingold

ZTE Settlement: One Hit for the US, but More Battlegrounds Ahead?

Jun. 18, 2018  |     |  0 comments

On June 7, 2018, the US Commerce Department announced that Zhongxing Telecommunications Equipment Corporation and its affiliate ZTE Kangxun Telecommunications Ltd. (collectively, “ZTE”) agreed to severe penalties and compliance measures to replace penalties imposed on ZTE in March 2017. Under the new agreement, ZTE must pay USD 1 billion and place an additional USD 400 million in suspended penalty money in escrow before Commerce’s Bureau of Industry and Security will remove the denial order imposed on ZTE in April that prohibited exports from the US to ZTE of crucial components used in ZTE products.

Although Senators are trying to legislate against the settlement in the National Defense Authorization Act (NDAA) currently under consideration in Congress, why did ZTE settle after its initial announcements to be in a state of shock and that the denial order caused major operating activities to cease? Perhaps it is as simple as China’s desire, expressed by its Commerce Ministry just prior to the settlement, that it does not want an escalation of bilateral trade friction. More likely, China sought to preserve ZTE’s role as a national technology champion and to save the fight over technology security and trade for a different battlefield in disputes that are increasingly over technology security and intellectual property rights protection as well as tariffs.

ZTE: A National Champion at Home and Abroad

With profits of USD 765 million and a market value of USD 19.5 billion, ZTE ranks 682 on Forbes’ latest Global 2000 list. Unsurprisingly, the export ban resulted in indignation among netizens and state media and Chinese citizens as a perceived attack on China. Xinhua, the state media outlet, called the ban “unfair” and “unacceptable” and cited ZTE’s “corrective measures” following the 2017 agreement with the US including USD 50 million spent on an export control compliance program. ZTE is a significant player in China’s economy, and the Chinese people are very proud of their national companies. Because of limitations on the freedom of information, Chinese netizens are well-informed of the ban, albeit not the circumstances that led to it.

Globally ZTE is rapidly moving from a manufacturer of network equipment to a handset maker with its own brand products. With the launch of its new dual screen, foldable Axon M smartphone in 2017, ZTE was on pace to export 20 million smartphones to the US. With a 12 percent market share, ZTE is the fourth largest smartphone brand in the US behind Apple, Samsung, and LG. For a company previously known for telecommunications-equipment, nearly a third of its revenues now come from phones. Not only did the US ban jeopardize a growing revenue stream in the United States, but ZTE faced difficulties in markets such as Australia (where its market share had expanded in recent years) when its partner stopped selling ZTE phones, and in the United Kingdom, where regulators warned ZTE posed potential risks to national security. 80,000 employees are estimated to be impacted President Trump tweeted during the ban, “Too many jobs in China lost” and China is always concerned about unrest that arises from labor disputes.

The Tech and Trade War Battlefield

Some Chinese view the US treatment of ZTE as part of a war between the two countries over technology; Tencent Holdings Chairman and CEO Pony Ma labeled it a “wake-up” call to China’s tech industry, and reminder that without chips, you cannot compete. China’s chip manufacturing sector is large, but not strong. Domestic producers have not yet mastered core technologies in memory chips, integrated circuit design and compound semiconductors such as silicon carbide and gallium nitride. The Commerce Department ban made it illegal for US firms to sell or supply such technologies to ZTE; American companies provide an estimated 25 to 30 percent of components in ZTE’s equipment. Nearly all ZTE smartphones use Qualcomm or Intel chips, and all use Android software.

One thing we know with certainty is that additional battlefields in the US-China technology wars exist.

China’s strategies to reduce this reliance on imported chips, the “Made in China 2025” manufacturing improvement plan and National Integrated Circuitry Investment Fund (which recently announced a second USD 19 billion fund that follows the original USD 22 billion fund) are a work in progress. Cynics might have also considered the ZTE ban as part of a simultaneous battle, the race to perfect 5G wireless services. The settlement allows ZTE to resume purchases of technologies it cannot source locally, and doubtless Chinese engineers will resume efforts to learn all it can from US suppliers.

US National Security Concerns Not Settled

As a punishment for Iran related violations, the ZTE settlement does not address US national security concerns. The Trump Administration and Congress are increasingly wary of Chinese technology business activities in the US; a recent US-China Economic and Security Review Commission report cited ZTE and other Chinese technology firms for commercial espionage against US businesses. On the same day as the settlement, the Senate Intelligence Committee chairman threatened hearings on Alphabet and Twitter’s data-sharing arrangements with Chinese companies. For the Trump Administration, the Committee on Foreign Investment in the US to halt the sale of US firms in tech and other sectors to Chinese companies has become an effective weapon, and a bipartisan bill proposes to strengthen this oversight.

Xi Jinping Saves ZTE and Trade Talks but Outlook Uncertain

The ZTE ban was imposed amid planning for the Trump-Kim Jung Un summit. President Trump noted that Kim took a harder line on denuclearization after meeting Xi in Dalian in May. Commerce Secretary Ross denied the ZTE agreement is part of a broader US-China trade deal though it comes amid the ongoing US effort to compel China to eliminate tariffs on US agricultural goods or to agree to buy more US imports. For Xi Jinping, the ZTE settlement removes one impediment to working with the US after the Trump-Kim summit, given that Trump has linked China trade policy with China’s willingness to assist on North Korea issues. Whether or not a breakthrough on trade could happen post-summit remains to be seen. Regardless, state media in China will certainly call a ZTE settlement a victory for Xi.

What’s Next for US: China Technology Wars

Despite dramatic words and fears, it was unclear what ZTE could do to prompt a reprieve, ZTE was always too big to fail. ZTE’s apology on June 8 and vow to prevent future breaches do not address broader concerns about bilateral trade in IT products, nor will a large fine impact ZTE’s finances in the long term. In fact, a monetary fine and more robust compliance regime simply adds ZTE to the list of US and foreign companies who similarly settle regulatory action in the US; for Iran violations this includes prominent financial institutions from US allies who subsequently continued to operate in the US and in some cases were fined again.

If the Senate proposal to re-impose ZTE penalties via language in the NDAA survives both a vote in the Senate as well as the House-Senate conference to finalize the legislation, and President Trump signs the bill into law, it is possible the Trump Administration will issue a signing statement or otherwise cite a legal basis to waive or otherwise modify the ZTE penalties. The legislation would raise legitimate separation-of-powers concerns as it overrides authority, in the Trump Administration’s view, that rightly belongs to the executive branch.

One thing we know with certainty is that additional battlefields in the US-China technology wars exist. This means that Chinese companies must carefully review their current operations to avoid similar disputes, and US companies must be aware that their transactions with Chinese companies will face greater scrutiny in the US.

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