By: Rio Liu

The ban will fuel foreign customer distrust of the American Semiconductor Industry which in turn, will become a lethal threat to American productivity.

Introduction:

On April 24th, President Trump announced that the U.S. Treasury Secretary, Steven Mnuchin, would travel to China “in a few days” to negotiate trade terms between the respective countries. In response, China’s Ministry of Commerce issued a statement welcoming the highly-anticipated visit. The so called “trade war” will now head to the negotiation stage and will probably end as soon as terms that ensure American intellectual property protection and Chinese financial market transparency are finalized. In addition to tariffs, there is a byproduct of the trade war that could give America a short-term advantage in the negotiations: The ban on ZTE,  China’s second largest telecom company, from trading with the U.S. The ban is a critical blow to China but will also negatively affect the reputation of America’s international commerce environment. Let’s first examine the ban.

The ZTE Ban’s effect on China

On April 16th, the U.S. Commerce Department issued a ban on Chinese-based ZTE from trading with any U.S. company for seven years. The department cited a number of ZTE violations concerning bonus payment issuances to employees who illegally re-sold American semiconductor parts to sanctioned countries and in particular, to Iran. The Bureau of Industry and Security (BIS) under the Commerce Department had already investigated ZTE for several years for such violations and had fined ZTE $890 million in March 2017. The reason for ZTE’s current outright ban is clear: A bargaining tool for the U.S. Government to use besides tariffs in upcoming negotiations with China.

ZTE’s products, which mostly consist of smartphones and telecom equipment, rely heavily on American semiconductor suppliers, such as Qualcomm, Acacia, Oclaro and Lumentum. Because ZTE previously imported approximately 30% of its telecom components, including integrated circuits, or “chips,” from America, it will now have to rely on suppliers from Taiwan and China, whose chips are less powerful. As a result, ZTE’s product quality will likely drop significantly and it will be exposed, as expected by analysts, to future bankruptcy in the near future unless helped by the Chinese government. Unlike its pushback on tariffs, the Chinese government hasn’t yet taken any effective retaliatory stance and doesn’t seem to have any solution to stop ZTE from failing. Moreover, on April 25th, BIS started investigating Huawei, another Chinese telecom giant, for also illegally exporting American semiconductor parts to Iran. Any ban on Huawei will likely affect its bottom line and solvency in a similar way to ZTE’s. And ZTE’s and Huawei’s potential insolvencies will negatively affect Chinese employment and productivity But their failures will also indirectly affect their American counterparts.

The ZTE Case & the Semiconductor Industry

On the day ZTE was banned, the stock price of all of its American suppliers dropped significantly. Qualcomm, a large-cap American semiconductor supplier and the producer of the famous Snapdragon chips, experienced a 9.9% loss in its stock price from April 18th to the 25th. The firm has warned that it expects $0.03 loss of its per share profit next quarter due to ZTE’s ban. The situation becomes even worse for mid-cap firms in the U.S. The stock price of Acacia Communications Inc plunged 35.97 percent while those of Oclaro and Lumentum have dropped 15.18 percent and 9.06 percent, respectively. Acacia, like many other parts suppliers of ZTE, relies on a small number of customers buying in bulk to earn revenue. In fact, ZTE alone in 2017 contributed 30% of Acacia’s revenue, or about $115 million. To make matters worse, American mid-cap firms stand to lose more vital revenue sources and even face likely liquidation and bankruptcy if the Huawei ban takes shape .And if the ZTE ban were to actually last for 7 years, large American semiconductor and telecom suppliers would experience continual revenue losses, possibly lose the ability to effectively fund their R&D departments to produce more powerful and high-tech semiconductor parts, and as a result, be unable to compete on a global scale.

Distrust of the American Commercial Environment 

The ZTE ban’s negative externality not only affects American firm’s stock prices but also damages their global reputations. The ban has in effect notified all foreign telecom companies of the political risk involved in buying American semiconductor parts. If the U.S. government is willing to ban foreign companies from importing parts to serve its political purpose, then it will destroy any belief in a reliable and credible commercial environment for international customers. The semiconductor industry and most likely other high-tech industries will be most affected by this perceived political risk.

The credibility crisis will then steer customers away from American semiconductor firms and to their foreign competitors. According to Qualcomm’s 2017 filings , 97% percent of its total revenues came from international customers with Samsung alone contributing  approximately 10% of those revenues. Other firms in the industry also strongly depend on foreign customers and as a result, losing those customers would be lethal to all of the firms involved. Although the U.S. owns a 50% market share of the global semiconductor market, foreign competitors such as Korea, Japan, the EU, and Taiwan, who currently hold 17%, 11%, 9%, and 6% of market share, respectively, will benefit from the credibility crisis and rise to challenge America’s dominance in the global market. Even presently, Chinese telecom companies  have already realized the drawbacks of relying too much on the U.S. to buy chips. Jack Ma, the co-founder of Alibaba, the Chinese E-Commerce giant, warned international companies to be aware of U.S. global chip dominance in a speech at Waseda University on April 25th in Tokyo:“Japan, China, any country should have their own technology. A company should take responsibility for its customers, for the global future.”

Because the semiconductor industry has always been a strong contributor to U.S. GDP, any potential decrease in American market share will significantly impact the U.S. economy. According to a 2014 report from the Semiconductor Industry Association (SIA), the industry adds the third highest value to the U.S. economy while its annual growth is 20 times that of annual U.S. GDP growth.  Such a vital industry to the American economy should not, by any chance, be harmed by any political trade-off or one-upmanship.

The High-Tech Industry will lose in the long run

Historically, American semiconductor firms have benefited the most from the globalized trade network. They are highly profitable because they are able to produce and sell high-tech parts and licences to companies mainly in Asia with very high margins. In turn, the Asian companies manufacture and sell the final goods to consumers with little profit left to spare relative to their American counterparts. For example, Qualcomm makes on average, double its production costs from selling its Snapdragon chip, the dominant SoC (System-on-Chip) of nearly all Android-based phones. Chinese-based smartphone producers such as Xiaomi, can make as small as a 5%  profit on its hardware products.

Should the globalized trade network break, American semiconductor companies won’t have the ability to only sell the profitable parts and licenses to trade partners anymore. The U.S. government can and should prevent Chinese companies from reselling semiconductors to sanctioned countries, but it would be unwise to deconstruct the very globalized trade network that it directly benefits the most from. It is a risky tactic for the U.S to use any high-tech industry as a political bargaining tool which might break the preexisted trade network. The tactic hurts both China and the U.S., but the U.S. will feel the negative impacts for far longer.

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