March 19, 2004 4:00 AM PST

Divide between U.S. tech firms, China--a great wall?

The honeymoon between China and the U.S. tech industry is over, and the warm feelings may be gone for a while.

In the past several months, China has adopted a series of regulations that seem calculated, at least according to Westerners, to help Chinese manufacturers as well as force multinationals to expand their local operations.

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What's new:
China has been adopting rules that to Western tech firms seem designed to help Chinese companies and force multinationals to expand operations in the East.

Bottom line:
Such trade quarrels can lead to global incompatibilities that linger for years and hurt both importers and exporters.

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The Chinese-developed Wi-Fi security protocol called Wired Authentication and Privacy Infrastructure (WAPI) is one example. Starting June 1, all Wi-Fi equipment sold in China will have to comply with the proprietary protocol, and Western chipmakers are now required to pay select Chinese companies a per-chip royalty for WAPI and/or partner with them on development. And because WAPI technology can't leave the country, Western companies will have to staff local facilities if they want to participate in the market.

"There are literally thousands of test hours in every driver," said Jeff Thermond, vice president of Home and Wireless Networking at Broadcom, which has decided to pull out of the Chinese Wi-Fi market after the June WAPI law takes effect. "All the work must be done by employees in China."

The country also continues to maintain a value added tax (VAT) on imported semiconductors that is prompting foreign chipmakers to build facilities in the country or sign up with local foundries. Imported products get saddled with a 17 percent VAT, while the VAT on locally made products can be as low as 3 percent. On Thursday, the Bush administration filed suit with the World Trade Organization over the VAT.

"It is an artificial way of forcing U.S. companies to invest in China," said Daryl Hatano, vice president of public policy at the Semiconductor Industry Association.

U.S. Trade representative Robert Zoellick has issued a statement calling for China to change its tax policy and repeal the WAPI law, and U.S. Secretary of Commerce Donald Evans and Secretary of State Colin Powell also sent a letter to Chinese Vice Premier Wu Yi and others urging them to reconsider the law.

"China must live up to its WTO obligations. It cannot impose measures that discriminate against U.S. products," Zoellick said in a statement.

Conflicts will also likely emerge around China's TD-SCDMA standard for 3G cell phones. The Chinese government is currently testing the standard and will issue licenses for four carriers later this year. To participate, though, Western companies need to find local partners. Germany's Siemens formed a $100 million joint venture with China's Huawei and will appoint 200 employees to the project.

Like other governments, China has also kicked off an initiative to get its internal agencies to buy local software.

To top it off, Taiwan is holding a national referendum this weekend that could further polarize relations by raising the question of Taiwanese independence. Taiwan and China joined the WTO in 2001.

Long-term trouble?
History shows that these sorts of trade problems can last a long time. In the '80s, Japanese and U.S. semiconductor manufacturers sparred constantly. A truce only began in the '90s when Japan was already mired in an economic slide. Moreover, such trade quarrels can lead to global incompatibilities that linger for years and hurt both importers and exporters.

"I believe there are genuine security concerns on China's part, although the domestic industry is also likely to benefit," said Lawrence Lau, the Kwoh-Ting Li professor of economic development at Stanford University. "This happens quite often. Our cell phones do not work in Japan, so the Japanese manufacturers and distributors have a lock in their home market. However, that did not exactly help Japan. By setting a different standard, Japan has actually limited the growth of its own cell phone companies."

On the other hand, the United States and China have strong incentives to cooperate. For one thing, trade is booming. China's trade with the United States came to $191.7 billion in 2003 ($28.4 billion in U.S. exports to China and $163.7 billion in Chinese exports to the United States), up 23.2 percent from the year before, according to statistics from the U.S. International Trade Commission. Electronics were the United States' largest export and the second biggest Chinese export.

Recently, The Bush administration slightly relaxed its stance on the exportation of 130-nanometer semiconductor manufacturing equipment to China and will let companies export this equipment under certain circumstances, said Maggie Angell, director of public policy at Semiconductor Equipment and Materials International (SEMI), a trade organization for chipmakers. Until recently, national security concerns barred these sales.

European and Asian governments already let their companies export this kind of equipment, which has been available in other countries since the late '90s, to China. Some semiconductor test equipment will be removed from national security classification as well.

"I do not see a wholesale change in export control, but there are some things going on that can be called forward movement," Angell said.

Chinese companies are also getting hit. Semiconductor Manufacturing International Corporation (SMIC), which makes chips for companies that don't maintain their own foundries, is one of China's premier chipmakers. The company has raised millions from U.S. venture capitalists like New Enterprise Associates and can count U.S. chip designers such as Broadcom among its customers. But despite the pedigree, the company saw its shares decline in its IPO on the Hong Kong and New York stock exchanges this week.

And, as many Western companies have seen, China is also discovering that promoting a new standard and getting people to adopt it are two separate things. So far, sales of DVD players based on China's Enhanced Versatile Disc (EVD) standard are disappointing because of high prices and a lack of titles, according to a January report in the People's Daily.

Differing opinions
One of the chief problems with the regulations, U.S. executives maintain, is that they seem to operate like jobs programs for China. Under the WAPI law, foreign companies effectively have to share revenue with local companies and risk transferring technology to potential future competitors.

"It is negative in a number of respects. It makes it more difficult to do business in China, and it also makes it more difficult for Chinese companies to export abroad," said Hatano.

For their part, local officials and organizations, such as the China Broadband Wireless IP Standards Group, which supports WAPI, assert that the policies are legitimate in that they will help China meet internal security goals and compete with and decrease dependence on foreign companies.

The EVD situation presents the converse problem. The Chinese invented the standard as a way to avoid paying royalties to the DVD consortium. Chinese manufacturers have to pay about $13.8 dollars for every player manufactured, according to the People's Daily. In other words, the regulations mean Western companies lose out on royalties.

Then there is the compatibility problem. If the standards aren't required elsewhere in the world, manufacturers have to design and/or test products specifically for China, which drives up costs. Additionally, Chinese consumers will inevitably buy DVD discs that are incompatible with EVD players or try to log on to hotspots that got installed before WAPI came about and are thus incompatible.

Besides the obvious effect of nationalism, trade disputes can be aggravated by the fact that national governments are given fairly wide discretion in many trade agreements.

WTO bylaws, for instance, do not allow countries to establish discriminatory import tariffs that allow local products to be sold for less.

On the other hand, the WTO permits countries to give businesses tax holidays. In China, foreign manufacturers can escape income tax for up to five years, and pay income tax at reduced rates for another five, by meeting certain requirements.

Sorting out legitimate versus illegitimate policies can be the subject of lengthy negotiations. U.S. manufacturers, naturally, follow their own interests in these matters. While the Semiconductor Industry Association roundly criticizes China's VAT, it holds up the tax policy as an example for government in action.

Another problem with the current wave of Chinese regulations is that they can be vague. When it first emerged, WAPI involved adding additional security software and removing existing software, said Thermond. Later, the government said that, at some point in time to be determined later, the software functionality would have to be integrated into a hardware module in the chip.

Some in the United States have said that co-manufacturing with Chinese companies is required, while others have said that foreigners only have to pay a licensing fee.

"There are a lot of different people with a lot of different opinions inside China," said Thermond.

Nonetheless, progress may be taking place.

"A lot may be happening behind closed doors," said Hatano.

 

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