The age of cooptation: The high cost of doing business in Xi’s China

UPDATE: Huawei has denied certain sections of this article. We have published a letter from Catherine Chen,  Senior Vice President and Director of the Board.

As someone who has lived and worked in China, advised companies about investing there, and quite happily been described as a China bull, I have struggled to accept this fateful conclusion in the era of Xí Jìnpíng 习近平. Like some other China Bulls, I had believed the early promises of Dèng Xiǎopíng 邓小平 , Jiāng Zémín 江泽民, and Zhū Róngjī 朱镕基 about China’s fair and open future, open markets, the emergence of a rule of law system. To be clear, I am still very bullish on the strength and trajectory of the Chinese economy – China will continue to grow and it will surpass the US as the largest economy in the world. However, the current era is just a much darker period for multinational corporations (MNCs).

Recently, while listening to an episode of the savvy Pivot podcast, I was reminded of how far we’ve come from that dream, as tech gurus Kara Swisher and Scott Galloway discussed the U.S. trade war with China, China’s economic belligerence, and the problematic alliances international corporations make when seeking to plant their flag on Chinese soil.

Galloway made some predictions with respect to China in 2020:

I think we are going to hear about Apple in China [in 2020]…The only big tech company that’s been able to make any real inroads in China has been Apple…I wonder what has gone on in terms of their supply chain, in terms of privacy, and Tim toes a pretty righteous line around his activities and he’s used it to his advantage.

I wonder what kind of deal with China he has struck and I think we are going to start hearing more uncomfortable things about what Apple has had to do to stay as relevant and sell as many iPhones. I think there is no free lunch over there. I think a company that big…We’re going to hear more about Apple in China in 2020, and it’s not going to be good for Apple.

It was interesting to hear Galloway’s take on China because it reflects my own conclusions about doing business in China in the era of Xi Jinping. I am not in the prediction business and thus don’t know if Galloway is right about what we are going to hear about Apple and China in the coming year. But I do know that he has suggested an important line of discussion for the coming years: What does it cost to do business in China in the Era of Xi Jinping?

My own view: There is no free lunch for doing business in Xi’s China — especially for technology companies. China will get its pound of flesh as the cost of operating there: you get to operate here and gain access to the the most innovative supply chain in the world and world’s largest marketplace; and China gets what it wants in terms of benefits to Chinese economy and society (as defined by the Chinese Government).

The history of technology transfer

I have spent my career as a China scholar, and I think of Shanghai as my second home, having done three extended “tours of duty” in that great city over the last 30 years. My first book, based on my time there in the 1990s, was about the transformation of the Shanghai industrial economy and what it meant for China’s economic transformation. Most recently, from 2015 to 2019, I was a senior director at Apple, again based in Shanghai, where I led Apple University’s efforts on leadership development in China and spent a significant amount of my time doing research on the risks for Apple in China. It has given me a unique perspective on the questions raised by Professor Galloway.

In the mid-1990s, when I was in the early days of my China research journey, I used to spend time consulting for MNCs on strategic market entry into the world’s most populous nation. Back then, the dynamic was very clear: consultants and executives would inevitably find themselves sitting across the table from a couple of Chinese officials; they would say, ‘here’s the deal: you are going to do a joint venture with this company, this company, or that company, and you are going to transfer technology along the lines of this technology transfer schedule; or you can go home and not have access to this manufacturing base or the world’s largest market.’

Technology transfer and ‘helping’ China were at the heart of joint venture agreements, and this dynamic was unavoidable if technology-driven companies wanted access to the Chinese market. There were a few exceptions in light industry goods (think garments, running shoes, plastic toys), where the technology was less important. But for companies that had something that China wanted, this was the cost of doing business there.

The end of the golden era of Hu and Wen

Then, in the early 2000s, two things happened. First, in 2001, China entered the World Trade Organization (WTO). Overnight, it became illegal (or at least against WTO rules) for Chinese officials to demand a quid pro quo for market access. Second, in 2002, Jiang Zemin and (more importantly) Zhu Rongji came to the end of their two terms leading China. They were replaced by Hu Jintao and Wen Jiabao, who were much weaker than their predecessors. So, in very short order, China became a playground for MNCs that wanted cheap labor, the world’s most innovative supply chain, and the world’s largest market. (Note: Apple entered China in 2001, so, from 2001-12, this was the China they had come to know.)

The era of Hu and Wen (2002-2012) can be viewed as a relatively laissez-faire period in the 40 years of China’s “economic opening.” There was a significant drop-off in joint venture deals (those officials were not sitting on the other side of the table anymore); companies like Apple, Walmart, and Nike could manage the supply chain as they liked; and the much-hyped 1.4-billion-person marketplace opened up significantly. Most China watchers, myself included, were expecting an authoritarian or centralizing shift in the political transition of 2012. I don’t think any of us imagined how aggressive the authoritarian shift was going to be, however.

For a company like Apple, the first shot across the bow came on March 15, 2013. Every year, on March 15, China holds an annual ritual called “International Consumer Day,” where the state media chooses one or two corporations to shame for bad corporate practices – almost always foreign corporations with significant operations in China. In 2013, it was Apple’s turn. (President Xi officially began his first term on March 14, 2013, so this was the first Consumer Day he presided over.)

Apple was targeted for warranty practices in China. Tim Cook formally apologized, and the world moved on. But it was significant to note that the tech sector was on notice. The basic tone that would re-emerge over the next couple of years would harken back to that of the 1990s: If you are not helping China through partnerships or outright technology transfer, you are no longer welcome in China.

And China used the law to reinforce its new mindset, with a strong reinvigoration of the “Rule By Law” system of governance. (Note: There is an important distinction between “Rule of Law” systems, typical of Western Democracies, which have independent Judiciaries, and the Chinese Rule By Law system, which uses law to force individuals and companies to do what the government wants.) Statutes such as the Dispatch Labor Law and the Cybersecurity Law were designed to send the signal that the requirements of doing business in China were going to be significantly different going forward. In short, the Dispatch Labor Law was set up to control the use of the internal migrant labor population (the so-called “floating population”) and the Cybersecurity Law was set up to control the flow of data and content. Both laws were set up to control the ways in which high tech companies operate in China.

Do what the government wants or get out

In relatively short order, most if not all major companies operating in high-tech sectors, including some of the most powerful MNCs in the world, unveiled ways to show they were giving back to Chinese society, from major investment announcements (Dell) to joint venture announcements (Dell, HP, IBM, Qualcomm, Cisco, Intel) to R&D centers and data centers (Apple) to incubators and accelerators (Microsoft). The list goes on. And from the exclusion of Facebook, Google, and Twitter to the shuttering of Apple’s iTunes Store (iBooks and iTunes Movies) in April of 2016, the Chinese government  made clear what it is willing to do to protect its domestic champions and control the flow of information. This is what it means to be intimately involved with an authoritarian government – you do what the government wants or you can leave.

But this isn’t just about foreign MNCs operating in China. Xi has also built a close alliance with the major domestic players in technology sectors. The government has always had direct control over the major players in the state sector (like ZTE), but private companies (like Huawei) have kept an arms-length distance from the government. Until now.

Realizing that making the difficult transition from investment-led growth to consumption-led growth, Xi enlisted companies like Baidu, Alibaba, and Tencent (the so-called BAT). While the Chinese Government has protected BAT from global powerhouses like Google, Facebook, and Twitter, two of them (Alibaba and Tencent) have thrived and also become the two largest investors in Chinese entrepreneurial endeavors, thus helping to build the consumption-led growth economy.

But there is a quid pro quo in play here: the Chinese government protects its national champions, but the government also wants their data. The situation with Alibaba has been clear and the company has been up front about this with its contributions to the emerging social credit system. Tencent has been less forthcoming, but we know that the government is monitoring and censoring WeChat aggressively. The government wants access to the data, and that desire is backed up by the Cybersecurity Law. And make no mistake about it, the government is using the data for a very sophisticated social monitoring program. Again, you don’t get to do business in China without playing the game that the government wants you to play, and this is the game right now. No one is immune. No one.

How Huawei caught up to Apple’s FaceID

In the spring of 2018, I flew to Shenzhen to spend some time with an old friend, Ken Hu (胡厚崑 Hú Hòukūn), the vice chairman of the Board of Directors at Huawei. I then went on to have lunch with Madame Chén Lífāng 陈黎芳, Huawei’s senior vice president, board member, and the head of the company’s government affairs office. (I have known Hu and Chen a long time and they were willing to take a friendly meeting to catch up on things.) I wanted to meet with Ken and Madame Chen to confirm a rumor I had heard in China technology circles.

The background for this story is that Apple is very good at supply chain innovation and helping suppliers build out manufacturing processes. Because Apple works with so many suppliers, there tends to be a significant amount of leakage in the supply chain, as Apple supply chain partners seek to leverage their Apple-acquired knowledge to make money by supplying Apple’s competitors like Huawei, Oppo, and Vivo. Thus, many competitors follow Apple around the supply chain, hoping to take advantage of the processes these suppliers have learned from working with Apple.

Huawei is often first in line for taking advantage of what these suppliers have learned from Apple. Sometime around 2015, there were rumors in the Chinese smartphone manufacturing community of something called FaceID (leading up to the launch of the iPhone X). There were also rumors of a hardware module, which would make FaceID possible. The rumors were that this would be a significant leap in innovation for Apple, and it would likely create a significant gap between Apple and its competitors. There were also rumors that Huawei was attempting to entice Chinese suppliers to reveal some of the secrets behind the new hardware module. This is the story I wanted Ken Hu and Madame Chen to confirm for me.

Huawei realized it would be a serious setback for the company if it didn’t have something similar to Apple’s FaceID, and Huawei went to the government for help. Initially, Huawei hoped the government would put some heat on Apple and force the suppliers to loosen up a little bit. Surprisingly, the government said the following (I am paraphrasing here, based on my conversation with Madame Chen):

Government: Forget about Apple suppliers on this issue.

Huawei: We can’t ignore this. It will be a serious competitive advantage for Apple iPhones if we don’t have something comparable.

Government: We did not say forget about FaceID, just forget about following Apple on hardware. What if we gave you access to a database of 1.4 billion faces and you used that database to develop an AI algorithm to recognize faces? Could you develop an AI solution rather than a hardware solution?

And that’s what Huawei did. The Chinese Government, which has probably been more aggressive (and intrusive) in collecting data through facial recognition than any government in the world, was offering to turn over a database of faces to a private company to build an AI algorithm for facial recognition.

Think about this: The Chinese Government was offering to make all of its facial recognition data available to a private company to help this company compete with an international, publicly-traded competitor. This type of coordination between the Chinese Government and the private sector would have been unthinkable six years ago. But what did Huawei owe the Chinese government as a result? What was the quid pro quo here? Very likely: data. And what does this case suggest about other companies that have significant manufacturing and sales operations there?

The Bottom Line

The Huawei case is just one example of the close collaboration between Xi’s government and the private sector — especially the high-tech sector. There are many other examples, including foreign companies. This is the cost of doing business in China in Xi’s Age of Cooptation. What does this mean for foreign companies doing business in China today? Galloway predicted that we are going to hear a lot more about this issue in the coming year. He might be right. The bottom line is this: if you are not helping China develop in the areas it wants to develop, you are no longer welcome. Whether it is data centers, 5G technology, or infrastructure that will help with the Belt and Road Initiative, there has to be a benefit for China. This is the cost of doing business in China today.

A version of this article was originally published at OnGlobalLeadership.com.