Scott Wallsten:
Welcome back to Two Think Minimum, the podcast of the Technology Policy Institute. Today is Thursday, October 14th, 2021. I’m Scott Wallsten, President and Senior Fellow at TPI. I’m here with my co-host, TPI Senior Fellow Sarah Oh.
Today we’re delighted to have as our guest, Xiaomeng Lu. Xiaomeng Lu is a Director in the Eurasia Group’s Geotechnology Practice, where she focuses on the interactions of emerging technologies with geopolitics, market dynamics, and regulatory norms. Before joining the Eurasia Group, she was the China Practice Lead at consulting firm, Access Partnership, where she helped top US financial and cloud service providers enter China’s market. Welcome, Xiaomeng.
Xiaomeng Lu:
Hi, Scott. Thank you for having me back.
Scott Wallsten:
We’re thrilled to have you, and we appreciate your taking your time out from your quarantine as you try to enter China.
Xiaomeng Lu:
Perfect timing. I’m more than happy to continue our discussion and keep my sanity in check.
Scott Wallsten:
Great. So let’s start off with a high-level question. Is the US, or the west in general, in a tech cold war with China?
Xiaomeng Lu:
I don’t think a cold war is the most accurate description, maybe a lukewarm war, if you will. I think there’s somewhat significant supply chain implications of the US-China trade conflict during the Trump administration, but still, I think if you look at a number of business community surveys, a lot of the Chinese firms, as well as US firms, tend to stay on track with their business model, and many of them still have high dependency on each other. Dependency goes both ways. So, I think to a certain extent, these two economies are still very much connected through the tech supply chain, and I think there may be conflicts around the semiconductor issue, particularly Huawei couldn’t use many semiconductor equipment or manufacturing capacity that was enabled by US IP anymore. But outside of that, I think many, many US companies still see China as a major manufacturing base and a critical part of their supply chain, and I think the feeling is mutual on the Chinese side.
Scott Wallsten:
Do you think that this talk of trying to rethink supply chains is mostly just talk?
Xiaomeng Lu:
For example, like China’s reaction to this major trade pressure coming out of US-China tension is in their 14th Five-Year Plan. There is a major new theme called “Science and Technology Self-Reliance.” It sounds very sexy, very patriotic or nationalistic, depends on how you view it. But I think “self-reliance” is somewhat of an exaggerated word. Maybe they can use this political push to reduce a little dependency on US suppliers and the rest of the world.
But I think a complete decoupling is somewhat unrealistic. I think the same applies here. There’s that US supply chain effort, in particular the semiconductor industry has been pushing for policy efforts to secure a significant amount of domestic manufacturing capacity that they feel is fundamental and critical to the strategic industry in case there’s any major supply chain disruption on the Chinese side. Between the US suppliers, and potentially in collaboration with European suppliers and Japanese supplier, they can still have a certain amount of semiconductor supply to support other industries in the technology ecosystem (if disruption indeed happens).
To reach this goal of securing fundamental capacity needed in the worst-case scenario the rough number they are seeking is somewhere around like 20%, 30% of the global semiconductor manufacturing capacity in the US with the $52 billion dollars of investment from recent legislative efforts. That’s kind of the general goal of the US supply chain security initiatives, but I think still they’re not looking for doing everything in one country. That very much runs counter to the nature of the global innovation system, as well as the global supply chain. Commercially, that’s simply not feasible.
Scott Wallsten:
And I mean, in the past, when countries have tried to adopt any sort of self-reliance mechanism, usually it just doesn’t work. You cut yourself off from trade and so on. Are these focused mostly on national security concerns rather than sort of broader trade issues or even trade in tech?
Xiaomeng Lu:
I think it’s both, it’s the recognition that some of the critical technologies and manufacturing capacities are important. If you’ll just look at the commercial fundamentals, supply chains are built for innovation and for market demand and not really for resilience against geopolitical shifts. And we are experiencing some of the most geopolitical shifts in recent decades right now. So, I think the political push will have certain impact in terms of reshaping the landscape of global supply chain. And I think in terms of the countries who have pursued this type of nationalistic or indigenous company promotion type of policy in the past, some of them have some success in the past. I think South Korea has done some of it and Taiwan still does it. Taiwan even has one of the best, most cutting-edge semiconductor manufacturers in the world. They still allocate subsidies and tax benefits and other preferential policies to their national champions.
in the current political environment, I think it’s somewhat inevitable for the major powers to do a little bit of this. At the same time, I think they realize, in particular the countries that have done this before, this may not be the most cost-effective way to promote your commercial capacity.
But there’s a sense of competition among even Japanese company, Korean company, Taiwanese company, European companies, that they need to assure their capacity in this area. So, you get this sense of competition. It’s hard to slow them down at this point.
Scott Wallsten:
So, let me ask an impossible question. How would you see the market looking in five years if so many countries are trying to secure their own supply chains, particularly in semiconductors? And we can make it further out if you want to make sure that nobody ever comes back to check to see whether you were right or not. But where do you see it going?
Xiaomeng Lu:
That’s a billion-dollar question, maybe a trillion-dollar question. in the optimistic scenario, I think some countries will realize that their approach implies a high cost, and it’s not cost-effective. And they’re producing less return on investment, and if it’s the return is so low, they may scale it back a little bit. I think that’s the one optimistic scenario. after the initial rush to commit significant funding to this initiative, hopefully decision-makers will form a longer-term view on this issue, and ideally switch to a more objective approach to this topic.
And in the less optimistic scenario, countries can’t keep doing this. Some countries may be able to roll out $50 billion, $100 billion deals every few years, using political will to twist economic and commercial rules though most countries probably can’t afford to do that for an extended period of time. they will hit some kind of financial bottom line.
Maybe there’s some middle ground scenario where some countries are smarter with their policy approach than others, and they put their money in the best places and actually gained some traction. I think if that’s a possible case, then those countries may be able to generate more incentive for them to keep pursuing this type of approach. That’s another scenario. So, maybe it will take five years to grow another national champion, maybe less than that.
Scott Wallsten:
We’ll schedule it now. We’ll send you a Zoom invite sometime.
Xiaomeng Lu:
Yeah. I’m sure I’ll be over quarantine at that point!
Scott Wallsten:
We’ve had these sorts of national security semiconductor issues in the past, in the 1980s in particular, and the Chinese government is known for making very, very long-term plans. Do they also look backwards at how other countries have dealt with these kinds of issues, or is there some thought that China is very different and, you know, the US experience with say SEMATECH and the things it did in the eighties just aren’t relevant anymore? And of course, obviously, I don’t think people in the US ever went back to see, to learn from what we did or not. Since China is so well known for looking forwards, do they also look backwards to learn?
Xiaomeng Lu:
I think they have. They look back at both others’ track record and their own experience. I think if you look at China’s 12th Five-Year plan, the 13th Five-Year Plan, there’s always an element of promoting semiconductor technology, of different levels of priorities. Right now it’s pretty much the top, top technology issue that keeps President Xi awake at night. But I think in the past, it’s always made the top 5, top 10 list, and I’m sure China has also looked at how the Korean semiconductor companies came around, and how Taiwan ended up being one of the powerhouses for the sector, and probably the US model as well. I think they look at the Asian countries’ environment, their political system, as well as the US market dynamic. They probably realize that their approach may not be the most efficient and it will take them a few rounds of trials and errors to make progress, but I think the geopolitical tension is so high, they don’t believe they have another choice.
They don’t think they can wait around, let the market’s invisible hand to play a dominant role and wait for this to happen naturally in the marketplace. That might take 10, 15 years, maybe never. The political environment just doesn’t allow that kind of options, at least in the mind of party leaders. Plus I think China somewhat learned, maybe this is not the right lesson from their past, that a few Chinese companies, like Huawei’s hisilicon chip design branch actually had some pretty impressive innovation in terms of the design capacity for the semiconductor supply chain, that’s very original and that’s a major breakthrough compared to their peers. Their innovation didn’t come from the US model, which is completely market driven—-like small entrepreneurs trying to invent technology in their garage. That’s not Huawei’s approach. Huawei has a lot of government support and put their employees into this very, very intensive work schedule. And eventually, they somehow made breakthroughs. I think the lessons for learnt for some Chinese engineers is that if Huawei can make a breakthrough in the design segment, move up the supply chain, maybe Huawei and other players with more government support and preferential policy treatment, can find other breakthroughs and can close other gaps on the supply chain that currently are the bottleneck in their technology ecosystem, such as the EDA tools. That’s a very, very critical cutting-edge technology that China doesn’t have a substitute of. And right now, a lot of the Huawei engineers who made that major breakthrough in the design section are trying to work with their industry peers and find out if they can reproduce their earlier success.
Scott Wallsten:
You talk about creativity, which obviously is a really important part of innovation. And we’ll talk about how China has been on the crackdown on some tech companies in a bit, but do you think that the stronger interventions and the various crackdowns that the Chinese government is imposing on various tech companies will affect this kind of creativity? I mean, creativity is, by its nature, the ability to think and do whatever you want. Is there any sense that that might be harmed by the sort of new approach?
Xiaomeng Lu:
That’s a brilliant segue, Scott. I think there is definitely that type of concern because for the past 15, 20 years, the platform companies of China have been operating in this very laid-back regulatory environment. And they pretty much have the leeway, a privilege I would say, to do whatever they want. Even sometimes, say, they have taken on tactics to pursue regulatory arbitrage, because they represent innovation, which is highly valued by the political leaders. They have this special status to do what they want for quite a while, but now the crackdown comes. The macro environment is changing.
And at one point I exaggerated a little bit and said, “Winter is coming,” especially for the major tech brands. the regulatory climate has changed, and the party leaders think these companies have enjoyed so much benefit over the past years and have taken advantage of China’s low labor costs and the relaxed regulatory environment, but they didn’t produce as much technological advancement as the political leaders wanted them to.
But the other side of the coin is that some of them are brilliant commercial innovators. The apps these companies produce and the algorithm they use, things like the algorithm that powers TikTok. They are, I would say in many ways, surpassing their American competitors, and for now, especially the big ones, Alibaba, Tencent, and Bytedance type of companies are being put back, being reined in by political leaders. Now they have to be concerned about how big we are, and whether my algorithm represents the party’s values, the social welfare centric policy agenda. We’ve seen these changes played out in the past months or so, and also many, many other aspects of their business practice are now seen to pose a threat to the party and even to some broader political agenda the party has been pursuing, and will keep pursuing, particularly leading up to the sensitive political cycle at the end of next year.
So, everyone is very nervous, and their hands are tied. I don’t think they have as much space to operate in terms of pursuing innovative ideas and finding new ways to commercialize their business model. I think that’s definitely a damper on the commercial innovation side. In addition, there is a (probably) minority view that this campaign can channel resources and human power from these major tech brands to focus on hard technology, whether that’s quantum computing, or robotics, or autonomous vehicles.
Ideally, I think at some point, the party will direct the Chinese platform giants who do some of the moonshot projects that American tech companies have been pursuing like Facebook, Google, and Amazon. You can say, maybe in the near term, five, 10 years, they may not produce immediate capital return, but in the long run, it seems to be a very cool idea and that could generate the next major technological breakthrough, like autonomous cars or Elon Musk’s idea to send people to Mars. I think at some point the Chinese government wants a Chinese company to do things like that. That will help them to reorient the economy towards growth driven by strategically important technology, and that will also help them to advance China’s strategic position.
Scott Wallsten:
It sounds like there are a couple of things that are going on in the government. One is that the party leaders worry about threats to the party and the message that it wants people to receive, and the other is this impulse that seems to be common to leaders all around the world, regardless of their politics, which is that they feel like they know better than the companies do, and so what direction innovation should go? And so, one is party and the other is human leaders. Are those sort of working together to push in particular directions?
Xiaomeng Lu:
Yeah, I think some of us comes back to the reaction to the rising power of major tech companies, right? for a while, governments around the world, and in particular the US government, were trying to rein in major banks. They were the most dominant forces in the US economy for a while. And then there came regulations for these guys, and arguably you can say that industry is way more regulated than the tech sector today. And I think there’s maybe a parallel here where tech companies are becoming more and more of an influential power, even on the global stage and in each of these national economies, and the regulators feel like they’re trying to catch up, but they’re falling behind and they’re losing power over to the rising technology giants. So, there’s the sense that a major wave of regulation is coming, and whether that will come down at the end of the day, to the level of regulation the banking sector is experiencing today. I think that’s the billion-dollar question.
Scott Wallsten:
Actually, you’re saying, “Winter is coming.” It seems like exactly the right metaphor, because we also don’t know whether George R.R. Martin will ever finish the book. So, we don’t even know if there winter will actually come.
So, going down a little bit into more detail about the companies themselves. Over the summer, we saw big crackdowns against DiDi and the education companies, and some of the stocks of those companies like DiDi have not really recovered, and others, some of the education companies have. Is this just the stock market being disconnected from what’s happening, or does it reflect something going on in the government of their decisions, which types of companies to pursue and which not?
Xiaomeng Lu:
I haven’t been watching the stock market that closely, but actually what you described seems to resonate with what I saw, or what I have been gathering, through virtual meetings with people on the ground in Beijing in the past week or so. from what I have gathered, there was the initial strong reaction to the industry crack down from Wall Street folks, but by now some of it seems to be fading.
When I talk to folks on the ground, I just asked everyday people, how old are your kids? Are they going to school? Are they going to after campus classes? And some of the elementary kids that fit into this age range, that’s the focus of the regulatory pressure to strictly limit the scope of after school educations, some of their parents told me that their kids are still attending off-campus, tutoring sessions online and offline.
And they told me to look very closely at the wording of the regulation issued by the government and the licensing requirement. These rules have placed restrictions on online education activities for kids between 6-15 ., You can’t offer classes on weekends and during summer and winter breaks, but after school during the week is permitted. it’s not a sweeping ban. It’s not a complete wipe out. As a result the total size of their businesses are going to be much smaller, but that part of revenue has not completely dried out yet.
And then beyond kids of 15 years old, for high schoolers, they can still provide training during weekends, weekdays, summer, winter break, that’s fine. And they can also focus on kids who want to prepare themselves for overseas study. They need to take GREs or GMATs, they can focus on this type of business as well.
So, I think the overall restrictions coming down the pike during the summer, it’s going to undermine the industry, but it’s not going to kill the whole sector. Especially, I think the top tier players will be there to stay. They may be less profitable, less lucrative, but from the investor perspective, I think a lot of them look at the long-term. If you look at the structure of the Chinese economy, the demographic overlaid with the regulatory trend. Some of investors still see opportunities in that sector, especially if you go into those stocks at the bottom, if you are able to catch their lowest points, then maybe you are in a favorable position.
And then in terms of DiDi, I recently heard that the company is really in trouble. The cybersecurity review is going through its second extension. And the length of the review suggests that the CAC, the Cyberspace Administration of China, is not going to walk away from this probe and say, “We looked through everything and you are fine.” It’s more likely that the company has very serious national security problems. The problems are so substantial, the rectification suggestion coming back from CAC, actually the suggestion’s more like an order that DiDi has to follow, is likely to involve major structural change of the company. This could involve the exit of top executives or the delisting from US stock market, or introduction of state-owned enterprises as stakeholders. I think this is what’s going to come in the next few months after they close the investigation on DiDi.
Scott Wallsten:
Well, I’m sure that there’s a lot of the investigation nobody can know about, but what extreme national security issues could a ride sharing app have?
Xiaomeng Lu:
It depends on how you define cybersecurity. National security is a very fluid term. I think there was a report back in 2016, 2017 where DiDi collaborated with a research center, trying to map out the daily work schedule of different ministries because their employees go to work and come back home with the ride sharing service. So, they have amounted a substantial amount of data, and then they can track the work schedules for different ministries. And find out government officials’ daily routine, which may have some national security implications
Scott Wallsten:
Oh yeah. They learned that from Uber. A couple of years ago, Uber was trying to figure out how to identify regulators when they were calling for cars.
Xiaomeng Lu:
Well, maybe Uber should be looking more closely at the security risk as well. these days, a lot of the legislators on Capitol hill say, “Oh, China did so and so. Maybe we should consider that.” Particularly on the gaming restriction side, because China put very restrictive terms out as a mandate for online gaming service providers. Minors can only play three hours of video game every week. And that’s eight to nine on Friday, Saturday, and Sunday, and US lawmakers looked at it and said, “Don’t you guys think we should do the same?”
But anyway, because Uber has over 90% of the market share in the ride share service marketin China, and the scale of their data may raise question marks on cybersecurity.
Scott Wallsten:
Wait, you mean DiDi has 90%?
Xiaomeng Lu:
Yeah. Didi has 90%. Uber has some share of DiDi, but no, Uber is not a business presence in China. Didi is Uber in China.
Sarah Oh:
Like Scott said earlier, you know, the danger of industrial policy is that governments will make wrong decisions. Like how can they know how to guide an economy from a command-and-control central place? There’s a knowledge problem. Is there a danger? I mean, obviously the Chinese government is applying kind of big government paternalistic policies to help promote its own economy and to help grow innovation and speed up the process of competition with other global players. But how does it correct on errors? Like if it’s pulling everything internally, like with a self-reliance framework, is it kind of a haphazard experimental, we’ll try this and try that approach, or is there like a long-term belief that China can be isolated and self-sufficient? Like, why would China be pulling domestic companies off of foreign stock markets? Does it believe that it can do everything internally? Capital markets, supply chain? Is this the belief that China could be self-sufficient in all aspects of the economy?
Xiaomeng Lu:
That’s a great question. I think in terms of the general approach for the major tech sector rectification campaign, President Xi’s comment in August, launched this new political campaign on common prosperity -that’s very much a populous agenda driving social welfare centric policy objectives. that theme kind of sums up the high-level political goals for the tech sector rectification movement staring late last year.
But in terms of specific tactics, I don’t think they really know how far this will go. And specifically, where should they put pressure, in how many areas. So, I think there inevitably will be some overshooting in certain aspects, and there will be things that maybe in a few years they will look back and say, we should take a step back a little, but there are also areas they’re experimenting with new regulatory approaches.
For example, there is a regulatory proposal governing algorithms used by platform companies. The proposed rule doesn’t allow firms to use it to rate a gig worker’s performance and benchmark everyone against the highest watermark, things like that. But they’re trying to take, generally speaking, the incremental approach. Maybe the education sector crackdown is an outlier to that that spirit of incrementalism, and maybe the gaming regulation went a little bit too far, but I think if you’re looking at the labor rules, the algorithm ones, the antitrust, and compare them to the EU approach, they are more targeted than the European regulators view on these issues. If you look at the Digital Market Act or Digital Service Act. They are very comprehensive frameworks that went beyond the traditional anti-monopoly legal framework, the US is currently still sticking to.
They don’t call it antitrust anymore. It’s called gatekeeper. There have very clear parameters to define who are gatekeepers. if you’re looking at that, it’s a fundamentally different approach to digital and tech market powers versus the Chinese version. Yes, Chinese government placed a $2.8 billion fine on Alibaba and then over $500 million fine on Meituan. But those are only 4% of their annual revenue, and they are mostly dealing with some of the China-unique anti-competitive practices these platforms have been employing.
for example, they force their supplier to pick themselves or their rivals. You can’t work with both, or they use AI to support a somewhat predatory pricing regime and take advantage of people who have higher budgets and give them a higher price for the same product that an average user will purchase. So things like that, I think it’s somewhat a China unique phenomenon.
And their antitrust enforcement actions are focused on that more that on how to push Alibaba completely out of this market and get a state-owned enterprise to occupy their space. That’s not their goal. In terms of the overseas stock market actions, I think that’s more geopolitically related. given the sustained US-China tech tension and the US regulator poised to delist companies in two to three years. Supposedly at the technical level, the Chinese regulator are still negotiating with officials at the SEC to figure out whether there’s some middle ground to reach the transparency requirement ofUS stock market. But the Eurasia Group’s view is that their discussion is not likely to produce a meaningful outcome in the immediate future. We don’t really see a pathway to resolve that issue. So, if this trend continues, Chinese companies will delist from the US stock markets in say two and half years anyway.
And at the same time, there are still a lot of Chinese platform companies that can’t wait to take advantage of this window before US stock market closes its door to them because they have so much pressure from their early-stage investors, to cash out. And that’s why they rush to list in the US stock market in the first half of this year and the second half of last year. Even as the window is closing, they are trying to capture that opportunity. And I think on this point, it seems like the Chinese and US government’s position are aligned.
The SEC Chairman Gerry Gensler made a video, recently saying these Chinese companies listed in the US are shell companies and investors who are buying stocks of Chinese platform companies, be aware of the significant risks. And at the same time, the Chinese government has put a very high bar for future Chinese firms to be listed in US stock markets, particularly for a platform company that manages a lot of data. It’s a very narrow channel to seek an IPO in the US at this point. On this issue the two governments are pretty aligned on their positions, ironically.
Scott Wallsten:
I mean, at a higher level, are Chinese officials surprised at the approach the Biden administration has taken? Did they expect lots of changes from the Trump administration, or are relations kind of the way everyone expected they would go under Biden?
Xiaomeng Lu:
I think they were initially a little bit surprised that Biden seems to be a more of a hardliner than the position he took on China when he was Vice-President and throughout his career. But I think just in the past couple of weeks, there’s some initial sign of a possible transition towards lowered tension in the bilateral relationship. Beijing authority definitely see this as a promising signal. You can see the state media and government officials start to take out the positive words from every major cabinet member of the US, and saying the US is sending these soft signals. If you’ll look at the Secretary of State’s statement, there are eight sentences and the seven of them are pretty hardline, but the Chinese media picked out the last line that shows a little bit of softening tones and say, “Oh, this is a good sign.”
They also saw one of the first major public appearance of USTR Kathrine Tai made in providing comments on the US trade policy position regarding China. The Chinese audience see people in the Biden administration are mostly professionals and they are rational actors and believe there will be more predictability from Biden’s side than during the Trump era.
During the Trump administration, Chinese government officials just didn’t know what they were dealing with. It’s so chaotic and there’s so much uncertainty. I think right now, the major issues between the US and China, especially trade and technology, is still very, very difficult to resolve. for major shows like cross-border data flows or cloud sector market access, they were brought up by Beijing during the phase one trade negotiation because China was under so much pressure during the tariff war, at some point they were considering making concessions.
But for those major issues, high pressure, it’s somewhat gone. It’s harder to make China concede on those issues anymore. But for smaller things like releasing the two Michaels or maybe potentially somewhat lifting the COVID travel restriction in the first half of next year or providing some tariff relief that’s also beneficial to domestic firms, I think smaller things like that may start to happen.
Scott Wallsten:
We are out of time, and I guess leaving it on a somewhat positive note is probably a good thing to do, and we’ll come back and see whether the hopefulness was justified. Xiaomeng, we really, really appreciate your time and your insights. Thank you so much for joining us.
Xiaomeng Lu:
Absolutely! It’s always a delight to connect with you and Sarah and talk about these exciting topics.
