Almost everybody in the modern world has heard about the Huawei scandal and the ban of their products first in the US an then in other countries belonging or linked to the western civilization. Many assume right away that it is part of the political games between higher political elite across nations and the commercial lobbies as the future implementation of the 5G networks is a central topic, because the Chinese tech giant is a main player in the field.
The long lasting division between the East and the West has been exploited heavily again. However, there are several issues, which make this topic very interesting and show that it deserves far more attention than a regular scandal reaching the height of diplomatic response on both sides.
Firstly, it comes as a consequence of series of security scandals related to Chinese produced networking equipment.
Secondly, it is not all of the Chinese producers that are affected by the ban – it is primarily Huawei and ZTE, while players such as Xiaomi and most of the 28 large manufacturers are allowed for commercial use among civilians in western markets.
Thirdly, the big elephant in the room when the East-West confrontation is brought up, Russia, has been eerily silent in all this, possibly indicating that we are not anymore in a simple 2 sides world model, but in a system with more complex dynamics.
In late July 2020, a report by Canalys, a 40 man IT market research firm with heavy focus on Asia, pointed out that Q2 2020 was an important milestone because there was another world leader in the market for smartphones. The Chinese giant Huawei had overtaken Samsung as the worlds largest smartphone seller as the smartphones they had shipped were 55.8 million, while the Korean conglomerate had sent 53.7 million from the factories to the distributors.
Reading this lightly, one might say that this is a remarkable market success story for entrepreneurship and corporate governance and give them big kudos for finding ways to overwhelm political decisions by world leaders which are limiting their reach. However, examining the strategy and the events that lead Huawei to this point, draws a far darker picture and that the political actions against them should have happened long time ago and possibly with a greater severity.
The year is 1994. Huawei is already one of the important tech producers in the Chinese economy. Founder and CEO Ren Zhengfei meets with Jiang Zemin, the Secretary General of the Communist Party and Chinese President at the time.
In the dialogue between the two, Ren states “that switching equipment technology is related to national security, and that a nation that does not have its own switching equipment is like one that lacks its own military”. As per Ren’s recollection, Jiang replied: “Well said.”. It should be noted that this is something that Ren stated himself.
This is far more important than a regular meeting with few words exchanged out of courtesy and dry etiquette. We can argue about the extent of knowledge that was behind this exchange, but there are two aspects, which are undeniable. Firstly, it indicates that Ren was aware of the strategically important way for his country and that Huawei had the capabilities to help. Secondly, Jiang Zemin’s agreement shows that this is no news to him, but rather acknowledging that Huawei knew that they would be the vehicle for that.
In other words, it was clear to all stakeholders in 1994 that Huawei was part of a strategy plan, which was central to the Chinese foreign and domestic policy crafted by the Chinese Communist Party. Which means that the plan must have been designed long time before that.
Understanding the Chinese government point of view at the time, however, is very important as well. These were the initial years of development of the internet and many of the functionalities we are so used to today were simply science fiction. The Chinese government understood the paramount importance for the future of the internet and wanted to be a key player in it. Because of that, the support was not targeted at Huawei only. It was part of a bigger strategy to develop an entire telecommunications industry which would sustain internal and external shocks and would generate the necessary R&D that would push it forward.
They knew what they had to achieve, but did not know how to do it. The different models of strategy and organisation testify for that. There were number of companies besides Huawei and various approaches were used. As it turned out, the model “state owned, privately manged” proved to be the most successful and it created leading international technological giants such as Huawei and Zhongxing Telecommunications Equipment Group (ZTE), while companies relying on government management and planning, such as Great Dragon, remained mediocre regional players.
Besides management differences, there were also differences in the way the companies were funded in those initial years. Huawei, a private company, relied heavily on government sanctioned loans, while ZTE, a state owned company, relied on the stock market in Shenzhen to be listed in 1997 to draw the necessary funds.
It is clear, that the Chinese government wanted to try every possible way to ensure future success, but it is also ironic that a communist party would rely on capitalist approaches to ensure the success of its goals. This is a further testament for the ineffectiveness of the communist ideology and one might argue that the highly praised communist ideals are used solely for internal propaganda of such regimes, while only capitalist approaches seem to work in real life.
Huawei’s heavy links with the state are nothing new and are shown in every step. Its founder Ren Zhengfei left the job as the Deputy Regimental Chief of engineering corps at the PLA directly associated with computer networks to find Huawei Technologies. The initial funding is blurry even to this day. However, it is more interesting what follows next. The first major successful switch model was produced in 1993 and Huawei got the contract to supply the first national telecommunications network of the PLA, which was considered a ground breaking step for establishing the company as a key player.
Only 5 years later, in 1998, the China Construction Bank, a bank directly controlled by the state and existing primarily to lend to projects with national importance, lent Huawei 3.9 Billion RMB, the equivalent of roughly 0.5 Billion USD, which also represented about 45% of the total credit that the bank extended that year. This fact alone testifies for the enormous importance of this client to the bank and, in turn, to the state.
Anyone with experience in lending to large corporates is aware that there is no chance that a normally operational bank, driven by market forces, will lend to a single entity half of what it lends per year. This quantity is unacceptably high because it constitutes enormous risk should there be future problems with repayment.
Even if there is no moral hazard and asymmetric information between borrower’s management and the lending bank, something which is impossible if the borrower and the bank are unrelated entities, there are numerous reasons why default risk is positive and increases with the borrowing time – market conditions affecting revenues, possible liquidity issues due to not optimal receivables and payables management, management changes due to various reasons, including unpredictable health complications and so on.
These factors are exactly the reason why default rates of corporations increase over years and if that is true for the thousands of companies that the major rating agencies, such as Moody’s, S&P and Fitch rate, then it is true for Huawei as well.
In these initial years of Huawei there were many eyebrow raising lending cases like that. Some of them are said to be a compensation for non payments by government affiliated entities, who purchased network equipment and delayed payments for whatever reason, often purely bureaucratic. In the same time, the international expansion was often fueled by undercutting competitors by as much as 30%.
If we assume Huawei’s prices were equal to the lowest in these markets, then the cut of 30% below the competitors was a very serious cut. If Huawei’s prices were higher, then the cut necessary to reach that 30% below threshold level would be even more serious. In order to illustrate what that means, we can look at the financial statements of the company. They operated in 2019 at a 5.6% net margin. Over the years, even back then around the time of those financings, they have operated in the 5.5-6% net margin range, indicating that such prices would require giving up profit for periods of at least 5 years.
Network equipment, however, has a certain life span of its own and keeping standards high, i.e. having uptime of 99.999% (ca. 20 min downtime per year allowed), the average lifespan would have to be between 3 and 5 yrs, roughly indicating that an entire batch of the same gear would have to be ordered again before Huawei would start making any profit.
This whole situation, which must have been analysed by the bank employees, leaves us with only 2 options since the bank is owned by the state – they either did not care if the loan was repaid, which is absurd for half a billion dollars, or were so interested in making sure Huawei had the potential to achieve their goals, that they were ready to lose the money and put the existence of the bank at risk and finance that loss through the taxpayers (considering government view). And their gamble paid off in the long run because the state also provided the market for Huawei – multitude of state contracts to supply the networks in regional governments and state run entities.
Anyway Huawei is analysed, it comes across as a very important state project even though it is in private hands. Every step of its creation and development over the years suggests that it works not only in compliance with state directive, which is something everyone would expect, but is, in fact, the very tool, through which this state strategy is implemented. Because of this, the trade limitations imposed on it are not limitations on a private company, but rather limitations on the reach of a government with objectives which are far more different than those of the governments of the destination markets.
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Fung, Brian (10 April 2019). “How China’s Huawei took the lead over U.S. companies in 5G technology”. The Washington Post.