China’s Attempt to Avoid the American Tech Monopoly Trap David Goldman
https://americanaffairsjournal.org/2021/05/chinas-attempt-to-avoid-the-american-tech-monopoly-trap/
One of the great paradoxes of recent economic history is how little the information technology sector has contributed to overall productivity. Economist Raicho Bojilov examined total factor productivity across the major industrial economies from the 1970s to the present and observed:
Somewhat surprisingly, we do not witness, even with a lag, a major pickup in the productivity growth in other industries that are directly and indirectly connected to the IT industry. One would expect that if the IT industry were the engine of the US economy that generates the products, technologies, and techniques of the future, then the other industries would eventually experience a jump in productivity rates to levels comparable to those of the IT industry. Thus, one may wonder why aggregate productivity in the US has not grown much more in accordance with the innovations and major productivity gains that have been achieved in the IT industry.1
Bojilov adds that “the annual rates of indigenous innovation in the US and the UK have made only a partial recovery during the IT revolution: while higher than the rates for the period 1970–1990, they are still lower relative to the rates witnessed in the postwar years until the late 1960s.”
Why have IT improvements failed to radiate through the broader economy? There are many possible explanations, but the transformation of once-disruptive tech companies into rent-seeking monopolies is surely an important one. The monopolization of information technology arises from the nature of the technology itself: so-called network effects make it convenient to have one venue on which to post political comments and cat pictures, one provider of office software that everyone uses, one giant internet retail marketplace, and so forth. But the fact that technological monopolies have their origin in network effects rather than in the nefarious manipulation of markets does not eliminate the potential for abuse.
Stagnating productivity worries Chinese planners at least as much as it does Western economists. China has by far the highest savings rate among the world’s large economies and an investment-to-GDP ratio of 43 percent (compared to about 20 percent in the United States). The productivity of capital investment, however, has stagnated, in part because China has maintained high rates of investment in older production facilities. Increasing productivity growth is, therefore, critical to China’s economic performance, especially as the movement of people from countryside to city tapers off and the workforce ages. To meet its economic goals, China needs its investments in IT—especially mobile broadband and artificial intelligence—to stimulate overall productivity.
Moreover, in China as in the United States, the top tech companies have a gigantic stock market footprint. Alibaba and Tencent, China’s two largest public tech companies, are not members of the Shanghai Composite Index; if they were, their combined $1.3 trillion market capitalization would make up 16 percent of the broad index. In the United States, as of February 2021, 23 percent of the S&P 500’s value belonged to Apple, Microsoft, Amazon, Tesla, Facebook, and Google, an unprecedented level of market concentration.
These are some of the motivations behind the antitrust measures that Beijing announced last year targeting its internet giants. American and Chinese regulators face similar issues, but China seems more serious about taking decisive action than its Western counterparts, and appears to be focusing on the monopoly problem in particular. The opening salvo of the Chinese government’s efforts to curtail tech monopolies came on November 3, 2020, when the Shanghai and Hong Kong Stock Exchange suspended the initial public offering of Ant Financial, which would have been the largest in history at around $240 billion. In subsequent actions, Chinese regulators warned the country’s internet giants that they could not maintain a monopolistic hold on the mass of personal data that drives their businesses and stifles competition from new market entrants, and proposed new regulations to prevent monopoly control of data. These measures have often been portrayed in Western media as old-fashioned Communist Party crackdowns on free enterprise, but they are in fact efforts to avoid the IT sector concentration problems that continue to plague the United States.
Innovation or Cannibalization?
Many conjectures have been offered to explain lagging U.S. (and Western) productivity despite the enormous improvement in IT. One is that the IT industry grew at the expense of traditional retail and advertising businesses. The ratio of U.S. advertising spending to GDP has remained constant or even declined during the past twenty years, despite an enormous shift toward internet advertising at the expense of traditional media.2 Similarly, the rise of internet retailing did not cause U.S. consumers to spend more than they otherwise might have, but only shifted sales away from brick-and-mortar retailers to online enterprises.
Another view holds that the exercise of monopoly powers by large internet companies has reduced profitability in other sectors of the economy, and therefore drained capital from other industries that might benefit from innovation. In other words, the sector of the U.S. economy that appears to be most innovative, namely IT, in reality is restraining innovation throughout the economy.
That was the conclusion of a 2020 report by the U.S. Congressional Subcommittee on Antitrust:
To put it simply, companies that once were scrappy, underdog startups that challenged the status quo have become the kinds of monopolies we last saw in the era of oil barons and railroad tycoons. Although these firms have delivered clear benefits to society, the dominance of Amazon, Apple, Facebook, and Google has come at a price. These firms typically run the marketplace while also competing in it—a position that enables them to write one set of rules for others, while they play by another, or to engage in a form of their own private quasi regulation that is unaccountable to anyone but themselves. The effects of this significant and durable market power are costly…. these firms wield their dominance in ways that erode entrepreneurship, degrade Americans’ privacy online, and undermine the vibrancy of the free and diverse press. The result is less innovation, fewer choices for consumers, and a weakened democracy.3
The same House subcommittee observed
a sharp decline in new business formation as well as early-stage startup funding. The number of new technology firms in the digital economy has declined, while the entrepreneurship rate—the share of startups and young firms in the industry as a whole—has also fallen significantly in this market. Unsurprisingly, there has also been a sharp reduction in early-stage funding for technology startups. The rates of entrepreneurship and job creation have also declined over this period. The entrepreneurship rate—defined as the “share of startups and young firms” in the industry as a whole—fell from 60% in 1982 to a low of 38% as of 2011.4
Moreover, “the ability of a dominant firm to extract economic concessions from smaller companies that rely on it to reach the market can also depress innovation, by extorting monopoly rents that reduce the profits of firms that are dependent on the monopolies.”5
Twenty-five years ago, America’s tech companies took risks and disrupted established business models. Today, they are the new utilities, earning monopoly rents by controlling markets. Microsoft chased its challengers out of personal computer software; Amazon crushed most of its internet retailing rivals; Apple created a duopoly of hardware and services with its rival Samsung; Google destroyed the commercial prospects of competing search engines; and Facebook, through targeted investments and acquisitions, dominates social media.
A Cautionary Tale
America’s experience with tech monopolies offers a glaring example of what other countries should not do. The weight of the big tech companies in capital markets is overwhelming. In 2010, the five biggest tech companies accounted for just 11 percent of the market capitalization of the S&P 500; by September 2020, their share of the index had doubled to 22 percent. Just ten companies in the S&P 500 hold two-fifths of all the cash balances of index members, and all but one is a tech giant.
Twenty years ago, the risk that investors assigned to the tech-dominated nasdaq index was double that of the overall S&P 500 index, as measured by the implied volatility of index options. At that time, the tech sector was still innovative because it still took risks, and the options market provides a fair gauge of perceived risk. By the late 2010s, however, the volatility of the nasdaq and the S&P 500 converged—which is no surprise, given that the big tech companies accounted for most of the growth in S&P 500 market capitalization.
The cash flows of the big tech companies are so predictable that they trade the way utilities used to. After U.S. interest rates fell sharply with the coronavirus recession last year, tech company stocks rose in lockstep with falling bond yields. That’s what gas and electric utilities used to do. The stocks of regulated utilities were the equity market’s closest equivalent to a bond. In 2020, however, the market treated the big tech companies like utilities. The chart below shows the straight-line relationship between real yields (the yields on Treasury Inflation-Protected Securities) and the tech-heavy nasdaq index (the r-squared of regression is 70 percent for nasdaq versus 55 percent for the S&P 500).
The top three cash holders in the S&P—Microsoft, Apple, and Google—hold a fifth of all the cash held by index companies. Apple is so cash-rich that it has bought back $327 billion of its stock since 2012. That explains why its stock price has risen by 82 percent in the past six years even though its operating income has barely changed. So much capital is concentrated in so few hands that the management decisions of a dozen companies set the tone for the whole economy. Indeed, the United States has lost most of its high-tech manufacturing industry because the tech monopolies decided that their cash was better put to use buying back their own stock than investing in stateside production facilities.
Apple alone bought back $73 billion of its outstanding stock in 2018 and another $67 billion in 2019. By contrast, it spent only $18 billion in capital expenditures and $30 billion in R&D during those two years, versus $168 billion on buybacks and dividends. Apple believes that its stock price will rise faster by levering up the cash flows on existing products than it would by investing in new products.
Earlier in 2020, Trump administration officials approached Cisco Systems and suggested that the former top manufacturer of internet routers buy one of Huawei’s competitors like Ericsson or Nokia, in order to outflank the Chinese market leader. They were told that the company “wasn’t interested in buying into low-margin businesses,” the Wall Street Journal reported.6 Cisco reported a 30 percent return on equity in 2019, compared to a 2.6 percent return on equity for Ericsson. America doesn’t produce any telecommunications equipment because its tech companies are reluctant to invest in anything but software (aside from share buybacks). Software profitability and return on equity metrics always outperform hardware manufacturing because the marginal cost of adding a software customer is zero; not so the marginal cost of producing a 5G base station.
Asian countries (including China) subsidize capital-intensive manufacturing, while America does not, so the reluctance of American tech companies to commit capital to manufacturing in the face of Asian competition is understandable. But that does not change the fact that America is behind the curve in the Fourth Industrial Revolution, and in some respects not even on the curve to begin with. It barely has begun to build out its 5G network. As of April 2021, only ten thousand base stations were installed in the United States, versus seven hundred thousand in China. Likewise, China’s newly constructed cities, with their broad internal highways, are well-suited for autonomous vehicles, while America’s crumbling urban infrastructure makes self-driving cars impractical in most parts of the country. America still struggles with telemedicine as well, in part because of legal barriers to the digitization of patient records (though blockchain technology could help solve the problem).
China Cracks Down on Tech Monopolies
The problems posed by the current shape of the American tech sector have not gone unnoticed in China. Western media portrayed the postponement of Ant Financial’s public offering as a political clash between the Communist Party and entrepreneurial champions of the free market, but this version of events is misleading, even if politics is always involved at some level. In fact, China’s regulators had legitimate cause for concern about excess leverage and abuse of consumer data at Ant Financial, and the issue appears to have been resolved through Ant’s proposed transformation into a regulated bank holding company.
Following the Ant Financial suspension, other measures followed in quick succession. On December 14, 2020, China’s State Administration for Market Regulation announced fines for each of the three largest internet marketing platforms, citing unapproved acquisitions of smaller competitors. Alibaba Group, Tencent, and SF Holdings were singled out for what the regulator called “monopolistic corporate behavior,” and the fines were levied “to protect consumer interests.”
On January 14, 2021, Zhang Gong, the head of the State Administration for Market Regulation, said that “enhancing anti-monopoly rules remains a top priority in 2021, and that the regulator “will closely monitor new trends and new issues, blocking companies from using their advantages in data, technology and capital to disrupt fair competition,” Caixin Global reported.7
Asia Times reporter Frank Chen summarized the new Chinese approach as follows:
In a hint of more monopoly-busting measures against a few “oligarchic firms and their platforms,” the State Council’s State Administration for Market Regulation published . . . a consultation paper on new anti-trust measures and penalties for internet platform operators. . . .
An internal memo . . . noted that these Internet companies and their platforms enjoying a stranglehold on the market had shown “obvious inclination” to abuse their dominance over transaction rules, algorithms and data and traffic to curtail deals with certain customers, turf out smaller rivals and newcomers and therefore limit competition. . . .
To rein in . . . “untrammeled and unchecked profit-making” by Alibaba following Ma’s controversial speech in Shanghai, the consultation paper has proposed legislation on digital resources property, stressing that data and traffic generated during online transactions are both proprietary and public.
The first major regulatory step that China has taken to limit the power of big tech is a new set of regulations proposed by the Peoples Bank of China to establish oversight of the aggregation of personal and corporate credit data. If artificial intelligence is the engine of the Fourth Industrial Revolution, data is its fuel. Consumer financial data is one of the most valuable commodities in the emerging world of AI-based fintech, and one of the most vulnerable to abuse.
In January 2021, the PBOC released a draft of the proposed rules based on November 2020 guidance from the State Council. In a January 13, 2021, statement accompanying the draft, the PBOC said, “The credit reporting industry has been growing rapidly and has entered the digital era, with new types of businesses emerging. However, the lack of clear regulations has led to problems such as ambiguous credit reporting boundaries and inadequate measures to protect the rights and interests of those whose data are being collected.” Individuals and corporations “must be guaranteed their legitimate rights and interests which include the right to know, consent, withhold consent, and complain,” the explanation said. “[We must] prevent the abuse of personal and corporate credit information, safeguard the security of credit information, and prevent data leakage.”
According to Caixin Global, “The updated rules give a clearer definition of credit information and mention specific data categories including what’s known as alternative data, such as telecommunications records, to reflect the changes in the sources and methods used for personal data collection.”8
As the demand for data has grown, cases of illegal data collection and security breaches have also soared. The Chinese Consumers Association (CCA), a quasi-governmental body, attacked the big internet retailers for allegedly bullying consumers through sophisticated algorithms. According to Nikkei Asia, “Among the grievances listed by the CCA are complex sales promotions that obscure the true costs of a product, targeted search results that create information asymmetry, and the practice of hiding negative reviews, which it says leaves consumers ‘squeezed by algorithms and the targets of technological bullying.’” The CCA has been particularly concerned with the practice of “algorithmic price discrimination,” through which the “personal data of an online shopper is used to calculate different prices for different individuals based on what they might be willing to pay.” The CCA proposed a government investigation of these “unfair algorithms,” and demanded that the big tech retailers turn their propriety algorithms over to regulators.9
China’s Alternative Vision
These policies arise out of China’s fundamentally different vision for its technological future. In contrast to America’s bet on entrenched monopolies with inflated stock prices, China is betting on innovation.
China’s government is already holding competitions for the best 5G applications, inviting entrepreneurs to find ways of harvesting the potential of ultra-fast, low-latency broadband. China views 5G not as a consumer technology but rather as the launching pad for the Fourth Industrial Revolution, as I reported in my 2020 book You Will Be Assimilated: China’s Plan to Sino-Form the World.10 China’s tech giants, including Alibaba, Huawei, and Tencent, will have to do a great deal of the heavy lifting, providing the artificial intelligence (AI) engines, data collection capacity, and cloud computing to make this possible.
China has already installed seven hundred thousand 5G base stations—more than the rest of the world combined—but plans to wire the whole country with ten million base stations at a cost of $280 billion. The chief technology officer of Hong Kong’s leading mobile broadband provider PCCW, Paul Berriman, told an Asia Times webinar that the broader benefits of the new technology require the full build-out of the network.11 That means PCCW will expand the present four million broadband connections to forty million. Most of these will be Internet of Things connections, rather than individual smartphone accounts. This is what will make possible autonomous vehicles, augmented reality classrooms, telemedicine, smart cities, and a host of other applications.
With its enormous national commitment to 5G, China’s government believes that if you build it, they will come—but not if they face a minefield of monopolistic barriers. China’s government also recognizes the importance of managing the risk that China’s internet giants might abuse their control of data to shut new entrants out of the market. China’s 5G network will reach a critical mass of installations by 2022, and its regulators want to ensure that new market entrants have access to the resources they need to turn potential into productivity.
The United States should have done the same thing a decade ago. By allowing its tech companies to turn into monopolistic, unregulated utilities, it has high stock prices—for a handful of stocks—and low productivity. U.S. tech companies still innovate, but only where it suits them. Their monopolies for the most part arise from the logic of the marketplace, rather than nefarious practices, but still do damage, and not only in terms of economics. Facebook and Google capture 70 percent of all digital advertising revenue, for example, crippling America’s independent media, which can’t compete for ad revenue. This in turn strengthens platforms that are increasingly controlling and limiting political speech.
Risk Management
Financial innovation is a parallel concern. The United States has been the world’s center of financial experimentation, starting with mortgage derivatives in the 1990s and credit derivatives in the 2000s. Wall Street learned to repackage home mortgages into complex securities and sell them at a substantial markup. When the Federal Reserve raised interest rates in 1994 and again in 1998, buyers of these securities realized too late that they owned levered exposure to interest rates. In the 2000s, Wall Street sold derivatives based on low-quality home mortgages as well as corporate debt, and the collapse of this market brought on the Global Financial Crisis of 2008.
These market crashes were occasioned by sophisticated risk models produced by the smartest quantitative analysts that Wall Street could hire. Some of the risk models accurately warned of impending trouble, but bank management ignored them in favor of keeping the game of musical chairs going.12
China’s current vice president, Wang Qishan, was the official responsible for mopping up the mess in 2008, and therefore understands the risks inherent in financial innovation. He warned at the Shanghai Bund Summit in October 2020 that China intended to reduce financial risk. Beijing doesn’t want financial innovation to produce the sort of disasters that it has brought to the United States.
Jack Ma’s Ant Financial borrows from state banks and relends to consumers (a $250 billion book) and small businesses ($58 billion outstanding). Ant claims that its artificial intelligence analysis of credit quality justifies its privileged position as an intermediary. But other AI practitioners in China’s fintech community think that Ant Financial’s claims are exaggerated, and that its loan book is riskier than it admits.
Traditional financial institutions in China are subject to tight regulations on capital and leverage based on the Basel Accords to prevent financial risks. But fintech companies have claimed they are technology platforms, not financial institutions, and for a variety of reasons, including government policy to encourage their expansion, previously enjoyed looser oversight in terms of their finance-related business.
Online lending has become a major income generator for Ant Group, contributing nearly 40 precent of its total revenue in the first half of 2020, according to its prospectus. Over the past few years, its two microlending platforms, Huabei and Jiebei, have expanded rapidly by increasing on- and off-balance sheet leverage and by issuing joint loans. Liang Fengjie, a banking analyst at brokerage Zheshang Securities Co. Ltd., said Ant Group’s leverage is forty-eight times, which means for every yuan of its own capital, it has taken on forty-eight yuan of debt. Ji Shaofeng, the founder of IT startup Jiangsu Wufeng Information Technology Co. Ltd., who spent sixteen years working in various roles for financial regulators, calculated that Ant’s overall leverage has actually surpassed sixty times.13
The last-minute decision by China’s regulators to postpone the IPO looked clumsy. It suggests that the regulators aren’t yet ready for prime time (although they have a great deal of company: U.S. regulators ignored the risks of credit derivatives completely in the approach to the 2008 crash, and refused to believe what was happening until the crash was already underway). But Chinese regulators now seem to have resolved the issue. According to news reports in early February 2020, Ant Financial had reached an agreement with regulators to reconfigure itself as a bank holding company. Its postponed initial public offering reportedly will proceed sometime in the next two years.
The use of fintech to mask excessive leverage was the regulators’ immediate concern, but the Chinese government is also concerned about monopoly advantages of businesses that control large amounts of consumer data. “Compared with antitrust regulation of traditional industries, oversight of big tech companies reflects regulators’ deep concerns over their control of data and information flows, analysts said. Tech giants can use big data technology and algorithms to influence information available to the public and leverage their access to personal data for profit,” Caixin Global reported.14
The Risks of Inaction
The Chinese government has no intention of suppressing the country’s most successful technology companies. The measures it has taken to suppress leverage, retailing monopolies, and data abuse are rather intended to prevent companies that were successful in the past from suppressing new market entrants in the present. China has little experience with antitrust regulation, to be sure, and the regulators will have a steep learning curve.
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