Apple Runs Afoul Of China's Changing Internet

| About: Apple Inc. (AAPL)

Summary

Apple is the victim of bad timing, not a crackdown, as China flexes its internet sovereignty.

As more and more Chinese citizens connect to the Internet and e-commerce continues its rise, Beijing is reacting to reassert control.

Apple’s image as an untouchable poster child makes the message Beijing is sending even clearer.

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Last week China shut down iTunes Movies and iBooks, shocking many investors. While Apple (NASDAQ:AAPL) has in the past managed to avoid the Beijing’s caprice, this latest development shows that Apple is not immune to the hazards of doing business in China.

While CEO Tim Cook has pledged to increase investment in China, recent events, along with slowing growth in China, come at a bad time for Apple. The company is already facing slower iPhone sales, for example. To add to Apple’s woes, the service shutdown came just a few days before the company released its Q2 earnings. Last week, Apple stock was heading towards $108, until news from China saw it hit a low of $104.72, before closing the week at $105.68. This was a largest share price drop since January.

Stability is king

As more and more Chinese citizens connect to the Internet and e-commerce continues its rise, Beijing is reacting to reassert control. China has created the world’s largest and most sophisticated digital censorship system, colloquially named the ‘Great Firewall of China.’ While this system does an effective job of preventing blacklisted content entering China, Beijing has come to realize that it also needs a firm hand on the hardware which enables access in the first place.

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In 2013, Edward Snowden scared Beijing into further insulating its netizens and digital sphere from the larger world internet. By the following year China’s top leadership, notably Xi Jinping, began pushing the term ‘internet sovereignty’ – an idea that encompasses a self-contained digital landscape for China. Specifically, this means the promotion of Chinese alternatives to globalized services such as Facebook (NASDAQ:FB) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL), as well as housing Chinese data on Chinese servers.

Since the Snowden revelations, China has identified eight American companies which it considers too deeply entrenched in the military-industrial-security complex to operate freely. These companies, which include the likes of IBM (NYSE:IBM), Microsoft (NASDAQ:MSFT), Qualcomm (NASDAQ:QCOM), and Cisco (NASDAQ:CSCO), have seen investigations, fines, and raids on their Chinese operations. Moreover, Beijing has forced them to sell off holdings and work with local partners in order to expand their businesses in China.

Apple has been able to survive and grow in China because it has met Chinese requirements, including partnering with China Mobile, the country’s largest service provider, in 2013 to sell its iPhones.

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Similarly, Apple partnered with Union Pay, China’s state-backed bank card provider to launch Apple Pay. Partnering with Apple allowed greater state influence in a sector that was being dominated by Alibaba and other homegrown companies. Interestingly, in 2013 Beijing asked Apple for its source codes in order to improve security – Apple refused, and was allowed to continue operating.

China’s homegrown Internet

In the last 18 months, China’s leadership has increasingly promoted internet sovereignty, with Xi Jinping leading a committee streamlining China’s technology and internet policy. One element of this effort is the promotion of Chinese firms over foreign rivals. Beijing is aware that while e-commerce and tech spending is shifting the country in the desired direction (i.e. towards a consumption based model), the government cannot tolerate a situation in which it is vulnerable to backdoors in foreign tech.

Apple is currently the third largest phone manufacturer in China, controlling some 12.5% of the market. China is seeking to promote domestic firms such as Huawei and Xiaomi, each with around 15% of the market.

One can see the tide turning, when in 2015, Qualcomm, the world’s largest semiconductor manufacturer paid a $975 million fine in an anti-trust lawsuit, which also saw the company pledge to sell goods to Chinese companies at lower prices. Using the spectre of security, Beijing is bolstering domestic firms in order to retain control.

In the case of Apple, one can see parallels with the problems faced by Uber (Private:UBER) in 2015, when its offices in China were raided. Uber had incited mass taxi protests, thus unwittingly brushing up against China’s national stability framework. Uber’s disruptive power outweighed its economic benefits, especially as it would directly compete against state regulated transport firms enjoying massive market share.

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Apple has also run afoul of China’s domestic security apparatus, as the company did not adequately prepare for new regulations released in March. These rules forbid foreign ownership of online publishing services, and mandate that all content shown to Chinese netizens be hosted on Chinese servers. Apple is the victim of bad timing, not a crackdown.

Six months ago Apple was in the clear, having received permission to launch iTunes Movies and iBooks, yet given that China is not overly forthcoming regarding policy changes, Apple has since paid the price. Gartner analyst Brian Blau explains that “there is a bit of a cat-and-mouse game between the tech and content providers and what’s acceptable and not acceptable in China.”

The regulations came into effect in March, yet Apple services were only interrupted a month later, ample time in Beijing’s eyes for Apple to have adjusted to the new rules. By disabling Apple’s services, Beijing can demonstrate that it is serious about the direction it is taking the country in.

Furthermore, Apple’s image as an untouchable poster child makes the message Beijing is sending even clearer, while not overly affecting Apple’s operations, which can rely on its brand, hardware, and iOS ecosystem to continue to attract customers in the short-term. Lastly, Beijing is able to deflect any fallout towards Apple, as annoyed customers choke customer service lines. Plus, if angry customers switch to Chinese companies, it is no skin off Beijing’s back – indeed iTunes Movies and iBooks compete with similar Chinese services.

The aforementioned month’s interlude portrays the government as merely implementing the law, acting as defender of Chinese law against noncompliant Westerners.

Apple a victim of external events

Apple has also been hit by the fallout of international events. Firstly, the Panama Papers have brought high-ranking Chinese leaders and their families into the spotlight, thus highlighting the dangers of storing Chinese data overseas. This likely further galvanized the government to push forward with its new internet regulations.

Secondly, China is keenly aware of the recent efforts by the FBI to hack iPhones belonging to the San Bernardino attackers. The eventual success of this effort unfortunately puts the spotlight on smart phones and Apple, in particular. Recall Apple’s 2013 refusal to share code with China: after San Bernardino and Apple’s service shutdown, the company is less able to refuse Beijing. This is especially true given that Chinese lawyers are pointing out that Chinese law requires companies to help with decryption when police or state security agents demand it for investigating or preventing terrorist acts.

Given that espousing a range of views counter to Beijing’s talking points – from religion, territorial integrity, and governance, – constitutes terrorism in the eyes of the CCP, Apple faces a difficult situation.

If Beijing can domesticate China’s entire digital ecosystem – from hardware to software to services – it will wield immense control. Ruffling the feathers of the likes of Apple is a small price to pay, as China can leverage its economic clout to ensure it does not lose investor confidence.