Huawei could trigger a major crisis

October 10, 2012, 2:08 PM UTC

By Verne Kopytoff, contributor

FORTUNE — A congressional report this week recommended in no uncertain terms that U.S. companies and government agencies avoid two of China’s biggest telecommunications companies. Buying equipment from them risks national security, the report said. The House Intelligence Committee’s withering attack on the two Chinese companies, Huawei Technologies and ZTE Corp., would seem like a big opportunity for U.S. firms to gain ground. The reality for U.S. businesses, however, could be the very opposite.

In response to the congressional assault, China may throw up roadblocks against the U.S. tech imports by raising tariffs or prohibiting certain kinds of equipment, according to trade policy experts. Such a tactic would harm U.S. companies, which increasingly count on China for sales and growth. The stakes are huge. Last year, U.S. firms sold $20 billion in advanced technology to China, according to the Commerce Department. “I’m afraid that there will be some sort of retaliatory attack,” said Christopher Tang, a business professor at University of California at Los Angeles whose focus is manufacturing and China. “It’s a political game.”

The bipartisan congressional report looked exclusively at Huawei and ZTE, two global businesses that sell gear for connecting phone calls and routing Internet traffic. Investigators said that China’s government could tamper with the technology to spy and to steal trade secrets. Both companies failed to provide details about their corporate control and government ties, they said. The presence of Communist Party offices in the companies’ headquarters also raised red flags. (Note that neither is a so-called SOE, state-owned enterprise.)

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On October 10, Shen Danyang, a spokesman for China’s Commerce Ministry, responded in an article by the official Xinhua news agency that the accusations were based on “subjective guesswork” and “untrue evidence.” He said that the U.S. had violated its long-held free-market principles and risked undermining cooperation and development between the two countries. “We hope the United States can make concrete efforts to create a just and fair market environment for the two countries’ companies and promote a sound development of bilateral economic and trade ties,” Shen said.

In the short-term, Ray Mota, managing partner for ACG Research, a market research firm that tracks the technology industry, said that U.S. companies like Cisco Systems (CSCO) and Juniper Networks (JNPR) would benefit. While their Chinese rivals try to repair their reputations, U.S. companies will likely win more contracts. Longer-term, however, U.S. tech companies may be in for turbulence, Mota explained. If a trade war starts, they will likely lose business in China. “It depends on how much hardball the Chinese government wants to play,” he said. “This is something that could hurt U.S. companies.”

Richard D’Aveni, a business professor at Dartmouth College, predicted that China would indeed retaliate, but that it would wait until later rather than acting quickly. And don’t expect a big announcement because it’s not their style. “I think the Chinese will be more subtle,” said D’Aveni, who is the author of Strategic Capitalism: The New Economic Strategy for Winning the Capitalism Cold War. “The Chinese don’t usually react directly. They will strike somewhere else, or in some other way to send a signal that they are displeased.”

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Eliminating U.S. tech imports in five years, or at least some of them — without ever publicly announcing such a plan — is one way, D’Aveni said. Another is to raise the price for Chinese-made integrated circuits, on which the U.S. technology industry depends. Curiously silent on the report is the U.S. technology industry. Several industry trade groups declined to comment or failed to respond to messages seeking an interview.

Defending Huawei and ZTE risks branding U.S. tech companies as unpatriotic, D’Aveni said. Meanwhile, siding against them would antagonize their Chinese suppliers, partners and customers. “Their best move is to stay silent, but behind the scenes, lobby for supplies,” he added.

Indeed, the situation is complicated by the interdependence of both nations. Cutting off trade is nearly impossible. China needs U.S. technology to keep its infrastructure and factories operating. Meanwhile, U.S. tech manufacturers depend on Chinese components. The lines are so blurry that a product’s origin is often a matter of semantics. Apple’s (AAPL) iPhones and iPads, for example, are largely assembled in China. Similar cross-pollination is the norm for U.S. telecommunications equipment makers. Congressional investigators, however, did not look at any security risks created by such ties.

U.C.L.A. professor Tang said that politics are helping to inflame the situation. China and the U.S. are in the process of selecting new presidents. Political forces from both countries are using the trade disagreement to drum up support. “The timing is a bit awkward,” Tang said. The topic will undoubtedly come up in future trade negotiations, he explained. But there won’t be any definitive move from China until it has a new leader, who will inevitably “say there’s a conspiracy — that the U.S. is against China — and we need to do x, y and z.”