Welcome to the Splinternet: What it means for investors

Remember the World Wide Web? It’s over. The global internet is fracturing along the major geopolitical fault lines. Quite soon there will be numerous mutually inaccessible internets. One will be controlled by the USA and another by China. A third will be policed by the EU. Then there will be the smaller onion rings beyond, controlled by states and pirates. The way in which we interact online and acquire information will be very different from now in ten- or fifteen-years’ time. Many of us are going to find this irksome. But we had better prepare for the splinternet – because it’s coming.

The new tech cold war

In 1957 the launch of the first Sputnik by the Soviet Union alarmed the USA. Washington realised it was losing the Cold War tech war. America responded and even landed the first men on the moon in 1969 – something the Soviets never achieved. Now, there is a similar challenge. The rise of Huawei and its advantage in 5G telecommunications technology that became clear in 2019 has had a similar impact. America – and its allies – risks falling behind in the technology war. But America still has a few aces up its sleeve.

An increasingly assertive Beijing is using telecommunications technology to build a strategic advantage over its adversary – America, and all who sail in her. The Chinese claim that Huawei is an entirely independent entity which operates beyond the reach of the Communist Party of China (CPC). But it was founded, and is still steered, by a man with a past in Chinese military intelligence.

Deng Xiaoping (the de facto leader of the People’s Republic of China, 1981-89) counselled that China should bide its time and not rock the international boat. But under President Xi Jinping China has become not just assertive but even belligerent with military incursions in the South China Sea, the Sea of Japan and even in the Himalaya. China’s case under President Xi (who is now in all but name president-for-life) is that the US ascendancy is fundamentally unfair, and that the global states system since 1945 has been fashioned in America’s image. What China wants is nothing more that a total re-structuring of the geopolitical architecture – no doubt with China on top. Mr Putin in Russia desires something similar.

China’s first objective is to grow its economy so as to challenge the economic pre-eminence of the United States. It is the second largest economy in the world – though still some way behind America. A second means to their goal is to undermine US Dollar-dominance – something which I have discussed elsewhere. A third and equally important goal is to attain a crushing technological advantage such that most nations will have to communicate and interact using Chinese-controlled technology.

China has hugely expanded its sphere of influence over the last 10-15 years or so by virtue of its Belt and Road Initiative, by means of which it undertakes massive infrastructure projects in developing countries on favourable terms, often using imported Chinese labour – but in return for certain commercial privileges. Notoriously, China never questions the human rights or democratic credentials of its client states – it leaves the ruling cadres be (and is said to cross their palms). This is in contrast to the moralistic West, which chides dictators for their heinous lapses (and then usually does business with them through the back door anyway).

So much is evident. But what is even more worrying from the point of view of America and its allies is that China is using nefarious methods to steal secrets from its rivals. Chinese state-sponsored cyber-hacking has become one of the most grievous concerns for Western intelligence. Tom Tugendhat MP, the Chairman of the Foreign Affairs Select Committee, has spoken in the House of Commons about verified hacks against UK engineering companies.

Mr Tugendhat is also concerned about the unchallenged acquisition of British tech companies by questionable offshore entities. For example, this year Hertfordshire-based Imagination Technologies, which manufactures chips for smartphones, was purchased by a Cayman Islands-based private equity firm called Canyon Bridge Partners. On closer inspection Canyon Bridge turned out to be a Chinese player (its website now confirms that it is headquartered in Beijing). In fact, according to the BBC’s Gordon Corera[i], Canyon Bridge seems to be a front for a state-backed group called China Reform. Canyon Bridge tried to change the management of Imagination Technologies on the day that the Prime Minister was hospitalised.

But the acquisition of Imagination Technologies was perfectly legal – and no doubt many would claim that American companies buy out technology superstars all the time – look at Google’s acquisition of UK AI champion DeepMind Technologies in 2014. Or indeed, consider Softbank Group’s (TYO:9984) acquisition of ARM in 2016.

What is new now is the suspicion that in certain technology domains Chinese firms are equal or even superior to their Western counterparts. How come the US does not have a single company producing 5G-compatible components even though much of Silicon Valley’s internet technology came out of research by DARPA, a US government agency? But, these days, US government funded scientific research accounts for much less as a percentage of GDP than what it was in the year of Sputnik.

Digital fracturing

In 2018 Professor Dame Wendy Hall, a computer scientist at the University of Southampton proposed, with Professor Kieron O’Hara, that there were now four diverging internets in the world. There was Silicon Valley’s utopian open internet; and there was Washington DC’s commercial internet. Then there was the EU’s Brussels Bourgeois Internet. And, finally, casting a long shadow, there was China’s paternal internet.

Who was driving this? Of course, we have known about the Great Firewall of China for a long time. Though, since Beijing’s notorious National Security Law was enacted in June, the Great Firewall now encircles Hong Kong. This was the CPC’s response to global transparency – to protect Chinese citizens from unwelcome ideas. Then there was Russia’s attempt to build a sovereign parallel network – again to maintain control over what its citizens accessed online. But a third driver has been President Trump’s intent to cut rival powers (i.e. China) out of the open internetbecause of fears about data privacy. Essentially, America fears that personal data, even from seemingly innocuous sources such as TikTok – a cult video-sharing platform for pre-teens and others – can be mined in sinister ways. Children, when online, can reveal highly sensitive data about their parents.

Only eight years ago Western politicians, exemplified by Barak Obama, lauded the internet as the inevitable scourge of dictators. The transparency facilitated by a free and open internet, they argued, would open up closed societies for the better. But in 2013, the traitor (or whistle-blower – depending on your point of view) Edward Snowden revealed that the US government itself was using the US-dominated internet to collect masses of intelligence for the CIA and other US agencies. Of course, other countries were also collecting data in their own jurisdictions: but not on the global scale of the CIA.

The Arab Spring of early 2011, which brought down, amongst others, Libya’s Muamar Ghaddafi and Egypt’s Hosni Mubarak, and which lit the flame of the never-ending Syrian Civil War, was lauded by Secretary of State Hillary Clinton as the world’s first Twitter revolution. That put many authoritarian leaders in the Arab world and beyond on guard. In fact, it was around 2011 that cyber-attacks – many orchestrated from Russia, China, and North Korea, though also from elsewhere – became systemic. Internet security tightened across the globe; China started building its Great Firewall.

The force that has speeded up the fracture of the global internet is the arrival of 5G mobile technology which is dominated by China generally, and specifically by Huawei, a Chinese company with a unique status (it is superficially owned by its employees but acts as if it were an agency of the Chinese state). With Huawei now effectively emasculated in America and its principal allies (the Five Eyes) we face the prospect of the splinternet of things. China is vigorously rolling out its own version of the internet across much of central Asia and sub-Sharan Africa – the very countries which it has enticed into its Belt and Road Initiative.

Technological Distancing

The Privacy Shield Agreement between the EU and the USA which allows European companies to transfer primary data to the US was recently struck down by the European Court of Justice. Margarethe Vestager, who was promoted last December from EU Competition Commissioner to Special Commissioner for a Europe Fit for the Digital Age is taking a much more aggressive stance towards US tech firms. Moreover, Europe is imposing sanctions on those judged guilty of cyber-attacks, including Haitai Technology Development of China.

But this struggle is much more than about competitive regulation. It’s about who gets access to technology. Last month, Foxconn Technology (TPE:4354) – the Taiwanese superconductor manufacturer which supplies Apple (NASDAQ:AAPL) – announced that it was moving production out of China and that it would restrict supplies of its products to Chinese customers. The putative reason was the advent of new (US-imposed) tariffs on Chinese exports. Young Liu, Foxconn’s CEO said: “China’s days as the world’s factory are done”.

To some extent, China was never going to remain the workshop of the world indefinitely, as Britain was for a time in the mid-19^th century. As rural-urban migration in China attenuates, so wages are rising, thus reducing the efficacy of the cheaper-in-China production model. Tariffs on Chinese technology exports – first imposed by India – have further eroded China’s cost advantage.

Foxconn promised to build a $10 billion factory in Wisconsin in 2017, though this project now seems to have stalled. In the meantime, another Taiwanese chip manufacturer, TSMC (TPE:2330), has announced plans for a factory in Arizona.

Apple’s next big iPhone update will also have huge repercussions. Hitherto, user data has been shared between advertisers by means of the unique Identifier for Advertisers (IDFA), which is embedded in every smartphone and which tracks users. This enables advertisers to see exactly what a user has searched for and what they are interested in. But in the forthcoming version of Apple’s smartphone operating system, iOS 14, advertisers will have to obtain specific permission to get access to this data. This could have consequences for Facebook and Google which rely heavily on advertising revenue.

Deglobalisation

The de-coupling of the American economy from China is now a fundamental US policy goal – and that is likely to remain the case even if Mr Biden wins the presidency this November. The Democrats are just as opposed to technology theft as Republicans; and Democrats are more vociferous in respect of China’s human rights abuses.

In his early days in office, Mr Trump promised that American jobs which had been outsourced to developing countries would be brought back to America. In reality, there has been little major restructuring of global supply chains. The Phase I trade deal with China which was signed with much fanfare back in January – before the coronavirus pandemic hit America – was thin gruel. It was the pandemic which necessitated the closure of borders and restrictions on movement. Moreover, the pandemic has revealed the West’s dangerous dependence on China for medical supplies.

Outsourcing was supposed to increase efficiency and productivity by reducing labour costs. But the pandemic has driven home the message that over-reliance on China can be very expensive. In the same way, the US has been arguing that inclusion of Huawei in the UK 5G network will carry hidden costs in terms of security. The main reason why the UK and others wanted to use Huawei’s equipment is because its technology is superior. (Arguably, Ericsson and Nokia also produce viable equipment.) Now Britain, Australia and Canada – all members of the Five Eyes intelligence-sharing arrangement – have agreed to cut Huawei out of their networks. But Australia is in the process of drawing up data sovereignty legislation which will stymie efforts by the US to access servers in Australia on national security grounds. Even within the Five Eyes there is tension.

One reason for China’s technological edge, so US security analysts argue, is that China has been adept at stealing US and European technology. Chinese state agencies are adept at hacking. Furthermore, China, an authoritarian one-party state has been able to censor local internet content by erecting the so-called Great Firewall of China.

In similar fashion, the Trump administration is considering the construction of a digital wall around the US internet – a cyber version of the physical wall under construction along the border with Mexico. The defenestration of TikTok by presidential decree (about which I wrote recently) and the threats made against Tencent (HKG:0700) in early August were signs of what is to come. The executive order said that the US would ban any transaction that is related to WeChat by any person. WeChat is Tencent’s multi-functional payments platform. Such platforms tend to vacuum up huge amounts of sensitive personal data.

The emergence of a splinternet – some are calling it cyber balkanisation – is likely to restrain businesses from penetrating new foreign markets. That will further intensify the trend towards deglobalisation. If companies want to offer products and services in countries where internet freedom is being curtailed, they will suffer a disadvantage relative to local competitors. It may even prove impossible to satisfy the requirements of different regulators in numerous jurisdictions, such that companies must focus on their target markets. That is not necessarily a bad thing.

In August, the Trump administration’s Clean Network programme was extended by Secretary of State Mike Pompeo to ensure that untrusted People’s Republic of China carriers are not connected with US telecoms networks; and all untrusted apps are to be removed from providers (of which the largest is Apple’s App Store). The Clean Network is also targeting smartphone manufacturers. It aims to prevent any US citizen’s data from being stored on cloud-based systems which are accessible to foreign adversaries. The programme specifically fingers Alibaba (HKG:9988), Baidu (NASDAQ:BIDU) and Tencent.

Consequences of the Splinternet

One fear is that the decoupling of the Western internet from China could result in China working harder to develop its own unique internet model. As Eric Schmidt, former Alphabet/Google CEO said recently: Once you diverge these platforms, you don’t get them back. The risk is that, with separate news flows, divergent populations will understand each other even less than they do now. The more segregated the platforms, the more divergence in thinking will occur, leading in places to a bunker mentality with increased mutual suspicion. (In a sense that is already happening within the USA and Europe. The BLM debate is a case in point, with different sides entirely unable to converse with their antagonists.)

In the age of the splinternet, the burgeoning alliance between the USA and India will accelerate. I’ll explain soon why India is uniquely positioned to benefit from the next stage of evolution of the digital economy and why it could be the last frontier for international tech investors. Companies like Reliance Jio can no longer be ignored as global players.

With deglobalisation, production costs are likely to rise as complex supply chains are disrupted. The wave of globalisation that occurred in the first decade of this century triggered deflation – what I call the Primark effect after the UK fashion chain that began selling essential items of clothing for just a few pounds. Similarly, the tendency towards deglobalisation in the coming decade could unleash a new wave of cost-push inflation. Cheapness is not everything; but with government finances so fragile across the West today, even mild inflation could wreak economic havoc.

It will also become more difficult for countries to steal technology from one another and to harvest data about foreign individuals. In terms of individual companies, this is probably not a great moment to invest in the Chinese tech sector. One long-term investor, Zhu Haifeng, sold half of his shares in both Tencent and Alibaba in mid-August, citing tensions with the US. He said that if these companies were to be confined to China then they are clearly overvalued. Capital flows are also likely to be affected. The US Federal government has already banned US government-sponsored pension funds from investing in Chinese equities.

What’s more, any non-US company which adopts a pro-Beijing stance could fall foul of the mighty USA. A case in point is a British bank founded in colonial Hong Kong – HSBC (LON:HSBA). When senior HSBC management refused to criticize China’s National Security Law, US Secretary of State Mike Pompeo warned the bank that it was playing a dangerous game. This need to choose between the USA and China is going to give many a corporate boardroom a collective nervous breakdown in the years to come.

The internet was never truly a world wide web. Authoritarian countries such as China, Russia, Iran, Saudi Arabia and North Korea have sought to restrict access to much content for political or religious reasons since the outset in the 1990s. In Russia, Google is perennially unavailable; instead, the local offering, Yandex, pops up. In China, Facebook and Twitter are inaccessible; in their place Baidu and Alibaba offer social networks with Chinese characteristics. In Iran, Instagram is intermittently unavailable. Brazil has blocked WhatsApp many times. And so on.

But the aspiration to a world wide web was once worldwide. Now we are going to retreat into our separate silos. But, then again, perhaps we have already done just that.

[i] Listen to BBC R4’s The New Tech Cold War first broadcast 23 June 2020. Available at: https://www.bbc.co.uk/sounds/play/m000k2bf