Edward Snowden, Economic Reforms Complicate Silicon Valley's China Challenge

NEW YORK (The Street) -- Competing in China is difficult enough but U.S. tech heavyweights Cisco (CSCO) IBM (IBM) are also having to withstand the backlash from recent spy scandals and the uncertainty of a new-round of economic reforms.

Cisco made headlines last month when CEO John Chambers said the fallout from the National Security Agency's spying controversy had damaged its business in the world's second-largest economy. The networker's China unit endured an 18% decline in its recent fiscal first-quarter compared to the same period a year ago. Chambers blamed the drop on "challenging political dynamics" in the country.

The furor over alleged U.S. spying against a host of countries, including China, followed the leaking of classified documents by Edward Snowden.  The former NSA contractor, currently living under temporary asylum in Russia, has been charged with theft of government property and espionage by the U.S. Snowden was in Hong Kong when the scandal first broke earlier this year.

China also featured prominently in IBM's third-quarter results as the tech bellwether said its China business was down 22% compared to the prior year's quarter. In an investor conference call IBM officials didn't reference the NSA scandal but CFO Mark Loughridge noted a "pause" in spending as China develops its new economic plans.

China certainly spells big dollars for Silicon Valley. Research firm Forrester estimates the country will spend $113 billion on IT purchases in 2013, making it the third-largest tech market after the U.S. and Japan. Although largely hardware-driven, China has been increasing its spending on software and services, Forrester reported.

Not surprisingly, Cisco's NSA comments generated much attention among U.S. technology companies though Laurence Brahm, an international lawyer and political economist based in China, said the country's planned economic reforms present a more concerning challenge.

"This thing about the NSA is not a big chip on the board - in China it's not even an issue, you don't hear anyone talk about it," he told TheStreet. "Right now, the main thing on peoples' minds is the current party meeting that has just taken place - that is where the interest is now."

China is reshaping its economy with a broad-ranging plan for economic reform designed to foster competition, encourage foreign investment and open the country's financial markets to foreign investment. At last month's Communist Party meeting, policymakers sanctioned the establishment of small-to-medium-sized banks by qualified private investors that would compete with state-owned financial institutions.

"All eyes, including the technology companies, are on the current reforms," said Brahm, who also advises the Chinese government on green growth policies. "The core reforms are financial reforms, opening up the financial services industry to stimulate retail and consumption. This is the main focus right now because China, as a manufacturing hub, has become too expensive."

Clearly, though, China's economic metamorphosis poses challenges for American tech companies. When IBM reported its third-quarter numbers in October, CFO Loughridge said China's move to open its markets to foreign investment will likely move judiciously, meaning that demand is unlikely to pick up until after the first quarter of 2014.

Nonetheless, reforms could spell good news for foreign companies with the correct skills and technologies, Brahm said. "There's going to be a big push in environmental technology as China moves to less fossil fuel usage," he added. "There's going to be huge investment in grid conversion, in energy efficiency systems and water conservation."

IBM, in particular, could benefit from its Smarter Planet initiative, which sells software and services to drive efficiency in areas such as industry, energy, transportation and government.

Still, U.S. companies have had to contend with some thorny political issues surrounding China's home-grown tech players. Last year, the U.S. House Intelligence Committee released a damning report on Chinese network-gear companies Huawei and ZTE. The 52-page document called for blocking acquisitions, takeovers or mergers involving Huawei and ZTE, citing the "threat to U.S. national security interests." The committee also said U.S. government systems and contractors should exclude Huawei and ZTE equipment.

The U.S. Government's stance may be weighing on Cisco, according to Mark McKechnie, telco equipment research analyst at Evercore Capital Partners. "I think that Cisco's sales to China were probably already a bit compromised as a result of the congressional backlash against Huawei," he told TheStreet. "That could explain why Cisco may be feeling it a bit more than some of the other U.S. tech companies."

Keen to gain market share, local firms are also increasing pressure on Oracle (ORCL), EMC (EMC) Cisco and IBM and  in China. Set against this backdrop, partnerships with major Chinese tech players, such as EMC's joint venture deal with Lenovo, could prove significant.

"China has certainly built good skills, capability and capacity to build a lot of these technologies on their own," warned Charles King, president and principal analyst of Pund-IT. "It doesn't take a big leap of the imagination to see a scenario where China says, 'thanks, but not thanks - we will buy a lot of these technologies from home-grown companies'."

Underlining this trend, China's National Development and Reform Commission recently started an anti-monopoly investigation of U.S. chipmaker Qualcomm (QCOM).

"They are clearly saying 'we want to develop our own industries'," said Evercore's McKechnie. "I would say that the Chinese government wants to make sure that local suppliers are benefitting from this [economic] growth as well."

--Written by James Rogers in New York.

>Contact by Email.

More from Technology

More Tech and Finance Executives Back Away from Saudi Ties

More Tech and Finance Executives Back Away from Saudi Ties

Google in Deal to Build Telecom Cable to France

Google in Deal to Build Telecom Cable to France

Dubai Shows Off Region's First Self-Driving Taxi

Dubai Shows Off Region's First Self-Driving Taxi

Nvidia 'Is Going to Miss the Quarter,' Jim Cramer Says

Nvidia 'Is Going to Miss the Quarter,' Jim Cramer Says

If Support Holds, the Rally Could Resume

If Support Holds, the Rally Could Resume