China's Race to The Bottom: Margin Zero
Huawei is going to repeat one of the most common playbooks, and semiconductor margins are the target
Good morning. I read this tweet by Angelica on X last week, and it struck me in the context of Huawei.
China’s technology industry has long followed a brutal pattern: when local competitors enter a new sector, they often decimate profit margins. The most striking example is solar panels. Once Chinese firms mastered panel production, they flooded the market with ultra-cheap supply, crushing global margins and wiping out competitors.
This race to zero has repeated itself across sectors. I flagged this dynamic two years ago in automotive. BYD’s vertical integration of batteries, semiconductors, and shipping costs cut margins and undercut rivals to the point where no one could feasibly compete with the full stack margins. BYD mechanically removed the highest component margins within an Electric Vehicle and subtracted that cost from the end product. This hurts anyone with a product along the value chain, and has hurt Western OEMs whose goal is to make some profit.
I’m talking about this today because I was thinking about the recent Cloud Matrix 384 that SemiAnalysis wrote about. I can’t help but think that Huawei will try to nuke semiconductor sector margins.
內卷 Ruins it All
Before we continue, I want to explain the concept this phrase (involution) is addressing. The best I can do is this Reddit forum post, but it is a form of fierce competition that almost spites your competitor. This is a race to the bottom, and ironically, this cultural thought process is pretty anti-capitalistic against the concept of profit margins and, in many ways, defeats the point of surplus and capitalistic profits.
This might seem dramatic, but this is a horrible inverse cost disease, and lowering profit margins creates consumer surplus. However, destroying profit margins also puts constraints on labor cost, which destroys the ability to consume the surplus that low margins create. Put differently, China and, by extension, Huawei for semiconductors are racing to the bottom. But it cannot avoid the trap, as all competitors also think in zero-sum margin games.
I am starting to think about this because this is effectively a culturally enforced economic contagion. And if you earnestly believe what this means for semiconductors if Huawei is successful, it isn’t very pleasant.
Huawei and Contagion
Huawei is applying this involution to semiconductors, one of the highest margin businesses on Earth. Semiconductors are the business of turning pure sand and metal into a thinking machine, and each step in the process often commands a 50% margin at each point. My stylized model turns ~200 dollars of input materials (semicap I am ignoring subsystems) into almost ~2,300 gross profit dollars. Each “step” is just technology transforming a primary good before it into a higher value finished good.
Now, what if you were to view this entire value chain as a single input and a single output good, cutting out each intermediate value-added step? Well, that is the story of BYD, which makes its own glass, tires, semiconductors, and distribution. And this is where Huawei is headed. Below is a Huawei Chip Ecosystem guide from SemiAnalysis.
Let’s apply the concept of race to the bottom, destroying margins along the value chain, and their willingness to incinerate profits. Instead of the ~2,300 (estimate) gross profit dollars, we are talking about a ~185 dollar or 2x transformation of goods into products.
This is the concept of what would happen if every business in the world were a low-margin commodity like a producer. It’s antithetical to common sense. The real threat isn’t just Huawei’s technology but the culture of involution. The West still plays capitalism. Huawei doesn’t. That’s the margin-killing mindset Western companies are up against.
This non-capitalistic business model wouldn’t work in other countries. Profit margins encourage capital spending, which then reinforces profits. There is an invisible hand of capital allocation, as the best and often most profitable can capitalize on bigger and larger investment opportunities. This logic doesn’t exist in China, so startups have effectively gone to 0 in recent years. This chart from the Financial Times puts it in context.
What would need to change? As it currently stands, this seems like an unstoppable cultural force meeting an immovable global problem.
Vertical Monopolies, Culture, and Pricing Power
The problem I am describing is effectively deflation, which is why Chinese goods destroy international markets. This level of price deflation is almost unimaginable to the West because of its pricing power. Everyone knows to charge more for a premium product, not less.
It would be like if Standard Oil became the vertically integrated giant it was and then lowered prices. I think the only thing that will make that stop is a change from the top, and the government of China truly doesn’t view companies as vehicles to make a profit. As high-profile shake downs (Alibaba’s Jack Ma) in the past have shown, companies operating in China are leasing your business; at any moment, the government can come knocking. It seems unlikely that the current business culture will change. Create too much excess (for the owners) and you’re at risk, so margin zero continues. Put simply - changing culture is almost impossible.
Competing Against Zero Margin
This is where things get a bit tricky. Traditionally, the thought process is that innovation beats commodity products, but Chinese companies consistently climb technology curves and then destroy profit pools. The reality is that ecosystem adoption and innovation are required to create install-base effects.
This is actually why the UAE deals make so much sense. After trying to force other countries to comply with the stick, it might be time to get them hooked via the carrot of technology adoption. By forcing infrastructure refreshes to be compatible, American companies can continue to edge out margin zero. Margin Zero behavior is almost impossible to compete against when it begins.
I have a few bits behind the paywall for more specific thoughts about Chinese competition.