After the break up

The dismantling of China Telecom last month ended five months of paralysis in the telecoms market, but it also raised fundamental questions such as how will fixed-line operators make profits in a rapidly changing and increasingly competitive sector.

Some five months in the making, the break up of the nation’s fixed-line monopoly China Telecom was finally consummated last month with the anointment of two new telecoms operators that will divide the Chinese market between them, primarily on a geographical, north/south basis.

With the former China Telecom now officially dead and buried, the telecoms market should finally be free of the paralysis it has endured since the announcement of the split last December. Managers will be able to allocate resources according to new investment priorities. Foreign equipment suppliers can initiate sales to the world’s only major dynamic telecoms market, and the multi-billion dollar foreign listings for either or both of the newly-created companies (see page 14), initially scheduled for later this year, can move towards completion some time in 2003.

But even as the market moves from one era to another, the aftermath of the split raises more questions than it answers. Clearly, the main motivation for change is to better prepare the domestic industry for competition from foreign service providers following China’s entry to the World Trade Organisation (WTO). Beyond that, however, there is little indication of how the market will develop.

Although much remains to be decided, some issues are clear. First, structural reform is far from over. The current industry regulator, the Ministry or Information Industry (MII), has become notorious for its protectionist tendencies, and appears to have outlived its usefulness, especially at a time when even-handed and consistent market regulation is seen as vital. For this reason, Premier Zhu Rongji, who has been instrumental in ramming through industry reform despite MII resistance, has created a new policy-making body answerable directly to the State Council, known as the Commission on Information Industries.

The CII is chaired by Zhu himself, and he is backed on the body by fellow political heavyweights vice-president Hu Jintao (Jiang Zemin’s heir apparent) and vice-premier Li Lanqing. The CII’s main purpose will be to oversee telecoms policy formation and smooth the transition to a new regulatory body that will ultimately be responsible for all China’s information industries. The MII’s days are therefore numbered, together with those of other ministries involved in the communications sector, such as the State Administration for Radio, Film and Television. A new regulator is expected to be in place by 2005.

How to make profits?

Second, quite apart from structural reform that is happening, China’s new fixed-line operators must now grapple with an issue that has until now not been their highest priority: how to make their businesses pay in a fast changing, increasingly competitive business environment.

While profits have come easily in China’s rapidly growing wireless sector, fixed-line business is another matter. Local fixed-line operations have always been a loss leader in China due to high infrastructure costs per subscriber in a low penetration, and often far-flung, market. This trend now appears set to worsen following the cancellation last year of a charge for residential telephone installation and in view of a recent decline in the rate of new sub- scribers in rural areas. According to MII statistics, the number of new fixed-line customers dropped 41 per cent in the first quarter of this year to 2.8m. Total revenue for fixed-line business in the countryside also decreased 6.4 per cent year-on-year to Yn4.78bn over the same period.

In the past, China Telecom has been able to offset losses in its local fixed-line operations by setting them against profits earned from urban fixed-line operations and from long-distance services, the industry’s traditional cash cow. After the break up, however, providing these types of subsidies will become problematic, for two main reasons:

In a competitive environment, cross-subsidies will distort pricing structures. This is particular problem for the reborn China Telecom (ie the southern arm) because under the current plan it will inherit the bulk of the fixed-line operations, including all those in the less-developed western areas such as Tibet and Xinjiang, where most of the uneconomic work must be done.

Long-distance pricing is also doomed to decline, in line with the worldwide trend. Growing use of e-mail and wireless services, an increasing migration of voice traffic to cheaper data-centric networks (using voice-over internet protocol services, which have proved highly popular in China), and vastly increased overall network capacity has meant that the volume of traffic on circuit-switched long-distance networks is declining even as prices are driven lower. Although China Telecom has jumped on the bandwagon and is itself a major voice-over internet protocol player, telecoms traffic of all kinds is becoming a commodity product in a rapidly converging market. While growth in numbers of fixedline subscribers will help to support revenues, over the long term, operating margins are bound to slump. According to a study conducted by Pyramid Research, long-distance spending per fixed line in China is projected to drop from US$38 this year to US$24 by 2006.

In a competitive environment that will soon include foreign service providers, the fixed-line business in China promises to become less attractive. Indeed, the warning lights flash all the stronger when the Chinese market is compared to that in the US, where deregulation introduced in 1996, combined with the rollout of an IP data network similar to that under construction in China, has resulted in a collapse of the long-distance market. Pricing competition flowing from the reforms has become so severe in the US that specialist long-distance giants such as AT&T, WorldCom and Sprint may well cease to exist as separate companies within a few years.

This phenomenon could be repeated in China, especially if it scraps fixed telephone tariffs and allows competing operators to set their own pricing levels. Historically, telecoms pricing in China has been set by the MII. However, under the terms of its WTO accession agreement, China is subject to the terms of the Basic Telecom Agreement, committing it, among other things, to using cost-based pricing schemes. Beyond that, part of the recent break-up reform package includes a pledge to allow greater price-fixing autonomy to market participants.

There are two major reasons why pricefixing autonomy may create problems. First, because Chinese industries are notorious for adopting predatory pricing practices that then lead to years of internecine warfare. Indeed, to the limited extent that pricing autonomy has been allowed for wireless telecoms services in China, price wars and even physical conflict has resulted. Second, because it is hard to see where the extra income will come from to fill the black hole in the balance sheets of the fixed-line operators. Although extra revenue can be expected ultimately to come from China Telecom’s fast-growing data services arm (revenues for which increased 86 per cent in 2001), the sector still represents only about 2.5 per cent of the former China Telecom’s total revenues. Even when combined with revenues from China’s other data service providers, there seems little prospect of short-term relief from this source.

Recognising the extent of the problem, the Chinese government announced in April its intention to introduce a ‘universal service fund’. This long-debated scheme will effectively tax telecoms operators, both foreign and local, in order to subsidise network construction in under-developed areas.

However, while such a fund would more equitably distribute the burden of financing the pr
ovision of rural telecoms services across the market, there are doubts as to how it would work in practice: in particular how the charge would be split between the various participants and whether it would even be legal under the terms of the WTO agreement.

Most important, a universal fund still fails to address the underlying issue: how to provide fixed-line services nationwide at a cost subscribers can afford and that allows carriers to compete profitably. The answers to these questions will weigh heavily on investors minds when these companies make their initial public offering pitches to foreign markets next year.