Cisco Affair Exposes The Dangerous Sino-American Spy Game

One week after the U.S. Department of Justice indicted five Chinese officials in a landmark cyber-espionage case, the world’s two largest economies have become enmeshed in a tit-for-tat exchange -- one that has ensnared major American technology firms.

Last week, China banned government computers from using Microsoft's Windows 8 software, citing concern that the tech giant (NASDAQ:MSFT) had curtailed support for XP, an earlier version of Windows that is widely used throughout the country. And on Tuesday, Beijing accused Cisco, a major American network equipment manufacturer, of colluding with the U.S. government and military to harm Chinese interests.

Cisco Systems Inc. (NASDAQ:CSCO) denied the claim. Nevertheless, the accusation threatens to hurt the company’s substantial business in China, a country where it generates about $2 billion in sales each year. Recently, Cisco announced that sales declined by 7 percent over the last nine months.

Trade disputes between China and the United States -- particularly over technology -- are hardly unprecedented: Google (NASDAQ:GOOG) famously withdrew from China in 2010 in protest of Internet censorship policies. But Beijing’s dispute with Cisco reflects a changing economic relationship between the two countries, one in which business interests and national security have become more entwined than ever.

Cisco, like many American tech companies, has long had a foothold in China, as part of the country’s major, long-term investment in bolstering its telecommunications infrastructure. But according to Patrick Chovanec, managing director and chief strategist of Silvercrest Asset Management and an expert on the Chinese economy, "in the last couple of years there have been a number of moves to tighten up access to U.S. tech companies in China," as part of Beijing's effort to champion indigenous firms. Last August, China's National Development and Reform Commission established cyber-security standards that restricted the ability of some companies to use non-Chinese components. Beijing hopes these standards will help domestic companies become major players in international markets.

"This is all about China using its own technology, and China building leading technology companies," James McGregor, chairman for Greater China at the consultancy APCO Worldwide, told Reuters.

Last year, events outside China's borders provided Beijing with a political rationale to buttress this economic policy. In March 2013, citing espionage concerns, the United States prohibited federal agencies from conducting business with Huawei, a Chinese telecommunications giant, leading Huawei Executive Vice President Eric Xu to say that the company “wasn’t interested in the U.S. market anymore.”

"China's basically saying to the U.S.: 'You're doing it, so we can do it too," said Chovanec.

But despite Cisco’s fresh problems with China, Chovanec said this does mean the company as a whole will struggle; Huawei, after all, has continued to grow despite having given up on the U.S. market.

According to Nicholas Consonery, Asia director for Eurasia Group, a political risk firm, businesses in the U.S. may decide that the costs of cyber-espionage are large enough to risk jeopardizing interests in China. And that, he said, makes de-escalation less likely.

"The cost of doing nothing is too high," Consonery said.