China's Cloud Ceiling

Cloud computing is hot. All cloud stocks are hot. Cloud was already growing everywhere and now accelerated by COVID, with massive adoption trends like remote work, e-commerce, digital health, and who knows what else. What used to be an outlandish approach to enterprise IT consumption is now becoming more mainstream. The TAM (total addressable market) is as big and far as the eyes can see.

China’s own domestic cloud market is also growing rapidly. According to the research firm Canalys, China’s cloud infrastructure spending grew by 66.9% in Q4 of 2019 and by 63.7% for the entire year to exceed $10.7 billion USD, making it the second-largest cloud market in the world.

So will cloud in China just grow and grow with no end in sight, like the rest of the world?

As it turns out, there are a few factors that could put a lower ceiling on this market, especially public cloud adoption. One part of that ceiling is regulatory, thus artificial. Other parts -- namely labor cost and product maturity -- may sort themselves out eventually by natural market competition, but will take many years to play out.

Regulatory Limitations

At the moment, no banks can run their core workload on a public cloud platform in China. Similarly, no securities exchange type workloads, e.g. a stock trading platform, are allowed either. Thus, a Robinhood on AWS situation would not be currently possible. The banks are regulated by the China Banking Regulatory Commission, while securities are regulated by the China Securities Regulatory Commission.

To my knowledge, the regulation as it stands today does not contain explicit rules against public clouds, but has a series of requirements that public clouds currently don’t meet. In order for core banking or securities workloads to get on the “cloud train”, either the vendors will have to make changes to their solutions or the regulators will have to update their rules. Most of these rules were enshrined before the public cloud was a thing.

This regulatory limitation presents two market hurdles. One is obvious: without banks being allowed to fully adopt the cloud, the whole market’s growth has a ceiling. Banks, and financial services in general, tend to spend a lot of money on technology.

The other is more subtle, but has a larger long-term implication: it’ll slow down Chinese domestic cloud players’ pace of product evolution to meet the stringent technical requirements of core banking or securities exchange workloads. This implication may impact the domestic cloud leaders -- Alibaba, Tencent, Baidu, Huawei, JD, etc. -- and their competitiveness vis-a-vis their American counterparts -- AWS, Azure, GCP, Oracle Cloud, IBM Cloud -- especially when fighting for businesses elsewhere. To be sure, Chinese tech giants have had plenty of experiences running financial products on a large scale, especially Alibaba’s AliPay and Tencent’s WeChat Pay, so the technical foundation is there. But operating another bank, and ideally multiple banks at the same time to benefit from the economy-of-scale of the public cloud, is quite another matter.

Running core banking workload (think of it as the transactions in your own bank account that must be kept in-sync and accurate at all times) is oftentimes the ultimate proof of strength and reliability of any IT infrastructure stack. That realm includes everything from hardware (processors and storage) to networking to multitudes of software services, e.g. databases, big data analytics tools, fraud detection models based on machine learning, etc. Sadly, it looks like Chinese public cloud providers won’t get the chance to prove themselves any time soon, nor make the big bucks while doing so.

Labor Cost

The conventional wisdom of China’s labor cost (and arbitrage opportunity) is that it’s still cheap, but getting more expensive. That’s generally true for tech talent as well, but there are important nuances to parse in order to understand the “ceiling effect” on the cloud market.

As I have written elsewhere, the competition for talent in high-end areas of technology -- distributed systems, large-scale infrastructure engineering, machine learning -- is fierce worldwide. Thus, the top of the talent pool in these areas command just as much compensation in China as they do in Silicon Valley; very little room for arbitrage is left unexploited. These types of talent are also who you’d need to build a robust, reliable, and performant public cloud.

With that said, other lower-end parts of the backend IT labor force are still materially cheaper in China, for example, database administrators, system administrators, network administrators, and DevOps. This isn’t to say their skills are inherently not valuable, but they aren’t currently rewarded in the market. Thus, when a large enterprise in China weighs the choice between using a cloud solution and hiring five more people to do the same work internally, hiring can still be a more attractive option. Even if the cloud solution is technically more performant and elegant, commanding more humans when the humans are cheap enough has its appeals, not to mention the ego-stroking that managers get from a larger headcount.

It’s difficult for me to precisely gauge how much cheaper these backend technical workers are. For front end developers and designers (another relatively lower skilled strata of the tech workforce), the ones in China tend to cost about one-third as their counterparts in Silicon Valley, controlling for skill and experience level. Since backend, infrastructure-level operations engineers tend to be higher on the value chain and more senior overall, I’d venture to say the salary gap is about one-half to two-thirds, which would be quite material.

A public cloud’s core value is to be a more cost-effective and flexible way to use IT resources and the people who operationalize them. The typical go-to-market pitch of any public cloud platform, or third-party solutions built on top of these platforms, is three-fold:

• Technology (our technology is better than what you can build internally, so you should rent ours versus build it yourself)
• Total Cost of Ownership (TCO or the total cost of resources, both hardware and software, you’d have to buy and maintain over time versus renting the same resources from a cloud)
• Labor Cost (the number of people you’d have to hire to build/maintain these services, say 2-3 experienced DevOps, versus outsourcing the same work to a cloud vendor.)

While the technology and TCO pitch still work and will fuel the cloud market growth in China to a certain level, the labor cost argument tends to fall flat, which puts a ceiling on more public cloud adoption.

Cloud-Native Product Maturity

This last limitation is a second-order effect that stems from both the regulatory and labor-related hurdles we just discussed.

With banking and securities customers being off limit, Chinese cloud vendors won’t have the chance to build cloud-native products for two of the most demanding use cases in the industry. With labor cost being materially lower, the same cloud vendors also won’t have the chance to design products for demanding users, because these users know if they don’t like the cloud solution, they can afford to throw bodies at the problem.

When these end users have both low expectations and low willingness to spend on cloud products, these products will be of less quality and less cloud-native, if only because the market they are serving doesn't need them to be. Consequently, the cloud ecosystem tolerates less quality products and produces less talented people with good product sense, which conditions the market to always expect less of these products, eroding their pace of evolution and pricing power -- a subtle downward cycle. If stuck in this cycle, Chinese public cloud providers will not only grow into a smaller domestic market than it could have been, they will also be less competitive globally.

Of course, this isn’t to say all the products in the US, the largest cloud market by far, are all that great. In his recent analysis “The Developer Experience Gap”, Stephen O’Grady of RedMonk, lamented the huge gap in developer experience that has yet to be solved, while developers toil in a growing but confusing technology market that seems to offer everything except an easy way to use all those things. As he noted:

The same market that offers developers any infrastructure primitive they could possibly want is simultaneously telling them that piecing them together is a developer’s problem.

The technology landscape today is a Scrooge McDuck-level embarrassment of riches.

Even (or especially?) the public cloud leader, AWS, is not doing a great job of offering top-notch, developer-friendly product experiences.

The data warehouse and analytics company, Snowflake, pushed the cloud hype to a whole new level with its eye-popping IPO. An important part of its success is due to its product experience being easy to use, deploy, scale, and pay for on a subscription basis -- the quintessentially cloud-native way of consuming technology. (The company’s fun billboards might’ve helped too.)

This cloud-first way of building data analytics products was anything but obvious, when Snowflake first started in 2012, during the much earlier days of public cloud adoption. With its glitzy IPO now behind us, China's tech sector is now searching for its own Snowflake. PingWest published an article recently on exactly this question, by talking to executives from PingCAP and Kyligence -- two startups with the best chance of becoming Snowflake. While the article explored the two companies’ early decision to build cloud-native products as evidence of that potential, another more important angle that was not discussed is their aggressive expansion into the more mature and demanding US cloud market, in order to hone their product maturity.

Despite both being relatively young, series C stage startups, PingCAP and Kyligence’s willingness to expose its offerings to American users and build them on American public cloud platforms, will do wonders to accelerate their products’ evolution and make them leaders in China. While the short-term revenue may not be meaningful (and the geopolitical headwind isn’t helping), the long-term benefit of expanding and serving customers’ with more demanding expectations is definitely worth the trouble.

Had they stayed comfortably within China to let that market guide their product development, their potential would have a lower ceiling just like China’s own cloud market. The same willingness to expand early beyond the domestic comfort zone will be necessary for younger Chinese startups, looking to compete and stand out in the global cloud ecosystem.

All in all, cloud computing in China will still grow rapidly, if only because the country is huge and the base is small, so wherever the ceiling is, it won’t be touched for the foreseeable future. But the ceiling may not be as high as you think, and China’s cloud market will evolve, as many things in China do, with its own “Chinese characteristics”.

Full disclosure: I’ve worked with both PingCAP and Kyligence in the past in a management and operator role. I don’t hold shares in either company.

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