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UPDATE 3-China's Huawei, ZTE should be kept from U.S. - draft Congress report

* Chinese telecom gear makers pose potential risk to U.S. -panel draft

* House Intelligence Committee seeks to block any mergers,acquisitions

* Huawei is world's No.2 telecoms gear maker by revs, ZTEfifth

* ZTE Hong Kong-listed shares down nearly 4 pct

* U.S. should set "prejudices" aside - China foreignministry

(Adds Chinese reaction, updates ZTE stock price fall)

By Jim Wolf and Lee Chyen Yee

WASHINGTON/HONG KONG, Oct 8 (Reuters) - China's top telecomsgear makers should be shut out of the U.S. market as potentialChinese state influence on them poses a security threat, theU.S. House of Representatives' Intelligence Committee said in adraft of a report to be released on Monday.

U.S. intelligence must stay focused on efforts by HuaweiTechnologies Co Ltd and ZTE Corpto expand in the United States, and tell the private sector asmuch as possible about the purported espionage threat, the panelleaders said, based on their 11-month investigation of the twofirms.

Employee-owned and unlisted Huawei is the world'ssecond-biggest maker of routers, switches and telecoms equipmentby revenue after Sweden's Ericsson . ZTE ranks fifth.In the global mobile phone sector, ZTE is fourth and Huaweisixth.

Huawei generated around 4 percent of its group sales fromthe United States, while ZTE's U.S. revenues made up 2-3 percentof its overall figure. The bulk of both companies' U.S. salescomes from selling handsets through U.S. carriers such asVerizon , Sprint and T-Mobile USA .

"The impact will be quite limited if the report is referringjust to telecoms equipment, but it's another story if handsetsare included as well," said Huang Leping, an analyst at NomuraSecurities. "Huawei and ZTE handsets have been consistentlygaining market share in the United States."

In the U.S. handsets market where Apple Inc andSamsung Electronics dominate, ZTE ranks sixth andHuawei eighth, according to industry figures.

<^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ GRAPHIC: Huawei by numbers GRAPHIC: ZTE at a glance Ren pits Huawei against the world ZTE not worried about Apple, patent rows ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^> "POLITICAL DISTRACTION"

The broadside comes as Huawei mulls a possible initialpublic offering, sources said, as part of its efforts to allaysuspicions that have all but blocked its U.S. ambitions,including business tie-ups. Huawei has been looking at thelisting issue for years, but there has been little progress dueto its complicated share structure and whether a listing wouldactually help, given that U.S. lawmakers remain suspicious ofZTE even though it's a listed company, analysts said.

Huawei spokesman William Plummer rejected the committee'sallegations in a statement emailed to Reuters.

"Baseless suggestions otherwise or purporting that Huawei issomehow uniquely vulnerable to cyber mischief ignore technicaland commercial realities, recklessly threaten American jobs andinnovation, do nothing to protect national security, and shouldbe exposed as dangerous political distractions from legitimatepublic-private initiatives to address what are global andindustry-wide cyber challenges," he said.

For its part, ZTE released a copy of the letter on Monday itsent to the committee after a hearing in September, stating it"profoundly disagrees" with the claim that it is directed orcontrolled by the Chinese government. "ZTE should not be a focusof this investigation to the exclusion of the much largerWestern vendors," it said.

Chinese foreign ministry spokesman Hong Lei urged the UnitedStates to "set aside prejudices" when it deals with Huawei andZTE. "Chinese telecoms companies have been developing theirinternational business based on market economy principles. Theirinvestment in the United States embodies the mutually beneficialnature of Sino-American economic and trade relations," he saidat a briefing in Beijing. "We hope the U.S. Congress will setaside prejudices and respect the facts, and also do more that isbeneficial to Sino-American economic and trade ties, rather thanthe contrary."

ZTE's Hong Kong-listed shares fell more than 5.5 percent onMonday, on track for their biggest one-day drop in more than amonth. The benchmark index was down 0.9 percent.

The U.S. panel's draft report faulted both Huawei and ZTEfor failing to satisfy its requests for documents, includingdetailed information about formal relationships or regulatoryinteraction with Chinese authorities.

U.S. companies thinking about buying from Huawei should"find another vendor if you care about your intellectualproperty; if you care about your consumers' privacy and you careabout the national security of the United States of America,"panel chairman Mike Rogers said in comments broadcast late onSunday on the CBS News program "60 Minutes."

Rogers and the committee's top Democrat, C.A. Ruppersberger,have scheduled a 10 a.m. Eastern time (1400 GMT) news conferenceto release the final, unclassified version of their report. Thepublication comes a month ahead of U.S. presidential electionswhere China - and its impact on U.S. jobs - has been a campaignissue.

"CREDIBLE ALLEGATIONS"

The panel said it received credible allegations from unnamedindustry experts and current and former Huawei employeessuggesting Huawei, in particular, may be guilty of bribery andcorruption, discriminatory behavior and copyright infringement.

The committee plans to refer such allegations to the JusticeDepartment and Department of Homeland Security, according to thedraft made available to Reuters. "U.S. network providers andsystem developers are strongly encouraged to seek other vendorsfor their projects," it said.

The document cited what it called long-term security riskssupposedly linked with the companies' equipment and services.But it did not provide detailed evidence, at least not in anunclassified version. A classified annex provides "significantlymore information adding to the committee's concerns," the draftsaid.

Based on classified and unclassified information, Huawei andZTE, which are both based in Shenzhen, China, "cannot be trustedto be free of foreign state influence and thus pose a securitythreat to the United States and to our systems," the documentsaid. Huawei and ZTE are rapidly becoming "dominant globalplayers" in the telecommunications market, which is intertwinedwith computerized controls for electric power grids; banking andfinance systems; gas, oil and water systems and rail andshipping, it noted.

ZTE's U.S. telecoms infrastructure equipment sales last yearwere less than $30 million. In contrast, two of the largerWestern vendors alone had combined U.S. sales that topped $14billion, ZTE told the committee in its Sept. 25 letter, anapparent reference to Finland-based Nokia Siemens Networks

and Paris-based Alcatel Lucent .

"It seems self-evident that the universe of companiesexamined by the Committee is so small as to omit most of theequipment actually employed in the U.S. telecom infrastructuresystem," the letter said.

"MEANS, OPPORTUNITY, MOTIVE"

Huawei and ZTE may not be the only companies that present arisk to U.S. infrastructure, the committee's draft report said,but they are the two largest Chinese-founded, Chinese-ownedcompanies seeking to market critical network equipment to theUnited States. Beijing has the "means, opportunity and motive"to use them to its own ends, it added.

Top executives of both told a committee hearing on Sept. 13that their companies would never bow to a hypothetical Chinesegovernment effort to exploit their products for espionage,equating any such move with corporate suicide.

"Huawei has not and will not jeopardize our globalcommercial success nor the integrity of our customers' networksfor any third party, government or otherwise," senior vicepresident Charles Ding testified at the time.

The draft showed that the committee is calling on aninter-agency government group that reviews national securityimplications of foreign investments to block acquisitions,takeovers or mergers involving Huawei and ZTE.

In addition, it said Congress should give thoroughconsideration to legislation seeking to expand the role of theinter-agency group, known as the Committee on ForeignInvestments in the United States, to include purchasingagreements.

U.S. intelligence officials have publicly denounced China asthe world's most active perpetrator of economic espionageagainst the United States.

Huawei has marketed its network equipment in the UnitedStates since last year, and has sold to a range of small- tomedium-sized carriers nationwide, particularly in rural areas.

The company, founded by CEO Ren Zhengfei 25 years ago afterhe was laid off by the Chinese army, has marketed mobile phonesthrough a broader range of U.S. carriers for the last fouryears. U.S. sales totalled $1.3 billion last year, out ofoverall sales of $32 billion, executives said.

(Additional reporting by Ben Blanchard; Editing by Bernard Orr,Ken Wills and Ian Geoghegan)

((jim.wolf@thomsonreuters.com)(+1 202 898 8402))

Keywords: USA CHINA/HUAWEI ZTE