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It started as U.S. government pressure on American companies to boycott specific Chinese entities. Now, that effort has widened to become a wholesale blockade of Chinese technology.    © Illustration by Eric Chow
The Big Story

Inside the US campaign to cut China out of the tech supply chain

Apple, Google and others shift production to prepare for 'decoupled' global market

LAULY LI and CHENG TING-FANG, Nikkei staff writers | China

TAIPEI --- It was a hot summer morning in Taipei when several officials from the American Institute in Taiwan, the de facto U.S. embassy, visited the top management of a major tech company, a key supplier to Apple.

It was immediately apparent that this was unlike previous courtesy visits, where U.S. officials stop in from time to time to hear what's happening in the industry. This time, they cut the chitchat and threw out a blunt question soon after they sat down: "Why aren't you moving more of your production capacity outside of China?" they asked. "Why aren't you moving faster?"

Participants described the conversation as "serious and unsettling." "We felt uneasy," said one. "They asked many questions that we didn't know if we could answer. The answers would have involved unreported strategies about ourselves and our clients." But the message was unambiguous: The U.S. government was directly appealing to his company to cut its ties to China, he said.

The American officials also met with several top Taiwanese chipmakers -- companies whose products are used by Huawei Technologies, the Chinese telecoms equipment supplier that Washington accuses of spying for Beijing. The meetings, likewise, appeared to be an effort to draw those companies over to the U.S. side in the escalating Washington-Beijing tech war, multiple sources with knowledge told Nikkei Asia.

"They were here to make sure we understood clearly about U.S. export control rules and told us the U.S. stance about Huawei," a chip industry source familiar with the matter said. "But we read those words as a warning."

For executives in Taiwan's electronics industry, the meetings are another sign that the battle for tech supremacy between the world's two superpowers has reached a new level. It began in 2016 with sanctions against telecoms equipment company ZTE, and has turned steadily more serious as Washington ramps up pressure on Chinese companies which it says threatens U.S. national security.

A person close to AIT declined to confirm the specifics of the meetings, but said that it is routine practice to keep in touch with Taiwanese companies about "supply chain restructuring and export control compliance."

In the space of one year, Washington has revised its export control rules three times to target Huawei -- changes that have affected both U.S. and non-U.S. suppliers of the Chinese company. Suppliers are now cautious over the long arm of the American law, they say. And over the past two years, the Trump administration has accelerated its efforts to blacklist Chinese companies by placing them on the so-called Entity List, adding some 70 more companies and organizations so far this year.

Now, what started as U.S. government pressure on American companies to boycott specific Chinese entities has since become a concerted effort to force non-U.S. suppliers to join a wholesale blockade of Chinese technology.

"Washington has weaponized tech supply chains, for example, in semiconductors, in order to slow down China's technology ambitions," said Alex Capri, a research fellow at the Singapore-based Hinrich Foundation and visiting senior fellow of National University of Singapore Business School. The U.S. is aiming to "suppress Beijing's techno-authoritarianism model," he said.

The message, as understood by the Taiwanese executives, was urgent: Move production facilities out of China, reduce ties with Chinese clients like Huawei and stand with the U.S., or face the potential worst-case scenario of becoming Washington's next target.

Both sides, now

The idea of unpicking the sophisticated tech supply chain that has grown up in China over the last two decades would have been unthinkable just two years ago. But pressure from the Trump administration has made this a reality, with companies from Apple to Google decamping from China to Vietnam, India, Thailand and Malaysia in the last 36 months. For the global tech industry, the question is whether the alternative supply chain that emerges can match the efficiency of the one in China that builds more than 200 million iPhones a year.

Taiwan is in a key position to witness this new emerging U.S. policy because its tech companies sell equally to both sides -- from Taiwan Semiconductor Manufacturing Co., the world's biggest contract chipmaker, to Foxconn Technology Group, formally known as Hon Hai Precision Industry, the largest electronics contract manufacturer globally. They count as clients top U.S. companies like Apple, Microsoft, Google, Amazon, Qualcomm, Hewlett-Packard, and Dell, as well as leading Chinese companies such as Huawei, Lenovo, Xiaomi, Alibaba Group Holding, and Oppo. Sitting astride a fault line separating China and the U.S. in a new technology cold war, Taiwan's companies are being forced, albeit unwillingly, to choose sides.

"It is a very confusing era. The tech industry in decades has never needed to pay such close attention to the international political dynamics as now," Tung Tzu-hsien, chairman of key Apple supplier Pegatron, recently told a Taipei forum on the post-coronavirus era.

Last month the U.S. government, via the AIT, publicly echoed its private message that all foreign technology suppliers should leave China.

On September 4, AIT Director Brent Christensen hosted a forum on supply chain restructuring, together with EU, Canadian, and Japanese counterparts, to publicly advocate for decoupling. It was the first time the U.S. had held such an event in Taiwan, a diplomatic gray zone without a full-fledged U.S. embassy, viewed by Beijing as a breakaway part of the People's Republic of China.

"Shared interests and shared values": American Institute in Taiwan Director Brent Christensen at the Sept. 4 forum on supply chain restructuring in Taipei.   © Reuters

International companies "increasingly recognize the dangers of linking their futures to the PRC" and have begun to seek alternative production and manufacturing hubs other than China, he said.

Christensen called on other countries to cooperate on rebuilding the supply chain elsewhere. "Our shared interests and shared values make us natural partners, and we believe we will be stronger and more effective if we work together."

But it is not so simple for technology companies, for whom China is not only a deeply-rooted production base but also their fastest-growing market. Twenty percent of Apple's total revenues, more than 20% of Intel's revenue and 60% of mobile chip king Qualcomm's sales come from China, although in many cases items sold in China are later re-exported to other markets.

A number of the biggest companies are doing their best to straddle the widening chasm between Beijing and Washington, in an effort to avoid picking a side. Apple, for one, has adopted a two-sided strategy to balance itself from the tech war. While it has been pushing suppliers to accelerate their shift away from China since late 2018, it has also been aggressively cultivating Chinese homegrown suppliers to play a more important role inside China, and secure continuous access to the 1.4 billion strong market.

With Apple's consent, Taiwan's Wistron sold its iPhone-assembly factory in the Chinese city of Kunshan this summer to local rival Luxshare Precision Industry. The handover was significant: It paved the way for the Chinese supplier to move up the Apple supply chain, fueling hopes that it could become China's equivalent of the Taiwanese Foxconn, a giant of tech manufacturing. China's Lens Technology also bought iPhone casing factories from Taiwan's Catcher Technology, a longtime Apple metal casing provider, in the city of Taizhou in August.

"Apple has always been cultivating Chinese suppliers. The rationale behind this used to be that it gave Apple more price bargaining power against the existing suppliers, but now it has also become a strategy to diversify geopolitical risks," said an executive-level source familiar with Apple's thinking.

Foxconn, meanwhile, has moved part of its production out of China, but insists they will not be choosing a side. "The global trend toward a G2 [group of two] is inevitable. How to serve the two big markets is something that we've always been planning for," Young Liu, chairman of Foxconn Technology Group told an investor conference in Taipei in August, referring to the U.S. and China.

But not every company has the resources to straddle the widening gap like the Apples and Foxconns of the world. The reality, they say, is that chip developers still rely on a handful of critical U.S. chipmaking production and design tool providers such as Applied Materials, Lam Research, KLA, Synopsys, and Cadence Design Systems to craft the most advanced chips possible.

That has forced all the chip suppliers in the world to apply for licenses from the U.S. government to ship to Huawei, an order which came into effect on Sept. 15. Since then, tech supply companies have put in a nearly impossible position, maneuvering between the U.S. and China to avoid incurring the wrath of either government.

"Generally speaking, multinational tech companies would not want to choose sides in the U.S.-China trade war, but they still have to prepare themselves for [a] possible worsening scenario," Chiu Shih-fang, a senior tech supply chain analyst at Taiwan Institute of Economic Research, told Nikkei.

So far, China's reaction has been muted, but few tech executives think they can count on continued forbearance by Beijing. One tech supplier told Nikkei that they have been receiving more requests to meet with local Chinese officials "for tea," and in those meetings, officials would seek assurance of no exit plans or job reductions.

Some suppliers have been asked to set up offices operated by the Chinese Communist Party within their manufacturing complex. These are all signs that the authorities want to be more informed about the movements of the suppliers, and to prevent any massive exodus, they said. Suppliers are mostly cautious not to make their diversification plans known, for fear of attention from Chinese local governments.

Meanwhile, on Sept.19, China also created its own version of the U.S. trade blacklist: the "Unreliable Entity List," reserved for any foreign companies that treat Chinese companies unfairly, according to the government's judgement. While no one has been put on the blacklist yet, China's state-backed nationalist newspaper Global Times in May said that Apple, Qualcomm, Cisco Systems and Boeing could potentially be added on the Chinese list.

"What we are trying to do is to protect ourselves from being hurt in this fight between two huge elephants [the U.S. and China]," said one supply chain executive, who added that they had been trying to quietly dispose of some Chinese assets and get the money out of the country to invest in Southeast Asia. "We are worried our assets in China could one day be a hostage if the tensions between the U.S. and China continue to deteriorate," he added.

'Out of China'

For the tech industry, it signals the end of an era. Previously, they could design products in the West and manufacture in China's industrial heartland, an area labelled by Bank of America as a "Goldilocks Zone" that, for three decades, has offered the optimum mix of costs, quality, human resources, and infrastructure.

Now, the industry as a whole must face the new reality of nationalism and trade protectionism, and rely increasingly on a scattered, decentralized supply chain emerging in Southeast Asia.

The industry has already begun a migration not seen in two to three decades. Some 2,000 Taiwanese, Japanese, and South Korean companies across all sectors -- including many key tech suppliers -- have indicated plans to diversify production away from China, according to government data. Tech companies, especially American brand vendors like Apple, are looking at moving 15% to 30% of their total output out of China, a share equivalent to their U.S.-bound shipments, and asked its Asian suppliers to help facilitate diversification plans over the next few years.

Japan has launched a 220 billion yen ($2.08 billion) subsidy program to encourage companies to bring manufacturing back home, and allocated an additional 23.5 billion yen to fund moving production to Southeast Asia. Nearly 90 Japanese companies were approved for the subsidies as of July this year, while more than 1,600 companies have applied for the funds. Taiwan, in turn, has been running a "move production back to Taiwan" campaign with special tax breaks and loan interest rates since late 2018.

Apple started mass-producing its popular wireless AirPods in Vietnam starting earlier this year and plans to bring more products to the Southeast Asian country, when, just last year, all such production occurred inside China. The Cupertino-based tech giant also asked key iPhone assemblers Foxconn and Wistron to expand manufacturing capacity in India, and rushed another key supplier, Pegatron, to quickly build a facility there this summer.

Samsung Electronics closed its last smartphone assembly facilities in China in 2019 to shift its focus entirely to Vietnam and India. Production of servers for Google, Amazon and Facebook data centers has moved to Taiwan -- two years ago, all such servers were made in China.

"The clients' mindset has changed. The rising tensions between Washington and Beijing forced them to think of their production strategies, just like buying insurance for themselves. In the next two to three years, you will see not just the big electronics assemblers, but also more and more component suppliers shifting their capacity outside of China to support a new supply chain," an iPhone supplier executive said.

The unexpected outbreak of COVID-19 further drove tech suppliers to diversify the risk in putting all their resources in a single region. Meanwhile, rising fears of foreign espionage have hardened attitudes against Chinese technology companies.

A manager at Taiwan-based Alpha Networks, a router, switch, and networking gear provider, told Nikkei: "Since last year, when we sat down with our U.S. clients, their first question has become: Do you offer an 'out of China' option, especially for those products that will go into mobile wireless networks?"

He added that, as a result, Alpha Networks has started to lower its dependence on China in terms of production. "These American clients now think it's not safe if these products are made in China."

For companies like Acter Group, a facility builder for Google, and key Apple suppliers such as Pegatron, Wistron, and many others, the tech supply chain's Southeast Asia-bound expansions have become an important growth catalyst. "We see our future projects from Southeast Asian nations such as Vietnam, Thailand and Indonesia jumping a lot," said Lai Ming-kun, general manager of Acter.

"Last year, we just heard a lot of news that certain companies are trying to diversify production from China," said Angie Tsao, director and spokesperson of Acter told Nikkei Asia. "But this year, all this news became reality. ... These tech suppliers really started building or expanding new facilities, and we also allocated some of our China staff to help our growing businesses there."

A costly migration

The costs of leaving China are immense, however. The country still offers an unbeatable combination of well-organized infrastructure, skilled labor that no other country can match, capable of mobilizing hundreds of thousands of workers and delivering components in hours with just one phone call.

Research by Bank of America Securities shows that the lead time for products to hit shelves in U.S. stores can take up to 40 days from Thailand, almost twice as long as from China.

Maurice Lee, an executive at Unimicron Technologies, a key printed circuit board maker, said it is still extremely challenging for his company and its peers to move production out of the country. "There are at least 30 to 40 manufacturing processes of making a PCB. ... In China, we've got a complete ecosystem and we are very close to all of our suppliers. ... Moving to anywhere else means all the processes, logistics need to be redesigned, and it also means we have to train workers all over again," Lee, also the chairman of Taiwan Printed Circuit Association, said. "That means an increase in costs."

"Tech manufacturing would face a fundamental change [if it were to move out of China]," said Pegatron's Tung. His company, which previously concentrated production only in China and Taiwan, has built new production facilities in Indonesia and Vietnam in the past two years and is about to build a new one in India. "In the past, it would only take two hours to mobilize the delivery of components from other Chinese provinces. But in the future, it would take at least one to two weeks of waiting time as the supply chain becomes decentralized outside of China."

"This is a new reality that we all have to face and adapt [to]," Tung added.

"Manufacturing would face a fundamental change": Tung Tzu-hsien, chairman of key Apple supplier Pegatron.   © Reuters

Government-led policies helped the little-known inner Chinese city of Zhengzhou of Henan Province transform from a deserted agricultural city to a manufacturing center churning out 50% of the world's iPhones every year. The city government of Chongqing, in China's west, assisted HP and its suppliers to establish one of the world's biggest notebook manufacturing hubs. It once produced one in every three laptops globally.

Even before the trade war, however, several suppliers were looking to move some production to Southeast Asia amid rising costs and labor shortages in China. For the past four to five years, it was already getting harder for manufacturers to attract enough production-line workers during peak season. Lack of workers and rising land prices and wages have become a common headache for suppliers in recent years, and had already prompted companies to look for alternatives outside of China.

Sean Kao, an analyst with IDC, said many companies have suffered the rising labor costs in China for several years and started to evaluate some diversification plans, but none of them had acted on these plans until the trade war started.

"Still, none of the countries could fully replace China," Kao said. "But the escalating tension between the U.S. and China and, later, COVID-19, pulled the trigger to push all these suppliers and their clients to be really determined to shift at least some production to other countries, and step out of their comfort zone. ... This new, irreversible move is happening."

Doubts, mosquitoes

Efforts to shift operations outside China have had mixed results. A new supply chain is emerging in Southeast Asia and India, less than 1,000 days after the first wave of punitive tariffs against Chinese imports was implemented in 2018 as tit-for-tat Washington-Beijing trade tensions escalated.

Big tech suppliers like Apple Watch maker Compal Electronics have secured land in Vietnam; AirPods and Xiaomi phone maker Inventec has facilities in Malaysia; while iPhone and Acer notebook assembler Wistron has plants in the Philippines. But those plants, often small-scale, are scattered across Southeast Asia and not operating at their full capacity.

Compal, which also supplies parts to HP and Dell, was given land for a factory in the northern Vietnamese province of Vinh Phuc. But it was fined in 2013 by the local government and had much of the property taken back, after it failed to make use of the land and hire local labor as promised.

"In some of the cases, there used to be no one in these idled factories. Only mosquitoes," a supply chain executive told the Nikkei, describing the state of his company's plants in Southeast Asia a few years ago.

While these factories are no longer idle, the lack of efficiency in Southeast Asia is a new challenge for the suppliers. Yancey Hai, chairman of Delta Electronics, a key power supply components provider for Apple, HP and Dell, said his company has launched a diversification plan for the trade war to expand production in Taiwan, Thailand and India.

However, he said, the Chinese government's efficiency during the coronavirus outbreak is hard to beat. It was among the quickest in the world to help manufacturers resume production with guidelines of virus prevention measures amid the pandemic.

Industries across sectors and market watchers are paying close attention to the upcoming U.S. presidential election, but not many of them believe the competition and geopolitical tensions between Washington and Beijing will die down, no matter who becomes the next American president.

Martijn Rasser, senior fellow of the technology and national security program at the Center for a New American Security, said the U.S. and China are not likely to go back to "good old days," as he put it.

"Should Joe Biden become president, I do expect a change in tone and tactics. [But] there is strong bipartisan consensus on the challenges that a rising China poses, as well as a broad acceptance among the international allies that ... bringing China into the world economy to gradually open [up], and prompt Beijing to moderate its position on a range of geopolitical issues, did not work."

Willy Shih, a professor of management practice at the Harvard Business School, told Nikkei: "The U.S. election could change the leadership on one side ... and that might somewhat improve relations. But there is also bipartisan support for a more aggressive policy toward China, so I'm not optimistic."

"I think a lot of supply chain movement in tech products has been set in motion, and it has momentum that will be hard to change."

Stay informed on the big issues of the day, from the technology supply chain wars to Asia's stake in the U.S. election. As part of Nikkei Asia's brand relaunch, we'll be holding a series of webinars through November. Learn more and register here.

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