Strategy in Global Economy

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http://nyti.ms/2iHpVtX

How China Built ‘iPhone

City’ With Billions in

Perks for Apple’s Partner

A hidden bounty of benefits for Foxconn’s plant in

Zhengzhou, the world’s biggest iPhone factory, is central

to the production of Apple’s most profitable product.

点击查看本文中文版 By DAVID BARBOZA DEC. 29, 2016

ZHENGZHOU, China — A vast, boxy customs center acts as a busy island of

commerce deep in central China.

Government officers, in sharply pressed uniforms, race around a maze of

wooden pallets piled high with boxes — counting, weighing, scanning and approving

shipments. Unmarked trucks stretch for more than a mile awaiting the next load

headed for Beijing, New York, London and dozens of other destinations.

The state-of-the-art facility was built several years ago to serve a single global

exporter: Apple, now the world’s most valuable company and one of China’s largest

retailers.

The well-choreographed customs routine is part of a hidden bounty of perks, tax

breaks and subsidies in China that supports the world’s biggest iPhone factory,

according to confidential government records reviewed by The New York Times, as

well as more than 100 interviews with factory workers, logistics handlers, truck

drivers, tax specialists and current and former Apple executives. The package of

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sweeteners and incentives, worth billions of dollars, is central to the production of

the iPhone, Apple’s best-selling and most profitable product.

It all centers on Zhengzhou, a city of six million people in an impoverished region of

China. Running at full tilt, the factory here, owned and operated by Apple’s

manufacturing partner Foxconn, can produce 500,000 iPhones a day. Locals now

refer to Zhengzhou as “iPhone City.”

The local government has proved instrumental, doling out more than $1.5

billion to Foxconn to build large sections of the factory and nearby employee

housing. It paved roads and built power plants.

It helps cover continuing energy and transportation costs for the operation. It

recruits workers for the assembly line. It pays bonuses to the factory for meeting

export targets.

All of it in support of iPhone production.

“We needed something that could really develop this part of the country,” said

Li Ziqiang, a Zhengzhou official. “There’s an old saying in China: ‘If you build the

nest, the birds will come.’ And now, they’re coming.”

American officials have long decried China’s support of its state-owned

companies, calling the subsidies and other aid an unfair competitive advantage in a

global marketplace. But the Zhengzhou operation shows the extent of China’s effort

to entice overseas multinationals to set up production facilities in the country.

Local and provincial officials, in an effort to create jobs and drive growth, have

courted manufacturers with incentive packages that make it easier and cheaper to do

business. Beijing, for decades, has encouraged such efforts at the national level, by

developing special economic zones that offer tax breaks to multinationals and

exempt them from costly and cumbersome rules.

In this way, China is not unlike other countries, including the United States,

where states and cities vie for companies. To compete in the era of globalization,

multinationals, which face pressures from shareholders and customers, must seek

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the best opportunities, increasingly by relying on a highly interconnected supply

chain spread across the world.

But the reasons behind their choices are not always transparent. In China, the

competition for companies is secretive and rarely exposed to public scrutiny or

debate — and it is often focused on manufacturing partners, rather than

multinationals themselves.

China’s lure is strong. Dell, Hewlett-Packard and Samsung have all flocked to

China to lower their production costs, bolster their bottom lines and tap into the

world’s largest consumer market. And many rely on local manufacturing partners

like Foxconn.

While Apple came later than many technology companies, it now generates

nearly a quarter of its revenues from sales in China and has some of the fattest profit

margins in the business. As such, the Zhengzhou operation provides an especially

illustrative look at China’s importance to American technology companies — and

specifically iPhone production and more recently, Apple’s consumer sales.

A 32-gigabyte iPhone 7 costs an estimated $400 to produce. It retails for

roughly $649 in the United States, with Apple taking a piece of the difference as

profit. The result: Apple manages to earn 90 percent of the profits in the

smartphone industry worldwide, even though it accounts for only 12 percent of the

sales, according to Strategy Analytics, a research firm.

It is difficult to tally the total value of government benefits for the Zhengzhou

operation, or to determine the exact effect on the profits of Foxconn or Apple. The

subsidies aren’t disclosed by the Chinese government or Foxconn. They aren’t

available in public records. And Apple says it was not a party to Foxconn’s

negotiations.

The confidential government records obtained by The Times detail multiple

meetings over several years in which Zhengzhou city officials discussed their

“support” for iPhone production, calling the benefits a “preferential policy.” The

records offer a snapshot of those benefits, including the specific aid for Foxconn in

multiple areas, like infrastructure, labor, taxes and exports.

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As China’s largest private employer, Foxconn, a Taiwanese company, has

enormous leverage in the negotiations for those incentives. The company’s size and

scale — and the sway that they afford in China — is connected to Apple. Foxconn is

Apple’s largest supplier. Apple is Foxconn’s largest customer.

The two companies are intertwined in Zhengzhou. When the factory opened,

Apple was Foxconn’s only customer here. Even now, the American technology

company accounts for almost all of the production at the Zhengzhou plant, where

about half of the world’s iPhones are made. Apple is also the main exporter using the

customs facility here.

In response to questions, Apple said it was aware of the government’s

infrastructure support. But the company added that it had no knowledge of specific

grants, subsidies or tax breaks given to its manufacturing partner.

Foxconn, in a separate statement, said it was grateful for the support of the

government, noting that it was “no different than similar tax breaks all companies

get in locations around the world for major investments.”

A growing backlash against globalization puts Apple and other big multinationals

directly in the sightlines of two increasingly combative giants: the United States and

China.

President-elect Donald J. Trump has vowed to bring down the full force of the

government on American companies that move jobs overseas, threatening punitive

tariffs on the goods they sell back at home. Apple has been a frequent target of Mr.

Trump, who said during the campaign that he would get the technology company to

“build their damn computers and things in this country.”

China, under the leadership of President Xi Jinping, is growing less tolerant and

more suspicious of Western influence, particularly American technology companies

and the huge influence they have over Chinese consumers. A state-owned

publication called Apple one of the “guardian warriors” that have “seamlessly

penetrated” China and may pose a threat to national security.

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China, no longer content with just being the world’s factory floor, is moving

aggressively to develop its own technology giants. Beijing is pressuring local

governments to cut subsidy programs that the country heartily encouraged even just

a few years ago. And big exporters, courted and protected for decades by Beijing,

now face broad scrutiny.

Regulators shut down Apple’s iTunes Movies and iBooks Store last spring, just

six months after the services were introduced in China. The Chinese authorities

fined the technology giant for failure to fully pay its taxes. And Apple went through a

national security review in China for the iPhone 6, delaying its release in the

country.

Apple is now engaged in the corporate version of shuttle diplomacy. In

December, the company’s chief executive, Timothy D. Cook, along with other Silicon

Valley executives, met with Mr. Trump in New York, part of an effort to build

bridges with the incoming administration. It followed a similar good-will tour in

China in August, when Mr. Cook sat down with the country’s vice premier at

Zhongnanhai, the government’s walled leadership compound in what was once part

of Beijing’s Imperial City.

The two countries are playing a high-stakes game.

Apple, like many multinationals, depends on a vast global supply chain that

includes multiple companies and countries, each with its own expertise and

advantages — a complexity that is often lost in the political debate over trade. The

iPhone is a collection of intricate parts that are made around the world and

assembled in China, spurring employment in many countries; Apple says it supports

two million jobs in the United States.

As China and the United States both brandish a new form of economic

nationalism, they risk disrupting the system, without necessarily achieving their

goals. And multinationals and their manufacturing partners would face serious

financial trade-offs.

As the Zhengzhou operation shows, China not only provides a large pool of

labor; it also offers incentives that would be difficult to replicate in the United States

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or anywhere else. The trove of benefits in Zhengzhou flows through the production

process for the iPhone, from the factory floor to the retail store.

Foxconn receives a bonus when it meets targets for exports. Those subsidies,

according to the government records, totaled $56 million in the first two years of

production, when the factory was exclusively dedicated to the iPhone.

The bonus is small on each of the tens of millions of iPhones produced during

that period. But the subsidies add up: The government records list more than a

dozen other forms of financial aid at the Zhengzhou operation.

The Zhengzhou government eliminated corporate taxes and value-added taxes

that Foxconn pays for the first five years of production; they are half the usual rate

for the next five. The city lowered Foxconn’s social insurance and other payments for

workers, by up to $100 million a year.

The customs operation is also in a so-called bonded zone, an area that China

essentially considers foreign soil, subject to different import and export rules. This

setup allows Apple to sell iPhones more easily to Chinese consumers.

Pursuing the iPhone

Apple was late to China.

In a bid to lower costs, some of the biggest American technology companies,

including Compaq, Dell and Hewlett-Packard, began dismantling their domestic

manufacturing in the 1980s and moving work overseas, largely to Asia. Not Apple.

The company’s co-founder, Steven P. Jobs, believed that software and hardware

development had to be closely integrated.

Rather than close plants, Apple decided to build them — in Colorado, Texas and

California. Apple would maintain some of them long after Mr. Jobs left the company

in 1985. The plants were highly automated, with the walls painted white, just as Mr.

Jobs liked them, and they were promoted as a symbol of American ingenuity.

“This is a machine that is made in America,” Mr. Jobs trumpeted in 1984, after

Apple opened a manufacturing facility in California to produce the Macintosh

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personal computer.

Finances forced Apple to change course. As Mac sales plummeted and

inventories began to bulge in the mid-1990s, Apple had to embrace outsourcing,

something with which it had only just experimented. After Mr. Jobs returned to the

company in 1997, he turned to his new operations chief, Mr. Cook, who had recently

joined from Compaq, to figure out how.

Under the direction of Mr. Cook, Apple shifted more business to Foxconn, then

an up-and-coming Taiwanese contract manufacturer that had started to gain a

following among big American brands like Compaq, IBM and Intel. The partnership

freed up Apple to focus on its strengths — design and marketing. Apple would come

up with a new idea, and Foxconn would find ways to produce millions of units at a

low cost.

“They have brilliant tooling engineers, and they were willing to invest a lot to

keep pace with Apple’s growth,” said Joe O’Sullivan, a former Apple executive who

worked in Asia.

When Apple’s sales took off after the introduction of the iPod in 2001, Foxconn

had the heft and expertise to meet the demand that accompanied each hit product.

Foxconn’s factories could quickly produce prototypes, increase production and,

during peak periods, hire hundreds of thousands of workers.

Foxconn’s founder, the Taiwanese billionaire Terry Gou, provided political

clout. Over the years, he frequently visited China to meet local officials and members

of the decision-making Politburo to lobby for subsidies, cheap land, workers and

infrastructure for facilities that churned out iPods, iPads and iPhones.

“The reason Foxconn’s so big is Terry Gou,” said Tony Fadell, a former Apple

executive who helped design the iPod. “He said he’d create the manufacturing, and

the Chinese government would give him some of the money to do it. As Terry grew

with the Apple business, no one else could compete.”

After the first iPhone was rolled out in 2007, Foxconn moved to expand

production and began scouting new locations around China — unleashing a fierce

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competition among cities eager for the business. Officials from various regions

camped out at hotels in Shenzhen, where Foxconn had its main operations.

“These have become like Olympic competitions,” said Gao Yuning, who teaches

public policy at Tsinghua University in Beijing.

The Zhengzhou government saw the factory as a huge opportunity for

development in an area that had been bypassed by China’s boom. Officials wanted to

rebrand a place derided as a source of migrant laborers and unfairly tarnished as a

land of thieves and counterfeiters.

City officials lavished money and favorable investment terms on Foxconn,

according to the government records. They promised discounted energy and

transportation costs, lower social insurance payments, and more than $1.5 billion in

grants for the construction of factories and dormitories that could house hundreds

of thousands of workers.

The city created a special economic zone for the project and provided a $250

million loan to Foxconn. The local government also pledged to spend more than $10

billion to vastly expand the airport, just a few miles away from the factory.

“We know that China has all sorts of policies to promote development, and this

one ticks all the right boxes,” said Barry Naughton, an authority on the Chinese

economy at the University of California, San Diego.

The city moved quickly. Factories were built, licenses were approved and

assembly lines began operating in August 2010, just a few months after the

government signed the deal. In Zhengzhou, the Chinese government effectively took

a huge tract of land on the barren, dusty plains of central China and transformed it

into a sprawling industrial park.

“I was impressed,” said Jeff Williams, Apple’s chief operating officer, who was

part of the early discussions about setting up a factory. “They were very focused.”

Made, and Sold, in China

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When Apple first moved into China, the country was largely a low-cost

production site. It quickly evolved into one of the world’s biggest consumer markets,

with more than a billion potential customers.

But Apple initially had to take the “Hong Kong U-turn” to get its products into

the hands of Chinese consumers.

Since China began opening its economy to the outside world in the 1980s, the

government’s policies have encouraged manufacturing and exports with the creation

of special economic zones. But those same policies have discouraged domestic

consumption of overseas brands.

Most products made in China by big multinationals had to be physically

shipped out of the country and then brought back so that they could be taxed as

imports — hence, the U-turn employed by many companies.

In 2005, Apple’s best-selling portable music device, the iPod, was manufactured

in southern China. To comply with the country’s stringent rules, iPods were loaded

onto a cargo ship and sent to Hong Kong. Often, when the ship arrived, it was simply

turned around and sent back to China.

“This was really a legacy of China’s old export-oriented economy,” said Edwin

Keh, the former head of global procurement at Walmart, who worked for the retailer

and other multinationals in China for 20 years. “Back then, we built supply chains

good at making things in the East and selling them in the West.”

Apple and other multinationals wanted a better system.

By the time Apple released the iPhone in 2007, China faced growing pressure to

loosen its restrictions and give global companies easier access to its market. Apple

and other companies believed that shipping goods to Hong Kong was a waste of time

and energy. They wanted to send goods from the factory gate in China directly to

their stores and distribution centers inside the country.

In discussions with Zhengzhou officials, Foxconn insisted that the operation be

located inside a bonded zone, equipped with customs right at the factory gate to

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facilitate iPhone exports. It also wanted the factory to be built within a few miles of

the city’s airport, to expedite Apple’s global shipments.

Although it wasn’t the first city to create such a cohesive operation, Zhengzhou

provided a convenient system, since it would serve what would become the world’s

largest iPhone manufacturing facility.

A bonded zone functions much like a diplomatic territory, in that the

government regards it as foreign soil. The zone eliminates the need for global brands

to pay duties or taxes on imported components. And it makes it unnecessary to

physically export the goods. In those zones, products can be imported and exported

virtually at customs, without crossing a single border. After that, they can move

swiftly around the country, or out to the rest of the world.

As the final assembly point for the iPhone, China also functions as a base for

Apple’s global tax strategy.

In the Zhengzhou bonded zone, typically at customs, Foxconn sells the finished

iPhones to Apple. After purchasing the iPhones, Apple then resells the goods to

Apple subsidiaries. The process largely takes place electronically.

The process also plays out with other Apple goods that are produced in the country.

Apple can assign some profits on these goods to an affiliate in Ireland, a tax-

advantageous locale, according to a 2013 American congressional report on the

company’s tax practices. It is a practice commonly employed by many big technology

brands and is not unique to China.

“U.S. multinationals are the world leaders in tax avoidance strategies,” said

Edward D. Kleinbard, the former chief of staff of the congressional Joint Committee

on Taxation. “In doing so, they create stateless income — income that has become

unmoored from the countries to which it has an economic connection.”

According to the congressional report, the process allowed Apple to move tens

of billions of dollars offshore and substantially reduce its tax bill, which one senator

called the “holy grail of tax avoidance.” The European Union in August ordered

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Ireland to claw back more than $14.5 billion from Apple in unpaid taxes from a

decade-long period.

Apple said it follows all applicable tax rules, insisting that the company pays all

its taxes. The company said it had made some changes to its tax procedures to

comply with new laws, including registering a subsidiary in Ireland that previously

had no tax jurisdiction. It is appealing the ruling in the European Union.

In Zhengzhou, local officials have lauded the package of incentives provided to

Foxconn, confident that the city’s iPhone production will continue to pay huge

dividends.

In August 2014, the city’s top leaders held a special meeting to discuss

“deepening collaboration” with Foxconn, according to the government records

obtained by The Times. They crowed that Zhengzhou was the “biggest production

base for Apple iPhone worldwide.”

There were 94 production lines producing the iPhone 6 and iPhone 5s, and the

government said about 230 million smartphones had already been exported from

Zhengzhou, making it one of the nation’s crucial export centers. Production capacity

had reached half a million iPhones a day. The city’s tax revenue was rapidly rising.

Officials had a name for it all: “Zhengzhou Speed.”

A State-Recruited Army

A crushing work force begins arriving for the early shift at 6:30 a.m. They travel

by foot, by bus, by motor scooter and even by pedicab.

They file steadily into dozens of factory sites, spread out across 2.2 square miles.

At the peak, some 350,000 workers assemble, test and package iPhones — up to 350

a minute.

Apple’s labor force, the size of a national army, relies heavily on the generosity

of the Zhengzhou government.

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As part of its deal with Foxconn, the state recruits, trains and houses employees.

Provincial officials call townships and villages to ask for help finding potential

workers.

“Every city’s department of labor and ministry of human resources is involved,”

said Liu Miao, who runs a private recruiting center in Zhengzhou.

The government pays recruiters a subsidy for every worker they hire, Mr. Liu

said. “If the demand is high, then they will pay more,” he said. “If the demand is low,

then the payment will be low, too.”

Cities like Zhengzhou have handed out subsidies to manufacturers in the hope

of driving economic gains. But increasingly those local interests don’t align with the

national agenda, creating a raft of uncertainty for multinationals operating in China.

As the economy slows, Beijing has started to shift its development path away

from manufacturing and exports and toward innovation and consumption. It wants

to empower Chinese brands and foster homegrown technology.

To advance its cause, Beijing has started to rethink the investment policies that

support overseas companies. In November 2014, China’s State Council, the country’s

cabinet, directed local governments to evaluate and eliminate any preferential

treatment, including subsidies and tax breaks that benefited multinational

exporters.

The threat prompted a pushback, mostly notably by Foxconn which, along with

other international businesses, fought to keep existing incentives. Since then, Beijing

has backed off the issue.

But the broad trend lines are clear: Overseas companies will no longer get the

welcome they once received. The Chinese government is tightening access to its huge

market and pressuring Western technology companies to advance domestic goals —

in a coordinated action that one congressional study in the United States called a

new form of “techno-nationalism.”

“The government wants to know what you can give to China,” said James

McGregor, who lives in Shanghai and has for decades advised American companies

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operating in China. “And they have the market and the muscle. They’re not playing

around anymore.”

Chinese regulators have been penalizing overseas companies, like the American

mobile chip giant Qualcomm, which was forced to reduce prices for companies that

sell smartphones within the country. It is a market increasingly dominated by

Chinese brands like Huawei and Xiaomi that undercut Apple and Samsung on price.

China is also scrutinizing Western technology companies over national security

issues. Beijing has increased oversight of the internet with new cybersecurity rules

and forced state companies to reduce spending on overseas technology. It pressed

Apple to hand over its source code. Apple said it refused.

Apple has agreed to the government’s request to store more of its local data on

Chinese servers. It must also undergo “security audits” on new models of the iPhone

before gaining approval to sell the product.

Beijing also expects American companies to help develop China’s own

capabilities. Apple is teaming up with UnionPay, a state-backed financial services

company. It has invested $1 billion in the Chinese ride-hailing service Didi Chuxing,

which has significant backing from state companies.

Mr. Cook, Apple’s chief executive, has also carefully cultivated Apple’s image as

a big employer, a good corporate citizen and a major economic contributor. He

comes to China regularly. He has donned factory uniforms and walked the assembly

line in Zhengzhou. He has courted regulators, the heads of state telecom giants and

the country’s top leaders, including Mr. Xi.

In an interview with Chinese state television last year, Mr. Cook explained how

Apple was planting trees in the country, calling the effort a “pillar of its

environmental strategy.” He detailed plans to build a massive solar project to power

Apple’s stores, headquarters and offices throughout the country. He also boasted

about creating over three million jobs in China, half of them in manufacturing.

At the Hall of Purple Light in the government’s walled leadership compound in

Beijing, Mr. Cook promised in August to build the company’s first research and

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development center in the country and to support the government’s big focus on

high-end manufacturing.

Opposite him sat the vice premier, Zhang Gaoli. Beside him sat his partner.

There was the chairman of Foxconn, Mr. Gou. Also present was the party leader of

the province where Zhengzhou is located, Xie Fuzhan.

Sui-Lee Wee contributed reporting from Zhengzhou, China. Zhang Ruoyao and Zhang

Tiantian contributed research.

A version of this article appears in print on December 29, 2016, on Page A1 of the New York edition with

the headline: China’s ‘iPhone City,’ Built on Billions in Perks.

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