The transition of high-volume electronics equipment manufacturing to China has resulted in that country becoming an important source for many electronic components.

As OEMs and EMS providers relocated manufacturing to China, they also brought along many of their suppliers. In addition, many indigenous Chinese suppliers have sprung up and Western and Asian component manufacturers have entered into joint ventures with Chinese companies to produce parts. The result is that many low-cost parts including resistors, capacitors, switches, relays, and low-end semiconductors are readily available in China. In fact, 85% of bare-printed circuit boards are now produced in China. Often component prices in China are 20% less than in the U.S. and Europe.

Parts purchased in China are primarily used for equipment being built there, but a growing number are exported, too. Ultimately most parts produced in China are exported because most end equipment manufactured there is exported.

While parts can typically be purchased for less in China, the old adage 'caveat emptor,' or buyer beware, still holds. Quality of many parts in China built by indigenous suppliers can be suspect although it is improving, according to analysts. In addition, counterfeit and substandard parts, which don't meet the stated spec, remain a problem. And while the price of parts may be lower in China, the total landed cost may be higher than parts produced in other regions of the world. Savvy buyers need to apply due diligence to make sure their total acquisition cost for parts sourced in China is worth the effort.

While there are a variety of parts available in China, most are low-cost commodity components. Semiconductor production is limited to such parts as diodes, analog ICs, commodity logic and other discrete parts.

Buyers interested in sourcing leading-edge microprocessors and memory ICs in China shouldn't hold their breath waiting. It will be years before fabs in China will produce such parts.

Greg Shoemaker, vice president of procurement for Hewlett-Packard, says many of HP's products are built in China, but higher-end semiconductors needed for production have to be imported.

"There aren't a lot of high-end fabs in China," he says. One reason is that there is not a lot of cost benefit in manufacturing high-end chips in China over some other region because chip production is not labor intensive.

"A DRAM fab is highly automated. It may be cheaper to build the fab from an infrastructure standpoint but there is not a lot of gain running it there," says Shoemaker, adding that many suppliers operating there do so, not because it is cheaper to produce there, but to gain access to the growing Chinese market.

Another reason for the lack of higher end chip production in China is that many are equipped with older, used chip-production equipment, that is based on .25 micron process technology. The latest microprocessors, application specific integrated circuits ( ASIC s), and high-end memory chips are built on 90 nanometer (nm) process technology and some chip suppliers are beginning to use 65nm technology. Chinese chip suppliers don't have access to that technology and equipment.

"The problem is China has import limitations on technology because of the Wasserman agreement," says Len Jelinek, director and principal analyst for market intelligence provider iSuppli. The agreement bans countries from exporting to mainland China equipment that enables production of wafers larger than 200mm or feature sizes smaller than 0.25 micron

"Until those export rules are removed, China will decline in regard to its ability to stay close in terms of technology development," says Jelinek. That means China will not be a source of leading-edge, higher price parts and the growth of the Chinese chip market in dollars will be limited.

"If global leadership of DRAM is at .90nm or .65 and you as a country can't import the equipment to do that, all you can do is compete on price on a more mature technology or product," says Jelinek.

That will limit growth of the Chinese semiconductor industry although it will still rise, even if Chinese chip suppliers are limited to production of lower-cost chips. The market is expected to grow from $51.1 billion in 2003 to $82 billion in 2006, says Joe Abelson, vice president of emerging markets for iSuppli. However, the percentage of the total global chip market growth will be limited. Consider: In 2005, China produced about 6% of the world's semiconductors as measured in dollars, according to iSuppli. However, it produced about 18% of electronics equipment. By 2007, the amount of equipment will rise to 21% and semiconductor production will only increase to 8% or 9%.

The reason that China has so little semiconductor market share is it is producing low-value commodity chips which have prices of less than $1. Many of the low-value chips are needed by the manufacturers of consumer electronics equipment such as DVD players, digital cameras and televisions.

While chip-production market share in China won't rise much, the amount of semiconductors consumed will increase dramatically. By 2008, Chinese manufacturing will consume about 25% of all semiconductors in the world, says Abelson. That means that China will continue to import many of the more sophisticated higher-end semiconductors such as microprocessors and leading-edge DRAMs.

About 85% of Chinese chip production occurs at foundries which build chips for other semiconductor companies. The Chinese foundry business is booming, says market researcher IC Insights. SMIC, the fourth-largest chip foundry, grew sales 166% in 2004; HHNEC had sales growth of 85% and ASMC posted revenue growth of 56%. Growth rate for foundries is expected to cool off a bit in 2005, but will outpace the overall semiconductor market.

Most chips and finished equipment produced in China are exported, but that may change in the future. Abelson says China's domestic market will soon grow as well.

"Dell notebooks, Cisco routers, Nokia handsets are built in China, but sold all over the world," says Abelson. "That helped accelerate the expansion of China as a manufacturing base and the supply base of materials. Now you have the emergence of China as a big domestic market. The Chinese economy expanded by 9.5% last year. The forecast is 9% for this year," he says.

The growth of the domestic Chinese market will further fuel electronic component demand and development of the Chinese indigenous supply base, Abelson explains. PCs and set-top boxes are two examples of growing end markets in China.

"China is rolling out its digital TV system and cable systems so there is an enormous growth ahead for set-top boxes. China's PC industry is also growing rapidly," he says. "China's importance as an exporter will not diminish and its importance as a market will increase," says Abelson.

Chinese branded products like TVs, DVD players, central office switches and handsets that carry the brand of a Chinese manufacturer are increasingly capturing market share outside of China. Such brands include TCL, Apex and Skyworth.

"This is significant because you have Chinese brands pushing Japanese and Korean brands off the shelf which is not a small thing. They are just starting to build gear that consumers around the world are satisfied with," Abelson says.

Chinese brands are already well established in other emerging geographies like India, the Middle East and Southeast Asia. A good example is Huwai, a communications hardware company competing with Cisco and Alcatel. Forty percent of the company's business is export. The company's products are popular in developing countries that don't need state-of-the-art communications gear. The pricing of Huwai's gear is better than multinational companies'.

What does this mean to electronics buyers? "All of these things are causing China to become a better source for a whole range of electronics components and related materials like printed circuit boards, enclosures, switches, etc.," says Abelson. "When you have so many high-volume applications being built in China—TVs, PCs, handsets—in order for China to be a competitive producer of those systems, the companies need a very capable network of component and materials suppliers," he says.

Chinese chip production will develop and eventually will produce more higher-end chips. However, its development will be based on what equipment manufacturers need.

"They will focus on applications that have a strong indigenous manufacturing base for instance chipsets for DVD recorders or for set-top boxes," says Abelson.

Buyers shouldn't expect broad-line semiconductor companies to emerge in China, as their focus will be narrow in market segments that are lucrative. Chinese semiconductor market will grow its offerings in discrete, power semiconductor, basic logic chips, MOSFETs and ASICs.

While there may be ample availability for a variety of low-cost components in China, it doesn't automatically mean buyers should purchase parts there. "Buying in China is very case-specific. It will depend a lot on the volume and how much flexibility is required," says Abelson. "If you're buying high volumes of bare boards or enclosures, there could be an advantage because they are labor intensive."

Electromechanical products, enclosures, switches, connectors, and relays are products that can be manufactured for significantly less in China and could be worth shipping around the word, but you have to consider the service requirements, he says.

"How much can you save? The price for the part may be $1.10 here and 60¢ in China. But there is the cost to get the part to where it needs to go," says Abelson.

Many Chinese suppliers lack the sophisticated IT systems—so doing electronic commerce with many of them is impossible.

"Things like electronic data interchange (EDI), Rosettanet or electronics schedule management are impossible to do with most Chinese suppliers today," says Abelson. However, many are beginning to invest in IT with assistance from their customers and will become IT enabled in the future.

In addition, doing business with Chinese suppliers may be difficult for a North American-based buyer because of the distance and time-zone changes. "If you are trying to manage a relationship that is 10,000 miles away, driven by different language, it can be difficult," Abelson says.

Communication issues are not uncommon, according to John Hoff, president of Global Point Technology, a Rochester, N.Y. company that provides offshore contract manufacturing of engineered components and assemblies in Asia.

"You may ask a question of someone at a supplier facility and the person answers yes or shakes his head, but all he was doing was acknowledging that he understood the question. He did not agree with what you wanted to be done," says Hoff.

He adds that while many companies source in China for low-cost parts and services, often "Chinese local factories don't know their costs. You can come to an agreement with the factory, but then get hit with a 50% price increase six months later because they didn't know their costs. You have to be patient if you're doing business in China for the first time," says Hoff.

Abelson says doing business in China for the first time and managing distant supplier relations is especially difficult for many smaller or medium size OEMs. Those companies may not have sourced in China before and may not be prepared "to source outside of their home base." Such companies need to "have people on the ground or have partners who can take advantage of sourcing opportunities in China."

There are a number of international procurement offices (IPOs) that can act as a go-between for an OEM or EMS provider and the Chinese supply base. A reliable IPO can help buyers avoid serious sourcing problems such as purchasing counterfeit and substandard parts. While counterfeit parts is not a new issue in the electronics industry, it continues to be a thorn in the side to many in the supply chain.

"Even if the number of counterfeit products in the market is small, the possibility of counterfeit parts is a problem," says Abelson. "If a part is slightly out of spec and the end product fails in the field three months after it is shipped, that can be really expensive."

He says, to avoid buying substandard or bogus parts, buyers should deal with authorized channels. There are a myriad of unauthorized channels for obtaining product in China," he says. "Distribution is very important in China. It includes Arrow and Avnet and other known North American distributors who are authorized—and a whole lot of other companies that aren't authorized."

Distributors can help screen product. "That is a service that some distributors are providing their customers. They are doing more of the screening and catching the bad parts before they ship to the customer," he says.

However there are 1,200 companies operating in some distribution capacity that are not authorized. Some of them are good but they don't have the backing of the suppliers, says Abelson.

Unauthorized channels are not going away anytime soon in China. There is a "5,000-year history of middlemen in China. It is not going to end today, but it does necessitate that if you source in China, be extra sure the supply chain leading from raw materials to receiving docks is a reliable, authorized one," says Abelson.

"There aren't a lot of high-end fabs in China. It may be cheaper to build the fab from an infrastructure standpoint but there is not a lot of gain running it in China," says Greg Shoemaker, vice president of purchasing for Hewlett-Packard.