Apple Built Its Empire With China. Now Its Foundation Is Showing Cracks.

Every September, Apple unveils its latest phones at its futuristic Silicon Valley campus. A few weeks later, tens of millions of its newest handsets, assembled by legions of seasonal workers hired by its suppliers, are shipped from Chinese factories to customers around the world.

The annual release of Apple’s iPhones usually runs like clockwork, a prime example of how the U.S. tech giant has become the most profitable company of the globalization era by seamlessly navigating the world’s two largest economies.

But this year, a smooth rollout for the iPhone 14 was the latest casualty of the growing difficulties of doing business in China. Beijing’s no-holds-barred approach to stopping Covid-19 and heightened tensions with the United States have forced Apple to re-examine major aspects of its business.

A recent outbreak of coronavirus cases in the region surrounding Apple’s largest iPhone factory, in Zhengzhou, in central China, prompted local officials to order a seven-day lockdown last week. As a result, the company said on Sunday, it will not be able to produce enough phones to meet the demands of the holiday season.

For much of this year, Apple has also been the focus of a bipartisan intervention in Washington, where alarm over Beijing’s military provocations and technology ambitions has upended orthodoxy about free trade.

Word trickled out in March that Apple was in talks with an obscure Chinese memory chip maker, Yangtze Memory Technology Corporation, or YMTC, to supply components for the iPhone 14.

That collided with work being done by a coalition of lawmakers and more than a dozen congressional aides, which had spent months examining the ins and outs of Apple’s supply chain in China. The Commerce Department issued restrictions last month that prohibited American companies from selling machinery to YMTC, making it difficult for Apple to go ahead with the deal.

Apple has confirmed publicly that it talked with YMTC, which didn’t respond to requests for comment. But an Apple spokesman declined to comment when asked if the company had abandoned the possibility of working with the Chinese memory maker.

The recent developments underscore how Apple’s close ties to China, once considered a strength of its business, have turned into a liability.

It is no coincidence that Apple’s rise from near bankruptcy in the 1990s to the world’s most valuable company has closely followed China’s economic ascent. It pioneered a best-of-both-worlds business model: Products designed in California were assembled inexpensively in China and sold to the country’s growing middle class.

Apple raked in profits as China’s economy roared. But as U.S.-China relations falter, and both governments meddle in Apple’s business, the company has gone from one of globalization’s greatest success stories to a symbol of its fracture.

“Apple is discovering that geopolitics drive business models — not the other way around,” said Matthew Turpin, a visiting fellow at the Hoover Institution specializing in U.S. policy toward China. “This whole collection of supply chain risks are creating a real liability for them.”

China’s leader, Xi Jinping, has forced business leaders to reconsider long-held assumptions about operating in the country. For several decades, economic growth was the Chinese government’s top priority. But Mr. Xi used an important Communist Party congress last month to make it clear that security issues and the more ideological viewpoints of the party would take precedence over business concerns.

Mr. Xi’s “zero Covid” policy has slowed factory output and throttled the country’s economic growth, and his government has faced pressure from business leaders and markets to ease the restrictions. But it has not signaled clearly that it will make a change.

Loosening Covid restrictions could allow Apple to fill some of its supply shortages and meet some demand, but the company will still lose sales this holiday season, said Jeff Fieldhack, an analyst with Counterpoint Research, a technology research firm.

It would be difficult for Apple to untangle itself from China. The company spent two decades working with manufacturing partners to build enormous factories supported by a vast network of suppliers in the country. Over time, it has added more Chinese components to its products and benefited from their lower prices.

In a bid to limit its exposure to China, Apple began manufacturing a small percentage of its newest iPhones in India. It shifted production of several other products to Vietnam. But both markets offer factories with only tens of thousands of workers — a small fraction of the scale that Apple enjoys in China, where its manufacturing partners employ some three million workers.

Apple depends on factories like the iPhone manufacturing plant in Zhengzhou, which is operated by Foxconn, its biggest assembly partner. When Covid-19 cases started to spike in the area, Foxconn walled its roughly 200,000 workers inside the grounds of a factory that can produce as much as 85 percent of iPhones worldwide, according to Counterpoint Research. It wasn’t long before Covid started to spread and Foxconn struggled to balance business demands with the country’s ultra-strict pandemic policy.

As stories of unrest and food shortages flooded Chinese social media, workers began to fear for their lives. Hundreds fled. The assembler initially offered workers an extra $14 a day to continue working. It later nearly quadrupled that amount, to $55 a day.

When officials ordered the region around the plant into a lockdown, the factory was forced to operate at “significantly reduced capacity,” Apple said on Sunday. It’s unclear when operations will return to full capacity.

The production slowdown in Zhengzhou forced Apple to warn investors — for the third time in three years — that sales would be affected by pandemic-related disruptions to its operations in China.

While Beijing’s stringent Covid policies are crimping Apple’s iPhone production plans, Washington is watching carefully what goes into its products.

YMTC, the small Chinese chip maker, was founded in 2016 with a $2.9 billion government investment and a mission to help reduce China’s dependence on foreign chip makers.

Apple, which declined to comment, was in talks about a supply agreement with the Chinese firm, according to two people familiar with the discussions. Memory chips, YMTC’s specialty, are one of the iPhone’s most expensive components, accounting for roughly 25 percent of its material costs, according to Susquehanna International Group, a financial firm.

Because it would offer lower prices to gain market share, YMTC could help Apple pressure its current Western suppliers to lower their costs, said Walter Coon, a semiconductor analyst with Yole Group, a market research firm.

But YMTC’s importance to China made it a target of U.S. national security researchers. In late 2020, a team led by James Mulvenon, a Chinese linguist and researcher at the U.S. defense contractor SOS International, issued a 17-page report that detailed YMTC’s connections, through its parent company, Tsinghua Unigroup, to entities that sold products to China’s military.

In February 2021, Mr. Mulvenon presented his findings to about two dozen Republican and Democratic staff members on Capitol Hill. He outlined the risks that he believed YMTC posed, because its government subsidies could empower it to undercut competitors on price.

“It never made sense to cluster the entire supply chain inside a country that was the most potent cyberthreat to the United States,” Mr. Mulvenon said.

As Apple geared up for this year’s iPhone release, Wall Street analysts at Credit Suisse issued a report saying that Apple might include YMTC chips in upcoming models. Though Apple and YMTC neither confirmed nor denied the report, the potential deal prompted lawmakers, including Senators Chuck Schumer, Democrat of New York and the majority leader, and Marco Rubio, Republican of Florida and a member of the Senate Intelligence Committee, to send letters urging the Biden administration to investigate Apple’s plans.

Semiconductor industry officials also raised concerns with lawmakers that Apple had assisted in recruiting engineers from Western companies to help YMTC improve its production, according to three people familiar with the matter.

Apple later sought to reassure lawmakers by telling them that it would use YMTC chips only for iPhones sold in China. But that did not address congressional leaders’ bigger concern that any purchase from YMTC would hurt the market for memory chips.

Lawmakers urged Gina Raimondo, the commerce secretary, to put YMTC on the United States’ “entity list,” a designation that would bar it from buying American technology and components without a waiver. On Oct. 7, the department stopped short of that, placing export restrictions on YMTC and 30 companies believed to have ties to China’s military.

The new restrictions cost YMTC access to critical American machinery for a new factory in Wuhan and may limit its ability to work with a company like Apple.

In the days after the restrictions were issued, the Japanese business outlet Nikkei published a report saying Apple had dropped its plans to use YMTC. When asked if the Nikkei report was accurate, an Apple spokesman declined to comment.

Lawmakers continue to pressure Apple and YMTC. In a statement to The New York Times, Mr. Rubio said, referring to Apple’s chief executive: “If Tim Cook understands the risks that YMTC and the rest of the Chinese Communist Party’s chip-making efforts pose to U.S. national security and that of our allies, then he and his company should clearly commit not to proceed.”

Ana Swanson and Edward Wong contributed reporting from Washington.