Offshoring: U.S. Semiconductor and Software Industries Increasingly Produce in China and India
Released: 2006-09-07T00:00:00

Letter

Background

“Offshoring” generally refers to an organization’s replacement of goods and services produced domestically with imports from foreign sources. For example, if a U.S.-based company decides to move its computer programming activities to an overseas supplier, this would be considered offshoring. The overseas supplier may be an affiliate of the company, in which case the company has also invested overseas. In contrast, the supplier may be unrelated to the domestic company, in which case the company has outsourced its computer programming activities, as well as offshored them.

Semiconductors are devices that enable computers and other products such as telecommunication systems to store and process information. Semiconductor device fabrication is the process used to create “chips,” the integrated circuits that are present in everyday electrical and electronic products. It is a multiple-step sequence of photographic and chemical processing steps during which electronic circuits are gradually created on a wafer made of pure semiconducting material, most commonly silicon. Improvement in the performance of increasingly sophisticated electronics products depends on more powerful semiconductors that can store more information and process it faster. Demand for semiconductors is driven by the demand for computers and communications products that use them.

The semiconductor manufacturing process can be divided into three distinct stages: (1) design of the semiconductor integrated circuit, (2) fabrication of the semiconductor wafer, and (3) assembly and testing of the finished integrated circuit. The design and fabrication processes are the most capital-intensive, while the assembly and testing process tends to be more labor-intensive, although still relatively technologically sophisticated. For example, semiconductors are designed by computer engineers with the assistance of advanced software. They are then fabricated using chemicals, gases, and materials combined in an intricate series of operations using complex manufacturing equipment to produce wafers containing a large number of chips. During assembly, the chips are assembled into the finished semiconductor components and tested for defects. The finished semiconductor consists of millions of transistors and other microscopic components.

The technological complexity of semiconductors is indicated by the diameter of the wafer and the density of the etched lines (feature size) on the wafer. The size of the wafer is an important element because the number of chips per wafer increases dramatically as the wafer size increases. The current leading-edge manufacturers produce 12-inch (300 millimeters) wafers. Smaller feature size measured in microns allows for more components to be integrated on a single semiconductor, thus creating more powerful semiconductors. Each reduction in feature size—from 0.35 micron to 0.25 micron, for example—is considered a move to greater technological sophistication.

The software services industry also includes several types of services and levels of technological sophistication. Software services include writing individual software programs or combined “modules;” supporting these programs and modules once they are installed on computers; designing software networks, which might include various software programs, as well as systems of networks; integrating and maintaining these networks and systems as they are applied to clients’ tasks; and managing and operating clients’ overall computer systems.

Software services are now broadly diffused throughout the U.S. economy. Firms across most industries now use some form of software services— whether it is basic accounting software, inventory control software, or a much more complex software product applied to manufacturing operations. Automobile companies, for example, use advanced computer software in the design of new car models, on production lines that manufacture these cars, and in the cars themselves that now contain electronic components.

Software services generally range in complexity from routine software programming and testing to complex software programming, software project management, and higher-end software systems integration, architecture, and research. In general, software programs and modules can be produced in various locations; integrating these requires some focal points capable of working closely with the various locations.

Both semiconductor manufacturing and software services are key industries within the broader information and communications technology (ICT) sector; they have contributed significantly to overall U.S. growth and productivity. For example, semiconductor and related device manufacturing in the United States represents about 24 percent of the total value of the ICT sector’s computer and electronic products manufacturing. Software services comprise about 48 percent of the total production of the categories of services industries included in the broader ICT sector— publishing industries (includes software), information and data processing services, and computer systems design and related services (averaged over 1990 to 2004).

Although the ICT sector represents a small share of the overall U.S. economy (about 4 percent), it has contributed significantly to U.S. economic expansion. According to the Department of Commerce’s Bureau of Economic Analysis (BEA), the ICT sector accounted for about 11 percent of total economywide value-added growth in 2004. Examining value-added growth is a useful way to compare growth rates across industries because it measures only the increase in output due to that industry, excluding any inputs or materials from other industries. Therefore, value-added growth measures the changes in output due to increases in factors such as labor and capital and to improvements in the productivity of those factors. Figure 1 shows that, from 2002 to 2004, the ICT sector’s growth in real value added accelerated more than any other industry group. Although the ICT sector’s growth slowed in 2001 during the recession, annual real growth has recently accelerated from 2.0 percent in 2002, to 6.7 percent in 2003, and to 12.9 percent in 2004.

The ICT sector also contributes to productivity in the rest of the economy. For example, other manufacturing and services sectors, such as automobiles and banking, have become more productive as they have used the latest products and advances from the ICT sector. Economic research has generally found that the investments made in ICT sector products by other industries contributed to a rapid economywide increase in productivity during the 1990s. In addition, the technological advances and competition within the sector have resulted in declining prices and rising performance in ICT products. This, in turn, has contributed to lower rates of inflation throughout the economy as other sectors benefit from these improvements.

We present information on multinational companies’ global operations in semiconductor and software services in appendix II.

U.S. Firms Continue to Offshore Increasingly Complex Semiconductor Manufacturing Activities and Software Services

The U.S. semiconductor industry has foreign operations in several locations, notably in Taiwan and China. The U.S. software services industry has turned to India for a significant share of its offshoring operations. The types of semiconductor manufacturing and software services that U.S. firms have offshored to Taiwan, China, and India have become more complex over time. U.S. semiconductor firms first offshored labor- intensive assembly operations in the 1960s, then wafer fabrication, and more recently, higher value-added activities, such as advanced fabrication and design. The offshoring of software services largely began in the 1990s in preparation for the year 2000 transition. Much like semiconductor products, the types of software services that firms have offshored have become progressively more complex as firms expanded their offshore operations to customized applications requiring highly skilled workers.

Semiconductor Manufacturing Moved Offshore as Competition from Other Countries Developed; Firms Offshored More Complex Production Over Time

Offshoring in semiconductor manufacturing began in the 1960s with labor- intensive manufacturing activities, such as assembly. U.S. firms invested in overseas manufacturing facilities to perform the labor-intensive assembly of semiconductors for export to the United States. Firms domestically sourced the design and fabrication of higher-skilled, more capital-intensive semiconductor manufacturing activities and then shipped the semiconductors to Asia for assembly. The finished semiconductors were returned to the United States for final testing and shipment to the customer. According to some industry experts, offshoring of assembly work kept the U.S. semiconductor industry cost-competitive as new foreign rivals emerged in countries such as Japan.

The overall U.S. business models for semiconductor manufacturing changed in the 1980s. Two types of company models developed for semiconductor production. Some companies, known as Integrated Device Manufacturers (IDMs), conduct their own research, produce their own designs, and operate their own fabrication plants to produce semiconductor wafers. Other companies, known as fabless design firms, develop their own designs and contract with independent fabrication plants, known as foundries, to produce their wafers. Foundries emerged during the 1980s as firms in Asia, particularly Taiwan, began to specialize in wafer fabrication. With the emergence of overseas foundries, U.S. firms developed global supply chains for sourcing different parts of the semiconductor production process over multiple global locations. They continued to design in the United States and other developed countries, while contracting with foundries in Taiwan to perform capital-intensive wafer fabrication. They also continued domestic fabrication, but Asian countries increased their share of overall production—with Taiwan expanding as a major supplier of fabrication services and China emerging as a new source of fabrication services in the late 1990s.

In recent years, some U.S. firms have offshored increasingly complex semiconductor fabrication and design activities—essentially going up the value chain (see fig. 2). As firms in other countries, notably Taiwan, became more adept at producing more complex semiconductors, U.S. firms increasingly turned to offshore manufacturers to produce these semiconductors. The most complex semiconductors now manufactured in fabrication plants (commonly called fabs) are 12-inch (300 millimeter) wafers with submicron feature size. U.S. firms were leaders in developing 12-inch wafers. According to industry experts, firms have offshored design services to Taiwan due, in part, to maintain close contact with Asian customers to meet their specific requirements. Also, as semiconductor manufacturing becomes more complex, some experts have noted, it becomes all the more important to develop close relationships among design and manufacturing activities, so as to enable feedback discussions.

The gap in semiconductor manufacturing capabilities has narrowed between the United States and Taiwan and China. Currently, Taiwanese and Chinese foundries are capable of producing technologically sophisticated semiconductors. For example, Taiwanese foundries are now capable of producing integrated circuits as small as 0.09 microns, and some Taiwanese firms provide design services to support this level of semiconductor technology. In addition, according to industry experts, the newest semiconductor manufacturing facilities in China are capable of producing integrated circuits up to 0.13 microns in size, with one Chinese foundry known to be producing circuits at the 0.09 micron size. Thus, currently the most advanced manufacturing facilities in Taiwan and China manufacture integrated circuits that are only one generation or less behind state of the art.

U.S. Firms Offshored Software Services in the Mid-1990s and Increasingly Offshore More Complex Activities

The software services industry was one of the first services industries to offshore significant activities as U.S. firms recruited foreign software programmers, particularly in India. Before the widespread use of the Internet, it was not economical to export software. U.S. firms either invested in overseas affiliates in India to directly provide software services for the firm or hired Indian programmers to work temporarily on-site at firms’ U.S. locations. Beginning in the 1990s, Internet communications combined with the availability of satellite connections and reduced telecommunication costs made it possible for foreign software programmers to remain abroad while working for U.S. clients. Many types of U.S. firms began re-engineering their business processes to concentrate on core competencies and outsource or offshore other activities, such as writing software programs. The offshored activities were those that could be reduced to step-by-step instructions, digitized, and performed at a distance.

In the late 1990s, preparations for the year 2000 changeover contributed to U.S. firms’ further use of foreign software programmers who were knowledgeable in certain programming languages. U.S. firms turned not only to foreign software programmers who were temporarily employed in the United States but also to programmers overseas, particularly in India, who provided work directly to U.S. clients. In recent years, U.S. firms have offshored increasingly complex software services, going up the value chain as occurred in the semiconductor industry. Examples of less sophisticated software services are operations involving basic computer language coding or programming and managing computer databases. More complex offshored services include advanced software design and development activities and researching, designing, developing, and testing new software technology.

U.S. firms experienced high-quality work in offshore locations; for example, they discovered that firms in India have the capabilities to produce high-end software services, such as software design at a low cost. In addition, firms often combine highly skilled labor available in India with skilled labor in other countries to create global teams with specific skill sets. For example, one firm in India stated that a firm might begin a high- end software development project in India and then transfer the work to a team in Ireland for further development before delivery to a U.S. client. Firms also use global teams to better serve local markets worldwide by providing customized programming services to local clients.

Currently, the types of offshored software services activities now include advanced software engineering and research and development. For example, in recent years Indian and multinational firms, including U.S. affiliates, have established high-technology research and design facilities in India to perform such high-end software services as software engineering and software product development. According to software services industry experts in India, many of these facilities employ hundreds of software engineers to develop and test a wide range of new high-end software designs and products for export to global customers. Some firms in India stated that the quality of high-end software design and development activities in India, combined with firms' need to introduce new products and new technologies, have attracted increasing interest in offshoring software development to India. Nevertheless, the bulk of offshored software services in India can be characterized as lower-level work, mostly in the applications development segment of the industry. Applications development primarily requires programming skills and has limited face-to-face interaction. Moreover, applications development can easily be segmented and standardized, features that characterize offshoring software services.

Technological Advances, Availability of Talented Human Capital, and Foreign Government Policies Contributed to Increased Offshoring of Semiconductor Manufacturing and Software Services

The combination of technological advances, available human capital, and foreign government policies has created a favorable environment for offshoring. Many firms in semiconductor manufacturing and software services use offshoring in their business models to increase their global competitiveness by lowering costs and gaining access to foreign markets. Advances in telecommunications enabled semiconductor firms to improve their logistics and inventory controls; they also were particularly important to the offshoring of software services. Firms in both sectors initially sought low-cost labor, but they expanded the scope of their offshoring activities as they discovered and helped develop highly educated workforces in Taiwan, China, and India. Foreign government policies played different roles in the countries we visited. In Taiwan and China, the national governments pursued various industrial policies to promote semiconductor manufacturing and, in India, the loosening of regulations and the availability of government-supported software technology parks afforded the software industry opportunities to grow relatively unregulated. Although offshoring conveys benefits to firms that choose to locate operations overseas, it also encompasses business risks that challenge management skill. See table 1 for an overview of the factors that have contributed to increased offshoring.

Technology Launched Important Changes in Semiconductors Manufacturing and Software Services

Improvements in telecommunication technology helped to expand the degree of offshoring in both semiconductor manufacturing and software services. With improved communications, U.S. semiconductor firms were able to create tighter linkages with overseas suppliers, and software services firms developed global teams that could transfer digitized information over the Internet.

Technology Improvements Allowed Semiconductor Firms to Develop More Efficient Global Supply Chains

Semiconductor manufacturing firms improved their management of supply chains through better telecommunications, logistics management, and modern transportation. Telecommunications has allowed better monitoring of the movement of products. For example, foundries in Taiwan use Internet-enabled software that allows real-time communication between engineering teams in different locations. Some U.S. companies use radio- frequency identification tags in Taiwan and China to track products shipped from these manufacturing locations to distribution centers in other countries. According to a representative of one U.S. firm, this technology has reduced the need for inventory sourcing redundancy, thus reducing inventory cost and the associated employment costs.

Logistics management is an important part of global business. Taiwan’s competitive logistics industry has offered advanced computerized systems that assist in the management of purchasing, storage, delivery, and distribution of products. According to a Taiwan government official, Taiwanese companies can provide production orders to their clients in 2 days. According to an industry researcher, the automation of the semiconductor assembly process also has improved efficiency in the overall semiconductor infrastructure, such as packaging facilities.

Modern transportation options using more powerful computer systems, advanced software, and telecommunications make faster delivery possible. Countries are upgrading all elements of their transportation infrastructure—airports, seaports, modern roads, and trucking. Because a product may travel around the world more than once during the production process, efficient transportation systems are essential. For example, China has made numerous improvements to its transportation infrastructure to permit more efficient distribution. According to one Internet firm operating in China, the transportation infrastructure within China for delivering the physical products to customers—an essential component for online auction sites—did not exist before the year 2000. China reportedly invested $30 billion in 2004 alone to improve its network of roadways.

The Software Services Industry Changed Its Global Business Model

In the software services sector, telecommunications improvements have changed the types of software services traded, the way the work is done, and the telecommunications investments made.

First, the essential advance in IT—the introduction of Internet communications—made it possible to trade some services that were previously not tradable. For example, software programs written in standardized programming languages could be digitized and transferred worldwide over the Internet.

Second, global teams have become common elements of firms’ business strategies. The ability to transmit data electronically made it possible to specify an application in one firm and develop it in another. Because of the availability of the Internet, teams can work 7 days a week, 24 hours per day to meet customer needs worldwide. These teams’ operations could be set up relatively quickly with office space, utilities, and communication tools, such as personal computers with broadband access. The ease of undertaking this type of offshoring has led to an escalating use of offshored IT services, including but not limited to software programming. According to one research firm, the value of IT offshoring and business process offshoring totaled $34 billion in 2005 and could double by 2007.

Finally, the services offshoring model has required investments in global telecommunications infrastructure, such as wired landline and satellite communication services. India has made the investments to facilitate the telecommunications industry. According to the government of India, in 2005, 47 million landline connections and 65 million satellite connections existed in India. Moreover, in 2004, after the telecommunication sectors declined due to overcapacity, one major Indian telecommunications services firm, partly owned by the government of India, purchased a large, privately owned U.S. undersea fiber-optic network linking Asia, Europe, and North America after receiving national security approval from the U.S. government. This acquisition strengthened India’s control of low-cost telecommunications infrastructure. According to an Indian government official and several U.S. companies operating in India, the growth in telecommunications infrastructure has also enabled firms to move from India’s major cities to smaller, lower-cost surrounding cities.

The Availability of Human Capital Was Key to the Expansion of Offshoring in Both Semiconductor Manufacturing and Software Services

The availability of high-quality workers overseas has been an essential component of the increased use of offshoring for firms in the semiconductor manufacturing and software services sectors. Through experience and training, the talent pool in several countries demonstrated their value to firms seeking skilled workers to perform tasks with various degrees of complexity.

Some Semiconductor Firms Turned to Low-Level Skilled Foreign Workers Initially but Gradually Offshored More Complex Work to Higher-Skilled Labor Forces Overseas

Access to human capital played an important role in the relocation of semiconductor manufacturing firms to Taiwan and China, especially as the need for skilled labor arose, and a quality workforce emerged in these countries. During the earlier phase of semiconductor offshoring in Taiwan, workers did not need advanced training. Taiwan emphasized vocational training during this period. Industry experts stated that, although lower- cost labor was initially attractive for assembly, the labor costs component in semiconductor manufacturing is not a decisive factor for companies’ location decisions overseas. New technology has computerized the entire production process, leading to a reduced need for labor and an increased need for skilled workers and managers. According to the representative of one research firm, the quality of the Chinese and Taiwanese workforce makes it easy to train and retain workers in semiconductor assembly and manufacturing.

Taiwan, China, and India are each able to provide a quality workforce, with a plentiful supply of engineers including emigrants who have returned to work in their home countries. Highly trained professionals with experience in U.S. firms assisted the development in each of these three countries of their semiconductor and software industries. According to one research firm, more than 5,000 overseas students and professionals return to China each year, bringing with them Western knowledge and skills. For example, several firms operating in China told us that Chinese returnees who have studied or worked abroad are an important part of their staffs. India, Taiwan, and China are each graduating IT and other engineers in large numbers. For example, China’s potential supply of engineers is large; according to one U.S. study, the number of Chinese engineering graduates with bachelor’s degrees in 2004 numbered 351,537, as compared with 137,437 in the United States. Moreover, engineers in Taiwan, China, and India typically earn less than their counterparts in the United States. For example, Taiwan’s domestic supply of engineers can be hired at approximately half the cost of engineers in the United States.

Software Services Firms Find a Large Supply of Human Capital Overseas with Top Quality Skills

We reported in 2004 that access to human capital, particularly lower-wage skilled labor, an educated workforce, and quality local vendors facilitated software services offshoring. India is the leading example of this trend. For example, Indian wages represent a fraction of the cost of hiring U.S. counterparts, with the salaries for Indian IT engineers starting at $5,000. According to industry experts, the increasing demand for these workers is causing salary rates to increase somewhat. Yet lower wages does not tell the entire story because India also provides a skilled workforce. India’s leading software services association reports that 44 percent of India’s services professionals possess at least 3 years of work experience. Moreover, many Indian nationals who studied computer technology in the United States and gained experience with U.S. IT firms have begun to return to India to pursue career opportunities in their native country. Some of these individuals have gone on to create or lead successful firms in India.

India has a strong national emphasis on advanced technical education, and its scientific and educational institutions produce well-trained scientists and engineers. The highly competitive Indian Institutes of Technology trains the upper echelon of talented students and, according to one industry researcher, produces highly skilled engineers with capabilities that match or exceed U.S. talent. In addition, an industry researcher in India stated that nontechnical programs are beginning to offer computer science and software programming courses to prepare students to meet the market demand of the software services sector. According to India’s software services association, of the 215,000 engineering graduates in 2003 to 2004, 141,000 specialized in IT (e.g., computer science, electronics, and telecommunications). India’s use of the English language gives it a further advantage, making India a prime destination for services offshoring.

Finally, the quality of the firms in India is another factor that is considered when firms decide to offshore services. The quality of local vendors, many with Capability Maturity Model (CMM) certifications, provides a sense of security to firms seeking to offshore software services to India. According to a business association in India, Indian companies work to attain these certifications to demonstrate the high quality of their work. For example, a business representative told us that more than 50 percent of the companies that have CMM Level 5 certifications are located in India. With the update of the CMM to the Capability Maturity Model-Integration (CMMI), the Software Engineering Institute reports 93 Indian and 74 U.S. entities (41 percent and 32 percent, respectively, of the world total) with CMMI certifications as of March 2006.

Foreign Government Policies Have Made Foreign Investment Attractive for Semiconductor Firms and Left the Software Services Industry Relatively Unregulated

Foreign government policies contributed to the development of dynamic semiconductor and software services sectors with opportunities for U.S. firms to offshore. The governments of Taiwan and China developed a broad range of policies to promote their respective indigenous semiconductor industries and to attract investment, technology and talent from abroad. India, in its transition from a socialist government to a market-based economy, has liberalized its software services market, thus permitting U.S. firms to access India’s low-cost high-quality workforce.

Government Policies in Taiwan and China Have Assisted Their Respective Semiconductor Industries

Taiwan has long pursued industrial policy to encourage the domestic development of science and technology. In 1972, it established a national research institute and within that organization an office to develop its semiconductor industry. Drawing upon the expertise of a U.S. advisory group, Taiwan successfully duplicated elements of the Silicon Valley technology cluster by establishing science-based industrial parks that brought together major universities, research labs, and a dynamic venture capital industry. Its universities feature programs sponsoring research specific to semiconductors, and the government targeted financial and tax incentives to the semiconductor industry. The government also emphasizes vocational training to develop quality resources. As a result, the government of Taiwan helped position its semiconductor industry as an effective contract supplier integral to the U.S. semiconductor supply chain. Its industrial strategy, which has been characterized as “close followership,” integrated Taiwan’s industry operations with those of U.S. companies. Although this strategy means that Taiwan’s industry may be a step behind the U.S. industry, firms in Taiwan capture high-technology industrial and research functions. As a result of its efforts, Taiwan is now a leading semiconductor producer with top-level manufacturing expertise.

Taiwan’s support of a strong semiconductor sector continues to evolve with a project that focuses on integrated circuits manufacturing infrastructure. The government is providing partial financial support to this project, which includes the expansion of university-based training, investments in new technologies, and a design park to focus on system-on- a-chip design. With added pressure from the opening of China’s market and the competition from Chinese firms, Taiwan is revisiting its restrictions on the level of technology that firms may transfer to mainland China. In April 2006, Taiwan announced it was removing restriction of the export of low-end semiconductor packaging and testing technology to China.

China’s current policies have helped its semiconductor sector to grow dramatically since 2000, but its wafer production represents a relatively small percentage of worldwide production. Nevertheless, China is considered a rising player in the field of advanced technology. Prior to 2004, China’s differential value-added tax, since normalized, was a notable policy that led to an influx of semiconductor firms into China —notably from Taiwan—that sought to avoid the impact of the tax. Following Taiwan’s strategy, China is creating a modern infrastructure to support semiconductor operations. For example, the government provides tax incentives, preferential loans, and opportunities to locate in special economic zones and science parks. China announced, in 2006, the adoption of a 15-year national technology strategy to develop, among other things, a world-class information sector and to focus on developing independent innovation. The result of China’s policies is an expanding semiconductor sector that relies heavily on the expertise of Taiwan’s managers and other expatriates whom China is actively recruiting to return to the mainland.

India’s Software Industry Was Not Subject to Many of India’s Restrictive Policies

India’s policy for software services differed from the deliberate industrial policy undertaken by Taiwan and China. India’s government policy shifted from protection of domestic industries to a gradual liberalization of some regulations. Although India maintains significant controls on some industries, the software services sector was not affected by some of the most restrictive policies, given the small size of its enterprises. Entrepreneurs in the software services sector were able to build the industry based on the special attributes of India —its English-speaking population, its supply of IT professionals, and its favorable telecommunication infrastructure.

Between the 1950s and 1980s, India generally protected domestic firms from foreign competition and undertook a policy of import substitution. India pursued policies that sought to support state-owned enterprises. Where private firms were permitted to operate, a cumbersome licensing bureaucracy controlled their operations. Initially prevented from expanding into higher value-added segments of the industry in the 1980s, software services firms nevertheless found areas of specialization that the government did not restrict. In 1991, India experienced a shortage of foreign exchange, which required liberalization of its economy as a condition to gain support of the International Monetary Fund. This led to further deregulation, which enabled software services to expand. Moreover, in the 1990s, India introduced software technology parks, which are similar to export processing zones. Firms in these parks were given tax exemptions, access to high-speed satellite links, and reliable electric power. India’s technical universities trained large numbers of engineers and specialists in their highly selective IT programs. Later reforms of foreign ownership rules, intellectual property protections, and venture capital policy further opened the way for trade in services.

Other Factors Constrain U.S. Firms’ Offshoring Decisions

Firms seeking to offshore also encounter risks, including unforeseen costs, geopolitical concerns, cultural differences, infrastructure adequacy, and foreign government requirements. The destination country’s legal system and contract enforcement affect firms’ decisions to offshore. Both the semiconductor and software services industries have specific concerns about countries’ intellectual property protection for their products and make location decisions accordingly. It should also be noted that offshoring places higher demands on firms’ internal management skills. Managers must be able to lead teams with cultural differences, establish metrics to assess contract performance, and manage teams located around the world, using telecommunications as a primary tool. Although firms have found some cost savings in labor, nevertheless, they have also found other management challenges that tend to moderate the overall cost savings. One recurrent concern of U.S. firms operating in China is the lack of middle managers with the combination of business training, business acumen, management skill, and creative thinking.

The United States Continues to Be a Global Leader in the Development of Semiconductors and Software at the Most Advanced Levels

While offshore suppliers are playing a larger and more sophisticated role as the industries globalize, the U.S. semiconductor and software industries have remained technological leaders in the most advanced research and development (R&D) and design work, and the United States remains one of the largest producers globally of products in both industries. Available indicators on production, employment, and trade show that both of these industries have generally rebounded since the 2001 recession and continue to grow. Traditionally, the U.S. economy has had several advantages that fostered strong semiconductor and software industries, including its highly competitive university system, talented labor pool, large domestic market for products, high levels of spending on R&D, and competitive business environment.

The U.S. Semiconductor Industry, Rebounding from a Recent Recession, Continues to Be a Global Leader

Despite having offshored some semiconductor operations, the U.S. semiconductor industry remains a global leader in cutting-edge semiconductor chip design and fabrication. U.S. semiconductor production has begun to rise again after a sharp decline during the 2001 recession. However, U.S. semiconductor employment, which also fell during this period, has remained relatively flat since 2003. U.S. exports have also remained flat, but imports declined more sharply creating a U.S. trade surplus in semiconductors. The United States generally exports high-value fabricated chips and wafers to lower-cost locations for assembly and testing. It imports integrated circuits (semiconductor wafers that have been assembled and tested) for use in a variety of industries. However, global demand for finished semiconductors has increasingly shifted to Asia where final assembly of electronic consumer products takes place.

The United States Is a Global Leader in Semiconductor Design and Fabrication

Semiconductor fabrication and design capabilities are spread among traditional producers such as the United States, Japan, the European Union, and newer producers such as South Korea, Taiwan, and China. According to industry experts and data, however, the United States remains one of the largest producers of semiconductors and, in particular, maintains cutting-edge development of both design and fabrication of new semiconductors. Industry estimates of semiconductor capacity vary, but the United States and Japan remain the largest two producers of semiconductors. Although a significant share of new high-end fabrication facilities are being built outside the United States for mass production, the United States is a key location for the fabrication facilities used for development of new semiconductor chips.

As a global industry, U.S. production includes both U.S. companies and affiliates of foreign companies operating in the United States. Foreign companies have established operations in the United States to take advantage of U.S. technology, skilled labor, and the large domestic market, according to industry experts. One estimate suggests that about one-fifth of U.S.-based fabrication capacity was owned by foreign companies in 2001. In addition, foreign companies also take advantage of experienced design teams in the United States. Companies can potentially benefit from having operations in key areas around the globe where innovation is occurring. These operations are able to access the experienced labor pool and new innovations occurring in a particular region and transfer those developments to their global operations. Silicon Valley, California, for instance, is widely known as a key center of innovation in the semiconductor industry.

Similarly, U.S. firms have invested in production capacity in Europe and Asia. However, according to industry experts, U.S. firms have generally not moved their R&D operations offshore. Data on patents and expenditures on R&D also indicate that U.S. semiconductor companies continue to locate their R&D work in the United States. Some industry analysts, though, are concerned that as production increasingly moves offshore to Taiwan and China, it will begin to draw more and more research activities with it.

Industry experts also believe that most U.S. company design work is still conducted in the United States rather than offshore. According to these experts, U.S. companies are significant technology leaders in both the IDM and fabless design models. Although U.S. IDMs and fabless design companies operate globally, a larger share of their R&D and design work is conducted in the United States. Most of the fabless design firms are based in the United States, and many of the largest IDM’s are also U.S.-based. Also, the development of foundries, particularly in Taiwan, likely allowed a wider range of fabless companies to develop in the United States than may have been possible without the existence of foundries. This is because the high cost of fabrication plants acts as an entry barrier to smaller firms. At the same time, there are a growing number of fabless design firms in Canada, Israel, and Taiwan, and U.S. companies are also operating design offices in these countries. Thus, the global share of design work by fabless companies is becoming less concentrated in the United States.

U.S. Semiconductor Production Rebounding from 2001 Recession, but Employment Has Remained Flat

U.S. production statistics show that the value of semiconductor production in the United States grew steadily during the 1990s even while offshoring expanded. U.S. production of semiconductors and related devices (measured by value-added) peaked in 1999 at about $68 billion, then declined steeply during the 2001 recession. It has since rebounded somewhat to $56 billion in 2004 (see fig. 3).

U.S. employment in the semiconductor industry did not rebound after the 2001 recession as production did. After a long decline from the mid-1980s through the early 1990s, U.S. semiconductor employment grew strongly through 2001 (see fig. 4). However, employment dropped sharply from a peak of about 292,000 in 2001 to around 226,000 employees in 2003. After hitting a trough in 2003, employment in the semiconductor industry has been stagnant, although overall U.S. employment across all industries resumed growth in 2004.

Employment in the semiconductor industry highlights the broader relationship between productivity growth and job declines in the U.S. manufacturing sector. Figure 5 shows an increase in productivity in the semiconductor and electronic components industry (a broader category than used in fig. 4) over the 15-year period from 1987. The pace of productivity growth sharply increased starting in late 1990s. Industry output continued to grow even after employment declined due to the increase in productivity (output per employee).

Since 2001, the United States has had a trade surplus in semiconductors, exporting more semiconductors and semiconductor components than it imported (see fig. 6). Both imports and exports grew rapidly from 1985 to 1995. From 1995 to 1998, exports continued to grow while imports remained flat. From 1998 to 2000, both imports and exports increased again rapidly, peaking in 2000 at about $48 billion (imports) and $45 billion (exports). From 2001 to 2005, imports declined sharply to about $26 billion, while exports also declined, but then leveled out in 2003 to about $34 billion.

The majority of U.S. exports of semiconductors consist of chips and wafers, which are used to produce finished integrated circuits in other countries. The top five destinations for U.S. semiconductor exports were all Asian locations: Malaysia (13 percent), Korea (12 percent), Philippines (11 percent), Taiwan (9 percent), and China (8 percent). Exports of U.S. chips and wafers are the result of the fabrication process, which involves some of the most technologically advanced manufacturing processes.

The majority of U.S. imports of semiconductors are finished integrated circuits (such as memory and logic integrated circuits), which are then used in other finished electronic goods, such as computers and cell phones. Finished integrated circuits are the result of chips and wafers being tested, cut, and packaged by separate manufacturing plants usually located abroad. This process, although still technologically sophisticated (and less labor-intensive than in the past), is still significantly less advanced than the fabrication process. In 2005, only 13 percent of imports were chips and wafers whereas 71 percent of U.S. exports comprised chips and wafers.

U.S. Exports to Asia Growing as Demand for Finished Semiconductors Expands in China

The decline in U.S. semiconductor imports since 2000 reflects the movement from the United States to Asia of manufacturing production of electronics products that use integrated circuits. Finished integrated circuits are moving to other countries in Asia, particularly China, for assembly into electronics products, rather than returning to the United States. Therefore, U.S. exports surpassed imports for the first time in 2001. Chinese trade statistics demonstrate the other end of this movement with Chinese imports of integrated circuits soaring over the last 10 years, making China one of the largest markets for integrated circuits in the world. Much of this increase has been supplied by Taiwan, Korea, Malaysia, Japan, the Philippines, and the United States (see fig. 7). Although the United States is sixth in terms of direct exporters to China, some portion of U.S. exports of chips and wafers are passing through other Asian countries for assembly and testing (including China) before use in China’s booming electronics industry. As mentioned above, the top destinations for U.S. wafer exports are Malaysia, Korea, Taiwan, the Philippines, and China. Those wafers are assembled and tested before being sent to electronics manufacturers for use in their products. These trade flows show the complex production chains that have developed across multiple countries.

The shift in production and trade flows toward Asia has two consequences. First, because final production increasingly takes place in Asia, the United States imports an increasing share of electronics and telecommunications products (that use semiconductors). Appendix III shows that this is reflected in the growing U.S. trade deficit with Asia and China, in particular, including in advanced technology products. Second, as electronics and telecommunications production chains increasingly locate in Asia, there are benefits to U.S. producers of semiconductors to locate abroad near their customers and take advantage of the production clusters developing there. Therefore, this trend creates an incentive for U.S. companies to offshore some activities.

The United States Is the Largest Global Supplier, Employer, and Market for Software Services

Although the industry is globalizing, the United States has maintained its leadership in the development and expansion of the software services industry. U.S. companies are global leaders in the packaged software and custom software services segments of the industry. Although statistics on software services are more limited than for semiconductor manufacturing, indicators show that the United States is a leading developer and consumer of software globally. U.S. production and employment data show that the industry has generally rebounded after declining during the 2001 recession. Also, while both imports and exports have grown rapidly, the United States maintains a trade surplus in software services.

The United States Is a Leading Software Developer and the Largest Supplier in the World

The U.S. software industry is the largest in the world and plays a leadership role in the global market for software services. U.S. companies are disproportionately ranked among the largest in the world, both in terms of revenues and numbers of top firms. U.S. companies also benefit from the large U.S. domestic market, which by one industry estimate accounts for about 50 percent of global demand for packaged software and about 40 percent of global demand for custom software services. U.S. software companies are also widely considered leaders in the development and delivery of leading-edge software services. According to industry experts, much of the development of these services takes place in the United States, although larger companies also employ teams of developers worldwide.

U.S. Software Production Has Rebounded from the 2001 Recession

Although the industry experienced a downturn during the 2001 recession, it has since begun to recover. As figure 8 shows, the U.S. software industry grew rapidly through the late 1990s, declined during the 2001 recession and, as of 2004, had rebounded to its peak in 2000 based on industry revenue. Packaged software appears to be leading the rebound, while custom software revenues have remained flat since 2002.

U.S. software industry employment is the largest in the world. According to one industry estimate, U.S. software employment makes up roughly about half of the global workforce in packaged software and about a third of the workforce employed in IT services industry, which includes custom software services. As a group, software occupations, or computer specialists as designated by the Department of Labor’s Bureau of Labor Statistics (BLS), experienced relatively large gains in both employment and hourly wages from 2001 to May 2005 (the most recent time period for which comparable occupation-based data are available). This period largely coincided with an economic recovery following the 2001 recession. Table 2 compares changes in employment and hourly wages for nine computer specialist occupations and that of all U.S. occupations. Seven of the occupations saw employment growth ranging from 1.1 percent to 46.9 percent compared to 1.8 percent for all U.S. occupations. Employment for two occupations (computer programmers and database administrators) declined by 22.4 percent and 4.7 percent, respectively, from 2001 to May 2005. The wages for these occupations also increased more slowly than the wages for all U.S. occupations. Hourly wages for five occupations increased more slowly than the wages for all U.S. occupations, increasing by 3.5 percent to 10.5 percent compared with 11.4 percent for all U.S. occupations. Wages for four occupations, however, increased faster than the wages for all U.S. occupations, rising by 12 percent to 22.2 percent.

Computer software engineers (including systems software and applications engineers, two high-wage occupations) saw modest increases in wages but relatively large increases in employment, growing by 22.6 and 26.1 percent, respectively. Computer software engineers design, develop, and test the software and computer systems, applying computer science, mathematics, and engineering expertise. The integration of Internet technologies and the rapid growth in e-commerce have led to a rising demand for computer software engineers. Although hourly wages of network systems and data communications analysts increased by a relatively low 7.7 percent, their job growth was the largest of all computer specialist occupations at 46.9 percent. This group of computer specialists designs, tests, and evaluates network systems and other data communications systems.

According to BLS, employment in computer specialist occupations, apart from computer programmers, is projected to grow much faster than overall U.S. employment. Although total U.S. employment is projected to grow 13 percent over the 2004 to 2014 period, employment of computer specialists is projected to grow 31.4 percent (see fig. 9). BLS projects that the demand for computer-related jobs is likely to increase as employers continue to adopt and integrate increasingly sophisticated and complex technologies. Growth, however, will not be as fast as the previous decade, as the software industry matures, and as routine work is increasingly offshored.

Projected job growth for computer software engineers and network systems and data communications analysts is especially robust. The BLS’s Occupational Outlook Handbook suggests that demand for workers with specialized technological skills is expected to increase sharply as employers use and improve the efficiency of new technologies. As the race for increasingly sophisticated technological innovations continues, the need for more highly skilled workers to implement these innovations will continue. More highly skilled computer specialists will be needed as businesses and other organizations try to manage, upgrade, and customize their increasingly complicated computer systems. Computer specialists who have a combination of strong technical and good interpersonal and business skills will be in demand.

Unlike other computer specialists, job growth of computer programmers is expected to lag significantly behind the growth in overall U.S. occupations. Programmers are projected to grow only by 2 percent from 2004 to 2014. Because computer programming requires little localized or specialized knowledge, computer programming can be performed anywhere in the world and transmitted electronically. Consequently, programmers potentially face a higher risk of having their jobs offshored than other computer specialists such as software engineers, who are involved in more complex information technology functions. Another factor limiting job growth in computer programming is progress in programming technology. Computer software has become increasingly sophisticated, enabling users to write basic code without programmers’ involvement for routine programming.

The United States Maintains a Trade Surplus in Software Services Trade, but Imports Are Growing

The United States is a net exporter of software services and has maintained this trade surplus for several decades. Although U.S. exports are rising rapidly, imports are also increasing in this category. Canada is the largest supplier of imported computer and data processing services to the U.S. market but, as we have previously reported, India is rapidly growing as a supplier of these services. Figure 10 shows U.S. exports and imports of computer and data processing services, the category that includes both custom and packaged software services (as defined by BEA) since 1986.

U.S. exports of software services make up about 13 percent of overall U.S. software revenues according to the U.S. Census Bureau (Census). However, most export revenue is derived from packaged software exports. These Census statistics show a much larger value of exports than the BEA trade in services statistics. As shown in figure 11, U.S. companies report nearly $22 billion in exports of software services, primarily comprising about $20 billion in U.S. package software exports.

Information on trade in software services is significantly more limited than information on trade in semiconductors. Although both BEA and Census collect statistics on software trade, as demonstrated by the previous two figures, the data are available only for the aggregate categories shown. In comparison, for semiconductors, over 230 individual semiconductor goods are identified by Census as they cross international borders. In addition, most countries in the world utilize the same goods classification system, known as the Harmonized System, to record trade in goods. However, efforts to create and utilize detailed and compatible classification systems across countries for services such as software are still relatively new. Part of the challenge in collecting detailed statistics on services industries, such as software, derives from the “intangible” nature of many services—they are not necessarily physical products—and the fact that they don’t cross customs borders like goods. Rather, services data is collected by surveying companies for information on their payments or receipts for services. In addition, services can be delivered to the customer through many different channels, including licensing agreements, imbedded in goods such as computers, or a commercial presence such as a foreign subsidiary.

The U.S. Semiconductor and Software Industries Benefit from the Large, Innovative U.S. Economy

The United States maintains substantial advantages as a large, technologically sophisticated economy. The U.S. high-technology industries, such as semiconductors and software, have benefited from a U.S. economic environment that supports innovation—world-class universities and research centers, a talented labor pool, and high levels of spending on R&D. The industries also benefited from a competitive U.S. business environment, an efficient legal system for contracts and intellectual property protection, and a large domestic market.

University and Research Centers, Talented Labor, and R&D Investment Have Helped Foster Innovation

Although a wide range of causes and circumstances leads to new innovations, certain enabling factors create an environment that fosters new ideas and their development. These include (but are not limited to) such factors as the higher education system and related research centers, pools of talent available, and the investments in research and development.

The U.S.’s world-class higher education system and research institutes create communities for researchers and educators and are widely considered a key competitive advantage. The higher education system in the United States includes many universities that are ranked among the best in the world in terms of research, education, and entrepreneurship. Also, a large number of top applicants from around the world apply for undergraduate, graduate, and postdoctoral study. More specifically, U.S. computer science and engineering programs—of particular importance to high-technology industries such as semiconductors and software—are leaders in their fields. The higher education system has provided both a strong research environment and a pool of talented labor—both native born and foreign students who remained after education.

A second factor that fosters innovation is the quality and number of available researchers and other skilled labor. Countries with larger and more talented labor pools are more likely to foster and sustain innovation. The United States has a world-class talent pool that includes both technical and managerial talent. The United States has the largest number of researchers worldwide, with about 1.3 million, followed closely by the European Union (EU-25), according to data from the Organization for Economic Cooperation and Development. China, ranked third, has rapidly increased the number of its researchers to surpass Japan. Although the quality of these researchers is not captured by the indicator, it does show the growing size of the Chinese research community.

A third factor that fosters innovation is a country’s investment in research and development. This investment may come from several sources, including the government, academia, and business. U.S. expenditures on R&D are the largest in the world and have continued to grow over time (see fig. 12). Currently, the United States spends about 2.7 percent of its gross domestic product on R&D expenditures, compared with about 3.2 percent for Japan and 1.4 percent for China. For certain industries such as semiconductors, early investments by the federal government—the military, in particular—have been key in the initial development of the industry. However, this role may change over time. For the United States, the increase in R&D expenditures over the past decade has been driven by the business community, while the total amount of federal R&D has grown much more slowly in comparison.

While the United States has generally maintained a strong advantage in areas that foster innovation, several studies have recently raised questions about continued dominance of the United States in cutting-edge innovation. They cite a range factors that indicate the rise of other competitors in traditionally U.S.-dominated areas. For instance, changes in U.S. visa and immigration requirements have been cited as hampering the number of foreign students, researchers, and high-tech workers who are attracted to the United States and allowed to reside here. At the same time, other countries’ university systems are increasingly competing with the United States to attract the most qualified students and researchers. According to these studies, these changes have led to a decline in the number of university applications from foreign students. Similarly, other countries have liberalized their economies and provided greater opportunities for higher skilled workers. Therefore, more students and researchers, including those from India and China, who may have once stayed in the United States have an incentive to return to their native countries.

Business Environment, Legal System, and Domestic Market Affect Commercialization of Innovation

In addition to an environment for fostering innovation, countries need to be able to commercialize these innovations to affect the wider economy. Several factors contribute to a U.S. competitive environment that encourages innovation to be commercialized. First, the business environment includes relatively competitive product markets that encourage businesses to take new products to market in order to gain advantage over rivals, while also allowing new entrants to challenge existing companies. The United States also has a relatively efficient financial system, including venture capital markets that fund new innovations and start-ups in high-technology industries. The U.S. legal and regulatory environment, including its intellectual property protections (such as patents), allows individuals and companies to be rewarded for their investment in innovation. Finally, the large U.S. domestic market provides an avenue for companies to sell new products to a wide range of sophisticated customers. The U.S. economy is by far the largest in the world, and per capita income is also one of the highest in the world. This creates an environment for U.S. companies to develop and sell new products profitably. In addition, companies that are close to their customers are able to spot new trends and preferences in demand and cater to them. This is particularly true in high-technology industries in which the product life cycle is relatively short and profit margin for older products declines quickly.

Concluding Observations

The past decade’s revolution in telecommunications and related advances in supply chain management capabilities have deeply affected the business models for both the semiconductor manufacturing and software services industries. These industries’ overall business model is now a global one, in which U.S. firms regularly consider a wide range of locations for their operations and source different parts of their operations wherever the advantages are most compelling. For the semiconductor industry, firms initially offshored labor-intensive assembly activities to cut labor costs, but more recently firms have offshored other activities for various reasons, including proximity to other industry suppliers, closer relations with foreign customers, benefits offered by foreign governments, and the availability of both skilled and unskilled human capital. In the software industry, the offshoring trend is more recent, but the motivations are similar.

For software services, however, an important difference may be the possible speed and scale of employment shifts. Software services offshoring, compared with semiconductor manufacturing offshoring, does not need the same physical infrastructure, such as ports, roads, and factories, and thus can be set up more quickly. It is more labor intensive than capital intensive, and thus may be more sensitive to wage differentials. In addition, service occupations related to software programming are large in comparison to manufacturing jobs in the semiconductor industry. In semiconductor manufacturing, there was relatively slow movement up the value chain as firms invested in the overseas workforce and factory facilities. India’s software industry development has advanced more quickly, with rapid technological changes bringing large numbers of highly educated, but underused, English-speaking workers to the doorstep of firms willing to operate from India. The data available to monitor the scale of services offshoring, unfortunately, are much more limited than those available for following trade in manufactured products. Semiconductor products, for example, can be identified and inspected at U.S. borders, whereas software imports and exports can be transmitted almost instantaneously over the Internet.

Government policies also played important, but different, roles in Taiwan, China, and India; however, all three governments have placed high importance on education. In recent years, China has been transforming large parts of its coastal cities through massive infrastructure investments and has provided more targeted inducements for firms, such as support for science and technology parks and various types of financial assistance. India liberalized parts of its central government apparatus in the early 1990s, but its investment in physical infrastructure such as roads and ports has been much more limited, although India has also supported its science parks and put in place advanced telecommunications infrastructure improvements. These incentives for software exporters appear to have been well targeted.

The comparison of these two offshoring experiences offers some insights for U.S. policies. Clearly, a large and well-educated population appears to be a central element to success in both semiconductor manufacturing and software services activities. Also, technological changes have impacts that are not always predictable and, in a now closely-connected global business world, such changes can have continuing dynamic effects on U.S. industries. India may have neither fully predicted or planned its current strengths in software services, nor foreseen how its pool of native English speakers could be such an asset, but it now realizes the importance of enhancing its strengths in these areas. In addition, ambitious national goals—whether China’s semiconductor development road maps or Indian businesses’ long-term strategies—are additional elements in the mix of factors that will shape these countries’ futures and will pose competitive challenges to U.S. firms.

As numerous recent studies have reported, the ability of the United States to continue to compete at the most advanced levels in high technology industries depends on a range of reinforcing factors: high-level R&D investment by companies and government, innovative academic environments attracting and training the highest-skilled researchers, a competitive business environment that fosters development and commercial application of new technologies, and a flexible and skilled workforce. These factors are being nourished in China, Taiwan, and India, as these countries seek to move further up the value chain and to “leapfrog” advanced country capabilities where possible. Indeed, these countries have modeled their industry development strategies on various aspects of the U.S.’s successful model. The United States is an integral part of this dynamic world economy—in which it will be important for U.S. businesses and policymakers to keep alert to technological changes, to anticipate competitor countries’ strategies, and to preserve and enhance the elements of the innovation environment that helped make the United States a model.

Agency Comments and Our Evaluation

We provided a draft of this report to the Departments of State and Commerce for their review and comment. The Department of State did not provide comments. We received written comments from the Department of Commerce, which agreed our findings. (See app. IV.) The Department of Commerce also provided technical comments, which we incorporated into the report, as appropriate.

We are sending copies of this report to interested congressional committees and the Departments of State and Commerce. We also will make copies available to others on request. In addition, the report will be available at no charge on the GAO Web site at http://www.gao.gov.

If you or your staff have any questions about this report, please contact me at (202) 512-4128 or yagerl@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. Key contributors to this report are listed in appendix V.

Scope and Methodology

This report discusses (1) the development of offshoring in semiconductor manufacturing and software services over time, (2) the factors enabling the expansion of offshoring in these industries, and (3) the development of these industries in the United States as they have become more global.

To obtain information about the key developments in the offshoring of semiconductor manufacturing and software services, we reviewed available literature; attended conferences on the subject; and interviewed government officials, representatives of private firms, industry associations, and research organizations in China, India, Taiwan, and the United States. We performed a literature search and obtained information from several research organizations, universities, and industry associations that have published industrywide studies on offshoring and the key developments in both the semiconductor manufacturing and software services industries, including the Association for Computing Machinery; Brookings Institution; Gartner, Inc.; McKinsey and Company; the University of California, Berkeley; Stanford University; Carnegie Mellon University; the Semiconductor Industry Association; and the Information Technology Association of America. We attended conferences on developments in the semiconductor and software services industries and the general offshoring phenomenon. We interviewed researchers at private research organizations, industry experts at the U.S. Department of Commerce and the U.S. International Trade Commission, and government officials from India and Taiwan. In addition, we met representatives of private sector firms in the semiconductor and software services industries in China, India, Taiwan, and the United States. We also interviewed representatives and obtained data from organizations representing semiconductor and software services firms and workers, including the Semiconductor Industry Association, the National Association of Software and Service Companies, and the Information Technology Association of America. We discussed with these sources the historical changes that have occurred broadly in the computer hardware industry, particularly with respect to China and Taiwan, and the software services industry, particularly with regard to India.

To determine the factors that have contributed to offshoring in semiconductor manufacturing and software services, we conducted a review of available literature and interviewed representatives of private sector firms, semiconductor and software services industry associations, business associations, and research organizations (see above). In addition, we interviewed industry experts within the U.S. government and the governments of India and Taiwan. We met with and reviewed relevant literature from researchers who have published on the offshoring phenomenon and the factors contributing to global developments in semiconductor manufacturing and software services; including experts from the Brookings Institution; the Institute for International Economics; the Milken Institute; and the University of California, Berkeley. We interviewed representatives of private sector firms in China, India, Taiwan, and the United States that have globally sourced semiconductor manufacturing and software services; trade and industry experts in the U.S. Department of Commerce; and the governments of India and Taiwan. In addition, we interviewed representatives of business and industry associations, such as the Federation of Indian Chambers of Commerce and Industry, the U.S.-Taiwan Business Council, and the Semiconductor Industry Association.

To determine developments in the semiconductor and software services industries in the United States as they have become more global, we examined available government data, information from experts in both the semiconductor and software services industries, and other private sector research. We obtained U.S. international trade data from the Bureau of Economic Analysis (BEA) and the U.S Census Bureau. We also obtained foreign countries’ international trade data through the United Nations and a private company, Global Trade Information Services. We obtained foreign direct investment data from BEA and domestic production data from Census. To assess the limitations and the reliability of various data series, we reviewed technical notes and related documentation and met with officials from BEA and Census, as well as individuals in the private sector familiar with these data. In addition, we reviewed relevant research studies and obtained data from several private sector entities. Although we do not report these data directly, we used them to corroborate information from other sources. To determine employment trends in the semiconductor and software services industries, we analyzed available U.S. government employment data from the Bureau of Labor Statistics (BLS). We cross- checked various employment data and reviewed technical notes in BLS publications to assess the limitations and reliability of these data. We also discussed the limitations and reliability of BLS data with BLS officials. We determined that the data we used in this report to show the development and trends in the semiconductor and software industries were sufficiently reliable for these purposes.

We conducted our review from October 2005 through August 2006 in accordance with generally accepted government auditing standards.

U.S. Multinational Companies’ Investment and Operations in the Semiconductor and Software Industries

U.S. multinational companies’ worldwide investments and operations (including production, employment, and research and development (R&D) have played an important role in the globalization of the semiconductor and software industries. U.S. statistics show that overall multinational corporation (MNC) investments have still tended to be in developed economies, rather than in developing economies such as India and China. However, certain manufacturing sectors such as the computer and electronic products industry (including semiconductors) have a relatively higher share of investment, production, and employment in developing countries. In particular, U.S. companies’ investments and production in this industry are relatively higher in the Asia-Pacific region (particularly Singapore) than other industries. Employment is even more concentrated abroad—likely due to the movement of more labor-intensive production operations overseas in order to reduce costs. Conversely, research and development expenditures are much more concentrated in the United States than they are in foreign affiliates.

In recent years, U.S. Investment Offshore Has Been Relatively Stable and Has Been Larger in Singapore and Malaysia, Than in Taiwan and China

U.S. direct investment abroad statistics show that overall U.S. investment (across all industries) in developing country markets is still a relatively small share of total U.S. direct investment abroad (less than 1 percent of the total each for India, China, and other developing countries, except Mexico and Brazil), according to statistics from the Bureau of Economic Analysis (BEA). However, within the computer and electronic products industry (which includes semiconductors), Singapore was the most significant Asia-Pacific country accounting for 15 percent of U.S. global investment in that industry as of 2004. Malaysia and Japan were next with about 5 percent; followed by Korea (4 percent); Taiwan (3 percent); and China, Hong Kong, and the Philippines (2 percent, each). Figure 13 shows the value of U.S. foreign direct investment (FDI) from 1999 to 2004 in this industry for selected Asian countries. As figure 13 shows, Singapore accounted for $8.8 billion in U.S. FDI in 2004 (down from $13.5 billion in 2001), or about 15 percent of the global total in this industry. Interestingly, the value of U.S. FDI in China in this sector has fallen since 2001—more significantly than for other countries, except Singapore. These data represent the accumulated investments (stock) made by U.S companies in the computer and electronic products industry. As discussed in this report, U.S. companies moved labor-intensive assembly and testing operations overseas over the past several decades. Also, U.S. exports of semiconductor wafers were largest to Malaysia, Korea, Taiwan, Philippines, and China. This reflects the production process in which fabricated wafers are then sent overseas for final assembly and test by U.S. companies’ affiliates (as well as unaffiliated contractors).

Within the semiconductor industry, the majority of U.S. companies’ global production (as measured by value-added) remained in the United States, although the share declined during the recent recession. As figure 14 shows, semiconductor value-added by U.S. parents (U.S. operations) took a steep decline in 2001, remained flat in 2002, and rebounded somewhat in 2003. Value-added by U.S. companies’ affiliates abroad accounted for about 28 percent of U.S. MNC’s global production, while the Asia-Pacific region (excluding Japan and Australia), in particular, accounted for about 9 percent of global production.

Global Semiconductor Employment by U.S. Companies Is Roughly Split between Their U.S. Operations and Offshore Locations

U.S. MNCs that operate affiliates offshore have overall split their employment between their U.S. operations and their foreign affiliates. According to data from BEA, about 53 percent of MNC’s global semiconductor employment was located in offshore affiliates in 2003, up from 49 percent in 1999. As previously discussed, this reflects the trend begun in 1960s of U.S. companies’ offshoring much of their labor-intensive assembly and testing operations to lower wage countries, particularly in Asia. BEA statistics also show that a relatively higher share of U.S. employment in semiconductor manufacturing is concentrated in Asia compared with other industries. Similarly, U.S. MNCs in computer and electronic product manufacturing industries (of which semiconductors is a part), in general had relatively higher shares of their global employment located abroad (about 38 percent) than other information and communications technology industries such as computer system design and related services (35 percent), as well as across all industries (28 percent) in 2003.

Employment statistics from the Semiconductor Industry Association (SIA) show a similar pattern for U.S.-based companies. According to SIA, about 54 percent of U.S. companies’ semiconductor employment was located in North America (mainly the United States) in 2004. This is down from a peak of about 60 percent in 1998 but still higher than in the 1980s and 1990s, which was between 45 and 50 percent. In addition, about 28 percent of U.S. companies’ North American workforce was engaged in R&D in 2004. According to industry experts, a much higher share of U.S. companies’ R&D employment is based in the United States, rather than offshore.

U.S. Companies Investments in Overseas Affiliates to Supply Software Services Still Relatively Low

As discussed above, U.S. direct investment abroad statistics show that overall investment (across all industries) in developing country markets is still a relatively small share of total U.S. direct investment abroad. This is also generally true in services industries that include software services. For example, U.S. direct investment in India in the information sector and the professional, scientific, and technical services sector are both less than 1 percent of global investment in those sectors. However, investment in Ireland in the information sector accounted for 30 percent of global U.S. direct investment abroad in that sector in 2004. Over time, Ireland has attracted investment by a large number of U.S. companies to produce software for the European Union market.

Similarly, U.S. multinational companies’ operations abroad (including employment) in software services are relatively small compared with the semiconductor industry and the broader electronics hardware industry. For example, table 3 shows that, for semiconductors, over half of U.S. MNC’s employment was located in their foreign affiliates (rather than their domestically based parent company). In contrast, services industries such as publishing (which includes packaged software) and computer systems design and related services (which includes custom software) had between one-fifth and one-third of their employment located in their foreign affiliates.

MNC’s Research and Development Relatively Concentrated in U.S. Operations

Compared with production or employment, U.S. MNC R&D expenditures are more concentrated in the United States. As shown in table 4, in 2003 about 14 percent of U.S. MNC R&D expenditures were made through U.S. majority-owned foreign affiliates (MOFAs) out of total MNC R&D expenditures (U.S. parents plus MOFAs). The share was similar for the computer and electronic products industry (about 13 percent) and publishing industries (about 10 percent) but less for semiconductors (8 percent), computer systems design and related services (about 5 percent), and information services and data processing services (1 percent). In comparison, MOFAs accounted for about 26 percent of value-added for all industries, 24 percent for computer and electronic products, and 28 percent for semiconductors. Likewise, MOFAs accounted for 28 percent of employment across all industries, 38 percent for computer and electronic products, and 53 percent of semiconductor employment.

Across industries, MNCs spent about 22 percent of MOFA R&D expenditures in the computer and electronic products industry (5 percent in semiconductors alone), making it the third largest industry overall in 2003. Other information and computer technology (ICT) sectors represented very small shares (see table 5). Across major industries, transportation equipment manufacturing accounted for 29 percent of total MOFA R&D expenditures (26 percent of that was autos). The next largest was chemicals with 25 percent of R&D expenditures (of which 21 percent was pharmaceuticals).

Asia-Pacific economies account for a relatively small share of U.S. MNC’s R&D expenditures. Except for Japan (7 percent overall and 15 percent in information), Singapore (10 percent in computer and electronic products), and Malaysia (5 percent in computer and electronic products), these countries each accounted for 3 percent or less of MOFA expenditures in ICT-related industries (see table 6). China accounts for about 3 percent of manufacturing, but details are not available for computers and electronic products. India accounts for less than 1 percent of R&D expenditures across most industries (note that in the computers and electronic products and professional, technical, and scientific industries, where amounts were suppressed in 2003 for India, prior years also showed less than 1 percent).

Larger Imports of Information and Communication Goods Drive the U.S. Advanced Technology Product Deficit

Since 1989, Commerce’s Bureau of the Census (Census) has identified products that use leading edge technologies or innovations. Commerce classifies these goods as Advanced Technology Products (ATP). Currently, Census identifies about 500 of some 22,000 10- digit commodity U.S. merchandise trade classification codes as ATP codes because they meet the following criteria: (1) the code contains products from 1 of 10 recognized high technology fields such as electronics (which includes semiconductors) and information and communications (which includes notebook computers and cell phones), (2) these products represent leading-edge technology in that field, and (3) these products constitute a significant part of all items in the selected classification code.

Partly as a consequence of the growing movement of electronics assembly to Asia, and China in particular, in 2005, the United States trade deficit with China in the ATP information and communications group, $51.5 billion, is slightly larger than the overall ATP deficit with China, $48.4 billion, and about 25 percent of the overall goods deficit, $203.8 billion, all of which have dramatically grown in recent years. Finished products—such as notebook computers and cell phones—are the largest U.S. information and communication ATP imports from China in 2005. Computer parts and accessories are the leading U.S. exports to China in this group. U.S. exports, imports, and the trade balance with China in this group are depicted in figure 15. This figure shows both the rapid growth in imports of these products from China, as well as the rising trade deficit.

In contrast, in the ATP electronics group, beginning in 2001, the United States has a trade surplus with China, largely due to the substantial exports of semiconductor wafers and integrated circuits to China. (See fig. 16.) However, this surplus of about $1 billion in 2003 has been declining somewhat in recent years. This current trade surplus is partly a result of slower growing U.S. demand for finished integrated circuits by downstream manufacturers of consumer electronics, as discussed previously.

The overall ATP trade deficit with China (as well as Asia overall) is largely due to information and communications imports. However, trade statistics rarely separate out the value of imported components embodied in finished products. Therefore, some part of the value of U.S. imports of information and communications products from China is attributable to U.S. exports of chips and wafers (and other ATP components) directly to China or indirectly through other Asian countries. However, to be a leading-edge product, Census must judge the product itself to use leading-edge technology, not simply some of its components. For example, although autos have many leading-edge components such as semiconductors and integrated circuits, autos are not leading-edge products.

Comments from the Department of Commerce

GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

In addition to the individual named above, Virginia Hughes, Assistant Director; Bradley Hunt; Ernie Jackson; Sona Kalapura; Judith Knepper, Analyst-in-Charge; Lynn Cothern; Yesook Merrill; Berel Spivack; and Tim Wedding made major contributions to this report.

Related GAO Products

Offshoring

Offshoring in Six Human Services Programs: Offshoring Occurs in Most States, Primarily in Customer Service and Software Development. GAO- 06-342. Washington, D.C.: Mar. 28, 2006.

Offshoring of Services: An Overview of the Issues. GAO-06-5. Washington, D.C.: Nov. 28, 2005.

International Trade: U.S. and India Data on Offshoring Show Significant Differences. GAO-06-116. Washington, D.C.: Oct. 27, 2005.

International Trade: Current Government Data Provide Limited Insight into Offshoring of Services. GAO-04-932.Washington, D.C.: Sept. 22, 2004.

Highlights of a GAO Forum: Workforce Challenges and Opportunities For 21st Century: Changing Labor Force Dynamics and the Role of Government Polices. GAO-04-845SP. Washington, D.C.: June 1, 2004.

China

China Trade: U.S. Exports, Investment, Affiliate Sales Rising, but Export Share Falling. GAO-06-162. Washington, D.C.: Dec. 9, 2005.

U.S.-China Trade: Opportunities to Improve U.S. Government Efforts to Ensure Open and Fair Markets., GAO-05-554T. Washington, D.C.: Apr. 14, 2005.

U.S.-China Trade: Observations on Ensuring China’s Compliance with World Trade Organization Commitments. GAO-05-295T. Washington, D.C.: Feb. 4, 2005.

U.S.-China Trade: Opportunities to Improve U.S. Government Efforts to Ensure China's Compliance with World Trade Organization Commitments. GAO-05-53. Washington, D.C.: Oct. 6, 2004.

World Trade Organization: U.S. Companies’ Views on China’s Implementation of Its Commitments. GAO-04-508. Washington, D.C.: Mar. 24, 2004.

Export Controls: Rapid Advances in China’s Semiconductor Industry Underscore Need for Fundamental U.S. Policy Review. GAO-02- 620. Washington, D.C.: Apr. 19, 2002.

Semiconductors

Export Controls: System for Controlling Exports of High Performance Computing Is Ineffective. GAO-01-10. Washington, D.C.: Dec. 18, 2000.

Federal Research: SEMATECH’s Technological Progress and Proposed R&D Program. RCED-92-223BR. Washington, D.C.: July 16, 1992.

Federal Research: SEMATECH’s Efforts to Strengthen the U.S. Semiconductor Industry. RCED-90-236. Washington, D.C.: Sept. 13, 1990.