Friend-Shoring Means You Have To Worry About The Health Of Your Friends

Friend-shoring is a term that has been making the news lately, with the U.S.-Japan trade agreement covering critical minerals being the latest example. It is shorthand for locating supply chains in countries where the political risk to disruption is low. It makes sense, because in a complex world, it is nearly impossible for a country to be self-sufficient in everything that it consumes. Not only would that be wasteful and duplicative when other countries might be able to produce something better or less expensively, it expands the overall pool of ideas from a larger overall population, which should be good for innovation. But it also means that leaders need to pay attention to the health of strategic sectors in the home bases of those friends. This is not something most people are accustomed to doing.

A case in point is the information display industry, and specifically flat panel displays (FPDs). Displays are ubiquitous and have become the human–machine interface for indispensable ICT products including smartphones, computers, TV sets, medical monitors, and a wide range of consumer and industrial products. A Boeing 787 has five 15.1 inch diagonal displays, an F-35 Joint Strike Fighter has an 8 x 20 inch panoramic display, and one of the central interfaces of a Tesla
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Model 3 is a 15 inch touchscreen display. Almost all of the flat panel displays in the world are manufactured in two time zones in East Asia, which means four countries: Japan, Korea, Taiwan, and China.

The assumption in the U.S. is that manufacturers like Apple
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or Tesla should be able to source in Japan or Korea, two strong allies, without political risk. But the recent bankruptcy filing of Japanese national champion JOLED, as well as Japan Display’s recent struggles casts doubt on the long term capacity of Japanese companies to be sources. How about Korea, where LG Display and Samsung Display have been dominant players for a decade and a half? These companies pioneered the industry and retained dominant market share as recently as 2018. Korea should be a reliable source of supply for decades to come, shouldn’t it? The answer seemingly is yes, unless the two companies get pushed out of the market, and they are already late in that struggle.

There are major two segments to the flat panel display business: liquid crystal displays (LCDs) and organic light-emitting diode displays (OLEDs). Modern LCDs predominantly employ what is known as an active-matrix design. These first started to be used on notebook computers in the 1990s, and the Japanese company Sharp popularized their use in TVs in the late 1990s. While Japanese companies had an early lead, a rocky transition from “Gen 3.5” (named for the production process that corresponded to generation 3.5 size displays) to Gen 5 during an industry downturn enabled Taiwanese and Korean manufacturers, who invested aggressively, to grab the market lead. By 2004, Taiwanese manufacturers commanded 38% global market share, while Korean firms had 36% and Japanese firms 22%. Chinese firms had no significant market share then, although it had several major Gen 5 fabs under construction. 2016 was a crossover year – Taiwanese, Korean, and Chinese firms each had close to 30% market share, but by 2020 Chinese firms reached 56% and are projected to reach 72% global share by 2024.

While the LCD industry has long been cyclical, with addition of new factories inevitably followed by excess capacity and a price collapse for end product, the over-building of new manufacturing capacity in China was carried to extremes. Between 2015 and 2022, Chinese manufacturers grew their capacity from 1.0 million glass sheets per month (measured on a Gen 8.5 converted scale) to 4.0 million glass sheets per month, increasing the number of multibillion-dollar fabs from seven to 16 during that time. All manufacturers lost money during the brutal price war that ensued, with Taiwanese and Korean manufacturers reducing their capacity and largely exiting the business. Chinese manufacturers’ share of the LCD market had reached 67% in smartphones, 68% in TVs, and 46% for automotive by 2022.

Both LG and Samsung had long feared the commoditization of LCDs and excessive investment by Chinese manufacturers, so they had invested heavily in OLED displays as an alternative, which have many advantages in brightness, superior color quality, and low power consumption. Of course, Chinese manufacturers were also unable to earn returns on their investments in LCDs, so they too invested heavily in OLED. In 2015, the two Korean firms had 94% of global installed OLED capacity compared to Chinese firms’ 2%, but by 2022 this had changed to 49% for Korea and 47% for China. By the fourth quarter of 2022, Samsung Display had exited the LCD market, and LG Display had posted a record loss, raising concerns about its imminent demise. An industry expert told me that the Korean flat panel display industry was “at the 11^th hour.”

Why did this happen, and what are the broader implications for friend-shoring?

It is important to understand what happened here because the FPD industry is a prototypical high-tech sector that is highly dependent on capital-intensive manufacturing facilities. It is also one where a great deal of manufacturing know-how is embodied in production tools, like semiconductors and advanced battery manufacturing. This is the basis for many export control regimes when trying to control the diffusion of strategic capabilities. The key questions are how large a percentage of the overall product cost is driven by the amortization of production equipment costs, and how is that amortization (depreciation) treated from an accounting standpoint. Together these point to how competitive a country can be in some important sectors.

A typical Gen 10.5 LCD factory is estimated to cost about $6 billion. I have been told that the local government subsidy in China for building such a facility can be as high as 85% of that cost. One of the leading display manufacturers estimated that depreciation made up 30~40% of the cost of producing an LCD panel in such a facility. An industry expert also suggested that Chinese firms can delay the depreciation charge until they have reached a certain level of utilization rate (70~80%) of their production process, which might take years to reach. These point to how Korean firms might have trouble competing. For a 6.7 inch high definition OLED display like one that might be used on a smartphone, estimated production costs in Korea are $62 which include $28 for materials, and $34 for labor and overhead, which includes the depreciation. Chinese suppliers have been pricing this display at $20 – 23, which would only be possible if you didn’t have to factor in capital costs. No wonder Korean competitors are at the 11^th hour, it would be almost impossible for them to survive, let alone invest further in future innovations.

The difficult question is what should national leaders do? There are no obvious answers when manufacturers in different countries use different business practices and standards. But it does give friend-shoring a different dimension and suggests that if countries like the U.S. want to practice it, leaders need to open up dialogues with counterparts in other countries about fair competition and level playing fields. Ursula von der Leyen, President of the European Commission, spoke in March of the need to counter economic distortions, and the need to align with partners around the world.

The display industry is likely not the only one that will face economic pressures because of market distrtions, semiconductors at mature nodes will likely be next. At the very least, leaders around the world should worry about the health of their friends.