The clandestine threat from China

Earlier this month Bloomberg Businessweek published an article with allegations that were, to say the least, explosive. The article asserts that during the manufacturing process, China had inserted trojan-horse chips into the motherboards of servers destined for the U.S.–an extraordinary feat, if true, as well as a grave security threat to any company or government agency using this compromised hardware. This hardware hack was described as “the most significant supply chain attack known to have been carried out against American companies”. Subsequent information throws the accuracy of the article into dispute –but regardless, the ramifications of the article are likely to still be significant.

The article alleges that a small microchip that did not form part of the motherboard’s original design was nested on server motherboards that were assembled by a company called Super Micro Computer Inc. (‘Supermicro’). In tracing Supermicro’s supply chain in reverse, the article said that U.S. intelligence agencies were able to ascertain that the hardware breaches were likely to have occurred at subcontractor facilities, a manoeuvre that is said to have been orchestrated by a secretive unit of the People’s Liberation Army that specializes in hardware attacks.

Such a breach, if true, is highly alarming due to: (i) the reliance on these servers by U.S. companies and government agencies, including the CIA and International Space Station; and (ii) the damage this causes to the relationship between the U.S. and China, particularly in light of the extent to which U.S. companies have already outsourced a large chunk of their supply chains to China.

Citing two people familiar with how the chips worked, the article stated that “the implants on Supermicro hardware manipulated the core operating instructions that tell the server what to do as data move across a motherboard.”A hypothetical example was used to frame the gravity of this alleged infiltration: “Somewhere in the Linux operating system, which runs in many servers, is code that authorizes a user by verifying a typed password against a stored encrypted one. An implanted chip can alter part of that code so the server won’t check for a password –and presto! A secure machine is open to any and all users”.

The Bloomberg article cited unnamed sources from both the national security establishment and employees from various companies. However, Apple and Amazon have issued unequivocal denials of the allegations of their supply chains being compromised. For both of these reputable companies to in no uncertain terms categorically deny the findings of the article casts doubt on the accuracy of the Bloomberg expose. While it can’t be said with complete certainty that this supply chain breach occurred, the timing of the article was no doubt interesting.

On the same day as the article was published, Vice President Mike Pence gave a highly critical speech which many have opined could herald the beginning of a Cold War between the U.S. and China. Some notable quotes from the speech are below:

  • Beijing is employing a whole-of-government approach, using political, economic, and military tools, as well as propaganda, to advance its influence and benefit its interests in the United States.
  • The dream of freedom remains distant for the Chinese people. And while Beijing still pays lip service to “reform and opening,”Deng Xiaoping’s famous policy now rings hollow.
  • And the Chinese Communist Party has also used an arsenal of policies inconsistent with free and fair trade, including tariffs, quotas, currency manipulation, forced technology transfer, intellectual property theft, and industrial subsidies that are handed out like candy to foreign investment. These policies have built Beijing’s manufacturing base, at the expense of its competitors -–especially the United States of America.
  • But in recent years, China has taken a sharp U-turn toward control and oppression of its own people.

Whether the Bloomberg article about Chinese supply chain interference is true is almost impossible to know. However, one thing is clear: the article will at a minimum have heightened U.S. suspicions towards the Chinese government. This comes at a time when the U.S./China relationship is the worst it has been in decades. Understanding the complexities of the U.S./China dynamic is critical in framing investment opportunities on both the long and short side. Inevitably there will be winners and losers, and we seek to optimise our portfolios to account for changes that could transpire from a worsening of relations between the U.S. and China.

Montaka is long the shares of Apple (Nasdaq: AAPL).

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George Hadjia is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.

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