Gambling chips in trade wars

Gambling chips in trade wars

by Pininvest Analysis

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Playing out in the wings, the most critical issue in the trade negotiations between the US and China is wrapped in tense silence

The stakes could not be higher for China

Simply stated, ever more voracious computational power requires ever faster chips, cramming billions upon billions of transistors on the silicone wafer - a feat setting leading chip firms and semi-conductor manufacturing companies apart from everyone else

The complexity of the strategic choices impacting the semi-conductor industry, as they relate to national security, is hard to understate

 

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Betting the house on the most advanced technologies, in 5G telecommunications, in artificial intelligence research, in world-beating chip design, in consumer hardware (from smartphones to drones and vision surveillance systems) and in cutting edge military applications, China could well be left with… nothing

 

China's challenge

China has engaged a strong push in chip manufacturing since 2016 to secure independent sourcing and correct their huge semi-conductor trade deficit, as discussed in China's Silicon Hearts, but the machinery and the entire plants sprouting up across China are imported from the West

A self-sufficiency manufacturing rate of 40% by 2020 for its semiconductor industry and 70% by 2025, has been part of the Made in China 2025 initiative to modernize China's industry, announced in....2015

The growth target assigned to the domestic industry was out of kilter, with factors causing local demand to increase and local production to be stifled - as reported by digitimes 

  • mammoth-sized Chinese demand of semi-conductors for the massive production of finished products is estimated at $251.1 billion which represents 58% of total world production, hardly a volume the Chinese semi-conductor industry firms could expect to cover in 10 years... or ever
  • the already substantial demand by Chinese tech firms (consuming 30% of world semi-conductor production in 2013-2016) is hitting 36% in 2018 ($155 billion) of which $60 billion for smartphones from top vendors alone (Huawei, Lenovo, Xiaomi and BBK)
  • the balance of $96.1 billion semi-conductor demand originates with Taiwanese and non-Chinese firms producing in China (such as Foxconn, Pegatron, Wistron, Quanta Computer, Inventec, Sony, Samsung and LG)

According to IC Insights, quoted by digitimes, worldwide demand of semi-conductors was $430.8 billion in 2018, expected to grow by 6.5% a year through 2025

  • from a low base, Chinese domestic production (which includes production by foreign firms in Chinese plants) was $23.7 billion in 2018, representing 9.5% of the needs of China-based tech industry
  • even with a 20% CAGR over 5 years, Chinese semi-conductor production could only cover 14% of the China-based demand (from Chinese and non-Chinese tech industry), assuming China demand of world production remains stable at 58%

Though China's domestic semi-conductor production will remain below target for good reason, blunt market share targets overlook a more dismal reality where none of the top-of-range semi-conductors are produced in China, putting the country's ambitions in the most advanced technologies on a very uncertain  footing

 

 

China's labyrinth

As we observed in ‘Unpacking foundational tech’, China is bound to follow very tenuous tactics in the short term and double down on their investments in the domestic (Chinese) semi-conductor industry to secure independent supply of high performing semi-conductors in the medium term

Labyrinth Old Summer Palace credit A.Moss on Flickr

In the short term, we are served an awkward spectacle around the supposed security risk created by Huawei

  • The company’s hardware is being fingered for potential spying chips, an possible occurrence (we would not know) but the massive attention paid to the issue in the West makes the tactic quite improbable
  • As controls multiply, the reputational risk to Huawei is simply too high and Huawei's founder, Mr. Ren Zhengfei has confirmed the obvious by stating that, if any country found a backdoor to spy, 'sales in 170 countries would tank'
  • As a software issue however, security risks cannot be ignored, with spyware slipped in anyone of hundreds of upgrades over time…

Following the inclusion of Huawei as of May 15, 2019 on the 'Entity list' monitored by the U.S. Department of Commerce’s Bureau of Industry and Security (“BIS”), a licence of approval is required in order for anyone, anywhere in the world to transfer US-origin commodities, software or technology to Huawei or the company's affiliates, a regulation also applicable to items produced outside the US but containing qualifying amounts of controlled US-origin content (which appears to be 25%)

While security risks must definitely be exposed and controlled securely, attention appears to be drawn away from China’s true focus, access to top-of-the-range semi-conductors for Huawei and for all the other applications under development, consumer-oriented as well as dual (including military)

 

America's dilemma

By acting with inconsistency, the American administration has probably lost some credibility with Chinese counterparts

  • Exports restrictions on semi-conductors to Huawei were lifted in principle last June, while exports to other Chinese clients were not halted and US allies (key semi-conductor providers such as Japan, South Korea and Taiwan) were left pretty much to their own devices
  • As Huawei stays on the Entity list, approval of licences requested by the major US technology firms has remained uncertain in the absence of clear policy guidelines regarding Huawei's security risk  (as of late July '19, none of the 50 licence requests from about 35 companies had been approved, according to Reuters)

 

In fact, because Huawei is the flash point of China's competitive advance at the heart of national communication systems, the US Administration - and governments worldwide - must come to terms with much broader policy issues and define what their national interests entails 

The complexity of these strategic choices impacting the semi-conductor industry, as they relate to national security, is hard to understate

Every movement around the negotiating table and every swing will be dissected, subject to interpretation and cause of long-term unexpected consequences...

Ice scene with golfers by H. Avercamp (1625) - credit Museum of Fine Arts Houston

Based on market shares reported in this note, China's lag in semi-conductor manufacturing  will not last beyond a 10-year time frame, if the effort engaged to gain expertise and production capacity is pursued doggedly (as it undoubtedly is)

The technological advance in semi-conductor equipment is at a unique turning point as we will explain in 'Lithography's holy grail', requiring industrial policy guidance implemented over time and necessarily by successive Administrations, but this US advantage is at risk of being frittered away by dithering around circumstancial 'trade deals'

Strict regulatory control will clash over time with global supply chains, confronting the tech industry with the costly overhaul of business models fine-tuned over decades

The advance of Western technology - though limited in time and shrinking fast - must serve a purpose of national interest to gain the unqualified support of industry, an imperious necessity which is hardly fullfilled

To cap it all, a geopolitical puzzle, stretching from Taiwanese foundries (producing the chips) to the Dutch leader in semconductor equipment manufacturing ASML, must realign allies for a common cause

 

By leaving a lot of ‘wriggle room’ to Chinese firms and labs in ordering top semi-conductors, the US bestows the most precious gift on China, time

  • Time is of essence to improve home-bred semi-conductors, to acquire and learn to master the more advanced semi-conductor manufacturing equipment
  • Time is given as a gesture of goodwill

Getting nothing in return ?