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Betting All the Chips: China Seeks to Build a World-class Semiconductor Industry

by Matthew Fulco

November 29, 2018

Betting on the Chinese semiconductor industry

Beijing is doing everything it can to reduce China’s dependence on foreign-made microchips, which the country now spends more on importing than crude oil. But catching up with the world’s leading semiconductor firms will not be easy

For China’s technology sector, the decision of the United States to hit Shenzhen-based telecommunications giant ZTE with a trade ban in April was an abrupt and painful wake-up call.

Until then, many in China had grown accustomed to thinking of their country as a global leader in technology. After all, China’s smartphones, high-speed railways and e-commerce platforms were the envy of the world. But in the days following the ban, designed to punish ZTE for violating US sanctions on Iran and North Korea, it became clear that one of China’s most successful companies was totally dependent on American suppliers.

ZTE’s business was crippled and it announced it would have to shut down. The firm, and the jobs of its 75,000 employees, was saved only by the Trump administration’s reversal of the ban in July.

The tech company’s most glaring weakness was reliance on American microchips. Deprived of Snapdragon processors from San Diego-based Qualcomm, the firm’s smartphones could not function. Overall, ZTE sources 53% of its chips from the US, at a cost of more than $3 billion per year.

Virtually every major Chinese tech firm is in a similar position. More than 90% of the integrated circuits (ICs) that China uses are either imported or made domestically by foreign chipmakers. In 2017, semiconductor product imports totaled $260 billion, more than the country spent on importing crude oil.

China imports more semiconductor products than any other country

Leaders in Beijing see this chip dependency as a national security threat, especially in a time of heightened tensions with the United States. Given the strategic importance of the semiconductor industry, they may be right to worry.

“You need semiconductors for everything,” says Roger Sheng, a semiconductor industry analyst at research firm Gartner. “On every digital, connected device, all information is transmitted on IC-based infrastructure.”

In May, while ZTE’s future still hung in the balance, Beijing called for the country to redouble its efforts to achieve independence in “core and key technologies.”

“The initiatives of innovation and development must be securely kept in our own hands,” said President Xi Jinping, according to state newswire Xinhua.

Officials and CEOs scrambled to answer Xi’s call. More than 10 local governments set up their own chip industry funds, and Beijing is set to announce a huge $47 billion national fund later this year. Major companies including Alibaba, Gree Electric and Tencent have pledged to invest more in IC research and development.

Flush with cash, China’s IC makers are expanding rapidly. The country’s chip industry revenues will grow 20% this year to reach RMB 600 billion ($87.5 billion), research firm TrendForce forecasts. Chinese IC designers now hold 30% of the global market.

China's semiconductor firms have steadily increased their market share

But Chinese firms still lag far behind top global firms such as Intel, Samsung and Taiwan Semiconductor (TSMC) in terms of technology. Domestic CPUs are only 30-50% as efficient as those produced by Intel, according to the Beijing Semiconductor Industry Association.

“We still face big challenges in producing reliable core components, and many products are still mid-tier to low-end,” said Xin Guobin, Vice-minister of Industry and Information Technology, in January. Catching up with the world’s leading semiconductor firms will be a daunting challenge for Chinese players and doing so will require more than just money.

Taking Back Control

Though the ZTE case has led to a surge of investment in semiconductors, China’s attempts to build a domestic chip industry go back much further. “The government has worried about [IC] supply crunches for a long time,” says Sheng.

Beijing first poured funding into the IC industry following another external shock from the US: the 2013 revelations by Edward Snowden. The former National Security Agency contractor made public that the US government was conducting widespread surveillance activities, including in China, often with the compliance of American hardware manufacturers.

“[After the Snowden leaks,] China felt that dependence on US and Japanese technology could compromise national security,” says Mario Morales, a senior semiconductor industry researcher at International Data Corporation (IDC) in California.

Beijing responded with a plan designed to develop a competitive chip industry in record time, named the National Guidelines for the Development and Promotion of the IC Industry, in June 2014. The government backed this up by setting up a $22 billion fund to invest in local chip firms.

Beijing’s strategy focused on acquiring foreign IC technology to help local firms catch up quickly. Officials encouraged the creation of national champions that could go out and buy prime overseas chipmakers. The approach had initial successes, but also led to a backlash that still hampers Chinese investment today.

Leading the charge was Tsinghua Unigroup, a private-equity arm of the elite Tsinghua University in Beijing. Sheng compares the firm to the Japanese telecom and tech investor SoftBank, but focused exclusively on IC investments.

Between December 2013 and September 2014, Unigroup merged with local IC maker Spreadtrum, acquired US-based fabless semiconductor company RDA and inked a strategic partnership with Intel. That deal gave the American IC giant a 20% stake in the holding company that owns Spreadtrum and RDA.

Following these successes, Unigroup grew bolder and set its sights on top global chipmakers. In 2015, the Beijing-based company reportedly offered $23 billion for Micron, a US company that is a world leader in memory chip technology.

After Micron’s executives rejected the offer, Unigroup turned to Taiwan, making high-profile bids for three firms involved in the lucrative IC packaging and testing industry. But these deals also fell through after the Chinese company encountered pushback from Taiwan regulators.

These abortive moves appear to have done lasting damage to Chinese companies’ ability to invest abroad. Foreign governments are increasingly wary of approving deals in sensitive industries. “Unigroup has been too aggressive in its announcements,” says Sheng.

Under President Donald Trump, Washington has blocked big-ticket Chinese bids for US chipmakers including Lattice and Xterra. It has also prevented the sale of Qualcomm to Broadcom amid concerns that the Singaporean company had close ties to Beijing.

Trump has also handed the US government greater powers to review and restrict foreign investments for national security reasons, a move implicitly directed at China’s tech ambitions. This will likely make it even harder for Chinese IC firms to invest in the US in the future.

“The primary concern of the Trump administration when blocking Chinese-linked companies from acquisitions of US IC companies is to safeguard US national security, whether assessed by risks to military hardware or the ability of US technology companies to remain at the forefront of the research and development curve,” says Ross Feingold, a Taipei-based political risk consultant and expert on US foreign policy.

“Past and ongoing incidents of intellectual property theft in the IC industry give the Trump administration sufficient political capital to block transactions, even if the acquirers in the blocked transactions were not involved in any theft incidents.”

Long Road Ahead

Blocked from external acquisitions, China’s IC industry will be forced to take the slow road, but China has arrived late to the game. It took the United States, Japan, South Korea and Taiwan decades to build up world-class IC makers.

“You can’t build a semiconductor sector overnight—the technology is too complex,” says Sheng.

To be sure, China will attempt to speed up this process by spending big. Bernstein Research forecasts that China’s spending on IC fab equipment will double to $7.1 billion this year and reach $11 billion in 2019. At least 11 local governments across the nation are aiming to set up production facilities: the cities of Beijing, Chengdu, Chongqing, Hefei, Shanghai, Shenzhen, Wuhan, Xiamen and reportedly Liaoning and Shaanxi Provinces too.

But some local governments, lacking knowledge of the IC industry, may end up building fabs to nowhere, according to one industry insider. “There are too many fab projects and not enough engineers to support the factories,” says the insider, who preferred not to give their name due to the sensitivity of the topic. “Local officials are just eager to show their support for a big central-government initiative.”

Talent shortages will be an ongoing problem for the IC industry. An August report in the state-run Global Times noted there are presently only about 400,000 of the 720,000 engineers needed for the growing sector.

Chinese chipmakers are attempting to overcome this by poaching engineers from Taiwan, where salaries are lower and workers share a common language with their mainland colleagues. Around 1,300 engineers have crossed the Taiwan Strait since 2014, and the brain drain is becoming a concern for Taipei. However, this still leaves an enormous number of vacancies to fill.

The IC industry is also adversely affected by the Sino-US trade war, as Washington has imposed tariffs on billions of dollars’ worth of semiconductor products imported from China.

“For this reason, chipmakers will focus mainly on the local market and therefore it will somewhat slow and limit China’s plans to grow the global influence of its IC industry,” says Jane Yeh, an industry analyst at the semi-governmental Market Intelligence & Consulting Institute (MIC) in Taipei.

Companies will likely continue efforts to acquire foreign technology wherever they can. South Korean media reported last October that Tsinghua Unigroup had approached Icheon-based chipmaker SK Hynix about establishing a joint venture in China. Reportedly, under the deal SK Hynix would license flash memory technology to Unigroup in a bid to bolster its presence in the massive China market.

Both SK Hynix and Tsinghua Unigroup have denied the reports. South Korean IC makers are unlikely to share their technology with Chinese counterparts, Morales says. SK Hynix rebuffed a previous overture from Unigroup in 2015.

Pressure is also being ramped up on foreign companies doing business in China. Foreign chipmakers complain of attempts to steal their intellectual property or force firms to sign patent-licensing agreements with domestic IC companies. Chinese regulators have also launched antitrust investigations into Micron, Samsung and SK Hynix, which are accused of using their strong market positions to hike prices, according to Japan’s Nikkei Asian Review.

Global firms will continue to invest in the mainland regardless, as China accounts for 60% of global demand for semiconductors, PwC estimates. But foreign companies are paying even more attention to information security in China. According to the semiconductor industry insider, one South Korean firm has become so concerned about trade-secret leaks that it has set up secure communications between its China factories and its headquarters.

The stakes are high for overseas players, since they have built up a formidable lead in IC research and development. Intel, Samsung and TSMC already produce 10-nanometer chips and are working on 7-nm chips. China’s leading semiconductor firms, meanwhile, have yet to move beyond 28-nm chips. There are no mainland Chinese companies among the world’s top 10 chipmakers in terms of R&D spending, according to research firm IC Insights.

US chipmakers, which make up half of the top 10, will be particularly hard to catch. The American players have acquired many crucial microprocessor and graphics-processor patents that have helped them secure “a rather dominant share” of the global IC market, observes Yeh. It will not be easy for China to develop similar technology independently.

“China’s goal of self-sufficiency in semiconductor production appears to be a distant dream,” concludes Yeh.

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