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The Future of China’s Semiconductor Industry

Over the past four years, the Trump administration—driven by growing concerns over China’s rise as a technological competitor and the coupling of its military and civilian industries—has ratcheted up controls on semiconductors and semiconductor manu­facturing equipment destined for Chinese end users. China hawks in the administration viewed American companies’ dominance of key semiconductor subsectors, particularly in areas such as electronic design automation and other tools needed to produce advanced semiconductors, as a key policy lever. They sought to use this lever to punish Chinese companies for specific types of activities deemed problematic by U.S. officials, and to push back on Beijing’s heavy subsidies to the semiconductor industry that some fear will distort market-driven global supply chains.

In response, Beijing, building on a series of policies in development for more than a decade, has over the past two years stepped up government support for the semiconductor industry across the board, via more traditional methods such as subsidies and through novel mechanisms designed to introduce market forces into the industry and attract domestic and foreign investment into this critical sector. This paper examines the challenges Beijing will face in trying to re­duce the dependence of Chinese technology companies on foreign sources of semiconductors and critical semiconductor manufacturing equipment, particularly from U.S. companies. For Beijing, this is a multiyear project, given China’s late entry into the industry, the huge and growing capital costs associated with manufacturing, shortages of trained personnel, and the fast-moving pace of innovation that keeps the cutting edge moving forward. Until recently, these factors have kept Chinese companies years and even decades behind leading global companies. To date, China’s progress has been highly uneven and inconsistent across the many subsectors that make up complex semi­conductor production value chains. This dynamic will continue to roil global supply chains in the semiconductor and broader technology sector over the coming decade, with significant collateral effects, both intended and unforeseen.

As this process unfolds, China will remain the largest global producer and export platform for electronic devices and systems, and thus also the world’s largest consumer of key inputs to advanced manufacturing in the semiconductor sector. China currently accounts for nearly one-third of global semiconductor demand, but domestic Chinese suppliers can provide for only around 10 percent of this demand. Chinese leaders have long been intent on reducing this gap, and much ink has been spilled designing plans and targets for domes­tic industry to begin winning market share across the many sectors that make up the semiconductor industry. Over the next decade, China will have to determine what level of domestic production of semiconductors and manufacturing equipment is appropriate and realistic, and at what cost that level can be reached.

Left to their own devices, Chinese companies competing in global and highly competitive sectors such as smart devices and telecommunications infrastructure prefer to use the best available technologies, including all types of semiconductors, regardless of country of origin. Even though Beijing is pushing for more domestic content, this dynamic will continue to hold for most Chinese firms with global market aspirations.

Senior Chinese leaders pushing the industry to be more innovative realize that China cannot realistically recreate, at home, the multiple and complex value chains that would be needed to achieve something like “self-reliance” in semiconductors. A leading Chinese semiconductor industry advisor, Professor Wei Shaojun, made this point in a speech at an industry conference in late 2020, cautioning that “the idea of ‘All Made in China’ is very hot, and is getting too hot.”1 Nevertheless, political leaders and industrial planners will continue to pull out many stops to achieve significantly lower levels of dependence.

Beijing Doubles Down on Core Technologies

Chinese industrial planners have long focused on the development of domestic capabilities in so-called core technologies, with semiconductors and software topping the list. Chinese companies were late in getting started on the design and manufacturing of semiconductors. During the period from roughly 1990 to 2000, the focus was on state planning, with the national and local governments backing large semi­conductor manufacturing efforts. Beginning with the 1991 Eighth Five-Year Plan (FYP) document, semiconductors have continuously been a focus of state planning—in the Eighth FYP, development of the industry was termed a “main task” of the state. These efforts ultimately did not produce major breakthroughs in domestic capabili­ties; they did, how­ever, begin laying the groundwork for eventual progress in some areas.

From roughly 2000 to 2013, state industrial planning continued, now coupled with a gradual internationalization of the Chinese semi­conductor sector. This period saw the establishment of China-based foundries—by far the most important being Semiconductor Manufacturing International Corporation (SMIC)—that were managed largely by foreign semiconductor industry veterans, many from leading Tai­wanese firms. It also saw the opening to foreign direct investment in the sector, a focus on developing Chinese companies that would come to play leading roles in areas such as assembly and testing, and the rise of China’s fabless design firms.

Critically, during the latter part of this period, Chinese semiconductor design houses began leveraging the advanced manufacturing capabilities provided by Taiwan foundry leaders Taiwan Semiconductor Manufacturing Corporation (TSMC) and United Microelectronics Corporation (UMC). The role of Taiwan-based companies in China’s rise as a semiconductor power would only grow. Chinese firms also began working with other foundry leaders such as GlobalFoundries and South Korean giant Samsung. This was because SMIC, despite making steady progress up the technology chain, found itself—and continues to find itself—several generations behind the leading edge of semiconductor manufacturing.

With the ascension of Xi Jinping to Party General Secretary in 2014, and Xi’s emphasis on turning China into a cyber superpower, including a renewed emphasis on developing core technologies, China’s approach to the sector changed. With very focused industrial policy choices becoming the norm, China introduced new and inno­vative approaches to developing domestic capabilities across the semi­conductor supply chain. The State Council’s release of its National Integrated Circuit Industry Development Guidelines in 2014,2 and the establishment of both the National IC Investment Fund in 20143 and the release of the Made in China 2025 (MIC2025)4 initiative in 2015, marked a new turning point in Beijing’s approach to pushing the sector toward reduced dependence on foreign suppliers.

The implementation of the strategy under the Guidelines fell to the National IC Industry Leading Small Group, led at the time by Vice Premier Ma Kai. Critically, the group is advised by a consulting com­mission (referred to as the A-Team), which includes twelve experts from government, academia, industry, and the government-backed national investment fund bodies. These experts, such as Wei Shaojun, Wang Xi (president of Shanghai Institute of Microsystem and Infor­mation Technology), Zhao Weiguo (chairman of Tsinghua Unigroup), and Xu Xiaotian (executive vice president of the China Semiconductor Industry Association or CSIA), are deeply involved with global semiconductor industry groups. Wei, for example, is a Chinese delegate to the World Semiconductor Council and a frequent participant in Global Semiconductor Alliance conferences. He is viewed as an expert particularly on the details of the market-driven global semiconductor industry value chain. It is not surprising that Wei is critical of a Chinese go-it-alone strategy in the semiconductor sector.5

In October 2015, a companion document to the MIC2025 program was released, drafted by engineers at the Chinese Academy of Engi­neering (CAE).6 It included details on the desired domestic market share percentage for key semiconductor subsectors. The document received significant attention from Western analysts, who frequently refer to it as an example of Beijing’s industrial policy goals.7 The document was written without reference to the market forces driving the industry, however, and its 2025 targets for domestic production are aspirational. Chinese companies are nowhere near being capable of meeting them. In addition, the M&A efforts fueled by the National IC Investment Fund during this period led to a major pushback against Chinese investments in the sector late in the Obama administration. Obama’s commerce secretary, Penny Pritzker, called the Fund an effort by China to expropriate the global semiconductor supply chain.8 Perceptions of the intent and aspirations of both the Fund and MIC2025 also contributed to the substantial pushback against Chinese semiconductor and technology companies under the Trump administration. Chinese industrial policies to promote domes­tic capa­bilities, including the Fund, feature prominently in the Section 301 report by the U.S. Trade Representative (USTR) on China’s trade policies in March 2018, which became the center of the U.S.-China trade dispute.9

The latest phase of China’s semiconductor industry arguably began around 2018, driven by new pressures from the outside—par­ticularly the U.S. reaction to the National IC Investment Fund and MIC2025, coupled with the weaponization of export control policies by the Trump administration. These restrictive policies cut several ways: they were first launched against leading telecommunications vendors ZTE and Huawei, and later against Chinese companies in other sectors such as artificial intelligence and supercomputing.10 They had the effect of re-galvanizing Beijing’s efforts to inject funding and innovative capacity into China’s growing semiconductor sector. In addition, U.S. efforts to restrict SMIC from acquiring advanced manufacturing equipment become clear during 2018–19, and industrial planners and senior Party officials became increasingly determined that China would have to adopt a two-track long-term policy to reduce China’s dependence on semiconductors and semi­conductor manufacturing equipment (SME) to avoid being subject to what they viewed as U.S. attempts to politicize complex global supply chains for semiconductors, critical design tools, and SME.

The State of China’s Semiconductor Sector in 2021

Before looking at the new two-track approach, it is necessary to survey and assess the current state of China’s semiconductor indus­try. Any attempt to determine where China’s semiconductor industry stands in relation to global leaders requires breaking down the sector along its separate lines, usually either by product line or, for SME, by different critical supply chain segments. In some areas, Beijing has long been concerned about overdependence on foreign sources for more than 80–90 percent of supplies, with little change in the num­bers over the past decade.

Two significant questions for Chinese industrial planners will continue to be salient: (1) what is the level of market share that Chinese companies can realistically achieve in key market subsectors, each of which has its own unique barriers to entry and technology road map; and (2) what is the most effective role of government in fostering companies that can successfully develop and compete in the many sectors where China is heavily dependent? Technology road maps can also change rapidly due to market conditions, and Chinese planners have been unable to anticipate major changes in most mar­kets. The most successful Chinese companies have been those in highly competitive, market-driven segments, such as Huawei in smartphones and telecommunications equipment. High levels of innovation are required to compete at the cutting edge of both handsets and infrastructure.

Before looking at specific pieces of the China semiconductor sector puzzle, it should be noted that China has one unique conglomerate, Tsinghua Unigroup, which includes subsidiaries that occupy places in a number of key subsectors. Unigroup’s five primary sub­sidiaries include memory producer Yangtze Memory Technologies (YMTC), fabless smart device designer Unisoc, smart card and mem-ory company Guoxin Microelectronics, and server, storage, and related technology provider H3C Technologies. Tsinghua Unigroup chairman Zhao Weiguo has attempted to drive the company’s devel­opment of core semiconductor design and manufacturing capabilities via mergers, acquisitions, and patent licensing.11

The company is viewed as a major piece of MIC2025 and Zhao is seen as a mover and shaker in the semiconductor sector. Industry observers believe Tsinghua Unigroup has close ties to senior Chinese leaders, including General Secretary Xi Jinping, and at least until last year, has benefited from government policies and financial subsidies from the National IC Investment Fund.12 There has been considerable discussion lately about Unigroup and Zhao’s star falling, given the struggles the company has had with mergers and acquisitions, master­ing a variety of technologies, and recent financial issues, including defaulting on several major bond issuances.13 Tsinghua Unigroup will continue to play an important role in China’s semiconductor ambi­tions, but it is becoming increasingly unclear whether the firm’s busi­ness model will facilitate breakthroughs in capabilities across key subsectors.

First, in terms of foundry capabilities—that is, manufacturing the designs of fabless companies—China has only two companies that are globally competitive: SMIC and Hua Hong. In 2019, these firms held just 5 and 2 percent, respectively, of global foundry market share, with TSMC (54 percent), Samsung (20 percent), Global Foundries (9 percent), and UMC (8 percent) holding higher shares.14 There are no Chinese integrated device manufacturers (IDMs), as most companies have or are moving to the foundry model. Nevertheless, under the influence of the Outline and the National IC Fund, the Chinese manufacturing sector has seen an average compound growth rate of nearly 25 percent since 2014.

In the related semiconductor design segment, China has made huge strides over the past fifteen years. In 2019, China’s design sector reached a level that surpassed Taiwan, making China the second-largest design industry cluster after the United States globally. Chi­na’s share of semiconductor design went from 3.6 percent in 2004 to nearly 43 percent in 2019.

On the product side, broadly speaking, Chinese companies have only really been able to gain significant market share in the mobile processor space. For most types of logic semiconductors, including central processing units (CPUs), increasingly important graphics processing units (GPUs), and other specialized semiconductors such as field programmable gate arrays (FPGAs), domestic Chinese com­panies hold very small market shares, in some cases less than 1 percent. After many years of government subsidies and other pref­erential policies, domestic firms such as Loogson and Tianjin Phyt­ium have a very small but growing market share, primarily in the domestic and not the global market, the latter being dominated by U.S. firms Intel and AMD.15 Phytium, in particular, part of the so-called PK system (where the firm’s CPUs are paired with domestically developed operating systems), could become a key player in efforts to replace Western CPU designs. Recently there have been a number of new entrants to the field, including e-commerce giant Ali­baba and start-up Zhaoxin, which are competing in the CPU and embedded CPU sectors. Chinese companies have so far not made a significant dent in the market share for GPUs, which are dom­inated by U.S. giants nvidia and AMD.

For mobile application and communications processors, Chinese firms including Huawei, Xiaomi, and Unisoc have made significant inroads into global market share, driven by meaningful advantages in design capabilities, coupled with the ability to manufacture at TSMC. In particular, Huawei’s design arm HiSilicon, prior to U.S. actions in 2020 that cut the firm off from manufacturing at TSMC, had moved into a position where some of its mobile handset and 5G infrastructure semiconductor designs were on par with Western leaders such as Qualcomm. HiSilicon was also pushing its semiconductor design capabilities across Huawei’s product lines, including for server and AI chips. Tsinghua Unigroup claims it is the world’s third-largest design­er of commercial mobile phone semiconductors and holds around 20 percent of the global SIM card market.

In the memory sector, Chinese firms are just starting to make significant inroads into the global market, after massive investment via the National IC Fund and local versions of the fund, and the failure of a number of ventures. Domestic firm GigaDevice, for exam­ple, accounted for nearly 20 percent of global market share for NOR flash memory in the first half of 2020 according to industry sources. Major Chinese memory players YMTC, a maker of 3-D NAND, and Changxin Memory Technologies (CXMT)—formerly called Innotron—a DRAM company, are both poised to break into global mar­kets in 2021 using fairly advanced manufacturing processes. YMTC is using an advanced 128-layer process, and expects to reach high-volume commercial production in mid to late 2021.

In a major new market segment, dedicated or optimized AI processors, there are a number of Chinese start-ups—including Cambricon, Horizon Robotics, Bitmain, Thinkforce, Enflame, and Novumind, and bigger players including Huawei, Alibaba, Tencent, and Baidu—that could become major players over the next five years. These are primarily edge AI processors, designed for specific tasks such as image recognition or natural language processing, and applica­tions in automotive, surveillance, or smart cities.16 A number of start-ups are also pursuing AI-optimized semiconductor development for cloud-based applications, attempting to challenge U.S. companies such as nvidia and start-ups such as Cerebras. Larger players such as Alibaba and Baidu have some advantages in this space, but will have a hard time competing both on the hardware performance side and in the software development ecosystem where U.S. companies generally have robust offerings.17

On the design tools and manufacturing equipment side, Chinese firms have even less market share in most areas. This sector breaks down into (1) electronic design automation tools (EDA) required for the design of cutting-edge chips and (2) manufacturing equipment, including a wide range of tools from lithography, etching, and mask writers to critical process control, metrology, and inspection tools. In addition, Chinese firms lag in the development of critical materials used for semiconductor production, such as IC-grade polysilicon, materials for advanced extreme ultraviolet lithography (EUV), and photoresists. The global EDA tools sector is dominated by U.S. firms Cadence and Synopsis as well as Mentor, a Siemens subsidiary. Chi­nese domestic leader Empyrean is focused on analog design tools, and claims its tools are used by leading players such as HiSilicon and UniSoc. Empyrean is also pushing into the digital/logic IC design tool arena, and its tools here have also been used by HiSilicon and Unisoc. In general, however, Chinese EDA tool developers are far behind the global leaders in the types of processes and IP they can support.18

It is in the area of advanced lithography tools that China is likely to face the most challenges. Chinese leader Shanghai Micro Electronics Equipment Co. (SMEE) is producing equipment only capable of handling critical and noncritical layers at the ninety-nanometer node, well behind industry leaders such as ASML, which are already sup­porting volume production at the seven- and five-nanometer nodes. Moreover, the U.S. government has pressured the Dutch government into blocking ASML from shipping EUV equipment to SMIC that had been contracted for in 2017.19 Details of the transaction and U.S. government policy on EUV technology remain unclear: there is U.S. intellectual property that is part of ASML’s EUV systems, and under the Trump administration, efforts to control advanced semiconductor manufacturing equipment have moved forward, but still have not been clarified.

Several other Chinese firms are beginning to move up the technology value-added chain in the SME sector, such as Advanced Micro-Fabrication Equipment (AMEC) and Naura Technology Group, which manufacture a range of semiconductor production systems, including oxidation, epitaxy, laser annealing, etching, and chemical vapor deposition (CVD) systems. But these firms hold only small market shares: in etching, Naura holds 1 percent as of 2019 and AMEC less than 1 percent, and Naura holds 1 percent in epitaxy. In most of these sectors, U.S. companies hold 70 or 80 percent market share.

Finally, a key area where Chinese firms have been able to grab significant market share is in the outsourced assembly and test (OSAT) sector. Here, companies such as JCET, Tongfu Microelectronics, and Tianshui Huatian Technology hold a significant share of the global OSAT market, which is largely dominated by Taiwan-based firms.

Beijing’s Semiconductor Strategy: A Tale of Two Tracks

To address these challenges and shortfalls, Beijing is constantly working to determine the most appropriate role for the state, at both the national and local levels, in helping to create a policy atmosphere that optimizes the potential for developing successful companies that can compete with leading players globally. In addition to commercial gains, Beijing’s goal is to reduce China’s dependence on foreign sources of semiconductors and SME and the political risks of such dependence going forward.

As Beijing surveyed the semiconductor industry landscape in the first half of 2018, along with the geopolitical situation, several things became clearer. The U.S. government was intent on using a range of policy instruments to punish Chinese firms for various reasons, including supply chain issues, alleged human rights violations, Chi­nese firms’ links to the Chinese military, and Beijing’s military-civilian fusion initiative, which Xi had begun touting again as a critical part of his efforts to modernize the People’s Liberation Army (PLA). At the same time, Beijing’s efforts to push domestic companies to buy Chinese-made semiconductor and other high-tech products such as software had shown mixed results, and in some critical sectors, such as SME, Chinese firms were far behind industry leaders.

Track 1: sharpen and provide resources for internal policies to push adoption of domestically produced technologies, including semiconductors. After a critical meeting in April 2018, Beijing launched a new project, centered on the concept of developing “secure and controllable” (安全可靠) supply chains. Details of this initiative are difficult to find in public media, and a number of references to the program have been pulled from various Chinese financial and industry-related web­sites. The project, designed to operate on a five-year time horizon (to 2023), under guidance from a senior Party organization, has the goal of replacing foreign—mostly U.S.—components and systems with domestic hardware and software in critical information systems. The goal of the project appears to be much more ambitious than the “De-IOE” (IBM, Oracle, and EMC) campaign that was launched after the 2012 disclosures by Edward Snowden about U.S. company involvement with U.S. intelligence agencies.

While the focus of the secure and controllable effort was initially on system vendors, as a result of U.S. export control pressure on the supply chains of ZTE and Huawei, officials in Beijing are now mandating that companies, particularly large state-owned telecommunications companies, begin to phase out reliance on U.S. semiconductors and other critical components. The effort does not apply to semiconductors from Japanese, South Korean, European, or Taiwan-based companies. The project also likely includes efforts to push the use of domestic alternatives to the x86 CPU architecture running a Windows operating system. A major Chinese bank in early 2019 indicated it was using a CPU designed by Tianjin Phytium (Feiteng) and the indigenously developed Kylin operating system for all its domestic and overseas offices.20 Other Chinese companies such as Alibaba, Tencent, Lenovo, and Inspur also announced server prod­ucts based on the “PK system.” The China Electronic Corporation (CEC), which owns Tianjin Phytium, continues to push the PK system as a completely indigenous, secure, and controllable alternative to foreign hardware and software. In December 2020, industry media reporting claimed that over four hundred “core” enterprises were working with the PK system to establish an indigenous IT industry and to promote the ARM architecture for corporate net­works, IoT, cloud computing, and big data applications.21 The latest Phytium chips are all ARM-based, and in July 2020 the company announced the Tengyun 2500 series, designed for servers. The Phytium roadmap for CPUs extends to 2022 when the firm claims it will be manufacturing at the five-nanometer node—and presumably this means the manufacturing will be done at TSMC.22

The long-term viability of the secure and controllable strategy remains unclear, but the elements of an alternative domestic stack that includes the PK system appear to be gaining traction, with internal government mandates to swap out Western semiconductors where possible, accelerating industry acceptance. But it remains unclear whether the PK system is capable of handling mission-critical work­loads for key industries such as the financial sector.

Track 2: develop new approaches to financing for the sector and new economic policies to incentivize investment in domestic capabilities. The second track that began to take shape in 2018 included initiatives undertaken by senior leaders and industry planners to introduce market mechanisms into the broader high-tech sector, and specifically the semiconductor industry. At the same time, there was a realization that new policies would be needed to further incentivize companies to step up R&D efforts and to provide support for the industry going forward in order to help bridge what is likely to be a long period of catch-up innovation.

First, in mid-2019, at the behest of Xi Jinping, financial market authorities rammed through approval for a new high-tech stock board in Shanghai, the so-called STAR market. The long-awaited board provides a new mechanism for funding promising tech start-ups, including in the semiconductor industry. It has also been used by established companies, such as SMIC, to raise money. In July 2020, SMIC raised nearly $8 billion before its IPO on the STAR board.23 In addition, as of July 2020, more than forty semiconductor companies were already listed or were applying for listings on the STAR board, suggesting that regulatory authorities were prioritizing an industry that Xi had emphasized as a key part of reducing China’s foreign dependence on core technologies. The long-term success of the new Shanghai STAR market, however, hinges upon capital and technology market dynamics through which innovative tech companies, mature institutional investors, and sophisticated regulators interact with each other and are able to establish a sustainable and healthy ecosystem.

In August 2020, Beijing unveiled a new set of measures to promote the domestic semiconductor industry, including significant tax relief for companies engaged in semiconductor manufacturing, design, or design-related software.24 The new State Council policy specifies that qualifying semiconductor projects and enterprises using processes at the twenty-eight-nanometer or more advanced nodes, and which have been in operation for more than fifteen years, are exempt from corpo­rate income taxes for up to ten years. Meanwhile, projects at the sixty‑five-nanometer to twenty-eight-nanometer nodes have a five-year tax-free period and will enjoy a 50 percent discount on the corporate rate for the following five-year period. For companies in the semiconductor design, packaging and testing, and other manufacturing equipment sectors, along with semiconductor materials and software (EDA) firms, their first two years of profits will be exempt from corporate income taxes, while these companies also get a significant discount on tax rates for the following three years. Currently, only SMIC and Hua Hong can produce products at the twenty-eight-nanometer level. While some industry observers did not think these measures would have a major impact, they were an improvement and reflect the importance Beijing is giving to the industry.

On October 29, the Party’s Central Committee released a communiqué summarizing its deliberations during the Fifth Plenum.25 Technology and innovation were at the center of the discussions, in terms of the impact that they would have on balances of power and economic growth, as well as on the efforts that China would need to undertake to remain at the forefront of global com­petitiveness. The Plenum document emphasized that achieving major breakthroughs in core technologies—meaning semiconductors and software—was a top priority for the country’s long-term development roadmap, aiming for completion by 2035. It also highlighted innovation as the driving force for modernization and technological self-reliance as the cornerstone of development in the dual circulation era. Xi, in speeches around the Fifth Plenum and discussion of the Fourteenth Five-Year Plan, and at economic and trade-related confer­ences, stressed the need for China to become self-reliant in core technologies.

The communiqué coined the new term “technology self-reli­ance” (科技自立自强)26 to describe Xi’s vision for a domestic-tech­nology-driven economic growth model amid decoupling pressure and weakening global demand.27 It also indicated that Beijing is likely to keep semiconductor technology development as its top priority for the foreseeable future. Next-generation technologies and digital infra­structure are of primary importance for the nation’s overall strategy. Noticeably, the statement did not mention controversial policies such as MIC2025 or the military-civil fusion policy, part of continuing efforts in China’s state-run media to downplay domestic industrial policies. The draft plan typically goes through two more rounds of internal comments before final publication, scheduled to take place in the spring of 2021.

The pathway to self-reliance in sectors such as semiconductor manufacturing equipment will be long and difficult for China. In a key illustration of the challenges China will face, as of late 2020 Huawei, under pressure from U.S. government export control ac­tions, was devising plans to equip a semiconductor manufacturing plant in Shanghai with non-U.S. tools, aiming to create a new supply chain free from the threat of U.S. export controls.

The firm’s semiconductor manufacturing partner, Shanghai IC R&D, is backed by the Shanghai municipal government and partially owned by state-run Huahong Group, which also has shares in domestic chipmakers Huahong Grace and Shanghai Huali Microelectronics Corporation (HLMC), two other leading domestic foundries.28 But IC R&D will start with the production of low-end chips at forty-five nanometers, an older generation of technology used by global industry leaders fifteen years ago. The company aims to meet Huawei’s goal of making twenty-eight-nanometer chips by the end of next year, to allow the telecom equipment major to incorporate home‑grown semiconductors into smart TVs and other Internet of Things devices. Assuming the facility can achieve this step, Huawei would like to move to more advanced twenty-nanometer semiconductors by the end of 2022. These chips could be used in the firm’s 5G infrastructure products, but it remains unclear how Huawei can maintain performance metrics for 5G systems using the less capable hardware.

Even if IC R&D is able to deliver products according to this aggressive timetable, domestic semiconductor manufacturing capabili­ties will not be sufficient to support Huawei’s smartphone business lines, which require the use of semiconductors at cutting-edge tech­nology nodes. The replacement of U.S.-origin semiconductors and cutting-edge devices manufactured in Taiwan using U.S. technology will be technically and financial challenging. This will be the case even with government policy and financial support, and other factors such as the fact that Chinese firms have higher tolerance for production cost and operational inefficiencies.

Finding adequate replacements for U.S.-origin manufacturing tools will be even more difficult. The Shanghai project will begin production with second-tier equipment from Chinese suppliers such as AMEC and Naura, together with secondhand, high-end tools made by foreign manufacturers available on the market. Industry experts believe that it will take years to substitute for the suite of cutting-edge foreign semiconductor manufacturing equipment required to produce devices at more advanced processing nodes.

Technological capability will be a major limiting factor going forward, despite all the other strategies Beijing is deploying to provide the domestic semiconductor industry with virtually unlimited financing and a very favorable policy environment. The dominant position of U.S. and Japanese companies in the manufacturing sector, for example, is the result of very strong and long-standing customer relationships. This means equipment suppliers codevelop manufacturing processes across multiple generations of increasingly advanced products, creating a virtuous cycle of knowledge development and technology iteration that results in considerable accumulations of engi­neering and systems-based knowledge that is very difficult to repli­cate or obtain through illicit means. While Chinese companies can gain in some limited market segments, it would be difficult for domestic manufacturing firms to rely on Chinese-developed equipment for scaled and sustainable commercial operations.

Each of these measures will take time to begin having an effect on domestic capabilities across all segments of the semiconductor indus­try. This is the problem facing Chinese planners: fostering a sizable group of capable companies that can master complex technologies across multiple sectors in a highly competitive global environment, where no single country has been able to go it alone.

The Industry’s Future in China, the United States, and Taiwan

As Chinese industrial planners and industry executives look forward to 2021 and beyond, they will have to grapple with a domestic industry that faces profoundly different challenges than it did in early 2018. These issues highlight how closely the American, Chinese, and Taiwanese semiconductor sectors are intertwined, via supply chains, manufacturing relationships, and close financial and personnel link­ages. Primary among Beijing’s challenges will be dealing with what appears to be the freezing of domestic manufacturing capabilities at around fourteen nanometers, and potentially further restrictions on Chinese companies’ ability to design advanced semiconductors and manufacture them in Taiwan. In addition, Beijing will be looking to determine if alternative approaches to semiconductor design and manufacturing, such as the open-source risc-v architecture,29 will mature in time to offer Chinese companies another path to reducing dependence on proprietary approaches subject to U.S. export control restrictions.

The new Biden administration could also review U.S. policy on allowing the sale of advanced manufacturing equipment to Chinese end users such as SMIC. Late in its tenure, the Trump administration pressured the Dutch government to block the transfer of advanced EUV lithography equipment to SMIC. After much debate and indus­try pushback, China hawks succeeded in adding the firm to the Entity List restricting exports in late 202030 and included the firm on the Department of Defense Section 1237 List.31 Additionally, a November 2020 executive order bars U.S. persons from investing in companies on the list.32 As of early 2021, SMIC and other Chinese companies were being removed from financial indices and U.S. exchanges an­nounced plans to delist the named companies.

Administration critics and some in the Biden team criticized the interagency process that led to the development of the Section 1237 List and might consider rolling back the executive order. But the political climate in Washington—and the linkage of restrictions on SMIC to the company’s alleged support for China’s military—will make it politically difficult. On the other hand, SMIC has denied providing support for the military, and elements of the U.S. semiconductor industry are likely to push for revisiting all aspects of the U.S. treatment of SMIC. The outcome of this debate will have a huge impact on the future development of China’s semiconductor manufacturing equipment. While the wording of the November 2020 Entity List action implied the presumption of denial for equipment unique to manufacturing at nodes below ten nanometers, SMIC is currently not manufacturing at that level, suggesting limited impact on current production. But the Entity List action could, depending on how licensing is implemented, have a major impact on the firm’s ability to do research on advanced manufacturing techniques needed to continue moving up the technology value-added chain.

If the Biden administration continues to block shipment of EUV equipment to SMIC, China’s domestic manufacturing industry will be essentially frozen at around fourteen nanometers. SMIC could push the capabilities of its existing dense ultraviolet (DUV) lithography equipment down to seven nanometers in some layers, but this would come with major challenges in maintaining commercial yields.33 In addition, the swirling regulatory uncertainty around SMIC as of late 2020 had also led to internal management problems, all of which threaten to undermine the ability of the firm to attract critical talent going forward. If SMIC is forced to refocus on less advanced tech­nologies, which seems probable, it will likely be very hard for the firm to attract the management and engineering personnel needed to remain a global player in the industry.34 Finding enough talented managers and engineers has been a general problem for China, but the shortage of managers with deep industry knowledge will be particularly difficult to overcome if U.S. pressure on the industry remains high.

In addition, the Biden administration could decide to add more semiconductor manufacturing technologies to the list of so-called foundational technologies called for under the 2018 Export Control and Reform Act (ECRA). While the Trump administration has been unable to agree on adding technologies to the list, the Biden administration might prefer to go this route, rather than targeting individual Chinese companies, to impose broad restrictions under Commerce Department authorities. It will probably take some time for the Biden team to develop its overall China strategy before considering a new approach to export controls for companies like SMIC and Huawei.

Finally, the Biden team will have to grapple with the argument raised since 2016 by Pritzker and others,35 including in the U.S. semiconductor industry, that the United States should restrict exports of SME and design tools to Chinese semiconductor firms that are heavily subsidized by Beijing because, over the long term, heavy subsidies will lead to market distortions that undermine trusted U.S. suppliers of semiconductors.36 This argument was made in the 2018 Entity List action against Fujian Jinhua, a DRAM manufacturer that was also indicted for participation in stealing IP from U.S. memory leader Micron.37 The same argument could be used to add virtually all of the current fabs under construction or operating in China. A U.S. government contractor report on YMTC released in early 2021 made similar arguments for action against the company, including placement on the Entity List and/or on the Department of Defense Section 1237 List.38 This issue may be one of the most complex to confront the Biden administration in determining what policies to implement to ensure both U.S. semiconductor industry innovation and long-term competitiveness, as well to blunt the impact of massive state-led industrial development of the semiconductor industry in China.

Foreign Pressure Will Not Deter Beijing

Meanwhile, Beijing’s domestic policy push under the secure and con­trollable program will continue to mean that local suppliers are favored and a localization trend will continue. For example, local suppliers are now able to supply some products in all manufacturing segments, except for advanced lithography tools. The lower cost of domestic tools and the improving levels of technology and quality will mean that local manufacturers such as SMIC, YMTC, and Hua Hong increasingly look to domestic suppliers.

While this process was underway, the geopolitics of semiconductors changed again for Beijing in mid-2020, when China hawks in the United States stepped up efforts to further restrict the semiconductor supply chain of Huawei. For the first time, Taiwan was dragged headlong into the fray, marking another major turning point. The United States in May 2020 took steps to cutoff Huawei from its critical manufacturing base in Taiwan, particularly from TSMC. The modification to the Commerce Department’s foreign direct product rule (FDPR) extended U.S. export controls globally to any company manufacturing semiconductors on behalf of Huawei.39 This led to TSMC’s decision to cut off its relationship with Huawei as of September 2020. China’s industrial planners likely fear that the FDPR change could be applied to other Chinese companies. The ramifications of these actions are still unclear, but they have the potential to generate major geopolitical conflict between the United States and China under the Biden administration.

The inclusion of Taiwan in the U.S.-China technology conflict under the Trump administration has so far not resulted in a major response from Chinese authorities. Any further pressure on Taiwan and Taiwanese companies, however—including perceptions that the U.S. government was forcing Taiwan to choose sides in a red-versus-blue supply chain contest—could provoke further reaction from Beijing and heighten the potential for a geopolitical confrontation centered on semiconductors.40

Much will depend on how the Biden team decides to approach these complex issues. Some U.S. semiconductor industry officials have argued that the types of policies pursued by the Trump administration have forced Chinese companies to consider excluding U.S. technology from their supply chains over the long term, and that this will eventually erode U.S. market share and the profits that U.S. companies could plow back into R&D. Industry observers also argue that the U.S. government needs to be more sensitive to the impact of policies targeting Chinese firms that are already threatening the sustained integration of Chinese technology firms into essentially U.S.-company-led semiconductor ecosystems.41 Biden administration officials will likely be more receptive to this argument than the China hawks on the Trump national security team were.

Still, balancing economic and national security policies in the semiconductor arena will be a challenge. Rolling back select Trump-era restrictions on Chinese firms would benefit—and be supported by—some parts of the industry, but such measures could run into opposition in Congress and other quarters. The degree to which the Biden team chooses to weaponize U.S. company advantages will be a key issue in determining where China’s semiconductor industry, across almost all segments, is headed.

For Beijing, the only choice is to continue building a favorable regulatory environment for the domestic semiconductor industry, while trying to avoid overheating and wasteful investment, and striv­ing to enable a long-term, sustainable semiconductor sector. Beijing has so far not shown any inclination to reduce the heavy subsidies to the sector, though as of late 2020 Chinese planners were concerned about overinvestment and were taking a hard look at the financial viability of major projects.42 The National Development and Reform Commission (NDRC) expressed concern in late October 2020 that the semiconductor sector had experienced “chaotic” development and many companies had “blindly entered into projects.” The NDRC indicated it would be working with financial institutions and banks to coordinate assessments of the viability of semiconductor projects going forward.43 Some industry observers have suggested this could be the start of a major rethink in Beijing of how to finance development of the sector.44

Several major semiconductor projects as of late 2020 were under financial pressure and had either folded or were on the verge of being restructured. The collapse of Wuhan Hongxin Semiconductor Manu­facturing (HSMC)45 in late 2020 may be a harbinger of trouble ahead for the industry, which already has seen massive overinvestment chasing too few viable projects. In addition, semiconductor major Tsinghua Unigroup’s financial difficulties, already impacting several high-profile memory projects, are likely to continue, and could require a major restructuring of the conglomerate’s semiconductor businesses.46

Another critical issue Beijing will be grappling with in 2021 is how to handle mergers and acquisitions in the semiconductor arena that could impact China. The proposed acquisition of ARM by U.S. giant nvidia, for example, could be rejected by China’s antitrust regulator. Many Chinese semiconductor design companies depend on ARM cores and architecture, and U.S. restrictions related to Huawei affect­ed ARM products. Chinese domestic companies are probably lobby­ing Beijing to reject the deal, concerned about the United States gaining dominance of another key piece of the supply chain that could potentially be weaponized.47

The tension between Beijing’s preference for managing the domes­tic industry and the market-driven nature of the global industry will continue to produce inefficiencies and wasteful investments. In the 2019–20 period, a number of major domestic manufacturing projects collapsed or had to be restructured, and there will likely be a major shake-up in the industry in 2021, with planners in Beijing hoping that some strong companies will emerge out of this process.

Regardless, for the foreseeable future, the semiconductor industry will remain a critical sector, a high stakes geopolitical issue, and a source of tension between Beijing, Washington, and Taipei. Many have argued that U.S. pressure on China in the semiconductor arena will ultimately mean that domestic companies step up and overcome the many challenges noted in this paper.48 But progress in reducing dependence will remain uneven over the many sectors involved in semiconductor value chains. Chinese companies could make relatively rapid gains in some areas, such as design and OSAT, while facing slower progress in areas such as manufacturing and materials.49 This process will play out over a long time frame, at least a decade or more, with major consequences for the sector, particularly if China succeeds in duplicating major portions of global value and supply chains.

This article originally appeared in American Affairs Volume V, Number 1 (Spring 2021): 90–113.

The author wishes to thank a number of industry experts and China technology watchers for helping to increase his understanding of the semiconductor industry and the complex technological, economic, supply/value chains, and geopolitics that support and shape it. In particular, he would like to thank Jimmy Goodrich, Dieter Ernst, Julian Snelder, Scott Kennedy, Chris Thomas, Doug Fuller, and Dan Wang.

1 Amy Guan, “6 Points to Consider Before Betting the Farm on ‘All Made in China,’” EE Times, November 15, 2020.

2 State Council (China), National Integrated Circuit Industry Development Guidelines (国家集成电路产业发展推进纲要), June 24, 2014.

3 State Council, “The National IC Industry Investment Fund is Officially Launched,” October 14, 2014.

4 State Council, “Notice on Made in China 2025,” May 8, 2015.

5 For more on the A-Team, see Dieter Ernst, “China’s Bold Strategy for Semiconductors—Zero Sum Game or Catalyst for Cooperation?,” East-West Center, September 2016.

6 Chinese Academy of Engineering, “China Manufacturing 2025 Key Area Technology Roadmap,” October 2015.

7 For an excellent analysis of MIC2025 that includes the CAE report, see European Chamber, China Manufacturing 2025: Putting Industrial Policy Ahead of Market Forces (March 7, 2017).

8 Penny Pritzker, “U.S. Secretary of Commerce Penny Pritzker Delivers Major Policy Address on Semiconductors at Center for Strategic and International Studies,” U.S. Department of Commerce, November 2, 2016.

9 Office of the United States Trade Representative, Findings of the Investigation into China’s Acts, Policies, and Practices Related to Technology Transfer, Intellectual Property, and Innovation under Section 301 of the Trade Act of 1974 (March 22, 2018).

10 Bureau of Industry and Security, Department of Commerce, “Addition of Certain Entities to the Entity List,” Federal Register 84, no. 196 (October 9, 2019): 54002; Bureau of Industry and Security, Department of Commerce, “Addition of Entities to the Entity List,” Federal Register 84, no. 98 (May 21, 2019): 22961; Bureau of Industry and Security, “Commerce Department to Add Two Dozen Chinese Companies with Ties to WMD and Military Activities to the Entity List,” U.S. Department of Commerce, May 22, 2020; Bureau of Industry and Security, “Commerce Department to Add Nine Chinese Entities Related to Human Rights Abuses in the Xinjiang Uighur Autonomous Region to the Entity List, U.S. Department of Comerce, May 22, 2020; Bureau of Industry and Security, U.S. Department of Commerce, “Addition of Entities to the Entity List and Revision of an Entry on the Entity List,” Federal Register 84, no. 121 (June 24, 2019): 29371; Bureau of Industry and Security, U.S. Department of Commerce, “Addition of Huawei Non-U.S. Affiliates to the Entity List, the Removal of Temporary General License, and Amendments to General Prohibition Three (Foreign-Produced Direct Product Rule),” Federal Register 85, no. 162 (August 20, 2020): 51596; Bureau of Industry and Security, U.S. Department of Commerce, “Export Administration Regulations: Amendments to General Prohibition Three (Foreign-Produced Direct Product Rule) and the Entity List,” Federal Register 85, no. 97 (May 19, 2020): 29849.

11 Dieter Ernst, “China’s Bold Strategy for Semiconductors.”

12 Tsinghua Holdings, which owns 51 percent of Unigroup, is fully owned by Xi’s alma mater, Tsinghua University. A group close to Xi at Tsinghua helps to drive the sprawling business empire of Tsinghua University, which some have called Tsinghua Inc.

13 Narayanan Somasundaram and Kenji Kawase, “Tsinghua Unigroup’s Bond Default: Five Things to Know,” Nikkei Asia, December 11, 2020.

14 Company reports and filings.

15 In late December 2020, Loongson was preparing for an IPO, to become the first domestic CPU producer to list on the Shanghai nasdaq-style STAR market, an example of one key new element of China’s semiconductor industry strategy. See: Ze Zhanqi and Ding Yi, “Homegrown CPU Maker Loongson Eyes First-in-Class Listing in China,” Caixin, December 31, 2020. Most of the critical workloads running on Loongson processors are industrial embedded applications.

16 Paul Triolo and Jimmy Goodrich, “From Riding a Wave to Full Steam Ahead: As China’s Government Mobilizes for AI Leadership, Some Challenges Will Be Tougher Than Others,” New America, February 27, 2018.

17 For an excellent and in-depth look at China’s AI specific semiconductor space, see Dieter Ernst, “Competing in Artificial Intelligence Chips: China’s Challenge amid Technology War,” Center for International Governance Innovation, March 26, 2020.

18 Dieter Ernst, “China’s Bold Strategy for Semiconductors.”

19 Alexandra Alper, Toby Sterling, and Stephen Nellis, “Trump Administration Pressed Dutch Hard to Cancel China Chip-Equipment Sale: Sources,” Reuters, January 6, 2020. Details of the U.S. government effort remain scarce, but it appears to have begun around 2018 after the Dutch government agreed to provide a license to sell EUV equipment to SMIC. The status of the equipment remains unclear, and neither ASML nor SMIC has clarified the status of the purchase.

20 See, for example, “Heavy! Based on the Take-Off 2000 Plus Domestic High-Performance Server Product Group Released,” eetop, May 8, 2019.

21 See, for example, “Four Grid Intersection ‘Asset Management Digital Platfrom’ through the PK System Certification,” Sohu, December 8, 2020.

22 See, for example, “Empower New Infrastructure! Take-Off’s Strongest Server CPU Tengyun S2500 Release: UP to 8 512 Cores,” ICSmart, July 24, 2020.

23 Naomi Xu Elegant, “China’s National Champion Chipmaker Becomes Its Biggest Listing in a Decade,” Fortune, July 16, 2020.

24 State Council, “Several Policies Concerning the Promotion of the High Quality Development of the Integrated Circuit Industry and Software Industry in the New Era,” August 4, 2020.

25 State Council, “Communiqué of 5th Plenary Session of 19th CPC Central Committee Released,” October 30, 2020.

26 Lucas Niewenhuis, “China Pushes for Technological Self-Sufficiency to Power Growth through 2035 and Hints at Xi Jinping’s Long-Term Plans,” SupChina, October 29, 2020.

27Communiqué of the Fifth Plenary Session of the 19th Central Committee of the Communist Party of China,” Xinuanet, October 29, 2020.

28 Kathrin Hille, Yuan Yang, and Liu Qianer, “Huawei Develops Plan for Chip Plant to Help Beat U.S. Sanctions,” Financial Times, October 31, 2020.

29 Paul Triolo and Kevin Allison, “The Geopolitics of Semiconductors,” Eurasia Group, September 2020.

30Commerce Adds China’s SMIC to the Entity List, Restricting Access to Key Enabling U.S. Technology,” U.S. Department of Commerce, December 18, 2020.

31DOD Releases List of Additional Companies, in Accordance with Section 1237 of FY99 NDAA,” U.S. Department of Defense, December 3, 2020.

32Executive Order on Addressing the Threat from Securities Investments that Finance Communist Chinese Military Companies,” Executive Office of the President, November 12, 2020.

33 For more on DUV challenges, see Triolo and Allison, “The Geopolitics of Semiconductors.”

34 He Shujing, Luo Guoping, and Yang Ge, “In Depth: Clash of Two Tech Whizzes Reflects Leading Chipmaker SMIC at Crossroads,” Caixin, December 31, 2020.

35 This argument was first articulated by the semiconductor industry here: Jimmy Goodrich, “China’s 13th Five-Year Plan Opportunities & Challenges For the U.S. Semiconductor Industry: Written Testimony Prepared for the U.S. – China Economic & Security Review Commission,” China’s 13th Five-Year Plan (Washington: United States–China Economic and Security Review Commission, April 27, 2016).

36 OECD, “Measuring Distortions in International Markets: The Semiconductor Value Chain,” OECD Trade Policy Papers, No. 234 (Paris: OECD Publishing, 2019).

37Addition of Fujian Jinhua Integrated Circuit Company, Ltd (Jinhua) to the Entity List,” U.S. Department of Commerce, October 29, 2019.

38 Roslyn Layton, “China Aims to Dominate Flash Memory,” Forbes, January 4, 2021.

39 Bureau of Industry and Security, “Addition of Huawei.”

40 For further implications and risks around this, Triolo and Allison, “The Geopolitics of Semiconductors.”

41 For an excellent discussion of this issue, see Scott Kennedy, “Washington’s China Policy Has Lost Its Wei,” Center for Strategic and International Studies, July 27, 2020.

42 Luo Guoping, Liu Leilin, and Anniek Bao, “Beijing to Inexperienced Companies: Stay Out of Chipmaking,” Caixin, October 21, 2020.

43 Guoping, Leilin, and Bao.

44 See, for example, Douglas B. Fuller, “Growth, Upgrading and Limited Catch-up in China’s Semiconductor Industry,” Policy Regulation, and Innovation in China’s Electricity and Telecom Industries, ed. Loren Brandt and Thomas G. Rawski (Cambridge: Cambridge University Press, 2019).

45 Luo Guoping and Yang Ge, “China’s $18.5 Billion Chip Champ Hopeful Fights for Survival,” Caixin, August 25, 2020.

46 As of late 2020, two massive Tsinghua Unigroup memory projects, a 3-D NAND flash facility in Chengdu, and a DRAM production plant in Chonqing are facing delays as a result of both technology and talent related issues, particularly lack of skilled management and heavy dependence on government funding.

47Huawei, Other Chinese Tech Firms Are Said to Seek Curbs on Nvidia’s US$40 Billion Arm Acquisition,” South China Morning Post, October 21, 2020.

48 Dan Wang, “New U.S. Restrictions Will Help Make China Great Again,” Bloomberg, December 18, 2020.

49 For an excellent discussion on this issue, see “Webinar Examining China’s Semiconductor Self-Sufficiency: Present and Future Prospects,” Semiconductor Industry Association, November 17, 2020.

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