Internet & Tech

In a stranglehold

America’s next tech target could be foundry SMIC


SMIC chairman: Zhou Zixue

What defines a superpower? For the American academic John Tkacik it comes down to the country’s military capability, including the superiority of the microchips that power its weapons. His assessment came with a warning that US military superiority is eroding because of insufficient “recognition of the potential challenge from China”.

It’s the kind of statement that could have been articulated at many points in the past couple of years but it was actually made in 2006, when Tkacik presented his findings on the semiconductor industry to the US-China Economic and Security Review Commission.

The research fellow made a number of recommendations but none of them were taken up at a time when the George W Bush administration was more focused on fighting Al-Qaeda and Middle East wars.

Tkacik said the American government needed to adopt three main measures to ensure that China didn’t threaten its superpower status. Firstly, decisionmaking on export licence approvals should be removed from the Department of Commerce because it was subject to intense lobbying by companies more focused on short-term commercial interests than the country’s long-term future.

Secondly, the government needed to codify and respect its unwritten rule of limiting tech exports to a minimum of two generations behind the best-in-breed (government officials also needed an up-to-date protocol of what constituted cutting edge technology, he added).

Thirdly, officials in Washington should do more to establish bilateral Wassenaar-type agreements (banning the export of items with military uses) with geopolitical allies such as Japan and then use them to pressure European companies to limit technology transfers to China as well.

Some of Tkacik’s recommendations are now being adopted by the Trump administration. Notably, the Pentagon has been the driving force behind the government’s latest warning that it is considering adding Chinese chip foundry Semiconductor Manufacturing Corp (SMIC) to its Entity List, effectively preventing it from purchasing hardware and software of US origin.

The move represents one of the biggest threats yet to China’s efforts to develop a homegrown semiconductor sector capable of challenging its American peers. Potentially, restrictions on sales to SMIC could be far more devastating than the recent actions against Huawei – which are designed to prevent it from installing the world’s 5G telecommunications networks or providing the Chinese government with an alleged opportunity to spy on others.

If companies are prevented from providing US-origin technology to SMIC China’s semiconductor sector will find it much harder to advance its technological standards to match Western ones. The country could even end up struggling to source chips for existing electronic products (commercial, industrial or military) because it won’t have access to foundries capable of making them.

An estimated 30% of SMIC equipment is US-origin. Huawei itself is now desperately setting up its own foundry to manufacture chips after being blocked from using Taiwan’s TSMC. It hopes to have a 45nm production line by year-end (where TSMC was back in 2007) but that will only cover low-end chips.

US firms have a stranglehold over a number of key manufacturing processes in the semiconductor industry that make it difficult for newcomers to forge their own path, no matter the amount of money they throw at the attempt.

Manufacturing computer chips has become so complex that new advances continually push against the boundaries of the laws of physics and chemistry. But the Americans have the benefit of almost a century’s headstart in refining their expertise. Despite a sustained campaign to close the gap in know-how over an accelerated timeframe, China has struggled to achieve its goals of 40% self-sufficiency in semiconductors by 2020.

In a research report this week, HSBC points out that foundries in China met 15.6% of the country’s chip needs in 2019. However, foreign companies control many of the factories so the real ratio of domestic delivery is more like 6.1%.

All of that output is being produced at lagging technologies too. SMIC is China’s most advanced foundry but it has been stuck a few process technologies behind global leaders TSMC and Samsung since it was established 20 years ago.

Some analysts wonder whether Washington will follow through with its threat to add SMIC to the Entity List, cutting off access to US technology. Last weekend’s announcement centred on a report by defence contractor SOS International, which alleged that researchers from the People’s Liberation Army have been using SMIC processes and chips for their R&D programmes. To SOS this suggests the foundry must be making chips for military purposes.

SMIC issued a statement describing its “complete shock and perplexity” at the allegations and insisting that it only manufactures chips for commercial use.

Surging orders for US equipment and machinery from Chinese foundries have highlighted how the local chipmaking firms are expecting the worst, however, and that they are stockpiling supplies in anticipation of future restrictions.

Take the example of LAM Research, a semiconductor equipment supplier that foundries in China could have difficulties replacing in their production cycles. During its June earnings call it revealed that Chinese government-related entities had increased orders from roughly $6 billion in 2019 to an estimated $10 billion this year.

Questions about who really owns SMIC are nothing new either. Previously it may have looked more foreign-owned (it was overseas-listed) but its Taiwanese-American founder Richard Chang was eased out in 2009 as the part of the price of settling litigation with TSMC over IP theft.

Last year the company delisted from the New York stock exchange and then floated on Shanghai’s STAR market this July, complementing another listing in Hong Kong.

Research on its largest shareholders also identifies Chinese government-linked entities: the China Integrated Circuit Fund leads on 11.7%; Datang Telecom (which sells mobile communications equipment to the Chinese military) holds 11.6%; Sasac-controlled CNIC has 11.6% and China Development Bank’s investment arm owns 10.36%.

Information from S&P Global Market Intelligence reveals how SMIC’s board of directors are members of the public-private nexus driving China’s state-directed development model. SMIC chairman Zhou Zixue was formerly at the Ministry of Industry and Information Technology, while CFO Gao Yonggang was formerly CFO at Datang. Non-execs include Datang’s chief technology officer Chen Shanzhi and its president Tong Guohua, who is also an engineering professor at Huazhong University of Science and Technology.

This April Huazhong announced that it had developed a prototype extreme ultraviolet laser (or EUV). This is lynchpin technology that Chinese firms must master if they are to build chips at the most advanced process nodes (areas where TSMC and Samsung are still well ahead). The technology helps chip firms to make ever-smaller chips and accounts for more than a quarter of the equipment costs on wafer production lines, as well as almost half the manufacturing time.

Production of EUV equipment is currently controlled by Holland’s ASML. As we reported in WiC480, the US government pressured its Dutch counterpart against licencing the newer generation of EUV machines to Chinese customers in 2018. The question now is whether the Chinese really are on the brink of developing similar technology (although there’s clearly a gulf between university prototypes and commercial products that can meet the industry’s exacting standards). ASML is always looking to improve its equipment too: it says it is developing new technology with significantly enhanced performance on the current generation of product.

That is exactly what the US is trying to ensure for its manufacturers in the sector: impeding China’s ability to catch up and giving them the breathing space to stay a generation ahead.

How might the Chinese retaliate if a fuller export ban comes into effect on SMIC? One of the US semiconductor equipment suppliers, Applied Materials, is waiting on approvals from Chinese regulators for a $2.2 billion acquisition of Japanese rival Kokusai Electric. Chinese antitrust authorities previously ran down the clock on Qualcomm’s $44 billion deal to purchase NXP Semiconductors, which failed in July 2018. Beijing could easily pursue the same strategy again.

As for the immediate downside for SMIC on the threat of a US ban, investors were soon reacting by selling down its shares. The stock fell 22.9% in Hong Kong and 11.3% in Shanghai on Monday, although this partly reflected the evaporation of a very large head of speculative steam from its recent flotation. Shares in companies including LAM Research and Applied Materials also weakened in the US on fears that sales to SMIC could soon be restricted.

Meanwhile in other bad news for China’s chip sector, Wuhan Hongxin Semiconductor (HSMC) had to pledge its 7nm lithography equipment – which Chinese media said is the only EUV machine made by ASML in China – to banks to stave off financial crisis. Caixin reports that a government report had declared HSMC to be on the brink of collapse.

© ChinTell Ltd. All rights reserved.

Sponsored by HSBC.

The Week in China website and the weekly magazine publications are owned and maintained by ChinTell Limited, Hong Kong. Neither HSBC nor any member of the HSBC group of companies ("HSBC") endorses the contents and/or is involved in selecting, creating or editing the contents of the Week in China website or the Week in China magazine. The views expressed in these publications are solely the views of ChinTell Limited and do not necessarily reflect the views or investment ideas of HSBC. No responsibility will therefore be assumed by HSBC for the contents of these publications or for the errors or omissions therein.