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Faced with Technology Decoupling by the United States, China Must Establish an Industrial Base for Integrated Circuits


Lu Feng, a Peking University professor, argues a closed-loop domestic integrated circuit (IC) supply chain is urgently needed in the face of U.S. and allied technology controls. He suggests Beijing advance this goal by encouraging Chinese enterprises in the field to buy from and sell to each other – decisions that, Lu argues, will be made easier by U.S. technology controls. Lu also suggests China play to its strengths and use its expansive market as a source of leverage to influence the scope of such controls.

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In 2023, the United States is continuing to escalate its technology war against China. In the face of the United States’ aggressive technological decoupling, as well as the ensuing “de-Chinaization” of the United States and its allies, China should play to its strength as the world’s number one demand market, strike back, and pursue cooperation in the midst of struggle. At the same time, we should concentrate resources as soon as possible on promoting the formation of the local integrated circuit (IC) production chain, fully leverage the advantages of our national system to create an independent manufacturing base, and change the passive situation in which our leading science and technology-based enterprises are repeatedly embargoed.


Advantage of being the world’s No. 1 chip market


Early in 2018, the Trump administration launched a trade war and a technology war against China. After Biden took office, the momentum of U.S. containment of China not only did not ease, but intensified. The United States has put 36 Chinese chipmakers on its ban list and has encouraged TSMC to relocate to the United States The U.S. bans will undoubtedly have a negative impact on China’s technological and economic development.


Semiconductor technology originated in the United States, and the United States has a strong technological advantage. Viewed from the supply side of the global market, U.S. semiconductor companies account for 46.3% of the overall semiconductor market share (2021 Global Semiconductor Industry Association (SIA) data) From the demand side, according to SIA data, global semiconductor sales in 2021 were $555.9 billion, a record high. Sales in the China market were $192.5 billion, accounting for 34.6%, a year-on-year increase of 27.1%, and it remains the world’s largest consumer market for semiconductors. This is a huge advantage for China.


Michael Porter’s Five Forces model is commonly used in management science to analyze the five internal and external determining factors of enterprises. One of these forces is the power of buyers. That is to say, the bargaining power of the demand side of the market can affect the profitability of an enterprise. In the case of the semiconductor industry, the industry pattern in which the United States dominates the upstream (supply) and China dominates the downstream (demand) reflects the relationship between the U.S. and Chinese industries: the United States is starting to decline in many downstream industries, including even semiconductor manufacturing, while China’s downstream industry is gradually developing, its upstream industry is still a weakness. This has formed a unique “nuclear terror” equilibrium in the semiconductor industry, with the United States and China each having their own “nuclear weapons.”


China is the world’s largest chip market. If China were to not import U.S. chips at all, the U.S. semiconductor industry would be hit hard. Over the past five years, the United States’ suppression of China’s S&T enterprises has been a case of throwing stones in a glass house. They know that once China becomes completely throttled, their own enterprises will be throttled at the same time. For example, U.S. companies, including Qualcomm and Nvidia, rely on the Chinese market for more than 70% of their operating income. If they lost the Chinese market, these companies would reduce investment and lay off staff, and their stock prices would plummet, which in turn would lead to a panic on Wall Street and other chain reactions. In this situation, the United States continues to exert a stranglehold on China in some key technological areas on the one hand, carrying out focused attacks on Chinese enterprises (such as Huawei) that challenge U.S. technological hegemony; on the other hand, it continues to expand sales of its products in the Chinese market. At the same time, the United States sought to bring in a TSMC plant, first to revitalize the U.S. IC manufacturing industry, and second because the U.S. strategic community is worried that the U.S. IC production chain will be broken after China recovers Taiwan. Therefore, this is an important move of the United States in using re-industrialization against China.


Why hasn’t China formed a local IC production chain?


Although China faces weakness in the field of integrated circuits, there are Chinese enterprises in every segment of the global semiconductor production chain, and they are actually very strong in some fields, such as chip design. The key reason for being in a U.S. “stranglehold” is that the supply and demand cycle of the production chain has not been formed domestically.


Why hasn’t it developed? It is not that we have not tried to do it. Rather, we gave up halfway several times, lacking the tenacity to stick with it to the end. Although China’s IC industry is still backward relative to the United States, it has a feature rarely seen globally, namely, there are Chinese enterprises in almost every segment of the semiconductor production chain. Thus far, however, the Chinese enterprises in the different semiconductor production chain segments have failed to form relatively strong supply and demand relationships with each other. Instead, each has formed supply and demand relationships with foreign enterprises, causing the fundamental problem of China’s IC industry. For example, ten years ago, because domestic chip design companies did not consider SMIC advanced enough, most of the orders it received came from overseas (though this has now improved). The chips designed by HiSilicon are ordered from TSMC. Until recently, it imported all of its equipment and did not use domestic equipment. Advanced Micro-Fabrication Equipment (AMEC) produced China’s first chip etching machines, but mainland companies did not buy them, and industrialization was not achieved until after they were sold to Taiwanese enterprises. It was only after China’s chip manufacturing enterprises were sanctioned by the U.S. that companies started to order domestically and procure domestically produced equipment and materials. Domestically produced equipment and materials are not advanced enough in terms of quality and performance, and are in a state of marginal substitution. Another aspect of why companies like SMIC do not dare to take orders from Huawei and HiSilicon is that they are afraid of coming under U.S. sanctions on technology and equipment.


Why has China’s semiconductor industry not formed a local production chain? The root cause lies in our model of following others. China began to develop the semiconductor industry in the 1950s, and made integrated circuits in the 1960s. It always insisted on independent R&D in technology, and products and technologies were constantly updated. Under the planning system of the time, products from China’s semiconductor industry were mainly used in military industries and scientific research, and were not combined with commercial applications, so development was severely constrained.


In the early 1980s, amid the wave of opening up to the outside, the domestic IC industry was overwhelmed by imports. Semiconductor enterprises that were mainly supporting military industries could not adapt to the mass market, and so they passively relied on imported equipment and technology. Research and development of IC technology were almost abandoned domestically.


At that time, the central government was not unaware of the importance of developing integrated circuits, and had organized efforts to introduce several more advanced production lines through the joint venture approach, such as the 908 and 909 projects and the Shougang [-NEC] semiconductor project. However, reliance solely on introduced production lines could not enable Chinese enterprises to develop their own capabilities, and they were unable to keep up with the rapid changes in technology and markets. After accepting the lessons learned, Project 909 turned to independent development and evolved into today’s Huahong.


China entered a third phase of semiconductor industry development around 2000, marked by the establishment of SMIC in Shanghai. The characteristics of this round can be summarized as China’s enterprises adopting an internationalized development approach and participating in the international production chain cycle. This coincided with China’s economy entering a high-growth phase, and expanding market demand and investment capacity enabled the semiconductor industry to achieve a great deal of development.


Since China has a long history of developing the semiconductor industry, there are Chinese enterprises in almost every segment of the semiconductor production chain. However, the internationalized development approach has not led to the formation of relatively strong supply and demand links between these Chinese enterprises distributed in the upstream and downstream, resulting in a situation where China’s leading chip enterprises can be easily held back by the United States.


Forming an industrial base is the primary goal and task


The key to dealing with the U.S. technology blockade is to form a production chain capable of domestic self-circulation.


Under U.S. suppression, the technological progress of every Chinese IC enterprise must rely on the technological progress of the entire domestic production chain. If Chinese enterprises in the various segments cannot form strong supply and demand links with each other, then the technological progress of each enterprise will be subject to U.S. suppression. Therefore, connecting and opening up the domestic IC production chain is equivalent to establishing the industrial base of this industry. Once the local production chain is formed, we will not need to fear U.S. technological embargoes, because China’s market is large enough.


Summarizing the past lessons learned and accelerating the formation of an industrial base should become the primary goal and task of China’s development of the IC industry.


Since the release in 2000 of State Council Document No. 18 encouraging the development of the software and IC industries, the State Council has issued documents every few years to support the development of integrated circuits, but these document’s objectives and content do not include the development of an independent industrial base. Major special projects are supported and financed by the state, with technical indicators as the criteria for project establishment, but those indicators take internationally advanced technology as the reference system. The projects under the “following others” system support individual technologies and take the existing foreign technologies as the targets to follow. They only follow the frontier of international technological progress, and most of them are undertaken by universities or research institutions.


China’s major special projects have been implemented for three five-year plans. We have seen the achievements of China’s new energy vehicles, which originated in the independent innovation movement of China’s automobile industry more than 20 years ago, thereby providing a basis for the national program. At the time, the relevant national authorities formed the concept of using new energy technology to promote the implementation of “overtaking around the turns,” but only enterprises with self-developed products would be able to try new technologies, implement “overtaking around the turns,” and prompt more enterprises to enter the new production chain. The new energy vehicle production chain or foundation formed from numerous independent development-based enterprises produced the achievement of China’s new energy vehicles, being number one in the world in production and sales. Contrast this with the IC industry. It has received no less national support than the new energy automobile industry, but so far, it is still as lacking in cohesion as scattered sand. We must draw a lesson from this.


The feasibility of fully independent manufacturing


In response to U.S. technology sanctions, China needs policy-level support to build an industrial base for ICs. China’s policy focus must concentrate resources on promoting the formation of China’s indigenous production chain, and change the status quo of enterprises going their own way, with decentralized pursuit of single projects or single technical indicators. The government should resolutely develop key links to promote the formation of the production chain. At present, the key links include independent R&D of the underlying technology and, especially, grasping fully independent manufacturing and using it to connect and open up the upstream and downstream production chains.


How can fully independent manufacturing be achieved? This can be divided into two steps:


The first step is to achieve the non-Americanization of production lines, that is, using domestic and Japanese, South Korean, European, and other non-U.S. equipment and materials in production lines. China’s IC manufacturing enterprises are already working hard on this. The second step is to replace all foreign equipment and materials with domestic ones. The development of fully independent manufacturing can go upstream in the production chain to provide traction for domestic equipment and materials, and downstream to strengthen the interaction between manufacturing and design enterprises. The principle is that there cannot be any risk of being put in a “stranglehold.” Whether there is 100% domestic production or not depends on the specific situation, however. The development of fully independent manufacturing needs to rely on the cooperation of Chinese enterprises in all segments of the production chain, as the technologies of each segment interact with those of other segments. As long as you seize the manufacturing link, you have seized the bull by the horns for forming the whole production chain.


When it comes to developing fully independent manufacturing, the world’s advanced level cannot be attained at present, but fully independent manufacturing starting from the 28 nm level is achievable. Some people ask, if Huawei’s chips are 7 nm, isn’t doing 28 nm fully independent manufacturing backward? This involves a fundamental perspective for viewing technological progress, which in turn involves two fundamental strategic issues:


First, when it comes to innovation, the foundation of technical capability is more important than the current level of technology. You must have that capability in order to grasp technological progress and innovate. At present, China’s IC industry has not formed an independent industrial base, that is, a capability base. This is also the real reason why most individual enterprises do not do deep-level technology R&D. However, relying on foreign technology will not allow the formation of a capability base, so the technological progress of individual enterprises depends more than ever on the technological progress of the entire production chain, i.e., the progress of the industrial base. The lack of a foundation is our biggest shortcoming in the China-U.S. technology war, which we have to overcome.


Given the current state of the industry, we can build fully independent 28-nanometer production lines, thereby opening up a connected production chain and forming the industrial base for the nation’s integrated circuits. From there, we will be able to build fully independent 14 nm production lines, and so on. Technological progress is iterative, and capabilities are developed cumulatively through product platforms.


Second, in terms of demand and usage, the global IC market is dominated by mature process chips. Advanced process chips are only a very small slice of the market. As of 2021, advanced processes below 10 nm accounted for only 2% of global IC capacity, while chips with processes from 28-180 nm and above accounted for nearly 61% of global capacity.1 In 2021, TSMC also significantly expanded production of mature 28 nm process chips to cope with a shortage of products in the market. Advanced process chips only represented 50% of TSMC’s annual revenue that year, while the key products supporting TSMC’s capacity utilization rate were still mature process chips of 10 nm and above.2 Currently, the automotive chip world is basically one of mature 28 nm, 45 nm, and 65 nm processes, and only a few automotive chips, such as self-driving chips, require the use of advanced processes. Engineering fields such as aerospace are still using even micron-level chips, albeit in limited quantities. If China can truly form a production chain at the 28-60 nm technology level that is not subject to intervention by external forces, it will have an industrial foundation for continuous technological advancement, and at the same time, can form another kind of competitive advantage. Chinese industry has one of the world’s strongest capabilities: As soon as it learns to make a certain product, it can quickly make the cost of that product the lowest in the world and capture a large share of the market. If China takes a major share of the world market for mature process chips, it will gain a bargaining position: If the United States sanctions 20% of advanced process products, we will reciprocate by sanctioning 80% of mature process products, and from a cost perspective, U.S. automobile factories will not switch to advanced process chips. In addition, because all the enterprises that monopolize advanced process products (including TSMC) are heavily dependent on mature process products to maintain profitability, the loss of this market would seriously shake their self-confidence in sanctioning China.


Utilizing the advantages of the national system to respond to the chip sanctions


How can the new national system play an effective role in independent innovation? The development of fully independent manufacturing calls for the use of entirely domestically produced equipment and materials. This requires a process, and will not be accomplished overnight. However, we need to build up our IC industry base in accordance with this goal. Once this foundation is formed, China’s upstream equipment enterprises and materials enterprises can join the technological progress chain, and downstream chip design development will not be subject to U.S. restrictions. Firmly grasping this key point will enable the connection and opening up of the whole production chain.


In China’s earlier success with “two bombs, one boat” [两弹一艇] (atomic bombs, guided missiles, and submarines), the “Central Special Committee” played an important role as a special institution. In discussing the new national system, our research has found that the fundamental feature of the national system historically has been that a special decision-making and executive body directly responsible to the top leadership must be set up to execute and complete the country’s major strategic tasks; otherwise, it is difficult to mobilize the power of the whole nation. With regard to China’s industrial system today, following the success of our own large aircraft project, we need to focus on addressing the industrial-level weakness in integrated circuits. This is a major task that China must resolve. The “two bombs, one boat” program has set a good example for the construction of the IC industrial base today. The Party Central Committee can set up an organization similar to the Central Special Committee, directly responsible to the Party Central Committee, and directly take charge of this project below it, because it is difficult for any department to cope with this major task. The overall goal of this major task must be to incubate a production chain in which demand and supply relationships form between the various segments, and to cultivate the production chain’s self-circulation capability. Achieving this goal will require relying on market mechanisms, but not entirely on market mechanisms. In other words, since the development of China’s IC industry must rely on enterprises that grow through market competition, the development of this industry must rely both on market mechanisms as well as the unified coordination of various forces, including market mechanisms. Otherwise, it will be difficult to make breakthroughs. Therefore, IC industry development needs a “Central Special Committee” for the new era to directly lead the major task of integrated circuits.


The development of independent manufacturing capacity is a key link for connecting and opening up China’s IC production chain, and for the project to succeed, market principles must be followed. Adherence to market principles has two meanings: First, there is complete reliance on enterprises to do projects, whether they are existing enterprises or new ones, and the number of enterprises can be greater than one. The ultimate guarantee of project success is the growth of the capacity of enterprises. Second, the standard of success of projects is whether products can be produced that meet the market’s needs and are competitive in terms of price and performance. For equipment and materials enterprises, it is whether the production lines work. Moreover, all product output must be products that can be mass-produced, and it must be on an industrial scale. Implementation of the fully independent manufacturing project must also rely on coordination beyond market mechanisms. The goals of the independent manufacturing project include using production lines to provide traction for the independent development of equipment and materials, and to provide manufacturing services for independently designed chips. Therefore, implementation of the project must be accompanied by cooperation among numerous companies in the production chain. Under existing structural conditions, such cooperation cannot be formed quickly (at least there will be financial risks that exceed the capacity of enterprises to bear), and it must be coordinated directly by the state institution carrying out the major task. The fundamental principles of such coordination are that production lines must use domestically produced equipment and materials, that the products of equipment and materials enterprises must meet the requirements of production lines, and that chip design enterprises must support the manufacturing and testing of production lines. Moreover, these are the only reasons for sponsoring enterprises. Of course, certain coordination work can be carried out partly through market mechanisms, but the fundamental nature of this major task is to achieve fully independent manufacturing.


By grasping fully independent manufacturing, the state will grasp the leverage for turning around the market structure. And by using policies to support the sale of fully independently manufactured chips, the state will provide equipment and materials enterprises with sales outlets and opportunities for technological progress. When all Chinese enterprises in the production chain are able to form supply and demand linkages between each other, and when all domestic technologies can gain application opportunities, China’s industrial base for integrated circuits will have been formed, and the conditions will be met for relying mainly on the power of market competition to promote the industry’s development.


Choking demand to give China’s local chip enterprise development opportunities


If the United States controls the supply of semiconductors as a means of suppressing China, then China can and should control the demand for semiconductors. Over the past few years, the United States has wanted to both keep China in a stranglehold, and also make money in the Chinese market. In that case, the right response for China is: Since you want to strangle me, I will not let you make money. The United States’ “nuclear weapon” is technology, and China’s “nuclear weapon” is the market. If you have the market but not the technology, you can develop the technology; if you have the technology but not the market, the technology is ultimately a dead end. In short, China must not let the United States have its cake and eat it too. Dutch lithography giant ASML’s revenue is mainly from mature process DUV lithography, rather than the most advanced. The United States is now demanding that its own enterprises stop supplying China with high-end chip manufacturing equipment, and that its allies participate in the siege of Chinese industry. If the enterprises of the United States and U.S. allies do this, it will be tantamount to choking off supply to Chinese chip production chain companies, and we can require any enterprises that carry out U.S. sanctions orders against China to submit to the Chinese government’s scrutiny when they sell in the Chinese market. These companies would then need to weigh the fact that it was the other side that started the sanctions against China first, not China that was violating any rules of free trade.


If ASML wants to follow U.S. policy and stop exporting state-of-the-art lithography machines to China, we can block its sales of ordinary lithography machines in the market after we enforce reciprocal sanctions (and actually, the number and dollar amount of ordinary lithography machines are much larger). By doing so, we can make it easier for Chinese companies to open up the domestic market for their lithography machines. By the same reasoning, China’s enterprises in the low-end chips field may have more opportunities for development, as no one will be able to stop enterprises that can make low-end products from continuing to advance to high-end ones.


In short, it is necessary for China to make a decision: In response to the U.S. government’s overall strategy of launching a technological blockade against China at all levels, we should control their access to the Chinese market, for example, by implementing controls on the orders of all foreign enterprises that sanction China in technological fields.


At the same time, we must unswervingly develop China’s indigenous IC production chain, and, in particular, develop weak areas such as chip manufacturing equipment and chip materials. Centralized coordination by a national-level authority will define the development of the IC industry as a major task. This task is more complex than “two bombs, one boat, one satellite” because it involves more enterprise growth, market competition, and indirect policy coordination. This complexity places higher demands on the special institution to accomplish the task.


In the face of the technological blockade, we must seek cooperation in the midst of the struggle


There are some who worry that if China goes for fully independent manufacturing, the relationship between China and the United States and its allies may become increasingly tense, or even that the United States and the West will accelerate their decoupling from China in the short term.


In fact, decoupling is not good for anyone, and this is our starting point. But if the other side forcefully decouples from us, we must fight back. At a time when the United States and its enterprises are enforcing technology bans on China, we cannot allow U.S. enterprises to make any more money in China. The United States has its advantages, but we have to see our own advantages. We must see that a very comprehensive industrial system is China’s strategic asset, the source of China’s strength, and China’s advantage. This industrial system includes the low end as well as the high end. Whether it is technological R&D services or labor-intensive types, they are all important. They are not divided into superior and inferior, and cannot substitute for each other.


A few years ago, when China was in the process of reducing excess capacity and transformation and upgrading, a large amount of low-end production capacity was forced to shut down, suspend operations, merge with others, or shift to different lines of production. That had a big impact on China’s industrial system. Because the traditional industry is the largest customer of the high-tech industry, when there is large-scale compression of traditional industry, the high-tech industry will also be affected. As far as the IC industry is concerned, the stranglehold exerted against the high-end technologies of Huawei and other enterprises has sparked a nationwide discussion, but we have to see that there are a large number of low-end enterprises behind these high-end technologies, and this provides the basic conditions for technological breakthroughs in this industry. The reason why China has such a large demand for integrated circuits is because China’s downstream industry is well developed, which in turn highlights the shortcomings of the upstream. This makes even more urgent the need for breakthroughs in the upstream of China’s industry. If someone thinks that upstream industry development must come at the expense of eliminating downstream industry, that is a fruitless “climbing trees to catch fish” approach. Imagine that in 2020, Chinese industry had switched to the production of masks, and after the outbreak of the COVID-19 epidemic, masks quickly became a global public good, making an important contribution to the global fight against the epidemic. Except for materials such as melt-blown cloth, which is high-tech, mask manufacturing is low-end and labor-intensive, but nonetheless indispensable. Therefore, we must adhere to the overall development of industry, and make key breakthroughs under this precondition.


How can China both not decouple itself from the rest of the world and, at the same time, establish our independent manufacturing in the IC sector? Independent innovation is not about shutting the door on technology. Rather, it is insisting on doing the technology ourselves, but also learning from others. In that case, how do we go about achieving both cooperation with the United States and other Western allies on an equal footing and, at the same time, achieve independent innovation? Our strategy should be to seek cooperation in the midst of struggle, and to insist on doing technology and industry independently under open conditions. If we give up the struggle, we will be unilaterally “strangled” by the United States.


We have to play to our strengths and do what we must. We do not expect that only Chinese companies will be the strongest in all areas of the semiconductor industry. We want to coexist with the world and establish equal trade relations, with each having its own advantages, but we do not accept unequal relationships where a country like the United States can strangle others with impunity. The more China backs down, the more blows it will receive. Therefore, at this time, China’s fist must be hard, and it must have the power to choke its opponent’s “throat.”


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Cite This Page

路风 (Lu Feng). "Faced with Technology Decoupling by the United States, China Must Establish an Industrial Base for Integrated Circuits [面对美国的科技脱钩,中国必须建立集成电路的产业基础]". CSIS Interpret: China, original work published in Economic Herald [经济导刊], December 5, 2022

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