Market Should Be Decisive in Developing China’s Semiconductor Chip Industry

Market Should Be Decisive in Developing China’s Semiconductor Chip Industry

Wu Danqing

Date: Mon, 04/23/2018 - 15:42 / source:Yicai
Market Should Be Decisive in Developing China’s Semiconductor Chip Industry
Market Should Be Decisive in Developing China’s Semiconductor Chip Industry

[Yicai Global is committed to providing an open forum to air a diverse range of views. The opinions expressed herein are the author’s alone. Yicai Global has redacted this article to conform to our style]

(Yicai Global) April 23 -- China has developed atomic and hydrogen bombs and man-made satellites, but why does it still not have its own high-end integrated circuit products?

Chinese companies have become global leaders in many advanced technologies, but why does the country still rely heavily on imports of high-performance engines?

The US commerce department banned ZTE Corp. from buying American components April 16, and the policy triggered heated debate over semiconductor innovation in China. Chinese manufacturers are with maximizing profits and failed to pay due heed to technological research and development. Tens of billions of yuan have been invested in bike-sharing, food delivery and group buying startups, but very few investors seem interested in high-tech businesses. The dilemma facing ZTE today results from the company’s long neglect of basic research and technical innovation.  

I have worked in the IC industry for 16 years, and I do not agree with them on this matter. The chip industry is where first movers have significant advantages over new entrants, so Chinese companies cannot rely purely on investment -- financing from funds, venture capital firms or private investors -- if they are ever to catch up with the US semiconductor giants. China needs to work out its own ‘Manhattan Project’ to leapfrog its Western rivals.  

Late-mover disadvantage of Chinese chipmakers

Chinese companies have made considerable headway in the telecommunication field in recent years. ZTE and Huawei Technologies Co. have developed very mature products and have been actively involved in setting international industry standards. However, both still depend on dominant US companies for core chipsets, a circumstance dictated by the current global division of labor and the unique features of the semiconductor market.

US manufacturers cannot beat Chinese competitors in the system integration business, so they have gradually abandoned the equipment market and instead diverted more resources to upstream chip development. This explains why most Chinese firms focus on equipment manufacturing and system integration, while their American counterparts specialize in core component development, giving the latter significant first-mover advantage in the chipmaking scene.

For the sake of clarity, let us consider the ‘battle’ between the world’s two major chipmakers, Intel Corp. and Advanced Micro Device Inc. in the 1990s. Intel developed the 486 chipset first and sold the product at a relatively high price. By the time AMD released its 486 chips about six months later, Intel had recouped its initial investment and made a fortune on the product, and it decided to mark the product down to the cost price, undercutting its main rival. It then reinvested the profits in the development of new-generation products. AMD, as the late mover, invested heavily in 486 chip research and development, but its profits were nowhere near that of Intel’s. The number of transistors in a dense integrated circuit doubles and the production price halves about every two years. American semiconductor companies applied this law to consolidate their competitive advantages and profit from it, and thus far it has been a virtuous cycle.

Like AMD, Chinese chipmakers are at a disadvantage relative to first movers. Every time they developed a new product with substantial investment of money and other resources, the US companies lowered their prices and kick off new product development. As a result, it was very hard, if not impossible, for new entrants to make money at all, considering the prohibitive investment involved. No company can sustain such losses forever.

Can Chinese chip companies achieve leapfrog development? Chipmaking is a capital- and tech-intensive business with three salient characteristics. First, technical accumulation is of paramount importance, meaning that it is almost impossible to skip a specific product and develop a newer generation of chips directly. European and American companies started semiconductor R&D in the 1960s and 70s, so they are far ahead in this respect. Second, leapfrogging in R&D necessarily involves higher spending on human resources. Third, it is impossible for an information technology firm to reduce R&D costs unless it manages to reach a certain production scale. Given the relatively limited number of users, Chinese chipsets have many defects and vulnerabilities that are difficult to find (and therefore solve), making them less competitive in terms of both product performance and pricing.

In short, most Chinese chipmakers have been operating at a loss, as dictated by the first-mover advantage enjoyed by Western companies. In my opinion, they cannot achieve leapfrogging development relying on government subsidies alone.

Chinese chipmakers should not count on government subsidies

The Chinese government has been subsidizing the semiconductor industry for many years. A dedicated R&D fund was established in the 1990s to support home-grown brands such as Shanghai Huahong Integrated Circuit Co., Semiconductor Manufacturing International Corp. and Hongli Clean Energy Technologies Corp.. Later, the government invested an aggregate of more than CNY10 billion (USD1.59 billion) in a special fund to promote core electronic device, high-end universal chip and basic software development, but the actual results were less than expected.

With a change of strategies, China started to purchase foreign companies to acquire existing semiconductor technologies, but the plan was soon detected by foreign governments. The US blocked a series of takeover deals proposed by Chinese companies. Their attempts to acquire core communication, storage, processor, sensor, radio frequency or high-end simulation technologies were unsuccessful, despite the generous offerings. Both approaches have proved non-viable.

As to why very few private investors are interested in high-tech businesses, I think all investors are after profit, and nothing can be said against this. Private investors are keen on internet startups such like food delivery and cab-hailing services, because they can make quick money from these businesses. As an emerging industry Internet + has limitless potential for development, which is something that appeals to all venture capitalists. It would be unrealistic to expect a reasonable investor to invest in such mature markets as chips. IC product development entails prohibitive financial input, but the commercial gains can be insignificant or even negative, so we should not count on VC companies to fund chip R&D activities.

Government subsidies and investment alone cannot close the gap between Chinese and Western semiconductor products. That said, we may have seen the first glimpse of light at the end of the tunnel with the recent rapid development of several Chinese chipmakers. HiSilicon Technologies Co., Spreadtrum Communications (Shanghai) Co., RDA Microelectronics, Inc. and Goodix now rank among top-tier global semiconductor companies. HiSilicon’s Kirin series, above all, are as good as similar high-end Western products in performance as well as price. It is simply a miracle! The price paid by Huawei is that it invested billions of yuan in product development and sustained heavy losses for nine years. The company subsidized the loss-making chip business using earnings from its communications divisions. Another important reason is that Huawei is not a public company; otherwise it could not possibly have weathered the massive losses.

China is increasingly aware of the strategic importance of the chipmaking industry and local governments are showing renewed enthusiasm in semiconductor products. It is said that hundreds of integrated circuit production lines have been built, or are being built, in the country. Having said that, I am personally skeptical as to whether these efforts will translate into a breakthrough in any core technologies.  

The chipmaking industry chain is quite long, encompassing raw materials and equipment manufacturing (upstream), processing (middle-stream) and chip design (downstream). Most production lines are still used for contract manufacturing. The business model is based on extensive inputs (or factors of production) -- a legacy from the industrial age -- and is therefore irrelevant to our discussions here. We already have very strong contract manufacturers like SMIC and Huahong, so I believe most new production lines represent repetitive investment in low-end production, which can easily lead to serious waste of low-end production capacity.

The semiconductor industry is capital- and tech-intensive. Over the decades, Europe and the US have created an almost perfect market system, so the Chinese government should devise its own ‘Manhattan Project’ through effective planning, focusing our limited financial resources on strengthening the weakest links.

China should encourage contributions by private investors

I believe that China’s semiconductor industry has the necessary conditions to overcome the challenges. First, we have an enormous domestic market. China is already a major player in the equipment manufacturing space. Second, we have more labor resources relative to Western economies. During the early years of economic reforms, our country relied on migrant workers to boost the export processing business, but we have passed the turning point now. However, the migrant worker ‘dividend’ has been replaced by the engineer dividend. China produces millions of science and engineering graduates every year, and many foreign multinationals have trained many qualified Chinese technical professionals. Third, we have enough funding. Chinese companies have all the necessary financial resources, but the real question is how to effectively leverage these resources to deliver the best results.  

In the light of the unique characteristics of the chipmaking industry and the Chinese status quo, I would like to propose the following strategy for catalyzing the domestic semiconductor industry.

Firstly, the government should stick to the market economy model and engender enthusiasm about the chipmaking industry among private investors, aiming to integrate policy support and private investment into a synergistic force. Ideally, research institute subsidies should be replaced by user-oriented subsidization -- that is, subsidies can be offered for downstream equipment manufacturers for every domestically-produced chipset they purchase, for two reasons: the prohibitive R&D expenditure associated with semiconductor products dictate that production costs cannot be lowered unless the products are installed and used in a significant amount of telecommunication systems; and (ii) a new chipset is not fully developed until it has been thoroughly adapted to various equipment. Additionally, such an approach is advisable because the subsidies are not allocated to any specific companies, and equipment manufacturers choose chip suppliers themselves. Chipmakers must compete against each other to be eligible for subsidies, so government funds are used to finance R&D of the most competitive products, without tampering with normal market competition.

Secondly, priority should go to startups to lower chip development and production costs. What China really needs now is not low-end contract manufacturing, but rather producers of core high-end chipsets. Therefore, instead of investing in dozens of production companies, the government should focus its resources on a small number of innovative startups. It can set up a fund for startups specializing in high-end semiconductor products, subsidizing their business development through tax incentives. Private investors must be mobilized to contribute to the formation of a virtuous cycle, because sustainable profits are the key to long-term development of the domestic chipmaking industry.  

Lastly, human resources acquisition is very important. Some of the best Chinese engineers are still working in Europe and the US, so well-targeted policies should be introduced to attract talented overseas Chinese professionals. This is critical especially because human capital is what matters the most for the development of semiconductors, software and all other high-tech businesses.

It has been said that the supply ban the US government slapped on ZTE is catastrophic for the Chinese telecommunication industry, but some people argue that it opens new opportunities for Chinese chipmakers. In my opinion, we should not be too pessimistic about the future of our semiconductor industry. What happened to ZTE poses both challenges and opportunities. On the one hand, it taught us a bitter lesson about the consequences of excessive reliance on foreign technology. On the other hand, it toughened our determination to grow away from the real-estate-based growth model toward technology and innovation driven development. The transition can be a very painful process, but it is the only way out. We must believe in the market economy system as the main driving force for the development of a strong domestic semiconductor industry.

(The author is a senior R&D director from a leading international semiconductor company)

Editor: Ben Armour

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Keywords: ZTE, R&D, Trade Dispute, economic sanction, Communication Chip