Feb 23

Keeping an eye on US–China semiconductor supremacy struggles

20 February 2017

Author: Stephen Olson, Hinrich Foundation

China’s ambitions for its semiconductor industry will provide a telling bellwether for the future of US–China trade relations. China’s objectives — and the way they intend to achieve them — will raise vexing issues for US policymakers. Similar issues are arising across several other key sectors, and the way the semiconductor issue is resolved will tell us a lot about whether the two countries will be able to work out a broader modus vivendi for their future trading relationship.

Semiconductors have become a fundamental building block of today’s high-tech knowledge economy, powering everything from cell phones to sophisticated medical diagnostic equipment and solar panels. The most formidable military weaponry in the world also relies on semiconductor technology. Maintaining a lead position in this critical industry is one of the hallmarks that separate advanced economies from the rest of the pack.

China has become the foremost global powerhouse when it comes to exporting the various information and communication technology products that depend on semiconductors. But it lags far behind the leaders when it comes to its ability to produce the semiconductors needed to power these products.

Indeed, the flagship Chinese semiconductor company, SMIC, is operating a foundry two to three generations old. Chinese companies lack the sophisticated design know-how that enables architectures for advanced applications, and they need to import roughly 80 per cent of the semiconductors used in their electronics manufacturing.

The predicament is obvious: the electronics sector is crucial within China’s economy, accounting for a whopping one-third of its overall exports, yet China is overwhelmingly dependent on imported semiconductors to produce these products. To solve this problem, China is seeking to bolster its semiconductor capabilities.

The complication this poses for US–China trade relations arises from the strategy China intends to use to get there. China has laid out in remarkably clear and transparent terms its intention to pursue an aggressive and highly interventionist industrial policy to rapidly develop its domestic semiconductor industry. The objectives are bold: China plans to be at an advanced world level in semiconductor capacity in all major sectors of the industry by 2030.

The techniques to be used include forced technology transfers in exchange for market access, requiring or ‘encouraging’ domestic customers to source from Chinese companies, providing subsidies to strengthen domestic firms and providing capital to support the acquisition of strategic foreign firms. Roughly US$150 billion in public and state-influenced private funds will be subsidising investments and acquisitions.

These formidable industrial policies will create a few thorny dilemmas for the United States. Maintaining a preeminent position in the semiconductor industry is just as important to US policymakers as the desire to ‘catch-up’ is to Chinese officials.

Broadly speaking, US policymakers have three options.

First, the United States could simply let the competitive marketplace determine who comes out on top — even though the Chinese government is employing a host of non-market tools to gain the upper hand.

Second, the United States could forcefully utilise all available means to overturn as many of China’s industrial policies as possible. This would mean an aggressive use of US trade law — including retaliation or the threat of retaliation — as well as the WTO dispute settlement mechanism, where appropriate. The Committee on Foreign Investment in the US could also undertake more stringent reviews of potentially sensitive merger and acquisition proposals.

Third, the United States could develop a concerted national strategy to boost the competitiveness of the US semiconductor industry — a move likely to resemble many of the policies that the United States has criticised China for pursuing. The history of the US tech industry (including semiconductors) is replete with examples of heavy US government involvement and support, and on a global basis, the semiconductor sector is far from being a truly free market.

No option is ideal. Letting the marketplace sort things out while your competitor enjoys a host of non-market advantages would be almost conceding the contest. Trade retaliation and an aggressive pushback would heighten the possibility of a larger and unwanted trade war. And pursuing similar industrial policies would fly in the face of traditional US aversion to ‘picking winners and losers’. It would also come with a hefty price tag in an era of already record-breaking US federal budget deficits.

US and Chinese officials should view this as an opportunity to work together constructively to find solutions and head off potential conflict. A workable resolution would likely include greater transparency on precisely where and how the hand of government is operating, less conditionality on market access, better intellectual property protection and a clear and predictable set of ‘rules of the road’ for investment, either in the context of a bilateral investment treaty or through some other mechanism.

In any case, the semiconductor issue will reveal much about how the United States and China are likely to manage their deep and increasingly complicated trade relationship in the years to come.

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