Monthly Note - January 2024

Written By Nathan Picarsic

A new year brings much of the same in the US-China techno-economic competition: The Chip War remains front and center in national and international headlines; the same holds among the policy making circles focused on sensing and shaping where Washington and Beijing are headed next.

The US government has started deploying funds from its CHIPS Act war chest: The first awardee was BAE Systems and the second was Microchip. These deployments ought to be heralded as proof not only that the US government can get moving in executing the lines of effort outlined in the CHIPS Act but also that it can select priority projects that contribute to the resiliency of the defense industrial base.

But those initial bets also foretell a scary reality: The current state of the microelectronics industrial base, especially that which can safely supply the US military in a trusted fashion, is abysmal. The limited supply capacity being bolstered by these initial CHIPS funding allocations are insufficient to backstop status quo demand from weapons programs let alone from potential surge demand. And that sorry state is worse still in a comparative context: America’s pacing great power threat, China, is well positioned at various nodes all along the semiconductor value chain – and showing little sign of slowing its progress toward controlling the commanding heights of supply chain dominance.

The House Select Committee on China published an economic strategy report to close out 2024. The report – “Reset, Prevent, Build: A Strategy to Win America’s Economic Competition with the Chinese Communist Party” -- advanced 150 bi-partisan policy recommendations that offer a cogent legislative roadmap for an emergent US-led salvo in the continued escalations of US-China technological and economic competition. The bi-partisan nature of these recommendations is notable and commendable. The competitive orientation that characterizes the Select Committee’s report is not simply political pandering or empty rhetoric; rather, this is the new Washington consensus. Industry and capital markets have much to glean from the Committee’s recommendations, the sectoral priorities to be targeted in legislation that will flow from this report in the year ahead, and from the new reality is underscores. The latent costs of doing business with China, in China, and through intermediaries that depend on China are set to come due. Companies that prepare their business models and supply chains for this reality quickest are bound to reap new competitive advantages; those that drag, will risk both reputational and financial harm.

The term “semiconductor” appears nine times in the Select Committee report; “supply chains” are referenced 46 times. Beyond those counting stats, the report gets down to the nitty gritty of both the defense and offense needed to keep America ahead in competition with China. On the defensive, the report clearly states that:

The United States must immediately stem the flow of U.S. technology and capital that is fueling the PRC’s military modernization and human rights abuses. General Secretary Xi has made plain his intent to “resolutely win the battle of key and core technologies.”

The corresponding offensive logic is summarized as a call for the United States to:

Invest in technological leadership and build collective economic resilience in concert with its allies. The best defense against the CCP’s predatory economic practices will fail if not paired with a proactive strategy to invest in America and increase economic and technological collaboration with likeminded partners. The United States must bolster its unique advantages in technological development by funding research, incentivizing innovation, and attracting global talent in critical areas.

Horizon Advisory’s analysis is cited in explaining the strategic necessity of combining offense and defense in face of China’s military-civil fusion strategy:

In their written testimony submitted to the Select Committee, Emily de la Bruyère and Nathan Picarsic quote a PRC scholar to describe the nature of the PRC’s military-civil fusion (MCF) strategy: “The military is for civilian use, the civilian is military, and the military and civilian are fused.” In other words, no line exists between civilian and military technological development. U.S. export controls have yet to adapt to this reality. According to Assistant Secretary of Commerce for Export Administration, Thea Kendler, the PRC’s MCF strategy “requires the United States to impose stronger export controls targeting advanced commercial items that can be used also in military applications.” The U.S. must modernize its export controls to fully adopt this mentality.

The report also includes a related, detailed set of export control revision recommendations. Those hint at a dangerous reality: The status quo remains ill-suited to the PRC’s tack and extant supply chain positioning. For example, at present, Entity List designations can readily be evaded by PRC based actors channeling the import of controlled items through subsidiaries, third parties, and trans-shipment; these channels can be identified and monitored, but all too often they fall through the cracks of export control enforcement. The Select Committee’s report advances recommendations for closing these simple loopholes and resourcing Commerce BIS appropriately to execute on an aggressive enforcement regime. But all the while, China’s players continue to access cutting-edge equipment and continue to invest to dominate nodes all along the value chain. This presents near and present dangers to hope that CHIPS Act bets will secure American technological leadership – not to mention the reliability of the critical supply chains they are meant to be solidifying.

Spotlight

SMIC caught a good deal of shine late in 2023 for the company’s 7nm support of Huawei’s Mate 60. And the hits keep coming in the new year according to Chinese industry observers:

SMIC's breakthroughs in market share and technological strength are of great significance to mainland China's chip industry. First of all, this breakthrough shows that mainland China's chip manufacturing capabilities have been widely recognized around the world, winning a greater say for China's chip industry. Secondly, SMIC's progress also represents the continuous improvement of mainland China's independent innovation capabilities in core technology fields, allowing mainland China to more independently control its own chip supply chain. Finally, SMIC's success will also provide more development opportunities and market space for the chip industry in mainland China and promote the stable growth of the industry.

SMIC has advanced to a tie as the third largest chip manufacturer in the world. And that might matter more than the company’s technological breakthroughs. It certainly registers sharply in Chinese observations about the SMIC, the prospects for China’s semiconductor industry more broadly, and the comparative weakness of America’s technological leadership. SMIC’s enormous market share engenders dependence on the company, and therefore on China; such market share and dependence might not be in the most sophisticated nodes of the semiconductor value chain. But they do give SMIC and China access to the most sophisticated nodes, leverage over the companies positioned at them, and broader influence over global industry.

To return to this note’s earlier focus, the market share and related dependence asymmetry between the US and China is all the more striking in the relatively technologically static realm of legacy chips. For legacy defense industrial base programs, that’s a near certain recipe for disaster from a military strategy standpoint. There’s not much of a better tale to be told for commercial prospects given China’s track record of overtaking international incumbents via market share-based disruption strategies.

What’s Next

The Chip Risk Monitor’s newest profile covers Huawei. The new year ahead will bring refreshed looks across the set of monitored Chinese semiconductor champions and deep dives into their global business footprints, their ties to overseas markets, and trends in supply chains exposed to the risks these players carry.

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Nathan Picarsic
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