In the week+ since the US government issued its sweeping set of restrictions on semis, a lot of good analysts have published very solid reviews of the regulations. There has also been considerable speculation on what will happen next, but these changes are so big it is likely to be some time before we can really get a handle on the answer to the question. So let’s take a deep breath.
The short window between the announcement of the rules and their enforcement (as little as a week in some cases) definitely has caused some very immediate pain for a handful of senior professionals in China’s semis complex who also hold US citizenship. At this point, it seems like they are going to have to make some very hard choices soon. But contrary to what this very viral tweet thread says, we do not think there is a mad panic in China semis boardrooms right now. Foreign companies seem to be pulling staff from Chinese foundries, but they are not pulling them from China entirely. It does look very bad for any company in China building leading edge fabs or building equipment for producing leading edge chips. Companies are reading the fine print and weighing their options. Beyond that…🤷🏼♂️. Let’s see what the lawyers have to say.
One important question is how will China’s government respond. (This is one we would very much like to know what the US government anticipates.) To date, they have not had much to say, in part because the domestic news cycle is focused on the Communist Party Congress, and this probably not a good time to highlight news that paints China as weak. China’s financial press has been covering the story. This is a good write-up from Caixin (in Engish), but we could not find a version of this story on Caixin’s Chinese web site. Nonetheless, the restrictions are so big and the consequences potentially so large, they will have to respond somehow, even if takes a long time for that response to become apparent.
We have been asked repeatedly if China will directly retaliate against US companies. Large US companies like Apple, Qualcomm, Cisco, Microsoft and Boeing would all make high-profile targets. And China’s government has shown that it can crimp the prospects for another country’s products in China, such as the demise of South Korean brands in China post installation of the THAAD missile defense system there. However, this approach is not a foregone conclusion, as this sort of response is likely counter-productive. These companies all have a lot of employees in China and all invest fairly heavily in training and R&D projects there already, and much of that activity does not seem to contravene the latest sanctions. The government could hit other sectors such as agriculture, but again this is likely to prove counter-productive given current macro conditions. We cannot rule out direct retaliation happening, but it seems unlikely.
Could China look for some other way to restructure the terms of trade? Again, this is not easy. China’s economy is heavily dependent on exports. And while many economists think that should or will change, there are few things that China sells which it would want to make harder for others to buy. Rare earths is always on that list, but this turns out to be a tough choice and likely ineffective.
China is now obviously going to redouble efforts to strengthen its domestic semis supply chain. But it’s not as if they were lacking in will before October 7. In the near term, there is very little they can do to close any technical gaps. Given these new restrictions and the CPC’s stated goal of “re-enforcing” government-private company coordination, we would guess that government agencies will take a larger role in acquiring foreign technology. Technology companies should take a hard look at their security measures. But even here, there is no easy solution. Much of what TSMC and ASML do revolves around process and management. Chinese foundries have been poaching TSMC employees for years, but there is no easy way to transfer all the soft skills the underpin semiconductor manufacturing. And more government involvement in the sector is not going to make learning those skills any easier.
Beyond trade, China can also start to make changes to its diplomatic and strategic posture. We are not policy experts, so we do not want to speculate too much here. If we want to take the glass-is-totally-empty viewpoint, we could take the view that the latest restrictions change China’s strategic calculus around Taiwan a bit. If China’s government starts to feel that it is totally cut off from TSMC’s manufacturing, the idea of cutting everyone else off to level the playing field makes a grim amount of sense.
But let’s step back from the brink, and instead look at ways that China can respond beyond the realm of retaliation.
First and foremost, it is important to remember that even though China’s access to leading edge semis manufacturing is blocked, China has a very significant capacity for mature processes. SMIC can do 7nm, at least on paper, and 16nm well. There are 100 or so other fabs in China all doing work here. And while the case is a bit thinner, they could probably put together wafer fabrication equipment to reach older nodes. As we have mentioned, 90% of the chips produced in the world today will take place on those older nodes.
Turning to fabless companies, China has a very robust industry of chip designers. There is still a lot of uncertainty as to the extent any of these will be able to manufacture on advanced nodes at TSMC and Samsung. If we had to guess, we would say the US government would like to cut them all off, but probably will not go that far, leaving some room for advanced chips to come out of China. This is important for autos, handsets and other consumer electronics. It is important for data center products too, but we think any Chinese company designing a CPU or GPU will face serious limitations.
Worst case scenario, even if all advanced fabless companies are cut off, China has already built a large number of companies who do not rely on those advanced processes. In our review of China’s semis from August, we focused mostly on industrial, IoT and analog companies. And we noted that it is only in the past year that we have started to see credible designs coming from China for more leading edge-dependent chips. The US government seems to be taking the approach that the horses have already left the barn for the trailing edge and sees no way to restrict them en masse, especially not when these companies can rely on domestic fabs to produce. Admittedly, there is not as much value in these sectors as there are in digital logic, memory and the other blocked sectors, but it is enough to build a foundation for China to potentially grow beyond the sanctions, somewhere down the road. Operative word – potentially.
We also have to be cognizant that China is starting to develop industries where it occupies higher strategic ground, albeit not in semis. These include areas such as industrial systems (machine tools, lasers, robots, etc.), electrical power systems, batteries and more. These are not as glamorous as semis, and Chinese companies still have some ways to go, but somewhere down the road they may become strategic enough to provide China with a little bit of the leverage it does not have now.