09 10 2022

The great decoupling

Signing Ceremony Phase One Trade Deal Between the U.S. Signing Ceremony Phase One Trade Deal Between the U.S. Wikimedia. https://commons.wikimedia.org/w/index.php?curid=85937183

Whether there will be a technological and trade decoupling between China and NATO+ is not up for discussion any longer – it is already ongoing. What we still don’t know, is how far it will go, and how fast. A vicious political circle may imply that it will go very far, and very fast, at least if the US is to decide. Whether China will be able to prosper despite this technology war, is anybody’s guess. My guess is that it will.

When former US president Donald Trump started the US trade war with China in 2019, I argued that this ‘will change the history of the 21st century’, independently of whether the US backtracked later on, as trust was already broken. There hasn’t been any backtracking since, and the process is going faster than most had imagined. The US under President Biden has maintained most of the Trump tariffs and has continued and deepened the technology war with China, a policy that is supported by a rare bi-partisan consensus and hence is likely to prevail.

How will China fare in this trade and technology war? I think nobody knows, not even the Chinese.

The tariffs that US put on most imports from China are one thing. It has since 2020 been China’s declared policy to stop its over dependence on exports and its senseless accumulation of trade surplus and foreign exchange reserves, by giving more priority to the domestic market (called ‘dual circulation’). We don’t see much result of this policy change yet, as China still runs an exorbitant trade surplus, but that will hopefully happen in a not too distant future.

What is more serious is the US-led intent to strangulate China’s future development by cutting off its access to key technologies. Lately, most attention has been paid to semiconductors, particularly equipment for the production of semiconductors, but the sanctions against China are much broader, and they keep broadening. Some of the results of this policy are astonishing, for example the killing off of Huawei’s flourishing mobile phone business, which had already overtaken Apple and was running neck-on-neck with Samsung. Without access to equipment for production of their very advanced self-designed mobile chips, their mobile business has no future. See – it is working!

China has shown that it is capable of achieving outstanding results, even when it is cut completely off from Western technology, for example in their space programme, where they have surpassed the Russians and now are neck-on-neck with the US. But at the same time, China is not in the club of rich countries. It is an upper-middle income country, much less affluent than the US, EU and Japan.

One factor that makes China’s achievements possible is an extremely high savings rate – it was 45% of GDP in 2020, compared to 34% for Russia, 27% for EU, 25% for Japan, 18% for the US and 17% for UK. The other is its high spending on research and development (R&D), which in absolute terms was 468 billion dollar in 2020 versus the US' investment of 582 billion dollar. As percentage of GDP it is not that impressive (2.4% in 2020 against 3.5% in the US, 3.3% in Japan, 2.3% in the EU and a paltry 1.1% in Russia), but here size counts, and China is big. A third factor is the priority given in China to turning out graduates and postgraduates in science, technology, engineering, and mathematics (called STEM) - in 2019, Chinese universities produced almost 50,000 PhDs in STEM fields, while US universities produced around 34,000. Again: size matters. And finally, most of the Chinese savings are in State Banks, which means that the Chinese Government has a big say in how they are used, which gives it leverage to direct investments to priority areas.

China is home to 18% of the world population against 14% for US and EU together, but while it has around 19% of world GDP (in purchasing power terms), it is still considerably smaller than US and EU together, which account for around 31%. As it appears that the EU and Japan will follow the lead of US in its offensive to contain China in the area of advanced technology, is China big enough to go it alone? Or will the US succeed in maintaining China in the “middle income trap” as a producer of low technology goods with low added value?

As mentioned, the main battlefield is just now in semiconductors, as this is a cornerstone for almost any advanced technology (quantum computing, artificial intelligence, robotics, space industry, biotechnology, etc.). China is dependent on the US, Japan and EU particularly in two areas: equipment for production of advanced semiconductors and software to design the semiconductors (called EDA). The US has broadened the sanctions against Huawei to a longer and longer list of Chinese firms, and it has forced Dutch Company ASML to stop the sale of the most advanced lithography machines (called Extreme Ultraviolet, EUV) to any Chinese company. It has also blocked China’s access to the more advanced EDA software (I think this is an empty gesture, as existing Chinese EDA software companies will be able to catch up quickly).

The competition in the semiconductor industry is at present aimed at making the chips smaller (and thus faster and more energy efficient), and the industry leaders (South-Korean Samsung and Taiwanese TSMC) are now aiming at a resolution in the chip-design of 3 nanometres (nm, equal to one millionth part of a millimetre). It is considered that the older generation of lithography machines (called DUV), to which China still has access, can go down to a resolution of 14 nm, but it is possible to use these DUV machines to increase resolution to 7 nm (which is what is presently used in most advanced mobile phones) by exposing the chip several times. The most advanced Chinese semiconductor company is SMIC, and it made waves a couple of months ago when a commercial 7 nm SMIC “chip” was discovered in the market (even if it was a very simple one).

US is therefore now pressing for a ban also on older DUV lithography machines to all Chinese companies that are producing chips smaller than 14 nm. So they want to block SMIC from producing a 7 nm chip, for example for Huawei’s mobile phones. They never give up, do they?

The Chinese Government is doubling down on its commitment to develop its semiconductor industry, concentrating the country’s resources, private and public, in the effort (the ‘whole nation system’). To stop it from advancing the US is trying to form an anti-China alliance with Japan, Taiwan and South Korea (called Chip 4). Despite its new, much more pro-US Government, South Korea is reluctant to be recruited into this alliance, as it stands to lose its biggest market and jeopardise its investments in China – but given the pressure from the US, it may give in.

In the short run, China has two possible ways of circumventing the US blockade of its semiconductor industry. The first is to exploit the older DUV equipment to make 7 nm chips. Even if there are people who consider it not to be profitable due to the costs and the lower efficiency of this process, it will give China access to relatively advanced chips anyway. The other is to exploit the new avenue of ‘chiplets’, which basically is to produce 3D chips by stacking them one upon the other, forming a single chip, which may achieve the same performance as more advanced 5 or 3 nm chips (which by the way is what Apple has done with its latest M1 mobile phone chip). Here, China is lagging less behind, as the technology is recent, and they are already strong within chip-packaging. However, rightly or wrongly, there are experts in China who think that this is only a stop-gap solution.

What about the longer run? As it is considered that the present technology is reaching its limit with the 3 and 2 nm processes, what is the new technology that will come after that? Knowing that it is a laggard in many fields, China has successfully followed the strategy of jumping directly to next generation technology instead of trying to catch up in the existing technology (as for example the successful jump to 5G and electric cars). For next generation semiconductors, it is expected that use of light instead of electricity (photonics) and use of Gallium nitride (GaN) and silicon carbide (SiC) instead of silicon, will play a role. Both are areas where China is in front or not far behind.

But even so, traditional silicon chips will be around for a time still, and China cannot wait for the next generation technology. So it will have to try to catch up by creating its own DUV and EUV equipment, at the same time as keeping ahead with expected new technologies. It was announced last year that a domestic equipment maker (SMEE, also under US ban) would have a machine on the market in 2022 with 28 nm capacity, which should also be able to go down to 14 nm. This has not happened yet (or has happened, but they keep silent about it), but supposing it does, and assuming it is of good quality, one of the key elements for an independent Chinese semiconductor supply chain in China would be in place.

In conclusion, it is far from given that China will be able to prosper despite the US technology war. There are those who think that it will not be able to prosper, because it is a top-down system, and that all the money spent on R&D and subsidies is simply lost. But I tend to believe that it will. And by the way, as China is the world’s biggest importer of semiconductors and equipment for their production, the decoupling will hurt both US, Japanese and EU firms, as they will be losing market share in the coming years. One of the biggest losers will be Dutch ASML, which for the same reason has been trying to avoid being embroiled in this US campaign against China, but to no avail, as the Dutch Government has given in to US pressure. Also big US firms as Nvidia and AMD are already being hurt, but there isn’t much they can do about it.

So what does the future look like?

Firstly, the probability for the US backtracking on its technology war against China is practically nil. The US is hell-bent on stopping China from catching up with US technology. Of course, this has nothing to do with suppressing a competitor – it is all about human rights, democracy, minority rights and so on. So there is no turning back to the situation before Trump started the technology war.

One possible scenario is that the present status quo continues. What we have now is an uneasy stand-off between China and the US, where the US is trying to impede the development of Chinese companies considered to be potential competitors by denying them access to technology from the US and its allies, while China protests and quietly tries to work around the sanctions promoting domestic technology. Non-sanctioned Chinese companies continue with business as usual, but at the same time at least some of them are aware that they are likely candidates for ending up on the ever expanding sanctions list (called the “entity list”), or be hit by secondary sanctions because they have business relations with companies on the list. An example of how this works can bee seen in the mobile phone market where other Chinese companies quickly have filled the void left by Huawei (Chinese companies Xiaomi and Oppo/Vivo had in second quarter 2022 together a global market share of 31% while Apple and Samsung together had a market share of 37%). But for example Xiaomi must be aware that it may easily go the way of Huawei, as it is working on designing and producing its own chips.

This scenario is the most probable in the short run, but it is hardly a stable situation in the longer run. There is increasing pressure among US politicians to take more extreme measures, and even if many US companies are unhappy with this, as they will lose a lucrative market in China, they are afraid of speaking up and tarnishing their image (getting the label ‘China Friendly’, which is about just as bad as being ‘Russia Friendly’). China has no interest in escalating the technology war, but on the other hand they are likely to invest even more funds to accelerate their domestic technological capacity, which will infuriate the Americans even more.

So the likely scenario is an accelerating technology war and hence increased decoupling. There are limits to how fast this can happen without leading to a complete chaos in several sectors, where China is an essential part of the supply chain, including within semiconductors and integrated circuits. The outcome that the US and its allies in Europe and Japan are hoping for in this scenario is that China gradually will fall farther behind in technology, and thus in the long run is relegated to a provider of second tier goods. The outcome that China is hoping for is a situation, where it succeeds in catching up in key areas, even if it turns out to be costly, and limiting the decoupling as much as possible, thus keeping a role as an important participant in the globalised economy.

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Thorbjorn Waagstein

Thorbjørn Waagstein, Economist, PhD, since 1999 working as international Development Consultant in Latin America, Africa and Asia.

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