China is undeniably a dominant force today. It is the second largest economy in the world and continues to grow rapidly. With a couple of points faster growth, Chinese GDP will overtake the US within the next two decades. When two large empires have come this close, there has been a hesitant handover. While the previous wars were fought on military prowess and resource independence, the coming war will likely involve technological independence.
The information revolution
The world is getting increasingly digital. An increasing share of the intellectual property created is in that domain. Analog businesses are realising the power of data in making smarter decisions. The word “digital transformation” has almost become an abused word.
Once digitised, information can be transformed into insights. The last decade and the rise of the big tech titans has proven that. New techniques for data analysis, such as machine learning, have emerged that were not possible before due to computing demand. The world has seen a technological revolution every 50-100 years. The next revolution is an information revolution.
The building blocks for this information revolution will be data, networking and artificial intelligence. Underlying all of these are semiconductors. Analog sensors would be needed to collect data in real time, networking infrastructure (including the upcoming 5G radio standard) would be needed to efficiently move the data around and, finally, various computational chips are needed to transform that information into insights.
Made in China 2025
Semiconductors have been one of the most important drivers of productivity growth the world has seen over the past 50 years. Over the years, the base of that competence has spread from the US to include Taiwan, and then Korea. That spread was not organic either, it was planned by the respective governments. These three regions are today the main centres of competence with respect to technology. China has taken the role of the world’s factory – offering cheap labour initially but now offering its best-in-class manufacturing capabilities.
In 2015, China realised the importance of acquiring technological competence when the State Council launched its ‘Made in China 2025’ plan, with a strategy to invest RMB 1 trillion (US$160 billion) over 10 years to build domestic chip production. The goal of this policy was to increase self-sufficiency for integrated circuit (IC) chips to 40% by 2020 and to 70% by 2025.
In 2020, based on discussions with various equipment makers, we estimate domestic Chinese spending on semiconductor equipment is still only 15-20% of global spending. The production is likely further behind. Moreover, what it produces is older generation technology, which has much lower value.
Visibly, and to much of the western world’s chagrin, China has been rapidly raising the pace of acquiring businesses in the West, across a range of industries – information technology to robots to space to new energy vehicles to materials to high-tech medical devices. Various semiconductors are used in all of these applications.
Not just a war of words – but a shifting argument
The current ongoing US/China ‘war’ started with Donald Trump criticising China’s trade practices while campaigning for his presidency. In March 2018, President Trump signed a memorandum to a) file a World Trade Organisation (WTO) case against China for their discriminatory licensing practices; b) restrict investment in key technology sectors; and c) impose tariffs on Chinese products. Since then, both sides have escalated the ‘tariff war’ during 2018.
The ‘tariff war’ continued during 2019 and resulted in the US putting Huawei on its ‘Entity List’ in May 2019. Effectively, this meant that US companies were not allowed to sell to Huawei without government approval. This ban has been significant because it was very specific and directed at a national champion within a high-tech discipline.
Today, Huawei is considered to be the leader in 5G technology. During his early years, Huawei’s founder, Ren Zhengfei, worked as a military technologist reportedly in the People Liberation Army’s Information Technology research unit. Several countries have cited this as a sign of Ren’s ties with the military and, hence, a national security concern. The only two other companies that operate in this discipline are European (Ericsson and Nokia).
During the rest of 2019, the tensions between the two countries slowly de-escalated and the process culminated with a signing of a ‘Phase 1’ deal on 15 January 2020.
On 23 January 2020, China put the cities of Wuhan, Xiantao and Chibi in Hubei province under quarantine. In a week, the World Health Organisation (WHO) declared the coronavirus a global emergency. It was reported¹ that the earliest known case of the virus could have back in been in November 2019.
US-China sentiment has soured post the outbreak of COVID-19 with the US administration becoming particularly vocal about (what they consider to be) China’s ‘poor handling’ of the crisis. President Trump’s anti-China rhetoric has swiftly led to further punitive actions this month, aimed at curbing China’s technological reach in the interests of US national security.
Last week, the US government tightened its control in order to prevent shipments of semiconductors to Chinese company Huawei. The US Department of Commerce made an amendment to the export rule that will require foreign companies using US chipmaking equipment to obtain a US license before supplying certain chips to Huawei, or its affiliates… and the language from the US became increasingly defiant:
“This rule is grounded in two basic truths: Modern war is high tech and China’s so-called ‘private sector’ is fake … Chairman Xi has erased any daylight between China’s businesses and the communist party’s military. We didn’t win the Cold War by selling cruise missiles to the Soviets, and we’re not going to beat China by selling semiconductors to the People’s Liberation Army. These rules are long overdue.” US Senator Ben Sasse²
This closes the ‘civilian’ route for Huawei to source military-grade US technology via foreign civilian sources.
Mutually assured destruction
In the short term, both the US and China have sufficient negotiating power to do damage to each other. While the US can block chip and semiconductor equipment exports (no small initiative as China accounts for almost a third of US semiconductor consumption), China holds sufficient cards to retaliate – in both the short term and the longer term.
China is the source of around 80% of the ‘rare earth metals’ imported by the US for making mission-critical products (including for use in defence and consumer electronics), and it is home to 85% of world capacity. The country is also the manufacturing home of most high-tech products including the Apple iPhone. Manufacturing bases and supply chains are generally sticky due to the physical infrastructure and an ecosystem of suppliers and trained labour. As such, it could take over a decade to redraw existing supply chains.
The COVID-19 pandemic has highlighted the US’ reliance on China for components and constituent goods for a number of products, across a variety of industries with global supply chains; not least areas like tech components and healthcare equipment…and the implications for the upheaval of existing supply chains extends well beyond the borders of the US and China.
Supply chains are intricate, tightly-knit, cross-border constructs in a globalised world. Any issue in China will also have a knock-on effect for other countries in the manufacturing supply chain. Consider a Taiwanese tech company supplying the chips for smartphones. If phones cannot be manufactured, those chips are no longer required. This ‘cold war’ will have its impact beyond the shores of just the two countries involved.
The arms dealer is the winner in a war
Near term, the ground is being laid for a period of uncertainty, which has negative implications for all parties involved. This behind-the-scenes bearing of arms has the potential to get very ugly if the conflict continues to escalate. Following this path in a linear fashion will, ultimately, lead to mutual destruction, but deviating from this course requires mutual recognition of the outcome.
It is likely that the near-term shocks will be resolved over the medium term, given the alternative if they persist for longer. However, progress towards a more sustainable framework will, inevitably, come in fits and starts. As we muddle through, tech companies in countries like Korea and Japan will benefit as alternative sources on the margin.
Longer term, the tensions are likely to lead to a period of onshoring or ‘re-domiciliation’ of capabilities, along with some amount of manufacturing capacity; a positive for in situ semiconductor capital equipment providers (the shovel makers in the goldrush!). Last week, a Taiwanese semiconductor foundry announced its plan to open a leading-edge fabrication plant (fab) in the US, with production targeted to begin in 2024. Other companies caught in the middle of multiple global supply chains may need to rethink how best to rearrange their business models and physical infrastructures to continue to thrive in a rapidly-changing world order. Active managers have the ability to be selective and timely here.
Finally, as we draw closer to US elections in November this year, the remainder of 2020 is likely to show the economic weakness on the back of widespread lockdowns. Then, this vilification of China and weaponising of the coronavirus pandemic is the perfect distraction away from domestic policies.
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