The Prognosis for the US-China Chip War

Under duress from the US, Beijing sees no other option but to hand over management of its digital sector to the government. However, history suggests that the massive drive for semiconductors will result in issues.

In the chip sector, the United States and China increased their rivalry last year. The CHIPS and Science Act, a $52.7 billion industrial strategy that seeks to support research, improve supply chain resilience, and revive chip manufacturing in the United States, was approved by the Biden government in August.

The government implemented the broadest limits on China’s semiconductor production sector to date in October. The selling of sophisticated processors to China is now restricted, denying China of the processing capacity required to teach artificial intelligence on a large scale. Additionally, it expands limitations on chip-making equipment to support sectors of the semiconductor supply chain, shutting off both American labor and the materials needed to produce the chip-making equipment.

Beijing has not received a workable “exit strategy” from the Biden administration, and neither has the White House insisted that Beijing alter its trade practices or given a timeline for the removal of sanctions. The new chip bans thus demonstrate, in the minds of the Chinese leadership, that the U.S. government is aggressively weaponizing its authority over key technologies in order to limit China. As a consequence, supply chain security was given top importance by the Chinese government.

The 20th Party Congress report identified the current trade conflict with the U.S. as the “economic main battlefield” and vowed to “realize high-level technology self-strength and self-independence.” To do this, the state will mobilize and concentrate all forces to “attack technological bottlenecks” and “win the war of conquering core technologies.” Thus, the report identified the current trade conflict with the U.S. as the “economic main battlefield.”

China’s leader, Xi Jinping, believes that its only choice is to switch from a system of market-based innovation to one of state innovation planning based on security. Economic planning, however, that prioritizes security considerations over economic success could result in long-term economic errors.

This difficulty is highlighted by China’s experience with the Third Front building effort. Midway through the 1960s, in reaction to the complex security situation, China began the Third Front effort. Following the Sino-Soviet Split, Mao Zedong was concerned about a conflict with Moscow in which China’s manufacturing center in Manchuria would probably be the first target. China’s concern over a U.S. assault on its industrial maritime area increased as a result of the Vietnam War. China’s manufacturing center was intended to be relocated to the hilly southwest as a result of the Third Front building. More than 4 million individuals had to relocate, and it cost more than 200 billion RMB.

The Third Front’s building after the Maoist period turned into a huge economic burden that left behind persistent economic errors. Mountains were a natural defense against bombs, but because transit was so expensive, they became a hefty weight for business growth. As a result, during the reform period, these state-owned companies (SOEs) struggled to keep up with their rivals and were heavily indebted. For instance, by 2015, China Second Heavy Machinery Group in Deyang, Sichuan, had lost more than $2 billion. Local governments stopped these SOEs from going into debt because their failure would result in severe jobless issues.

As a consequence, many SOEs from the Third Front period turn into “zombie” businesses that rely on grants from municipal budgets and policy loans from banks to live. Also encouraging them to stay “zombies” rather than undergo difficult reforms to adjust to market circumstances are the soft budget limits and municipal handouts.

Long-lasting economic imbalances will also be a result of China’s chip push. Promotions of innovation give local authorities the opportunity to maintain China’s investment-led economic model, which has contributed to a number of issues, including graft, local debt, and the real estate crisis. Since the start of his administration, Xi has implemented policies like the deleveraging campaign, real estate laws, and land use rules to cool down China’s irrational infrastructure investment. The drive to create innovation zones enables local authorities to evade these regulations and step up infrastructure building.

In China, the national building site allotment is established by the federal government and distributed to all regions. towns receive the allotment from the province administrations, and towns then spread it to districts. Provincial administrations also hold onto some building limits for important economic worth initiatives. Local administrations are allowed to build more outside of the normal allotment when they obtain these unique permits. As a result, local governments create innovation zones in order to apply for a unique land allotment from the provinces, which enables them to carry out more building.

Local governments must also create “complementary infrastructures” in the innovation park, such as public transit, roadways, and other amenities, in addition to constructing science laboratories. Making recently expropriated land “ripe” is a procedure that allows the local government to market the property for much higher rates while keeping all of the proceeds. Local governments can convert the ostensible innovation zone into commercial spaces and residential structures even if they are unable to draw high-tech businesses. Local leaders use this procedure as an opportunity to benefit themselves and award friends.

Chinese businesses profit from invention funding and take advantage of the absence of responsibility. A merchant called Cao Shan founded a joint venture firm, Wuhan Hongxin Semiconductor, in a well-known scam case, with the Dongxihu district government owning 10% of the shares. Local authorities trusted him because of his pledge to produce 10 nanometer and 7 nanometer circuits and his alleged princeling position. To demonstrate success and draw in more funding, Hongxin even recruited TSMC’s former vice president Chiang Shang-Yi and bought an ASML 7nm photolithography machine.

Investigations, however, showed that Cao never carried through with his financial portion. Even after receiving extra government funding, Hongxin never began actual production and promptly mortgaged the photolithography equipment to the bank. Before media were able to uncover the scam, the Dongxihu district had squandered over 15.3 billion RMB in total. Hongxin is not the only instance; even after the controversy emerged, Cao founded Quanxin, a different chip business, and garnered significant funding from the Jinan government.

The frequency of deception is due to a variety of factors. The majority of semiconductor controllers are non-technical generic officials. As a result, they are unable to recognize technological issues, which causes deception and waste. Additionally, the national push for innovation encourages local officials to draw in high-tech investments because doing so is seen as a significant political accomplishment that benefits officials in the corps assessment and advancement system. As a result, firms like Hongxin profit from authorities’ haste to support high-tech firms by making grandiose claims.

Furthermore, nepotism is used by municipal authorities to distribute funds. For instance, an official in Huaian, Jiangsu, named Dong Huaichen was detained for misconduct after exchanging chip funding for personal favors. As a consequence, businesses backed by princelings and others with high-level ties get the most state funding.

Fostering national winners also lowers the viability of Chinese businesses abroad. Entrepreneurs will turn their attention away from research and invention and toward keeping good ties with the government and obtaining state funding. High-tech companies are drawn into soft-budget restrictions by subsidies and policy loans, which lowers their output and makes them less competitive in the market.

In addition, creating high-quality goods at competitive costs is generally the key to Chinese companies’ success. Chinese products frequently outperform rivals in terms of price-performance relationship. Accessing the global value chain and modifying cutting-edge foreign technologies are crucial components of this business strategy. The standard of the products will be compromised by making Chinese businesses buy domestically, which will result in a falling price-performance relationship. In the worst situation, China will become an import-substitution system that creates subpar products that cannot compete on the international market as a result of the innovation push.

The vast expenses of trial and error until China finds success are believed by many watchers of the Chinese economy to be borne by China. However, China’s security-focused industrial strategy will only produce a few notable innovations over the short term rather than a long-term surge in economic output. Massive deception and dishonesty will make China’s fundamental economic issues worse. The effort to develop homegrown national stars will also lessen the productivity and viability of Chinese businesses. Long-term economic imbalances would result from disregarding market motivations. A “rare Sputnik illuminates galaxies of mediocrity” in China’s science growth paradigm, which is akin to the Soviet Union.

The CHIPS and Science Act and the chip prohibition in the United States are attempts to replicate China’s unsuccessful model. Due to China’s importance as a crucial market, it is firstly ineffectual at entirely cutting China out of the global chip value chain. For instance, entity list businesses can use overseas shell companies that don’t seem to have any connection to each other to offer goods to Huawei’s shell companies.

Second, by urging multinational semiconductor goliaths to “de-Americanize” the semiconductor supply chain, the industrial strategy will undermine American supremacy. Many American chip makers are contemplating developing state-of-the-art fabs in Asia using American machinery made abroad and ASML lithography equipment. These factories can serve Chinese consumers while avoiding American governmental oversight.

Third, China’s experience shows that economic planning cannot produce world champions in technology. Finding new markets and selecting champions in the market results in enormous wastage. Additionally, distributing funds encourages nepotism and dishonesty. All of the leading high-tech businesses in the United States are examples of open rivalry and the free market, not economic planning, which would explain why they are successful.

The United States shouldn’t be frightened by Beijing’s ambitious investment plans and should resist the urge to slavishly imitate China’s strategy. The United States must have “courage and self-confidence to cling to our own methods,” as George Kennan proposed in the Long Telegram.


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