investment insights
US/China ‘chip’ race centres on Taiwan’s expertise
Lombard Odier Private Bank
Key takeaways
- US/China tensions over Taiwan’s status highlight the island’s strategic importance as a global supplier of semiconductor chips
- The US, China and Europe are all investing in semiconductor production to build their strategic resilience
- The complexities of chip manufacturing mean that it will take years to increase expertise and capacity: the US has started to coordinate with allies, excluding China
- Semiconductors illustrate how economies remain interdependent in the global trade system. While geopolitical tensions continue, financial markets will price this premium.
When US House speaker Nancy Pelosi visited Taiwan earlier this month, increasing geopolitical tensions with China, her schedule included an appointment with the management of TSMC, the world’s largest maker of semiconductors, or computer chips. The meeting underlined the strategic and economic importance of Taiwan and its semiconductor know-how.
Headlines focussed on the potential for Taiwan’s status to spark more direct confrontation between the US and China. “The world faces a choice between democracy and autocracy,” said Mrs Pelosi during her visit. “America’s determination to preserve democracy here in Taiwan and around the world remains ironclad.” Since the civil war, China’s communist government has considered Mandarin-speaking Taiwan, an island of 28 million people, a rogue region. In support of its ‘One China’ principle, and to demonstrate its displeasure at the US politician’s visit, China launched a series of military drills around Taiwan. Formally, the US pursues a policy of ‘strategic ambiguity’ over its willingness to defend militarily the status-quo in the Taiwan Strait, and in recent days a delegation of five American congressional lawmakers arrived in Taipei.
But there was another justification for Mrs Pelosi’s visit. Taiwan is the world’s largest and most sophisticated manufacturer of semiconductors. Computer chips are both key to Taiwan’s economic success and integral to its geopolitical survival. The world’s electronics depend on chips to operate and communicate. Any threat to Taiwan’s autonomous status – it is recognised as a nation by only 13 small countries – endangers the global economy.
Semiconductors or ‘integrated circuits’ are minute, typically no larger than a fingernail, and can incorporate more than 8 billion transistors. The more sophisticated semiconductors come in two main types: the first are memory chips physically constrained by the need for capacitors to store a charge. The second, more complex ‘logic chips,’ are the focus of governments’ efforts in the US, Europe and China to catch-up with Taiwan, and then scale-up capacity.
Where memory chips are bigger than 10 nanometres (nm) thick – or 10 billionths of a metre - ‘leading edge’ logic chips can be as little as half that size. For comparison, a sheet of paper is typically around 100,000 nm thick. Just three firms globally can manufacture ‘leading edge’ chips: Taiwan Semiconductor Manufacturing Company (TSMC), Samsung and Intel, and only TSMC can make the very thinnest chips, measured at 5 nm, and plan to reach 3 nm by 2025. Samsung, SK Hynix and US-based Intel are investing heavily to catch up. The latter reports that it will to be able to make 7 nm chips by 2023.
The complexities of making increasingly powerful chips at ever-smaller scales demands ever-more sophisticated manufacturing techniques. These include silicon nanosheets to conduct signals, photo-resistant coatings, lithography, or atomic layer deposition and ‘dry-etching’ technologies to construct the layers that create a semi-conductor. ‘Moore’s Law,’ named after Gordon E. Moore, a founder of Intel, refers to his observation in 1965 that the number of transistors on a chip doubles roughly every two years, while its cost simultaneously halves. Nearly six decades later, the observation still holds true.
Tanks and fridges
Taiwan manufactures an estimated 20% of the world’s semiconductors, and around three-fifths of outsourced chips. Semiconductors are vital to electronics. Without them, everything from car airbags and parking cameras, to computers and mobile phones would be useless. Chips are as fundamental to weapons systems as they are to fridges and dishwashers. They can even be interchangeable: Western export sanctions have led to reports that Russia is using chips from kitchen appliances to maintain its tanks in Ukraine.
More significantly from the strategic point of view, Taiwan’s companies, dominated by TSMC, supply 92% of the market for the most sophisticated logic chips, according to estimates by Boston Consulting. The remaining 8% market share is held by Samsung in South Korea.
Demand is also growing and expected to rise 10% in 2022 to more than USD 600 billion worldwide, according to accounting firm Deloitte. The importance of semiconductors was illustrated by their shortage during the pandemic, which stalled production – and the economic recovery – at automakers. That lack inflated the prices of second-hand vehicles and reduced revenues by USD 210 billion in 2021. Still, there are signs that in the short run, the rush to meet the pandemic’s demand is leading to some slowing of demand in consumer computing and entry-level smartphones.
‘Risk of disruption’
In June 2021 the Biden administration published a review of US supply chains, spelling out the risk to the American economy in blunt terms. The US “is heavily dependent on a single company – TSMC – for producing its leading-edge chips.” Along with smaller supplies from Samsung, that “puts at risk the ability to supply current and future national security and critical infrastructure needs.” The administration fears that the fragility of the supply chain for semiconductors “puts virtually every sector of the economy at risk of disruption.” In March 2022, the US Commerce Department set out a strategic plan to improve domestic manufacturing capacities generally, and in semiconductors specifically. As part of that effort, the US is trying to make the semiconductor supply chain more robust in coordination with South Korea, Japan and Taiwan in a grouping labelled ‘Chip 4.’
The world’s major economies are all investing in their capacity to build chips. Still, a semiconductor fabrication plant or ‘fab’ takes around two-years to build, assuming the expertise is available, and can cost as much as USD 12 billion. On 9 August, the Biden administration signed into law the US ‘CHIPS and Science Act,’ to support new and greater domestic ‘fab’ capacity, designed to benefit Intel and Micron Technology Inc., among others. The legislation will, according to the White House, cut costs, boost jobs, reinforce supply chains “and counter China.” The same day, Micron announced a USD 40 billion investment to build ‘leading edge’ manufacturing capacity in the US, funded by the Act, by 2030. That means that the CHIPS Act’s total budget of USD 52.7 billion, deployed over a decade, will take several years to begin closing the gap with Taiwan and South Korea. TSMC, in comparison, plans a three-year investment of USD 110 bn.
The European Union has proposed similar legislation and Japan passed an economic security law in May 2022. European Commission President Ursula von der Leyen in February described the bloc’s dependence on a limited number of foreign exporters as “unacceptable.” The bloc, which currently accounts for around 10% of all types of semiconductor production globally, expects demand to double by 2030 and plans investments worth EUR 43 billion in public and private initiatives.
China has set itself a target of 80% chip self-sufficiency through a range of programmes under its ‘Made in China 2025’ strategic initiative. China has created state funds worth almost USD 180 billion by some counts, as well as offering tax incentives, local subsidies and trade barriers to boost investments in manufacturing. As a result, China’s domestic infrastructure for chip production is accelerating, but still lags. In 2021, by some estimates, just 16% of China’s semiconductors were made domestically, and two-thirds of those were built in conjunction with foreign suppliers.
The net result of all these initiatives in the US, Europe and China is that, over time, we are likely to see two independent or ‘decoupled’ semiconductor-manufacturing networks, reflecting wider political alliances.
One economic lesson of 2022’s geopolitical tensions may be that every economy remains dependent on the liberal trade system, at least for now. The question is whether democratic allies can collectively defend and maintain their technological lead. Although the danger that tensions turn into conflict by a military mistake or miscalculation around Taiwan cannot be excluded, we see intermittent Chinese military exercises around Taiwan as the most likely scenario, rather than more direct confrontation. In the meantime, the tensions can only complicate any solution to the existing US/Chinese tariffs and Chinese company listings on US markets. At this stage, that continues to justify the political risk premium evident in today’s financial markets.
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