Why China's Chip Industry Won't Catch America's

In the 1980s, the U.S. was consumed with fear that Japan would become the preeminent power in manufacturing and technology. Those fears never came to pass. Today the same fears are focused on China. The Middle Kingdom appears to be an even more daunting foe, with its enormous foreign reserves, fast-growing economy, oceans of scientists and engineers, and enormous subsidies to high-tech companies. How real is the China threat?

There is no doubt that China is making rapid strides in both infrastructure and technology, but U.S. anxiety of being overtaken by China appears to be misplaced. It takes more than money and might to achieve innovation. This is what I learned when researching the inflated estimates of engineering graduation rates in China and by analyzing its pharmaceutical industry. And this is one of the key findings in a new book titled Chips and Change: How Crisis Reshapes the Semiconductor Industry (MIT Press). Written by professors Clair Brown and Greg Linden of the University of California at Berkeley, the book provides a wealth of information about semiconductor development cycles as well as a fresh and informed look at some of China's key technological capabilities in those realms.

A few years ago, China seemed to be on track to dominate the global semiconductor industry in the same way it currently dominates the electronics manufacturing sector. In 2004, China's most advanced chip manufacturer, SMIC (SMI), went public on the Hong Kong and New York stock exchanges. The next year, two Chinese chip design companies, Actions (ACTS) and Vimicro (VIMC), had successful Nasdaq IPOs. Boosters of China's chip industry said there were hundreds more semiconductor design firms waiting in the wings and many new Chinese chip manufacturers were also starting up.

Barriers to Progress Five years later, most Chinese chip companies remain unprofitable. Why? A number of interlocking reasons that provide clues as to why training lots of engineers and spending money to subsidize companies and build facilities is not enough to create a successful industry.

Because of China's poor reputation for protecting intellectual property, multinationals have limited technology transfer to China. For instance, chip giant Intel (INTC) is now building a plant in northeastern China but has long delayed locating its most cutting-edge fabrication facilities in China, even though this increases the cost of logistics to supply China-based electronics factories, which are among the biggest consumers of Intel processors.

While Chinese semiconductor companies have produced some design wins, the general perception is that China's design shops are good with common reference designs but struggle to produce true silicon breakthroughs. This is likely a product of the variable quality of engineers produced by China's fledgling academic programs which, while ambitious and well funded, produce quantity at the cost of quality. Likewise, China's pool of MBAs does not have the depth of consistency of MBAs from countries with longer histories of business studies and research. And unlike young engineers and MBAs in Silicon Valley, young Chinese engineers and MBAs lack role models who have taken companies public or created truly innovative products earlier in their careers.

China also suffers from an unhealthy competition for marquee facilities among its local governments. This can lead to overinvestment in favored industries, such as semiconductors. SMIC has been hired by at least two city governments to build and manage chip manufacturing plants for which the municipalities, and not SMIC, will bear the risk. This is occurring at a time when China already has excess chip capacity and idle fabrication lines in a number of semiconductor plants. Such lack of market discipline is critical because semiconductor lines not in use have absorbed billions of dollars in investments that could have been used for far more productive endeavors.

Strong Stimulus None of this is to say that China won't develop the skills to innovate in the future or won't emerge as a formidable competitor in industries like clean energy, where the U.S. has not yet established an effective beachhead. China has a lot of technological strengths and the advantage of large numbers, and it is making massive investments in this area. It will gain sizable cost and technology advantages and some of her entrepreneurs are bound to be both smart and lucky. The current global recession may even work to the benefit of Chinese companies because the government adopted a large stimulus program and consumer purchasing remains strong. And returnees to China from Silicon Valley have begun to add both seasoning and depth to the Chinese entrepreneurial bench. These returnees have worked for top American companies and know how to compete and innovate.

But will China actually overtake the U.S. and other centers of innovation in the next decade in the most complex areas of value creation such as new designs for semiconductors? To get an answer, it's worth revisiting the U.S. experience with Japan in the 1980s. With fears over the loss of competitiveness hanging like a pall over the U.S., the American government negotiated strict trade agreements with Japan and ponied up hundreds of millions of dollars over a decade to help fund a semiconductor R&D consortium. Oddly enough, neither of those moves proved to be hugely consequential; indeed, the trade agreements were somewhat regressive.

Rather, to compete and survive, U.S. companies changed what they were doing. Intel quit the low-profit, low-innovation field of making commodity memory chips and successfully bet the store on microprocessors. Startups, especially in Silicon Valley, exploited opportunities made possible by advances in design automation and by the contract chip manufacturing pioneered in Taiwan to usher in new forms of semiconductor companies that outsourced the relatively low-margin business of chip production. Today the top three design-only (or fabless) companies—Qualcomm (QCOM), Broadcom (BRCM), and Nvidia (NVDA)—are all based in the U.S., and one of them (Nvidia) was launched by a Taiwanese immigrant to the U.S. These multibillion-dollar companies were all started in the decade after 1985, when the fear of Japan was reaching its peak.

Centralized, Not Spontaneous And what of Japan's monolithic national technology policies? These policies that favored huge business conglomerates like Hitachi and Toshiba stifled the market for chip startups. As a result, Japan to date has no fabless companies of any size, and fabless ethos never caught hold in a corporate culture where ownership of factories is still viewed as essential. Japanese firms have remained overly inward-looking and dependent on the mature and slow-growing domestic market. With a rapidly aging populace and a stagnant economy, this market has lagged behind the rest of the world. The result has been a distinct lack of competitiveness of Japanese companies in the two biggest boom areas of the past two decades, PCs and cell phones.

China is different from Japan in some key ways but not so different that the lessons of Japan Inc. don't apply. The takeaway from Brown and Linden's book is that our fears of Chinese technology dominance are overblown. Yes, China has produced some successful companies, such as search engine Baidu (BIDU) and telecom equipment maker Huawei. Chinese companies lead the world in the fast-growing sector of multiplayer online games. But a centralized effort to replicate the spontaneous upwelling of creativity and innovation, which has formed and informed the U.S. technology sector in general and the semiconductor sector in particular, is a difficult and unlikely route to global technology hegemony.

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