Why China Can’t Catch Up With Chip Design

By Cecilia Lim

On April 16, the US Department of Commerce (DOC) announced the activation of the denial order that bans US companies from selling parts and software to China’s ZTE Corporation (ZTE) for seven years.

ZTE was found to have violated US sanctions against Iran and North Korea by illegally shipping telecommunications equipment to both countries.

China’s severe air pollution may pose challenges on its path to development in chip making. Over and above all the technology barriers, it still needs to improve its environment.

According to DOC, ZTE had been “engaging in a multi-year conspiracy to violate trade embargo against Iran”.  It set up several shell companies to circumvent the embargo and sold products containing US-origin components to Iran.

To resolve the case, a settlement agreement was signed by ZTE and The Bureau of Industry and Security (BIS), an agency under DOC, in March 2017.

In the settlement agreement, ZTE agreed to a suspended order that denies ZTE’s export privileges for seven years, which could be activated if ZTE fails to comply with the terms of the agreement.

However, earlier this year, it was found that ZTE made false statements to BIS regarding disciplinary actions taken against its employees engaged in the illegal conduct. The false statements were made in 2016 and in 2017 during the probationary period.

ZTE claimed to have issued letters of reprimand to or reduced bonuses of the involved employees – which it never did. Instead, it paid them full bonuses. This led to the seven-year ban that cuts off a majority of ZTE’s supplies from the US.

Later on June 7, the ban was held in suspension again for 10 years, which would allow ZTE to resume operation. However, ZTE has to face additional stringent penalties and compliance measures. In particular, ZTE agreed to replace its entire board of directors and senior management in 30 days and to have a compliance team assembled by the US Commerce Department embedded in its operations for 10 years.

How Reliant Is ZTE on US Tech Companies?

The ban in April prompted a personal plea from Chinese President Xi Jinping to US President Donald Trump to look into the restrictions placed on ZTE.

Why was China so nervous about the ban? How important are US tech supplies to the Chinese company?

ZTE is China’s second largest telecom equipment manufacturer and fourth largest mobile phone vendor in the US. Contrary to its prominent place in the global telecom market, however, it can hardly survive without high-tech components from US companies.

The telecom giant halted most of its assembly lines almost on the same day the order was issued by DOC, according to Chinese media Caixin. In an April article by Forbes, it was even projected that ZTE could file for bankruptcy in a few weeks following the ban.

Such pessimistic predictions of ZTE’s fate are not without basis. It was estimated that around a quarter of the components used in ZTE’s products are imported from the US.

Take ZTE’s Axon M dual-screen foldable smartphone, which was released last year, as an example. According to statistics published by ABI Research, US companies supplied 60% of the semiconductor components used in the phone.

Headquartered in San Diego, US chipmaker Qualcomm is ZTE’s biggest supplier. It provides 38% of the components used in Axon M smartphones. Out of the 25 key components used in the Axon M smartphone’s main circuit board, at least eight were manufactured by Qualcomm.

Around 21% of the components used in Axon M were sourced from SanDisk, a flash memory product manufacturer, and another 1% of the components were sourced from Skyworks Solutions, a semiconductor manufacturer.

The protective glass on the phone display was manufactured by Corning Inc., headquartered in New York.

In addition to the hardware, the Android operating system used by the phone was powered by Google.

According to Bloomberg, China imports about US$200 billion (S$267 billion) worth of semiconductors annually, even exceeding its oil imports.

Reactions Within China

According to Reuters, most of the Chinese news media attributed the trouble facing ZTE to China’s excessive reliance on foreign semiconductor products.

Alibaba’s co-founder Jack Ma warned companies in China and other countries not to rely on US companies for chips, during a speech to students at Waseda University in Tokyo. A few days following the ban on ZTE, Alibaba Group announced that it had bought a Chinese chip making firm.

A Reuters report on May 27 mentions Tencent chairman Pony Ma pledging “to advance China’s semiconductor industry” after the ZTE “‘wake-up’ call”, although he admitted that semiconductor R&D is “not [their] strong suit” and they “may need the help of others in the supply chain”.

At the same time, China’s state-backed semiconductor investment fund, also known as the “Big Fund”, has raised close to 120 billion yuan (S$25 billion) during the second investment round to support its chip industry by April 26.

While the call for home-produced chips in China is on the rise, Senior Editor and Chief Financial Commentator of Financial Times Chinese (FT Chinese) Xu Jin argued that the lesson to be learnt by ZTE is not about controlling all of the technologies, but something simpler – following the regulations.

Xu also argued that China will not be able to and should not own the whole supply chain. Instead, it should focus on developing its own comparative advantages.

Why China Didn’t Catch Up With Chip Design

Why didn’t China catch up with chip design in the past? Will the billions of dollars of investment really transform China into a leading chipmaker?

Misallocation of resources could be hindering China’s chip ambition.

According to an earlier report by The Wall Street Journal, the US estimates that China could invest US$150 billion (S$200 billion) on chip development, equivalent to about half of annual global semiconductor sales.

 

Behind the rivalry of the technologies between the US and China is essentially the rivalry of two different political and economic systems. While the US has its faith in markets and developments led by the private sector, China relies on government financing and planning to foster industry leaders, which sometimes backfires.

In an analysis by Bloomberg, central planning was named to be a “serious impediment” to China’s chip industry in the past: “In 2016, Intel Corp. alone spent $12.7 billion on R&D. Few if any Chinese companies have that capacity or the experience to make such an investment rationally. And central planners typically resist that kind of risky and far-sighted spending.”

Even with specific funds, how the money would be spent is another issue. Several mainland Chinese news media revealed that for the past few years, about 40% of research grants was spent on R&D, while another 60% was spent on attending conferences or business trips.

The Hanxin scandal could serve as another reminder of how government financing ended up in fraud.

In 2003, Chen Jin, a former dean of the microelectronics school at Shanghai’s Jiaotong University, claimed to have invented a digital signal processing microchip called “Hanxin I”. However, thanks to a whistleblower, in 2006 it was found that “Hanxin I” was actually a Motorola chip with the name Motorola being scratched away and replaced with Hanxin by some migrant workers.

Using “Hanxin I”, Chen applied for more than 10 research projects and obtained over 110 million yuan (approximately S$22.93 million) of research funds.

Another problem facing China is the lack of talent in its semiconductor industry. According to several online posts that went viral in China, pressure from rising housing prices and low income from doing research forced many to switch to business or finance-related industries.

Adding to the difficulty, technology acquisition is getting harder and harder for Chinese companies. According to Bloomberg, China’s attempts to purchase US semiconductor companies are often blocked for security reasons. Japan, South Korea and Taiwan are also restricting acquisitions from China.

But even if it could get access to the technologies, whether China can manufacture high-quality chips is still doubtful.

Dr Zhang Xinyu, founder of Global Information Freedom Movement, mentioned that the air and water quality in China may not meet the requirements for semiconductor production, during an interview with New York-based NTDTV.

The use of water is vital to semiconductor manufacturing, especially ultra-pure water – water that is treated to the highest levels of purity for all contaminant types. Similarly, semiconductor manufacturing is also very demanding in terms of air cleanliness, with constantly increasing requirements.

China’s severe air pollution may pose challenges on its path to development in chip making. Over and above all the technology barriers, it still needs to improve its environment.

The Technology Node and What Chipmakers Can Achieve

Traditionally, technology node refers to the manufacturing process and design rules of a semiconductor. Though its meaning has changed over time, in general, the smaller the technology node, the smaller, faster and more power-efficient the transistors will be.

For example, Apple’s A9 chips used in iPhone 6S were manufactured either on a 14 nm process by South Korea’s Samsung or a 16 nm process by Taiwan’s TSMC. Compared to Apple’s A8 chips used in iPhone 6, manufactured on a 20nm process by TSMC, A9 was claimed to be 70 percent faster. So here the technology node is 14 nm or 16 nm for A9 and 20 nm for A8.

The most advanced microchip manufacturing plants in China are producing 28 nm chips. Headquartered in Shanghai, China’s largest foundry vendor SMIC is one such plant.

In October 2016, Samsung announced the mass production of 10nm chips that were used in the Samsung Galaxy S8, which was released in 2017.

Apple’s A10X chips used in the iPad Pro, released in 2017, were also produced on the 10 nm process by TSMC.

Some analysts say that Intel’s 10 nm process is comparable to 7 nm processes at foundries.

Certainly, China is facing the challenge of developing more advanced processes. Lagging about two generations behind, it will not be an easy path, going forward.

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