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The Global Semiconductor Ecosystem is Highly Interconnected

Broadly speaking, semiconductors, also known as integrated circuits (ICs), computer chips, microchips, or chips are the building blocks of technology. A semiconductor is a crystal material that possesses features of both insulators (materials that do not conduct electricity) and conductors (materials that do). Semiconductor devices such as transistors, which perform an essential function of controlling electrical current flow, are often connected or “printed” onto circuit boards, a hardware component of an electrical product that provides structural support to hold all other components in place and provides necessary wiring to connect signals and power to these components. Each device performs specific functions across various microprocessor chips such as central processing units (CPUs), memory chips, sensor chips, graphics processing units (GPUs), and power management. Semiconductor devices can also allow communication among devices like mobile phones, gaming systems, aircraft, industrial machinery, and military equipment and weaponry.

While demand for semiconductors has been surging, the cyclical nature of the industry contributes to market volatility and unpredictable returns. Profits depend on types of chips produced, consumer preferences, and shortening product lifecycles and demand for newer, faster applications that make tech quickly obsolete. As each new generation of semiconductors becomes smaller and more densely packed with transistors, the complexity and cost of production increases, giving each segment of the supply chain a chance to enhance product competitiveness and quality. Because of this, only a few companies can design and manufacture advanced chips while also being flexible enough to make continual technological improvements. From equipment production to chip manufacturing, companies with products and services that are marginally better than their competitors are able to capture an outsized portion of industry revenue (on average half).

The three main segments of the production process include: design, manufacturing, and assembly, testing & packaging (ATP)—with various design and fabrication facilities, or “fabs” contributing to the supply chain. The largest semiconductor manufacturers are in the U.S., South Korea, Europe, and Japan, but only a handful are vertically integrated; these Integrated Device Manufacturers (IDMs) include companies such as Intel, Samsung, SK Hynix, and Micron Technologies. Much of the industry, however, employs a “fabless-foundry model,” which delineates tasks to specialized companies, and relies on outsourcing parts of the value chain— notably to firms in Taiwan, China, and Singapore —to mitigate production costs and leverage local expertise to improve product performance. The “fabless” firms have no manufacturing capabilities and specifically design chips, while foundries focus on manufacturing, and outsourced semiconductor assembly and testing companies (OSATs) support testing and assembling semiconductor components into workable devices. Ninety percent of the value of a chip is split evenly between the design and fabrication stages, and 10 percent is added during the ATP stage. The graphic below details the general production process for semiconductors starting with raw material sourcing, which is critical to enhancing the industry’s rate of technological innovation, through distribution for use in electronic goods.

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Over the past few decades, the trend has been toward the fabless-foundry model to mitigate production costs and leverage specialist knowledge throughout the value chain. Capital-intensive portions of the supply chain, such as design and manufacturing, which require highly specialized knowledge and advanced production equipment at a capacity utilization rate of 90 percent, typically occur in Canada, Europe, or the U.S. ATP, or the back-end production where components are tested before being assembled and packaged into finish products such as laptops, is the most labor-intensive segment of the supply chain and often occurs in countries where wages and taxes are comparatively low, such as Malaysia, Vietnam, and the Philippines. As a result, the semiconductor industry today is highly globalized with a typical production process spanning four countries and 25,000 miles. The map below walks through the semiconductor production process in detail. It highlights the globalized nature of the industry and the various countries and private sector actors involved.

COVID-19’s disruptions on supply chains has been a wake-up call for the industry, forcing companies to evaluate and map out their value chain models, with many recognizing that they are unaware of all the tiers of suppliers that they rely on. Operational segments of the supply chain that are more labor intensive, such as the manufacturing and ATP stages have been particularly affected by social distancing, travel restrictions, and lockdown measures. Concurrent and heightened demand for private IT infrastructure (for example, PCs, servers, wireless and wired communications for home schooling and working from home, and automobiles for independent travel), has increased total industry revenue by 8 percent in the past year but pinched these already tenuous chains. With emerging technology developers driving demand, especially artificial intelligence applications, which are expected to grow 50 percent by 2022, manufacturers and end-users across sectors are scrambling to secure access to chips.

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Still Global Leaders, U.S. Firms Largely Outsource Manufacturing - Notably to Asia

While American firms dominate many segments of the semiconductor supply chain, they have long specialized in research & development (R&D), which is essential to drive continued innovation. Because of arduous market conditions including intense competition and rapid technological changes that require continual development, R&D and greater innovation is the number one strategic priority for companies. American firms annually invest about 20 percent of their revenue (or $40 billion) in R&D, making it the second-highest share of any major U.S. industry after the pharmaceutical industry. The industry’s R&D investments have paid off, with advanced semiconductors among the top five U.S. exports after aircraft, oil (crude and refined), and automobiles. Notably, 82 percent of the American industry’s revenue comes from overseas,  36 percent (or $70.5 billion) of which is from China. Export revenue is essential to U.S. firms’ ability to reinvest in the R&D required to remain on the cutting edge and maintain leadership in the industry given that federal government support to private sector semiconductor innovation is relatively limited. Although half of production by American firms takes place in the U.S. across 80 fabs and 19 states, U.S.-based fabs account for only 12 percent of the world’s manufacturing. The bulk of the production process has been shifting toward Asia so organizations could reduce costs, diversify their supplier base, and create resilient supply chains that can withstand shocks such as COVID-19 and mitigate fallout from trade disputes.  By 2022, the Office of Commercial and Economic Analysis of the U.S. Air Force estimates, 90 percent of leading-edge chip production will be based in Taiwan, South Korea, and China with U.S.-based global share of fab capacity dropping to 8 percent and Chinese capability increasing to 35 percent. This concentration of production and trend of American firms to increasingly rely on Asia for the manufacturing of semiconductor technologies poses risks to American economic competitiveness and national security should supply chains get further disrupted or U.S. firms become unable to operate or transport goods in the region.

By 2022, the Office of Commercial and Economic Analysis of the U.S. Air Force estimates, 90 percent of leading-edge chip production will be based in Taiwan, South Korea, and China with U.S.-based global share of fab capacity dropping to 8 percent and Chinese capability increasing to 35 percent. This lack of U.S.-based manufacturing and overall industry consolidation is partly because of the immense cost of building and maintaining a fab, which ranges from $15 billion to $20 billion for a leading-edge facility. Manufacturing equipment is expensive, with front-end lithography equipment that is used to draw highly complex circuit patterns on wafers costing up to $100 million per unit. The next generation semiconductor manufacturing technology that will be used to create 7 nanometers or smaller semiconductors, such as extreme ultraviolet (EUV) lithography, costs $120 million to $170 million.  For advanced semiconductor production such as 5 nanometers, a single wafer can have up to 14 EUV layers applied to it, significantly increasing capital costs. Overall, creating a new fab in the U.S. costs an added 30 percent to 50 percent to build and operate over 10 years, compared to Taiwan, South Korea, Singapore, or China. Beyond fab expenses, environmental regulations in the U.S. also deter investment in U.S.-based semiconductor manufacturing. According to the President’s Council of Advisors on Science and Technology (PCAST), the Federal Clean Air Act is perceived by the industry as a barrier to timely facility permitting. Pre-construction and operating permits are issued by state and local agencies, which for large projects can take 12 to 18 months to receive. In an industry where bringing projects to fruition is exceptionally important given the pace of competition and innovation, the lengthy permitting process can deter building facilities in the U.S.

The decline of America’s share of global manufacturing is also attributed to the lack of incentives from the federal government, which have pushed firms to send production segments overseas, particularly in Asia. Industry leaders point to the U.S.’ corporate tax system, which has the highest rate in the Organization for Economic Cooperation and Development (OECD), relatively low R&D tax credits, and discourages capital investment in asset-heavy industries. Recognizing the trend and with growing strategic concerns over weakening U.S. domestic semiconductor capability, provisions in the National Defense Authorization Act (NDAA) 2021 under title XCIX, “Creating Helpful Incentives to Produce Semiconductors for America,” offer companies up to $3 billion to build a U.S.-based fab. This is the only existing government incentive program designed to spur construction of domestic semiconductor manufacturing, with Capitol Hill staffers stating that the provision is meant to strengthen the entire supply chain. The industry has applauded the enactment and is urging Congress to immediately allocate funding. Some experts are skeptical as to whether the NDAA provision will successfully promote U.S.-based chip manufacturing or, instead, motivate China to further strengthen its efforts toward indigenization. Given the highly globalized nature of the supply chain and the unique nature of each stage of the production process, the broad NDAA provision is unlikely to be able to address all the weaknesses of the entire value chain model. Other supportive legislation such as the Creating Helpful Incentives to Produce Semiconductors (CHIPS) for America Act, proposed in Congress in June 2020, which includes a larger, $22 billion incentive program, and an income tax credit for chip equipment and manufacturing, and the American Foundries Act of 2020, which authorizes $25 billion for R&D, facility construction, equipment, and IP acquisitions, could further support the industry, but both have yet to be passed and now stand in committees.

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Doubling Down, China is Intent on Becoming a Semiconductor Superpower

China has long prioritized the development of its technology sector with goals of digital self-reliance and primacy that officials contend will foster self-sustaining growth through domestic consumer spending. However, competitive semiconductor manufacturing is essential to realize this vision, and China plays a limited role in the production process, owning only 5 percent of the total chip share and primarily participating in the manufacturing and the ATP segments of the supply chain. It is heavily dependent on imports and consumes more than 60 percent of all semiconductors in the global market for internal use and eventual export in the form of Chinese-made technology such as smartphones, computers, telecommunication networks, and more. China’s import dependence coupled with national security concerns, specifically the possibility that adversaries could intentionally install and exploit vulnerabilities into devices for intelligence and military purposes, has the Chinese Communist Party (CCP) doubling down on bolstering its domestic chip capacity to mitigate supply chain risks and to support the country’s tech-driven international competitiveness.

According to the Office of the U.S. Trade Representative, China’s goal is to create a “closed-loop semiconductor manufacturing ecosystem” from raw material and equipment production to the final product. In other words, China wants to catch up with—and then surpass—Western competitors in the semiconductor value chain, which risks disrupting the industry at large. Through the 2014 National Integrated Circuit Plan, China has worked to establish itself as a leader in the semiconductor industry throughout the supply chain by 2030 and has been advancing its agenda by restricting market access for foreign semiconductor products, forcing technology transfers to acquire IP, offering generous subsidies, and mobilizing state-owned enterprises. Aligned with the Made in China 2025 initiative launched in 2015—which seeks to shift China from being a low-end manufacturer to a high-end producer of goods, particularly in areas pertaining to information technology and telecommunications, advanced robotics, and AI—the National Integrated Circuit Industry Investment Fund (also known as the Big Fund) allocated an initial $22 billion to semiconductor development. Since 2014, China has invested $150 billion overall in its domestic semiconductor industry—equivalent to China’s annual total semiconductor market value and twice what the global industry spends annually on R&D—through investments from all levels of government.

Despite China’s immense resource allocation to its semiconductor sector, 84 percent of China’s semiconductors are still imported or made domestically by foreign manufacturers. However, despite China’s immense resource allocation to its semiconductor sector, 84 percent of China’s semiconductors are still imported or made domestically by foreign manufacturers. In fact, the largest Chinese-based integrated circuit (IC) foundry, Semiconductor Manufacturing International Corporation (SMIC), is four years behind in terms of innovation compared with market leaders in the U.S., Taiwan, and South Korea. Desperate for core IP to enable production of the most advanced semiconductors, from 2015 to 2017, Chinese investors tried to acquire U.S. and European-based firms such as Micron Technology, Western Digital Corporation, and Lattice, but governments blocked their efforts because of security concerns. Recognizing the gap, in 2019, China announced an extra $29 billion in funding via the Big Fund, and President Xi Jinping pledged $1.4 trillion through 2025 to further develop emerging tech as part of a new infrastructure initiative and ongoing effort to establish itself as a world-class chip giant and an international standard-setter for a range of high-tech, semiconductor-powered applications (such as 5G). Despite the funding, China’s ambitions are being hindered by a growing trend among private companies to move operations out of China because of rising labor costs, the instability of the Chinese market from the U.S.-China trade war, and the COVID-19 pandemic undermining confidence in China’s manufacturing sector. Companies are shifting their supply chains out of China to neighboring Asian countries, notably Vietnam, for its younger workforce, tax benefits, relatively weak regulations, six-day workweeks, and 40 percent lower labor costs. Taiwanese contract manufacturer Foxconn, for example, announced in 2020 that it would move some of its iPad and MacBook assembly to Vietnam at the request of Apple to minimize the impact of the U.S.-China trade war. In 2021, iPhone assembler Wistron similarly moved 50 percent of its production outside of China to India and Vietnam. As companies look to more attractive markets, China must adapt to the changing global economic landscape to maintain its growth.

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Semiconductors at the Heart of U.S.-China Tit-for-Tat Competition

To combat Chinese tech ambitions, maintain its leadership in the semiconductor industry, and curtail the use of U.S. cutting-edge technology and know-how by Chinese companies, the Trump administration leveraged the powers of the exports control regime and ramped up activity in 2018. Through the Committee on Foreign Investment in the U.S. (CFIUS)—which reviews foreign direct investments and allows the president to suspend or block foreign mergers and acquisitions if they present credible threats to national security—the U.S. Department of Commerce (USDOC), and the United States Trade Representative (USTR), the Trump administration sought to squeeze out China from the semiconductor supply chain. According to the U.S. Treasury Department, after broadening CFIUS’s oversight to include critical technology and critical infrastructure, CFIUS opened 443 investigations within President Trump’s first three years, resulting in more cross-border transaction reviews—notably for the semiconductor industry. CFIUS was also responsible for stopping Broadcom’s acquisition of Qualcomm, citing that the merger could cut U.S. investments into semiconductors and wireless tech, giving Huawei a lead in the industry.

In addition to foreign investments, the former administration targeted global supply chains, which has had cascading effects for the global industry. The government expanded the definition of the foreign direct product rule through the USDOC to require a license for the use of any products that relied on American technology and software. The expanded rule disincentivizes foundries around the world such as TSMC, Applied Materials, KLA, and LAM research from working with HiSilicon, Huawei’s in-house production unit, by threatening to ban companies’ access to new tools from American firms. After the USDOC’s rulings, TSMC complied with U.S. export controls and stopped taking orders from Huawei, who was then TSMC’s second largest customer after Apple. TSMC subsequently announced plans to build a 5 nanometer chip plant in Arizona that could create 1,900 jobs over five years. Huawei was later added to the USDOC’s Bureau of Industry and Security (BIS) Entity List in 2019, followed by SMIC and 60 other entities in 2020, a measure that effectively restricts those entities’ access to American SMEs because of their ties to the Chinese military, human rights abuses, and/or theft of U.S. trade secrets. The Trump administration took other unilateral actions to limit trade in sensitive technologies, including leveraging Section 301 of the U.S. Trade Act of 1974, to “mitigate Chinese mercantilist practices” that the administration charged were unreasonable or discriminatory, and burdened or restricted U.S. commerce. In March 2018, the USTR also filed a report on China’s trade policy practices, citing abuses related to IP, leading to U.S. imposed tariffs on China. (Despite its impacts, legal questions remain regarding the Trump administration’s use of Section 301 given that legal experts assert the U.S. should not use Section 301 unilaterally to confront trade practices.)

The Trump administration’s protectionist measures have reinforced President Xi’s ambitions to decouple Sino-American economic ties (despite his recent calls for multilateralism and global collaboration). One year after Huawei was put onto the U.S. Entity List, for example, local Chinese semiconductor companies were able to capitalize on the absence of American firms. Although performance is not equivalent to U.S. designs, China’s efforts to localize semiconductor manufacturing point to longer-term pressure on U.S. companies’ market share there. To further circumvent U.S. measures, Xi has been creating industrial backup systems to replace American-led industrial and financial institutions and address the “changes in the global political and economic environment, the upsurge in deglobalization, unilateralism, and protectionism by [the United States].” For instance, after China’s SMIC was delisted from the New York Stock Exchange in 2019, the CCP announced plans to raise $2.8 billion through the Shanghai Stock Exchange Science and Technology Innovation Board (STAR Market), a tech-centered exchange modeled after the Nasdaq that supports the Made in China 2025 initiative and provides an alternative forum for corporations to raise capital. According to Refinitiv, STAR ranks second behind the Nasdaq in terms of IPO’s value after several semiconductor firms, namely SMIC, joined the listings in 2020. Today, STAR includes 120 corporations and is valued at $400 billion. While small compared to the Nasdaq, which tracks 3,300 companies and has a market cap of $19.06 trillion, it is symbolic and is growing.

China’s recent rule changes and rising tensions in the tech-war demonstrate increasing difficulty for companies and countries, such as TSMC and Taiwan, to pursue strategic autonomy amid potential economic decoupling between the U.S. and China. Throughout the trade conflict, Sino-American relations have been principled on reciprocity, or tit-for-tat, with both countries using tariffs, sanctions, and export controls to influence each other’s behavior. In January 2021, the Chinese Ministry of Commerce promulgated a bylaw that discourages companies from taking steps to comply with U.S. economic sanctions and export-control restrictions imposed by the U.S. government over the past year, including TSMC’s refusal to work with Huawei. Citing reciprocity, the law stipulates national sovereignty matters and gives Chinese firms the right to sue a foreign company for abiding by American rules. Although some commenters characterize TSMC’s decision to “side” with the U.S. (illustrated by its cutting off business ties with Huawei) as a win for President Trump, China’s recent rule changes and rising tensions in the tech-war demonstrate increasing difficulty for companies and countries, such as TSMC and Taiwan, to pursue strategic autonomy amid potential economic decoupling between the U.S. and China.

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Supply Chain Bottlenecks Hampering China and Posing Risks for the Global Industry

Despite all its initiatives and funding, China struggles to achieve its goals and lags considerably behind U.S. and other global semiconductors manufacturers. Analysts estimate that China's share of the semiconductor market will be 40 percent in 2025, short of the government's goal of 70 percent. China is falling short of its ambitions to become a global standard-setter, which would require producing advanced chips within a Chinese semiconductor sector that is, at least two to three generations behind leading edge companies like TSMC and Samsung. China will need at minimum five to 10 years to catch up in terms of technological sophistication. Indeed, the U.S.-China trade war has harmed China’s indigenization efforts, but China’s lack of success in developing a self-reliant chip ecosystem is because of several bottlenecks throughout the global supply chain that its industry is facing, including limited access to advanced semiconductor manufacturing equipment and software, and a lack of talent and expertise.

Industry analysts estimate that China’s plans to create new fabs and expand capacity will drive China’s equipment spending to more than $40 billion in 2025. Although China already invests heavily in equipment with 80 domestic companies devoted to semiconductor equipment research and manufacturing, it has limited capability to manufacture any equipment locally and still depends on American, Taiwanese, South Korean, and Japanese suppliers for critical production materials such as high-end photoresist materials. As a result, China has sought to reduce its import dependence by purchasing used machines and luring companies such as Intel, Samsung, and SK Hynix to set up fabs in China to meet local demand and increase China’s overall semiconductor exports. But U.S. export restrictions blocking Chinese SME companies such as SMIC, Yangtze Memory Technologies (YMTC), and ChangXin Memory Technologies (CXMT) from accessing the global supply chain have hindered China’s capability building, particularly in obtaining cutting-edge lithography machines and essential manufacturing chemicals.

In addition, while the creation of the Big Fund is China’s primary source of financing for the development of foundational semiconductor devices, little transparency or accountability exists for how the money is spent. Local governments have reportedly invested and approved chip projects blindly without sufficient knowledge about the industry or the manufacturing process, leading to dozens of failed and stagnant chip companies. In 2020, after the collapse of high-profile companies such as Tsinghua Unigroup and Wuhan Hongxin Semiconductor (HSMC), the Chinese National Development and Reform Commission (NDRC) warned that local governments will be held accountable if projects result in huge losses, waste resources, or “invoke big risks.” Chinese investors and executives have stated that Chinese fabless firms are “too immature” to use funding effectively. It is unclear how the Big Fund’s resources have been spent to date, particularly given that over 50,000 entities are registered as “semiconductor” companies, which risks investment fragmentation, and most of known funding appears to be used to expand fab capacity—not R&D.

Given the nature of the semiconductor industry that requires decades of research and accumulated expertise to create cutting-edge technology, experts contend that China will not be able to resolve its human capital deficit within five to 10 years. Finally, although foreign technology acquisition, collaboration, and transfer through joint ventures, licensing agreements, and U.S.-led open-source technology platforms for chip design have marginally improved China’s domestic production efforts, China fundamentally lacks the knowledge to produce cutting-edge ICs. It remains dependent on foreign talent for technical know-how and has used its resources to aggressively attract employees from top firms. Chinese companies offer double or triple existing salaries of chip experts in Taiwan, resulting in as many as 3,000 Taiwanese engineers joining China’s leading chipmakers in 2019 and at least 100 former TSMC engineers in 2020. Huawei’s addition to the U.S. Entity List has spurred Beijing to accelerate recruitment efforts and raised concerns from American firms about Taiwan’s ability to protect U.S. companies’ IP given that, in addition to design and other forms of intellectual property, a company’s tacit knowledge resides in its employees. The effectiveness of China’s recruitment approach, however, is still limited given that the number of engineers needed to run a facility can range from 1,000 to well over 3,000, making it unlikely that China will be able to obtain the necessary people in the immediate or medium term.

The Chinese education and technical training systems also are not producing the skilled workforce China needs to scale up its production process. For decades, China has maintained a strategy of revitalizing China through science and education, and launched its first semiconductor school in 2020. As the Big Fund demonstrates, the Chinese system is highly effective at shifting resources to address critical shortages in its economy. However, given the nature of the semiconductor industry that requires decades of research and accumulated expertise to create cutting-edge technology, experts contend that China will not be able to resolve its human capital deficit within five to 10 years. It will be a multidecade process to assemble the critical mass of skilled workers and IP that underpin Western companies’ competitiveness, particularly in the upstream portion of the supply chain. And even then, China is unlikely to be able to replicate the entire ecosystem that other companies such as Intel, Samsung, and TSMC have cultivated (and continue to cultivate) over decades and with billions of dollars in investments. Even if China successfully develops domestic fab capabilities, Chinese firms will continue to rely on American, European, Japanese, South Korean, and Taiwanese firms for chip technology and materials. Moreover, the semiconductor ecosystem is constantly evolving as companies continue to innovate and increase the efficiency of their production models. It will become increasingly difficult for China, particularly when it lacks access to industry leaders, to continually manage every part of the supply chain given that, depending on the chip type and a particular production node, continuous management of all key suppliers and an ongoing process of optimization will be required.

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Taiwan: A Geopolitical Flashpoint and Linchpin in the Innovation Race

At the center of growing U.S.-China tech tensions and struggle for tech supremacy is Taiwan, which plays a critical role in the manufacturing advanced logic chips that are used in aircraft, satellites, drones, wireless communications, data centers, automobiles, and other technology that the U.S. and China (as well as countries around the world) rely on for their economic and national security. Taiwan’s semiconductor industry is highly concentrated and is dominated by two manufactures, TSMC and United Microelectronics Company (UMC). Ranking third in global semiconductor leadership, TSMC is the world’s top pure-play foundry. Currently, only three companies in the world—Intel, Samsung, and TSMC—are capable of manufacturing advanced semiconductors (7 nanometers or smaller). In 2020, TSMC raised its R&D spending by 24 percent to $3.7 billion to stay competitive. Intel ranked first in terms of the industry’s total R&D expenditures, accounting for 19 percent (or $12.9 billion) of the industry’s total, while Samsung, ranked second in 2020, increased its R&D spending by 19 percent (or $5.6 billion) in leading-edge logic processes to compete with TSMC.

As rivals like UMC and Samsung fall behind technologically, China-based SMIC struggles with American restrictions, and Intel considers outsourcing to TSMC after several in-house slip-ups, TSMC’s “pivotal role” in the tech industry will likely expand in 2021. TSMC is essential to the supply chain, particularly for clients such as Apple, Nvidia, AMD, Qualcomm, Xilinx, and MediaTek, which design bespoke technology but do not have the capacity to develop the most advanced chips at high volumes. According to industry experts, as rivals like UMC and Samsung fall behind technologically, China-based SMIC struggles with American restrictions, and Intel considers outsourcing to TSMC after several in-house slip-ups, TSMC’s “pivotal role” in the tech industry will likely expand in 2021. However, government officials and business leaders are increasingly concerned about the risks posed by the disproportionate and growing reliance on TSMC for critical chips, particularly given Taiwan’s economic ties to China and increasing U.S.-China tensions surrounding Taiwan.

Although Taiwan has been trying to reduce ties with China by increasing trade and investment with regional neighbors through its 2016 New Southbound Policy, Taiwan and TSMC are heavily dependent on both China and the U.S. for most of their economic activity and technological development. China is Taiwan’s biggest trading partner, representing 24.3 percent of its total trade and 20.1 percent of Taiwan’s imports in 2019. Taiwan relies on the Chinese market for a significant portion of its semiconductor sales and manufacturing with one-third of purchases by Chinese importers for semiconductors (some of which were also used by Taiwanese firms in China). According to Taiwan’s Ministry of Economic Affairs (MOEA), more than 70.8 percent of Taiwan’s information and communication technology (ICT) related products were manufactured in China. China’s market demand increased TSMC’s revenue by 17 percent (or $6.9 billion) in 2019, effectively more than doubling China’s share of the company’s sales from 9 percent to 20 percent from 2016 to 2019. Overall, Taiwan’s exports in semiconductors and semiconductor-enabled devices to China grew nearly 89 percent from 2014 to 2019.

By comparison, the U.S. is Taiwan’s second largest trading partner, accounting for 13.2 percent of total trade and 12.2 percent of Taiwan imports. Taiwan is also an important trading partner for the U.S. as the U.S.’ 10^th largest goods trading partner, with $85.5 billion in total two-way goods trade. For TSMC, North America accounts for 59 percent of its total revenue, which is critical for its ability to reinvest in R&D. As the “Global Path of a Semiconductor” map demonstrates, the semiconductor supply chain relies on a handful of American companies for specific production steps, particularly electronic design automation (EDA) software and SMEs. EDA software is necessary to design any chips and leading vendors—Synopsys, Cadence, and Mentor Graphics—which are all American, often work closely with foundries and SME producers. The SME market is similarly dominated by American firms making all global chip firms, TSMC and SMIC included, reliant on U.S.-based firms for their semiconductor equipment and software to run its fabs. According to the Taiwan Machine Tool and Accessory Builders’ Association, Taiwan’s semiconductor industry is “overwhelmingly dependent on imported production equipment,” with 90 percent of SME coming from abroad.  Deeply integrated into U.S. and Chinese supply chains, TSMC owns 55 percent of the Chinese foundry market (compared to SMIC’s 19 percent) and has three wholly owned subsidiary fabs in China and the U.S. with another fab planning to be built in Arizona. The graphic below shows the inter-dependence of Taiwan, the U.S., and China for growth in the semiconductor market. It highlights how the trade measures imposed by the Trump administration significantly affected U.S.-China trade flows as Chinese exports to the U.S. decreased by 45 percent during this time period. Deteriorating trade relations and rising costs of semiconductor R&D adversely impact chip firms’ abilities to reinvest revenue into critical research necessary to remain at the cutting edge.

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As tensions rise in the Taiwan Strait and U.S.-China relations steadily degrade under mounting economic and technological pressure, Taiwan has become a flashpoint for potential commercial and regional security instability. This risks not only the disruption of the global semiconductor supply chains and, by extension, myriad technology-based manufacturing processes, but Taiwan’s domestic economic security as the semiconductor industry accounts for 15 percent of the country’s GDP with TSMC contributing about 4 percent of it. At the same time, the Taiwanese industry has shown enormous adaptability amid challenging regional dynamics and shocks to the supply chain, including those unleashed by COVID-19. According to the MOEA, the country’s export orders grew by an annual 10 percent (or $534 billion) in 2020. As a critical part of the government’s Six Core Strategic Industries, President Tsai Ing-wen has been committed to accelerating the industry’s development from talent cultivation programs to financial support. In 2016, Taiwan launched the Asian Silicon Valley project, to which the administration allocated $350 million (or 11.3 billion New Taiwan dollars) to support its startup ecosystem by partnering with U.S.-based firms to gain firsthand knowledge of the American market. Through collaboration with American companies, aggressive investment in higher education, tech transfers, targeted R&D funds into electronics, and its homegrown venture capital industry, Taiwan’s dependence on the IT sector, particularly the semiconductor industry, has been critical to its overall economic development. In 2020, the Taiwanese federal government provided an added $260 million in subsidies for the development of its domestic semiconductor industry. According to the MOEA, Taiwan’s semiconductor sector is estimated to grow to $169.76 billion by 2030.

However, overlaying political dynamics of Taiwan’s sovereignty continue to complicate the stability and security of the chip supply chain. China considers Taiwan to be firmly under the “One China” policy and has never excluded the potential use of force to assert its position. Although the U.S. has historically acknowledged but not affirmed the “Chinese position that there is but one China and Taiwan is part of China,” the Trump administration before leaving office sought to strengthen U.S.-Taiwan relations. Overt diplomatic and military relations between the U.S. and Taiwan such as several high-ranking official visits, the dedication of $250 million to upgrade the unofficial embassy in Taipei, and a provision of enhanced military capabilities  (with air-to-ground missiles that can be used with F-16 fighter jets that the U.S. also sold to Taiwan) have heightened tensions and increasingly angered China. In response, China warned fiercely “not to send any wrong signals to ‘Taiwan independence’ [in order] to avoid severe damage to China-U.S. relations,” and most recently sanctioned former officials, including former Secretary of State Mike Pompeo, for their anti-China policies and violating China’s sovereignty. It is unmistakable that the threat to Taiwan from China is growing with disinformation campaigns,  cyberattacks,  political influence operations,  and Chinese military flyovers crossing the median line of the Taiwan Strait, which had not happened in 20 years.

For now, the country’s silicon-based semiconductor sector has mitigated overt conflict between the U.S. and China given the significant role Taiwan plays in the supply chain and has been referred to as a “Silicon Shield” to hedge against potential aggression from China. TSMC is China’s biggest contract supplier, selling $7 billion worth of chips to China in 2019. TSMC’s production capacity, innovative chip manufacturing, and reputation for protecting IP make it, and Taiwan in general, highly valuable for the U.S., China, and the private sector. Although the Taiwanese semiconductor industry has tried to maintain friendly ties with both sides, the government’s dependency on the U.S. for its defensive security combined with the intensifying tech war is pulling Taiwan closer to the U.S. This geopolitical nexus is increasingly dominating the outlook for global technology and commercial security. Supply chain uncertainty is no longer limited to the private sector, and control over semiconductors is becoming the new strategic national security fulcrum of the 21^st century.

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Trade Restrictions Hurting America, Taiwanese, and Chinese Companies Alike

The Trump administration’s “America First” policy stance recognized China’s growing assertiveness in the international arena with the U.S. Indo-Pacific Strategy Report specifically pointing to cooperation with allies and like-minded partners such as Taiwan on areas of advanced technology research and infrastructure movement to “prevent China’s industrial policies and unfair trading practices from distorting global markets and harming U.S. competitiveness.” Although the administration’s use of export controls, tariffs, and limitations on the industry have hindered Huawei and China’s chip independence efforts by restricting access to critical players such as TSMC, leading to Huawei announcing it was running low on chips under U.S. sanctions, the measures have harmed American firms as well.

In the long run, pinching the supply chain to weaken China will hinder U.S. firms’ ability to innovate and optimize operations and could ultimately undermine the U.S. high-tech industry. Underdiscussed tension is growing within the U.S. between Washington, D.C., and tech firms with respect to Sino-American relations. Rather than a security risk, Silicon Valley largely recognizes the value of China more as a competitive location for manufacturing and a critical source of revenue essential to further reinvestment in R&D. Despite increasingly antagonistic rhetoric and calls for economic decoupling, the U.S. and China remain highly interconnected and dependent on each other. The Chinese market represents almost two-fifths of U.S. semiconductor total revenue. Given that the U.S. federal government provides relatively little support for R&D funding compared to China, the American semiconductor industry is highly reliant on its export revenue from China to generate the funds needed to maintain firms’ competitiveness and drive further innovation. In the long run, pinching the supply chain to weaken China will hinder U.S. firms’ ability to innovate and optimize operations and could ultimately undermine the U.S. high-tech industry. The impacts of supply chain disruptions and segmentation are clear, as illustrated by the recent halts in production plants across the automobile and smartphone industries where chip shortages have prevented companies from fulfilling the growing demand for technology amid the pandemic. The automotive industry, in particular, has been harmed by chip shortages with industry analysts predicting that the effects of which could cripple automobile companies until 2023.

Uncertainty around the future of supply chains and market access has incentivized countries to invest in competing U.S. versus China production models and localize production. Despite dependence on U.S. and Chinese markets, Taiwanese firms are seeking to secure their own supply chains amid the U.S.-China tech war. As a protective measure, in December 2020, the Taiwan’s government and industry groups announced “post-globalization defense move[s]” and plans to localize SME production and reduce dependency on American firms to preemptively address potential supply chain disruptions to critical manufacturing equipment.

After the increasingly restrictive U.S. trade measures and concerns over unpredictable trade and export policies, companies around the world have sought out other partners and new markets to build semiconductor devices using non-U.S. equipment and reduce reliance on U.S. R&D. Following Huawei’s addition to the U.S. Entity List, Huawei approached TSMC and Samsung to build advanced process lines based on non-U.S. equipment and to produce chips under the U.S. ban. Although Samsung asserted that it would stop trading with Huawei as of September 2020, U.S. vendors are challenging U.S. regulations by expressing intent to participate in China’s 5G growth, which companies such as Intel and Micron Technologies did in 2019 by avoiding labeling goods as American-made. U.S. restrictions are also motivating smaller companies that have suffered losses from the U.S.-China trade war to work with Chinese companies to target American firms. In 2018, Taiwan’s UMC pled guilty to working with Chinese-based Fujian Jinhua (JHICC) to hack a computer memory chip stolen from American firm Micron Technologies to facilitate China’s self-sufficiency in computer memory production—a strategic priority for China. UMC is seen as a major casualty of the U.S.-China trade war and the company has long been cooperative with Chinese chipmakers, particularly JHICC, which planned to build a fab using UMC technology in 2019. But after JHICC was placed on the U.S. Entity List in 2018, it had to halt production, and both companies suffered significant revenue losses. U.S. restrictions risk fueling distrust between countries and companies, with U.S. allies asserting that they cannot be sure about America’s long-term commitments to international economic stability after four years of unilateral approaches to China overall. Going forward, constructive engagement among U.S. friends, partners, and allies as well as the private sector is necessary to stabilize the global supply chain and ensure that tech firms do not suffer undue costs and inadvertently undermine the U.S. and its allies’ economic competitiveness.

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China Intensifying Pressure on Taiwan

As tensions rise in the Taiwan Strait, business leaders and decision-makers alike are increasingly concerned about the disproportionate concentration of chips and reliance on Taiwan for semiconductors. Security experts assert Beijing is “more willing to take risks internationally and with a larger and more coercive toolkit than ever before,” risking the possibility of military conflict breaking out and disrupting a critical link of the supply chain. Military action, be it invasion or a blockade, in the Taiwan Strait may prevent corporations from being able to transport goods in and out Taiwan. The experiences from the past few years, particularly those with respect to the U.S. tightening restrictions on Chinese high-tech and exerting influence on Taiwan’s semiconductor firms, will not only drive Beijing to work to mitigate damages to its chip efforts but may push China to exert nonmilitary punitive measures, such as economic coercion and cyberattacks on semiconductor companies and Taiwan more broadly.

For China, conflict in the Taiwan Strait remains risky, especially as assessments of Chinese maritime power finds that although China has steadily built up its naval capabilities over the past 30 years with Taiwan as a primary inflection point, it lacks the means to accomplish a successful invasion. In addition to enhanced asymmetrical Taiwanese defense capabilities, U.S. support to Taiwan, China’s reliance on Taiwan’s manufacturing hub, the seasonal environmental variation of the strait that affects maritime navigability and makes it geographically hazardous for ships, the risks and costs of conflict are high. Regional experts note that there does not appear to be any urgency from Beijing for reunification given that conflict in the Taiwan Strait could potentially damage other Chinese interests, notably Xi’s goal for “economic rejuvenation” by 2049. Xi’s rhetoric is consistent with that of previous rulers regarding Taiwan and appears to recognize the risk conflict in the Taiwan Strait could pose to China’s economic and technological growth. Should China resort to the use of force, chips could be potentially used as part of China’s justification for war, but chips will likely not be the driving force for conflict.

Although China has not imposed significant economic sanctions or other restrictive measures in Taiwan to date, it could take more aggressive actions if leaders perceive a threat to its strategic interests. Recent actions against Canada for arresting Huawei executive Meng Wanzhou and Australia for barring Huawei and ZTE from its 5G networks are illustrative. In addition, recent legislation from China’s Ministry of Commerce that allows Huawei to sue TSMC over its chip ban and the Foreign Ministry’s threats to cut off the U.S. from critical material supplies, including silicon and gallium, which are essential to create semiconductors and other high-tech products, indicate that China may be willing to exercise similar measures against Taiwan after TSMC’s decision to abide by American regulations.

Access to core IP risks undermining Taiwan and the U.S.’ competitiveness and security as it would help China to build advanced technology as well as identify (and potentially exploit) hidden vulnerabilities in critical computing hardware over the longer term. Although China continues to leverage its “market for technology” through its equity restrictions and administrative approvals and by granting foreign investors limited market access if they can transfer advanced technologies to China, China may increase its cyberespionage activities to secure core IP for advanced semiconductor designs should it be unable to access the semiconductor equipment and devices it needs. Such a risk is heightening concerns among industry players given China’s advanced cyber capabilities, which ranks second behind the U.S. in sophistication and ability to achieve its policy objectives in the cyber domain. China has indeed used its cyber capabilities against private corporations for similar objectives, with hackers associated with the Ministry of State Security running a 12-year IP theft campaign against 45 tech companies and other Chinese hackers targeting more than 100 entities, including software development companies, computer hardware manufacturers, telecommunication providers, and governments for confidential information. Most recently, in August 2020, Chinese state-sponsored hacker group Winnti (otherwise known as Barium, Axiom, or Chimera) launched Operation Skeleton Key to “steal as much intellectual property as possible, including source code, software development kits, and chip designs” from Taiwanese semiconductor firms based in Hsinchu Industrial Park, Taiwan’s technology hub. Cybersecurity experts note that China’s attack on Taiwan is one example of a larger trend of China using cyber tactics to “shift the power relationship up and down the [semiconductor] supply chain.” Access to core IP risks undermining Taiwan and the U.S.’ competitiveness and security as it would help China to build advanced technology as well as identify (and potentially exploit) hidden vulnerabilities in critical computing hardware over the longer term.

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Biden’s Central Challenge: Managing U.S.-China Relations While Fostering U.S. Security and Competitiveness

Although the Biden administration has said it intends to cooperate with China in areas of overlapping interest such as global health, nuclear weapons proliferation, and climate change, it has also signaled that tensions between the U.S. and China over semiconductors will continue under President Biden. In an interview at the Hudson Institute, U.S. Secretary of State Antony Blinken stated, “the status quo [with China] was not really sustainable particularly when it comes to China’s commercial and economic practices, the lack of reciprocity in the relationships needs to be dealt with…We are in a competition with China, and there’s nothing wrong with competition if it’s fair.” Biden has also similarly criticized China’s economic behavior, citing Beijing’s unfair subsidies to state-owned firms and “robbing” U.S. companies of technology. In the short run, foreign policy experts assert that the administration will likely exacerbate trade conflicts with China given the administration’s goals to bolster U.S.-made goods, subsidize domestic industries, and ban foreign companies from government procurement. Moreover, Biden has stated that he will not immediately reverse the trade measures, including restrictions on semiconductors and advanced technologies, until the U.S. consults with allies.

Unlike the previous administration, the Biden team is prioritizing a multilateral, ally-focused approach with initiatives aimed to boost American economic competitiveness to curb China’s rise rather than use punitive measures. The administration could build security and resiliency in the semiconductor supply chain and the industry at large by working with Taiwan along with like-minded allies toward their common objectives. Both the U.S. and Taiwan seek to reduce their reliance on Chinese suppliers for key components and materials. The Taiwanese government has implemented rules to ensure that American companies’ properties and interests are safeguarded in the Trade Secrets Act and the Copyright Act, as demonstrated by the government’s indictment of UMC’s actions with JJHIC against Micron Technologies. Given Taiwan’s essential role in the foundry segment of the supply chain, Taiwanese firms could work with American companies to reorient their production models and diversify their supply chains, both in terms of physical manufacturing locations and its suppliers.

Another core element of the administration’s agenda to reduce U.S. dependence on foreign manufacturers is enhancing domestic manufacturing. In particular, it is devoting $300 billion to research and development efforts in “breakthrough technologies” such as AI, 5G, and electric vehicles, and $400 billion for a “Buy American” procurement fund to incentivize manufacturers. The Biden administration has also promised, within the first 100 days of his presidency, to initiate an ongoing, governmentwide process to monitor supply chain vulnerabilities, close identified gaps, build resiliency so the supply chain can withstand shocks like COVID-19, and “crack down on anti-competitive practices.” In February 2020, President Biden followed through on his promise, after announcing plans to sign an executive order to address semiconductor shortages and evaluate the current state of the supply chain. These initiatives are critical to maintaining the U.S. lead in the semiconductor industry, and more broadly, ensuring that the U.S. has continued access to essential technology. TSMC’s new factory in Arizona is a significant step toward bringing manufacturing back to the U.S., but more work must be done. Some companies have looked to move their operations out of Taiwan, but not necessarily to the U.S., because of costs to build and maintain a fab there.

Given the Trump administration’s anti-China policies over the past four years, China may push Biden to take a more definitive stance on the One China policy and establish boundaries on U.S. unofficial relations with Taiwan. But while the Biden administration will likely be less public about American cooperation with Taiwan than the Trump administration, early signals by the Biden team, such as Blinken’s outward support for closer U.S.-Taiwan economic relations, indicate strong support for stronger U.S.-Taiwan ties. Phone calls between national security advisor Jake Sullivan and President Tsai, the White House National Security Council’s statement committing “rock solid” support to Taiwan, and Taiwan’s de-facto ambassador to the U.S. attending Biden’s inauguration for the first time indicate that Taiwan will remain a focal point. Biden’s appointment of Katherine Tai, who spent seven years litigating against China on behalf of the U.S. at the World Trade Organization as U.S. Trade Representative, further demonstrates U.S. resolve to hold China accountable on trade practices. Similarly, U.S. Secretary of Commerce Gina Raimondo said in her Senate confirmation hearing that she will be “very aggressive in combating China’s unfair trade practices” and work with allies to address China’s IP theft, state subsidies, and efforts to block out Western companies from the Chinese market.

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Looking Ahead: Key Opportunities for the Biden Administration and Beyond

Semiconductors represent an essential building block for all digital goods and services, and are fundamental for advanced manufacturing and military applications. The proliferation of IoT devices, increasing integration of artificial intelligence, and the drive for quantum computing will only compound demand and raise the stakes for industry and our economies on which they increasingly depend. The U.S.-China-Taiwan nexus demonstrates the complex economic, technological, and geopolitical dynamics at each node of the semiconductor supply chain and highlights the importance of this strategic economic and technological conflict for foreign policy going forward.  The U.S.-China trade war and associated supply chain disruptions have been a wake-up call for the industry, forcing companies to thoroughly evaluate and map out their production and supply chains. Shortages of materials, components, and finished goods have reduced the industry’s short-term growth, and many firms acknowledge that they are unaware of the tiers of suppliers they rely on.

The U.S.-China trade war and associated supply chain disruptions have been a wake-up call for the industry, forcing companies to thoroughly evaluate and map out their production and supply chains. As semiconductors play an increasingly important role in the global economic and security arena, tension is growing between national security and commercial interests and creates potential for conflict. Existing multinational frameworks such as the 1996 Wassenaar Agreement (WA), the first global arrangement on export controls for conventional weapons and sensitive dual-use goods and technologies, including semiconductors and related technologies, attempts to address supply chain issues by increasing transparency and cooperation among member states on export controls. The agreement is not itself legally binding with enforcement coming from the 42 member countries themselves and the WA notably does not include Taiwan or China—although Taiwan does follow the international standards set by the agreement independently.  Other multi-stakeholder forums that include the private sector such as the Economic Prosperity Partnership Dialogue (EPP) and the Strategic Economic Dialogue, which focus on U.S.-Taiwanese and Sino-American relations, respectively, are opportunities for comprehensive strategic cooperation on supply chain, telecommunication, and overall technology security.

Although China is unlikely to achieve advanced independent semiconductor manufacturing in the near term, increased collaboration among all global actors of the industry—private and public—is necessary to help ensure resilient supply chains. Beyond strengthening IP rules and establishing a fair standard of trade practices, further attention must be given to current tax policies and structures in the U.S. that disincentivize companies from investing in local manufacturing facilities, streamlining the permit process to reduce the time it takes to obtain permission to build domestic fabs, and increasing transparency in the export control process, specifically the exceptions to commerce rules that are currently not public information. Consideration of industry input by Congress and relevant agencies could help ensure that a comprehensive approach is taken to address key supply chain risks that companies face. This includes applying the scope of Huawei-related Entity List prohibitions to all entity lists, such as anti-terrorism-only and EAR99 technology, which industry associations argue will advance U.S. tech leadership while allowing non-U.S. member to contribute unpublished U.S.-origin technology. More narrowly defining foundational technologies and national security objectives to clarify what technologies fall within the scope of potential controls, and implementing a metric to assess the impact export controls may have on industries before adding entities to the Department of Commerce’s BIS, could also help manage policy impacts.

The Biden administration’s focus on multilateralism and enhancing U.S. economic competitiveness to curb China’s rise in the global arena opens opportunities for cross-regional and cross-sector collaboration. As the world becomes more interconnected and emerging technology redefines society, the U.S. will need to rely on its friends, partners, and allies whose contributions to the semiconductor ecosystem stimulate innovation and sustained global economic growth going forward.