China's path to building a cutting-edge semiconductor industry is narrow. Recent measures to curtail the country's access to advanced chips and equipment will challenge its progress for years to come. However, S&P Global believes the restrictions will drive China to marshal its considerable resources in a "moon-shot" style push to advance the sector.

These restrictions are narrow in scope. We do not expect them to materially hit China's economy, but they do create major obstacles for the country in the global competition in cutting-edge technologies, particularly those applicable to military use.

Although China has a large mature-chip industry that supplies electric vehicles, smartphones and computers, know-how in producing such chips does not easily translate to capabilities in producing advanced chips.

Currently, the country's advanced chips production is heavily reliant on U.S., European, and Japanese suppliers. China has domestic equipment makers, but they also rely on foreign technology, and their abilities remain well behind advanced global peers.

Challenges posed by recent restrictions imply it could take decades for Chinese firms to catch up, requiring significant time and a mobilization of national resources.

That said, innovation doesn't follow a straight line, and developments can occur unexpectedly. One example is Huawei Technologies Co. Ltd.'s new Mate 60 Pro smartphone that uses a 7 nanometer (nm) chip (see Huawei box).

China's efforts to catch up on advanced chips will involve mobilizing the country's financial and human capital, backed by both the public and private sectors, including the country's tech giants. Recent restrictions have only made the call more urgent.

A Matter Of National Security

Jarring supply disruptions during the pandemic drove policymakers around the world to secure access to chips as a matter of national security.

The U.S. passed the CHIPS Act in 2022 to provide US$52.7 billion in semiconductor research and development and manufacturing incentives over 10 years. Less than a year later, the EU passed the €43 billion EU CHIPS Act with an explicit target of doubling its share of global production of advanced chips to 20% by 2030. This came within months of Japan announcing a plan to triple the sale of semiconductors made in the country to more than ¥15 trillion (US$113 billion) by 2030.

These initiatives were accompanied by restrictions against the sale of advanced chips and equipment. The U.S. unveiled sequential measures in 2022, and in October 2023, which restricted the export of advanced chips and equipment to China that could be used for artificial intelligence, military use, and supercomputing. Japan and the Netherlands followed with similar measures in 2023 (see chart 1).

Chart 1

U.S.-Led Export Controls Present A Headache To China

The U.S. has imposed the so-called "small yard, high fence" controls on technology exports to China. This means they are narrowly targeted at specific chip-making processes but are highly restrictive. They will significantly curtail China's ability to buy and make advanced chips.

This is because China relies on imported equipment and materials to make advanced chips, particularly those from U.S., European, and Japanese suppliers. Chinese chip firms are particularly dependent on the offshore providers of electronic design automation (EDA) software, integrated circuit (IC) design, semiconductor manufacturing equipment and materials.

For example, the Dutch government has barred ASML Holding N.V. from selling its industry-leading lithography machines, particularly the more advanced extreme ultraviolet (EUV) standard to "print" circuit patterns onto silicon wafers. This ban effectively prevents mainland Chinese semiconductor fabrication plants (fabs) from making the most advanced chips.

China has domestic makers of lithography machines such as Shanghai Micro Electronics Equipment Group Co. Ltd. (SMEE). However, despite being the country's most advanced semiconductor equipment manufacturer, SMEE's lithography machines can only produce chips at the 90nm node, according to its website.

According to media reports, the company aims to deliver its first deep ultraviolet lithography systems later this year that can support 28nm chip production.

Even so, Chinese lithography equipment suppliers use components that may rely on imported technology from foreign partners. For example, the optics firm Changchun UP Optotech Co. Ltd., which sells equipment to SMEE, identifies the German-based iC-Haus GmbH as its second-largest supplier.

Localization And Its Discontents

Although current policies focus on curtailing China's access to advanced chips and equipment, shifts in approach may occur over time.

In just one year, discussions among U.S. policy makers have already moved away from "decoupling", or economic separation from China, to "de-risking", or reducing the risk of excessive reliance on China.

Discussions among foreign companies have also shifted from full onshoring (moving production onshore) to a mix of near-shoring (moving production to a nearby country) and China-plus-one (keeping some production in China but moving some capacity to another country). Over time, if the costs of localization mount and the post-pandemic impulse to localize eases, further policy shifts may occur.

These shifts are more likely for industries with highly specialized and globally distributed supply chains, such as semiconductors. TSMC's case study is often cited as an example of the effectiveness of state support (see TSMC box). However, it equally highlights the semiconductor sector's reliance on imported talent, equipment, and technologies from advanced global peers.

Such interdependence spans the semiconductor supply chain. Currently the U.S. leads in EDA software, chip design, core IP (intellectual property in chip design), and fab tools. Europe leads in core IP and advanced lithography equipment, Korea leads in design and fabs, Japan leads in assembly, testing and packaging (ATP) tools and fab materials and ATP materials, while China and others lead in ATP and ATP materials.

Chinese fabs rely on Dutch EUV lithography machines to make advanced chips, and Dutch machine makers such as ASML rely on equipment from dozens of highly specialized global suppliers.

As China's semiconductor equipment imports decline (see chart 2), global makers of such equipment may feel the pain, particularly if alternative markets of comparable size are not readily available. Managers at international firms unhappy with lost sales could eventually move against further restrictions.

Chart 2

Catching Up Is Hard To Do

As much of the supply chain to make advanced chips resides outside of China, catching up will be difficult. China has little presence in intellectual property (IP) cores, particularly those used for IC design on key microprocessor architectures such as ARM or x86. It is also behind on the fab tools needed to make advanced chips, such as EUV machines.

As one indication of the magnitude of the gap, leading global EDA software companies, chip-design firms, and foundries on average have 4x-7x more patents than their Chinese counterparts (see chart 3).

China is leveraging open-source architectures such as RISC-V to develop its own IP cores for microprocessor designs. However closing the gap in these segments will take significant time, resources, and persistence.

Marathon versus sprint

China has shown a commitment to long-term planning focused on a set of national priorities. Beijing views such endeavors as best led by the state rather than left to the private sector alone. Catching up on advanced chips will be no different.

China began prioritizing chipmaking in June 2014 (see table 1 in the Appendix), when the State Council issued guidelines for the development of the IC industry. This document set out financial, tax and other support for developing design, manufacturing, package testing, and equipment materials.

This was followed in 2015 by the State Council's "Made in China 2025", which aimed to boost domestic chips production to meet 70% of the country's needs by 2025, and to achieve global leadership in all stages of production by 2030. It also designated ICs and special equipment as new-generation IT industries and included them in the 10 key development fields.

The National Development and Reform Commission, China's top economic planning body, issues guidance every year to identify and promote areas for improvement for the country's chip development (see table 1).

In March 2023, then-Chinese Vice Premier Liu He called for a mobilization of nationwide resources across both the public and private sectors to develop the country's semiconductor industry. A week later, in the closing address of the National People's Congress, President Xi emphasized that "China should work to achieve greater self-reliance and strength in science and technology".

Chart 3

State-led development

The government's efforts, in combination with China's large manufacturing production base and entrepreneurial private sector, helped the country to become the global leader in solar energy, making about 70% of the world's photovoltaic modules.

State support also pushed China's electric vehicle (EV) penetration rate to the highest in the world in just two years, producing more EVs than all other countries combined (see "Glimmers Of Winners Emerge In Asia's EV Push," May 15, 2023).

Beijing is also leveraging its dominance in EV batteries and materials and pushing next-generation technologies including 5G, cloud computing, internet of things, and autonomous vehicles (see "Cutting China From Supply Chains--Easy To Say, Hard To Do," June 1, 2022). Catching up on advanced chips is an integral part of these plans.

A Well-Resourced Public Push

Recent advanced-chip restrictions have made catching up more urgent. This has further aligned the interests of the public and the private sectors.

The government is channeling considerable capital to these efforts. For example, the state-backed China Integrated Circuit Industry Investment Fund (CIIF) raised over US$50 billion between 2014 and 2020. In September, Beijing launched another fund under CIIF to raise up to US$41 billion. The fund will specifically target the domestic development of chip manufacturing equipment. The Ministry of Finance reportedly aims to contribute US$8.3 billion.

CIIF has a mixed record in supporting the sector's development in part due to implied government backing, which could lead to poor investments. Nevertheless, the additional funding signals the government's commitment and will fuel related efforts for years to come.

Calls on the private sector

The private sector may also be called upon to channel its significant pools of human and financial capital to this effort.

For example, the government may encourage the country's large tech firms to support the development of an indigenous advanced chips market. Huawei, Xiaomi Corp., Alibaba Group Holding Ltd., Tencent Holdings Ltd., Baidu Inc. and others could be called upon to support domestically made advanced chips. The launch of Huawei's Mate 60 Pro shows that China's large consumer base is also likely to support products seen as made in China.

The advanced chip restrictions also led to an unintended consequence: it created incentives for China's semiconductor industry to collaborate. Before their imposition, because of the industry's highly specialized and globally distributed supply chain, Chinese firms preferred to work with leading foreign firms of the supply chain segment they depended on. The restrictions removed this dependency and compelled Chinese firms to collaborate with Chinese suppliers, which could facilitate the localization of the country's chip industry.

Human capital and talent pools

The government may look for ways to better leverage the country's large pools of science and technology talent.

By 2025, China will produce almost three times as many math and science PhDs annually as the U.S., with nearly 80,000 graduates, versus about 21,000 for the U.S. If the estimated 20,000 international students studying in the U.S. are included in the latter, China's estimated total would still be double that of the U.S. (see chart 4).

Chinese policies that encouraged talent to commit to key, nascent industries has supported the country's rapid progress in technology over the past decades. Although the country is producing more science and technology talent, such policies remain critical to the effective use of that resource.

Chart 4

A Matter Of Time And Economics

China's efforts to catch up on advanced chips parallel state-led efforts in other countries. Recent restrictions only made the call more urgent.

The industry is one where government support makes a key difference, but it is also one where global integration is crucial. The present approach of pushing localization and escalating restrictions may prove costly over time, particularly for global consumers and chip producers, given it raises costs, requires expenditure, and obstructs the industry's development

Advanced chip restrictions are the main factor now limiting China's semiconductor advancement. This suggests these constraints may not deter the country's ambitions as it mobilizes its considerable resources in pursuit of its long-term goals.

Appendix

Table 1

Table 2

Writer: Jasper Moiseiwitsch

Digital designer: Evy Cheung

Related Research

• Glimmers Of Winners Emerge In Asia's EV Push, May 15, 2023
• China's Semiconductor Industry Can't Quit German Optics, The China Project, May 1, 2023
• Cutting China From Supply Chains--Easy To Say, Hard To Do, June 1, 2022