Impact on China of US semiconductor export regulations, bump in the road or worse?

In the latest episode of the Emerging Markets Equity podcast, Nick Robinson sits down with Pruska Iamthongthong and Karl Li to discuss the new chip export restrictions, what they are, and also implications for China and those companies in the supply chain.

Transcript

Nick: Hello everybody, and welcome to the abrdn Emerging Markets Equity Podcast. I'm Nick Robinson from the EM Equity team. In this podcast series we explore the factors that underpin our thinking on emerging markets from key individuals to evolving trends. We seek to answer the five W's: Who; What; Where; When and Why that are shaping investment opportunities in the region. 

In October this year, 2022, the US Department of Commerce issued a new and exceptionally broad set of restrictions on exports to China of semiconductor chips and other high end tech equipment. After the Trump era, there had been hopes that trade relations with China might normalize, that these new rules mark a major shift in the Biden administration's China strategy, and they present a serious threat to high tech industries in China. Washington think tank CSIS, called the White House's new approach to the Chinese tech sector, ‘strangling with an intent to kill’.

The idea that over time, China should be less dependent on foreign imports or localization, has been a key theme of the country's vision for the future. However, semiconductors are one area where China struggles to compete, and non-Chinese manufacturers still dominate. Today, China remains dependent on chip imports, particularly of high-end chips, and the country spends more on importing chips each year than it does on oil. So in this episode, we're going to discuss these new chip export restrictions, what they are, and also implications for China and those companies in the supply chain that will be impacted. 

Today, I'm lucky enough to have two colleagues joining me to help make sense of these rules. Firstly, Pruksa Iamthongthong – Pruksa’s been with the firm for 15 years, and one of her many expertise is covering semiconductors and tech hardware companies. Pruksa, I think we could describe you as a regular now that you're on your third time. So welcome back to the podcast. 

Pruksa: Hi, Nick. Good to be back. 

Nick: And then today, we're also joined by Karl Li. Karl is an analyst at the firm who's based out of our Shanghai office, and he covers Chinese tech hardware and semiconductors companies. Karl, welcome to the podcast, and thanks for joining today.

Karl: Great. Hello. Thanks, Nick.

Nick: So Pruksa, let's kick off with some broader questions. Do you think you could provide a bit of an overview of these new export regulations and how do they compare to previous protectionist measures and sanctions we've seen?

Pruksa: Yeah, sure, Nick. I think you can summarise the new regulations to see they are certainly more complex and more comprehensive. And I think it's really quite a thick set of documents that the industry including ourselves have been trying to go through as well. 

So, if you were to break things down a bit, in terms of export control, it's focused on three key areas. The first would be on chips; the second would be on the equipment that make these chips; and the third would be on the people that make these chips. So pretty comprehensive from a restriction point of view. 

So first, let's start with the chips. On the chips front, the restriction is really on exports of high-performance IC which stands for Integrated Circuits and this is restricted without a licence. Now, the question is how is ‘high performance’ actually defined? If you look at that, then there will be IC’s that have bi-directional transfer rate over all inputs and outputs of 600 gigabytes per second or more. Basically, that may not mean very much to you, but in conclusion, this will impact a very high-end GPU in terms of the way that this is defined. 

The second area will be in terms of equipment, you actually need a licence to sell to semiconductor fabrication facilities in China for the equipment to hit this threshold and this threshold are the ones that such as you know, you look at the logic chips, then it will be those with nonplanar transistor architecture of 16 nanometer or 14 nanometer or below. The second area will be in terms of DRAM memory chips of 80 nanometer. And the third area would be in terms of NAN flash memory chips with 128 layers or more. So essentially again to summarise, what this means is that equipment that are used to make some of this higher end semiconductor chips - whether on the logic or memory front -   are also being restricted. And what I've mentioned just now is really about the way that advanced semiconductor chips are defined by the rule. 

So, the third area will be in terms of people. And in this case, when we talk about people, we refer to US persons. The control is really on US person activities on development and production of integrated circuits at semiconductor fabrication facilities for advanced semiconductors, so this is a control at the factory level. The other control is also on semiconductor production equipment in China. And this is at the equipment level. So you'd see again, that the rule itself has extended and becomes a bit more comprehensive. And this is the reason why this is pretty important, it’s really because a lot of IP intellectual properties in terms of the knowledge of how to make these chips actually also sit with Chinese returnees that have been either educated in the US or have worked in the US and many of them have also become either US citizens or hold the green card. And this definition falls under US persons. So this overall would also impact talent retention and development in this field, where you actually do need this knowledge to develop advanced semiconductor chips. 

So now when you put everything together, overall, this is an aim at controlling key inputs in advanced semiconductor manufacturing, and it's really designed to pluck some loopholes left in the last round of export control regulation. 

Nick: So there's been some debate over the extent to which these new regulations are designed not just to limit development of chips for military, but to hobble the entire semis industry in China, and even go as far as damaging the Chinese economy. So, what's your take on what the US is trying to achieve here?

Pruksa: I think what the US is trying to achieve here is not really to inflict huge damage to the Chinese economy, so they are not looking for like a decoupling of the economies altogether. Overall, what these rules are designed to do is to really stop China from advancing in leading edge semiconductor technologies, which they are deemed to be used by China to advance their military capabilities, and as a result, pose a national security threat to the US. So really, the restriction is on advanced semiconductor technologies. And just to quote the press released by the BIS, which stands for the Bureau of Industry and Security, these updates will restrict China's ability to both purchase and manufacture certain high-end chips used in military applications and builds on prior policies to restrict China's ability to obtain advanced computing chips, develop and maintain supercomputers and manufacture advanced semiconductor. 

The other thing that is quite interesting that we are observing right now is also that the nature of this approach is also looking to be changing. I'm quoting another advisor here. So, Jake Sullivan, who is the National Security Adviser just made a recent speech in September 2022, just prior to the release of these rules, and his thoughts is that with respect to export controls, we have to revisit the long-standing premise of maintaining relative advantages over competitors in key technologies - competitors in this case, is really referring to China. And he shared that given the foundational nature of certain technologies such as advanced logic and memory chips, we must maintain as much of a lead as possible. So when you put that together again, reading between the lines, there seems to be a shift of a relative sliding scale kind of approach to one that is more ‘absolutely’, as well. And the distinction here is pretty important. Because while the restrictions are targeted at advanced semiconductor chips today, and as a result, it does not impact mature technologies, this actually doesn't mean that it will not impact mature technologies of tomorrow. And this is really because computing power improves everyday. So it really remains to be seen if the US will look to update the threshold down the road when we look into the future. And I think ultimately, that will determine the impact on the Chinese economy over the long run.

Nick: That's really interesting in terms of how the impact of the regulations may become more severe over time, depending on how they're updated. I suppose, you know, it's pretty early days with the regulations. Today at time of recording, they’re only a couple of months old. So are there any indications of what the impact’s been so far? And, what the international companies that sell into China that I know you cover what have they been saying?

Pruksa: Yeah, still pretty early days. And as you can imagine, we are trying to get as much information from our companies as possible. And our companies are also trying to get as much information from the legal experts that they engage with as much as possible as well. 

 But I think, to summarise overall, it really differs from company to company, because the way that the rules are returned, it is actually very company specific, depending on their relative exposure, but also depending on how the companies actually interpret the rules. So, so far, operationally, there are some disruptions, as companies are taking a more conservative stance until they are able to get sufficient legal advice or they are able to have further clarifications on some of the interpretations of the above complex and comprehensive set of regulations. 

So, we have heard by now, how companies have actually removed that US persons from customer sites. In terms of maintenance, for example, some companies go to that extreme. But overall, the mitigating factor for that is that because of the pandemic in China, many companies actually cannot send the US persons in, anyway. And therefore, therefore, they have actually developed a local servicing capability as a result. So, from that perspective, is actually not that bad. 

But I've put together a few examples here just to share with you how things differ as well. So in the case of one of our Dutch semiconductor equipment companies, that obviously have customers in China, while they assess that direct impact for them is actually minimal. Given that they are a Dutch company, and they have lower US content that is below the threshold, there is actually some indirect impact, because their clients may not actually get access to other US equipment that make up the whole manufacturing value chain. And as a result, this might impact the demand of the specific equipment that the company sells. 

In the case of our Korean or Taiwanese companies that have fabrication facilities in China, what we have heard is that they have actually been granted a temporary licence. And this means that they are able to obtain equipment that are necessary to support the production. So in that sense, their production is actually not impacted. However, the key here is that we got to see what this actually means for longer term capacity planning and additional investment in China. And this is really, because when you think about capital expenditure in this area, it is actually very expensive. And a one year type window doesn't really give you sufficient comfort for making those investments as well. So what we are trying to do today is we are very busy speaking to every company in our portfolio, just to understand how they are interpreting these regulations, you know, what assumptions they are making when they make a certain statement in terms of the assessment of the impact to the earnings, and really how this impacts their strategy in China and ex China expansion going forward over the long term as well. So clearly a lot of moving parts, but it's still pretty early days.

Nick: Yeah, sounds like a lot of work being done there. So I think it'd be great now to switch over to you, Karl, and get a bit of a view from the ground in terms of what's going on at the moment. So, yeah, as I mentioned in the introduction, localization is a pretty big theme in China investing at the moment. So how's that been going in terms of China chip technology?

Karl: Yeah. Thanks, Nick. And yes, as you say, China's quite determined in localization. So as you know, China is basically the largest semiconductor importer now globally, and the value of semiconductor imports every year has now exceeded that of oil and gas. So there's a strong desire in first place to be self-sufficient and self-abundant. Moreover, there's critical urgency now to close the gap. Because semiconductor deficit, has now further escalated into a national security issue. Pretty much on tensions with the US. And the sustainability of the supply chain in advanced tech and manufacturing, which is quite important to the company might be also crumbling, if they are not able to secure the underlying chip technology. So, China has been doing a lot of work here. The localization efforts can be dated back as early as 2000s. And it's not until recent year when we start to see more remarkable progress. 

So, the localization effort can be roughly sorted into two directions. The first one is localization of semiconductor products. This is a relatively easier go as local design houses have been bumped up their technology competitors in the past decade quite well. So the national call on semiconductor has certainly brought capital flows into the space. And this has greatly appreciated valuation of semiconductor company and attracted many written needs from the likes of Silicon Valley. And that serves a diverse batch of talent pool and a source of know how in chip technology, pretty much as a result of this, some categories like smartphone chip, analogue, has seen a quite sharp localization rates back in the past few years, from just low single digit to double digit and even above nowadays.

Turn to the other page is localization of manufacturing of capacity. This is bumpy road, I have to say, as just where China has lagged western world by decades, and US has certainly tried to curtail China in its own fabrication capability. This can be done by restricting semiconductor equipment export to China, as you can see in the latest export control. That said, China has not given up this effort. They have been doing a lot of things by bringing up this home grown semiconductor equipment makers. This makers are either transformed from a state owned Research Institute, leveraging on the power of local academics, or established by leveraging on technology know how in developed markets. 

So as of today, as you can see, I think the model has worked pretty well. And in some equipment sections, like cleaning or etching, China has been able to achieve at least double digit of localization rate, and some equipment makers have already started to ship overseas. So to summarise, I n short, we have seen very impressive growth in China's chip localization in the past few years. But we are still at a very early stage of the giant semiconductor consumer voice localization stage,

Nick: When the US in the past when it's issued sanctions has been more focused on limiting development of military technology within China. Whereas there is certainly scope for much more commercial applications of semiconductors to be limited by these new regulations. So how do you see that in terms of the extent that commercial uses of semis might be restricted going forward?

Karl: So as Pruksa mentioned, the intention of this new export control is just to stop China from advancing and leading as chip technology, so as to avoid, for example, military use of US technology. However, another important thing or the bottom line thinking is that this needs to be balanced with the consideration of commercial opportunities, because China is also a very big market for US semiconductor equipment companies, as it is the world's largest semiconductor importer. So a result of this balance, comes from two lines. 

First one is advanced note, and second line is fabrication facilities. So everything falling into these two lines will be considered critical, and hence will be restricted while the rest of the semiconductor products extension exchanger are left intact to ensure that the big market has not gone. So if we look back to the two lines that we've just discussed of localization by China, then the picture will be quite clear. So coming first on semiconductor products, the restriction on this new role have been quite deliberately limited within certain types of high end chips, which are conceded relevant to artificial intelligence or military use. So as a result of this, vast majority of consumption and design activities are actually left intact. So our visit with local clients like internet companies or consumer electronics brands, suggests that there have been very limited impact to their daily procurement aside from certain high end chips. 

While there are also some concerns on US personal restriction as Pruksa has mentioned, the various companies that we visit also comment that there has been no impact on their management and talents who are US citizens, because they are not involved in any fabrication facilities. So, turning to manufacturing capability, that's where things have been very critical and complicated. So one of the biggest additions of this new export control is the inclusion of YMTC who has been playing a very key role in verifying and running local equipment. This may curtail the further evolution of local equipment makers and hence stop China from advancing this local manufacturing capability. And another restriction on US person is also quite critical, I would say, as this will also bottleneck China's ability to further gain technology know how in fabrication from US through attracting talents or attracting return needs. Hence, as you can see, both equipment and talents being critical to China's ability to advance its technology in the long run, are more quite constrained by this new export control rule. So, in short, the new export control does not pose a big strike to China's existing demand and design of semiconductor products. But it has a pretty profound restriction on China's ability to advance its technology in chips in the long term.

Nick: I suppose thinking about the long term and future growth drivers of economies worldwide, there's been a lot of focus on artificial intelligence and the advanced chips that are required to facilitate that technology. I mean, it's early days yet but you know, what's your initial take on how much of a setback China's had here by lack of access to some of the higher end chips.

Karl: I think one of the critical bottom lines that has specifically stated their intention to block China's ability of AI, this is going to be quite painful if we're looking to the long term. 

So starting with near term, I think it is still okay, because the impact should be still controllable, given multiple mitigation measures in place. For example, some of the consumers may have quite lengthy periods of inventories. US vendors like Nvidia also work to the spec to some extent, to come below that threshold. So, so far, most of the customers that we have visited have commented, quite limited impact with their chip procurement and AI development. So, in near term, they’re still okay. But coming to long term thing, the setback is quite likely to happen. So if we're based on the new export control rule, all Chinese companies are subject to US licence requirements if they want to buy advanced chips that's restricted by the US. So basically, this is defined by the tops of 600 gigabytes per second transmission speed. This rule is designed as a presumption of denial, which means that it is highly unlikely that any licence will be granted. So the performance thresholds set like limits a lot of HPC AI or GPU or ASIC accelerator chips, so companies involving for example the lack of quantum computing or autonomous driving, are quite likely to be affected as a result, especially if the threat score does not evolve over time.  So this clamps the visibility for, or I should say more precisely capped China's AI capability in the long run. And that's the risk that we need to monitor going forward.

Nick: I mean, that's really interesting. So another example of how the regulation might become more impactful as time goes on. I think that's a good place to draw the podcast to a close. So with that, I'd really like to thank my guests, Pruksa and Karl, it’s been great having you on today.

Karl: Great. Thanks, Nick. 

Pruksa: Good to be here, Nick. 

Nick: And thanks to everyone who took the time today to listen in. If you enjoyed today, then please download our other podcasts from our website or wherever you normally get your podcasts. Watch out for our next episode, and tune in.