China’s “COVID zero” policy hurts its semiconductor dreams

Despite the easing of the strict lockdown in Shanghai in early June, the market was obsessed with gloomy forecasts for the city and even for the outlook for China’s national economy, especially supply chain of the main industrial sectors, such as integrated circuits (ICs). In recent years, the Chinese government has been more eager than ever to revitalize its integrated circuit industry with a “nationwide system” in response to fierce technological competition from the United States. However, there is no doubt that Beijing’s commitment to “zero tolerance” for local outbreaks has also hit the development of high-tech industries hard.

Faced with two pressing priorities, the Chinese Communist Party (CCP) will have to make a strategic choice.

“National system” and technical competition between China and the United States

Adopted in the Soviet Union, the “nationwide system” is a centralized mechanism for developing states to achieve a strategic goal by mobilizing all possible resources. One of the most typical examples is “Five-Year Plan”, a comprehensive social and economic development initiative issued by the CPC since 1953, outlining national strategies for the regime’s vision of socialist transformation and industrialization. In particular, this political model of mass mobilization represents Beijing’s determined response to make up for its shortcomings in a certain area, and it is generally effective. To some extent, China’s leading position in sports is the result of this nationwide system of mobilization.

It is widely acknowledged that the deterioration of Sino-US relations is the most important factor behind Beijing’s plan to develop the integrated circuit industry. Since March 2018, when the Trump administration has consistently initiated Section 301 investigationBy targeting China and imposing retaliatory tariffs on Chinese steel and aluminum, the bilateral conflict has gradually spilled over into the technology industry. Washington and its allies have violently suppressed and marginalized Chinese high-tech companies in the global marketplace. By December 2021, the US Bureau of Industry and Security had blacklisted it. 611 Chinese companies and institutions, most of which are in the high-tech industry, such as the design and manufacture of microchips. In addition, the differences between the two sides on human rights and political issues are reflected in US sanctions against Chinese tech giants who allegedly maintain close ties to the CCP, making the initial technical rivalry more difficult.

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The Sino-American technology competition has accelerated China’s efforts to independently develop and manufacture integrated circuit equipment. In December 2020, chip design and manufacturing played an unprecedented priority role in expanding the state’s capabilities in technological innovation and breakthrough, industrial transformation and expansion of the digital economy in the 14th five-year plan. As a result, Beijing again resorted to a nationwide system to achieve its strategic goal in the IP industry.

In 2019 the Ministry of Finance created a special fund with $30.5 billion to invest in the IP industry. Enterprises and IC projects enjoy tax credit ranging from 10 to 25 percent, depending on the duration of operation and technical criteria. On the other hand, local authorities also pursue a variety of industrial policies, following the guidance of top decision makers. Shaanxi aims to surpass the share of the digital economy to more than 10 percent of GDP by 2025. In Guangzhou, the local government committed to strengthen the protection of the intellectual property of chips through package of legislative acts.

The training of chip specialists is another incentive to strengthen the integrated circuit industry. Until 2021, a group of China’s leading colleges, including Tsinghua University, Peking University and Fudan University, open IC schools or faculties for growing professionals. The number of research institutions continues to grow. In addition, high-tech enterprises are another incubator for chip talent. According to the official white paper, the demand for talent in the domestic IP market will increase to around 745 000 by 2022. This alone helps to demonstrate the sheer size and momentum of semiconductor companies in China’s tech market.

Undoubtedly, the government, higher education institutions and technology enterprises constitute the “iron triangle” of China’s strategy to invest in the integrated circuit industry. This model supports the aspiration of the state to become one of the leading players in the global market. Between January and September 2021 internal data showed that China’s chip manufacturing capacity grew rapidly with revenue of $108.4 billion, an increase of 16.1 percent year on year. Meanwhile, China has become the largest market for semiconductor products as its orders for chip manufacturing equipment from foreign suppliers up 58 percent.

However, with Beijing’s uncompromising stance in implementing a zero-COVID policy to combat local outbreaks, China’s strategy to rejuvenate the integrated circuit industry is facing the internal challenge of another nationwide policy.

How the zero-COVID policy has affected China’s IC supply chain

Along with the deterioration of China’s diplomatic relations with the Western world, the global pandemic has forced the ruling elites in Beijing to transform economic governance into “Double Edition” that gave priority to domestic consumption while remaining open to international trade. However, the IC supply chain is still collapsing due to the local government’s tough response to the Omicron outbreak since March in Shanghai. The metropolitan area is home to many leading Chinese and global semiconductor manufacturers such as SMIC and TSMC.

Although the supply chain management approach was more conservative in the past, prioritizing sustainability over expansion, the drastic measure of forced shutdowns still triggered a new wave of supply chain logistics crisis in the Yangtze Delta region. According to official data released by the National Bureau of Statistics (NBS), IC production in China fell 4.2 percent in the first three months of the year, as chipmakers reported a sharper decline in March. This is the worst quarterly result since the first quarter of 2019, when decline 8.7 percent. With the chip business already hampered by a shortage of semiconductors, the coronavirus lockdown was a double whammy for China’s integrated circuit industry.

In response to the industry’s problems, Beijing has taken several steps to save the supply chain. April 18th, national conference hosted by Chinese Vice Premier Liu He proposed that the government raise 1 trillion yuan ($157 billion) in funding from fading central bank projects to strengthen the supply chain. According to the instruction, the Ministry of Industry and Information Technologies issued a whitelist of 666 businesses in IC, automotive, equipment manufacturing and pharmaceuticals, enabling them to resume production. At least 62 semiconductor companies profited from the new policy.

Having received permission to resume work, IC plants were allowed to operate in accordance with closed control; the system allows the appropriate people to move and act in the designated area, guaranteeing the operation of a certain mechanism and preventing the spread of the coronavirus. The local chip manufacturing plant in Shanghai of TSMC, one of the world’s leading semiconductor companies based in Taiwan, has been allowed to continue operating to produce 8-inch wafers under a “closed loop system”. The manager even said 70 percent of the workforce can maintain full production capacity.

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In line with the government’s aid package and the easing of restrictions related to COVID-19, China’s semiconductor manufacturing rose in May. jumped slightly more than 6 percent to 27.5 billion from 25.9 billion units in April, according to the NBS. But this number was still less than 28.5 billion units produced in March, before quarantine in Shanghai. Moreover, with increase in new confirmed cases in July, it is unclear whether potential drastic measures by local authorities to combat the pandemic will affect production in the integrated circuit industry. Consequently, China’s semiconductor strategy faces more serious internal challenges than external ones.

The double-edged sword of the Chinese “nationwide system”

Jeffrey Hertz & Miles M. Evers comparative study of government-business relations between China and the United States. points to the strengths of Beijing in the fight against geo-economic competition with Washington. The nature of party-state and state capitalism, which combines elements of a market economy with significant state intervention in key industries, demonstrates the resilience of China to a greater extent than the Soviet blocs. In the short term, China’s competitiveness in the technology industry will be reduced, but the institutional advantage will increase the state’s ability to guarantee supply chain security in critical industries.

In the case of the integrated circuit industry during the COVID-19 pandemic, there is more evidence that Beijing has suffered a backlash caused by its own proud institutional superiority. While a “zero tolerance” approach to local epidemics is stifling the further spread of the coronavirus, on the other hand, it is also hindering China’s ambitious plan to revive the semiconductor industry. Which one has higher priority? It is clear that the conflict of interests between the two national strategies is practically irreconcilable.

As Hertz and Evers argued, both state-owned enterprises and the private sector have a strong interest in complying with the CCP’s directives. This point has manifested itself in the current stalemate faced by Chinese IC companies. This is just the tip of the iceberg of the Chinese economy during a global pandemic. In this sense, the “nationwide system” has become a “double-edged sword” that poses a strategic dilemma for Beijing’s ruling elites.