China’s ‘Zero COVID’ Policy Is Hurting Its Semiconductor Dreams

Despite the easing of Shanghai’s strict lockdown in early June, the market was fixated on gloomy forecasts for the city and even the outlook for China’s domestic economy, especially the supply chain of the main industrial sectors, as integrated circuits (IC). In recent years, the Chinese government has been more ambitious than ever to revitalize its integrated circuit industry through the “national system” in response to fierce technological competition with the United States. However, there is no doubt that Beijing’s adherence to pursuing a “zero tolerance” attitude towards local outbreaks has also seriously affected the development of high-end industries.

Faced with two urgent priorities, the Chinese Communist Party (CCP) must make a strategic decision.

The “National System” and China-US Technological Competition

Adopted from the Soviet Union, the “national 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 the “Five Year Plan”, the comprehensive social and economic development initiative issued by the CCP since 1953, outlining national strategies for the regime’s vision for socialist transformation and industrialization. In particular, this mass mobilization policy model represents Beijing’s strong response to make up for its shortcomings in a given area, and it tends to be effective. To a certain degree, China’s leading position in sports it is the result of this system of national mobilization.

It is widely recognized that the worsening of relations between China and the US is the most important factor behind Beijing’s plan to advance the integrated circuit industry. Since March 2018, when the Trump administration successively launched Section 301 InvestigationBy targeting China and imposing a retaliatory tariff on Chinese steel and aluminum, the bilateral conflict gradually spilled over into the tech industry. Washington and its allies vehemently suppressed and marginalized Chinese high-tech companies in the global market. By December 2021, the US Bureau of Industry and Security had blacklisted 611 Chinese companies and institutions, most of which are in high-end industry such as chip design and manufacturing. Furthermore, the two sides’ divergences on human rights and political issues are reflected in US sanctions against chinese tech giants who allegedly have close ties to the CCP, complicating the original technical rivalry.

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Technological competition between China and the US accelerated China’s effort in independent design and production of integrated circuit equipment. In December 2020, chip design and manufacturing played an unprecedented priority role in advancing the state’s ability in technological innovation and advancement, industrial transformation and expansion of the digital economy in the XIV Five-Year Plan. As a result, Beijing once again turned to the national system to achieve its strategic objective in the integrated circuit industry.

In 2019, the Ministry of Finance set up a special fund with $30.5 billion to invest in the integrated circuit industry. CI companies and projects enjoyed tax reduction ranging from 10 to 25 percent, depending on the duration of the operation and the technical criteria. On the other hand, local authorities also carry out a variety of industrial policies, following the instructions of the highest decision makers. Shaanxi province aims to surpass the proportion of the digital economy to more than 10 percent of GDP by 2025. In Guangzhou, the local government has pledged to improve chip intellectual property protection through a package of legislation.

Chip talent training is another push to strengthen the integrated circuit industry. As of 2021, a group of China’s top universities, including Tsinghua University, Peking University, and Fudan University, have inaugurated IC schools or departments for the cultivation of professionals. The number of research institutions continues to grow. Also, high-tech companies are another incubator for chip talents. According to the official white paper, the demand for talent in the domestic IC market will increase to approximately 745,000 by 2022. That alone helps demonstrate the sheer size and momentum of semiconductor companies in China’s tech market.

Undoubtedly, the government, higher education institutions and technology companies have formed an “iron triangle” for China’s investment strategy in the IC industry. This pattern supports the state’s ambition to be one of the major players in the global market. During the period between January and September 2021, national data showed that China’s chip-making power grew rapidly with revenue of $108.4 billion, rising 16.1 percent annually. Meanwhile, China became the largest market for semiconductor products, as its orders for chip-making equipment from foreign suppliers increased 58 percent.

However, with Beijing’s uncompromising stance in implementing a zero COVID policy to deal with local outbreaks, China’s strategy to rejuvenate the IC industry faces domestic challenge from another national policy.

How the “Zero-COVID” Policy Affected China’s IC Supply Chain

Coupled with the deterioration of China’s diplomatic ties with the Western world, the global pandemic forced Beijing’s ruling elites to transform economic statecraft into “Double circulation”, that prioritized domestic consumption while remaining open to international trade. However, the IC supply chain continues to reel along with the harsh response by local authorities to the Omicron outbreak since March in Shanghai. The megacity is home to many of China’s and the world’s leading semiconductor manufacturers, such as SMIC and TSMC.

Even though the supply chain management approach had previously shifted to be more conservative, prioritizing resilience over expansion, the stark measure of mandatory closures triggered a new wave of crises in supply chain logistics. supply in the Yangtze Delta region. According to official data released by the National Bureau of Statistics (NBS), China’s IC production fell 4.2 percent in the first three months of the year, as chipmakers reported a steeper drop in March. That is the worst quarterly performance since the first quarter of 2019 when there was a drop from 8.7 percent. With the chip business already strained due to semiconductor shortages, the coronavirus lockdown has dealt a double blow to China’s integrated circuit industry.

In response to industry challenges, Beijing has taken several steps to rescue the supply chain. On April 18, a national conference hosted by Chinese Vice Premier Liu He he proposed that the government would tap 1 trillion RMB ($157 billion) in funds from the central bank’s declining projects to bolster the supply chain. Following the instruction, the Ministry of Industry and Information Technologies launched a white list that includes 666 companies in integrated circuits, automobiles, equipment manufacturing and pharmaceuticals, granting them the resumption of production. At least 62 semiconductor companies benefited from the new policy.

Upon receiving permission to resume work, integrated circuit factories were allowed to operate under “closed loop” management; the system allows relevant people to move and act in the designated area, ensuring the operation of a specific mechanism and preventing the spread of the coronavirus. The local Shanghai chip plant of TSMC, one of the world’s leading semiconductor companies based in Taiwan, was allowed to continue operating to produce 8-inch wafers under the “closed-loop system.” The manager said even 70 percent of the workforce could keep full production capacity.

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Under the government’s rescue package and relaxation of COVID-19 restrictions, China’s semiconductor output in May has recovered slightly by more than 6 percent to 27.5 billion compared to 25.9 billion units in April, according to NBS data. But this number was even less than the 28.5 billion units produced in March, before the closure of Shanghai. Also, with the increase in new confirmed cases in July, it is not clear whether the possible drastic pandemic management measures by local authorities will affect the production of the integrated circuit industry. Consequently, China’s semiconductor strategy faces more of an internal challenge than an external one.

The double-edged sword of China’s “national system”

Geoffrey Gertz and Miles M. Evers’ comparative study on the government-business relationship between China and the US.. points out the strengths of Beijing to face geoeconomic competition with Washington. The nature of the party-state and state capitalism, which combines elements of a market economy with substantial government intervention in key sectors, shows China’s resilience more than the Soviet blocs. In the short term, China’s competitiveness in the tech industry would suffer, but the institutional advantage will enhance the state’s ability to ensure supply chain security in critical industries.

In the case of the IC industry during the COVID-19 pandemic, there is more evidence that Beijing has suffered a backlash caused by its own proud institutional superiority. While the “zero tolerance” approach to local epidemics suppresses further spread of the coronavirus, on the downside, it also hampers China’s ambitious plan to strengthen the semiconductor industry. What is a higher priority? It is clear that the conflict of interests between two national strategies is almost irreconcilable.

As Gertz and Evers argued, both state-owned companies and private sectors are highly incentivized to comply with CCP directives. This point has manifested itself in the current impasse facing Chinese IC companies. This is just the tip of the iceberg for the Chinese economy under the global pandemic. In that sense, the “national system” has become a “double-edged sword” that poses a strategic dilemma for the ruling elites in Beijing.

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