Geopolitical Briefing: Taiwan’s semiconductor sector on

Economics and Strategy

Geopolitical Briefing

February 16, 2021

Taiwan’s semiconductor sector on the front line of great power rivalry By Angelo Katsoras

Taiwan has long been a major point of friction between the United States and China. This dates back to 1949 when the U.S.-backed nationalists lost the civil war to the Communists. The defeated side was forced to flee the mainland for Taiwan. China to this day regards the island as a breakaway province, which it has vowed to take back by force if necessary.

In 1979, the United States agreed to recognize the Communist Party as the sole legal government of China without, however, clarifying its position on Taiwan’s sovereignty. To counter accusations that it was abandoning its ally, the United States passed the Taiwan Relations Act, which mandated continued close economic relations, including with respect to weapon sales. Maintaining a policy of strategic ambiguity, the United States has long refused to say what it would do if China attempted to invade Taiwan.

Taiwan’s emergence over the past few decades as the leading manufacturer of advanced semiconductors (commonly known as chips) has further increased the island’s strategic importance in the eyes of both the United States and China. One Taiwanese company alone, Taiwan Semiconductor Manufacturing Company (TSMC), accounts for about one fifth of all the world’s chip manufacturing and half the production of the most advanced chips on the market today.1

An overview of the semiconductor sector Simply put, semiconductors are the brains behind all IT products from smartphones to advanced defence systems to automobiles. About a trillion chips are currently being produced annually.2

While demand for semiconductors is surging, the number of companies able to manufacture leading-edge chips has plunged from over 25 in 2000 to only three today (see graph below) and, if reports that Intel is thinking of outsourcing some of its manufacturing are true, this would essentially bring the number down to two: TSMC of Taiwan and Samsung of South Korea. While there are other firms that manufacture chips, such as American-based GlobalFoundries or China’s Semiconductor Manufacturing International, the chips that they produce are older and less advanced.

Source: “Chipmaking is being redesigned. Effects will be far-reaching,” The Economist, January 23, 2021

1 “The struggle over chips enters a new phase,” The Economist, January 23, 2021 2 “Global chip shortage puts car supply chain under the microscope,” Financial Times, January 25, 2021

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For the most part, this consolidation is due to the astronomical cost of building a chip factory. TSMC recently built a plant capable of manufacturing 3-nanometre semiconductors, its most advanced chips, for a cost of $19.5 billion.3 Advances in semiconductors are measured in nanometres, or billionths of a metre, with ever-smaller transistors being placed on the newest models.

China’s reliance on imported semiconductors After being heavily criticized for its initial handling of COVID-19, China has emerged from the pandemic in a relatively strong position. It became one of the first countries to get the pandemic largely under control and was the only major world economy to grow in 2020.

However, one of China’s major vulnerabilities is being dependent on Taiwan for advanced semiconductors that incorporate key technological inputs from the United States. It is estimated that China produces only 16%4 to 30%5 of the chips it requires. In 2020, China imported $350 billion worth of semiconductors.6 China’s goal is to produce 70% of the chips that it needs by 2025.

The United States has attempted to exploit this vulnerability by imposing ever-tighter restrictions on the sale of U.S. technology. This includes requiring foreign companies like TSMC to obtain a licence before selling chips that contain American software or components to Chinese firms. The Biden administration is unlikely to roll back these bans any time soon.

China has doubled down on efforts to reduce this dependence by dramatically ramping up financial support for the chip industry via its plan to spend $1.4 trillion through 2025 on key technologies.

China’s efforts to become more self-reliant include: 1) pressuring TSMC to increase production on the mainland7 and 2) ramping up its efforts to recruit semiconductor engineers from Taiwan and South Korea. It was reported in late 2019 that over 3,000 such engineers had left Taiwan for positions at Chinese companies over the space of a few years. In all, there are about 40,000 semiconductor engineers in Taiwan.8 The following graph illustrates some of the big names that made the jump to China.

3 “Chipmaking is being redesigned. Effects will be far-reaching,” The Economist, January 23, 2021 4 “Beijing’s quest for chip independence is made in Taiwan,” Fortune, January 21, 2021 5 “China’s “dual-circulation” strategy means relying less on foreigners,” The Economist, November 7, 2020 6 “China boosts semiconductor production in 2020, but imports keep apace, frustrating self-sufficiency goals,” South China Morning Post, January 19, 2021 7 “TSMC's bet on global dominance pays off after decades of planning,” Nikkei Asia Review, January 30, 2021 8 “Taiwan loses 3,000 chip engineers to 'Made in China 2025',” Nikkei Asia Review, December 3, 2019

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2014 2015 2016 2017 2018 2019 2020

China: imports of semiconductors Current prices

$ billion USD

NBF Economics and Strategy (data via Refinitiv)

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Source: “Taiwan loses 3,000 chip engineers to 'Made in China 2025',” Nikkei Asia Review, December 3, 2019

The United States is also facing its own semiconductor-related challenges At first glance, the position of U.S.-based semiconductor companies appears to be on solid footing, with about 47% of the global market share. However, only about 12% of the world’s semiconductors are currently produced in the United States, down from well over 30% in 1990. Most U.S. chip companies have contracted out their production to Asian producers such as TSMC.9

9 “Why Fewer Chips Say ‘Made in the U.S.A.’,” Wall Street Journal, November 12, 2020

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Share of global chip manufacturing capacity

Source: “Why Fewer Chips Say, ‘Made in the U.S.A.’,” Wall Street Journal, November 12, 2020

While U.S. companies still hold dominant positions in the chip-manufacturing software and equipment market, there is a growing risk companies that have perfected the manufacturing process will inevitably move into these segments as well.

Reshoring Like China, the United States has become increasingly uneasy about being overly dependent on imports of advanced semiconductors. As a result, there is a growing push for companies to build plants on American soil, which includes offering them increased financial incentives.

Last November, TSMC announced that it would build, with the help of generous U.S. subsidies, a $12-billion chip plant in Arizona. More recently Samsung announced that it was considering building a $17-billion factory in the United States. A key factor in its final decision will be the size of government incentives.

On the legislative front, a bill called the “CHIPS for America Act’ was introduced in 2020 with bipartisan support that would secure $25 billion in federal funds and tax incentives.

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Convergence of factors leading to a global chip shortage The geopolitical tensions surrounding semiconductors, in conjunction with the repercussions of the COVID-19 pandemic, have led to a global shortage of chips. The exact reasons for this are the following:

The fact that people have been forced to work and study from home has led to a surge in demand for personal computers and other electronic items, all of which are powered by semiconductors.

At the onset of the pandemic, automakers slashed orders for chips, wrongly assuming that a long-term plunge in sales was imminent. Semiconductor manufacturers responded by shifting production toward electronic products, thus leaving insufficient capacity to meet the car companies’ renewed demand for more chips. Electronic components, which rely on chips to power them, accounted for about 40% of the cost of a new automobile in 2017, up from 20% in 2007.10

Geopolitics have played a role as well. When SMIC, China’s main chip producer, was barred from buying U.S. technology, many of its customers switched to other companies. The problem is that many of these companies were already running at near full capacity.

Before the full force of U.S. trade restrictions went into effect last September, Chinese companies like Huawei rushed to build up huge stockpiles of chips.

Because it can take six to nine months to realign production, the shortage of chips is expected to last well into 2021.11 TSMC raised its prices 10% to 15% last fall and is considering another round of price hikes.12 Going forward, many companies will be tempted to stockpile semiconductors to avoid the risk of being hit by shortages again.

Would China invade Taiwan? As the chart below illustrates, China has an enormous military advantage over Taiwan.

Source: “Defending Taiwan is growing costlier and deadlier,” The Economist, October 10, 2020

Despite this advantage and the fact that China has turned up the pressure on Taiwan of late by conducting intensive military exercises, we do not feel that an invasion is imminent.

So long as Taiwan does not declare independence, China’s strategy of ratcheting up pressure will likely be limited in the near term to selectively applying regulations to Taiwanese business operations on the mainland, intercepting or delaying Taiwanese cargo ships for supposed regulatory infractions, and continued military exercises.

10 “Semiconductors – the next wave,” Deloitte, April 2019 11 “Lack of Tiny Parts Disrupts Auto Factories Worldwide,” New York Times, January 13, 2021 12 “TSMC and Taiwan chip peers weigh new price hikes for autos,” Nikkei Asia Review, January 26, 2021

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China realizes that a major outbreak of hostilities would turn international public opinion against it and have negative economic and social consequences, particularly given its close economic ties with the island. Trade between Taiwan and China reached $150.5 billion in 2018, up from $35 billion in 1999,13 Taiwanese companies have invested $190 billion in Chinese operations over the past three decades, and as many as 1.2 million Taiwanese, or 5% of Taiwan’s population, live on the Chinese mainland.14 Finally, Chinese leaders are no doubt worried that a protracted war could turn public opinion against the government.

However, over the longer term, some analysts worry as China’s economic and military advantages over Taiwan continue to widen, the risk of a military conflict will increase. Under this scenario, China’s opening moves could involve seizing the Taiwanese-controlled Islands closest to the mainland, cutting Taiwan’s underseas internet cables and/or blockading the delivery of oil.

Source: “China’s War on Taiwan Won’t Start in Taiwan,” Geopolitical Futures, August 21, 2020

13 “China-Taiwan Relations,” Council on Foreign Relations, January 22, 2021 14 “Why commercial ties between Taiwan and China are beginning to fray,” The Economist, November 19, 2020

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Would United States fight to defend Taiwan?

In the unlikely event of a full-blown Chinese invasion, the United States would find itself in an almost untenable geopolitical position. On the one hand, it would be very costly to defend Taiwan militarily in terms of both blood and treasure. This is particularly the case given China’s growing military power and its ability to concentrate its forces while America’s military might is spread out around the globe. The higher the level of casualties, the greater the risk of a political backlash at home, as Americans would be wondering why they are involved in a conflict so far from their shores.

On the other hand, deciding not to defend Taiwan would cause a huge loss of global geopolitical prestige and other countries, particularly in the Asian region, would think twice before basing their security on an American-led alliance.

In such a situation, America’s dilemma would be made more difficult by the likelihood that control over Taiwan and its plants would place China on the path to technological supremacy in the semiconductor sector (provided that the plants in question were not significantly damaged).

Further, both great powers are aware that even a minor outbreak in hostilities between the two would shake the global economy and financial markets.

Conclusion While we do not feel that increased tensions over Taiwan will lead to an outbreak of hostilities anytime soon, it will over the longer-term lead to the reconfiguration of semiconductor supply chains. This means that both China and the United States will require, for reasons of national security, that more semiconductors be produced domestically even if this translates into higher costs.

More specifically, Taiwan Semiconductor Manufacturing Company will ultimately be forced by the United States and China to set up production lines in their respective countries, with each country requiring its supply chain to exclude the other’s technology.

Other major countries, such as Japan and Germany, will also try to develop their own domestic capacities.

Bottom line: While all these moves might help ensure security of supply in times of crisis, producing semiconductors in a multitude of locations will reduce economies of scale and significantly add to costs. This makes further hikes in the price of semiconductors and related electronic products likely.

This is in addition to efforts by the United States and other countries to develop their own capacities, regardless of the higher costs involved, in the areas of health care equipment/medicines and rare earth minerals. For further details on cost pressures impacting rare earth mineral production refer to our report entitled: “Superpowers competing for control of minerals and supply chains to fuel the next industrial revolution.”

Finally, while it would level the playing field for companies based in countries with stricter climate regulations, proposals by the United States and the EU to implement carbon border taxes on imports from countries with lesser environmental standards would also increase costs.




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Stéfane Marion Matthieu Arseneau Warren Lovely Chief Economist and Strategist Deputy Chief Economist Chief Rates and Public Sector Strategist [email protected] [email protected] [email protected]

Paul-André Pinsonnault Angelo Katsoras Kyle Dahms Taylor Schleich Senior Economist Geopolitical Analyst Economist Rates Strategist [email protected] [email protected] [email protected] [email protected]

Daren King Jocelyn Paquet Camille Baillargeon Economist Economist Intern Economist [email protected] [email protected] [email protected]

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