The Breakdown - Why Chip Manufacturing Is at the Center of Great Power Tension

Starting point is 00:00:00 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The Breakdown is sponsored by Nexo.io, Circle, and FtX, and produced and distributed by CoinDesk. What's going on, guys? It is Saturday, October 15th, and that means it's time for the weekly recap. Now, one quick note before we get into that, there are two ways to listen to the Breakdown podcast. You can listen on the CoinDesk Podcast Network feed. which comes out in the afternoon and features other great coin desk shows alongside the breakdown, or you can listen on the breakdown-only feed, which comes out a few hours later in the evening.

Starting point is 00:00:43 Wherever you listen, I would so appreciate it if you would take the time to leave a five-star rating or review. It makes a huge difference, and I really appreciate it. Also a disclosure, as always, in addition to them being a sponsor, I also work with FTX. As you can probably hear, I am just a podcast or two away from completely losing my voice. Preschool has begun again, which means that I don't get to be not sick for the next nine months. or so. Today we're going a little bit deeper on a topic that has been in and around the news. It's one that absolutely fits the label of big picture power shifts in that there are technology power shift dimensions, economic power shift dimensions, and certainly geopolitical

Starting point is 00:01:20 power shift dimensions. And that is the shifting sands around chips, the little pieces of silicon that enable virtually everything around us at this point and whose production has become a flashpoint for our changing understanding of global power. So what we're going to do today is a very very primer slash 101 level look at the topic. If this is something that you're already familiar with, I apologize for all the details I inevitably leave out. There are a lot of places we could start our story. We could go back to Silicon Valley and how it became Silicon Valley in the 1950s. We could look at the admittance of China to the World Trade Organization in 2001. But where we're going to start this version of the story is with COVID-19. During the opening months of the shutdown of the global

Starting point is 00:02:03 economy in 2020, many, many goods found themselves in shortage. Some of these were based on changes in people's routines. Gym equipment was, of course, an example, as was famously toilet paper. The dramatic shift in demand for these products, in some cases for reasons that made sense like gym equipment, in some cases for reasons that didn't like toilet paper, created huge problems for global supply chains, which had been used to much slower changes in demand over time. One of the most impactful shortages was the shortage of computer chips. There were a number of reasons why. The shift from work to home and the rise of remote learning meant that global demand for

Starting point is 00:02:39 computers and related equipment rose by 26% over the previous year. The squeeze also affected car manufacturing. The average modern car contains around 1,400 chips, and the auto industry makes up about 15% of the global demand for chips. Still, this was a large-scale, widespread phenomenon. According to Goldman Sachs, at least 169 industries have been impacted by the chip shortage. Indeed, the world quickly learned that everything from jets to refrigerators requires a reliable supply of microchips.

Starting point is 00:03:08 Importantly, the shortage wasn't just a story about demand, but also about supply. Not only did pandemic restrictions hamper logistics, but the worst drought conditions in half a century were seen in Taiwan, limiting the semiconductor superpowers manufacturing capacity. There's also an element of underinvestment in the story. Global computing trends have been moving particularly quickly over the last decade. As new manufacturing capacity takes years to establish, manufacturers often cannot meet changing demand trends in a timely manner. As a minor example,

Starting point is 00:03:36 Nvidia released its first chip optimized for Ethereum mining in February 2021, four years after the ICO boom saw surging demand for GPUs to use for mining. Now, there were also political dimensions to the chip shortage as well. What started as a ban on the leading Chinese telecommunications company had escalated into a trade war. In September 2020, the Commerce Department imposed restrictions on China's largest chip manufacturer, barring U.S. firms from exporting intellectual property without a license. This was significant as a large portion of semiconductor design is done by U.S. firms. Now, to the extent that someone hoped that the election of Joe Biden would bring a new normalization

Starting point is 00:04:12 of the U.S. relationship with China and a rollback of trade restrictions, they were sure to be disappointed. China was, in fact, one of the only bipartisan issues in the 2020 election cycle. According to Pew Research in 2021, 89% of Americans consider China a competitor or enemy. 70% support trying to promote human rights in China even if it harms economic relations. 55% support limiting Chinese students studying in the U.S. 53% said it's more important to get tougher on economic issues than to build a strong relationship. And what's more, these stances are hardening.

Starting point is 00:04:44 In 2018, 32% said limiting China's power and influence should be a top foreign policy priority. In 2021, 48% said that. In 2018, 46% of people had a cold feeling towards China. In 2021, that was 76%. To the extent that anyone did have hopes of a new type of relationship, those hopes were quickly dashed. In March 2021, high-level talks between government officials in Alaska hit an extremely sour note, with the Biden administration rejecting Beijing's request to remove Trump-era tariffs and bans. As relations between the nations continued to deteriorate, the Biden administration firmed up its foreign policy. It decided in September this year to ban U.S. firms that received federal funding from

Starting point is 00:05:21 building, quote, advanced technology facilities in China for the next 10 years. This addresses concerns of an over-reliance on China which were raised by American business groups who had production slowed by the chip shortage. Now, while some of the big headline bans are well reported, there have also been dozens of smaller and less splashy trade restrictions globally that have hampered the Chinese chip industry. From July of this year, the Biden administration has been dealing with firms and governments in allied nations and at home to ensure that Chinese access to advanced chips is curtailed. Restrictions have targeted chip manufacturing equipment and finished goods, including

Starting point is 00:05:51 computer memory and video cards. The stated goal is to ensure that the Chinese military cannot have easy access to advanced computing components, but a side effect has been to rearrange global supply chains. Want to keep more profits when trading? Get the best possible prices and trade with 50% lower fees on Nexo Pro. The new Spot and Futures trading platform uses aggregated liquidity of over 3,000 order books collected from multiple sources. Utilizing the complete NXO Suite allows you to earn interest and borrow funds as you wait for the next trade setup. Visit pro.nexo.io. That's PRO. N-EXO.I.O. and sign up today.

Starting point is 00:06:37 The breakdown is sponsored by FTXUS. FTXUS is the safe, regulated way to buy and sell Bitcoin and other digital assets with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no with a.m. draw all fees. One of the largest exchanges in the U.S. FDXUS is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTX, you pay no gas fees. Download the FTCX app today and use referral code breakdown to support the show. The military component of this story is, I think, key. Modern warfare has moved digital in the last

Starting point is 00:07:17 decade, with drones and other high-tech gadgets becoming a mainstay of the battlefield. Even low-tech military hardware contains chips as a key component. One of the most impactful sanctions against Russia was the restriction of semiconductor imports from Western firms. It was enacted on the day of the invasion weeks before economic sanctions were finalized. In announcing the sanctions, President Biden made it clear how the U.S. government views access to advance U.S. technology in the modern world. Quote, the unprecedented export control measures will cut off more than half of Russia's high-tech imports, restricting Russia's access to vital technological inputs, atrophying its industrial base,

Starting point is 00:07:50 and undercutting Russia's strategic ambitions to exert influence on the world stage. The reality is that access to advanced semiconductors is analogous to access to modernity. So now let's discuss the Chips Act. The kneecapping of the Chinese chip manufacturing industry has left a sizable hole in projected manufacturing capacity, especially when it comes to advanced chips. Many projects have been scuttled by the changing geopolitical landscape, and this led to the U.S. government to step in and attempt to address the shortfall. In August, efforts to strengthen the American semiconductor supply chain culminated in the

Starting point is 00:08:21 passage of the Chips Act. The Act represented a $50 billion investment from the U.S. government into domestic chip manufacturing. This is mostly in the form of tax incentives for companies to onshore production, but also includes $11 billion going towards funding multiple new government institutions that will conduct research into chip design technology and industrial processes. This process of onshoreing is already underway. Micron has committed to spend up to $100 billion over the next two decades building the largest semiconductor manufacturing facility in the world in upstate New York, as well as $40 billion to build out memory manufacturing capacity on shore. Intel has also committed to investing 20 billion in the

Starting point is 00:08:56 construction of two chip-making factories in Ohio. Now, what's clear is that the transition to domestic chip production isn't going to be cheap or fast. Chip facilities typically take three to five years and 10 to 20 billion dollars to build. Semiconductors require some of the most complicated and sensitive manufacturing processes ever devised. Significant portions of the process require clean room conditions and the labor is precise and highly skilled. The workforce requirement is another problem, as the U.S. just doesn't have the skilled workers required to operate a chip facility. The entire U.S. semiconductor industry employs around 185,000 people and has stayed flat for a decade, only hiring enough people to replace those who exit the industry.

Starting point is 00:09:33 In contrast, the Taiwanese-based industry employs 290,000 people and is desperately hiring more currently. At the end of last year, there were 34,000 job openings in the Taiwanese semiconductor industry. According to Fortune 2022's Global 500 rankings, six of the top nine Taiwanese companies are either semiconductor or electronics manufacturers. The whole Taiwanese economy has been geared towards efficient manufacturing of high-end semiconductors and electronics over the last decades. The U.S. onshoreing plan isn't just about building facilities and encouraging investment. There are very real constraints in the labor market that will need to be addressed.

Starting point is 00:10:05 The current plan is to hire and train 42,000 additional workers to operate the domestic industry. But questions remain about whether or not it will be possible to replicate the success of the Taiwanese industry using the U.S. labor force. In a very real way, the U.S. is not just trying to build factories onshore, but to build out an entire industry from something of a seated start. And there is a really key point here. These changes to U.S. chip policy are not about beneficial economics. Reshoring is, in fact, going to increase prices. It is instead about geostrategic and security thinking. Now, in early October, the Biden administration tightened the screws on the chip industry once again. Using the Commerce Department's foreign direct product rule, the U.S. government has imposed what the Guardian

Starting point is 00:10:45 calls, quote, the biggest shift in U.S. policy towards shipping technology, to China since the 1990s. This is essentially a formalization of previous policies, and the move bans exports of chip manufacturing equipment, high-end computer components, and chip designs by all U.S. firms. It aims to limit China's ability to progress in technologies including nuclear weaponry, supercomputing, and AI. Whereas previously the Commerce Department may have been inclined to grant license to enable U.S. firms to continue operations in China, the new policy has made the administration's stance absolutely clear, according to senior officials. Firms should, quote, requests will be denied. Another big addition to the policy is the U.S. government seeking to block the

Starting point is 00:11:24 export of foreign-made chips manufactured using U.S. technology into China. The Commerce Department has acknowledged that these restrictions are toothless without international cooperation, but so far, the willingness of U.S. allies to mirror U.S. policy on this issue has been solid from Fortune magazine this week. The U.S. will stop companies from exporting advanced chips made using U.S. equipment to China, the new export controls with the broadest in years. The imposed ban is part of the Biden administration's drive to stop China from developing advanced computer chips, it'll block the sale to almost 30 Chinese companies. Though companies can apply for a license to export advanced chips to China, officials said most applications would be denied. More controls may still be coming. The Biden administration

Starting point is 00:12:03 also ordered inspections at dozens of Chinese companies to ensure that exported equipment is not being diverted to third parties or unapproved uses. China's foreign ministry blasted the new U.S. controls as an attempt to preserve American, quote, technological hegemony. Meanwhile, the new controls brought in a policy of using the U.S.'s position on cutting-edge shipmaking to constrain rival countries like China. Paul Schar, the Vice President and Director of Studies at the Center for New American Security, says, a subtle but key point in the new chip export controls. They will automatically act as a de facto one-way ratchet over time if the tech threshold stands still as chips continue to advance. Today's advanced chips will become tomorrow's legacy chips.

Starting point is 00:12:40 To some extent, this is baked into all export controls as technology advances, but the pace of progress is particularly fast than chips. GPU price performance is doubling every 2.5 years. On odd lots, Dan Wang said, there are three things that I would really highlight that are important in this order. First controls on chips themselves. A lot of the most advanced chips that are important for supercomputers are now being cut off from China. That's the first item. The second item consists of controls on semiconductor production equipment. The Commerce Department has been fairly clear that if you are shipping semiconductor production equipment that is below 14, 16 nanometers or less to China, above 128 levels for nan memory chips as well as below 18 nanometers, half pitch or less for

Starting point is 00:13:17 dram, then you need to get a license for the U.S. Department of Commerce with a presumption of denial. The third most important highly novel control announced by commerce is a license requirement on U.S. persons from being able to supply the development of China's advanced semiconductor industry. This is fairly a novel, I think, for the U.S. Department of Commerce to impose law controls on the level of U.S. persons and also trying to cut off more people-to-people exchanges with China with prospective technology. Now, there is one other big issue that has to be discussed in this context. One of the reasons semiconductor supply has been so fraught is industry concentration.

Starting point is 00:13:47 Taiwan, as we mentioned previously, is the global leader in ship manufacturing, and it's not close. Taiwanese firms produce around 20% of the global semiconductor supply. Manufacturing of advanced semiconductors is even more highly concentrated, with 90% of global supply coming out of one mega firm, Taiwan semiconductor manufacturing company or TSM. TSM works with over 400 suppliers and has a supply chain that is so fiendish complicated that the Taiwanese Ministry of Economic Affairs said, quote, it is almost impossible to try to copy the well-established infrastructure or TSM,

Starting point is 00:14:15 or other semiconductor companies elsewhere, even if one spends a fortune. Most of the advanced manufacturing is physically located in Taiwan, which is a large part of what makes the island a flashpoint for U.S.-China tensions. While an obvious aim of a Chinese invasion would be to capture Taiwanese chip manufacturing facilities intact, it seems an unlikely scenario. In the event that an invasion takes place, the strategically vital industry would likely be destroyed, either through the scuttling of factories or the evacuation of the domestic workforce who hold the knowledge required to operate the industry. The loss of TSM during an invasion would

Starting point is 00:14:45 disrupt the global economy to the tune of $1 trillion, according to the U.S. National Security Council. Now, following a recent bombshell Bloomberg report, both Taiwanese and U.S. officials have denied that plans to evacuate the TSM workforce to exist. The report used anonymous sourcing to discuss the wargaming that has gone on within the Biden administration around the need to evacuate these personnel in the event of an invasion. It also noted that there are some advocates for articulating a scorched earth policy to the Chinese, where in the event of an invasion, the TSMC plants would be destroyed. Such a policy was laid out in the November 2021 issue of the U.S. Army War College quarterly, so it's clearly real enough to be seriously analyzed. The Taiwanese have made it clear that

Starting point is 00:15:23 such measures would be unnecessary. Speaking with CNN in July, TSM's CEO, Mark Liu, said that the company could not be controlled by force and that an invasion in and of itself would, quote, render TSM factories inoperable through the disruption of supply chains in the labor force. These rising tensions could themselves cause problems within China. While China is heavily dependent on the global chip supply in their industry, their military expansion and the operation of their surveillance state, the nation still produces relatively few chips domestically. China only supplies around 5% of the chips to the global market, which compares poorly to the 10% supplied by the US. So just like the rest of the world, China is reliant on Taiwan and TSMC to keep

Starting point is 00:15:59 their supply of chips flowing. Ludres Casanova, the director of of the Emerging Markets Institute at Cornell said, The stoppage of supply of TSM's semiconductors would be the worst-case scenario for China and for many other countries. TSM's semiconductors are used by Foxcon, another Taiwanese firm, which is the main manufacturer of the iPhone in plants based in China and elsewhere. So far, Taiwan has not cut off exports to China, but pressure from U.S. officials is mounting. China is Taiwan's primary trading partner, accounting for 28% of exports,

Starting point is 00:16:26 of which more than 60% are semiconductors. China spends more annually importing chips than it does importing oil, And given that, it's clear that Taiwan cannot decouple from China without flirting with economic ruin. So far, Taiwan is only committed to work closely with U.S. officials to ensure that China does not acquire state-of-the-art military technology using their chips. With the imposition of new rules from the Biden administration on exporting chips manufactured on U.S. design machinery, Taiwan will likely comply, ceasing the export of the most advanced ships required for AI and supercomputing into China. So that is a brief overview of the story of chips right now. They strike at so many

Starting point is 00:17:00 different aspects of these global power shifts that we like discussing here. And so I think trying to have at least a conversational familiarity with what's happening, why it's important, and what might happen next is really valuable. Let me know what you think. Hit me up on social or in the Discord. And for now, I hope you're having a great weekend. I want to say thanks again to my sponsors, nex0.com, circle and FTX. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace. I want to tell you about CoinDesk's new event, the investing in digital enterprises and asset summit or ideas. The event facilitates capital flow and market growth by connecting the digital economy with traditional finance. Join CoinDesk October 18th and 19th in New York

Starting point is 00:17:43 City for a 360-degree investment experience, where you can source, invest, and secure the next big deal in digital assets. Use code breakdown 20 for 20% off at General Pass. You can register today at coindex.com slash ideas.

The Breakdown - Why Chip Manufacturing Is at the Center of Great Power Tension

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