Chips and China

Intel may not be the most obvious place to start when it comes to the China chip sanctions announced by the Biden administration three weeks ago (I covered the ban in the Daily Update here and here); the company recently divested its 3DNAND fab in Dalian, and only maintains two test and assembly sites in Chengdu. Sure, there is an angle about Intel’s future as a foundry and its importance in helping the United States catch up in terms of the most advanced processes currently dominated by Taiwan’s TSMC, but when it comes to exploring the implications and risks of these sanctions I am much more interested in Intel’s past.

Start with the present, though: two weeks ago Intel CEO Pat Gelsinger announced a restructuring of the company, with the goal of putting more distance between its design and manufacturing teams. From the Wall Street Journal:

Intel Corp. plans to create greater decision-making separation between its chip designers and chip-making factories as part of Chief Executive Pat Gelsinger’s bid to revamp the company and boost returns. The new structure, which Mr. Gelsinger disclosed in a letter to staff on Tuesday, is designed to let Intel’s network of factories operate like a contract chip-making operation, taking orders from both Intel engineers and external chip companies on an equal footing. Intel has historically used its factories almost exclusively to make its own chips, something Mr. Gelsinger changed when he launched a contract chip-making arm last year.

Back in 2018 I wrote about Intel and the Danger of Integration:

It is perhaps simpler to say that Intel, like Microsoft, has been disrupted. The company’s integrated model resulted in incredible margins for years, and every time there was the possibility of a change in approach Intel’s executives chose to keep those margins. In fact, Intel has followed the script of the disrupted even more than Microsoft: while the decline of the PC finally led to The End of Windows, Intel has spent the last several years propping up its earnings by focusing more and more on the high-end, selling Xeon processors to cloud providers. That approach was certainly good for quarterly earnings, but it meant the company was only deepening the hole it was in with regards to basically everything else. And now, most distressingly of all, the company looks to be on the verge of losing its performance advantage even in high-end applications.

That article was primarily about Intel’s reliance on high margin integrated processors and its unwillingness/inability to become a foundry serving 3rd-party customers, and how smartphones provided the volume for modular players like TSMC to threaten Intel’s manufacturing dominance. However, it’s worth diving into the implications of Intel’s integrated approach relative to TSMC’s modular approach, because it offers lessons for the long road facing China when it comes to building its own semiconductor industry, highlights why the U.S. is itself vulnerable in semiconductors, and explains why the risk for Taiwan has increased significantly.

TSMC’s Depreciation

Fabs are incredibly expensive to build, while chips are extremely cheap; to put it in economic terms, fabs entail massive fixed costs, while chips have minimal marginal costs. This dynamic is very similar to software, which is why venture capital rose up to support chip companies like Intel, and then seamlessly transitioned to supporting software (Silicon Valley, which is today known for software, is literally named for the material used for chips).

One way to manage these costs is to build a fab once and then run it for as long as possible. TSMC’s Fab 2, for example, the company’s sole 150-millimeter wafer facility, was built in 1990, and is still in operation today. That is one of seven TSMC fabs that are over 20 years old, amongst the company’s 26 total (several more are under construction, including the one in Arizona). The chips in these fabs don’t sell for much, but that’s ok because the fabs are completely depreciated: almost all of the revenue is pure profit.

This may seem like the obvious strategy, but it’s a very path dependent one: TSMC was unique precisely because they didn’t design their own chips. I explained the company’s origin story in Chips and Geopolitics:

A few years later, in 1987, Chang was invited home to Taiwan, and asked to put together a business plan for a new government initiative to create a semiconductor industry. Chang explained in an interview with the Computer History Museum that he didn’t have much to work with:

I paused to try to examine what we have got in Taiwan. And my conclusion was that [we had] very little. We had no strength in research and development, or very little anyway. We had no strength in circuit design, IC product design. We had little strength in sales and marketing, and we had almost no strength in intellectual property. The only possible strength that Taiwan had, and even that was a potential one, not an obvious one, was semiconductor manufacturing, wafer manufacturing. And so what kind of company would you create to fit that strength and avoid all the other weaknesses? The answer was pure-play foundry…

In choosing the pure-play foundry mode, I managed to exploit, perhaps, the only strength that Taiwan had, and managed to avoid a lot of the other weaknesses. Now, however, there was one problem with the pure-play foundry model and it could be a fatal problem which was, “Where’s the market?”

What happened is exactly what Christensen would describe several years later: TSMC created the market by “enabl[ing] independent, nonintegrated organizations to sell, buy, and assemble components and subsystems.” Specifically, Chang made it possible for chip designers to start their own companies:

When I was at TI and General Instrument, I saw a lot of IC [Integrated Circuit] designers wanting to leave and set up their own business, but the only thing, or the biggest thing that stopped them from leaving those companies was that they couldn’t raise enough money to form their own company. Because at that time, it was thought that every company needed manufacturing, needed wafer manufacturing, and that was the most capital intensive part of a semiconductor company, of an IC company. And I saw all those people wanting to leave, but being stopped by the lack of ability to raise a lot of money to build a wafer fab. So I thought that maybe TSMC, a pure-play foundry, could remedy that. And as a result of us being able to remedy that then those designers would successfully form their own companies, and they will become our customers, and they will constitute a stable and growing market for us.

It worked. Graphics processors were an early example: Nvidia was started in 1993 with only $20 million, and never owned its own fab.1 Qualcomm, after losing millions manufacturing its earliest designs, spun off its chip-making unit in 2001 to concentrate on design, and Apple started building its own chips without a fab a decade later. Today there are thousands of chip designers in all kinds of niches creating specialized chips for everything from appliances to fighter jets, and none of them have their own fab.

By creating this new market TSMC ended up with a massive customer base; moreover, most of those customers didn’t need cutting edge chips, but rather the same chip that they started with for as long as they made the product into which that chip went. That, by extension, meant that all of those old foundries had a customer base, enabling TSMC to make money on them long after they had been paid off.

Intel’s Margins

Intel’s path, though, preceded TSMC’s, which is to say that of course Intel both designed and manufactured their own chips (“real men have fabs”, as AMD founder Jerry Sanders once famously put it); to put it another way, the entire reason why Chang saw a market in being just a manufacturer was because every company that proceeded TSMC had done both out of necessity, because a company like TSMC didn’t exist.

And, it’s worth noting, there was no reason for TSMC to exist: Intel’s chips, for the two decades it existed before TSMC, were never good enough: every generation would result in such massive leaps in performance that it simply wouldn’t have made sense to keep the old assembly lines around. Still, this stuff was expensive, which is where being integrated helped.

This was the other way to manage the cost of cutting edge fabs: because Intel was at the cutting edge, it would charge a huge premium for its chips (and thus have the highest margins in the industry that I referenced earlier). At the beginning, when fabs were cheaper, Intel was happy to sell off its old equipment and make a few extra bucks on the back end. Over the last decade, though, as equipment became more and more expensive, and as Intel’s leadership started to care more about finances than about engineering, it increasingly became a priority to re-use equipment to the greatest extent possible. This wasn’t easy, I would note: Intel would stick with (relatively) outdated equipment in not just one fab but also in the fabs it built around the world.

This is where the integration point was critical: because Intel both designed and manufactured its chips, the latter could call the shots for the former; chips had to be designed to work with Intel manufacturing, not the other way around, and this extended to not just the designs themselves but all of the tooling that went into it. Intel, for example, used its own chip design software, and favored suppliers who would do what Intel told them to, and then hand the equipment off to Intel to do with it as they saw fit. Intel would then get everything to work in one fab, and Copy Exactly! that fab in another location: everything was identical, down to the position of the toilets in the bathrooms.

As I noted in the conclusion of Intel and the Danger of Integration, Intel’s strategy worked phenomenally well, right up until it didn’t:

What makes disruption so devastating is the fact that, absent a crisis, it is almost impossible to avoid. Managers are paid to leverage their advantages, not destroy them; to increase margins, not obliterate them. Culture more broadly is an organization’s greatest asset right up until it becomes a curse. To demand that Intel apologize for its integrated model is satisfying in 2018, but all too dismissive of the 35 years of success and profits that preceded it. So it goes.

So it goes, indeed — or rather, the correct conjugation is the past tense: so went Intel’s manufacturing advantage.

ASML’s Rise

I mentioned TSMC’s Fab 2 earlier and its 150-millimeter wafers; that is 1980’s era technology. The 1990s brought 200-millimeter wafers (which are used in seven of TSMC’s fabs). It was the transition to today’s 300-millimeter fabs in the early 2000’s, though, that marked the rise of ASML.

Intel’s partner in the lithography space — the use of light to draw transistors on wafers — was Nikon, and Nikon’s approach to 300-millimeter wafers was to scale up its 200-millimeter process. There was a downside to this approach, though: because the wafers were larger they had to move more slowly (more mass means more force, unless acceleration is decreased). This was fine with Intel, though: they were their own only customer, and their margins were plenty high enough to handle a decrease in throughput (indeed, Intel was well-known for running their machines well below capacity).

Lower speed wasn’t fine for TSMC and Samsung, the other up-and-comer in the space: like any challenger they were operating on much lower margins, and they didn’t want a decrease in throughput — the entire point of larger wafers was to increase the number of chips that could be produced, not to give away that gain by running everything more slowly. ASML saw the opportunity and designed an entirely new process around 300-millimeter wafers, creating dual wafer stage technology that aligned and mapped one wafer while another was being exposed.

TSMC and ASML were already close, in part because both were part of the Philips family tree (Philips was the only external investor in TSMC, which licensed Philips technology to start, and ASML was a joint venture of Philips and ASMI). What was more important is that both were ignored by the dominant players in the industry: the big chip makers, from Intel to Motorola to Texas Instruments, were matched up with Nikon and Canon; the former didn’t want equipment from a new entrant, and the latter didn’t have capacity for a foundry that was not only working on low margins but also, as part of its cost consciousness, wanted to learn how to service the machines themselves (the Japanese companies preferred to deliver black boxes that their own technicians would service).

ASML’s 300-nanometer process, though, required a reworking on the fab side as well. Now TSMC and ASML weren’t simply stuck together like two kids picked last at recess: they were deeply enmeshed in the process of working through the new process’s bugs, designing new fabs to support it, and maximizing output once everything was working. This increase in output had another side effect: TSMC started to make a bit more money, which it started pouring into its own research and development. It was TSMC that pushed ASML towards immersion lithography, where the space between the lens and the wafer was filled with a liquid with a higher refraction index than air. Nikon would eventually be forced to respond with its own lithography machines, but they were never as good as ASML’s, which meant that even Intel had to come calling as a customer.

ASML, meanwhile, had been working for years on a true moonshot: extreme ultraviolet lithography. Here is the Brookings Institution’s description of the process:

A generator ejects 50,000 tiny droplets of molten tin per second. A high-powered laser blasts each droplet twice. The first shapes the tiny tin, so the second can vaporize it into plasma. The plasma emits extreme ultraviolet (EUV) radiation that is focused into a beam and bounced through a series of mirrors. The mirrors are so smooth that if expanded to the size of Germany they would not have a bump higher than a millimeter. Finally, the EUV beam hits a silicon wafer — itself a marvel of materials science — with a precision equivalent to shooting an arrow from Earth to hit an apple placed on the moon. This allows the EUV machine to draw transistors into the wafer with features measuring only five nanometers — approximately the length your fingernail grows in five seconds. This wafer with billions or trillions of transistors is eventually made into computer chips.

An EUV machine is made of more than 100,000 parts, costs approximately $120 million, and is shipped in 40 freight containers. There are only several dozen of them on Earth and approximately two years’ worth of back orders for more. It might seem unintuitive that the demand for a $120 million tool far outstrips supply, but only one company can make them. It’s a Dutch company called ASML, which nearly exclusively makes lithography machines for chip manufacturing.

It’s not just ASML, though: that mirror is made by Zeiss, and the laser is made by TRUMPF using carbon dioxide sources pioneered by Access Laser (a U.S. company later acquired by TRUMPF). They are the two most important of over 800 suppliers for EUV, but it’s the end users that are equally essential.

When TSMC Passed Intel

In 2012 Intel, TSMC, and Samsung all invested in ASML to help the company finish the EUV project that had started 11 years earlier: there were very real questions about whether or not ASML would ever ship, or die trying, while it was clear that immersion lithography was reaching the limits of what was possible. The investment amounts are interesting in retrospect:

Company Intel TSMC Samsung
Investment in stock 15% for $3.1 billion 5% for $1.03 billion 3% for $630 million
Investment in R&D $1 billion $345 million $345 million

Intel, despite investing the most (and having contributed a big chunk of the underlying technology), was convinced it could stick with immersion lithography as it transitioned first to 10-nanometer and then 7-nanometer chips. Yes, those were awfully small lines to be drawing with a light source that was 193-nanometers in width, but it wasn’t clear that EUV yields were going to be high enough, and besides, Intel had a lot of lithography equipment that, if used for one or two more generations, would make for some very fat margins. That was more of a priority for Intel than technological leadership, even as decades of said leadership had created the arrogance to believe that Intel could use quad-patterning — i.e. doing four exposures on a single wafer — to create those ever thinner lines.

TSMC, on the other hand, had three reasons to commit to EUV:

  • First, TSMC had a multi-decade relationship with ASML that included two significant process transitions (to 300-millimeter wafers and immersion lithography).
  • Second, because TSMC was a foundry, it needed to manufacture smaller lots of much greater variety; this meant that fiddly multi-pattern approaches that took many runs to improve yields didn’t make sense. EUV’s 13.5 nanometer light offered the potential for much simpler designs that fit TSMC’s business model.
  • Third, Apple was willing to pay to have the fastest chips in the world, which meant that TSMC had a guaranteed first customer with massive volume whenever it could get EUV working.

In the end, TSMC started using EUV for non-critical layers at 7 nanometers, and for critical layers at 5 nanometers (in 2020); Intel, meanwhile, failed for years to ship 10 nanometer chips (which are closer to TSMC’s 7 nanometer chips), and had to completely rework its 7 nanometer process to incorporate EUV. Those chips are only starting mass production this fall — the same time period when TSMC is shipping new 3 nanometer chips. Intel, by the way, is a customer for TSMC’s 3nm process: the company’s performance was falling too far behind AMD, which abandoned its own fabs in 2009 and has been riding TSMC’s improvements (along with its own new designs) for the last five years.

China’s Integrated Path

Only now, 3,500 words in, do I turn to China, and the country’s path forward to building the sort of advanced chips that the U.S. has just cut off access to. That, though, is the point: the chip industry’s path to today is China’s path to the future.

This is a daunting challenge: it’s not just that China needs to re-create TSMC, but also ASML, Lam Research, Applied Materials, Tokyo Electronic, and all of the other pieces of the foundry supply chain. And, to go one layer deeper, not only does China need to re-create ASML, but also Zeiss, and TRUMPF, and Access Laser, and all of the other pieces of the global supply chain, much of which is not located in China. China’s manufacturing prowess is centered on traditionally labor-centric components; even though Chinese labor is now much more expensive than it was, and automation much more common, path dependency matters, and China’s capability is massive but in some respects limited.

Globalization made all of those Chinese factories extremely valuable, because the world was China’s market. At the same time, globalization also meant that China could buy high-precision capital-intensive goods abroad: it didn’t need to build them itself to get the benefits immediately. By the same token high-precision capital-intensive goods are exactly what Western countries like the U.S., Germany, Netherlands, Japan and Taiwan invested in, in part because they couldn’t compete with China on labor. To put it another way, the principles of comparative advantage governed an infinite number of decisions on the margins that led to the U.S. government having the ability to impose these sanctions on China; the realities of semiconductor manufacturing, where every paradigm shift costs massive amounts of money, years in R&D, and the willingness of partners to take the leap with you, are a further manifestation of comparative advantage: it simply makes the most sense for one company to do lithography, and another to lead the world in fabrication.

In other words, China is going to need to build up these capabilities from the ground up, and it’s going to be a long hard road. Moreover, China will not have the benefit of partnership and distributed expertise that have driven the last decade of innovation: in some respects China is going to need to be Intel, doing too much on its own.

That said, the country does have three big advantages:

  • First, it is much easier to follow a path than to forge a new one. China may not be able to make EUV machines, but at least they know they can be made.
  • Second, China has benefited from all of the technological sharing to date: Semiconductor Manufacturing International Corporation (SMIC) has successfully manufactured 7nm chips (using ASML’s immersion lithography machines), and Shanghai Micro Electronics Equipment (SMEE) has built its own immersion lithography machines. Granted, those 7nm chips almost certainly had poor yields, and the trick is for SMIC to use SMEE on the cutting edge, but that leads to the third point:
  • China has unlimited money and infinite motivation to figure this out.

Money is not a panacea: you can’t simply spend your way to faster chips, but instead must move down the learning curve on both the foundry and equipment level. Money does, though, pay for processes that don’t have great yields: the problem for Intel at 7 nanometer, for example, wasn’t that they couldn’t make chips, but that they couldn’t get yields high enough to make them economically. That won’t be a concern for China when it comes to chips for military applications.

What is more meaningful, though, will be the alignment of China’s private sector behind China’s chip companies: TSMC didn’t only need ASML, it also needed Apple and AMD and Nvidia, end users who were both willing to pay for performance and also work deeply with TSMC to figure out generation after generation of faster chips. Tencent and Alibaba and Baidu will now join Huawei in being the China chip industry’s most demanding customers, in the best possible sense.

China’s Trailing Edge

There is one more advantage China has: remember all of those old fabs that TSMC is still operating? It turns out that as more and more products incorporate microprocessors, trailing edge chips are exploding in demand. This was seen most clearly during the pandemic when U.S. automakers, who foolishly canceled their chip orders when the pandemic hit, suddenly found themselves at the back of the line as demand for basic chips skyrocketed.

In the end it was China that picked up a lot of the slack: the company’s commitment to building its own semiconductor industry is not a new one (just much more pressing), and part of the process of walking the path I detailed above is building more basic chips using older technologies. China’s share of >45 nanometer chips was 23% in 2019, and probably over 35% today; its share of 28-45 nanometer chips was 19% in 2019 and is probably approaching 30% today. Moreover, these chips still make up most of the volume for the industry as a whole: when you see charts like this, which measure market share by revenue, keep in mind that China has achieved 9% market share with low-priced chips:

China's increasing share of chips by revenue

The Biden administration’s sanctions are designed to not touch this part of the industry: the limitations are on high end fabs and the equipment and people that go into them, not trailing edge fabs that make up most of this volume. There is good reason for this: these trailing edge factories are still using a lot of U.S. equipment; for most equipment makers China is responsible for around a third of their revenue. That means cutting off trailing edge fabs would have two deleterious effects on the U.S.: a huge number of the products U.S. consumers buy would falter for lack of chips, even as the same U.S. companies that have built the advantage the administration is seeking to exploit would have their revenue (and future ability to invest in R&D) impaired.

It’s worth pointing out, though, that this is producing a new kind of liability for the U.S., and potentially more danger for Taiwan.

Go back to Intel’s strategy of selling off and/or reusing its old fabs, which again, made sense given the path Intel started on decades ago: that means that Intel, unlike TSMC, doesn’t have any trailing edge capacity (outside of what it acquired in the Tower Semiconductor deal). Global Foundries, the U.S.’s other foundry, had the same model as Intel while it was the manufacturing arm of AMD; Global Foundries acquired trailing edge capacity with its acquisition of Chartered Semiconductor, but there is a reason why the U.S. >45 nanometer market share was only 9% in 2019 (and likely lower today), and 28-45 nanometer market share was a mere 6% (and again, likely lower today).

Again, these aren’t difficult chips to make, but that is precisely why it makes little sense to build new trailing edge foundries in the U.S.: Taiwan already has it covered (with the largest marketshare in both categories), and China has the motivation to build more just so it can learn.

What, though, if TSMC were taken off the board?

Much of the discussion around a potential invasion of Taiwan — which would destroy TSMC (foundries don’t do well in wars) — centers around TSMC’s lead in high end chips. That lead is real, but Intel, for all of its struggles, is only 3~5 years behind. That is a meaningful difference in terms of the processors used in smartphones, high performance computing, and AI, but the U.S. is still in the game. What would be much more difficult to replace are, paradoxically, trailing node chips, made in fabs that Intel long ago abandoned.

China meanwhile, has had good reason to keep TSMC around, even as it built up its own trailing edge fabs: the country needs cutting edge chips, and TSMC makes them. However, if those chips are cut off, then what use is TSMC to China? This isn’t a new concern, by the way; I wrote after the U.S. imposed sanctions on Huawei:

I am, needless to say, not going to get into the finer details of the relationship between China and Taiwan (and the United States, which plays a prominent role); it is less that reasonable people may disagree and more that expecting reasonableness is probably naive. It is sufficient to note that should the United States and China ever actually go to war, it would likely be because of Taiwan.

In this TSMC specifically, and the Taiwan manufacturing base generally, are a significant deterrent: both China and the U.S. need access to the best chip maker in the world, along with a host of other high-precision pieces of the global electronics supply chain. That means that a hot war, which would almost certainly result in some amount of destruction to these capabilities, would be devastating…one of the risks of cutting China off from TSMC is that the deterrent value of TSMC’s operations is diminished.

My worry is that this excerpt didn’t go far enough: the more that China builds up its chip capabilities — even if that is only at trailing nodes — the more motivation there is to make TSMC a target, not only to deny the U.S. its advanced capabilities, but also the basic chips that are more integral to everyday life than we ever realized.

MAD Chips

So is this chip ban the right move?

In the medium term, the impacts will be significant, particularly in terms of the stated target of these sanctions — AI. Only now is it becoming possible to manufacture intelligence, and the means to do so is incredibly processor intensive, both in terms of quality and quantity. Moreover, not only does AI figure to loom large in military applications, but is also likely to spur innovation in its own right, perhaps even in terms of figuring out how to keep pushing the frontier of chip design.

In the long run, meanwhile, the U.S. may have given up what would have been, thanks to the sheer amount of cost and learning curve distance involved, a permanent economic advantage. Absent politics there simply is no reason to compete with TSMC or ASML or any of the other specialized parts of the supply chain; it would simply be easier to buy instead of build. Now, though, it is possible to envision a future where China undercuts U.S. companies in chips just like they once did in more labor-intensive industries, even as its own AI capabilities catch up and, given China’s demonstrated willingness to use technology in deeply intrusive ways, potentially surpass the West with its concerns about privacy and property rights.

The big question that I am raising in this article is the short run: while I have spent most of the last two years cautioning Americans who thought Taiwan was Thailand to not go from 0 to 100 in terms of the China threat, this move has in fact raised my concern level significantly. I am still, on balance, skeptical about a conflict, thanks in large part to how intertwined the U.S. and Chinese economies still are: any conflict would be mutually assured economic destruction.

Chips did, until three weeks ago, fall under the same paradigm; I wrote earlier this year in Tech and War:

This point applies to semiconductors broadly: as long as China needs U.S. technology or TSMC manufacturing, it is heavily incentivized to not take action against Taiwan; when and if China develops its own technology, whether now or many years from now, that deterrence is no longer a factor. In other words, the short-term and longer-term are in opposition to the medium-term…

There is no obvious answer, and it’s worth noting that the historical pattern — i.e. the Cold War — is a complete separation of trade and technology. That is one possible path, that we may fall into by default. It’s worth remembering, though, that dividers in the street are no way to live, and while most U.S. tech companies have flexed their capabilities, the most impressive tech of all is attractive enough and irreplaceable enough that it could still create dependencies that lead to squabbles but not another war.

Those dependencies are being severed; hopefully we still find sufficient reason to go no further than squabbles.

  1. The very first Nvidia chips were manufactured by SGS-Thomson Microelectronics, but have been manufactured by mostly TSMC from the original GeForce on