Government Policy and the Growth of the Chinese IC Industry

On February 9th, the first workday after the Chinese New Year, the State Council of China released the country’s first industrial policy of this year: “policies on further encouraging the development of software and integrated circuit (IC) industry”. Known as New Document No. 18 by the Chinese IC industry community, this policy replaces the one expired that at the end of the year 2010. The continued commitment of the Chinese government to supporting the IC industry meant that all major Chinese IC companies, including foundries and fabless design houses, saw a rise in their stock prices on the day after the policy announcement.

Released in 2000, the original Document No. 18 was one of China’s most influential industrial policies. Adopting an import substitution strategy, Document No. 18 offered a series of favorable tax treatments to domestically produced IC chips, in addition to heavy government investment in infrastructure, education and basic research. The United States, the world’s largest IC chip exporter, has viewed Document No. 18 as a threat to the competitiveness of its semiconductor industry. In 2005, by complaining to the WTO for China’s violation of trade rules, the United States forced China to drop most of Document No. 18’s value-added-tax (VAT) rebate for IC producers located in China. But other industry-promoting policies besides the VAT rebate in Document No. 18 remained effective until the end of 2010.

For the Chinese IC industry, Document No. 18 launched a decade of fast growth. During this time, China’s share of world IC chip production rose sharply from less than 1% in 2000 to almost 9% in 2009. Today, China produces 60,000 million semiconductor chips annually. The chip industry’s export revenue increased from US$1,690 million in 2000 to US$23,300 million in 2009, according to CCIDnet. Since the implementation of Document No. 18, large-scale semiconductor clusters not only have consolidated in China’s costal manufacturing centers, such as Yangtze River Delta, Pearl River Delta, Beijing, and Tianjin, but also are emerging in inland Wuhan and Sichuan Province. During this time, giant semiconductor multinationals accelerated the relocation of their productive capabilities, from back-end packaging and testing to chip design and manufacturing, to China. But most of all, the spectacular growth is driven by indigenous Chinese competitors. A Shanghai-based startup in 2000, SMIC( 中芯国际) has already become the world’s fourth largest chip contract manufacturer, operating the largest and most advanced chip fabrication facility in China.

Yet even after ten years of fast growth, China still needs to import roughly 80 percent of the chips it consumes today. In 2010, China spent more money on importing IC chips (US$156,990 million as the largest category of imports) than on crude oil (US$135,150 million) and iron ore (US$79,430 million), according to trade data from China Customs. Even though the trade deficit in semiconductors is primarily the result of the country’s re-export processing business, it nevertheless lays the background for the government’s continued involvement in industry promotion.

Indeed, as early as 2005, the Chinese IC industry was seeking new forms of subsidies from the government when the VAT rebate was terminated. Regional governments, from the high-income metropolitan areas of Shanghai and Beijing to relatively poor Wuhan and Chengdu, have all invested heavily in the construction of extremely expensive semiconductor fabs in their municipalities. The New Document No. 18 legitimizes such subsidies, allowing budget money from central and regional governments to be allocated to subsidize technological upgrading. Moreover, the new policy plans to contract government R&D projects to these IC firms, aiming at nurturing R&D capabilities at the firm level.

With the implementation of the New Document No. 18, the growth of the Chinese IC industry is likely to accelerate again. But will the policy promote the emergence of more innovative firms? As this column pointed out earlier, the social conditions of innovative enterprise require strategic control, organizational integration and financial commitment. Even with the intensive involvement of the Chinese government, the decision-making process has remained inside the firms, so the strategic control over the allocation of resources by executives of chip companies has stayed intact. The investment from the government is likely to be long-term, low-cost financial commitment. What remains in questions is whether these Chinese firms will be able to build learning organizations to engage in the uncertain, collective and cumulative process of innovation. The New Document No. 18 calls for using stock-based compensation to place incentives for the managers and engineers in these high-tech firms, following the paradigm of the Silicon Valley model. It could be a good idea, as long as the Chinese policy makers can prevent the companies from being “financialized”, with key people in these companies becoming more interested in making money for themselves than in generating high quality, low cost products for their companies.