6. Securing the semiconductor supply chain in an era of geopolitical uncertainty
Key Point Summary
Semiconductors are the building blocks of modern life: From smartphones to energy networks and advanced weapons systems, having a resilient supply of semiconductors is vital to world prosperity and security.
China’s threats against Taiwan pose a catastrophic risk to the semiconductor supply chain: Analysts predict that disruption to semiconductor foundries in Taiwan could cost US$490 billion in revenue for electronic device manufacturers annually, with knock-on effects for supply chains in nearly all manufacturing sectors.
Onshoring semiconductor supply chains is not viable: The complexity of the semiconductor production means that creating an end-to-end domestic supply chain would be slow and hugely expensive. Instead, governments should pursue ‘friend-shoring’ strategies whereby partners benefit from specialisation and comparative advantage.
Safeguarding Taiwan’s security is key to supply chain security: Taiwan’s indispensable role in semiconductor supply chains means that maintaining peace across the Taiwan strait must be a part of any countries' semiconductor strategy. Democratic countries should work to deter Beijing’s aggression against Taiwan through increased political, economic and defence cooperation in the region.
What are semiconductors?
Semiconductors (commonly referred to as ‘chips’) are components that enable electronic devices to function. They are found in nearly all electronic goods, not only laptops and smartphones, but also cars, fridges and traffic lights. Demand for semiconductors is set to grow rapidly in the coming decades, with the components vital to development of technologies in smart devices, green energy and next generation communications infrastructure such as 5G networks. Semiconductors will also play a vital role in the future of the military industrial sector, with advanced weapons systems, artificial intelligence and space all dependent on the development of semiconductors. The total global semiconductor market in 2022 was valued at 601 billion US dollars.
What are the risks posed by semiconductor supply chain disruption?
The foundational role played by semiconductors in nearly all industries means that disruption to international semiconductor supply chains has knock on effects across the global economy.
The need for a stable supply of semiconductors was put into sharp relief at the onset of the COVID-19 pandemic, as lockdown restrictions created bottlenecks and shortages in labour intensive stages of the semiconductor production process. It is estimated that these shortages impacted 169 industries globally, with costs to the automotive industry alone estimated to total $210 billion in fallen revenues and the lost production of 7.7 million vehicles in 2021.
Given the vital role played by semiconductors in defence and dual use technologies, countries that cannot guarantee a resilient supply of semiconductors risk their prosperity, security and have a reduced room for manoeuvre when rising to meet new challenges.
What would the impact of military action against Taiwan have on global semiconductor supply chains?
The prospect of Chinese military action against Taiwan is not a remote possibility. President Xi Jinping has repeatedly reiterated the Chinese Communist Party’s desire to ‘reunify’ the island with the mainland and refuses to rule out the use of force to do so.
It is difficult to understate the detrimental impact that Chinese military action or economic blockade against Taiwan would have on global semiconductor supply chains. The Taiwan Semiconductor Manufacturing Co. (TSMC) alone is responsible for around 60% of the world’s semiconductor production by revenue, and over 90% of production in the most advanced semiconductors (defined as those less than 10 nanometers in size). Some of the world’s largest tech firms, including Apple, Amazon and Google rely on Taiwan-based contract manufacturers for nearly 90 percent of their chips.
According to expert estimates, a full-scale disruption of semiconductor foundries in Taiwan would have an annual spillover impact of a US$490 billion in lost revenue for electronic device manufacturers across different markets. Such disruption would be a major contributing factor to the US government’s reported estimates of $2.5 trillion in annual losses to the global economy should China blockade Taiwan.
The impact would be more than short term disruption. Taiwan has achieved its position as the world’s leading advanced semiconductor manufacturer through five decades of accumulating capital investment and technical expertise. Taiwan is unique in having comprehensive manufacturing capabilities across different stages of semiconductor production and has a large talent pool of engineers at differentiated levels of expertise. Analysts predict it would take at least three years and a $350 billion investment for the rest of the world to build enough capacity to replace Taiwanese foundries.
Building a resilient semiconductor supply chain
Onshoring an end-to-end supply chain is not viable
Governments looking to secure critical supply chains may consider ‘on-shoring’ – whereby domestic production capacity is developed to replace reliance on imports. However, this is not a viable option for the semiconductor supply chain. The semiconductor supply chain is complex and relies on drawing designs, materials and manufacturing inputs from across the world. Each stage of the production process is highly specialised and no one country has dominance across all stages of the design and production process. To replace the existing international supply chain with an end-to-end, domestic supply chain would require an incremental upfront investment of more than US$1 trillion and would push semiconductor prices to climb sharply.
Building an effective ‘friend-shore’
Instead, governments must look to increase semiconductor supply chain resilience by ‘friend-shoring’. This strategy sees like minded countries working together to ensure that all stages of production are covered between the partnering countries. In this way, each country can maintain its supply even while relying on foreign inputs, while also gaining from efficiencies of specialisation and comparative advantage.
Building an effective friend-shoring relies on each partner in the group playing to its strengths. The ‘Chip 4 Alliance’ between the US, Taiwan, Japan and South Korea serves as one model for this. This partnership is viable because while Taiwan and South Korea act as the world’s leading semiconductor manufacturers, Japanese firms can lead the supply of key materials and equipment while US firms dominate the supply of semiconductor design software and IP cores.
For each partner to play to its strengths, governments need to invest in their specialist capabilities. For example, the US and Europe are leaders in electronic design automation (EDA), IP core and chip designs. The US and EU Chips Acts both set out ambitious investments in R&D, with state investment having been found to be critical to retaining these industrial advantages. This represents a far more strategic use of resources than the related initiatives in the same Acts which seek to boost domestic production that can be better done abroad. Though there are some advantages to increasing domestic semiconductor production in the US and Europe, this will not be at a sufficient quantity or efficiency to meaningfully reduce import dependence on other countries, particularly with regards to the most advanced chips from Taiwan.
A key challenge for the Chip 4 Alliance and other friend-shoring initiatives is the reliance on China for rare earth materials. China currently holds 60% of global rare earth mined production and 85% of rare earth processing capacity. To ensure the viability of the friend-shoring, initiatives must include leaders in rare earth mineral production and processing, such as Australian firms.
Preventing the outflow of intellectual property
A key to protecting strategic advantages in semiconductors is preventing attempts by hostile competitor’s to steal or to buy up domestic technologies and know-how. Of particular note is the Chinese government’s ‘Made in China 2025’ strategy, which seeks to ‘decouple’ from the West in critical technologies, including through acquiring foreign expertise for Chinese firms. For instance, the UK government was right to use ‘call in’ powers granted under the National Security and Investment Act to unwind the Chinese owned Nexperia’s takeover of British semiconductor manufacturing firm Newport Wafer Fab, citing concerns that the firm could use the takeover to gain advances in compound semiconductors to the detriment of the UK’s own capabilities. Ensuring that government investment instruments have sufficient capacity to analyse acquisitions is particularly important given the Chinese government’s strategy of using third country’s companies as the vehicle to make acquisitions of technology companies abroad. It is notable that only 14 EU Member States have national investment screening mechanisms.
It is worth noting that guarding against hostile mergers and acquisitions led by the Chinese government does not mean countries should seek to block all commercial activities with China. Taiwan's regulation requires semiconductor producers to obtain government approval for partnerships with Chinese firms, while investments are limited to building up to three 12-inch wafer foundries in China. Outside of these requirements, Taiwanese companies can pursue their business interests in China.
It is reasonable that governments are seeking regulation since China is catching up with other countries’ strategic advantage in semiconductor production. However, highly restrictive export controls can be a blunt instrument in this regard. While US efforts to restrict the export of advanced semiconductor to China may be sensible in preventing China from building strategic capabilities, attempting to block chip-equipment being sold to China risks hurting semiconductor firms and alienating allies. In most cases, private firms trading with China can be trusted to protect their intellectual property, as this is within their commercial interest.
Safeguarding Taiwan’s security
Taiwan plays an unparalleled role in the semiconductor supply chains, and will be indispensable to any friend-shoring initiative. Taiwan’s dominance is particularly high in the most advanced chips, where it produces over 90% of the world’s supply. Analysts estimate it would take several years and at least a US$350 billion investment for the rest of the world to build enough capacity to replace Taiwanese foundries.99 It is neither feasible nor desirable to cut dependency on Taiwanese semiconductors.
Guaranteeing Taiwan’s security and maintaining peace across the Taiwan strait therefore should be a common major focus of semiconductor strategies. Especially for those countries that are passive and lack advantages in the semiconductor supply chain. By deterring China from carrying out military action against Taiwan, countries are not only supporting a key democratic ally in the region but are also acting to secure its critical supply chains and the prosperity of the global economy. The middle powers with military capability could increase participation in freedom of navigation missions with allied partners, and signal its commitment to the region’s security.
Countries should also make clear to the Chinese government that the severity of economic sanctions and diplomatic isolation resulting from any action against Taiwan would be at least on par with measures taken against Russia following the invasion of Ukraine. China’s attempts to isolate Taiwan from the international stage are a core part of its strategy to weaken international resistance to future coercion against Taiwan. By fostering greater political, economic and people to people ties with Taiwan can push back against these attempts, including supporting Taiwan’s existence in multilateral institutions, such as the World Health Organisation, International Civil Aviation Organization and International Labour Organisation.
Recommendations
Expand and expedite friend-shoring initiatives. Progress on the Chip 4 Alliance has reportedly stalled, and proposals currently contain no European members. To maximise their effectiveness, friend-shoring initiatives must also address rare earth minerals and rare earths processing.
Identify and invest in areas of strategic advantage. For an effective friend-shoring, partners must understand and build their comparative strengths. While the US and Europe may be tempted to invest in domestic manufacturing capacity, resources are more effectively spent on maintaining existing leads in chip design.
Protect existing technological leads. Governments must establish effectively resourced investment screening mechanisms to prevent hostile takeovers and technology transfer to China and other systemic competitors. While semiconductor trade with China must be restricted in sensitive areas, private firms can be trusted to protect their own intellectual property.
Safeguard Taiwan’s security. Providing a strong economic and military deterrent to prevent China from taking coercive actions against Taiwan, as well as strengthening Taiwan’s role in multilateral institutions, is a central component in ensuring the resilience of semiconductor supply chains.