China's Chip Woes: Dominating Low-End, Missing Out on High-End

Although China continues to advance in legacy chip production, it remains far behind the West in the most advanced models needed for the next generation of military technologies

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China continues to find new ways to import high-end semiconductor chips and other technologies in violation of US export controls introduced in late 2022. On July 2, a Wall Street Journal investigation revealed an underground network of over 70 Chinese entities that receive shipments of contraband chips and chip manufacturing equipment each week. This investigation's results are only the latest in a series of efforts by Chinese entities to procure these items in recent years.

Although China has continued to import smuggled chips since 2022, these are hardly enough to meet local demand. This lack of imports, combined with a limited domestic capacity, could deprive China of the next generation of advanced military technologies.

Export controls and their impact

In October 2022, the US Department of Commerce revised its export controls on semiconductor technology to limit China's access to high-end chips, manufacturing equipment, and know-how. This agreement was followed by a three-way export control agreement with the Netherlands and Japan, further revisions to the 2022 export controls, and restrictions on outbound investments in semiconductors and quantum information.

The results of these restrictions have been mixed. They have impaired China's ability to legally procure advanced chips used in areas such as artificial intelligence (AI) development. Nvidia, now the world's most valuable company, is one of the largest producers of specially-manufactured chips for AI applications. Due to the export controls, China has been unable to tap into this supply and the equipment needed to produce homegrown alternatives, undercutting progress in spheres such as AI and military modernization. However, gaps in the enforcement of export controls have allowed China to continue to import some of these technologies.

International export restrictions have impacted the balance sheets of Chinese semiconductor companies, with the country's largest chipmaker, Yangtze Memory Technologies, reportedly burning through $7 billion to maintain operations as a result of them. Meanwhile, China's premier semiconductor foundry, Semiconductor Manufacturing International, experienced a 13.1% fall in annual profits in 2023. However, China has significantly expanded its production of so-called 'legacy chips'; these older model units are primarily used in cars, home appliances, and consumer electronics but also have military applications. The proliferation of these 'dual-use' chips is a major concern to policymakers around the world due to their expanding usage in low-cost drone and missile technologies, which pose a significant threat to conventional militaries.

The Iran-made Shahed 131 contains several Western-made legacy chips, demonstrating the deadly consequences of the proliferation of these older units. Image source

China's struggle to keep pace

China has long aspired to technological self-sufficiency, as evidenced by its 2015 'Made in China 2025' initiative that aims to make the country an advanced manufacturing hub. During a 2018 tour of northeast China's rust belt, President Xi Jinping said, "Unilateralism and trade protectionism have risen, forcing us to travel the road of self-reliance." Beijing also expressed its goal to enhance China's technological self-sufficiency in its fourteenth and current Five-Year Plan, which it adopted in 2021. However, increased export controls have likely lengthened China's timeline toward technological self-sufficiency.

China has adopted a multipronged approach to achieve its technological goals. Intellectual property theft is a significant component of this strategy. According to the Centre for Strategic and International Studies, Chinese entities have engaged in 224 publicly reported instances of intellectual property theft and industrial espionage in the US since 2000; 78% of these cases occurred between 2010 and 2022. Several notable cases have occurred in recent years, such as the 2016 theft of microchip designs from an American company that paved the way for a $5.7 billion production plant in China.

Export controls will likely accelerate the pace of China's industrial espionage if they have not already. China aims to produce 70% of its own chips by 2025 but currently only produces around 20%. China must acquire advanced lithography machines for chip production to achieve this goal. Last year, ASML, Europe's largest tech company and the world's only manufacturer of sophisticated Extreme Ultraviolet (EUV) lithography machines, said that a Chinese company had misappropriated proprietary data from the company. Semiconductor companies from Japan, Korea, and Taiwan have experienced similar thefts.

Another pillar of China's strategy is to circumvent export controls. It is doing so by setting up shell companies and offshore entities en masse, which, coupled with falsified documents, allow it to smuggle in chips in vast quantities. On multiple occasions, chips have been imported to a country far from the US and then rerouted to China. In this way, several Chinese military and state-owned AI research institutions have reportedly accessed small batches of advanced H100 chips made by Nvidia. In other cases, China has exploited export control loopholes to import chips and equipment legally. In one example, China frontloaded imports of lithography machines from US allies before these partners could follow America's lead in imposing restrictions. 

Export restrictions have also spurred a flurry of illicit activity from individual buyers within China, as well as smuggling rings, which purchase chips from Nvidia insiders in places such as Hong Kong, Malaysia, and Singapore. Human couriers transport these chips to mainland China; in one incident, a woman wore a prosthetic pregnant abdomen containing several chips and other devices before airport customs intercepted her. However, this kind of smuggling primarily caters to the demand of retail consumers and smaller Chinese research institutions and companies rather than large conglomerates due to the relatively small quantity of units a single person can transport. Moreover, the lithography machines needed to produce chips are massive, with some as large as a school bus; this represents a problem that Chinese smugglers cannot address.

In the longer term, China aims to improve its technological self-sufficiency by fostering domestic research and development. Last year, the government empowered firms such as SMIC and toolmakers such as Naura to access privileged R&D resources. It has also infused funding into the sector, setting up a $47.5 billion state investment fund, the third of its kind. The effects of this push are already visible across several parts of China's semiconductor value chain. For example, China's imports of semiconductor chips declined in 2022 and 2023, which Citigroup Global Insights claims could be a sign of import substitution.

Many believe China is poised to dominate the global legacy chip market. Image source

Way forward

Various studies note that the Chinese government is now working to exert greater control over its legacy semiconductor chip markets while pushing out US customers such as Intel and Broadcom. Specifically, China will likely continue to ramp up its capacity to make these dual-use chips, with some claiming it is poised to become a major exporter of these moving forward. Like other domestic industries, the Chinese government guides this process at every step, from procuring machinery to setting up factories and attracting top talent. Last year, the Chinese government launched a new talent program called Qiming to attract Chinese engineers and chip designers from around the world, many of whom have been educated at top American universities.

Although China continues to make significant strides in its domestic production of legacy chips, the technological gulf between it and the US continues to widen regarding cutting-edge chips. This gap is mainly due to China's lack of extreme ultraviolet (EUV) lithography machines, which are only produced by ASML and subject to heavy export restrictions. EUV machines are essential for producing advanced AI chips, hindering China's development in this area to the point that Chinese firms are reportedly rationing their computing power until they can find an alternative solution. China is reportedly working to develop a domestic EUV machine in response. Still, the innovative capacity and high capital intensity required to achieve this could make such a feat years off, likely depriving China of the most critical military technological advances moving forward. In response, China has already begun restricting its exports of other items with military applications, such as shipbuilding and aerospace components.

EUV lithography machines produce the world’s most advanced chips. Each one is around the size of a school bus and costs over $380 million. Image source

Conclusion

The competition for advanced chip supply chains will remain central to the strategic competition between the US and China in the years to come. China's growing edge in legacy chip production may work in its favor as the US will not want to be crowded out of those markets. Although Washington's efforts to curb China's development in the most advanced fields of military technological development, including AI, have been largely successful, China’s proliferation of older legacy chips on the world stage could have significant consequences moving forward.