Two dates from 2022 are destined to echo in geopolitical history. The first, Russia’s invasion of Ukraine on February 24, hardly needs further elaboration. The second is October 7, 2022, when the United States enacted a new set of export controls designed to cripple China’s future progress in AI technology. Rather than target AI software, the export controls choke off China’s access to the advanced (and almost exclusively American-designed) computer chip hardware that powers AI. More than a decade of breakthrough after breakthrough in AI technology has convinced policymakers in both Beijing and Washington that leadership in AI technology is foundational to the future of economic and military power. On October 7th, the U.S. government committed to stopping China from becoming an AI-enabled authoritarian superpower.
Things got tougher for China in March 2023, when Japan and the Netherlands announced that they were also adopting new export controls on advanced semiconductor manufacturing equipment. Combined, the U.S., Japan, and the Netherlands provide roughly 90% of all the equipment that is used in computer chip factories worldwide. All three countries are now enforcing strict export controls on advanced semiconductor manufacturing equipment, so China not only can’t buy U.S. chips, but it also can’t buy the equipment needed to make Chinese alternatives.
In the months since October 7, the world has waited to see how China would retaliate against the U.S. and its allies, as China’s diplomats have constantly threatened to do. “This will not be without consequences,” said a Chinese ambassador in March. “We won’t just swallow this.”
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Now, the wait is over. With three targeted moves, China has begun striking back.
First, China’s anti-trust authority has effectively blocked any and all corporate mergers involving a U.S. semiconductor company that operates in Chinese markets. While this is hardly as significant as the U.S., Dutch, and Japanese export controls, it is more painful for the U.S. semiconductor industry than it might at first sound. Corporate mergers are critical for U.S. companies to acquire innovative technology and to make strategic changes to their business model. Intel CEO Pat Gelsinger recently visited China in an effort to persuade officials there to approve Intel’s $5.4 billion acquisition of Tower Semiconductor – a deal that Intel’s leaders see as vital to the company’s future. The completion of the deal is six months behind schedule and rapidly approaching its August 2023 termination deadline.
Second, China initiated a cybersecurity review of Micron, the leading U.S. producer of memory chips. In late May, China’s regulators banned purchases of Micron chips in China’s critical infrastructure sector. Though Chinese regulators publicly claim that this decision was made entirely on cybersecurity grounds, Chinese diplomats privately acknowledge that this is indeed politically motivated retaliation for the October 7 export controls. Thus far, there has been no indication that Micron has been banned from the entire Chinese market, though that could change in the future. Micron’s annual sales to China total $3.3 billion, so losing access to Chinese customers would be painful.
Third, China has announced that exports of gallium and germanium, two minerals that are important raw inputs for electronics manufacturing, are now subject to export license requirements. China is the dominant global supplier of both materials, and China’s government can now block exports at its discretion. Gallium, in particular, is critical for many types of semiconductor technology. Though China’s government has not explicitly stated that the export controls are a response to October 7, this is undoubtedly what they intend.
Gallium and Germanium are hardly rare commodities that the world would struggle to replace, even in the event of a total Chinese export ban. Both commodities are natural by-products of mining other minerals, such as aluminum and zinc, so U.S. or other non-Chinese mining companies can easily get into the business of selling germanium and gallium if China seeks to choke off supply. Numerous international semiconductor companies, including ones that specialize in gallium-derived products, have stated that they expect no material impact to their business.
Thus, China’s government likely intended this move as a warning shot to deter future action by the U.S. and its allies. The new export restrictions are not especially significant in and of themselves, but China is threatening to exercise its control over the broader mineral supply chains. Most notably, China dominates rare-earth metal mining and refining, controlling more than 60 percent and 80 percent of global capacity, respectively.
An export ban on rare earths would hurt far more, but even in this case, the potential availability of non-Chinese substitutes is a question of political will, rather than technological feasibility or geographic availability. Rare-earth ore deposits are available in many places, not just China. If U.S. and allied governments are willing to spend the money (and expedite approval of regulatory permits) it is much, much easier, even if it takes some time, for them to replace China in mineral supply chains than it is for China to replace the U.S. and its allies in semiconductor supply chains. China is decades behind the state of the art in semiconductor manufacturing equipment achieved by the United States, Japan, and the Netherlands.
Moreover, if China were to exercise its ability to restrict supplies of rare earths, it would call into question reliance on China as a trustworthy supplier not only in critical minerals but in every other economic sector. “Decoupling” is out of fashion as a policy term, but “de-risking” and “diversification” both featured prominently in recent Group of Seven (G7) and European Union economic security announcements. Policymakers and corporate executives around the world are trying to establish new and expanded trading relationships with partners who can provide viable alternatives to China as both a customer and a supplier. This is only an acceleration of a trend that was already underway. Samsung, for example, closed its last Chinese mobile phone factory in in 2019, moving production to Vietnam, India, and elsewhere. Likewise, computer manufacturer Dell announced plans to cease purchases of Chinese-made chips by 2024.
This is the basic reason why the Biden administration calculated that it has escalation dominance when it comes to technology export controls. There are some critical technologies where China simply cannot do (at least for now) what companies in the U.S. and allied countries can do. Thus, any time that China wants to inflict pain upon the U.S. or its allies, it can do so, but only by hurting themselves even more.
In the wake of October 7, analysis and speculation surrounding China’s retaliation have dominated the news coverage. However, retaliation is not the most significant element of China’s strategy. Four parts of China’s new and updated semiconductor strategy really matter:
First, China is working to evade the chip export controls by smuggling in advanced AI chips and other technology so that it can continue its AI development efforts. The Bureau of Industry and Security (BIS) at the U.S. Department of Commerce is the agency charged with enforcing export controls, not just on semiconductors bound for China, but for all U.S. controlled dual-use exports worldwide. To implement its work overseeing trillions of dollars in economic activity, BIS has fewer than 600 employees and a relatively paltry budget of just under $200 million. China is betting that its network of smugglers and shell companies can find the leaks in the BIS export control enforcement barrier. As long as Congress continues to neglect BIS with grossly inadequate resources compared to the size and importance of its mission, China may be right.
Second, China is working to divide the U.S. from its allies. In the case of the Netherlands and Japan, China already failed to dissuade them from adopting new export controls. But, that doesn’t mean China is giving up, only turning its attention to other countries in Europe as well as South Korea. China may be decades behind the U.S., Japan, and the Netherlands in semiconductor manufacturing equipment, but Germany and South Korea are not. The combination of German and Korean technical expertise with Chinese financial resources and engineering capacity would be a serious threat.
Third, China has stepped up its pre-existing industrial espionage and talent recruitment efforts. During the Cold War, the U.S. Central Intelligence Agency (CIA) concluded that the Soviet Union’s effort to illegally acquire semiconductor manufacturing equipment and the knowhow to operate it dwarfed every other Soviet industrial espionage activity. The situation is no different for China, which has radically stepped up its use of cyber espionage tools and talent poaching. ASML, the world’s leading semiconductor equipment manufacturer, stated that it faces thousands of cybersecurity incidents each year, and has repeatedly struggled with its employees and partners in China stealing proprietary engineering data and illegally selling it to Chinese government-backed firms. American, Japanese, Korean, and Taiwanese semiconductor companies are all facing similar challenges.
Fourth and most importantly, China is investing hundreds of billions of dollars to build an all-Chinese supply chain that eliminates dependence on foreign technology suppliers. The Biden Administration’s export controls did not cause this; it has already been underway for more than a decade. China’s Made in China 2025 policy (originally announced in 2015) had among its goals for the Chinese semiconductor industry “replacement of imports with Chinese-made products.” A diplomatic backlash led China to stop talking openly about Made in China 2025, but the policy never went away. In fact, China’s leaders doubled down on the fundamental “self-reliance” goals of Made in China 2025 in the wake of the Trump administration’s trade war and export controls on Chinese tech firms ZTE and Huawei. The Chinese State Council’s July 2020 semiconductor policy (adopted nearly a year before Biden took office) described imports of foreign semiconductor manufacturing equipment as a “temporary” necessity until Chinese companies had sufficiently advanced to replace their foreign competitors.
These are unacceptable terms for the basis of any trading relationship between China and the U.S. The Biden administration’s efforts have routinely (and erroneously) been attacked as a decoupling strategy. In reality, however, China’s policy is far closer to decoupling than America’s. The October 7th export controls didn’t change China’s strategy, but by blocking access to chip-making equipment, they did make it harder for China to succeed.
Thus, German and South Korean firms who might be attracted to the short-term profits that would come with transferring technology to their Chinese competitors would do well to remember that they are helping to build a Chinese future that foresees no meaningful long-term role for non-Chinese companies. The quarterly and annual profits will probably be great. The five- and ten-year outcomes will be disastrous. One hopes that their governments are taking this into account as they consider adopting new export controls similar to those of the U.S., Netherlands, and Japan.
China’s retaliatory efforts are meant to scare the U.S. and its allies, and in that sense they are probably working. Fears of retaliation continue to dominate the news cycle and loom large in the minds of policymakers, particularly in key fence-sitting countries such as Germany and South Korea. But, despite the genuine pain being inflicted upon the firms targeted by China, the more strategically significant issues are China’s multi-decade policy of eliminating foreign firms from its technology supply chains and the threat of an authoritarian superpower that dominates the future of AI. The U.S. and its allies will likely never succeed in persuading China to give up on those goals, but if they stand strong together, they can ensure that China’s strategy fails.
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