commentary

(Asian Wall Street Journal )

September 24, 2003

Buying Cheap Chips From China

by Caroline S. Wagner

IBM's recent announcement of layoffs at its U.S. semiconductor plant sounds strangely familiar, bringing back memories of when I started my career as a U.S. government policy analyst in the early 1980s. At that time, I found myself in the midst of a great swirl of concern about the technological ascendancy of Japan. Two decades ago, Japan's policies and programs—combined with a focus on quality and export strength—allowed its companies to surge into the marketplace with highly competitive products. Fear abounded, as seemingly indomitable Japanese companies gobbled market share from more traditional suppliers. Today, the same fears are focused on China.

China is now entering the semiconductor industry that helped create Japan's 1980s competitive surge. In recent U.S. Congressional hearings, American industry complained that China provides preferential treatment for its semiconductor industry. And the World Semiconductor Council warned in May that preferential tariffs for semiconductors conflict with China's World Trade Organization obligations.

No doubt, analysts in Washington and Brussels are churning out trade arguments just as I did 20 years ago. Policy makers soon may be petitioning the WTO to penalize China for its preferential tax treatment of the semiconductor industry. The rumblings of a new trade war may be heard on the horizon. Perhaps there is a lesson to be learnt here: The U.S. was only half-right to fear Japan, and it will be only half-right to fear China.

This much is not in dispute: China is making cheap chips. Chinese government aid includes tax breaks and training. Coordinated links are promoted among industries that use semiconductors in low-cost products, like toys and watches. This clustering of benefits and incentives has proved an effective strategy for developing countries that seek to enter high-tech industry. It is especially effective when the capital and infrastructure costs of getting into business are very high, as with semiconductor facilities.

But what we missed in the 1980s, and only dimly understand today, is that technological competition occurs not among countries, but within networks of industry. The benefits produced by these networks can easily accrue to businesses and consumers far from a company's home base. Trade liberalization and deregulation, the rapid development of information technologies and the creation of the global production networks have fundamentally shifted the competitive landscape in which China now finds itself. It is not the same world that created fears of "Fortress Japan."

Global production networks—where Chinese components are placed into computer motherboards made in Taiwan, assembled into computers in Mexico, combined with flat panel displays from Texas, and shipped to a customer in London—are in the ascendancy. The ability of companies to enter swiftly into this network and sprint to market is what makes the difference.

The companies that participate in these networks are not multinational companies operating according to some vague rules of globalization. That era is over. These companies are global; they are often small players, linked in a virtual value chain. They engage with each other based on trust, speed, and quality. They engage with nations to the extent this makes sense for them to do so. Now, instead of nations helping their national champions to compete, nations are competing to grow or retain these highly competitive companies, encouraging them to put down roots and provide local benefits like jobs and new knowledge.

Semiconductors are commodities. By lowering their price, China is doing the market a favor. By freeing labor and capital from low-end production, smarter business can focus on integration and the leading technological edge. This is where the higher margins are made and markets are captured. Use trade barriers to cut off your links in this networked world, and you lose. To the extent you are a trustworthy and price-competitive supplier, you win a place as a hub in the production network.

Ironically, Japan's coordinated support of its electronics industry helped create this global network. This is where a little fear was a good thing. As Japan appeared stronger, many companies in the U.S. and Europe stoked the fires of their research engines, and began squeezing costs and time-to-market to compete with Japan. As they did so, they moved production and research to the places where it made the most sense in terms of cost and efficiency of knowledge transfer.

Many of the resulting companies are highly competitive household names like Dell, Nokia, and SAP. For its part, Nokia is the largest supplier of mobile phones in China, illustrating that, in a network, what goes around comes around.

A lag in China's compliance with WTO tariff rules will damage its ability to attract foreign direct investment and reduce its ability to be a partner in the global-production network. Even without the WTO agreements, China will soon see that national tariff barriers are counterproductive. Global production networks don't mix with barriers at the border.

The trade wars of the 1980s created bad feeling among many participants. Political relationships soured and xenophobia increased. Similarly, isolating China would be as politically dangerous as it is economically unproductive. Western governments must work with China to address far more pressing military, political and strategic issues, from North Korea's nuclear program to global terrorism and regional stability.

The U.S. and Europe could dust off the invectives and engage China in a new semiconductor trade war. But to what end? Trade wars are the refuge of those that seek to gain through political means what they cannot achieve economically. True economic gains are achieved by creating efficient global relationships, incubating domestic business to enhance knowledge flows, and removing barriers to networked trade. And for the U.S. and Europe, this may mean buying cheap chips from China.


Ms. Wagner holds research positions at RAND Europe and the University of Amsterdam.

This commentary originally appeared in Asian Wall Street Journal on September 24, 2003. Commentary gives RAND researchers a platform to convey insights based on their professional expertise and often on their peer-reviewed research and analysis.