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SPECIAL REPORT-TAIWAN CHIP INDUSTRY EMERGES AS BATTLEFRONT IN U.S.-CHINA
SHOWDOWN

By Yimou Lee, Norihiko Shirouzu, David Lague

17 Min Read

TAICHUNG, Taiwan, Dec 27 (Reuters) - On the front line of the superpower
struggle between the United States and China, Taiwan has fashioned a defensive
masterstroke. It has become indispensable to both sides.

In dominating the fabrication of the most advanced semiconductors, the giant
Taiwan Semiconductor Manufacturing Company Ltd (TSMC) has captured a technology
that’s crucial to the cutting-edge digital devices and weapons of today and
tomorrow. TSMC accounts for more than 90% of global output of these chips,
according to industry estimates.

Both superpowers now find themselves deeply dependent on the small island at the
center of their increasingly tense rivalry.

For Washington, allowing an increasingly powerful China to overrun TSMC’s
foundries in a conflict would threaten U.S. military and technological
leadership. However, if Beijing invades, there is no guarantee it could seize
the prized foundries intact. They could easily become a casualty of the
fighting, severing the supply of chips to China’s vast electronics industry.
Even if the foundries survived a Chinese takeover, they would almost certainly
be cut off from a global supply chain essential to their output.

Both America and China want to break their dependency. Washington has persuaded
TSMC to open a U.S. foundry that will make advanced semiconductors and is
preparing to spend billions rebuilding its domestic chip-making industry.
Beijing, too, is spending big, but its chip industry lags a decade or so behind
Taiwan’s in many key areas. Analysts say that gap is expected to widen in the
years ahead.

So valuable are these foundries to the global economy that some here refer to
Taiwan’s chip sector as a “silicon shield” that deters a Chinese attack and
ensures American support.

In an interview, Taiwan Economy Minister Wang Mei-hua told Reuters in September
that the industry is deeply intertwined with the island’s future.

“This isn’t just about our economic safety,” she said. “It appears to be
connected to our national security, too.”

In a later statement, the ministry played down the silicon-shield theory.
“Rather than saying that the chip industry is Taiwan’s ‘Silicon Shield,’” the
statement said, “it is more appropriate to say that Taiwan has an important
position in the global supply chain.”

The danger for Taiwan is that TSMC’s fabs, as the chip fabrication plants are
known, are right in the line of fire.

The foundries are located on the narrow plain along Taiwan’s west coast facing
China, some 130 kilometers away at the nearest point. Most are close to
so-called red beaches, considered by military strategists as likely landing
sites for a Chinese invasion. TSMC’s headquarters and surrounding cluster of
fabs at Hsinchu in northwest Taiwan are just 12 kilometers from the coast.

The industry’s vulnerability was on display in July last year, when Taiwan
mobilized thousands of troops to fight off a simulated Chinese attack on the
west coast industrial city of Taichung, home to TSMC’s Gigafab 15, one of the
foundries that make cutting-edge chips.

In the counter-invasion exercise, “enemy” paratroopers dropped on Ching Chuan
Kang air base and captured the control tower, just nine minutes’ drive from
Gigafab 15. Off the coast, a virtual Chinese invasion flotilla steamed towards
the city’s beaches. Fighting enveloped Taichung as Taiwanese troops and tanks
counterattacked to regain control of the air base; commanders called in
airstrikes, missiles and artillery, using live ammunition to pound the “invasion
fleet.” The invasion was repulsed.

In mocking the exercise scenario, reports in China’s state-controlled media
reinforced the potential for destruction: Waves of missile strikes would destroy
the island’s forces before a Chinese landing, they said.

China’s defense ministry and the Taiwan Affairs Office didn’t respond to
questions for this story.

Asked about the threat to the island’s fabrication plants, the Taiwan economy
ministry said that in “the past 50 years, China has never given up trying to use
force to control Taiwan, but its aim is not the semiconductor industry.” Taiwan,
it added, had the ability to “face and manage this risk.”

TSMC did not answer specific questions about the exposure of its foundries. In a
statement, it emphasized that the chip industry is global and relies on design,
raw materials, equipment and other services from several regions and many
specialized companies. “Therefore, rather than one company or one region, global
collaboration is vital for semiconductor industry success,” the company said.

AMERICAN ANXIETY

As China ratchets up its military intimidation of Taiwan, Washington is
signaling anxiety over U.S. chip dependency.

“The big concern in Washington is the possibility of Beijing gaining control of
Taiwan’s semiconductor capacity,” said Martijn Rasser, a former senior
intelligence officer and analyst at the U.S. Central Intelligence Agency. “It
would be a devastating blow for the American economy and the ability of the U.S.
military to field its (weapon) platforms,” said Rasser, now a senior fellow at
the Center for a New American Security.

In one of the Biden administration's clearest statements on the need to resist a
Chinese attack on Taiwan, a top Pentagon official told the Senate Foreign
Relations Committee here on Dec. 8 that the island's semiconductors were a key
reason why Taiwan's security was "so important to the United States."

A spokesperson for the White House National Security Council had no comment on
the chip vulnerability, but said Washington “would regard any effort to
determine the future of Taiwan by other than peaceful means a threat to the
peace and security of the Western Pacific.”

Taiwan’s chip supremacy, while clearly a strategic advantage, might not be
enough to deter China from trying to take the island by force, some warn.

The deep economic interdependence among the nations of Europe failed to prevent
war in 1914, said retired U.S. Marine Corps Lieutenant General Wallace Gregson,
a former assistant secretary of defense in the Obama administration. While the
semiconductor industry is “thoroughly beneficial” to the island’s security,
Gregson said, it’s questionable whether this would prevent conflict once the
“dogs of war get loose.”

What’s more, he added, Chinese President Xi Jinping has staked his legacy on
bringing Taiwan under Beijing’s control. “He can’t be seen to compromise, much
less back down,” Gregson said. “He is tied to this achievement.”

At risk for China and America is access to chips that power almost all advanced
military and civilian technologies, including mobile phones and the medical
diagnostic and research tools that have been invaluable in fighting the COVID-19
pandemic.

The most advanced chips, which are critical in the U.S.-China arms race, are
those described as 10 nanometers or below – the sector dominated by Taiwan.
These tiny devices pack billions of electronic components here in an area as
small as a few square millimeters.

A major U.S. worry is losing ground in the race to use artificial intelligence
in weaponry. AI enables machines to outperform humans at solving problems and
making decisions. It is expected to revolutionize warfare, and it hinges on
semiconductors.

In a March report to Congress, the bi-partisan National Security Commission on
Artificial Intelligence warned here that the threat to TSMC exposed a glaring
vulnerability. Taiwan produced the "vast majority of cutting-edge chips" a short
distance from America's "principal strategic competitor," the report said. "If a
potential adversary bests the United States in semiconductors over the long term
or suddenly cuts off U.S. access to cutting-edge chips entirely, it could gain
the upper hand in every domain of warfare."

Much is at stake for Beijing, too. The loss of chips from Taiwan would crush
Chinese industry. China accounts for 60% of world semiconductor demand,
according to an October 2020 report from the Congressional Research Service.
More than 90% of semiconductors used in China are imported or manufactured
locally by foreign suppliers, the report said.

Taiwan is a critical supplier. In the first quarter this year, nearly half of
Taiwan’s exports to China, the island’s largest trading partner, were
semiconductors – a 33% increase from the same period last year, according to
data from the island’s economy ministry.

The global chip shortage caused by supply disruptions amid the COVID-19 pandemic
is giving a foretaste of the havoc a Taiwan conflict would wreak. The loss of a
single year’s output from Taiwan would bring the international electronic supply
chain to a halt, according to an April report from Boston Consulting Group and
the Semiconductor Industry Association, the lobby for the U.S. industry.

The contours of this silicon standoff, with both China and America dependent on
Taiwan, began taking shape decades ago as a consequence of U.S. and Taiwanese
policy choices. The U.S. semiconductor sector remains dominant in many ways,
through its leadership in research, development and design. It accounts for
almost half of revenues in a global industry worth an estimated $452 billion
this year. But America has largely outsourced manufacturing of advanced chips,
mostly to Taiwan.

BREAKFAST BREAKTHROUGH

Taiwan’s rise as chip power dates back to a breakfast in early 1974 at a
downtown Taipei eatery known for its soy milk and steam buns, according to an
account by the island’s Industrial Technology Research Institute.

A Chinese-born executive from a leading U.S. tech company, Radio Corporation of
America, discussed a bold idea with Taiwanese officials: Build a semiconductor
industry from scratch on the island. Taipei struck a tech-transfer agreement
with RCA and sent engineers to work there.

“Back then, no one knew these technologies would become so important,” said Chen
Liang-gee, who served as Taiwan’s Science and Technology Minister until May
2020.

In 1985, Chinese-born engineer Morris Chang, a 25-year veteran of another U.S.
semiconductor power, Texas Instruments Inc, was recruited to head technology
development in Taiwan. In 1987, Chang founded TSMC with the government as the
major shareholder.

Chang made a decision that reshaped the global industry: He decided that TSMC
would be a pure foundry, making chips for other companies. Orders poured in from
Western makers who wanted to focus on design and cut costs.

Today, TSMC has the eleventh-highest market capitalization of any listed
business. This year, it plans to outlay about $30 billion in capital investment,
dwarfing Taiwan’s $16 billion defense budget.

In a speech in Taipei in April, Chang likened Taiwan’s chip industry to a “holy
mountain range protecting the country,” a phrase popular in Taiwan that is used
to describe TSMC’s pivotal role in the island’s economy. “I used it to make my
point that it would be very difficult for Taiwan to create another company with
TSMC’s influence,” Chang told Reuters.

Taiwan now accounts for 92% of the world’s most advanced semiconductor
manufacturing capacity, according to the April report from Boston Consulting and
the Semiconductor Industry Association. South Korea holds the remaining 8%.

THE CHALLENGE FOR CHINA

Early on, Taiwan protected this crown jewel. In the late 1990s, then-President
Lee Teng-hui imposed curbs on the island’s high-tech companies doing business in
China to ensure they didn’t offshore their best technology. The restrictions
have been relaxed, but TSMC and its peers remain barred from building their most
advanced foundries in China.

“Looking back now, the industry supply chain could have been entirely moved
there,” said Chen, the former Taiwan tech minister.

Under Xi, China has set a goal of self-sufficiency in manufacturing advanced
chips – what some have dubbed the “great semiconductor leap forward.” The
Taiwanse curbs aren’t the only obstacle to Xi’s vision. Also at play are two
other factors: a U.S.-led effort to limit tech transfers to China, and the sheer
complexity of fabricating advanced semiconductors.

America and its allies have for decades imposed chip technology barriers on
China, mostly aimed at curbing Beijing’s development of advanced weaponry. The
United States maintains a list of specific chip technology that requires a
license for export, and restricts tech exports to China’s leading chipmaker,
Semiconductor Manufacturing International Corporation. SMIC did not respond to
questions from Reuters.

The controls on SMIC are tailored to block items needed to produce advanced
chips of 10 nanometers or smaller. So far, China mostly produces lower-end chips
for consumer electronics.

A key tool in this containment strategy: the Wassenaar Arrangement, a voluntary
pact among 42 nations to curb the spread of “dual-use” technology, with both
commercial and military applications. Under Wassenaar, Washington and its allies
have harmonized controls over the flow of chip technology to China.

The most significant restriction is on equipment that uses extreme ultraviolet
(EUV) light beams. This light is generated by lasers and focused by mirrors to
lay out ultra-thin circuits on silicon wafers. EUV is at the bleeding edge of
semiconductor manufacturing. It allows chipmakers to build faster and more
powerful microprocessors and memory chips.

According to Kevin Wolf, a former assistant secretary of commerce in the Obama
administration, the EUV curbs are aimed at blocking China’s effort to produce 5
nanometer chips – today’s state of the art – or even more advanced
semiconductors now under development.

For China’s economic planners, semiconductor independence is a top priority. The
aim is what’s known as a “closed loop,” analysts say, with domestic companies
responsible for the entire sector: raw materials, research, chip design,
manufacturing and packaging.

This is a huge challenge for any economy because the existing global supply
chain for chips is so complex – involving hundreds of materials and chemicals,
more than 50 types of high-tech equipment, and thousands of suppliers across
Europe, North America and Asia.

A Biden administration review of U.S. supply-chain vulnerability reported in
June that Beijing was directing $100 billion in subsidies to its chip industry,
including the development of 60 new plants. Some of this spending has already
led to huge losses, however, with a spate of bankruptcies, loan defaults and
abandoned projects.

Even if China were able to acquire foreign technology and direct money into
better-run projects, there’s no guarantee it would succeed in advanced chips,
say U.S., Japanese, Dutch and Taiwanese semiconductor industry veterans.

Advanced chip making is among the most complex manufacturing processes yet
devised, they say. Fabricating chips takes three to four months and over a
thousand manufacturing processes. It must be done in a pristine environment and
requires precision equipment that manipulates particles on sub-atomic levels.

China also faces a talent gap. It has recruited engineers and technicians from
Taiwan, South Korea and America. But these efforts have yet to deliver major
breakthroughs. Companies like TSMC have huge teams of specialists for a vast
array of processes. Poaching individual experts can only deliver gains in niches
of the craft, industry executives say.

These elite professionals are the most important asset of Taiwan’s chip
industry, says retired navy Captain Chang Ching, a research fellow at the
Taipei-based Society for Strategic Studies. “If it invades Taiwan, the Communist
army will do its best to protect the personnel working in the tech sector,” he
said.

Having relinquished chip fabrication to Taiwan, America is now trying to reverse
that move. The U.S. AI commission called for the government to spend $35 billion
in incentives to rebuild a chip manufacturing industry.

But Taiwan says it has no intention of surrendering primacy.

TSMC has begun trial production of what will be its most advanced chip, using
so-called 3-nanometer technology. And it has launched an R&D drive to make
2-nanometer chips.

Between now and 2025, local and foreign companies plan to invest more than T$3
trillion ($108 billion) in Taiwan’s chip industry, according to Kung Ming-hsin,
head of the island’s economic planning agency, the National Development Council.

After this splurge on factories and equipment, Kung said, “Taiwan’s
semiconductor industry will have very few competitors.”

Reporting by Yimou Lee, Norihiko Shirouzu and David Lague. Additional reporting
by Ben Blanchard and David Shepardson. Edited by Peter Hirschberg.

Our Standards: The Thomson Reuters Trust Principles.

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