Why "Made in China" is good news for the U.S.

In 2004, more than 40 tech companies staged public offerings of their stock on Wall Street. Ten were domestic Chinese firms. A microchip company led the way; in one of the largest initial public offerings of the year, China's Semiconductor Manufacturing International Corp. raised $1.8 billion.

If chip industry experts across the globe weren't already obsessed with China, SMIC's IPO riveted the attention of the remaining holdouts. Five years ago, China hardly had a chip industry to speak of. Each year since then, led by SMIC, production has exploded. Today, China makes about 8 percent of the world's chips; by 2010, that number may be up to 20 percent.

From nowhere to world domination has been the story of China and globalization for the past decade. Textiles, toys, televisions and cellphones -- one global industry after another has been battered by Chinese competition. Why should chips be any different?

Because the chip industry can be an example where globalization works right.

Predictably, China's increasing economic power has sparked a sustained anti-China backlash in the United States. In the last week of July, the House of Representatives approved a bill that would make it easier for U.S. companies to seek restrictions on Chinese imports into the United States. And over the past month, U.S. politicians mounted an extraordinarily successful campaign to oppose a Chinese energy company's bid to buy the U.S. oil and gas company Unocal. There's no mystery why: If you're looking for examples of the downside of globalization, China offers them in abundance. China's low-cost workers are depressing wages for manufacturing employees all over the world. Its incredible appetite for raw materials and energy has warped commodity prices and raised fears of a global struggle for resources that could lead to the 21st century's defining showdown.

China's emerging push into chips would seem to jack up the stakes and has fed the growing backlash. Chips are a crucial link in the global tech economy, essential to nearly every modern electronic device but also critical to national defense and the entire global digital infrastructure. The chip industry's health is symbolically resonant, a marker for high-tech prowess. In the 1980s, Japanese inroads into chip manufacturing provoked an orgy of alarm and self-criticism in America. Today, the Chinese high-tech push is being compared to the Soviet Union's launch of Sputnik, which set off the fabled space race in the 1960s.

Defense hawks are now warning that the United States may soon be dependent on a potential enemy for the production of next-generation chips and are calling for increased controls on the export of advanced technology to China. (Last week, the Bush administration appeared to heed those calls as it announced plans to significantly tighten such restrictions.) U.S. chip company executives, even as they pack their bags to move yet another part of their operations offshore, decry Chinese government help for domestic chipmakers (while holding out their hands begging for their own government's assistance). Labor advocates fear that more good, high-paying jobs for American workers are set to vanish.

But there's a little fact that gets lost in the larger to-and-fro over China: Right now, in the face of a vast trade deficit with China, chips are one of the few sectors in which the United States enjoys a surplus. Thanks to China's emergence as the world's manufacturing headquarters for high-tech devices -- computers, DVD players, cellphones, iPods and just about everything else -- U.S. companies currently sell far more chips to China than they buy from that nation. The United States is at the top of the food chain in both chip design and chip-making equipment, and China is potentially its largest growth market.

It is entirely true that Chinese ambitions have no limit, and given China's astonishing surge forward as a high-tech powerhouse, perhaps one day China will rival the United States. But increasing controls on technology exports or pumping up protectionist tariffs is likely to do little more than slightly slow China down, say economists and China experts, while simultaneously hurting American consumers and companies doing business with China. In the meantime, the anti-China crusaders may be missing the real threat, the enemy who lives at home rather than across the Pacific.

In a perfectly working global economy, each country prospers by doing what it can uniquely do best, by, in technical terms, relying on its "comparative advantage." For decades, the United States' comparative advantage has been the excellence of its own science and technology. The chip industry offers a classic example -- U.S. chip makers maintain their edge by pouring high percentages of revenue into research and development.

But federal spending on basic science and R&D in the United States, as measured by its percentage of the gross domestic product, has been flat or in decline for 30 years. So too has federal support for science and engineering education. As a result, the basic infrastructure that supported fantastic achievements in science and technology for generations is fraying.

At the same time, U.S. corporations and investors are pouring billions of dollars into China. And if last year's IPO statistics are a sign of what's to come, the flow will only increase. By itself, that might not be a bad thing. But in conjunction with the U.S. failure to nurture its own comparative advantage, the China gold rush presents quite the paradox of globalization. The United States has done more to push global markets and free trade than has any other nation. But now it seems to be forgetting how to play its own game. Instead of looking to punish China for doing well, policymakers should be looking at the U.S. chip industry, figuring out why it is thriving and applying those lessons to the rest of the economy.

"It is remarkable," says Peter Kuo, a managing director at the investment bank W.R. Hambrecht, referring to the growth rate of China's chip industry.

Even the most cursory look at the statistics proves that something big is brewing in China. Five years ago, China manufactured only 2 percent of the world's semiconductors. Today it has 8 percent and is predicted to go as high as 20 percent by 2010. Thirty-five chip plants are already in operation, and according to at least one prediction, 20 new plants are scheduled to be built in China in the next three years, an expansion plan that far outstrips that of any other nation.

Such predictions are, it must be noted, highly speculative, as the chip industry is notoriously cyclic. China's own build-out could lead to a global glut of semiconductors that sends prices plummeting and ends up putting the brakes on plans for new plants. Still, every significant global manufacturer of semiconductors, including America's own Intel, Texas Instruments and IBM, is setting up shop in China. And every sector is growing at high speed, including providers of raw minerals, the specialized gases necessary for chip manufacturing, and assembly and testing services. Even the high ground, chip design, is flourishing. The market intelligence firm iSuppli estimates that China now contains 400 chip design companies, many of them staffed by engineers freshly returned from the United States. Industry leaders in China are also lobbying the government for financial support for the development of semiconductor-manufacturing equipment, which would help further reduce dependence on the West.

"A dramatic shift in semiconductor manufacturing is now underway," said George Scalise, president of the Semiconductor Industry Association, during April testimony before the U.S.-China Economic and Security Review Commission in Palo Alto, Calif. "China's semiconductor industry is predicted to grow at twice the pace of the global semiconductor industry over the next five years."

There are many reasons for the China boom. They include government incentives for domestic companies and cost savings for foreign corporations. China's newfound openness to direct foreign investment, its cheap labor costs and generous tax incentives make the Middle Kingdom an attractive destination for global companies. China also has the advantage of being physically close to Taiwan, the world's primary manufacturing center for all kinds of electronic devices, and a leader in semiconductor manufacturing for more than a decade. When so much of the world's electronic devices are being made there, it makes sense to set up shop as close as one can. Last but not least, semiconductor manufacturing is a fairly easy business to get into. The technology behind it is well understood, so if a country has the capital to invest and a large supply of engineering talent, the process is straightforward. China has both resources in plenty.

The surge is great news for semiconductor equipment makers but has ruffled some serious feathers in the U.S. defense community. Witness a report released in April by the Defense Science Board, a federal advisory committee that works with the secretary of defense and investigated the movement of advanced semiconductor chip manufacturing technology away from the United States.

The authors of the report mince no words. Current developments are "alarming" and "deleterious" to U.S. interests. The "security and economic well-being" of the United States are at risk. Their chief concern is the evolution of the "fabless" chip design industry, in which U.S. companies focus on designing chips and leave the manufacturing, or "fabrication," of the chips to companies in East Asia -- meaning that in the not-too-distant future, the U.S. military will be dependent on foreign nations for the production of chips crucial to next-generation weapons systems.

"There is no longer a diverse base of U.S. integrated circuit fabricators capable of meeting trusted and classified chip needs," announces the report, titled "High Performance Microchip Supply." "From a U.S. national security view, the potential effects of this restructuring are so perverse and far reaching and have such opportunities for mischief that, had the United States not significantly contributed to this migration, it would have been considered a major triumph of an adversary nation's strategy to undermine U.S. military capabilities."

Strong words. But while perhaps a bit overblown -- America still owns the leading edge of semiconductor technology -- the United States has clearly aided and abetted the transfer of chip technology overseas. Countries such as Taiwan and South Korea built up their chip-making infrastructure with the direct help and encouragement of U.S. corporations. By one line of argument, it was only by relentlessly moving operations offshore in search of cost savings and flexibility that the United States was able to meet the much-ballyhooed Japanese challenge of the 1980s.

"If it is not economical to have a chip industry in the U.S. then we won't have one," says venture capital firm Mohr Davidows Michael Borrus, who tracks China, expressing a basic tenet of globalization. The segments of the chip industry that can be executed more economically in China will naturally flow there. But according to the DSB report, there are consequences to the migration of technology offshore that could have long-term effects on the balance of industrial power.

It is a "historical fact that leading-edge R&D tends to follow production," the report says. "The most attractive positions for talented process scientists and engineers move with advanced production."

In other words, if you are a cutting-edge engineer interested in working with innovative new techniques for chip manufacturing, the action is not necessarily in Silicon Valley, but at the scores of brand-new chip plants being built in Asia. That is where engineers are being trained to use the newest tools, and that is where further innovations in technology are likely to spring from. To the extent that China represents a "cluster of innovation for semiconductors," says Kuo, "you have Shanghai as a semiconductor hotbed." By ceding manufacturing to China, the United States is ceding the likelihood of future technological breakthroughs.

Or so the theory goes. There are definitely signs that talent that once would have looked for a home in Silicon Valley is now headed to China, and in many cases is doing so with funding raised from U.S. investors. Often, such talent consists of native-born Chinese who came to the United States for graduate education and now are returning to China. (One ironic note: As a result of tightened immigration controls put into place after 9/11, foreign students face much greater difficulty than previously in finding jobs in the United States after graduation. So they are essentially forced to return home.)

So, yes, China's chip industry is booming, and the boom is likely to result in an accretion of expertise and capital that pushes the sector to ever greater heights. But even if the DSB report is completely correct, it fails to give enough attention, say experts, to one salient data point -- it is not how many chips China produces but how many it consumes.

China's new status as a global center for low-cost manufacturing has turned it into the world's third largest market for semiconductors. The figures vary depending on who is counting, but by one estimate China consumed around $35 billion worth of semiconductors in 2004.

China's domestic production of chips, however, doesn't come anywhere close to matching its appetite. Domestic production for 2004 has been valued at $5.5 billion of chips. More important, the rate of consumption is growing faster than the rate of production. The gap is getting bigger.

"I don't think China is a threat," says Nicholas Lardy, a China specialist who is a senior fellow at the Institute for International Economics in Washington. "China's semiconductor imports are many times domestic production. I'm not saying that's a permanent condition, but the gap has to start narrowing before we can talk about China being a threat."

For all its vaunted growth, China is generally at least one, and usually two, generations behind the state of the art in chip production. Currently, many of its chip plants, or "fabs," are stocked with used equipment sloughed off by other nations, such as Taiwan, that have moved on to higher ground. China does not yet make its own equipment for fabricating chips, and most observers argue that it will be much harder to make a dent in that industry than in simply manufacturing the chips themselves.

While the vast majority of computers, cellphones, DVDs and other electronic devices are now assembled in China, the top-of-the-line chips that run those devices are imported, either from East Asian neighbors like Taiwan, South Korea and Japan or from the good ol' United States. Intel, to pick just one very huge example, earns as much as 10 percent of its total $30 billion a year in revenue from selling computer microprocessor chips to China.

This is worth noting because the United States suffers from a well-publicized trade deficit with China that is vast and growing, engendering huge economic and political pressures. But don't blame the chip business! Semiconductors are America's second largest export to China; U.S. companies export far more chips to China than they import, mainly because the United States dominates at the very top of the line -- the manufacture of highly complex microprocessors that are the brains of new computers. The United States may not have a "diverse" base of producers of these chips, as the Defense Science Board report notes, but the companies that do exist, such as Intel, are formidable forces in the global economy.

A close look at China's chip industry also reveals that some of the warning signs stressed by nervous observers don't bear a whole lot of scrutiny. Venture capital may be flooding into chip design companies in Shanghai and Guangzhou, but the companies themselves, says Kuo, are mostly targeting low-end markets that do not require the latest technology. SMIC, China's chip-making leader, is struggling to become profitable. Western companies will continue to hold tremendous advantages by virtue of their ownership of key intellectual property involved in the design of both chips and chip-manufacturing equipment.

This is not to say that even those sectors won't eventually also move offshore. But as Borrus observes, "I'm not sure we are in any worse shape now than we were 10 years ago, frankly. Then it was IBM and Intel and Motorola and [Texas Instruments] and one or two others. And today it is IBM and Intel and Freescale [formerly Motorola] and T.I."

So why is the United States doing well in semiconductors while other industries, such as textiles, are getting shredded? One explanation is that chip making, with its fast-moving production cycles and constant emphasis on packaging an ever greater number of transistors into an ever smaller space, requires an ongoing investment in research and development that keeps a company, or an industry, at the top of the heap. Borrus points out that companies like Intel, by manufacturing the brains for new computers, will always be at the leading edge of semiconductor-manufacturing-process technology.

The pertinent question is whether the United States, as a whole, is making the kinds of investments in the future that are necessary for its long-term economic health. America has always thrived by inventing new markets, new businesses, new technologies -- and it has historically done so with fairly significant government help. The commercialization of the transistor was hugely influenced by federal funding, motivated by national defense. So was the development of basic computer technology and the Internet.

But there are signs that the federal government has become distracted. A report released in June by the National Bureau of Economic Research documented trends that appear to be very troubling for anyone concerned with the future of U.S. dominance in science and technology. Titled "Does Globalization of the Scientific/Engineering Workforce Threaten U.S. Economic Leadership?" the report answers its own question with a qualified yes.

"The U.S. share of the world's science and engineering graduates at all degree levels is declining rapidly," states the report's author, Richard Freeman. As one consequence, "the [U.S.] faces a long transition to a less dominant position in science and engineering associated industries."

Another recently published book, Ernest Peeg's "The Emerging Chinese Advanced Technology Superstate," reports that as a percentage of gross domestic product, federal spending on basic science has stayed basically unchanged for 30 years, while spending on physical science research has actually decreased. Meanwhile, Chinese government support for basic science, R&D, and science and technology education is surging. Chinese R&D expenditures grew by 22 percent per year between 1995 and 2002, compared with 6 percent in the United States. Chinese science and doctoral degrees increased by 14 percent per year from 1995 to 2001, compared with a 1 percent decrease in the United States. Certainly, the Chinese are starting from a smaller base and growth is naturally faster, but the long-term consequences of such numbers are eye-opening. By every measure deemed important -- patents filed, technical papers published, engineers who graduated -- the Chinese are surging.

It is difficult to see how any of the punitive measures being proposed, such as tariffs and export control measures, will address this fundamental shift. Protectionist moves, say most economists, would likely leave U.S. workers and citizens even worse off than they are now, as prices for all kinds of products would rise, while there would be no guarantee that U.S. firms would be better able to compete globally. Likewise, attempts to prevent China from gaining access to advanced technologies, through measures such as the Wassenar Arrangement, are widely seen as ineffectual. Even if the Bush administration succeeds in preventing U.S. semiconductor equipment manufacturers from selling their wares to China, it will be handing a golden opportunity to competitors such as Japan and Germany.

"I'm not sure that controlling the frontier can be technically done," says Lardy.

Instead, the United States must push at the frontier. But in the absence of consistent government support, who is going to make that push? Ten years ago, one might have looked to the venture capital firms of Silicon Valley, busily funding the Yahoos and Googles of the world. But guess where Silicon Valley is headed today?

Backlash be damned. On Sand Hill Road in Palo Alto, the heart of Silicon Valley's venture capital industry, China is the new, new, new thing. According to the research firm Zero2IPO, venture capitalists invested $1.3 billion in China in 2004, up 29 percent over 2003. Anecdotal information from investment bankers and venture capitalists suggests that this trend is continuing in 2005.