Semiconductor Manufacturing International Corporation (SMIC), whose secondary listing in Shanghai on July 16 raised close to RMB 50 billion – more than double the initial target – will be channeling part of the proceeds towards building the production line of 12-inch semiconductor wafers. The wafers will then facilitate the mass production of 14 nanometer (nm) and 7nm processes[1].

Understandably, a 14nm chip or a 7nm one may not mean much to an ordinary investor given that nanometer is not a measurement unit accessible by the naked eye. While each unit only rounds up to one ten-thousandth of a single hair, it is critical to how advanced a semiconductor foundry is in the industry.

Globally, chipmakers currently possessing the capability of producing high-end chips are far and few between. Taiwan Semiconductor Manufacturing Company (TSMC) and Samsung are the only two capable of fabricating chips smaller than 7nm. While SMIC’s 14nm process technology has been iterated on Huawei’s smartphone production, it will be a long haul before the company can rival the manufacturing level of TSMC, which makes 5nm chips, and TSMC has set the development of 3nm chips and even 2nm process, in motion.

Why SMIC?

Edging closer to the US presidential election, tensions between US and China have escalated again recently, leading to uncertainty around the bilateral relationships. But what’s clear amid the turmoil is the US’s determination to quashing China’s technology industry.

Following the Trump administration’s ban on telecom company ZTE Corporation and Huawei, it has moved to take aims at Bytedance and Tencent. Under the US embargo, building a local supply chain for the technology industry has never been more important to China. So with semiconductor chips being the life force of the tech sector, having a robust chipmaking industry is a key to China’s quest for technological self-sufficiency.

The domestic tech sector has only begun to gain independence over the past two decades. Before then, China had to rely on imports such as elevator controllers, laser generators or injection molding machines. But China has come to be self-sufficient in manufacturing most of these mid-tier products.

However, China will have to make a breakthrough in the high-tech segment, particularly in information and communications technologies, to continue moving forward. Indeed, it won’t be a walk in the park for China, given that countries in the West have led the development of existing technologies over the years, with a firm grip on various patent rights. It’s difficult enough to decipher existing patents, so getting around them will be yet a more daunting task for China.

In SMIC’s early days, the company’s key management staff, including the former chief executive officer, joined from TSMC. But SMIC suffered a setback after TSMC filed lawsuits in the US in 2003 and 2006 alleging the company of theft of patents. In addition to paying for TSMC’s compensation, SMIC had to stop using contested technologies following court rulings.

How will SMIC catch up with rivals?

When it comes to investing, we look for companies with the 4Rs: Right business, Right cycle, Right price and Right management. So Liang Mong Song, SMIC’s new co-chief executive officer, who managed to raise the production yield – the percentage of non-defective items – of 14nm chips to 95% from 5% just after 300 days of his appointment, has clearly exhibited good management, and will serve to bolster the Chinese chipmaker’s development[2].

Moreover, talents lie at the heart of the tech industry. China boasts a lot of local scientists and engineers, while its R&D investment as a percentage of GDP reached 2.19% in 2018[3]. But the country has only begun rolling out policies recently to back technological research. The spending on the industry was also relatively lower than that of Japan, South Korea, Israel and the European Union. In fact, truly experienced engineers specialised in chipmaking are still considered a scarcity in China.

Owing to laws of physics, there is a limit to how small the distance between transistors in a semiconductor can be. In terms of manufacturing capability, TSMC has already started mass-producing 5nm chips in the second quarter this year, meaning that it is around four to five years ahead of SMIC. But if front runners struggle to maintain Moore’s Law, which suggests that processing power will double about every two years, and fail to narrow the distance between transistors, SMIC will then have time to catch up with rivals. The chipmaking race will be vastly different from how companies compete today, where leading rivals grow simultaneously as you do, posing an insurmountable hurdle for the rest to gain more ground. Though it is not clear yet where the end of Moore’s Law lies.

But of course, luck is also key to technological development. For example, Intel, whose chipmaking technology was once the best in the industry, was overtaken by TSMC over the past year due to a research blunder. The Taiwanese company’s technology lead may well be lost to SMIC or other chipmakers just the same over a slip-up in the future.

Another racetrack

China is completely aware of how difficult it is to play catch-up in the information technology industry. So not only is it investing in areas where it is lagging behind, China is also injecting capital in new technologies, such as electrical vehicles, artificial intelligence and quantum computing. Such novel technologies will then level the playing field for China and the West, raising its chance in becoming the world’s top technology innovator.

In the automotive industry, one-third of the cost of making an electric car goes to the battery, which is basically equivalent to the engine of a conventional gas-powered car. So getting hold of the battery production will be critical to dominating the automotive sector. A foreign news outlet previously reported that a Chinese company has already developed a battery with a lifespan of 16 years, or two million kilometers[4].

New technologies will obviously be important assets to China, but advancing innovation in basic mechanical engineering components is no easy feat. China is still lagging behind western countries in producing ball bearings, an essential part of rotating tools, for example. As such, local engineers will need years of research as well as trial and error – just as those required of experts in the past – before they can achieve the same level of sophistication in making these products, and in the material science behind them. It was only three years ago that China got the hang of producing the balls of ballpoint pens. So given time and perseverance, China will eventually be neck and neck with, or even outpace, other countries in one of the racetracks of technological development.

---

[1] Source: Wall Street Journal, as of Jul 2020

[2] Source: HKET, as of Jul 2020

[3] Source: World Bank, as of Jul 2020

[4] Source: CNBC, as of June 2020

Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.