Like many global electronics companies, IBM buys a lot of production materials in China. Big Blue spends millions of dollars each year on bare printed circuit boards, board assemblies, chassis, power supplies and thermal management devices. However, IBM buys very few semiconductors in China.

The reason is the semiconductor products that IBM needs are not available in China. "The semiconductor industry in China is still developing," says Frank Crnic, procurement program director at IBM's integrated supply chain business practice.

"Most electronic components are produced outside of China. Raw wafer and integrated circuit (IC) technology exists in China, but it is substantially behind product that is available from other regions," he says.

IBM builds high-end servers and point-of-sale equipment for retail stores in China that require processors, high-end memory and application specific integrated circuits (ASICs) which are not widely available in China. Chips produced in China tend to be lower-value parts and it is unclear whether China will be able to build higher value, more sophisticated ICs anytime soon, even though the chip industry there is positioned for very strong growth.
Forecasted growth is so strong that at first glance, it appears that China is becoming a hot spot for sourcing semiconductors. Chip production is expected to grow at a 36% annual growth rate through 2010 when it will reach $12.1 billion, according to market researcher IC Insights.

At the same time, there is a very strong market for semiconductors in China. The amount of integrated circuits consumed in China by OEMs and electronics manufacturing services (EMS) providers will grow from $40.8 billion in 2005 to $124 billion in 2010.

But before purchasing executives at OEMs decide to open up international procurement offices (IPO) in China to find new semiconductor sources, they should take a close look at other data about the chip industry and consider what kind of chips will be produced there.

While the dollar value of chips produced by China-based semiconductor suppliers will grow to $12.1 billion, it will represent only 3.8% of the total dollar value of ICs produced globally. In 2005, that percentage was 1.3%, according to IC Insights.

While the amount of semiconductors consumed in China will grow to more than $40 billion, most chips will have to be imported by electronics equipment manufacturers.

One reason total dollar value of chips produced in China will be low when compared to the global semiconductor market is that for the most part only low value semiconductors such as diodes, discretes, and low-end analog chips will be produced in China. Chinese manufacturers lack the intellectual property (IP) to build high-end semiconductors such as microprocessors, digital signal processors and ASICs. It is unlikely that Chinese manufacturers will get access to IP in the next few years for several reasons.

"There are significant limitations against China in the form of Taiwanese government not allowing any company to transition semiconductor process technology below .25 micron to China," says Len Jelinek, director and principal analyst at researcher iSuppli.

Taiwan is home to many semiconductor foundries some of which have opened facilities in China. However, the foundries in China use older semiconductor processing technology such as .25 or .35 micron. Leading-edge chips such as microprocessors and ASICs use leading edge 90 nm and 65 nm process technology, which cannot be transitioned to China from Taiwan.

"If the Taiwanese government and China embrace a free technology exchange, then all of a sudden you could paint a different scenario," says Jelinek. "But in the next two years, the chance of that happening is slim." That's because the current Taiwanese government that supports the current policy toward China will remain in power.

In two years there will be an election and "there may be a heated debate as to what Taiwan's political stance should be on these types of issues concerning mainland China," says Jelinek.

Besides Taiwan's current policy, the Wasserman Agreement bars many Western countries from providing leading-edge technology to China if the technology has military applications. Leading-edge semiconductor processing technology is covered under the agreement.

Politics aside, many semiconductor suppliers are leery of putting fabs in China because of concerns over IP theft. "China is a big market, but there is a risk for IC suppliers to set up factories there. If I am Intel I would like to be close to that huge potential market and tap into it, but I am leery of building parts in an area that has a reputation for stealing and copying and duplicating," says Matas. Analysts say China is a source of many counterfeit parts and illegally copied software.

Most equipment manufacturers understand the risk for semiconductor companies that are reluctant to build fabs in China, says Eric Miscoll, chief operating officer for Technology Forecasters, an EMS industry market researcher and consultant.

"The reality is China is still a risky place, regardless of how they wish to paint it. It is wise for semiconductor companies to be very cautious. Once you lose IP, you lose it for good."

Besides a lack of IP, another factor that will slow semiconductor development in China is that the chip industry is highly competitive and requires a huge amount of capital.

"I don't think the Chinese can just jump in and immediately begin to serve their domestic or global markets," says Matas. A lot of investment is needed for capital equipment and design and support services. "It takes a big financial commitment," says Matas. "That's where the Chinese are at the crossroads right now. They made the first step and have themselves off the ground, but it will take an ongoing commitment if they want to compete against the big foundries."

China's largest semiconductor company, SMIC is a foundry and the foundry business is especially competitive. "[Entering the foundry market means] you are going up against big established foundries that also have big budgets. You may be able to compete against some of the foundries in Malaysia but when you go up against the big boys in Taiwan—TSMC, UMC or even Chartered—it is a whole new ball game," says Matas.

The challenge may be even more daunting if Chinese chip manufacturers want to build microprocessors or high-end memory.

"If they want to get into DRAM or flash they have to go up against Samsung and Hynix; for processors or DSP they are going up against Intel or AMD and TI," he says. "They are finding it is not a bed of roses for them."

Chinese foundries will also have to overcome reluctance by fabless semiconductor companies to use relatively inexperienced Chinese fabs.

"There is still an element of uncertainty in terms of manufacturing reliability," says Matas. "There may be a bit of hesitation especially. They want to make sure their chips are produced in a timely manner. They want to make sure the parts are built right the first time and they get a good yield on that product," he says.

In the short term, while the Chinese semiconductor industry posted healthy growth in 2006, its development was impacted by the overall "soft landing" of the semiconductor industry. The global chip industry grew only 4% in 2005 so there was limited demand for more chips, which resulted in less than expected revenue for Chinese chip companies. That resulted in expansion plans being put on hold, according to Jelinek.

"Last year was a surprise for them," he says. "The demand for locally designed products has not matured at a rate fast enough that it would keep their fabs full. So 2005 was a tough year compared to 2004." As a result, construction of new fabs was delayed.

"The only green field project was the STMicroelectronics-Hynix joint venture," says Jelinek. "Except for that, there were no new company fabs that started up. In 2004 there were four that started up, but shut down in 2005. I know of five buildings that were built that don't have any equipment in them," he says.

With the STMicroelectronics-Hynix joint venture, 200mm wafer production will begin later this year and 300mm production next year, according to Bob Krysiak, corporate vice president and general manager for ST in China. The fab in Wuxi will build flash memory and DRAM. ST has a 33% minority stake in the facility.

He says the $2 billion facility will become one of the largest and most advanced wafer fabs in the country.

Besides the fab, ST is also investing $500 million to build a second back-end fab in Shenzhen for chip assembly and test. "Today, we are the number three semiconductor supplier in China and we plan on becoming number one," says Krysiak.

He says ST will focus on the EMS industry in China and "partnerships and alliances with major emerging players, many of which will come from China and Asia." Krysiak says it makes sense for ST to boost its presence and investment in China. He says that's because 25% of ST's sales are in China.

Many buyers and EMS providers would agree that it makes sense to have chip production in China because chip demand is so high. They would like to see the semiconductor supply base further develop there.

"We are very deeply engaged in the China marketplace in supporting our hardware requirements as well as procurement services clients," says Crnic of IBM. He adds that IBM is interested in the development of the semiconductor supply base "to the extent it creates a better value and a lower total landed cost."