Insight September 3, 2009, 1:54PM EST

Why China's Chip Industry Won't Catch America's

Chinese semiconductor companies have produced some design wins, but they are still struggling when it comes to any true silicon breakthroughs

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In the 1980s, the U.S. was consumed with fear that Japan would become the preeminent power in manufacturing and technology. Those fears never came to pass. Today the same fears are focused on China. The Middle Kingdom appears to be an even more daunting foe, with its enormous foreign reserves, fast-growing economy, oceans of scientists and engineers, and enormous subsidies to high-tech companies. How real is the China threat?

There is no doubt that China is making rapid strides in both infrastructure and technology, but U.S. anxiety of being overtaken by China appears to be misplaced. It takes more than money and might to achieve innovation. This is what I learned when researching the inflated estimates of engineering graduation rates in China and by analyzing its pharmaceutical industry. And this is one of the key findings in a new book titled Chips and Change: How Crisis Reshapes the Semiconductor Industry (MIT Press). Written by professors Clair Brown and Greg Linden of the University of California at Berkeley, the book provides a wealth of information about semiconductor development cycles as well as a fresh and informed look at some of China's key technological capabilities in those realms.

A few years ago, China seemed to be on track to dominate the global semiconductor industry in the same way it currently dominates the electronics manufacturing sector. In 2004, China's most advanced chip manufacturer, SMIC (SMI), went public on the Hong Kong and New York stock exchanges. The next year, two Chinese chip design companies, Actions (ACTS) and Vimicro (VIMC), had successful Nasdaq IPOs. Boosters of China's chip industry said there were hundreds more semiconductor design firms waiting in the wings and many new Chinese chip manufacturers were also starting up.

Barriers to Progress

Five years later, most Chinese chip companies remain unprofitable. Why? A number of interlocking reasons that provide clues as to why training lots of engineers and spending money to subsidize companies and build facilities is not enough to create a successful industry.

Because of China's poor reputation for protecting intellectual property, multinationals have limited technology transfer to China. For instance, chip giant Intel (INTC) is now building a plant in northeastern China but has long delayed locating its most cutting-edge fabrication facilities in China, even though this increases the cost of logistics to supply China-based electronics factories, which are among the biggest consumers of Intel processors.

While Chinese semiconductor companies have produced some design wins, the general perception is that China's design shops are good with common reference designs but struggle to produce true silicon breakthroughs. This is likely a product of the variable quality of engineers produced by China's fledgling academic programs which, while ambitious and well funded, produce quantity at the cost of quality. Likewise, China's pool of MBAs does not have the depth of consistency of MBAs from countries with longer histories of business studies and research. And unlike young engineers and MBAs in Silicon Valley, young Chinese engineers and MBAs lack role models who have taken companies public or created truly innovative products earlier in their careers.