Chip Grants in Return for China Guardrails

The next great American (policy) innovation!

~Cover photo designed on Midjourney~

At what point does the ratio of cheese to pasta turn “macaroni and cheese” into “cheese and macaroni?” As I sat to write this article about the guardrails restricting expansion in China from the CHIPS and Science Act of 2022, I couldn’t help racking my head over this. The most significant piece of the bill was undoubtably its $39 billion in federal funding for semiconductor manufacturing grants, but the accompanying guardrails also have the potential to revolutionize the U.S.’s approach to economic competition.

Is the CHIPS and Science Act a case of “grants and guardrails” or “guardrails and grants?” Keep that question in mind as you read ahead. The CHIPS China guardrails are an innovative new policy tool, epitomizing the latest fusion of national security and industrial policy.

Restoring American Semiconductor Dominance

Congress and the White House are blazing ahead with an unprecedentedly hawkish agenda to restore America’s strategic industries and limit China’s access to national security critical technology. To implement their plans, however, policymakers face a perennial dilemma: Industry and allied governments are not nearly as keen to cut off the Chinese market.

To sidestep the inevitable onslaught of lobbying that trade restrictions typically spur, U.S. lawmakers last year tried a different approach. The CHIPS and Science Act offers multibillion dollar grants for semiconductor manufacturing projects, conditioned on guardrails prohibiting recipient companies from expanding manufacturing capacity in China for 10 years. Whether consciously or not, this incentive-based approach to encouraging compliance with U.S. national security policy is incredibly creative. Companies usually lobby heavily against rules that limit their access to the Chinese market, and allied nations are often unwilling to sacrifice their domestic industries by cooperating with U.S. export controls.

By offering grants in return for guardrails, the CHIPS and Science Act not only staunches chipmakers’ opposition to trade restrictions but nearly causes companies to embrace the U.S.’s China policy. Furthermore, by enticing foreign semiconductor companies to accept guardrails in return for grants, lawmakers spare U.S. trade negotiators the arduous task of convincing allied governments to adopt the strictest parts of the U.S.’s China policy.  

How unprecedented are the CHIPS guardrails? This article will dive into the texts of semiconductor incentive programs in South Korea, Japan, the E.U., and Taiwan to show that no other country has implemented such a “money-for-national-security-compliance” program before. This is a genuine “Made in America” policy innovation. As semiconductor companies start signing the dotted line for CHIPS grants this year, the world will see the guardrails’ power tested in real time.

Industrial Policy Born Out of Crisis

To understand lawmakers’ intentions with the CHIPS guardrails, it helps to recall the context in which the whole subsidy program was conceived. An immediate supply chain crisis combined with longer-term concerns about China’s rise to inspire industrial policy on a scale not seen since the space race.

At the onset of the COVID-19 pandemic, automobile manufacturers around the world canceled their orders for new chips fearing a sudden drop in demand for new cars. After a few months, however, demand for cars rapidly recovered, but auto chip production lines needed months to switch back into gear. Beyond demand shocks, a slew of natural disasters exacerbated already tight supply for all types of chips. The February 2021 winter storm in Texas knocked out power for facilities across the state, including fabs run by Texas Instruments and Samsung. A March 2021 fire at a Renesas fab in Japan further strained automotive chip supplies, and TSMC had to cut production due to Taiwan’s spring 2021 drought.

These immediate supply chain crunches played into longer term concerns over the U.S.’s waning share of global semiconductor manufacturing and China’s rise. The U.S. saw its share of global chip manufacturing fall from 37% in 1990 to 12% in 2020. Meanwhile, China’s share rose from 3% in 2000 to 15% in 2020.

While the P.R.C.’s chip industry has long been limited to the least advanced ends of the supply chain, Washington took a collective gasp when the Chinese Semiconductor Manufacturing International Corporation (SMIC) announced it produced 7nm node chips for the first time. This placed SMIC just one generation behind the most advanced chips currently in commercial production globally, and in absolute terms this accomplishment allows China to produce the high-performance chips required for servers and smartphones. While U.S. restrictions on advanced manufacturing equipment will limit how well the P.R.C. can implement 7nm production in the mid-term, Washington now faces a triple threat. China’s chip industry is catching up in 1) relative manufacturing capacity, 2) relative technological advancement, and 3) absolute technological advancement.

Incentivizing Teammates

The Biden administration is responding to China’s rise with what it calls the “protect and promote” agenda. “Promote” means offering support to American industry (as with the CHIPS grants), and “protect” meant cutting off adversarial nations’ access to U.S. technology. While industry and even allied nations are thrilled by the idea of federal funds to grow the West’s chip industry, getting companies and governments onboard with the “protect” agenda is much more challenging.

Multi-sectoral Restrictions Fail

Lawmakers’ most recent crack at the protect agenda was a bipartisan bill establishing an outbound investment screening mechanism aimed at blocking any U.S. investment in China that threatens national security interests. The bipartisan National Critical Capabilities Defense Act would have covered industries ranging from semiconductors and pharmaceuticals to the vaguely defined “artificial intelligence.”

Due to its broad scope, the bill faced adamant opposition from industry groups ranging from medical technology to software to pharmaceuticals. Industry representatives negotiated the bill down from one that empowered the U.S. government to cancel proposed foreign investments (as represented in the bill’s House version) to a softer one just requiring the reporting of certain foreign investments (as represented in the bill’s Senate version). Despite these concessions, the bill’s champions could not include it in the CHIPS and Science Act for fear of sinking the whole bill, and it remains to be seen if the 118^th Congress will have any more success with such a broad effort.

A Deal with One Industry Succeeds

For externally observable strategic reasons, semiconductor companies were much more controlled in their critique of the NCCDA. As the broader business community fought back outbound investment review legislation, policymakers and chipmakers danced a more intricate tango over CHIPS guardrails.

Cash is fungible. Fearing that CHIPS grants would simply offset the cost of further expansion in the P.R.C., China hawks in Congress insisted that recipients of federal funds be subject to certain guardrails. Most significantly, Section 103 of the CHIPS and Science Act restricts grant recipients for 10 years from “the material expansion of semiconductor manufacturing capacity in the People’s Republic of China or any other foreign country of concern.” The bill permits the expansion of “legacy semiconductor” capacity primarily serving the Chinese market as this would leave China dependent on chips from U.S. companies.

Restricting trade for national security reasons is usually a zero-sum game that spurs unmitigated opposition by all industries involved. By targeting restrictions to only companies receiving grants, however, lawmakers turned this dynamic on its head. Companies can decide for themselves whether the economics make sense to sacrifice expansion in China in return for subsidized expansion in the U.S.

To that end, no semiconductor manufacturers, who would be the most natural opponents to the guardrails, openly rejected the imposition of China guardrails. Intel, for example, only sought to ensure the definition of “legacy semiconductor” remained flexible so older generations of technology could be progressively built in China as the leading edge advances. Since passage, the Semiconductor Industry Association, Intel, Micron, and Texas Instruments have all urged that the restrictions on expansion in China be limited to the wafer fabrication stage of manufacturing and exclude other stages like assembly, test, and packaging (ATP), but they have not openly sought to undermine the underlying goal of the guardrails. As far as the rest of the industry was concerned, the guardrails are a non-issue. Fabless companies offered no push back as they do not operate physical manufacturing facilities subject to the restrictions, and companies like Skywater that only manufacture chips in the U.S. have even advocated for stronger restrictions that capture ATP as well as wafer fabrication.

Lastly, once chipmakers agree to guardrails in return for CHIPS grants, the marginal cost of complying with further U.S. restrictions on business with China goes down. After the U.S. in October 2022 rolled out a wide-ranging set of export controls hamstringing China’s access to semiconductor equipment and services, Intel CEO Pat Gelsinger told the Wall Street Journal that these restrictions were “inevitable” and “that’s why the rebalancing of supply chains is so critical.” Having already determined to apply for CHIPS grants and accept the guardrails, Intel’s business strategy now aligns much more closely with the U.S.’s China policy and has relatively little to lose from further restrictions.

Sidestepping Allied Governments Via Allied Companies

The U.S.’s most powerful tool for restricting China’s access to critical technology lies in export controls. For export controls to be effective, however, all countries with companies that provide the strategic technology in question must agree to restrict sales to China; otherwise, U.S. suppliers will simply be replaced by foreign competitors. This can take a long time, and, as reporting on decisions by the Dutch and Japanese governments indicates, the restrictions allies ultimately impose may not be nearly as stringent. [At the time of publication, news outlets have widely reported on an agreement by the Dutch and Japanese governments to join the U.S.’s effort to restrict semiconductor equipment and talent exports to China, but the actual contents of this agreement have not been divulged.] The CHIPS and Science Act, however, once again sidesteps skeptics by paying for companies’ cooperation via grants.

By accepting CHIPS grants, foreign companies agree to tighter restrictions on business with China than any of their home governments require. As with the U.S. manufacturers, foreign industries have advocated narrowing the guardrails. The Korea Semiconductor Industry Association (KSIA) urges that guardrail restrictions “not unduly impede” grant recipients’ existing facilities in China, but it recognizes “that the CHIPS Act requires effective limits on manufacturing in foreign countries of concern.” Similarly, TSMC supported the CHIPS and Science Act along with its guardrails, only urging that “expanding semiconductor manufacturing capacity at [its] Nanjing fab… be appropriately considered in time.” By putting foreign industries into the position of asking for exceptions to guardrails, the CHIPS and Science Act places U.S. national security policymakers in a much stronger position than when they were just trying to convince foreign governments to impose restrictions.

An American Policy Innovation

Such a “money-for-national-security-compliance” program is unprecedented in any other jurisdiction’s semiconductor subsidization scheme. This American exceptionalism primarily derives from the fact that no other semiconductor producing region places as high an emphasis on limiting China’s advancement. This section will briefly survey the limited restrictions other nations do place in their programs to show what a major departure the CHIPS and Science Act has taken with its guardrail provisions.

South Korea

In August 2022, major Korean legislation offering tax exemptions for semiconductors and other “strategic industries” went into force. The legislation included new restrictions whereby the same “strategic technologies” that qualify for tax exemptions are now subject to review by the Ministry of Trade, Industry and Energy before they may be exported.

Unlike the U.S. guardrails, however, which are focused on limiting manufacturing capacity expansion in China, the Korean restrictions are focused on maintaining Korea’s relative technological leadership compared to all nations. This policy is much more akin to longer-standing U.S. export control goals which have focused on keeping the U.S. a certain number of technology generations ahead of geopolitical adversaries. The CHIPS and Science Act guardrails, alongside the October 2022 export controls, have expanded American policy to limiting U.S. adversaries’ absolute technological and capacity capabilities as well.

Japan

In 2021, Japan passed its latest tranche of semiconductor subsidies offering $7.3 billion for advanced chip manufacturing, $4.1 billion for R&D, and $2.6 billion to strengthen other parts of the supply chain. Like the Korean legislation, Japan directed its implementing ministries to ensure technology does not leak to foreign competitors. It also included a quintessential domestic operations requirement, saying that projects receiving Japanese government support must maintain production in Japan for 10 years.

Japan’s 10-year domestic production requirement is akin to a provision in the CHIPS Act’s authorization legislation requiring the Commerce Department to ensure projects receiving grants are financially sustainable. Far from an anti-China tool like the U.S.’s guardrails, this provision in the Japanese subsidy package is merely a due diligence requirement to ensure grants have their intended effect of supporting domestic industry.

Europe

The EU Chips Act provides €3.3 billion in manufacturing grants and support for R&D, with additional funding being proposed by individual member states. As it has not been implemented yet, however, it is not clear whether the EU grants will come with conditions limiting expansion in countries of national security concern. The text proposed by the European Commission does not include any such restrictions.

Taiwan

In January 2023, lawmakers in Taiwan passed the latest addition to the island’s incentive regime for semiconductor companies. The amendments to Taiwan’s Statute for Industrial Innovation offer a 25% tax credit for expenditures in R&D and a 5% credit for advanced equipment purchases. Article 22 of the Statute for Industrial Regulation requires that, after receiving benefits under the legislation, “[c]ompanies wanting to undertake overseas investment shall apply for approval from the central competent authority before making the investment.”

Though this provision appears quite open-ended, it is not analogous to the U.S. CHIPS and Science Act’s national security-focused guardrails. Article 22 appears in the context of the Statute’s Chapter 6 on “Promoting Investment in Industry.” The purpose here is much more akin to commonplace requirements ensuring that funding for domestic projects does not simply offset the price of expansion abroad. Taiwan is certainly concerned about the leakage of sensitive technology to China, but investments in China are primarily governed under pre-existing export control and national security law. The P.R.C. is listed as a “restricted region” on Taiwan’s Export Control List of Strategic High-Tech Commodities, and further legislation recently expanded the types of IP transfer to China subject to review by Taiwanese authorities. Taiwan’s semiconductor support regime is not a case of trading chip subsidies for national security compliance.

China

A future Chip Capitols article will dive into the flip side of U.S. restrictions by examining how Chinese semiconductor subsidies actively encourage international cooperation and expansion abroad.

An Innovative Industry Births an Innovative Policy Tool

The U.S. may yet succeed in implementing a broad outbound investment screening mechanism domestically and a new comprehensive multilateral export control regime internationally. In the meantime, the CHIPS and Science Act’s guardrails stand as a dynamic short-term tool to win adherence to the U.S.’s China policy one company at a time. Whether this “money-for-national-security-compliance” precedent will expand to other industries or countries, remains to be seen. If this does represent a turning point in the fusion of industrial policy and national security, however, we may have to once again ask whether the CHIPS and Science Act is a case of “grants with guardrails” or “guardrails with grants.”

[Post Scriptum: Your author is too young to remember an era when export controls were used for anything other than economic competition. The thought that this policy tool was originally designed for nuclear nonproliferation is crazy!]