US embassy cable - 05TAIPEI343

C O N F I D E N T I A L SECTION 01 OF 04 TAIPEI 000343 
 
SIPDIS 
 
DEPT FOR EAP/TC, NP/ECNP 
DEPT PLEASE PASS AIT/W 
 
E.O. 12958: DECL: 01/25/2015 
TAGS: ETTC, ECON, EINV, ETRD, CH, TW, Cross Strait Economics 
SUBJECT: SEMICONDUCTORS - TAIWAN FIRMS FACING CHINA,S 
CHALLENGE 
 
REF: A. TAIPEI 268 
 
     B. TAIPEI 278 
     C. 04 TAIPEI 3930 
 
Classified By: AIT Director Douglas H. Paal, Reason 1.5 b/d 
 
Summary 
------- 
 
1. (C) With a market downturn expected to continue in 2005, 
Taiwan semiconductor manufacturers will be increasingly 
concerned about competing in the PRC chip market with local 
firms.  Relatively new PRC firms like Semiconductor 
Manufacturing International Corporations (SMIC) and Grace 
Semiconductor Manufacturing Corporation (GSMC) have been very 
successful over the last year at increasing production 
capacity and implementing more advanced manufacturing 
technology.  Taiwan Semiconductor Manufacturing Corporation 
(TSMC) has blamed, at least in part, illegal business 
practices for SMIC's success and has filed suit in the U.S. 
However, Taiwan firms still have the advantage.  They are 
making important investments to maintain that advantage, and 
it appears that Taiwan's manufacturing base will maintain 
dominance for the next five years.  Meanwhile, some Taiwan 
firms want their government to further liberalize 
semiconductor investment in the PRC, an issue that will have 
strategic implications for the U.S.  The Taiwan government 
should further relax investment restrictions in a manner that 
maintains consistency with U.S. export control regulations 
and avoids damaging Taiwan's semiconductor manufacturing 
base.  (End summary.) 
 
Stiffer Competition in 2005 
--------------------------- 
 
2. (U) The semiconductor industry is the centerpiece of 
Taiwan's economy.  It has important symbolic value as the 
driving force in Taiwan's emergence as a major center for 
high-tech industries, and even after more than two decades, 
it continues to be a critical component in Taiwan's economy. 
With total projected output of NT$ 1,114 billion (USD 35 
billion) in 2004, the integrated circuit (IC) industry alone 
(excluding those suppliers and buyers who rely on the IC 
industry) accounts for almost 3 percent of Taiwan's total 
GDP.  Chip manufacturing still dominates Taiwan's industry, 
accounting for 58 percent of total IC revenue.  Semiconductor 
foundries, or manufacturers that produce made-to-order ICs on 
contract, make up the largest portion of IC manufacturing 
with 66.4 percent of revenue.  Taiwan has the world's two 
largest foundry firms ) Taiwan Semiconductor Manufacturing 
Corporation (TSMC) and United Microelectronics Corporation 
(UMC).  Nevertheless, other segments of the IC industry are 
also important.  IC design firms earned NT$ 260 billion (USD 
8.1 billion) in 2004, and packaging and testing firms took in 
NT$ 159.5 billion (about USD 5 billion). 
 
3. (U) The year 2004 was good for the semiconductor industry 
in Taiwan and around the world.  Taiwan firms were producing 
at overcapacity for much of the first half.  TSMC's sales for 
2004 rose 30.3 percent from 2003. UMC's sales increased by 
38.2 percent.  However, prospects for the industry worsened 
toward the end of 2004.  By the fourth quarter, TSMC's 
capacity utilization had declined to 84-86 percent, with 
analysts predicting a further decline to 70-80 percent in the 
first half of 2005.  TSMC's CEO and Chairman Morris Chang 
told AIT/T he expects a return to growth in the third or 
fourth quarter of 2005.  For the IC industry as a whole, some 
observers predict zero growth or even contraction for 2005. 
 
PRC Success 
----------- 
 
4. (U) An industry-wide slowdown will sharpen Taiwan firms' 
focus on the Mainland chip market and competition from 
relatively new, but highly successful Chinese firms like 
Semiconductors Manufacturing International Corporation (SMIC) 
and Grace Semiconductor Manufacturing Corporation (GSMC).  A 
recent report by market research firm iSuppli estimated that 
China's chip-making foundry capacity grew by 78.2 percent in 
2004.  Taiwan firms are not only concerned by the growth of 
PRC firms in scale, but also by advances in technology.  SMIC 
already has capability to produce memory chip with 
90-nanometer feature size.  According to reports in the 
online trade journal Silicon Strategies, SMIC is also working 
with Texas Instruments to develop 90-nanometer manufacturing 
processes for logic chips as well.  Their pricing is highly 
competitive too.  Citigroup analysts recently reported that 
SMIC is undercutting TSMC's price for 0.13-micron logic chips 
by 30 to 40 percent.  Not to be overlooked, media reports 
indicate that GSMC is in negotiations with a U.S. firm to 
develop .13-micron tech and will break ground on a 12-inch 
wafer manufacturing plant in 2005. 
 
Accusations and Recriminations 
------------------------------ 
 
5. (U) Accusations have been exchanged in Taiwan about who is 
to blame for the success of PRC firms.  Stan Shih, the 
recently retired Chairman of Taiwan PC manufacturer Acer 
Inc., blames Taiwan's investment restrictions for the success 
of PRC semiconductor firms.  He believes that Taiwan firms 
could have eliminated PRC competition early had they been 
allowed to compete on their turf (ref C). 
 
6. (U) TSMC blames illegal business practices for at least 
part of SMIC's sudden success.  In suits pending before 
California State Courts and the U.S. International Trade 
Commission, TSMC accuses its PRC rival of various forms of 
industrial espionage and intellectual property rights 
infringements.  It claims SMIC violated TSMC patents and 
hired 100 TSMC employees by offering higher salaries.  The 
employees included many key engineers accused of provided 
TSMC trade secrets.  The dispute may have taken on a more 
 
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personal tone with the annual Taiwan and China Semiconductor 
Outlook Conference in San Jose December 7.  Media reports 
speculated that TSMC boycotted the event because SMIC CEO 
Richard Chang was a keynote speaker.  TSMC had sponsored the 
event in the past.  However, according to the reports, not 
only did TSMC decline to sponsor the 2004 event, its 
executives did not even attend. 
 
Staying Competitive 
------------------- 
 
7. (U) Taiwan firms still have a clear advantage over their 
PRC competitors.  In 2003, Taiwan firms controlled 71 percent 
of the foundry market.  Furthermore, more advanced technology 
accounts for a larger portion of Taiwan firms' revenue. 
According to a study by Taiwan's Industrial Technology 
Research Institute (ITRI), more than 20 percent of TSMC's 
sales are 0.13-micron semiconductors.  For SMIC this more 
advanced technology accounts for less than 10 percent of 
sales.  Some observers also point out that SMIC's production 
is not as efficient as its Taiwan competitors with lower 
yield rates that TSMC and UMC. 
 
8. (U) TSMC's Chang told AIT/T that TSMC would not sit back 
and let the competition get ahead of them or even catch up. 
Taiwan firms are taking important steps to stay competitive 
in the medium and long term.  TSMC, UMC and other Taiwan 
firms continue high levels of investment; expanding levels of 
production of the most advanced products, such as 
90-nanometer chips, while developing new technologies, 
including 45-nanometer products and immersion lithography 
processes.  Although Chinese firms are also making huge 
investments to expand capacity and improve technology, 
they're not keeping pace with Taiwan firms.  According to 
media reports, SMIC's planned investment for 2005 is less 
than half of TSMC's. 
 
9. (U) The outlook for Taiwan's position in the industry over 
the next few years is good.  TSMC's Chang told us, he 
predicts Taiwan will maintain its advantage over the PRC for 
at least five years.  According to Taiwan's Ministry of 
Economic Affairs (MOEA), Taiwan firms have six 12-inch wafer 
semiconductor fabs under construction on the island and plans 
for two more on top of four plants that are already 
operational.  MOEA predicts that by 2006 Taiwan will have at 
least 10 such plants compared to seven in the U.S., five in 
Japan and two in South Korea.  On the other side of the 
Strait, SMIC currently has one 12-inch fab in operation and 
one on the drawing board.  GSMC also has one in the planning 
stages.  iSuppli predicts that by 2007 the PRC will have no 
more than three functioning 12-inch fabs.  Taiwan also 
appears poised to maintain its advantage in IC design.  The 
ITRI study, predicts that Taiwan's IC design revenue will be 
five times Mainland China's until 2006. 
 
Taiwan Investment in Mainland 
----------------------------- 
 
10. (C) Nevertheless, the PRC chip market is essential to the 
future of Taiwan firms.  Many analysts predict that the PRC 
will be world's largest market for semiconductors by 2008. 
Some Taiwan firms will be able to supply Mainland demand with 
manufacturing based in Taiwan.  James Fang, Assistant Vice 
President of Winbond Electronics told AIT/T that there was no 
need for Winbond to invest in manufacturing in the PRC, even 
though up to 60 percent of its output is sold to firms in the 
Mainland.  He pointed out that his firm is a product firm not 
a foundry, selling its own standardized semiconductor 
products instead of manufacturing made-to-order chips on 
contract for other firms.  Because of this, it does not need 
to base manufacturing close to the buyer. 
 
11. (U) Other firms believe they need to have fabs in the 
Mainland to compete.  Foundries in particular point to the 
need to consult closely with clients.  TSMC was the first 
Taiwan firm to build a plant in the Mainland with an 8-inch 
fab near Shanghai, which started production in the fourth 
quarter of 2004.  In the last week of 2004, two more Taiwan 
firms, ProMos and Powerchip, submitted applications to 
Taiwan's MOEA to build their own fabs in the PRC.  Because 
Taiwan has only agreed to approve a total of three such 
projects, the two new applications will fill this quota if 
approved and cut off new semiconductor investments until 
further liberalization (ref A).  In addition, many industry 
observers believe that UMC has circumvented Taiwan government 
restrictions in its close relationship with Mainland foundry 
He Jian. 
 
12. (C) TSMC, especially Chairman Chang, has been very vocal 
in urging the Taiwan government to liberalize semiconductor 
investment restrictions to allow Taiwan firms to use 
0.18-micron technology in PRC manufacturing facilities. 
Previously, TSMC had indicated that it could meet Mainland 
demand with 0.25-micron products.  TSMC's CEO F.C. Tseng 
recently told the press that 80 percent of TSMC clients are 
shifting to 0.18 or 0.13 technology.  Justin Wang, Director 
of TSMC's Market Analysis and Forecast Division, told us that 
TSMC would also be interested in 0.13-micron manufacturing in 
 
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the PRC if allowed.  Without further liberalization, Wang 
says that TSMC will have to consider other options like 
investing in existing semiconductor manufacturing enterprises 
in the Mainland. 
 
13. (C) MOEA's Investment Commission asked AIT/T what the 
U.S. government's reaction would be to Taiwan lowering its 
restrictions to allow investment in 0.18-micron manufacturing 
technology (ref B).  Taiwan's government has also been 
considering for some time the legalization of investment in 
the PRC in semiconductor packaging and testing industries. 
Mainland Affairs Council Economics Department Director Fu 
Don-cheng told AIT/T earlier this month that Taiwan may 
approve these categories within the next two months. 
 
Comment - Implications for the U.S. 
----------------------------------- 
 
14. (C) A few years ago, many observers predicted that the 
semiconductor industry would stay in Taiwan and resist the 
trend in other industries to move manufacturing operations 
across the Strait.  They noted the importance of the 
semiconductor "cluster" in Taiwan, pointing to the 
collocation of design, manufacturing, packaging and testing 
firms centered in the Hsinchu Science Park.  The cluster 
provided a solid source of highly skilled personnel and 
facilitated collaboration and the exchange of new ideas. 
Clearly, a new cluster is forming in the PRC.  The emergence 
of this cluster in the PRC suggests at least two important 
questions for the U.S. 
 
15. (C) First, how will the development of domestic 
semiconductor manufacturing affect the PRC's military 
capacity?  The U.S. will have to manage this issue together 
with other governments through careful implementation of 
technology transfer restrictions, especially export control 
restrictions.  We should encourage Taiwan to maintain 
vigilance in using its investment policies toward this end. 
The second question concerns the viability of the 
semiconductor industry in Taiwan.  What are the implications 
for U.S. security if the Taiwan cluster disappears? 
According to the U.S. Taiwan Business Council, Taiwan 
accounts for nearly 90 percent of the world's graphic chips 
and over 20 percent of all memory chips.  If Taiwan firms 
cannot stay competitive, the U.S. could actually begin to 
rely on the PRC's semiconductor manufacturing infrastructure. 
 
 
16. (C) Taiwan's technology transfer regime appears to be 
more restrictive in some ways than our own.  Restrictions on 
PRC investment are holding back some Taiwan firms as they 
endeavor to compete for the Mainland chip market.  Modest 
relaxation at this time will help keep Taiwan firms in the 
game and reduce the momentum of PRC competitors, possibly 
even benefiting the Taiwan manufacturing base.  Nevertheless, 
liberalization measures will have to be carefully calibrated 
to limit technology transfer and maximize benefits to the 
Hsinchu semiconductor cluster.  Taiwan should also take other 
steps to liberalize cross-Strait economic relations that 
would facilitate Taiwan semiconductor firms' ability to 
engage the PRC market.  These include direct transportation 
links and liberalization of personnel and financial flows. 
(End comment.) 
PAAL