SEMICONDUCTORS - TAIWAN FIRMS FACING CHINA,S

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
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