China’s Electronics Domestic Substitution Mandate Is a Sign of Weakness

In a move to further exclude the US from its technology ecosystem, China unveiled new guidelines last year on December 26 to effectively phase out American PCs, microprocessors and operating systems (OS) under usage by its government agencies. The guidelines jointly issued by the Ministry of Finance and Ministry of Industry and Information Technology (MIIT) mandated all government and party organs above the township level to ensure ‘safety and reliability’ while purchasing PCs, microprocessors and OS. Subsequently, a list of approved domestic vendors regarded as ‘safe and reliable’ by the administration was published by the China Information Technology Security Evaluation Centre (CITSEC). This move led to commentaries claiming China’s growing confidence in competing with the US at all levels of the electronics supply chain — from chips to systems. However, we explain why such an assessment is inaccurate.

Not the First Time
To begin with, this is not the first instance when China has resolved to replace all the foreign content in its IT infrastructure with the domestic ones. In 2019, the government unveiled a similar policy to substitute all foreign computer equipment hardware and software in service from all government offices and public institutions. The instructions envisaged phasing out 30% of the content in 2020, 50% in 2021, and the remainder 20% a year after, thereby completing the process in 2022. However, the policy which came to be known as the 3-5-2 policy fizzled out astonishingly quickly. The initiative was never to be heard of or mentioned ever again in any of the subsequent government documents or reports. The fact that China has refrained from disclosing any update on localisation targets achieved even after 5 years since the policy was announced underscores the handicap its self-sufficiency drive suffers from.

Making sense of the decision

One of the motivations for issuing these guidelines could either be China’s suspicion or paranoia surrounding espionage and stealing of sensitive information by US companies through backdoor means. Alternatively, it could be fuelled by the realisation that sooner or later the Chinese dependence on American technology might become a vulnerability vis-a-vis its principal rival. And therefore, it must have home-grown alternatives to US tech.

But by no means, these measures should be construed as a sign of Chinese domestic or national capabilities. China’s steps to exclude the US from its tech infrastructure are nowhere comparable with the latter’s similar effort to exclude the former. The US actions that so far include export controls announced on October 7, 2022, and October 17, 2023, strike at the core of China’s ambitions to be a leader in high technologies by restricting the latter’s access to the most fundamental technologies.

Underrated Repercussions

China’s actions, if anything, expose the weakness of its Xinchuang initiative (IT applications innovations). The mandatory domestic content and sourcing requirement was a result of the realisation that China’s homegrown alternatives aren’t as competitive and have failed to capture any significant market against their overseas rivals such as Intel, AMD or Microsoft.

Furthermore, two of China’s promising alternatives for the x86 processors, Zhaoxin and Haiguang Information Technology, which are amongst the list of 18 approved vendors, either continue to depend on foreign assistance or are sanctioned by the US. Zhaoxin, a joint venture between China’s Shanghai Municipal Government and Taiwan’s VIA is dependent on the latter for the x86 licence. Haiguang, after it was added to the US Entity List in 2019, lost access to x86 IP rights as its licensing agreement with AMD fell off which could no longer honour the arrangement.

The move also exposes the limitations of economic/techno-nationalism as consumers are not willing to purchase local substandard products which are often costlier when the superior alternatives are available.

Observers who underline that China’s big market will somehow facilitate its drive to attain technology supremacy are mistaken. The belief that underlines China’s consumers' readiness to bear the pain to support its domestic tech companies fails to appreciate that unless forced by the state, the consumers are likely to prefer quality and experience in the long term.

A case in point is when the Chinese government directed BYD and other EV companies to sharply increase their purchases from local auto chipmakers even in cases where prices offered by foreign bidders were 30% cheaper than local vendors (Bloomberg, 15th March 2024). Even large-scale manufacturers like BYD who are the big consumers of chips are likely to prefer overseas vendors over domestic ones if given a choice. In other words, China is pursuing costly import substitution, a policy that results in decreasing export competitiveness, as readers in India are well aware.

China’s belligerent foreign policy and US export controls have had the combined effect of making foreign nation-states wary of China-made chips entering their economies. Thus, the latest steps by the government are a desperate attempt to secure a small but exclusive market for its domestic firms. This means that Chinese chipmakers cannot rely on robust export demand, as was the case a decade ago. Without this necessary life support, China’s Xinchuang initiative, in which it has invested millions, will die its slow death.

Moreover, the domestic players will have no incentive to partner with foreign firms as that would either be regarded as unsafe by the Chinese government or sanctioned by the US government. Luckily for the US, this would only accentuate the decoupling of Chinese companies from the global ecosystem.

Amidst the daily barrage of news claiming China’s growing technology strength, it is often forgotten that the strides China made in the past were helped by a world order that permitted a freer flow of ideas, talent, products, and technology. Once China began closing its doors on the world with its Made in China 2025 initiative, it triggered a series of actions that have made many countries rethink easy technology transfer to Chinese firms. Local sourcing mandates might well help achieve China’s aim of a less-vulnerable technology ecosystem. But the far more important long-run effect is that China’s economic and technological leverage over its competitors is likely to weaken as it turns inwards.

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