Japan's pursuit of the most potent microchip drives the resurgence of the semiconductor industry.

• In the 1980s, Japan held a dominant position in the semiconductor market. However, significant changes in the chip supply chain's operation weakened its leading edge.
• Tokyo has released billions of dollars in subsidies to revitalize Japan's semiconductor industry.
• The Japanese government and eight domestic companies founded Rapidus Corporation in 2022 to develop and manufacture advanced semiconductors at the core of Japan's efforts.

In the 1980s, Japan held a dominant position in the semiconductor market. However, significant changes in the chip supply chain's operation weakened its leading edge.

Taiwan, the world's largest and most advanced semiconductor manufacturer, has begun to dominate in the production of chips. The U.S. is key in areas like design, while the Netherlands has a company that makes tools required to manufacture cutting-edge chips.

Japan is now on a drive to revitalize its semiconductor industry.

The Japanese government and eight domestic companies founded Rapidus Corporation in 2022 to develop and manufacture advanced semiconductors, which has attracted billions of dollars in subsidies for the sector.

TSMC and Samsung are currently leading in the production of 2 nanometer chips, and Rapidus Corporation aims to catch up by manufacturing these chips by 2027.

In this episode of Beyond the Valley, Tom Chitty and I are joined by Fei Xue from the Economist Intelligence Unit (EIU) to discuss Japan's efforts to revitalize its domestic semiconductor industry.

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The "Beyond the Valley" episode, released on August 6, 2024, has been edited for clarity and brevity.

Tom Chitty

The senior analyst at the Economist Intelligence Unit, Fei Xue, is a guest on Beyond the Valley. The EIU, established in 1946, is a research and analysis division of The Economist Group, which also publishes The Economist newspaper. Fei Xue's focus is on North East Asia, where he provides forecasts and analysis on economic development, public policy, and international relations. Since the 1980s, Japan has been a major player in the global semiconductor market, but other countries have since taken over. Now, Japan is planning to revitalize its semiconductor industry and is working to develop the world's most advanced microchip.

Fei Xue

Thank you. Glad to be here today.

Tom Chitty

To provide an understanding of why people should care about the topic being discussed today, I will briefly summarize the importance of semiconductors, which I covered earlier.

Fei Xue

Semiconductors are increasingly seen as a commodity, with their use extending beyond electronics devices to even running shoes. They are used to measure things, and as the world becomes more connected, semiconductors will become even more essential. There are two main types of semiconductors: logic chips, which are processors, and memory chips, where data is stored. Each segment has dominant players in the market.

Tom Chitty

Before we resume, let's review the state of the week, Arjun.

Arjun Kharpal

The stat of the week is 97 billion U.S. dollars.

Tom Chitty

Can you provide some background on Japan's semiconductor industry?

Fei Xue

Japan was once a leader in global semiconductor research and development, with Japanese companies accounting for 51% of the global semiconductor market at the end of the 1980s. This was due to a breakthrough in 1980 when a consortium of Japanese companies developed electron beam lithography technology, making semiconductors easier and cheaper to produce. The Japanese government provided funding and financing to support this development, allowing them to quickly dominate the global semiconductor market. However, their market share began to decline in the 1990s, and today their collective market share is below 10%. Most of the semiconductors produced in Japan are specialty or legacy semiconductors, which are larger than 28 nanometers.

Arjun Kharpal

What were the changes that led Japan to lose some of its leadership? I know that part of it was political, but were there other reasons as well?

Fei Xue

Two significant factors contributed to the decline of Japanese semiconductor chip makers' competitiveness in the global market. Firstly, the 100% semiconductor tariffs imposed by the U.S. in 2018 undercut their competitiveness. Secondly, the U.S.-Japan semiconductor agreement signed in 1986 forced open the Japanese semiconductor market to foreign players, creating opportunities for the U.S., South Korea, and Taiwan. Additionally, a generational evolution in semiconductor development in the 1990s led to specialization in sectors, which gave U.S. companies a competitive edge. Taiwanese chip maker TSMC became a contractor, focusing on manufacturing semiconductors designed by other players, allowing these companies to leapfrog Japanese semiconductor makers by investing heavily into specific segments or sectors. Despite government support and a decline in fixed investment, many Japanese semiconductor makers could not keep up with the competition.

Arjun Kharpal

In summary, the decline of investment in politics, the increase in competitiveness of foreign players, and the rise of the fabless model are some of the key factors affecting Japan's semiconductor industry. What steps is Japan taking to revive its industry?

Fei Xue

The Japanese government is taking a comprehensive approach to the semiconductor industry, combining state-led initiatives with private sector resources and development capabilities. On one hand, they are collaborating with IBM in the US to enter the chip designing sector. On the other hand, they aim to attract international investment in semiconductor making and establish fabs in Japan's territory. Early stages have seen some success, with TSMC establishing fabs on the Kyushu island and planning a second fab. Additionally, eight Japanese electronic companies have formed a consortium called Rapidus with state funding support, aiming to create the most advanced semiconductors, two nanometers semiconductors by 2027.

Tom Chitty

Japan's semiconductor industry is currently producing the best microchip with a size of 40 nanometers, but the leading microchip is three nanometers. Therefore, when someone mentions two nanometers, it's just like being one nanometer better, but it's still a significant difference.

Fei Xue

The complexity of miniaturizing semiconductors increases exponentially with each generation, necessitating significant investment, research and development, and making it challenging. However, Rapidus' plan to produce two-nanometer semiconductors by 2027 may already place them behind the most advanced cutting-edge semiconductors, as TSMC and Samsung plan to produce 1.5-nanometer semiconductors by 2026. Moreover, Japanese companies are exploring alternative technologies, such as advanced chip packaging, to improve chip performance, while still aiming to create the most advanced or miniature semiconductors.

Arjun Kharpal

What is the reason for continually reducing in size at the nanometer level?

Fei Xue

The use of semiconductors will enhance the performance of processors and increase their usefulness.

Arjun Kharpal

One of the intriguing points you made was that even if Rapidus successfully commercializes two nanometers by 2027, it will still lag behind TSMC and Samsung, among others. This is a challenge, isn't it? Despite their efforts to promote their domestic industry, many countries still heavily rely on production from TSMC and Samsung due to the significant R&D investments these companies have made over the years, as well as their head start.

Fei Xue

Japanese companies are not necessarily required to produce the most advanced semiconductors as there will be a significant market for legacy chips and their products can cater to domestic demand. Additionally, even though TSMC and Samsung can produce 1.5 nanometer semiconductors by 2026, their capacity will not meet the demand, which means there will still be a substantial demand for two nanometer semiconductors.

Arjun Kharpal

High-end smartphones currently use cutting-edge semiconductors, including those from Apple, Samsung, and Nvidia. However, there is still a significant market for legacy nodes, which are not as advanced as the latest technology. For example, cars and other applications do not require three-nanometer chips.

Fei Xue

Currently, I believe that 28 is sufficient for many car specialty semiconductors.

Tom Chitty

The government-driven revival, supported by businesses, has led to the growth of a burgeoning industry. However, national security concerns must also be taken into account.

Fei Xue

The Japanese government aims to promote economic growth through its initiatives, which include reviving the semiconductor industry. However, semiconductors have already commoditized in the global market and are critical to many advanced technology areas, including artificial intelligence, electronic devices, and EVs. As a result, many countries are competing to gain space in this niche area and reduce their reliance on foreign companies. To achieve this, they are establishing domestic companies to create and design manufacturing semiconductors for domestic uses. Currently, 90% of cutting-edge semiconductors are manufactured by TSMC and Taiwanese players, with Samsung from South Korea and a small amount made by U.S. companies. Japanese companies that require these cutting-edge semiconductors must rely on foreign supplies, which poses a national security issue.

Arjun Kharpal

The geopolitics surrounding semiconductors have become increasingly complex in recent years, with many different factors coming into play. The U.S. and China have been at the center of this mix, with the U.S. implementing a strategy of cutting off China's access to critical tools, investing in its own domestic semiconductor industry, and striking up partnerships with allies. However, the U.S. has also been considering expanding some of the restrictions on China through the foreign direct product rule, which could potentially impact Japanese and Dutch firms. As a result, countries like Japan may find themselves caught in the middle, trying to balance their alliances with the U.S. while also avoiding being negatively impacted by the geopolitical tensions surrounding semiconductors. How does Japan navigate these difficulties on the geopolitical level?

Fei Xue

The semiconductor industry is always concerned about geopolitics. The U.S. has already imposed restrictions on semiconductor exports to unfriendly foreign countries, including Japan, which has been in effect since last year. Japanese companies cannot sell the most cutting-edge semiconductors or chip making tools to Chinese companies. Before the restrictions came into effect, there was a surge of Japanese exports to China, especially in chip making tools, as Chinese companies tried to avoid the cost of these restrictions and build their own semiconductor industry. However, the Japanese government has introduced a set of restrictions on semiconductor exports to unfriendly foreign countries, which will likely lead to a loss of market share for Japanese companies. However, there is still demand for semiconductors and chip making tools, as many countries are trying to reshore or establish chipmaking capacity within their own soil or in friendly countries. This will increase demand, especially given the continued technological advancement in AI, EV, and data centers.

Tom Chitty

What is the urgency for Japan to become a leader in generative AI? Let's discuss AI.

Fei Xue

In the semiconductor sector, Japan requires two types of semiconductors for AI development: logic chips and memory chips. Japanese companies lack the capacity to produce logic chips currently, but aim to develop this capability by the end of the decade to capitalize on the surge in AI demand. On the other hand, AI development and cloud computing require a large capacity of data centers, which necessitates memory chips. Japanese companies are attempting to both develop their own capacity and attract phone companies to establish fabs in Japan. Micron and Samsung have already established plans to set up research centers or fabs in Japan to produce advanced memory chips. Japanese companies plan to gradually catch up in this area.

Arjun Kharpal

Canon, a well-known Japanese company that has been in business for many years, is attempting to revive the semiconductor industry by developing a nano imprint lithography system to compete with ASML. This story is intriguing as it highlights Japan's efforts to reinvent itself in the tech industry. Is it likely that other traditional Japanese companies will follow suit and try to do the same? Japan has a long history of innovation in technology, and many of its brand names still survive today, including Sony, Nintendo, and Canon. What is happening in this area?

Fei Xue

Japan still holds a significant advantage in various niche areas of the semiconductor sector, and is actively involved in the production of precision equipment and semiconductor materials. Canon has improved its nano imprint lithography technology, making it commercially viable. However, the company needs to achieve a certain level of success rate to be competitive with existing leaders in this area. Many existing fabs design their layouts to accommodate extreme ultraviolet lithography technology, which may require modifications. The main competitiveness of Canon's technology lies in its lower production cost and reduced energy consumption. Japanese companies are more likely to collaborate with existing market dominant players and explore new technologies rather than trying to surpass them. For example, Sony collaborated with TSMC to establish a fab in Kumamoto, with the goal of developing image or next-generation image sensors. By pooling their resources and technologies, Japanese companies can expand their global share and increase their competitiveness against South Korea's Samsung Electronics.

Arjun Kharpal

We have discussed Japan's historical strengths in the semiconductor industry, the evolution of the global semiconductor landscape, and Japan's attempts at revival. Additionally, you have mentioned that Japan has niche areas of strength in semiconductors. However, we have also discussed the complexity of the semiconductor supply chain, which involves software, design, manufacturing, materials, testing, and packaging. Given this complexity, where do you see Japan's strengths at the moment? Specifically, Japan holds an 88% market share globally for coaters, 53% for silicon wafers, and 50% for photoresists. These are all technical areas. So, what are Japan's strengths in these areas?

Fei Xue

Japan's niche materials, components, and precision chip-making tools are its strengths. Photoresist is a prime example of this, as Japanese companies, including Shin-Etsu Chemical, dominate the global market share of photoresist as a material used in lithography technology and also the coating technology. Japanese companies hold up niche areas or segments in the long semiconductor supply and technology chains, which they can utilize to their advantage by utilizing these materials and chip-making technology and tools.

Tom Chitty

If you'd like to play "stat of the week," I'll leave it to Arjun. He dreams of being a game show host one day.

Arjun Kharpal

Fei, as our special guest today, I'll give you the first guess. So, contestants, the stat of the week is 97 billion U.S. dollars. That's the dream, one day.

Fei Xue

Is that the cost required to make fabs by TSMC?

Arjun Kharpal

Your guess, Tom?

Tom Chitty

The estimated total investment required by the Japanese government to produce two nanometer chips is not specified.

Arjun Kharpal

The market cap of Tokyo Electron as of August 1, 2024, is more interesting than my stat.

Tom Chitty

Thank you, Fei, for joining us. That concludes this episode. Before we end, kindly follow and subscribe to our show and leave us a review if you'd like. Thank you, Fei.

Fei Xue

Thank you, Tom. Thank you, Arjun.

Tom Chitty

Thank you, Arjun

Arjun Kharpal

Thank you, Tom.

Tom Chitty

We'll return next week for another episode of Beyond the Valley. Farewell.