In Fencing China Out is Washington Fencing Itself In?

As Washington doubles down on its semiconductor embargoes, a troubling paradox emerges: in trying to stymie China’s technological advances, the United States might just be fencing itself in. Each successive restriction aims to choke off China’s progress, specifically in artificial intelligence and high-performance chips. Yet these measures risk isolating the United States from global tech supply chains, harming its own industry and allies.

Take the new U.S. Treasury rule, effective January 2025, which tightens restrictions on American investments in Chinese semiconductors and quantum computing. Although the Biden administration’s objective is clear—to kneecap China’s semiconductor ascent—this gambit is not likely to work. The complexity of today’s tech landscape, with its entangled supply lines and “gray channels” of unofficial trade, underscores the futility of isolating China. Chinese firms continue advancing, with the support of both local innovation and resilient demand for tech alternatives.

Despite escalating sanctions designed to strangle China’s chip industry, the true costs of these measures ripple far beyond Beijing. American allies find themselves isolated, and domestic companies feel the sting of lost revenues. Take Nvidia, for instance. The American AI chip giant introduced its groundbreaking Blackwell architecture  in March but offered a downgraded version to maintain ties with the Chinese market, a reluctant acknowledgment of a complex interdependence that persists despite Washington’s aspirations.

These efforts to stem China’s progress are as much a commentary on America’s anxiety over competition as they are on Beijing’s resilience in pushing forward, innovating, and navigating the geopolitical minefield. Even American firms like Semianalysis, which advocates for the strictest sanctions, concede that China is now advancing past the United States in achieving intelligent computing capabilities. The “wall” designed to keep China out is riddled with gaps. China’s resourcefulness exploits these gaps. With substantial clean energy reserves to power vast computing clusters, where the United States often struggles with shortages, China is less beholden to America’s chip arsenal. Although its H20 chips fall short of Nvidia’s H200, innovative local firms are rapidly narrowing the gap. Meanwhile, U.S. attempts to regulate global trade through restricted entity lists has proven little more than a game of “whack-a-mole,” where new avenues emerge faster than they can be closed.

Perhaps the most significant gap in Washington’s strategy is China’s capacity to manufacture advanced chips domestically. Semiconductor giants SMIC and TSMC illustrate this shrinking technological divide, with China trailing the United States by an estimated five years. By 2024, as Huawei and local giants like Changxin Storage join forces, China’s investments in wafer equipment will propel it to the world’s second-largest buyer, outpacing all American firms. The United States can tighten its grip, but innovation continues to slip through its fingers.

Calls are growing within the United States not just to restrict the export of advanced equipment but to clamp down on components that enable the manufacturing of these technologies. This, however, demands that allies join the United States in constructing an even taller wall. But such a strategy would ultimately require Washington to compensate its allies, effectively paying a steep diplomatic toll for a policy that isolates more than it secures.

While the U.S. may dominate advanced semiconductor technologies, China holds critical leverage in other parts of the supply chain, particularly in rare earth elements essential to chip production. China supplies 60 percent of the world’s rare earth minerals and controls over 85 percent of their processing. In response to American export controls, China has restricted exports of gallium and germanium—key materials in chipmaking—and has hinted at further action if pressures persist.

While these controls aim to hinder China’s tech ambitions, they could have substantial repercussions for the United States too. American chip companies, deeply reliant on the Chinese market, face looming financial losses. U.S. firms could lose up to $83 billion in annual sales and 124,000 jobs, with semiconductor equipment companies especially exposed since 30–40 percent of their sales depend on China.  Meanwhile, Chinese firms like SMIC have pivoted sharply, now producing 80 percent for domestic use compared to just 40 percent five years ago. A prolonged restriction may curtail U.S. R&D, weakening its competitiveness in a market shaped by shifting alliances and growing interdependence.

There’s increasing talk of an emerging “American island,” a scenario where the United States, in its quest for dominance, finds itself hemmed in as other nations gravitate towards the Chinese supply chain. This trend, already visible in connected cars, is making inroads into the semiconductor sector. Since 2018, China has skillfully maneuvered around these restrictions, using strategies like “design-out” (substituting U.S. technologies with Chinese or third-country alternatives) and “design-around” (innovating to bypass controlled technologies entirely).

The U.S. strategy to contain China’s tech industry has spurred an unexpected transformation. Chinese companies, supported by the government, are choosing local suppliers more assertively, aiming to reduce reliance on an unstable supply chain. This shift is creating a robust local market and a fortified tech ecosystem within China. Meanwhile, foreign companies, fearing the loss of access to China’s vast market, are moving away from American technology and components. Third-party nations and their companies, unburdened by these geopolitical tensions, are stepping in to fill gaps left by restricted American firms.

With revenues and R&D investments shifting to non-American firms, U.S. leadership is in jeopardy. American firms may face diminished market share as they are overtaken by agile competitors less constrained by Washington’s restrictive policies. Once focused on replication, Chinese companies are now emphasizing original technological advancements. With expertise in packaging technology and close integration into the global supply chain, China has boosted its investments in hybrid bonding and advanced substrates, fields where U.S. companies are lagging.

Data from the first half of this year highlight China’s impressive strides. While global semiconductor equipment revenues held steady, China’s top equipment manufacturers achieved a 50 percent year-over-year revenue increase, reducing their gap with global giants from 24 to 15 times. As the contest between China and the United States deepens, third-party players will continue to leverage this shifting dynamic, optimizing their own interests amid the rivalry.

This first appeared in FPIF.

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