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The global chip shortage, which first reared its head late last year, has sent shockwaves across industries. According to Goldman Sachs, at least 169 industries, from automobiles and guided missiles to lawn equipment and shipbuilding, have faced disruptions due to the shortage, potentially shaving 1% off US GDP in 2021. The pandemic combined with electrical grid failure and maritime disasters has led to a perfect storm for the US$ 522 billion semiconductor industry. But, with the effects of the crisis said to last until 2022 it begs the question of what led to the chip shortage? What are the implications of the shortage? How can we fix it?

What led to the global chip shortage?

Image courtesy of ManyPixels

The origin of the chip shortage can be traced back to the minor bump in consumer demand caused by the pandemic. In the early days of the pandemic, consumer spending tanked. Fast forward to a few months later; consumers were lapping up all kinds of chip-heavy gadgets as they upgraded their home office setups and sought out electronic diversions. From gaming consoles to air fryers to 4K TVs, consumer electronics were flying off the shelves in what seemed like an extended Black Friday sale; this led to the manufacturers of these products ordering more semiconductors which quickly overwhelmed the handful of chip foundries that manufacture almost all of the world’s computer chips. Shortages soon followed. 

This phenomenon is known as the bullwhip effect. Despite the cowboy moving his hand only by a few inches, the ripple down the length of the whip grows larger, sending the tip of the whip several feet through the air. The term coined by Stanford business school professor Hau Lee is used to describe the phenomenon where small shifts in demand for certain goods get amplified as they move up the supply chain causing larger swings in production. As retailers cannot gauge the exact future demand, they introduce errors when they scale up their orders in response to expected demand. This error gets amplified as wholesalers and manufacturers do the same, leading to further distortions of demand signals. 

The winter storm in Texas, which caused the electrical grid failure, led to three major semiconductor chip makers- NXP, Samsung and Infineon to shut down manufacturing temporarily . Other events such as the blockage of the Suez Canal, an equipment fire at the Renesas semiconductor factory located in Japan and the panic buying by companies that wanted to stockpile chips to ride out the crisis further exacerbated the problem. 

Automotive Industry

Image courtesy of ManyPixels

The shortage has severely affected the automotive industry, which spends 4.7% of industry GDP on microchips and related semiconductors. Now more than ever, cars rely on chips, using them to perform a variety of functions such as power steering and infotainment systems. The chips used in cars are usually less advanced than the bleeding edge ones used in gaming PCs. Assuming that the pandemic will cause a slump in sales, automakers who generally follow ‘just-in-time’ production decided to cut down on their supplies of semiconductors. 

But automakers were caught off-guard when vehicle purchases rebounded faster than anticipated, with Q4 2020 sales numbers outpacing Q4 2019. Meanwhile, as the demand for consumer electronics skyrocketed and automakers were not purchasing chips, semiconductor makers started focusing on chips for consumer electronics. Upon realizing that they need more chips, automakers placed orders as even if a 10-cent chip is missing, they won’t be able to sell their US$ 50k car. 

For foundries, automakers are a lower priority; case-in-point- Taiwan Semiconductor Manufacturing Company (TSMC). In 2020, only 3% of the world’s largest semiconductor producer’s sales were from automotive chips, compared to 48% for smartphones. Compared to automakers, tech companies provide higher margins, have long-term contracts with the foundries, and never cut their orders. 

From Ford to Tesla to Honda, almost every manufacturer has faced disruptions due to the shortage, with a rare exception being Toyota, the company which pioneered just-in-time manufacturing. Toyota stated that it doesn’t expect to reduce its rate of production because it had stockpiled four months’ worth of chips to ride out the crisis and raised its full-year earnings forecast by 54%.

As consumers in the US could not get their hands on new cars, they turned to the next best thing- used cars. With a 10% increase from March to April 2021, the prices of used cars are booming, and it is the biggest spike since 1953.

Chip Wars 

Semiconductor manufacturing is a tricky business to crack. Setting up a semiconductor foundry involves a steep learning curve. It requires massive upfront investment in the range of US$ 10 billion to US$ 12 billion and at least three years to become production-ready. The fact that chips rapidly become obsolete combined with price pressures further complicates the issue. 

With such harsh conditions, it made sense for only a handful of large players to operate in these markets. Close to 70% of the world’s semiconductors are manufactured by just two companies- Samsung and TSMC

TSMC pioneered the foundry business model and enabled the emergence of the fabless industry. The company is a pure-play foundry meaning that it only operates on a contract basis and doesn’t sell devices of its own design, unlike manufacturers such as Samsung, which designs and makes the chips used in its own products. Top semiconductor companies are now fabless, meaning they only design the chips and the technology in them, and foundries such as TSMC actually make the chips. 

Image courtesy of ManyPixels

The fabless industry has democratized the innovation process and allowed for vertical specialization, eliminating the financial burden associated with semiconductor manufacturing. 

TSMC’s chips can be found in everything from laptops and smartphones to F-35 fighter jets and data centres. It counts some of the largest companies in the world, such as Apple, Broadcom, Sony, and Qualcomm, as its clients. Over the past 30 years, TSMC has invested in 18 state-of-the-art chipmaking facilities known as fabrication facilities or fabs- in Taiwan and accounts for more than 50% of the US$ 42 billion foundry segment of the semiconductor industry.

TSMC is of major importance to Chinese and American companies. Taiwan’s complicated relationship with China and the ongoing trade war has put the spotlight on the company. Last year, the US placed restrictions on Semiconductor Manufacturing International (SMIC), preventing it from getting advanced chip manufacturing gear and forced TSMC to cut ties with one of its biggest customers- Huawei. 

Apart from its 18 state-of-the-art fabs in Taiwan, TSMC also operates two fabs in China and an older subsidiary facility in Washington state. In May last year, the company announced plans to build a fab in the state of Arizona. 

With the global chip shortage shedding light on the importance of semiconductors, nations worldwide have pushed reforms to increase the domestic production capacity of semiconductors. Europe, which currently accounts for less than 10% of global chip production, aims to double the figure by investing around US$ 24 billion to US$ 36 billion. The White House’s infrastructure plan includes US$ 50 billion for the American semiconductor industry. China has issued a tax break for chipmakers to ramp up production. 

Conclusion

For now, the market needs a central authority that determines how many chips each company really needs and ensures that no company hoards chips. The role of the central authority can be played by the chip foundries, which can assign allotments to each of its customers. Sooner or later, the chip shortage will be resolved by some combination of lower demand and higher supply. Undoubtedly, semiconductor chips are fundamental to the functioning of industries; but chips are now becoming more intertwined with geopolitics and are no longer just a matter of economics.  

For more extensive analysis and Market Intelligence reports feel free to approach us or visit our website: Venture Capital Market Intelligence Reports | VCBay.

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