China vs. USA – No leverage

History looks set to repeat itself.

• China’s limitations on Gallium and Germanium will cause some short-term disruption but it will not deliver negotiating leverage and will only accelerate the decoupling and increase China’s isolation in the long term.
• China has announced that it will impose limitations on the export of Gallium and Germanium in order to “safeguard the national security and interests” and exporters will need to apply for export permits from August 2023.
• This looks like a re-run of the rare earth metals limitations that were in place between 2010 and 2015 which created a spike in the price of rare earth metals but failed to limit the world’s access to them.
• This is because while China exports 71% of the world’s rare earth metals it controls only 37% of the known reserves.
• Refining rare earth metals is a dirty business and other countries have been more than happy to send the ore to China and pay it to do the refining for them.
• Consequently, a spike in the price of rare earth metals created an incentive for other countries (like Vietnam and Brazil) to develop refining industries of their own.
• Consequently, after a few years, China realised that its restrictions would only hurt its own industries and it abolished its export regulations.
• I suspect that something similar will occur here also.
• China produces 94% of the world’s Gallium and 83% of the world’s Germanium but like rare earth metals, China has a much lower share of global reserves and therefore does not control them.
• Gallium and Germanium are important substances for the semiconductor industry as they are used to produce compound semiconductors.
• Compound semiconductors are more resistant to harsh environments and consequently are good for use in military hardware.
• Furthermore, compound semiconductors are often produced on older nodes (45nm and larger) meaning that China should be able to produce them without running up against export restrictions.
• Gallium commonly occurs with Bauxite which is one of the most abundant ores in the earth and is used to produce aluminium in many parts of the world outside of China.
• As the lowest-cost producer of Gallium and Germanium, other countries ceased refining these elements years ago allowing China to consolidate refining and become even more cost competitive.
• However, a quick glance at the US Geological Survey report on Gallium (see here) indicates that there are deposits of Gallium in many different parts of the world much like rare earth metals.
• Hence, export restrictions of these two elements will trigger a spike in their price and incentivise countries which used to refine Gallium and Germanium to resume doing so.
• I suspect that the situation for Germanium is similar as it often occurs in zinc deposits which are found fare widely distributed across the world.
• The net result is that the cost to refine Gallium and Germanium will now rise as new facilities will need to be built and deconsolidation of refining will also cause costs to increase.
• Hence, there is likely to be some supply tightness in the short-term but if China is no longer viewed as a trusted supplier, then buyers will be willing to pay higher prices and there will be no shortage of countries willing to take over China’s position.
• This is why I think that these restrictions will have no material impact on China’s negotiating position when it comes to accessing advanced semiconductor manufacturing technology.
• Consequently, there is unlikely to be any change to the restrictions being put in place by the USA, Japan and The Netherlands and I do not expect to see compound semiconductor supply materially impacted.
• This means that the majority of the pain will be felt by the Chinese refiners and exporters of Gallium and Germanium who will see their revenues decline substantially.
• These restrictions will also further sour an already poor relationship and hasten the decoupling that is already in full swing as it is becoming increasingly difficult and risky to do business in China.
• While China is really struggling in advanced semiconductor manufacturing, it is doing much better in other areas like AI, autonomous driving and quantum computing.
• The USA is now looking to hamper China’s development of these technologies using access to advanced semiconductor manufacturing as a weapon.
• With Japan on board, US restrictions are likely to be highly effective and I don’t think that restrictions on Gallium and Germanium are going to make any difference.
• This combined with the lack of any real economic recovery in sight means that the China technology recovery theme for 2023 could take much longer than expected.
• Chinese technology stocks are some of the cheapest in the world but with the current outlook, they look like value traps rather than short-term opportunities.
• I still hold Alibaba, but I have the luxury of being able to sit on it indefinitely, and I remain confident that a recovery will come at some point.