USA vs. China – Closing Loopholes

ASML bucks the Chinese trend.  

• Excellent results from ASML indicate that China is still buying as much equipment as it can get its hands on but potential further tightening of restrictions from The USA threatens to turn equipment in China into very expensive doorstops.
• ASML reported Q2 24 revenues / EPS of €6.2bn / €4.01 ahead of estimates of €6.1bn / €3.72 and kept guidance unchanged for the year.
• The better-than-expected profits were driven by an increase in sales mix towards older immersion machines which carry higher gross margins.
• This went hand in hand with China now making up 49% of total revenues during Q2 24 which is a pretty sure sign that the Chinese are buying as much equipment as they can before they are no longer able to do so.
• This will have a negative impact on the USA’s strategy to limit China’s rise as a technological superpower because it will allow Chinese companies to manufacture semiconductors at nodes less than 20nm for many years to come.
• In October 2022, the Department of Commerce created new export rules designed to prevent China from acquiring equipment that could make chips at 20nm – 10nm that were not leading edge (extreme ultraviolet (EUV)).
• This was a much more difficult proposition as the USA does not have unilateral control over this technology like it does in EUV and so this required the co-operation of The Netherlands and Japan.
• The Netherlands and Japan have largely fallen into line with the USA but with 49% of ASML’s revenues still coming from China, it is clear that the restrictions are not working as well as the USA would like.
• This is why it is considering implementing the foreign direct product rule (FDPR) which would prohibit the export of any product to China that has any component or software that was created in the USA.
• In practice, this would mean almost every piece of semiconductor equipment product made in Japan and The Netherlands would be hit but this is a double-edged sword.
• This is because it also incentivises the targets of this rule to design out US technology and will annoy US allies potentially to the point of non-compliance.
• A change or tightening of the rules is becoming an annual event and so sometime in early Q4, we are likely to see some changes or modifications.
• Using the FDPR would be a radical change and so I don’t expect the USA to go this far, but it is clear from ASML’s Q2 24 revenues that China is doing everything it can to dodge the rules and hawks in the USA will see The Netherlands as being complicit.
• There is a twist to this tale which is that all of the machines that China is stockpiling need servicing, maintenance and software upgrades, all of which come from overseas.
• Hence, if the post-sales service and maintenance were to become blocked, the machines that China has already purchased would become far less useful and in some cases, useless.
• This could have the effect of greatly reducing China’s ability to circumvent the rules by stockpiling equipment while it still can.
• This is the negotiation that I am sure is going on right now between the USA, Japan and The Netherlands.
• The USA will want the Chinese equipment to be limited in its functionality while Japan and The Netherlands will be very keen to not see revenues from China go to zero overnight.
• I suspect that it will be somewhere in the middle where the eventual meeting point is found which means that in October, there will be a further tightening but not as severe as the implementation of the FDPR.
• The net result is that further restrictions on sales of semiconductor equipment to China are coming which may impact revenues for ASML, AMAT, Tokyo Electron and so on in 2025.
• I think that any dip would be short-lived as demand from China will be replaced by demand elsewhere but that would still be enough to make the market nervous and cause a correction.
• RFM and Alavan Independent do not think that a change in the USA administration is likely to change very much and so the US election is unlikely to have very much impact.
• Hence, we continue to see a balkanization of the technology industry with China going one way and the West another which will be bad for everybody as competing and incompatible standards mean a smaller network and less value creation.
• Everybody loses even if one side wins the geopolitical struggle.