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The Perspectives Podcast
Episode 11:
"China and the Global Smartphone Economy"
With Candace Browning
Head of BofA Merrill Lynch Global Research
Chris Hyzy, Chief Investment Officer,
Merrill and Bank of America Private Bank
Helen Qiao, Chief Economist for Greater China,
BofA Merrill Lynch Global Research
Brett Hodess, Head of Americas Equity Research,
BofA Merrill Lynch Global Research
Konstantin Kakaes, editor at MIT Technology Review, clip #1:
“In terms of the materials that go into an iPhone, most of the periodic table is needed. It’s almost easier to say the things that aren’t in an iPhone.”
CANDACE: That’s Konstantin Kakaes, an editor and journalist at the MIT Technology Review who has researched what exactly goes into smartphones and what it takes to assemble them.
Kakaes, clip #2:
“There’s no uranium.”
CANDACE: I imagine we're all relieved to hear that. But how smartphones get made and what actually is in them can be highly revealing.S
Kakaes, clip #3:
“They have extremely complicated microprocessors inside of them, chips that communicate with the cellular radio network, fingerprint sensors, multiple cameras, speakers, microphones. The screens that they have are extremely complicated, a separate little layer for the touch sensitivity. Batteries, obviously.
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CANDACE: Those parts aren't all made in one big smartphone factory. They're made by many suppliers.
Kakaes, clip #4:
“And those suppliers in turn have their own suppliers. There’s a very complicated web of companies and manufacturing and parts getting shipped back and forth globally in a very sort of intricate dance.”
CANDACE: At the center of that dance is China, and it turns out that the smartphone is the perfect lens through which to view complex dynamics at the heart of the global economy, as well as the international race for technological supremacy. That's what we'll be talking about today.
[Theme music]
CANDACE: You're listening to the Perspectives podcast. I'm Candace Browning, Head of BofA Merrill Lynch Global Research, and with me is Chris Hyzy, Chief Investment Officer, Merrill and Bank of America Private Bank.
CHRIS: Hi Candace.
CANDACE: And Brett Hodess, Head of Americas Equity Research for BofA Merrill Lynch Global Research.
BRETT: Hi, Candace.
CANDACE: Brett, let's start with you. You were a semiconductor analyst for 25 years and have deep working knowledge of a lot of what we'll be talking about today. So first, can you just tell us some of the things that go into a smartphone to actually make it work and also where do all those things come from?
BRETT: So, the smartphone you can sort of use as a metaphor for all other electronic systems out there today. First, there's two major blocks on a cell phone. There's analog sector and there’s a digital sector, and it turns out in the analog there's one or two key things that are called filters that are super hard to make. And only a couple of companies make those.
In fact, they're mainly U.S. companies and they have over 80% market share of the filters that go into your advanced smartphone. (Source: Global Technology Equity Research, BofA Merrill Lynch Global Research, 2019.)
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On the digital side, there's three big blocks. There's a modem, which is what turns the radio frequency signal into a digital signal. Then there's what they call an application processor, which is essentially the brains inside your cell phone. And then there's the memory that holds all of your information.
So it turns out that the application processor can be made by a lot of different people because it's all based on a company called ARM’s architecture. So you can buy the IP from ARM and build that. And many companies can do that.
The biggest companies like Apple, Samsung, Huawei make their own application processors, but the modem is almost all made by U.S. companies.
So, when we look at the total phone bill of materials, if you will, there's many components from a volume standpoint, from smaller companies outside of the U.S., but the massive dollars that go into the phone come from the U.S. — well over half.
CANDACE: So what you're actually saying is while there's a lot of different suppliers, there's a few very key suppliers where there's huge market share held by a small number of incumbents.
BRETT: That that's exactly right. So, if you look for instance in the U.S., about 80% of the filters that I mentioned are all made by just one U.S. company. (Source: Global Technology Equity Research, BofA Merrill Lynch Global Research, 2019.)
CANDACE: Wow. Okay. So switching to semiconductors, which is the heart of this, I read that China accounts for about 60% of global demand for semiconductors, but that it actually only produces about 13% of global supply. (Source: Council on Foreign Relations, “Is ‘Made in China 2025’ a Threat to Global Trade?”, May 2019.)
So, Chris and Brett, where does China stand right now in its ability to create these super powerful chips, and why is it so difficult for an economy like China to make inroads in the semiconductor area?
CHRIS: I think when you step back and you think about the evolution of the semiconductor industry, what China's trying to do is catch up to the tune of about seven decades worth of advancement that the US and to some degree, the EU have enjoyed, particularly in the United Kingdom.
So there's a catch up factor there. But the real key here, Candace, is this switch from hardware and pure manufacturing to a software enterprise system. And that software system is where they have not been a leader. And that’s the area that’s very difficult.
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CANDACE: So Brett, why is it so technically difficult and how long do you think it would actually take China to build a large semiconductor industry?
BRETT: So, let's put some numbers around this. So Chris correctly identified that the Western world has been investing in semiconductor technology for basically 60 to 70 years.
Now, China has come out and talked about the fact that they're spending $90 billion to develop their industry and they just announced another $115 billion. This is spread over a five- to 10-year period. So $205 billion. In addition, Chinese semiconductor companies on top of what the government is spending are spending another this year about three-and-a-half billion dollars of their own. (Source: Center for Strategic
& International Studies, “China’s Pursuit of Semiconductor Independence,” Feb. 27, 2019.)
Okay, so $208 billion sounds like a lot. However,
CANDACE: Seems like a lot of money to me!
BRETT: Seems like a lot of money. Except for one thing, the rest of the world semiconductor business is going to invest $92 billion in R&D just this year. In addition to make this work, you have to build factories. So, if you look at capital spending and R&D together, the rest of the world is going to spend $200 billion this year versus $208 billion over five to 10 years for China. (Source: Bloomberg,
semiconductor industry company capex and R&D data, 2019.)
CHRIS: And Brett, you mentioned the word factory. Can you just describe what a semiconductor facility is actually like?
BRETT: Sure. So a typical semiconductor factory today costs around $15 billion to build, and about two thirds of the stuff in that factory is semiconductor equipment. (Source: Reuters, Dec. 2017.)
The semiconductor equipment is almost completely controlled for the key equipment by the U.S. The three of the four largest companies are in the United States and the other one is in Europe. All these factories have to buy from this small handful of companies.
And what they have to buy is an amazing amount of equipment, because if you're in a memory factory, there's 32 layers on a chip, which results in something like a thousand process steps to make a memory chip. If you now move on to logic like a microprocessor, you could be at 2,000 to 2,500 process steps in a factory.
On top of that, the factory has to be ultra-clean. So that means basically it's completely robotic. They call them a lights-out factory. All the wafers that the semiconductors are built on are moved around the factory in robotic systems that
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put them in and out of all these tools that we just talked about. So just to run the factory, you have to have incredibly high technology, super high precision.
CHRIS: So not complex at all.
BRETT: Not complex at all.
CANDACE: And interestingly, it sounds like semiconductor factories don't create a lot of employment, which may be another reason that China was not traditionally interested in it.
BRETT: You hit the nail on the head with that. They originally started to go into them and then they realized that they can, they create a lot of construction jobs and then the jobs go away because then you have a small number of highly skilled engineers running the factory.
CANDACE: And a lot of robots.
BRETT: And a lot of robots. Yep.
CANDACE: Okay. So let's switch gears just a little bit and start to talk about what does this mean for the future of trade and for economic growth. I want to start with intellectual property.
News clip montage Male voice #1:
“Scientists in China have unveiled a supercomputer that’s twice as powerful as any existing machine.” (Source: Al Jazeera, 2013)
Male voice #2:
“China has ranked first in the world in patent filings for the fifth consecutive year.”
(Source: CCTN, 2016)
Male voice #3:
“Tensions between the U.S. and China are rising, and Silicon Valley is feeling the effects.”
(Source: CBS News, 2019)
Female voice #4:
“Intellectual property theft. We’re talking to the tune of $600 billion dollars a year potentially.” (Source: FOX Business Network, 2018)
Female voice #5:
“There are open espionage investigations involving China—now, get this—in all fifty states in high tech, agriculture and academia.” (Source: TODAY, 2018)
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CANDACE: So Chris and Brett, intellectual property theft is being talked about a lot now, but you've also pointed out how hard it will be for China to catch up on their own. So is this whole intellectual property discussion, you know, kind of overblown. What are the real issues here?
CHRIS: Brett really talked about the complexity of what a semiconductor chip is. And it's one of the reasons why China hasn't been able to catch up to the seven-decade advance that the U.S. predominantly or the Western world has had.
So intellectual property acquisition through whatever means is one of the few ways that you can catch up.
And you're talking about companies that have spent billions of dollars, over the course of many, many years, in R&D, in new plant and equipment in accessing patents and copyrights and other elements of intellectual property only for that to be acquired in a particular way overnight. No, I don't think the discussion is overblown.
CANDACE: So clearly China cannot go on its own for making the most sophisticated hardware that powers smartphones or super computers. And clearly China needs high-end chips from the US and also to a certain extent from Europe.
Is the smartphone an outlier here or is China actually dependent on the rest of the world for a lot of other high-tech products?
BRETT: Well, I would say, the smartphone is more of an example rather than an outlier. Because if you look at any type of high-end computing system, high-end network, communication system, or data storage, you can argue that because these are newer markets, you could design your own chip, you don't have to rely quite as much on the legacy chips.
But the problem then is you still have to make these chips on the most advanced technologies if you're going to be a major world player, otherwise you're going to be relegated to building systems that don't operate as well.
For instance, battery life could be very short, or the area where you're going to get reception could be significantly reduced, things like that. The graphics on the screen could be substantially weaker, how quickly you could download or watch a movie could be slower.
CANDACE: I think what I heard both of you saying is that intellectual property is really at the heart of this matter and it's affecting not only the future and China's ability to, for example, create a semiconductor industry, but it's also hurting the
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revenues of a number of global companies around the world today. So it's really got two components to it.
BRETT: That's right. And I think the way you have to look at it as this: it's not, could China ever catch up and have a strong semiconductor industry? Of course, if they spend enough money and take enough time. The question is, are they willing to have inferior product if in fact that we can't get some kind of agreement, are they willing to have an inferior product for a long period of time that would of course affect the economy of their country.
So that's one part of it. And then the other part of it is the U.S. companies and whatnot, China has been a good growth market for them, right? So if you shut that off on the one hand, U.S. and European tech companies, will probably pick market share up in the end products. But at the same time that you still lose that giant populace that's in China as a marketplace.
CANDACE: So Brett, how many years do you think it will take China to build a globally competitive semiconductor industry?
BRETT: So this morning I had a global conference call with our tech team to ask them exactly that question. They believe that somewhere between 10 to 15 years to be able to build competitive microprocessors.
However, they would run different software, which means that they wouldn't necessarily be able to compete on the global stage. Even if their performance was similar. And that assumes that they can continue to buy semiconductor equipment from the U.S. and European companies that make that equipment. If they didn't do that, they think you have to add five to maybe even 10 years onto that. (Source: Global Technology Equity Research, BofA Merrill Lynch Global Research, 2019.)
CANDACE: Brett, we've been talking about semiconductors and existing technology. Are there any potentially new technologies like quantum that China could use and just leapfrog ahead?
BRETT: Sure. That's a great question. China and the U.S. as well as Europe are very interested in moving onto quantum computing for two reasons. First, it's going to be incredibly powerful.
But secondly, from national security standpoint is that there's been a huge concern that if you actually had quantum computing working that you'd never be able to have any security on your systems cause it could break through any type of encryption or code that you might have firewalls and whatnot. And I think it is a technology that breaks with traditional technology. So it's an opportunity for China to catch up and leapfrog.
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But at the same time, you have to understand that China has put about $400 million directly towards quantum computing R&D, and Trump has just put, 1.2 billion dollars.
CANDACE: So $400 million and $1.2
BRETT: Versus $1.2 billion. And the three biggest spenders right now as far as companies go in the world are Intel, IBM and Google and combined their spending is probably somewhere in the two to $300 million range with $450 million of venture capital money as well. (Source: New York Times, “Google Claims a Quantum Breakthrough That Could Change Computing,” Oct. 23, 2019.)
So, I do think China has a great shot at being a leading player in quantum. But from an investment standpoint, if you look at what's being spent in the U.S. in Europe, it's probably on the order of about somewhere between three and four times more.
CANDACE: Great. Well, Brett, thank you very much. So let's pivot now to another key part of this story, which is China’s economy and how it fits in with all of these dynamics. And joining us for this part of the conversation is Helen Qiao, who is Chief Economist for Greater China for BofA Merrill Lynch Global Research.
Welcome Helen.
HELEN: Hello Candace.
CANDACE: So Helen, it wasn't too long ago that China was mainly seen as a cheap place to manufacture mass produced, low-end goods. How did it get to be the global powerhouse that it is today?
HELEN: I think it all started with a couple of advantages that China already had. They've got an ample supply of reliable labor that is of a reasonably low cost. And then there was also the policy stability along with a very stable inflation and as well as the infrastructure.
And as they continue to grow per capita income, they also are building a much bigger market which everyone wants to get access to and that really built a base for them to accumulate the capital and then they kind of slowly get up from there.
CANDACE: Okay. I recently heard an American CEO explain why his company assembled its products in China. And it wasn't because it was so cheap. He said it was actually because of the workers, the craftsmanship, the vocational training and the entire sort of manufacturing ecosystem that exists because of that.
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So, how does that factor into China's ambitions and long-term goals such as the China 2025 initiative? Because that the 2025 initiative seems to be not to be actually not so much focused on workers and the labor advantage.
HELEN: That's right. So they build on top of what they had in the labor abundant kind of resources they begin with and they have accumulated a lot of the skilled laborers who also have the managerial kind of talent that they, and the experience that they put together over time.
But on top of that there is now a very competitive environment where a lot of these manufacturing-based and increasingly more R&D driven type of companies are competing against each other over this very large market.
So let me say a little bit about this very ambitious plan called Made in China 2025.
The idea is that they would like to move China up the value chain and especially to focus on industries such as pharmaceutical, auto, aerospace, semiconductor, green energy, IT, robotics, ocean engineering, you name it. So this is the future that they envision for the Chinese current mid- to low-end manufacturing to finally end up in the next 10 to 20 years.
But I think the interpretation is that China is super ambitious and they're going to take over the world and from a technology perspective is going to be a formidable rival to the rest of the world.
CANDACE: So let's delve into that image of a super-aggressive China wanting to dominate the world a little bit. Chris, do you think that there are threats to national security from China's race to be a global tech powerhouse?
And also, on the flip side, could there actually be some benefits to that for the U.S. because it will compel the U.S. companies to spend more on R&D and innovation?
CHRIS: Absolutely. First of all, competition is always good. It is what forces what we know today as capitalism to take many leaps forward. And that's what we've seen over the course of time.
With that competition comes, like you mentioned, an increase in R&D, innovation labs developing all over the place in the private space, in the public space, from VC to new companies being born, new industries. It attracts new talent from all around the world. We all know that there's a war for talent right now already. It could potentially force major changes to education in the United States as well, both primary and secondary to increase mathematics and sciences and engineering.
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And as a corollary to this, Candace, in terms of technological leadership, it's what do you do with the supply chain, and can the supply chain in some cases come back home or onshoring?
I think it would fast track a good portion of that. On the flip side, national security is always a concern. It’s probably gonna continue to increase given what's going on geopolitically.
So from my perspective that's the downside of what this technological leadership war is around the world. We've seen it before in other industries. But this is completely across all industries.
CANDACE: So do you think that these national security concerns could ultimately force a fragmentation of supply lines into sort of a China block and a U.S. led block? Is that likely and how feasible is that to actually occur?
CHRIS: Yeah, you could literally see in the next decade, two supply chains, one driven by the U.S. and one driven by China. And countries would have to decide what inputs do they need in an environment that they need to prosper for their own economy and what they do with trade.
So absolutely, I think you see a dual lane highway being created as we speak. We’re in the early days of it, but it’s something that will be a development we’ll watch very closely.
CANDACE: So Helen, despite all the progress that China's made on manufacturing and technology, it still faces substantial challenges. Obviously, we're aware of things like basic needs such as access to water and pollution is a huge concern.
I also read that the per capita GDP in China is about $8,000 per person, whereas in the U.S. it's about $56,000 per person. (Source: Council on Foreign Relations, “Is ‘Made in China 2025’ a Threat to Global Trade?”, May 2019.)
So can you talk a little bit about what those issues mean for the Chinese government? Why not direct more effort into closing the per capita GDP gap?
HELEN: I think they are trying hard, but I think they are also encountering couple challenges in the short term. So actually, in 2018 to 2019, they have been prioritizing three most important policy tasks.
Number one is deleveraging and number two, poverty reduction. Number three, environment protection. In the past they have always been trying to pursue and push and push for faster growth and higher per capita GDP level. But then they suddenly look back and found that there are a couple of problems that comes with it and they
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have to address them before they move on. And these include these environmental issues.
Putting it as a policy priority at a time when actually the overall growth is not necessarily the most of stellar means a lot because they understand how important these are for them.
But in the short term, what they're doing perhaps means the following: They probably have to opt to for the high-quality growth for a while over the, you know, faster pace. For the long term, the benefits is it probably can give them more sustainable growth.
So I would say that this is probably the tradeoff they have to take. They need to definitely spend more and invest more in the short term to make sure that they get to where they want to go.
CANDACE: And also areas I would think like health care and education, pension reform those are other areas where they could focus?
HELEN: Absolutely. Completely agree.
CANDACE: So Chris, are there sectors here in the U.S. that are benefiting from the competition between the U.S. and China and what should investors be watching for in terms of potential growth opportunities?
CHRIS: So the obvious answer would be technology. The software is most replicable part of technology, but it's also the one that you can innovate the easiest with. One dollar spent in software goes a lot farther than anywhere else. And that's an area that is constantly reinventing itself. So that's one to think about.
The industrial sector. Most people know it as large industrial manufacturing companies, which is true, or chemical companies, but there's aerospace and defense. And last time I checked, the geopolitical side of the equation isn't getting easier each day. So that's another area.
Switching gears, what we're hearing is with 5G the health-care sector is probably going to be the biggest beneficiary of that. Digital imaging, surgical operations, the ability to get real time information to make surgeries less costly and at the same time easier to do.
Retailing. Think about 3D printing. Just in time creation of custom manufactured things is already here, but to do that much quicker onshore without going offshore for it.
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And last but not least, energy — the ability to create cleaner fuels through the use of technology, et cetera, in the energy space. That's coming as well. So it's across the board, but those are the five or, or so main areas.
CANDACE: Well, Helen and Chris, thanks so much for your insights on China and why it's so important. I have a feeling that we're going to be following this topic for a long time to come.
You've been listening to Perspectives. I'm Candace Browning, Head of BofA Merrill Lynch Global Research.
My cohosts have been Chris Hyzy, Chief Investment Officer at Merrill and Bank of
America Private Bank, Brett Hodess, Head of Americas Equity Research, BofA Merrill Lynch Global Research and Helen Qiao, Chief Economist for Greater China, BofA Merrill Lynch Global Research.
We hope these episodes inspire you to see your financial life in a new light.
What would you like the power to do?
Thanks again for joining us.
This podcast was published on November 6, 2019.
Any opinions or other information correspond to the date of this recording and are subject to change.
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