CHIP TRADE WAR - US WATERLOO?

U.S. and Japanese trade officials have hammered out an overall settlement of the "semiconductor war" that would have far-reaching consequences for world trade in memory chips.

Basically, Japanese products will be forced to charge higher prices on their worldwide sales of leading-edge memory chips, and grant a larger share of the Japanese semiconductor market to U.S. companies.In return, the United States will drop a series of trade complaints involving the Japanese-made chips. If it is effective, the agreement will mark an extraordinary - some would say frightening - episode in U.S. post-war trade policy while failing to strike at the root of U.S.-Japanese trade friction in this critical area of manufacturing.

This agreement is extraordinary for at least two reasons. First, it involves one of the most high-technology products known to man. Configurations of these chips form part of the "brain" in virtually all electronic apparatus from toy games to the most advanced computers and spacecraft. This fact means that for the United States, the contemplated agreement represents something of an embarrassment.

In free trade circles, resort to import relief - even in response to General Agreement on Tariffs and Trade illegal unfair trade practices - has been associated with the "protection" of industries like footwear, carbon steel, and apparel. But the United States is thought to have a comparative advantage in "knowledge intensive" industries like semiconductors, making import relief unnecessary.

The agreement is symptomatic of the fact that conditions in the world economy today are leaving fewer and fewer such niches in which U.S. manufacturing can take refuge.

Second, the agreement will mark the first occasion in which the United States has sought extra-territorial application of a U.S. legal remedy against dumping practices in the U.S. market that have harmed a U.S. industry. In effect, end-users of semiconductors in places like Singapore and Europe will be forced to pay more for chips as a result of the settlement of this U.S. trade case. Whatever the costs and benefits might be to others, the precedential effects for trade actions in other, unrelated products and by other countries cannot be controlled.

These two negatives might be worth taking on the chin if the agreement works. But it will not. To be sure, Japanese "dumping" into the United States and other unfair trading practices involving semiconductors have harmed U.S. producers and should be offset with the appropriate remedies under U.S. law. But the form that the remedy has taken will not "level the playing field" in the manner envisaged.

The real U.S.-Japanese struggle in the case of semiconductors is between antagonistic principles of economic and business organization, and has come to represent shocking challenge to makers of U.S. corporate strategy, as well as to trade officials. None of the existing paradigms for analyzing and guiding corporate behavior seems to work any longer. The harmony - or "wa" as the Japanese call it - of competitive business development is in disarray.

Leadership in the production of memory chips is determined by how quickly a competitor can bring into commercial production successive generations of increasingly advanced products. This is because there is a strong, inverse relationship between a producer's unit costs and the magnitude of the total number of units produced over time.

If a producer is relatively slow in moving down this "experience" curve, the downward-trending market price will continually be lower than his marginal costs, causing profits to elude him. Aggravating this competitive reality is the fact that the incremental capital cost required to develop and bring into production successive generations of chips is rising.

This helps to explain how both the trade conflict and the nature of the proposed settlement came about. Until the rapid Japanese penetration of the U.S. memory market in the late 1970s, the prevailing U.S. market price for the latest generation of commercial chips was determined by competition among U.S.-based firms, which operated within common competitive parameters of cost and capital formation established by the U.S. business environment and competitive capital markets. This allowed a new entrant into a state-of-the- art memory chip to forward price his chip at the prevailing market price, and take some losses until his accumulated production experience was at the level that allowed the market price to be profitable for his firm.

The Japanese entry profoundly disrupted this functioning of the industry by forcing market prices for the state-of-the-art chip (which was then the 16K dynamic RAM) to levels below those that would have prevailed under normal U.S. competitive conditions.

This action depressed U.S. producers' profitability at the same time when capital costs as a proportion of total costs were rising rapidly. The profitability of many U.S. competitors ultimately became insufficient in relation to the volume of capital required to lead the advance into the next generation. As a result, U.S. firms began selling out or exiting the memory chip market entirely.

The objective of the agreement with Japan is aimed at rectifying this problem by forcing Japanese market prices for the chips sufficiently upward to cover the total costs of production. (The basis for the U.S. anti-dumping complaints was that the Japanese were selling their chips in the United States at a price that was not permitting full cost recovery over a reasonable period of time.)

If effective, such an agreement would indeed impair the ability of Japanese producers to accumulate market share through underpricing. However, it does nothing to address why Japanese underselling could have been sustained in the past for so long, because it ignores, at the U.S. industry's peril, the relative disadvantage of U.S. industry at mobilizing progressively larger increments of capital over time.

A Japanese semiconductor company can attract up to nine times the capital as can a U.S. semiconductor firm, while earning the same return on its sales and operating under the same cost-price relationships. This extraordinary leverage is made possible by the risk-free conditions under which the major Japanese producers are financed.

My concern, therefore, is that by raising Japanese profit margins to at least the U.S. level, the absolute magnitude of low-cost capital that the Japanese firms can mobilize will be boosted sharply and dwarf the resources that a U.S. company can muster, given the same return on sales.

Although Japanese companies may no longer be able to buy themselves production experience through underpricing on state-of-the-art chips, they can finance development of the next generation at a faster rate than can a U.S. company while meeting the U.S. price. In the end, the purpose of the trade agreement - leveling the commercial playing field - is defeated.

There are only two possible solutions to the semiconductor problem for the United States. Each is superior to what is being negotiated.

One is to impose severe quantitative limits on the volume of chips that Japanese companies may sell in the U.S. market. The United States accounts for the majority of world demand for memory chips and the majority of world demand at the early stages of the experience curve following introduction of a new generation.

The U.S. market remaims the critical "proving ground" in which producers must accumulate production experience. If access to this proving ground is severely limited, a producer will not be able to accumulate the necessary production experience.

The alternative might be more palatable to those who instinctively eschew any restrictions on trade. The objective would be to enable U.S. semiconductor companies to match the capital-raising power of their Japanese competitors with the aid of U.S. government guarantees on debt for capital investment.

It is only through the introduction of equivalent risk-free finance that comparable financial leverage can be effected at an acceptable cost and in a manner that allows competitive pricing of the end-product. Such a program actually would give U.S. companies somewhat of an edge over their Japanese counterparts, because the former tend to generate more sales for each dollar of assets employed.

With fiscal incentives for industrial investment likely to be reduced or eliminated entirely in the tax bill emerging from Congress, government will have to be involved more openly in supporting strategic industrial objectives in situations where the international field is not level and where the standard remedies are not workable.

The Defense Department already has taken the hint and is pouring hundreds of millions into its Industrial Modernization Incentives Program.

Under this program, originally known as "Tech Mod," the participation of the U.S. government has made feasible industrial investment in leading edge manufacturing technologies.

The same principle can be applied readily to the semiconductor industry in a constructive manner.

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