Weekend Long Read: Sacrificing Local Losses to Strengthen China’s Chip Industry

China’s semiconductor industry is facing challenges in moving forward with mergers and acquisitions (M&A) due to the reluctance of local officials to acknowledge losses on underperforming assets, resulting in declining valuations and deteriorating assets. This reluctance stems from the complex nature of state-owned assets and the government’s aversion to recording losses on investments, hindering the much-needed consolidation in the industry.

The issue of stalled M&A efforts is exacerbated by the involvement of state investors, particularly local government-backed funds and state enterprises, who resist marking down assets in the face of decreasing industry valuations. This resistance often leads to failed negotiations as buyers seek reduced prices for underperforming projects, while government officials are hesitant to realize official losses on these state-owned assets, consequently impeding the consolidation process.

Since 2014, there has been a surge in state-backed investments in China’s semiconductor industry, with the establishment of the China Integrated Circuit Industry Investment Fund (“the Big Fund”) leading to the proliferation of similar funds for semiconductor projects nationwide. However, changes in the industry landscape and the poor performance of many projects have made it imperative to address the disposition of state-owned assets to facilitate M&A activities. Urgent policies are required to preserve value while disposing of these assets to prevent broader economic losses.

A significant challenge underlying the industry’s woes is the reluctance of government investors, especially at the local level, to acknowledge losses on underperforming assets, for fear of accountability and penalties associated with asset devaluation. Unlike large-scale industry consolidations in sectors like automotive, many semiconductor investments are overseen by smaller, local government stakeholders who lack the mandate and operational flexibility of private enterprises, leading to slow progress or standstills in consolidation efforts.

Risk management officers handling failing projects face personal risk due to stringent asset preservation regulations, with semiconductor investments often involving billions of yuan. Even when potential buyers are interested, declining valuations deter deals as stakeholders prefer to avoid formal losses, ultimately exacerbating depreciation and financial challenges if action is delayed further.

While addressing poor-performing assets was less urgent in times of economic prosperity, the current economic slowdown has brought a renewed focus on removing these assets to support national economic recovery efforts. China has past experience managing large-scale bad assets, particularly in the banking sector reforms of the mid-1990s, and recent government policies have aimed at addressing hidden local government debts and improving fiscal management. Central government intervention may be necessary to drive consolidation, as seen in directives for major industries in 2024, indicating a potential pathway for semiconductor industry intervention if needed.

Proposed policy solutions to facilitate semiconductor industry M&A and asset cleanup include bankruptcy restructuring to address debt and maximize asset value for new buyers, embracing market-based pricing, allowing limited depreciation of state assets for legitimate projects, and injecting quality assets to enable viable consolidations. These measures are essential to overcoming the challenges hindering the consolidation and growth of China’s semiconductor industry.