Will the Asian crisis end Silicon Valley's boom?

Published July 30, 1998 7:00PM (EDT)

In July, Taiwanese chip manufacturers slashed their spending on future expansion.

So what? Amid the steady drumbeat of bad economic tidings from Asia -- nations plunging into recession, banks closing, currencies imploding -- the news failed to generate banner headlines in the United States beyond the ever-attentive semiconductor trade press. When prime ministers are resigning and unemployment is skyrocketing, what does one more glum data point of economic distress signify?

Quite a lot, actually. Taiwan's high-tech sector is Asia's most faithful copy of Silicon Valley -- endlessly flexible, nimble, innovative and successful. A nation of only 21 million people, Taiwan is nevertheless the third-largest producer of high-tech products in the world, behind only the United States and Japan. Taiwan has also been one of the lone economic bright spots in Asia over the past year -- a poster advertising the vigor of Silicon Valley-style capitalism. But now Taiwan is finally feeling the pinch, and anyone who cares about the future performance of the U.S. economy should take heed.

Many economic observers scoff at the notion that the Asian financial crisis will end the economic good times of the roaring '90s. Some even go so far as to claim that the high tech-spawned "new economy" has abolished the old boom/bust business cycle. Even now, as U.S. economic growth finally begins to slow, the true believers cite the current rock-bottom levels of both unemployment and inflation as evidence that a recession is nowhere in sight.

But if the news from Taiwan proves anything, it is that in today's world, it doesn't matter how sound your own economy is. A seemingly insignificant event halfway around the world can wreak havoc right in your own backyard, in less time than it takes to say the word "globalization." Through no fault of its own, Taiwan's prize possession -- its silicon chip manufacturing industry -- is faltering. The "Asian flu" is spreading. Silicon Valley and, by extension, the entire U.S. economy, is next.

Consider this sequence of events: The Korean distributor for the Oregon-based chip design company Lattice Semiconductor goes belly up late last fall, leaving Lattice with a backlog of unpaid-for inventory. Lattice is hurt; its earnings fall. But Lattice is a "fabless" semiconductor company -- it has no fabrication plant for actually manufacturing chips. Instead, Lattice contracts with a "pure-play foundry" in Taiwan that specializes in manufacturing chips for a horde of similar companies.

Lattice -- along with a flock of other fabless design houses both in the United States and Asia -- cuts back on orders from the Taiwanese foundry operator, United Microelectronics Corp. (UMC). In turn, UMC decides to slow down its rate of expansion, to decrease the amount of capital spending allocated to building new "fabs." Next stop on the food chain is a return to the United States -- to the corporations that build the machines necessary to manufacture chips. Some of these companies (such as Applied Materials and Novellus) are Silicon Valley's biggest mainstays. But now they're in trouble: Taiwan is one of their biggest markets.

The chain reaction doesn't stop there. In the semiconductor business, often every step of the production process is handled by a different independent entity -- the ultimate demonstration of successful outsourcing. There are enterprises that test chips fresh from the foundry for flaws, as well as companies that build equipment for diagnosing programming bugs in the chip-making machines. Now they're all suffering.

From Korea to Oregon to Taiwan to Silicon Valley and back: Never before has high-tech manufacturing been as flexible, as international, as interconnected -- and as vulnerable.

Says Michael Borrus, an economist at the University of California at Berkeley and co-director of the Berkeley Roundtable on the International Economy: "While most of [the Asian financial crisis] was driven by the withdrawal of financial flows and the move by investors to scrutinize their loans more closely, nonetheless the speed with which it was transmitted -- the reason this contagion spread as fast as it did -- is a function of how deeply these economies have become interconnected at the level of production."

The Asian crisis began almost exactly one year ago, in Thailand. The collapse of the Thai baht currency precipitated a banking crisis, and jittery foreign investors suddenly abandoned the country. The same scenario soon played itself out in Malaysia and Indonesia, and then South Korea, and it is far from over. Malaysia, Thailand, Indonesia and South Korea are all currently in recession -- their economies are predicted to contract this year and probably next. Even Hong Kong and Singapore have succumbed: Singapore is facing negative growth next quarter for the first time since 1985, and Hong Kong's economy is already shrinking. Meanwhile, Japan has been mired in an economic slump for most of the decade and shows no signs of shaking it off.

In hindsight, economists have attributed the collapse to inherent weaknesses in the economies of the fast-growing region -- frenzied real estate speculation, political corruption, risky investment strategies. Some even argue that the crisis, ultimately, is a positive development: Now that these flaws have come to light, they can be fixed, and Asia will be stronger in the long run.

But countries whose economies display few apparent flaws, like Taiwan, are also falling victim -- and revealing, in the process, an intriguing paradox. The same international linkages that have spurred the growth of the semiconductor industry now also serve as incredibly efficient conduits for transmitting economic ailments. Throughout the '90s, the semiconductor chip industry pioneered state-of-the-art models for the international division of technological labor. Its current trouble suggests it may now be paying the price for its own creativity.

Some analysts are now saying that 1998 may be the worst year ever for the chip industry. But no one predicted the collapse. As late as January, the Semiconductor Industry Association and a number of analysts were predicting 17 percent growth for the $138 billion a year (in 1997) semiconductor industry. The latest independent report, just six months later, now expects a 12 percent decline. Motorola just announced its first quarterly loss in 13 years. Intel, National Semiconductor, Rockwell and a slew of other chip companies daily announce layoffs, work stoppages (to clear out inventory) and depressed earnings.

The Asian financial crisis is by no means the only reason for chip woes. The rise of the sub-$1,000 personal computer, with its emphasis on cheap chips, delivered a completely unexpected blow to high-end chip manufacturers like Intel. The chip industry is also notoriously cyclic -- periodic orgies of overcapacity lead to dramatic price cuts, leading to a downturn.

Usually the chip industry comes out of a downturn by jumping up to a new and higher technological rung -- new fabrication plants employing state-of-the-art technology manufacture more-advanced chips with higher profit margins. But that isn't happening right now -- the current down cycle has lasted three years and looks set to go at least another, defying everyone's best prediction.

Asia is largely to blame. Before the currency crisis even began, aggressive expansion by Japanese, Korean, Taiwanese and Singaporean chip manufacturers resulted in huge overcapacity and dramatic price cuts. Then, Asia's collapse dramatically constricted the end-user market for those very chips. Now, it's all ricocheting back to the United States.

The deep interconnections between the U.S. and Asian high-tech economies, while fueling the negative feedback cycle, are by no means an entirely bad thing. Berkeley's Borrus argues that the ability of U.S. corporations to take advantage of what he calls "cross-national production networks" partially explains how the U.S. regained leadership in the semiconductor industry after being threatened by Japan in the late 1980s.

The old model of direct investment and hierarchical ownership by huge multinationals proved too inflexible. Innovation and technological change advance with blinding speed in the chip business. In that kind of environment, says another Berkeley professor, AnnaLee Saxenian, a "decentralized" mode of production is most suited for keeping up with the times.

That's Silicon Valley -- and on a lesser scale, that's Taiwan.

"The story about Taiwan is a story about much more decentralized relationships," says Saxenian, who has written one book about Silicon Valley and is working on another about Asian entrepreneurs in Silicon Valley. "Taiwan is much more entrepreneurial and adaptive [than other Asian countries], in ways that are similar to Silicon Valley."

Indeed, to an ever growing extent, Taiwan is Silicon Valley. Taiwanese venture capitalists are active in the Valley, and the biggest Taiwanese chip companies are engaged in numerous joint ventures with their chip-design cohorts in the Valley. Taiwan Semiconductor Manufacturing Company (TSMC), the biggest pure-play foundry operator in the world, has even built a fab in the United States, as part of a joint venture with several fabless design companies -- some of which are run by Americans, and some by Taiwanese. The cross-pollination between the Valley and Taiwan is fueled by a constant exchange of money, ideas and engineering talent crisscrossing the Pacific.

Taiwan's adoption of flexible, decentralized high-tech capitalism has been dramatically successful. Taiwan dominates the international market for computer scanners, mice, modems and motherboards. It produces 10 percent of the world's desktop personal computers and 32 percent of laptops. The CEO of TSMC, Morris Chang, boasts that TSMC's industrial techniques are only "six months" behind Intel's.

Indeed, when South Korea's huge conglomerates ran aground late last year, Taiwan's entrepreneurs only saw opportunity. South Korea specializes in memory chip production -- in fact, its overproduction of 16-megabyte DRAM (memory) chips is partially responsible for the dramatic price drops in memory that have so delighted personal computer purchasers over the last two years.

Taiwan's chip manufacturers wanted a piece of the DRAM action. For the past several years they have poured billions of dollars into ramping up DRAM production, even as prices fell. Their goal: While others crumbled, weakened by price cuts and the Asian financial crisis, Taiwan would grab market share.

But in recent months, aggressive optimism has turned to "panic," according to one report. Taiwan's DRAM makers are said to be losing $20 million a month. And they're not alone. All of Taiwan's chip manufacturers, including both TMSC and United Microelectronics Corp., have reined in their expansion plans for the first time ever.

Don Brooks, CEO of international operations for UMC, is quick to stress that his company is merely slowing down its rate of expansion, not ceasing to grow altogether. He says UMC is attempting to tie future expansion much more closely to current, month-by-month demand.

Jeff Weir, a spokesman for the U.S.-based Semiconductor Industry Association, isn't alarmed by the Taiwanese cutbacks. He sees them as just a natural part of the chip business cycle.

"That's an indication that the companies that make chips are saying we need to reduce the amount of supply," says Weir. "That's a good sign. It means that there will be an overall reduction of the number of chips on the market. It's a logical business decision."

And if that means that the semiconductor equipment manufacturers continue to hurt, so be it. For chipmakers to prosper, prices must go up.

Weir notes that for every negative economic consequence, someone benefits. Chipmakers get hammered by low memory prices -- but consumers of personal computers prosper. Depreciating currencies in Thailand and Malaysia depress local standards of living, but at the same time lower the manufacturing costs of U.S. companies that own plants in those countries.

Taiwan's chipmakers are determined to be the ones who benefit from the current crisis.

"There is a ton of self-confidence," says Saxenian. "Things are quite dynamic in Taiwan still. Their dependence on the semiconductor industry makes them very affected by the Asian downturn. But my sense is that there is a recognition that they need to move up-market, that the ties between Silicon Valley and Taiwan are just deepening."

Fred Li, a veteran of Taiwan's technology industry, sums up the Taiwanese attitude with a joke. "There are two guys on a trip to Africa," says Li. "They woke up in the middle of the night and heard a growling lion approaching. One guy started putting on his Nike running shoes. The other said, 'Are you crazy? You can't outrun the lion!' The first guy, finishing up tying his laces, replied, 'I don't need to outrun the lion, I only need to outrun you!'"

"Since the economic ties between Asia and the Valley [are now] closer, the shakedown comes sooner," says Li. "In the Valley, the shakedown weeds out firms that are built on the [Asian financial crisis] bubble and leave the innovators ... There is no use arguing with evolution."

Ultimately, says Saxenian, decentralized production networks like those in Taiwan and Silicon Valley will bounce back. "If you get spreading economic recession, eventually that will play back on all the actors," says Saxenian, "but I do think that you get more resilience in a decentralized structure."

According to UMC's Brooks, bad news may travel faster than ever before in today's closely interlinked economies, but that's not necessarily a disaster. "The time is relatively short to get the bad news back, if you like," says Brooks. "But on the other hand that's best for all. A slow lag time stretches out the recovery process."

Still, Brooks doesn't see the current depressed market for semiconductors rebounding any time soon. While many analysts are optimistically predicting a rebound in the fourth quarter of this year, Brooks says a recovery won't arrive before 2000.

He wouldn't speculate on whether semiconductor industry problems might trigger a wider Silicon Valley meltdown or a U.S. recession. But the Semiconductor Industry Association's Jeff Weir is unworried. "I don't think that there is any likelihood that the U.S. is going to be thrown into a recession because of the Asian financial crisis," says Weir.

Hopeful words. But it's worth remembering that just nine months ago, neither Weir -- nor anyone else in the chip business in the U.S. or Asia -- foresaw the plight they're facing now.

Does that mean a recession is around the corner? How long before layoffs at Intel and Motorola spread to other high-tech stalwarts? The stock market has been in steady decline since its mid-July peak, dragged down by slower growth statistics for the U.S. economy. Where will it end?

No one knows. Predicting the onset of recession is a loser's bet, anyway. And the growing interconnections in the global technology industry mean that economic swings will only get more unpredictable and more volatile.

The old trope used to illustrate the nature of chaotic, complex systems is the famous image of a butterfly flapping its wings in the South Pacific causing a hurricane in the Atlantic. The more interconnected the world's economies become, the more likely it is that a butterfly -- or a bank run in Thailand -- triggers a tsunami in Silicon Valley or a meltdown in Taiwan. Maybe the surviving companies and economies will be stronger. But from now on, it's going to be a bumpier ride for everyone.

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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