Do trade wars drive up inflation?

Dieter Adam, 31 January 2023

Workers at Dutch firm ASML Preparing one of their photolithography machines for delivery

From a manufacturing perspective, making advanced silicon semiconductors is about as complicated and challenging as it gets. Not surprisingly, then, that the machinery and equipment required to manufacture semiconductors is equally sophisticated and an art mastered by but a few manufact­urers. We have an example of that in New Zealand with Auckland company Buckley Systems, who manufacture high-precision specialised magnets used in ion implanter accelerators that ‘dope’ silicon with ions of other elements as a key early step in semiconductor production.

The most critical step in the chain of processes to manufacture semiconductors is the imprinting of ever-smaller circuits on silicon wafers using beams of (extreme) ultraviolet light. The smaller the circuit – 3 nm is the current leading-edge – the shorter the wavelength required of the light source for the photolithography process. Dutch manufacturer ASML is the leading international supplier of photolithography machines, with a global market share of about 65% and a global monopoly (for now) for supplying the extreme ultraviolet lithography (EUV) machines used to manufacture the most advanced chips. ASML has a close collaboration with and is critically dependent itself on German companies Trumpf and Zeiss to provide CO2 high intensity lasers, used to create a luminous plasma which delivers extreme ultraviolet radiation (EUV) exposure to the substrate, and optical systems to direct the EUV beams, respectively.

Humans have created wealth through trade for thousands of years. It allows for specialisation, put­ting people, companies, and countries who are best at a particular economic activity in the role of key suppliers of a product or service. Almost as old is the use of measures to restrict or suppress trade as a means of economic or strategic political intervention; colonial powers fought with each other over the right to trade exclusively with overseas colonies in the 17th century, for example. And the USA maintains a plethora of trade and financial sanctions today against countries, companies and individuals, for example. An in-depth account of the (recent) history of trade wars can be found here.

Trade sanctions work best where they restrict or suppress trade in goods and services that are of critical importance to the country (~ies) targeted and cannot easily be circumvented. No surprise, then, that ASML find themselves caught up in US trade sanctions against China. ASML has been restricted by the Dutch government in shipping its EUV machines to China, due to U.S. diplomatic influence, since 2019. However, it still sells slightly older DUV (Deep Ultraviolet Light) machines in China, where it had 16% of sales in 2021.

Last Friday, then, the US, the Netherlands, and Japan, agreed on further restrictions to sell photo­lithography machines to China, including DUV machines, for which Japan is an important supplier.

If trade is a mechanism to improve economic efficiency, then trade restrictions will have the oppo­site effect. And indeed, as prominent University of Chicago professor of economics and former IMF Chief Economist, Raghuram Rajan, pointed out in a recent interview, deglobalisation pushes up inflation. If Chinese electronics manufacturers have to ‘re-invent’ chip-making machines – and they do, in droves – it pushes up their cost, at least for a time, leading to an increase in the price of Chinese-made electronics. A recent article in the Economist estimates that “replicating the cumulative investments of firms in the global tech-hardware, green-energy and battery industries would cost $3.1trn-4.6trn (3.2-4.8% of global gdp).” That is an extreme scenario, of course, but it demonstrates the dimensions of potential economic impact.

Are or will New Zealand manufacturers be affected by escalating trade wars? Like many other countries, we already have an extensive list of goods, the export of which is controlled and requires a permit, and generally manufacturers will be responsible and make their own decisions to avoid getting into trouble. There are three problems with this:

1. For dual-use goods that make up the bulk of the 319-page list, it’s not always straightfor­ward to decide what’s in, and what’s out

2. Chain-of-custody: Goods that are manufactured in New Zealand will in most cases require an end-user certificate signed by the ultimate end-user. Our Ministry of Foreign Affairs and Trade (MFAT) may be willing to waive this requirement when the goods are components to be incorporated into a larger piece of equipment in the destination country. That applies to a lot of our exports of machinery and equipment that consist of parts and components, rather than end products. Maintaining the chain of custody will not always be easy in such circumstances. There was a case that ultimately ended in a $75k fine in 2018 for a New Zealand aircraft manufacturer who sold spare parts for one of its planes that was legally sold to a Chinese customer, but ended up in North Korea

3. With a rapidly expanding international sanctions regime, the scope of markets our manu­facturers can legally export to will shrink, and compliance with export controls will become increasingly complicated and time-consuming.

Furthermore, deglobalisation also forces manufacturers to retain production in countries where the cost of labour and other inputs is higher, again pushing up prices. And with higher inflation come higher interest rates, meaning higher cost of capital for manufacturers as well as everyone else, and a risk of recession – in New Zealand as well as elsewhere.