Given that sobering long-term prognosis, why do Taiwanese companies keep flocking to China? First, China offers sweeteners. Until recently, China tantalized outsiders by taxing China-produced chips at a significantly lower rate—up to 14 percent less—than foreign-made chips. But that helping hand was withdrawn after China joined the Geneva-based World Trade Organization three years ago. Now China relies on more informal understandings, which are harder for outsiders to criticize. The most important of them is the unofficial requirement that at least 30 percent of the total value of electronic goods made in China be supplied by local companies.

Second—and more important—China is where the growth is. This year its electronics industry will buy chips worth $59 billion, more than any other country in the world, according to the research firm iSuppli Corp., in El Segundo, Calif. Less than 5 percent of those chips are now made locally, leaving the other 95 percent up for grabs [see graph, "Plenty of Room at the Top"].

No company understands those economics better than TSMC. Its founders invented contract chip making in the late 1980s, when they noticed that the cost of a fab—now generally a 10-digit figure—was spiraling in relation to other industry costs. They realized chip makers that could no longer afford to own their manufacturing capacity would have little choice but to rent it.

In an interesting parallel to the role of Taiwanese engineers in China in this decade, it was technologists who returned from the United States two decades earlier—TSMC founder Morris Chang among them—who gave Taiwanese foundries their start.

These foundries bred new chip makers, the so-called fabless companies. Later they began getting business even from the biggest players, as such companies as Intel Corp., in Santa Clara, Calif., and Motorola Inc., in Schaumburg, Ill., came to realize that sometimes it made more sense to rent a bit of spare capacity than to build a fab that wouldn't be fully exploited.

Throughout the 1990s, as tech-related exuberance built to a crescendo, TSMC thrived. It now has 11 foundries—8 in Taiwan, 1 in Singapore, 1 in Washington state, and 1 in China. The Chinese plant is run by a subsidiary, TSMC Shanghai, which won approval from Taiwan's government in February 2003. Y.C. Chao, the president of TSMC Shanghai, in the city's Songjiang suburb, says he is now ready to take orders.

In the competition between the two companies, convolutions abound. Start with SMIC's charismatic chairman, Richard Chang. China-born but Taiwan-bred, he graduated with a degree in mechanical engineering from National Taiwan University, in Taipei, in 1970 before earning a master's degree from the University at Buffalo, the State University of New York, in 1973 and a Ph.D. in electrical engineering from Southern Methodist University, in Dallas, in 1986. After working for 20 years in Dallas at Texas Instruments Inc., he returned to Taiwan to found the Worldwide Semiconductor Manufacturing Co., quickly selling it to none other than TSMC. Then he moved back to China, in 2000, to found SMIC.

By 2003, SMIC had three plants running in Shanghai. And last year, the company bought a plant in Tianjin from Motorola. Earlier this year, the company began operating one more in Beijing, and two more Beijing plants are being readied for production. At his spacious steel-and-glass headquarters in Pudong, 15 kilometers east of the old, historic part of Shanghai, Chang can gaze out at an employee village that makes up for the deficiencies in local infrastructure by providing apartments, supermarkets, sports fields, and that school for 1200 students, who can study in English, Mandarin, or both.

Lately, the investment seems to be paying off. Slowly but surely, SMIC is creeping closer and closer to TSMC's cutting-edge capabilities. SMIC's best plants, in Beijing, can now make chips with 90-nanometer wires on 300-millimeter wafers—which is the state of the art. Those are the parameters typical of fab facilities used to make gigabit memories and chips for cellphones. Chang points out that SMIC makes chips only for commercial applications, not for military ones.

In other aspects, though, SMIC still lags. Its Pudong plants produce chips with wires only as narrow as 130 nm on 200-mm wafers, good enough for controllers for DVD players, sensor chips for low-end digital cameras, or decoders for high-definition television sets. One of the three Pudong plants supports the other two by connecting circuit elements with copper, the metal of choice; it also offers the increasingly obsolete standby, aluminum.

SMIC's engineers have not yet mastered the technique of putting a thin veneer of silicon over a layer of silicon dioxide, a technique that lets circuits run faster than those on ordinary silicon wafers. Nor does it yet embed germanium atoms in the upper layers of silicon wafers to strain their crystalline structure, tremendously speeding up the passage of signals. Still, matters have improved significantly over what they were a decade ago, when China's semiconductor makers were laying down wires 10 times wider than those used in the most advanced processes.

Meanwhile, TSMC isn't resting on its laurels. Chao plans to focus his production on local Chinese markets, building chips for Chinese customers and also for international customers who want to sell to Chinese electronics and appliance companies. He says that at the beginning of this year, the plant was cranking out 5000 wafers per month—a third of its planned capacity and only a small fraction of the 120 000 wafers that SMIC's foundries can produce.

But production numbers don't tell the whole story about the competition between SMIC and TSMC. In that battle, TSMC is prohibited from deploying its most potent weapon—superior technology—to full effect. As a Taiwanese entity, Chao's company is not allowed to produce circuits with wires smaller than 0.25-micrometers. But Chao expects that the Taiwanese government will soon approve more advanced technologies, capable of making wires with widths down to 0.15 um. Once that happens, he says, the company will install the equipment and ramp up production rather quickly.

Chao tries to put the best face on the restrictions: the resulting chips are good enough for cars, toasters, power controllers, and analog circuits, though not for most portable applications—including cellphones and laptops—which require, above all, the low power and compactness that the most advanced technologies offer.

"We spend according to the market needs and according to the level of approvals from Taiwan," he says. There's plenty of demand in China for chips built with older technologies, he adds, and as demand for more advanced technologies grows, TSMC will be able to keep up with it.

Other experts disagree with Chao's outlook, noting that local customers are already paying for better chips than he can provide. SMIC data supports this view. In the third quarter of 2004, the company produced more than two-thirds of its chips at 0.18 um or less. While TSMC and other firms tagged with Taiwan's flag may lobby their government for permission to use more advanced technology, the express political point of the export restrictions is to limit trade—and the economic point is to limit transfer of technology.