However, recent shifts show that multinational companies are increasingly diversifying their production bases away from China. This trend, while significant, doesn’t spell the end of China’s role in global manufacturing. While There Is No Equivalent, there are Alternatives. Although viable options are emerging, no single country offers the scale, efficiency, and integrated infrastructure that China does. For years, China has been a remarkable, centralised solution for the world’s manufacturing needs, but now companies must adapt to a more fragmented landscape. This requires a refined approach to international relations and a nuanced strategy for supply chain diversification.

As this new era of globalisation unfolds, multinationals are tasked with balancing China’s enduring advantages against geopolitical risks and rising costs. The challenge of managing multiple production centres across different regions signals a shift from the efficiencies of centralisation to the complexities of resilience—a transformation that will likely redefine the global manufacturing landscape.

By now, China’s property collapse and its strategic pivot into tech manufacturing and electric vehicles have been extensively covered in the media. But in this piece, I bring the perspective of a technologist and manufacturer—someone immersed in the realities of manufacturing and investment decisions—to the conversation.

Disclaimer: This is economic analysis from a tech and manufacturing guy; viewer discretion advised. This piece has been sitting untouched in my drafts for months because I’ve been super busy. Some of the research might be slightly stale, but I believe there’s still valuable insight here for readers. I hope you enjoy.

Key Takeaway

In the shifting landscape of global manufacturing, while FDI is gradually moving away from China, "Factory Asia" remains the undisputed backbone of global export potential. Regions like Saudi Arabia, Mexico, and Eastern Europe are rising as specialised hubs—Saudi as a future regional powerhouse, Mexico as the cost-effective supplier to the US, and Eastern Europe as Europe’s industrial engine. However, the intricate supply chains of Asia, honed over decades, are challenging to replicate or compete with on a global scale.

That said, these advantages don’t come without risks. Vietnam, a rising star in manufacturing, is better integrated into "Factory Asia," benefiting from its access to raw materials and established supply chains. With so much FDI from China, Vietnam is essentially diversification with Chinese characteristics, enabling it to attract global investment while gaining benefits from the regional economic powerhouse. However, Vietnam’s position in the South China Sea exposes it to geopolitical vulnerabilities. While Vietnam itself is unlikely to face sanctions, a Pacific conflict could severely disrupt maritime trade, effectively isolating its supply chains. Ho Chi Minh City, located further south, offers the lowest risk for Western companies aiming to minimise potential disruptions, but no location in the region is entirely risk-free.

In the end, while India and other emerging markets have their strengths, Vietnam remains the more competitive manufacturing option due to its connectivity to Asia’s established supply networks. Its lower-cost structure and strategic access to inputs make it a natural fit for investors seeking reliable export channels—albeit with the caveat of geographic and political exposure. As global manufacturing evolves, businesses will need to balance these emerging centres with the enduring strength and complexities of Factory Asia.

China Shock and The Surplus Problem

The Chinese government's strategic investments in infrastructure, education, and technology, coupled with its large labor force, suppressed labor rights and favorable business environment, have enabled the country to attract a significant portion of the world's manufacturing surplus. China's surplus has played a crucial role in driving the relocation of manufacturing from Southeast Asia to China. As foreign companies sought to capitalize on China's labor pool they began to shift their production lines from their home countries as well as from countries like South Korea, Taiwan, and Hong Kong to China. This influx of foreign investment helped to fuel China's rapid industrialization and economic growth, transforming the country into the world's manufacturing hub. This investment led to huge manufacturing surpluses, now a point of contention.

Germany's Wage Suppression and its Impact on Mediterranean Manufacturing

A useful example of the effect of policies aimed at creating large manufacturing surpluses is evident in Germany and the Eurozone in the past two decades.

Starting in the early 2000s, Germany implemented labor reforms, including the "Agenda 2010" reforms, which made the labor market more flexible but also led to suppressed wage growth. This strategy allowed Germany to maintain competitive labor costs, making its exports cheaper compared to those of countries with higher wage growth.

The impact of Germany's wage suppression was felt across the Mediterranean region, where manufacturers in Greece, Italy, and Spain struggled to compete with German products. As German goods became more attractive in the domestic market and across Europe, local manufacturing sectors in these countries found it increasingly difficult to compete. This contributed to a deindustrialization effect in some sectors of these economies.

Germany's economic policies also led to significant trade surpluses, resulting in the country exporting far more than it imported. This imbalance had a disproportionate impact on Mediterranean countries, which often ran trade deficits with Germany. The common Euro currency meant that Mediterranean countries could not devalue their currency to make their exports cheaper and imports more expensive, a traditional method to correct trade imbalances. The strict fiscal austerity measures imposed as part of bailout agreements during the Eurozone crisis further squeezed these economies, reducing domestic demand and investment in manufacturing sectors.

The situation has led to criticisms of Germany's role in the economic challenges faced by Mediterranean countries, particularly concerning manufacturing and wage growth. The complexities of economic integration within the Eurozone, where differing national policies can have wide-reaching impacts across the union, are highlighted by this situation.

The Global Economy: A Tale of Two Strategies

Both Germany and China have utilized economic strategies that prioritize national interests and competitiveness, often at the expense of other economies. Germany's wage suppression within the Eurozone has contributed to economic disparities that challenge the cohesion of the EU's single market. In contrast, China's trade surpluses with the U.S. have raised issues about global economic fairness, prompting shifts in global supply chains and trade policies.

The effects on Spain and the U.S. highlight a critical aspect of international economics: the delicate balance between national strategies and their international impacts. For Spain, economic recovery and growth may hinge on the ability to innovate beyond traditional industries and possibly re-negotiate EU economic policies that constrain fiscal and monetary flexibility. For the U.S., addressing trade imbalances with China involves not only negotiating trade terms but also enhancing domestic capabilities in technology and manufacturing.

The China-US trade imbalance has had significant implications for the US economy, including a decline in the manufacturing sector. To address the imbalance, the US is implementing policies focused on increasing its competitiveness in the global market to retain and grow value added manufacturing, while diversifying imports of low value added products.

China: From Property to Industrials

While protectionist actions were already kicking off with Donald Trump in 2016, since 2020, Beijing has doubled down on support for the manufacturing sector. Beijing got ahead of the ‘investor riot’ of 2022.

China's economic landscape is undergoing a significant transformation as the country pivots away from its reliance on property and infrastructure development toward manufacturing technology. This shift is driven by the need to rebalance the economy and address the challenges posed by a slowing growth rate. However, this transformation comes with its own set of challenges and implications for the Chinese economy.

This is probably one of the most important charts right now about the Chinese economy. To offset the collapse in the real estate sector, Beijing has managed to surge credit to the manufacturing sector, which has helped prevent a total collapse of domestic credit growth and demand Shanghai Macro Strategist, X account

Bloomberg: Banks Are Roaring Back in Xi’s New China

The Problem with Doubling Down, The World is Satisfied

While change in investment in 2020 was a possible way to saving Chinese banks from failing property sector, it will create knock on effects for global manufacturing and trade dynamic. It adds fuel to the fire of cheap Chinese manufacturing and provides yet more fodder for targeted anti-China political blocs and protectionist moves.

While China accounts for 18 percent of global GDP and only 13 percent of global consumption, it currently accounts for an extraordinary 31 percent of global manufacturing. If China maintained annual GDP growth rates of 4–5 percent while also maintaining the role of manufacturing in its economy, its share of global GDP would rise by less than 3 percentage points in a decade, to 21 percent, even as its share of global manufacturing would rise by more than 5 percentage points, to 36 percent. What’s more, if—as a result of the massive shift in investment from the property sector to the manufacturing sector—the GDP share of China’s manufacturing sector rose above its current 28 percent to, say, 30 percent, China’s share of global manufacturing would rise to 39 percent.

To accommodate this and prevent a global overproduction crisis, the rest of the world would have to allow its manufacturing share of GDP to drop between 0.5 and 1.0 percentage points. It would also have to allow a surge in China’s trade surplus—currently equal to nearly 1 percent of the GDP of the rest of the world—as a 5–8-percentage-point increase in China’s share of global manufacturing would be backed by a 2-percentage-point increase in China’s share of global consumption. What Will It Take for China’s GDP to Grow at 4–5 Percent Over the Next Decade?, Michael Pettis

… The arithmetic, however, is quite straightforward: unless the rest of the world is willing to reverse its strategic economic priorities to accommodate Chinese growth ambitions, global constraints imply that China cannot continue growing its share of global GDP without sharply reducing the growth rate of investment and manufacturing. The only way to reduce these without a sharp drop in GDP growth would be through a sharp rise in consumption growth. That, in turn, would require a reversal of the past direction of transfers, with the only sector capable of funding these transfers being the government.

But that must result in a sharp change in the roles of Beijing and local governments in the Chinese economy. This change would be difficult. In the days of rapid growth, when income was transferred from households to subsidize preferred sectors of the economy, the main political issue was one of deciding who the winners among businesses and governments would be. Now that rebalancing requires that income be transferred back to the household sector, the political issue is one of deciding who the losers are going to be among those same sectors. Picking winners is much less disruptive than picking losers, and it requires either a transformation in the structure of government or—as has been the case in most other countries that have faced this problem—an acceptance of much lower growth rates.

Protectionism Reaction

In recent years, the global economic landscape has witnessed a significant shift toward protectionist policies, driven largely by China's aggressive subsidization of its manufacturing sector. This strategy has not only disrupted traditional trade dynamics but has also sparked a series of retaliatory measures and trade disputes across the globe. This article explores the multifaceted impact of China's subsidization policies, focusing on the resulting protectionism and the global response. Here are some pertinent examples:

US Tariffs on Chinese EV are Purely Symbolic

One of the most significant retaliatory measures has been the United States' decision to quadruple tariffs on Chinese electric vehicles (EVs). This move, as reported by the Wall Street Journal, aims to counteract the competitive edge gained by Chinese manufacturers through state subsidies. The tariffs are intended to level the playing field for American EV manufacturers, who have been struggling to compete with the lower-priced Chinese alternatives. Chinese EV’s however have an extremely low market share in the US.

It is commonly agreed that the Biden administration’s recently announced 100% tariff on Chinese made electric cars is entirely symbolic. Already impeded by a 25% tariff, China automobile makers have sold very few electric vehicles in the United States. The purpose of the announcement was the announcement. This is an election year, Michigan is a key swing state, and even though it has no actual impact, the tariff announcement gave President Joe Biden an opportunity to say that he wants to see cars made in America, and by union workers.

Yet while it will have no impact on sales of Chinese electric vehicles to the United States, the decision does draw attention to the widening battle between the United States and China for supremacy in advanced manufacturing. The Biden administration now offers vast subsidies to advanced manufacturing, replicating those offered by Chinese provincial governments. It denies China advanced semiconductors and the equipment to make them, with the intent of hindering China’s advance in technologies such as artificial intelligence models, which use advanced chips. Whether EVs or solar panels, protectionism has the same distorting effect

Australia is Buying Cars from Whoever Sells them Cheap

The Australian government has so far not followed the lead of the US in introducing tariffs, largely because Australia no longer has an automotive industry to protect.

But the international backlash has not escaped the attention of the Department of Foreign Affairs and Trade, which said it will "encourage cooperative avenues to manage these issues, in a manner consistent with international trade rules".

"Australia is committed to maintaining a level playing field for our manufacturers and producers by supporting a robust multilateral rules-based trading system," a spokesperson said.

When asked whether Australia would consider introducing tariffs, the department said decisions on trade policy matters were "made in Australia's national interest".

The FCAI said it supported competition "including an increased presence of Chinese-produced vehicles, that will ultimately benefit Australian consumers". While the US and EU are putting up barriers to Chinese cars, Australians are buying them at record levels

Saudi Deal Failure

China's ambitious plans to expand its influence through trade agreements have also faced significant setbacks. According to Reuters, negotiations for a free trade agreement between China and the Gulf Cooperation Council (GCC) have stalled, largely due to Saudi Arabia's industrial agenda. The failure of these talks highlights the challenges China faces in securing favorable trade deals amid growing global skepticism of its trade practices.

Saudi Arabia's reluctance to move forward with the deal reflects broader concerns about China's economic strategies. Many countries are wary of becoming overly dependent on Chinese trade and investment, fearing that it could undermine their own industrial and economic policies. This impasse is indicative of the growing resistance to China's economic dominance and the protective measures countries are willing to adopt to safeguard their interests.

CBAM, Increases Material not Product Import Tariffs.

The European Union has also responded to China's subsidization practices with its own set of protective measures. The introduction of the Carbon Border Adjustment Mechanism (CBAM) is a clear attempt to address the competitive disadvantage faced by European manufacturers due to China's lower environmental standards. By imposing tariffs on imports based on their carbon footprint, the EU aims to level the playing field and promote sustainable manufacturing practices.

CBAM covers a wide range of products, namely: iron and steel, cement, fertilizers, aluminium, electricity and hydrogen, as well as certain goods incorporated in their production. You can see why CBAM isn’t being applied to end products, because it would take a PhD per product to determine carbon consumed and embodied in production. But without CBAM for end products, this is an awesome way to increase the cost of raw materials for European manufacturers.

EU importers of goods covered by CBAM will register with national authorities where they can also buy CBAM certificates. The price of the certificates will be calculated depending on the weekly average auction price of EU ETS allowances expressed in €/tonne of CO₂ emitted.

EU importers will declare the emissions embedded in their imports and surrender the corresponding number of certificates each year.

If importers can prove that a carbon price has already been paid during the production of the imported goods, the corresponding amount can be deducted.

Carbon Border Adjustment Mechanism

In addition to CBAM, the EU has implemented specific protections for its EV industry. These measures include subsidies for European EV manufacturers and stricter regulations on imported EVs, aimed at boosting the competitiveness of local producers. The EU's approach reflects a growing trend of regional protectionism, where economic blocs seek to shield their industries from external competition through regulatory and fiscal measures.

Manufacturing Hot Spot No More

A perfect storm of factors has created an unfavorable environment for manufacturing in China. Tariffs, investment restrictions, and the challenges of operating in an increasingly authoritarian country have all contributed to a decline in foreign investment and technology transfer. Rising wages and a less business-friendly environment have also taken a toll. Meanwhile, the rest of the world, particularly the US, is accelerating its development of data center capacity and AI capabilities. As a result, Chinese businesses are struggling to find niches where they can succeed.

High Wages

The rising cost of labor in China has become a significant concern for foreign investors. With wages in China increasing by as much as 2-3 times compared to South Asian countries, the cost of production is escalating. This shift in labor costs has made China a less attractive destination for foreign companies, particularly those in labor-intensive industries. As a result, many manufacturers are reevaluating their supply chain strategies and exploring alternative locations with lower labor costs. This trend is likely to continue, as China's labor market continues to tighten, driven by a rapidly aging population and increasing labor costs. As a consequence, companies are being forced to adapt to this new reality, seeking out more cost-effective manufacturing destinations to maintain their competitive edge in the global market.

FDI and Trade Collapse Signals Shift in Global Manufacturing Landscape

The recent collapse in Foreign Direct Investment (FDI) in China is a stark indication that foreign businesses are no longer willing to invest in the world's second-largest economy. Gone are the days when companies would flock to China to set up new factories, invest in new plant and capital equipment. Instead, foreign companies are now opting for alternative manufacturing destinations, driven by a cocktail of perceived geopolitical risks, trade tensions, and regulatory uncertainties.

To get a gut feel of the impact consider that while FDI has cratered -110% to below zero, if we take a guess that on average that FDI goes into assets with a 5-year life (some will be taken up by services and some by longer life assets, but lets use 5-years) then the capital equipment that was established through FDI has only declined 10% and would take another 5 years to depreciate to zero.

The shift is largely attributed to the growing concerns over geopolitical risks, including the risk of sanctions and war. Rather than shutting down existing operations in China, companies are choosing to let their factories depreciate while setting up new facilities elsewhere. This strategic move is a clear indication that foreign businesses are no longer willing to take on the perceived risks associated with operating in China. Washingtons trade policies, including tariffs and trade restrictions, have further exacerbated the situation, making it increasingly challenging for foreign companies to operate in China.

The implications of this shift are far-reaching, with significant consequences for the global manufacturing landscape. As foreign companies diversify their manufacturing operations, new markets and destinations are likely to emerge as attractive alternatives. This could lead to a reconfiguration of global supply chains, with companies seeking out more stable and predictable environments in which to operate.

The sudden decline in foreign direct investment (FDI) in China serves as a stark reminder for policymakers and business leaders to re-examine the intricate relationships between geopolitics, trade, and investment. While a war or further escalation can be avoided, it is plausible that FDI in China will rebound as Beijing continues to woo foreign businesses and invests in maintaining existing production capacity in China. This presents an opportunity for China to revitalize its economy and reassert its position as a global investment hub.

IP Creation Still Limited in China

The shift away from China coincides with an era where the country is increasingly reliant on imported intellectual property (IP). Despite the attention-grabbing headlines in Chinas development, China continues to face a significant shortfall in IP trade. For historical context, consider Japan before the Asian crisis in 1997, when its population was still growing at a rate of 0.2% per year; it faced an IP trade deficit of just over $3 billion in current USD. In contrast, China, now experiencing zero population growth, grapples with an IP trade deficit exceeding $30 billion USD. This is further compounded by the decline in Foreign Direct Investment (FDI) and an aging population, intensifying China's reliance on foreign IP. These factors together pose substantial hurdles for the development of Chinese technology, signaling potentially profound challenges ahead for its innovation landscape.

Key Ingredients for a Production Hub

When searching for manufacturing alternatives, it is crucial to pay close attention to countries that implement policies that suppress wages and labor rights to make exports more competitive. These policies, often referred to as "beggar-thy-neighbor" strategies, can have far-reaching consequences for the global economy and the workers who are affected. By identifying countries that engage in these practices, investors and businesses can make informed decisions about where to establish or expand their operations. For instance, Germany's wage suppression policies have contributed to a significant trade surplus, while China's state-led industrial policies have driven its economic growth. Similarly, countries like Vietnam and Cambodia have implemented policies to attract foreign investment by offering low wages and lax labor regulations. By monitoring these policies, businesses can assess the potential risks and benefits of investing in these countries and make informed decisions about their global supply chain strategies.

Assessing Favorable Business Environments

Evaluating development indices such as the Corruption Perceptions Index, Global Innovation Index, EF English Proficiency Index, and Economic Complexity Index alone cannot fully determine the optimal location for manufacturing. While these indices provide valuable insights into various aspects of a country’s environment, the decision ultimately hinges on the ease of operating within the country and the robustness of its local tech environment and supporting industries.

Corruption Perceptions Index (CPI) is an index that ranks countries "by their perceived levels of public sector corruption, as determined by expert assessments and opinion surveys." The CPI generally defines corruption as an "abuse of entrusted power for private gain". The index is published annually by the non-governmental organization Transparency International since 1995. https://www.transparency.org/en/cpi/2023/

The Global Innovation Index is an annual ranking of countries by their capacity for, and success in, innovation, published by the World Intellectual Property Organization (WIPO). The index is computed by taking a simple average of the scores in two sub-indices, the Innovation Input Index and Innovation Output Index. https://www.wipo.int/global_innovation_index/en/2023/

EF English Proficiency Index (EF EPI) attempts to rank countries by the equity of English language skills amongst those adults who took the EF test. https://www.ef.com/wwen/epi/

Economic Complexity Index (ECI) from Harvard Growth Lab’s Country Rankings assess the current state of a country’s productive knowledge. Countries improve their ECI by increasing the number and complexity of the products they successfully export. https://atlas.cid.harvard.edu/rankings

Ability to Manufacture and Export

A robust manufacturing sector, measured by its contribution to GDP and exports, is a hallmark of a favorable business environment and effective policies. Vietnam stands out as the only emerging market that has consistently grown its manufacturing sector over the past decade. In contrast, India's manufacturing sector remains underwhelming. Interestingly, many Asian countries have a significant portion of manufacturing as a percentage of their GDP, highlighting the diversity of manufacturing landscapes in the region.

Vietnam: Diversification with Chinese Characteristics

Vietnam has emerged as a standout in the manufacturing sector, with a proven track record of success and export market share growth over the past decade. The country's geographic proximity to China and pragmatic one-party leadership have contributed to its success. However, Vietnam's economy faces long-term challenges, including its reliance on exports and a worrying debt trajectory.

The country's unique position in a multipolar world has allowed it to profit from its geographic location. However, Vietnam's economic growth is also vulnerable to disruptions in global trade, particularly in the event of a conflict in the Pacific. The country's government has been consolidating power, which could lead to tighter control over the economy and private sector. Despite these challenges, Vietnam remains an attractive destination for foreign direct investment, with a surge in FDI from China and other Asian countries.

Currency controls: Vietnam's currency management has been characterized by a mix of flexibility and control. The State Bank of Vietnam (SBV) has implemented a managed float regime, allowing the dong to fluctuate within a narrow band. This approach has helped to maintain stability and confidence in the currency, while also allowing for some flexibility in responding to external shocks. The SBV has also implemented various measures to manage capital flows and prevent excessive volatility in the foreign exchange market. While these measures have helped to maintain stability, they have also been criticized for limiting the ability of Vietnamese companies to access foreign capital and invest abroad.

Open to Indian trade: Vietnam's export-oriented economy benefits from a significant advantage: low tariffs for exporting to India. In contrast, India has implemented a 30% tariff on most foreign products to protect its local industries. However, ASEAN has negotiated a trade agreement that has reduced tariffs on many goods to 5% or 0% in recent years, including Vietnamese exports. This favorable trade environment has made Vietnam an attractive destination for exporters. India still maintains high tariffs on Chinese exports.

Chinese foreign direct investments (FDI) are often funneled through Singapore and reclassified as Singaporean. This allows Chinese companies to circumvent various international regulatory restrictions and tariffs, leveraging Singapore’s favorable investment treaties and robust legal framework. This reclassification facilitates Chinese access to markets that might otherwise be restricted, which has led to geopolitical tensions, particularly with the United States. The U.S. views this as undermining its regulatory efforts and enabling China’s economic strategies, giving Chinese firms an unfair competitive advantage and enhancing China's strategic influence. This dynamic highlights the complex and sometimes contentious role Singapore plays in the global economic landscape.

India

The Indian government faces a unique challenge that sets it apart from the Vietnamese government: Elections. The Indian government needs to balance the demands of various stakeholders, of the 2024 general election. This electoral imperative makes it difficult for the Modi administration to implement reforms that might be unpopular with certain segments of the population, such as economic reforms, wage suppression, and lax labor rights.

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Saudi Arabia has embarked on a transformative journey to diversify its economy and attract foreign investment. The Kingdom has opened up to foreign ownership of businesses, introduced locally manufactured content requirements for government projects and has made significant strides in intellectual property protection. A notable shift in energy pricing, from a highly subsidized $0.01 per kWh to a slightly more market-reflective $0.05 per kWh, reflects a broader strategy to rationalize resource use and promote energy efficiency. Saudi Arabia's vision extends beyond its borders, aiming to establish itself as a hub for investment and a gateway for exporting to the broader region.

Saudi Arabia's economy, while substantial, is just over half of Australia's GDP but maintains its position as one of the top oil producers globally, second only to the United States. The nation is transitioning from its traditional role as a leading oil supplier, however, its capacity to quickly adjust oil production remains unmatched. Saudi Arabia aims to consolidate itself as a religious, military, and economic powerhouse, bridging the Arab world with the global community. The House of Saud has cultivated a reputation for stability and is forging a path toward economic innovation. However, the path of liberalization in the Muslim world has been marked by the downfall of kings, dictators, and oligarchs, where Saudi Arabia's administration will face the ultimate test.

Saudi Arabia's system of government, based on royalty and heritage, is complex and multifaceted, and combines traditional governance with modern structures in novel ways. The first order priority of the Kingdom has been to maintain independence and stability in a region where the concept of a nation-state is still relatively new. Arab thinkers have long grappled with the challenge of reconciling Islamic values and society with the rapid technological and civic progress in Europe. Saudi Arabia stands out in the region, having avoided colonization, Islamic revolution, unruly Mujahideen, and the Arab Spring. With the support of global powers, the Saudi monarchy has been instrumental in maintaining the country's stability and prosperity. The royal family has been able to navigate the complexities of modernization while still upholding the country's Islamic values and traditions. This has allowed Saudi Arabia to maintain its unique identity and culture while still embracing technological and economic progress.

Analyzing Saudi Arabia without bias is challenging due to its intricate ties with global powers, often at odds with its Arab neighbors' experiences with those same allies. Historically, Saudi's strict religious norms have limited personal freedoms and created a rift with Western perspectives. Yet, Saudi plays a crucial role in shaping moderate Islamic discourse. The Kingdom's complex relationship with the West combines conflicting cultural and religious values with mutual economic and security goals, and a shared interest in economic collaboration, making the dynamics between them complex. This overview aims to shed light on these nuanced relations.

While Saudi Arabia's future looks promising under Vision 2030, businesses and investors should study the of potential risks by understanding Saudi Arabia's complexities. Unraveling Saudi’s historical tapestry, from its origins to its evolution, is key to grasping the country's present identity and risks to its development trajectory.

The Saudi Origin Story

The first Saudi state was established in 1744 as an alliance between Islamic preacher Muhammad ibn Abd al-Wahhab and Saudi leader Muhammad ibn Saud, based on the principles of Wahhabism. The first Saudi state expanded through military conquest and became a major power, but was defeated by the Ottoman Empire in 1818. The second Saudi state was established in 1824 and led by Turki ibn Abdullah Al Saud, the founder of the modern Saudi royal family. The second state was able to re-establish Saudi control over much of the central Arabian Peninsula until 1891, when it was defeated by the rival Rashidi dynasty. The third Saudi state was established in 1932 by Abdulaziz ibn Saud, the founder of the modern Saudi state. Ibn Saud was able to unify the various tribes and factions of the Arabian Peninsula under his leadership and establish a centralized government and modern state institutions.

The British faced a difficult decision as they weighed whether to support Mecca, their Hashemite allies in the Arab revolt against the Ottomans, or Ibn Saud and the Saudi-Wahhabi movement. The Hashemites' broader ambitions for Arab unity and independence under Hashemite leadership were at odds with British (and French) imperial interests in the region, which aimed at maintaining control over territories and newly established mandates. The British decided to support Ibn Saud against the Hashemite Kingdom of Hijaz. The British support for Abdulaziz Ibn Saud during the formation of Saudi Arabia was a significant factor in his consolidation of power and the establishment of the modern Saudi state. This support was part of the broader British strategy in the Middle East, which aimed to secure British interests, particularly in relation to the route to India and access to oil reserves.

The defeat of the Sharif of Mecca's forces by Ibn Saud's forces in the early 1920s marked the end of the Sharif's dreams of ruling a unified Arab kingdom. After his defeat, the Sharif was exiled from Arabia and eventually settled in Transjordan, where he was made king by the British. From there, he and his descendants went on to rule Jordan, Syria, and Iraq, establishing the Hashemite dynasty that continues to this day.

Ibn Saud leveraged his understanding of tribal politics, his religious legitimacy, and strategic marriages to expand his control and consolidate the peninsula. The founding of the Kingdom of Saudi Arabia in 1932 marked the culmination of Ibn Saud's efforts to unify the tribes and regions under a single national identity. The leadership dynamics between the Hijaz and Najd were crucial in the formation of the modern Saudi state. The Hijaz brought religious prestige, while Najd contributed a robust ideological and military foundation through the Wahhabi movement. Abdulaziz's ability to balance and integrate these diverse elements was instrumental in the creation and stabilization of Saudi Arabia.

Arabian-American Cooperation, Aramco

After its establishment, Saudi Arabia, alongside Iran, stood out in the Middle East as one of the few states that never came under colonial administration. This unique status enabled the Kingdom to pursue independent development paths and form strategic alliances based on its national interests rather than colonial mandates. A pivotal moment in Saudi Arabia's history was the establishment of ties with the United States, which laid the groundwork for a partnership that would significantly impact the country's economic trajectory.

The foundation of the Arabian American Oil Company (Aramco) marked a departure from the British economic model prevalent in Egypt, Iraq, and other parts of the Arab world. Unlike the British approach, which often involved direct colonial control and economic exploitation, the American involvement in Saudi Arabia was characterized by sometimes tense, but overall collaborative effort to develop the Kingdom's oil resources culminating in 50-50 sharing of oil revenue after 1950 and full control by the Saudi government in 1970. This collaboration provided Saudi Arabia with the necessary technical know-how and capital investment to tap into its vast oil wealth, setting the stage for the country's future prosperity and strategic importance in global energy markets.

It is our wish and purpose that the processes of peace, when they are begun, shall be absolutely open and that they shall involve and permit henceforth no secret understandings of any kind (i.e. Sykes-Picot…). The day of conquest and aggrandizement is gone by; so is also the day of secret covenants entered into in the interest of particular governments and likely at some unlooked-for moment to upset the peace of the world. It is this happy fact, now clear to the view of every public man whose thoughts do not still linger in an age that is dead and gone, which makes it possible for every nation whose purposes are consistent with justice and the peace of the world to avow now or at any other time the objects it has in view. U.S. President Woodrow Wilsons, 14 points for peace after WWI.

Washingtons actions have been less than perfect in aligning with Wilsons ideals, but the emphasis on self-determination and transparent diplomacy set the foundation for the US-Saudi relationship. The relationship with the United States not only facilitated the extraction and export of Saudi oil but also represented a form of economic partnership that was markedly different from the colonial exploitation experienced by many of its neighbors. As a result, Saudi Arabia was able to leverage its oil wealth to pursue development and modernization on a negotiated version of its own terms, laying the foundation for its role as a key player in the global oil industry and international politics.

Distributive, Unproductive Economy

Saudi Arabia's economy has been heavily reliant on oil income and exports, a dependency that has shaped both its domestic and international economic strategies. The Kingdom is the world's largest oil exporter, with the oil sector accounting for about half GDP, 70% of export earnings, and more than 85% of budget revenues. This reliance on oil has allowed Saudi Arabia to amass considerable wealth, that was not driven by productivity. The state has used oil revenues to maintain social stability and loyalty through generous, non-performance-based government jobs. As of recent years, government spending has constituted a significant portion of GDP, with a substantial portion of the Saudi workforce employed in the public sector. This economic model has led to several challenges, including low productivity outside the oil sector and an extremely high energy consumption per unit of GDP.

New King, New Rules

In 2015 King Salman inherited a Saudi economic system grappling with budget deficits, prompting an ambitious path of economic reform. Despite the challenges, Saudi government finances remain healthy by global standards, thanks in part to the Kingdom's substantial foreign reserves and relatively low debt levels. However, recognizing the unsustainability of relying heavily on oil revenues amid fluctuating global oil prices, the leadership has embarked on Vision 2030, a comprehensive plan aimed at diversifying the economy, developing non-oil revenue sources, and implementing structural reforms. These reforms include the introduction of a value-added tax (VAT), privatization of state-owned enterprises, and efforts to attract foreign investment in various sectors beyond oil. The need for action was clear: to ensure the long-term financial health and stability of the Saudi economy, reduce its vulnerability to oil price shocks, and create a more dynamic and sustainable economic model for future generations. The stated goals of Vision 2030 are:

• Increase the private sector contribution to GDP to 65%

• Increase SME contribution to GDP to 35%

• Increase FDI contribution to GDP to 5.8%

• Increase the contribution of non-oil exports to non-oil GDP to 50%

Transforming Saudi Arabia's economy is a challenging task, mainly because the government's income is subject to global oil price fluctuations. This volatility affects the government's ability to sustain public sector wages, subsidies, and investments in new industries. Moreover, oil exports have been cyclical but stagnant since 2008, which further emphasizes the need for diversification. The oil price volatility has a direct impact on the country's current account surplus and investment in the growth in non-oil exports. Because of this dynamic, oil prices will remain the primary geo-economic indicator for Saudi Arabia, and maintaining them one of their primary geopolitical objectives.

To overcome these challenges, the government is making efforts to diversify income sources and increase non-oil revenue. However, these efforts face resistance due to their potential impact on the population's cost of living and the traditional social contract in Saudi Arabia.

Socio-Cultural Reforms

The initiation of social reforms in Saudi Arabia, marked by the historic decision to allow women to drive in June 2018, signifies a pivotal shift in the kingdom's approach to modernization and inclusivity. Spearheaded by MBS, these reforms are part of a broader strategy under Vision 2030. By dismantling some of the strict social codes that have long defined the kingdom, Saudi Arabia aims to improve its image on the global stage, attract foreign investment, and enhance the quality of life for its citizens. The reforms, including the opening of cinemas, the scaling back of the guardianship system, and the hosting of international sporting and entertainment events, are designed to make Saudi Arabia a more attractive place to live and work, not just for Saudis but for expatriates as well. This transition reflects an acknowledgment of the need for a more vibrant and open society to achieve the ambitious economic diversification goals set forth by the leadership.

Ideological Credibility And Stewardship

Saudi Arabia's leadership is often criticized for oppressing its citizens, but it's important to note that the country also has a large conservative population that resists social change. Additionally, Saudi Arabia plays a significant role as a source of moderate Islam, particularly as the steward of the two holy sites in Mecca and Medina. This role gives the country a unique responsibility to promote an interpretation of Islam which promotes stability in the region.

State Sanctioned Islam

Saudi Arabia's response to the challenge posed by Al-Qaeda and other extremist groups within its borders has been multifaceted, leveraging its unique position to assert religious credibility and authority. Recognizing the threat these groups posed not just to regional stability but to the very heart of Islamic faith and Saudi legitimacy, the kingdom initiated a comprehensive counterterrorism strategy. This approach included security measures, financial controls to stem the flow of funds to extremists, and an ideological counter-narrative to extremist interpretations of Islam. The kingdom supported religious scholars and institutions that espouse moderation and condemn violence. Through a combination of religious discourse, educational reforms, and rehabilitation programs for former extremists, Saudi Arabia has sought to reclaim the narrative of Islam from those who use it for radical ends.

Three centuries from the day we created glory with our own hands.

My fellow citizen... my resident brother... towards a society whose members participate in creating their security and aspirations. Field Operations Center 990, headed by State Security, receives your reports in full confidentiality about terrorism, misguided ideology, and everything that affects and threatens security, via the following communication channels.. Our awareness...is our safety.

This is the marketing SMS you receive in Saudi. SIM cards are also tied to fingerprints. This messaging could be described by conservatives as part of a campaign of religious oppression.

Remaking the Social Contract

The Saudi government's perspective on regional upheavals, from the Iranian Revolution to dictatorships in Iraq and the waves of the Arab Spring, has fundamentally shaped its approach to governance and reform. Witnessing the instability these events have brought to neighboring states, the House of Saud has historically emphasized strong leadership and control to safeguard its realm. Stability in its realm has always been priority number 1 for the Saud and it’s success is a strong point of difference from other Arab leaders. With Saudi established as the military and economic center of gravity in the region, the regional geopolitical landscape becomes relatively less threatening. Now the kingdom is embarking on ambitious economic projects and is navigating the delicate process of social reform. Historically, Saudi Arabia utilized the austere Wahhabi doctrine to foster societal unity, but it now faces the challenge of moderating this stance. Saudi leadership is tasked with integrating its conservative Islamic society with global norms, marking a significant pivot in its traditional governance model.

Weakening the Religious Apparatus

Saudi Arabia is taking steps to reduce the influence of religious police and establishments. The government has curtailed the powers of the religious police, formally known as the Committee for the Promotion of Virtue and the Prohibition of Vice, by restricting their ability to arrest and detain individuals. The religious police have historically been a powerful force in Saudi society, enforcing strict adherence to Islamic law and morality. However, in recent years, the government has sought to limit their authority and promote a more moderate form of Islam. The Saudi government has also taken steps to regulate and control the activities of religious establishments, such as mosques and Islamic centers, to limit their influence. Additionally, the government has launched initiatives aimed at promoting a more inclusive and tolerant form of Islam, such as the establishment of the King Abdullah International Centre for Interfaith and Intercultural Dialogue. These efforts are part of the Saudi government's broader strategy to modernize the country and reduce the strength of potential sources of opposition: religious traditionalism.

Reform is a Vulnerable Time for Islamic Leaders

The Shah of Iran, Mohammad Reza Pahlavi, faced opposition from conservative and religious segments of the Iranian population, partly because he was perceived as not being sufficiently religious and for his policies that aimed at secularization and westernization of the country. His rule, especially during the latter years, was characterized by rapid modernization efforts, social reforms, and efforts to reduce the influence of religious clerics in public life and politics. These efforts were encapsulated in the White Revolution, a series of reforms launched in 1963 that included land reform, the extension of voting rights to women, and the promotion of literacy and education.

These reforms, while intended to modernize Iran and improve social conditions, also alienated many in the conservative and religious communities, who saw them as a threat to traditional values and Islamic practices. The Shah's close ties with Western countries, particularly the United States, and his lifestyle, which was seen as extravagant and out of touch with the everyday struggles of many Iranians, further fueled discontent. This opposition eventually contributed to the support for the Islamic Revolution in 1979, led by Ayatollah Ruhollah Khomeini, which resulted in the Shah's overthrow and the establishment of the Islamic Republic of Iran. The revolution was supported not only by religious conservatives but also by various segments of society who were dissatisfied with the Shah's authoritarian rule.

The rapid liberalization of Iran under the Shah's rule serves as a cautionary tale for leaders of Islamic countries who seek to modernize their countries, as it can create vulnerabilities that empower conservative elements of society against ruling families. Tehran will be closely watching these dynamics as Saudi Arabia liberalizes, looking for opportunities to undermine al-Saud through conservative elements of society.

Challenge to the Saudi-Iran Detente

Saudi Arabia needs a calm and stable situation to make Bin Salman's "Saudi Vision 2030" operational, so it welcomed Iran's interaction with other Persian Gulf countries in economic, security and political fields, he added." IRNA, Iranian State Media

As part of the Saudi-Iranian detente, Saudi Arabia allegedly agreed to limit its support for media networks that have been critical of the Iranian regime, while Iran supposedly committed to reducing arms shipments to Houthi rebels in Yemen. However, these promises have appeared to lose credibility in the wake of increased Houthi activity and the spread of anti-Iranian narratives in Saudi media. While the Houthis have been aiming south and not north since Oct 7th, the fragility of the detente is evident. Allowing the young MBS to continue full speed down the path of reform may provide Iran with an ideological opening to undermine al-Saud. While the detente has kept a lid on violence, the competition and conflict is far from over.

The litmus test for the deal’s success [Saudi-Iran detente] will be whether the sides keep interfering in the domestic politics of countries across the region. Riyadh has long complained about Iranian support for militant groups across the region and alleged Iranian attempts to stir up rebellion among Saudi Arabia’s minority Shiite population. Likewise, Iran has accused the Gulf Arab states of facilitating the presence of the U.S. and Israel on its doorstep. There are two obvious first steps Iran and Saudi Arabia can undertake to demonstrate their commitment to non-interference, both of which the two countries reportedly agreed to as part of the deal itself. Saudi Arabia reportedly said it would curb its support for media networks that have agitated against the Iranian regime, while Iran reportedly said it would curtail arms shipments to Huthi rebels in Yemen. [both of these promises appear to have lost credibility with amplified Houthi activity, and counter Iranian narrative being spread in Saudi media] The Impact of the Saudi-Iranian Rapprochement on Middle East Conflicts, Crisis Group, April 2023

Modernization Over Secularization

Mustafa Kemal Atatürk, the founder of the Republic of Turkey, implemented radical reforms in the early 20th century to secularize and Westernize Turkey, transitioning it from the remnants of the Ottoman Empire into a modern, secular nation-state. Atatürk's reforms included the abolition of the Caliphate, introduction of the Latin alphabet, Western legal codes, and the promotion of secular education. Unlike MBS, Atatürk explicitly reduced the role of Islam in public life and governance, aiming to separate religion from the state entirely.

Turkey's lira dropped further on Monday before recovering slightly following a speech by Turkish President Recep Tayyip Erdogan on state television that cited Islam as a reason for not raising interest rates despite a rapidly depreciating currency and rampant inflation… Erdogan insisted it was Islam that guided his decision in demanding the central bank keep interest rates low... "As a Muslim, I will continue doing what our religion tells us. This is the command," Turkey: Lira falls as Erdogan cites Islam on monetary policy

Erdoğan's reversion towards a more overtly Islamic governance model in Turkey demonstrates the potential for religious identity to regain prominence in public policy, even after periods of secularization. This highlights the importance of caution in assessing the trajectory of Saudi Arabia's reforms under MBS. As such, the balance between modernization, economic reform, and the maintenance of Islamic identity presents a complex challenge for MBS and the Saudi leadership.

The comparison of MBS to Atatürk and the observation of Erdoğan's leadership offer valuable insights into the challenges of reform in predominantly Muslim countries with strong religious identities. MBS's reforms, while aimed at modernization and economic diversification, do not entail a wholesale secularization of Saudi society. Instead, they represent an attempt to balance modernity with Islam's role in public and private life.

Economic Reforms

Upskilling Saudi Industry

As part of vision 2030, the government has invested heavily in education and training programs, including technical education. This has led to a significant increase in the number of Saudi nationals pursuing technical degrees in engineering. Saudi Arabia has one of the highest percentages of adults entering tertiary education for the first time, at 73%, above the OECD average of 66%, with the highest new entry rate at bachelor's or equivalent level, at 59% (OECD average, 57%). 98% of Saudis at age 18 are in secondary, post-secondary non-tertiary or tertiary programs, the highest rate of all countries (OECD average, 76%).

Reforming Energy Markets

Saudi Arabia's energy consumption per GDP is among the highest in the world. According to the World Bank, in 2020, Saudi Arabia's energy consumption per GDP was 0.37 kWh per dollar of GDP, which is significantly higher than the global average of 0.07 kWh per dollar of GDP. Saudi Arabia's economy is highly energy-intensive, primarily due to the country's heavy reliance on energy-intensive industries such as oil refining, petrochemicals, and desalination. Globally, Saudi Arabia ranks among the top ten countries in terms of energy consumption per GDP. This is a concern for the country's economic sustainability, as the government subsidizes energy and water which burdens the states financial resources while consuming oil which could otherwise be used for the export market.

Increasing Electricity Prices

One of the key reforms has been the increase in energy prices, which have been raised from SAR0.05/kWh (1.3 cents) to SAR0.18/kWh (4.8 cents). This hike in energy prices is still ridiculously cheap but is part of the country's efforts to reduce its dependence on oil exports and promote renewable energy sources. Electricity rate increases have to be done in proportion to capex replacement cycles. There is a glut of inefficient machinery and infrastructure in Saudi that would be completely uneconomic at market driven energy costs. If prices were raised overnight all of that equipment would be impossibly expensive to operate. Saudi Arabia has set ambitious targets to increase its renewable energy capacity, with plans to generate 50% of its electricity from renewable sources by 2030 which is unfeasible at the current low prices, so businesses can expect more price raises. This will dramatically raise demand in Saudi for efficient machinery and infrastructure.

Forcing Product Localization

In a move to boost local employment opportunities and promote local manufacturing, the Saudi Council of Ministers issued a decision in 2021 (Cabinet Resolution 658) extending local content regulations to companies majority-owned by the state. This decision is an extension of the Local Content and Government Procurement Authority's (LCGPA) original laws covering government procurement. The key aspects of the new regulations include:

• Mandatory list of national products: Companies must comply with a list of national products. Any national products on this list must be purchased locally.

• Mandatory reporting: Companies must report annually their local content score.

• Price preference for SMEs: All contracts with an estimated cost of less than SAR 50 million ($13.3 million) can buy local products at a 10% premium.

• Price preference for local content: National products may be given a price preference.

• Weighting of local content score: As part of a financial bid, the weighting of a vendor’s local content score can’t be less than 30%.

The new regulations will have significant implications for companies doing business in the Kingdom, especially those that do business with SOEs on megaprojects. Foreign companies will have to establish local production or build relationships with local producers in their industries. These partnerships are key to competitive pricing and efficient procurement agreements.

Establish Saudi as a Manufacturing Hub in The Region

While the UAE and other GCC countries continue to rely heavily on imports, Saudi Arabia is taking a different approach. By enforcing local content regulations, Saudi Arabia aims to create new opportunities for local businesses but also reduce its reliance on imports.

The localization laws came into effect in 2022, so their effects are yet to be measured in the economy, however non-oil exports in Saudi have increased 12% YoY for the past two decades. Extrapolating this trend out would increase the contribution of non-oil sector to 40% to 50% of GDP by 2030. Every single manufacturer in the Middle East I spoke to (at least 10) who provide inputs to the construction industry were in the process of establishing manufacturing operations in Saudi. Smaller companies were doing JV’s and larger companies invested the requisite capital to run manufacturing operations themselves.

Localizeflation

The Saudi government is a significant contributor to construction projects, with more work available than local players can handle. This presents a significant opportunity for driving growth of locally manufactured goods; however, there are some challenges for Saudi manufacturing.

Saudi manufacturing wages are much higher ($10-15/hr) than those in South Asia and Egypt ($4/hr), making locally manufactured goods more expensive which will ripple through construction costs. However, for higher-value products, Saudi manufacturing may still be globally competitive. The localization requirement for government projects will increase construction costs which adds to inflationary pressure, forcing local manufacture for all products will increase costs for low value add/commodity products.

For regional economies in Iraq, Syria, and Lebanon, lower-cost goods may be sourced from Egypt, India, or South Asia. As an example, Egypt exports more wire cable than Saudi, while Saudi exports more mobile phones and electronics. Saudi Arabia will be a source of mid/high-value products, while lower-cost goods will likely be imported from other regions.

Reduce Government Employment

For several years, Saudi government jobs have offered Saudis an easy way to profit from their country's oil riches. With the Saud family princes enjoying lavish lifestyles and substantial annual stipends, the only opportunity for everyday Saudis to capitalize on their oil heritage was through obtaining a government position.

In the early 2000s, Saudi government employment made up close to 50% of the total workforce, significantly higher than international standards. In contrast, countries such as the USA and Australia maintain public sector employment rates of around 15-18%, while Japan's rate is below 10%. Nordic countries, with their extensive welfare states, have government employment rates of approximately 30%.

The high percentage of government employment in Saudi Arabia can be attributed to several factors, including the expansion of the public sector during the oil/China boom era and the government's efforts to provide employment opportunities for the growing Saudi population. These jobs have often not been performance based, productive roles. The Saudi government has been taking steps to reduce its share of employment and promote private sector growth. Consequently, government employment as a percentage of the total workforce has been gradually decreasing, following a downward trend since its peak in the early 2000s.

Achieving Nordic levels of government employment, around 30%, is a realistic and desirable goal for Saudi Arabia. On its current trajectory, the country would reach a government employment rate of approximately 30-32% by 2030. This would leave 65-70% employment in the private sector, roughly in line with the Vision 2030 goal of private sector contribution to GDP to 65%.

Saudi IP Law is in a Different League to China

Saudi Arabia has made significant strides in intellectual property (IP) protection and enforcement, leading to its removal from the Priority Watch List of the United States Trade Representative (USTR) in 2022. The Saudi Authority for Intellectual Property (SAIP) has taken various measures to strengthen IP protection, including publishing its IP enforcement procedures, increasing enforcement against counterfeit and pirated goods and online pirated content, and creating specialized IP enforcement courts with trained judges and expedited timelines. The removal of Saudi Arabia from the USTR Priority Watch List in 2022 is a significant achievement, given that Saudi Arabia was previously listed alongside countries like China, with next to zero IP protection.

Foreign Business Ownership Reform

Saudi Arabia, the largest economy in the Middle East, has long been known for its conservative business environment, particularly when it comes to foreign ownership. Historically, foreign investors were only allowed to own up to 49% of a business in Saudi Arabia, with the remaining 51% being owned by a local partner. However, in recent years, the Saudi government has made significant strides in reforming its business ownership laws.

In order to support the increase FDI contribution to GDP to 5.8% the Kingdom introduced the "Foreign Investment License" in 2019. This license allows foreign investors to establish a business in Saudi Arabia with 100% foreign ownership provided they invest a minimum of 30 million Saudi Riyals (approximately USD 8 million) in the business. The structure of the Foreign Investment License favor large multinationals, while protecting the SME, and tech startup space for Saudi’s.

Reflections, Risks and Recommendations for Business

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The détente between Saudi Arabia and Iran has significantly shifted the balance of power in the Middle East. Saudi Arabia has pulled support for political and militia forces in Iraq, allowing Iran-backed militias to gain significant control over Iraq's political, military, and judicial landscapes. Saudi Arabia is by far the largest military spender in the Middle East, and with it’s economic superiority over Tehran, appears to be comfortable with this arrangement.

Not a lot stands between an Iraq capable of setting its own national agenda or falling wholesale into Iran vassalhood. Iran aligned Shia militias within the Iraqi Popular Mobilization Forces (PMF), now outnumbers the conventional Iraqi military, buoyed by budget boosts and electoral successes favoring Iran-leaning parties. The pervasive influence of warlords and their militias manifests through activities such as racketeering, property deals, shell companies, and siphoning off the country's oil wealth. The leaders of the various Iran backed militias have increasing influence across various area of Iraq’s government and state oil companies, however they are beholden to US military power and have constrained influence over policy making.

On the 11th of Feb the Iraqi parliament gathered to vote for the withdrawal of U.S. forces from Iraq and it was a complete flop. All Sunni representatives abstained, all but two Kurdish reps abstained and nearly 100 members of the Shia Coordination Framework (SCF), a dominant political bloc, abstained from voting. Only 82 SCF members out of 329 members of parliament showed up. This abstinence from voting to remove US forces underscores a consensus among Iraqi lawmakers that the U.S. military should stay. This vote reveals a tacit acknowledgment of the stabilizing role played by U.S. forces amid the country's ongoing challenges with militia influence and sectarian divisions.

The Gaza conflict and U.S. military strikes in Iraq, have tilted public opinion in the Middle East against the United States. Although Iraqi lawmakers remain cautious of Tehran's sway, Iran has leveraged these events to strengthen its support within the Iraqi population. While the U.S. relies on its military might, Iran has been expanding its intelligence, media and paramilitary influence across Iraq. This contest for influence over Iraqi governance and policymaking places Iraqi politicians in a precarious position. They must navigate the challenging task of stabilizing public sentiment, integrating militias into state security forces, and ensuring that Iraq's development trajectory serves national interests rather than being subject to external powers.

With Iraq at the fulcrum of the Middle East, paying attention to the status of US presence in Iraq will be crucial to defining the trajectory of the region.

Credit for the catchy title goes to u/SerendipitouslySane.

Saudi is the Center of Gravity of the Mid-East

Saudi Arabia is the center of gravity in the Middle East when it comes to defense and military spending. Accounting for 50% of the military expenditure for the entire region, the Kingdom has established itself as a major military power. The Saudi military budget for 2022 was estimated to be around $56 billion, making it the third-largest military spender in the world. Saudi spends 3x more than the next biggest spender in the region, Israel, and 7x more than the next biggest spenders Kuwait and Qatar. Saudi’s military budget is more that 10 times that of Iran.

The Kingdom has invested heavily in the development of advanced missile defense systems, such as the Patriot and Terminal High Altitude Area Defense (THAAD) systems, to protect its critical infrastructure and population centers. Additionally, the Saudi military has a significant arsenal of anti-tank weapons, including modern main battle tanks and armored vehicles, to counter any ground threats.

Despite its significant military capabilities, Saudi Arabia relies on the support of the United States for its defense and security. A significant portion of the Saudi military budget goes towards renting protection from the US. Saudi Arabia has also committed to purchasing large amounts of military equipment from the United States, including fighter jets, tanks, and missile defense systems. This has created a significant source of revenue for the US military-industrial complex, but it has also raised questions about the long-term sustainability of the Saudi military's capabilities and independence.

Saudi-Iran Detente Leaves Iraq in the Lurch

The détente between Saudi Arabia and Iran culminating in the March 2023 announcement has significantly shifted the balance of power in the Middle East, with Saudi Arabia appearing to concede Iraq to Iranian influence by pulling support for political and militia forces. This shift has allowed Iran-backed militias, known collectively as the muqawama, to gain significant control over Iraq's political, military, and judicial landscapes. Despite challenges, such as the elimination of key muqawama figures and setbacks in the 2021 elections, the muqawama has effectively navigated the political terrain, securing government funding for the Popular Mobilization Forces and even appointing the prime minister. Take a look at our previous piece for a closer look on this.

Saudi Arabia, with it’s military superiority over Tehran, appears to be comfortable with this arrangement, having withdrawn support for Iraqi leader al-Sadr and other groups opposed to Iran. This was evident when Ammar al-Hakim, a key player in the Iran-aligned coalition, visited Saudi Arabia seeking support to pressure Muqtada Sadr, a Iraqi political figure opposed to Iran’s influence, to back down from his bid for leadership in 2021. Saudi Arabia is taking a more cautious and neutral approach to Iraq's domestic affairs, and focusing on it’s own interests.

What Has Tehran Achieved in its Regional Agenda Since Oct 7?

Invasion of Gaza has Deepened the Divide with Israel/US

Since the invasion, views of the US have significantly worsened, with 94% of Arabs taking a negative view of the American position in the war. Conversely, only 27% of Arabs evaluate the Iranian position in the war as negative while 48% view Iran’s position positively. Additionally, 40-50% of people in Arab countries believe that Western countries expressed support for Israel because of “their hatred for Islam”. This widespread disapproval of US policy towards Palestine and the high perception of Israel as a threat highlight significant challenges for regional diplomacy and underscore the complexities of Middle Eastern geopolitics.

Support for Israel Recognition Lower, Particularly in Saudi

The Palestinian cause remains a unifying issue, with 76% of respondents asserting its importance to all Arabs, not just Palestinians. This widespread solidarity emphasizes the potential for the Palestinian issue to serve as a unifying or divisive factor in regional politics.

Half of those open to recognizing Israel condition their acceptance on the establishment of an independent Palestinian state, highlighting the centrality of the Palestinian issue in Arab Israeli relations. Criticisms against Israel, citing colonial, expansionist policies, and racism towards Palestinians, dominate the reasons for opposing diplomatic recognition.

The prospect of recognizing Israel remains overwhelmingly unpopular, with 84% disapproving of their countries formalizing diplomatic ties with Israel. Notably 57% of respondents in Saudi Arabia declined to respond which alludes to (هيبة) fear and respect toward the Kingdoms stated goals of normalization with Israel. However, after the invasion of Gaza, only 29% of Saudi’s were unsure with the majority opposed.

Iran Scored Seats in Iraq’s Provincial Elections

In the recent 2023 provincial elections in Iraq, the Shia Coalition Framework (CF), a conglomerate of Shia groups aligned with Iran, secured a significant victory by winning 101 of the 285 available council seats. This election, held across all of Iraq's governorates on December 18, marks a considerable step towards consolidating Iran-aligned influence ahead of the parliamentary election scheduled for 2025. The CF's success in most of the country's southern provinces, including Baghdad, reflects a shifting balance of power within Iraq, where factions close to Iran have been gaining ground. The Shia Coalition Framework's achievement in obtaining the largest bloc of votes solidifies their position as a dominant force in Iraq's political landscape, further supported by their backing of the current government under Mohammed Shia al-Sudani.

Pressure for Exit of US Military Presence

The presence of U.S. troops in Iraq allows for close monitoring of regional dynamics and Iranian militia activities. While their deployment can make them targets for attacks, they serve as observation outposts that afford the U.S. a vantage point to counteract Iranian-aligned militia operations. Acting as a deterrent, they also allow the U.S. to execute targeted actions against militia leaders who become overly aggressive or claim responsibility for attacks against U.S. interests. This strategy helps maintain a measure of control over Iranian militia activities and curtails their expansion.

American Violence Alienates the Local Population

The recent drone strike by an Iran-backed militia on a base in northeast Jordan resulted in the deaths of three U.S. service members, leading to U.S. precision strikes against militia targets in Syria and Iraq. However, growing popular support for U.S. withdrawal from the region raises questions about the long-term sustainability of American military engagements in the Middle East.

Shia Militia Leaders Add Pressure for US Withdrawal

Shia militia leaders in Iraq have intensified their calls for the withdrawal of U.S. forces, leveraging local sentiment and political pressure in the aftermath of American military actions on Iraqi soil. Following U.S. strikes, these militias vocally denounce American interventions, rallying the local population against what they perceive as unwarranted foreign aggression. Incidents of hostility towards foreign journalists, such as the BBC team being rebuffed by locals at the site of an attack, underscore the deep-seated resentment towards foreign presence "You are foreigners, and foreigners are to blame for this".

“We strongly condemn the heinous crime committed by the criminal American forces, by targeting one of the headquarters of the Popular Mobilization Forces in the capital, Baghdad, this day, by assassinating the martyr Commander Abu Taqwa Al-Saeedi and his companions.

We also hold the Iraqi government responsible for any disregard or laxity in the serious demand for the immediate removal of the so-called international coalition forces from Iraqi soil… We confirm our previous positions on this presence, which has become a threat to the security and safety of the Iraqi people, and an infringement blatantly against Iraqi sovereignty." Hadi al-Amiri INA News, Iraq state media

Gulf Countries Limiting Support for US Attacks from Their Bases

In the Gaza conflict of 2023, Arab governments found themselves navigating a delicate balance between quelling domestic outrage against Israel and supporting Washington's efforts to counter Iranian-backed assaults. This geopolitical tightrope walk led to increased restrictions on U.S. military operations from Arab territories. Particularly in the case of the UAE, these measures stem from a desire to avoid antagonizing Iran and to maintain a moderate stance in the eyes of the international community and their own citizens, wary of being perceived as too aligned with Western and Israeli interests. This strategic positioning is nothing new for GCC states in balancing the interplay of regional diplomacy, security concerns, and public sentiment, juggling their internal and external commitments amidst escalating violence and civilian casualties in Gaza.

Amid a rising civilian death toll in Gaza, several Arab countries, particularly those “attempting a detente with Iran,” are “increasingly restricting” the U.S. and partners from conducting self-defense operations from their soil, according to the U.S. official. This includes limits on retaliatory strikes against attacks in Iraq, Syria, and the Red Sea, the official said.

…The reason the UAE in particular is doing this, per one of the Western officials, is “they don’t want to appear like they’re against Iran and they don’t want to appear too close to the West and Israel for public opinion reasons.” POLITICO

The Gulf War of 1990-1991 was a stark contrast to the 2023 Gaza conflict in terms of Arab states' engagement with and support for U.S. military operations. During the Gulf War, Arab governments, particularly those from oil-rich Persian Gulf states, were major contributors to the coalition effort against Iraq, both financially and logistically. These states covered a significant portion of the operation's costs, with Kuwait, Saudi Arabia, and others contributing billions of dollars. This financial support significantly offset the expenses borne by the United States, which, despite deploying the majority of troops, incurred just about 12% of the total costs.

This collective action reflected a unified stance against Saddam’s aggression and a willingness to openly support U.S. leadership in the conflict. A scary throwback for Iranian revisionists. In contrast, the cautious approach of Arab states in the Gaza conflict of 2023 is marked by a hesitancy to facilitate U.S. military actions due to concerns over Iranian relations and public opinion, but again this is nothing new for the GCC.

Caught Between Iraq and a Hard Place

The media reporting on the withdrawal of US troop presence in Iraq has been schizophrenic, largely because communications out of Iraq have been unclear. Iraq's Prime Minister, Mohammed Shia al-Sudani has stated the need for a strategic reassessment of Iraq's relationship with U.S.-led forces. This re-evaluation is underscored by U.S. retaliatory strikes on Iran-linked militant groups followed by the increasing calls, from Shi'ite factions within Iraq, for the withdrawal of the U.S. coalition.

Senior advisers to Iraqi Prime Minister Mohammed Shia al-Sudani told U.S. officials that his declaration was “an attempt to satisfy domestic political audiences” and that Sudani himself “remained committed” to negotiating the coalition’s future presence in Iraq, according to a Jan. 6 State Department cable obtained by POLITICO, Iraqi officials privately signal they want US forces to stay, 9^th Jan 2024.

Following the above leak reported by Politico, al-Sudani spoke at Davos a few weeks later and contradicted what was reported by stating that it was his will and the will of the Iraqi people that the US forces withdraw as soon as possible. After leaks from al-Sudani’s government to reassure US partners that withdrawal talks were all political theatre, al-Sudani commented at Davos where he backtracked on the leaks. The Pentagon statements have indicated that there is no current plan to withdraw the roughly 2,500 U.S. troops from Iraq, however, focus groups have started meetings between Iraqi and US officials to arrange a withdrawal.

John Harris, Politico Founding Editor: I've been confused as I've read the news stories about your response to the recent U.S. drone strike that killed an Iranian target in Baghdad. It looked like you had reached the conclusion it was time for all U.S. troops to leave Iraq. I've later seen news stories saying that's not your position. Could you clarify what your position on that is?

Mohammed Shi’a al-Sudani: Indeed, one of the challenges in Iraq is that we don't have a proper picture of what is happening. Some agencies, even your agency lately, tend to take news, and we don't know how correct, how accurate the information that is referred to… Iraq's government and people are respectful and appreciate the position of the International Community, which contributed along with the Iraqi people to defeat ISIS…The other issue now is the justification of the presence of the Allies of the coalitions is to face and fight ISIS… ISIS is no longer a threat to the Iraqi people… Now, the preparedness of our army is clear, and it is a sign of stability and a guarantee to safeguard the situation in Iraq. Based on these indicators, we started to implement a commitment made by the ministry council to negotiate with the coalition to discuss how to finish this mission in Iraq. That was the aim of the delegation of our visit in 2023 to the US, to set up a bilateral group to implement the withdrawal of the coalition. A Conversation with Mohammed Shia Al Sudani, Prime Minister of Iraq | Davos 2024 | WEF

Manufacturing Support for Full US Withdrawal from Iraq

The Iraqi government crafted a text message poll sent to Iraqi citizens on January 9, inquiring about their support for the Coalition's presence, which smacked more of Iranian political theatre than a genuine attempt to gauge public opinion. The subsequent announcement of forming a committee to discuss withdrawal further exemplifies the often-ineffectual nature of Iraqi bureaucracy, raising questions about the government's commitment to actualizing this policy shift. Despite the Shia militia and popular support for U.S. withdrawal, the steps taken by al-Sudani's government suggest a lack of urgency and calculated delay tactics.

Mohammed Shia al-Sudani: Now, what happened on October 7th stopped the meetings that were in line, and today, after the aggressions happening on Iraqi positions, we have to start the discussion on how the international coalition moves from Iraq and then have bilateral partnerships with regional countries. We are a sovereign country, and therefore it is only natural that we move towards this position, as it's a request from the people and a democratic country.

John Harris: You're reflecting the wishes of the people, but in terms of your personal priorities as prime minister, is your position the sooner, the better, or do you feel the transition should take place purposefully and not necessarily on any set timeline?

Mohammed Shia al-Sudani: Indeed, yes, I believe that the sooner we withdraw the coalition, it is a necessity for the stability and security of Iraq and to safeguard constructive bilateral relationships between Iraq and the countries of the coalition. This is my position as a prime minister, it is not the position of any other body. It is myself directly. Mohammed Shia al-Sudani interview at Davos

Despite Tehran’s Pressure, Iraq Needs US Forces

Iraq’s Shia Warlords

Hadi Al-Amiri is a case that highlights the intricate landscape of Iraq-Iran relations. From being born in Iraq, to siding with Iranian forces in the Iran-Iraq War. This shift laid the groundwork for his involvement in political and military spheres, culminating in the creation of the Badr Organization while in Iran. The organization, with strong ties to the Islamic Revolutionary Guard Corps (IRGC), played a crucial role in post-2003 Iraq, reinforcing Iran's influence in the region. Al-Amiri has styled himself as a revolutionary leader of an independent Iraq. When asked a question about living in Iran and influencing Iraqi politics, al-Amiri responded with the below:

أثناء حرب التحرير الأمريكية، كان الفرنسيون يساعدونكم. ساعدكم الفرنسيون كثيرًا في حربكم ضد الإنكليز. هل بهذا أصبحتم عملاء للفرنسيين؟ سأشبّه لك حالنا بما حدث لديكم. نحن، الفصائل أو الميليشيات أو أيًا ما كان المسمى، أشبه بالآباء المؤسسين في "أمريكا". نحن مثلهم.

During the American War of Independence, the French were helping you. The French greatly assisted you in your war against the English. Does this make you agents of the French? I will compare our situation to what happened with you. We, the factions or militias or whatever the name may be, are similar to the Founding Fathers in "America." We are like them.

هادي الأميري Hadi al-Amiri, Leader of Iranian Militias in Iraq

Leaders Without Personal Militias are Vulnerable

Under Prime Minister Mohammed Shia al-Sudani's administration, the budget for Iraq in 2023 soared to a record $152 billion, significantly benefitting the public sector and, notably, the Popular Mobilization Forces (PMF), a state-sponsored umbrella organization comprising mostly Shia militia groups. The PMF, which Al-Amiri has been closely associated with, received a substantial allocation of $2.7 billion, enabling a dramatic increase in its ranks from 122,000 to 238,000 personnel. The PMF now outnumbers the regular armed forces of Iraq of about 200,000 soldiers.

The rise of the Popular Mobilization Forces (PMF) in Iraq and Iran aligned politicians (see Tehran wants control of Iraq, not Gaza) has raised concerns about the balance of power within the country and the role of influence from Iran. With the PMF surpassing the size of Iraq's regular armed forces, questions arise about the implications for Iraq's future stability and security landscape. Reports suggest that individuals within the Ministry of Oil are seeking patronage from militia leaders in order to advance their careers, highlighting the growing influence of militias within the Iraqi government. This has led to a situation where militia leaders have become the de facto authority in many areas, with the state's security forces often serving as their personal militias. The PMF's growing power and influence raises concerns about the potential for Iranian-backed terrorist organizations to capture the Iraqi state.

“The boss cannot protect them, so they seek a patron, to make their own top cover. The lesson we have all learned under al-Sudani is that you need a militia protector—all the way from minister to director-generals, commission managers, and department heads.” Another 2023 interviewee from Ministry of Oil noted: “They look at every [director-general] and put them on probation. If they have a militia, they leave them alone, but if they don’t, they remove them” Iraq’s New Regime Change: How Tehran-Backed Terrorist Organizations and Militias Captured the Iraqi State, CTC

Moderate Politicians Benefit from Stability Provided by US Troops

Neutral nationalist politicians in Iraq find an unexpected ally in the stability that U.S. troops provide. While Shia militias seek greater autonomy to expand their influence, the moderate politicians aim to temper the escalation of conflict and prevent any single faction from monopolizing power. Sunni and Kurdish communities, in particular, advocate for the continued presence of U.S. forces as a counterbalance to the dominance of the Shia majority. The maintenance of U.S. military presence serves multiple interests, offering a semblance of equilibrium that benefits those seeking a unified, pluralistic Iraq.

Controlling Violence in Iraq is an Unpopular Job

Forces have gained control over ISIS, but the Iraqi government currently does not have credible control of violence on their own territory. Turkish forces stationed in northern Iraq continue to engage Kurdish positions, mirroring Iranian military actions against the same groups. Meanwhile, Shia paramilitaries outnumber Iraqi national forces and clash with the U.S. military presence, creating a fragmented landscape of authority and power.

The US is taking a leaf out of Saddam’s book in using the stick against militant Shia factions and extending carrots to their moderate counterparts. The Iraqi foreign minister Tariq Aziz said in the 1980s “If there are those in this country who seek martyrdom, my government is prepared to accommodate them – all of them”. Biden and US presidents since 2010 have effectively employed the Teddy Roosevelt Big Stick version of this ideology - U.S. Secretary of Defense Lloyd Austin, January 2024 “They have a lot of capability; I have a lot more.” 

29^th of Jan, three US service members were killed and 40 were injured by Shia militia, Kataib Hezbollah.

31^st of Jan, Kataib Hezbollah said it was suspending attacks on American troops to prevent "embarrassment" to the Iraqi government.

7^th of Feb, Abu Baqir al-Saadi, a commander in Kataib Hezbollah was killed in a US drone strike.

The broader context of Saddam Hussein's rule over Iraq provides a historical lens through which the current dynamics can be viewed. Saddam's regime, despite its brutal tactics, managed to maintain stability within Iraq, balancing the suppression of dissent with strategic ethnic politics. Harkening back to our previous article, most Iraqis view life under Saddam as better than today. Keeping a forceful lid on sectarian violence is worth it to Iraqi’s. Just ask Hobbes: "The only way to avoid this war of all against all is to establish a common power to keep them all in awe." (Leviathan, Part II, Chapter XXVII)

Iraq Parliament Vote on US Withdrawal Flopped

On the 11^th of Feb the Iraqi parliament gathered to vote for the withdrawal of U.S. forces from Iraq and it was a complete flop. All Sunni representatives abstained, all but two Kurdish reps abstained and nearly 100 members of the Shia Coordination Framework, a dominant political bloc, abstained from voting. Only 82 SCF members out of 329 members of parliament showed up. This abstinence from voting to remove US forces underscores the consensus among Iraqi lawmakers for the U.S. military to stay in Iraq. The abstention reveals a tacit acknowledgment of the stabilizing role played by U.S. forces amid the country's ongoing challenges with militia influence and sectarian divisions.

Warlords Constrained to Racketeering, For Now

In Iraq, the pervasive influence of warlords and their militias manifests through activities such as racketeering, engaging in significant property deals, utilizing shell companies for financial maneuvers, and siphoning off the country's oil wealth. Despite these underhanded dealings, the Iraqi parliament continues to function in the interests of the nation, suggesting a complex interplay between overt political processes and the shadowy dynamics of power wielded by these warlords. This dichotomy reflects the challenges facing Iraq in its efforts to establish a cohesive state governance model while being pulled in different directions by the vested interests of these powerful factions, each carving out their own spheres of influence at the expense of national cohesion and development.

US Withdrawal Timeline, Conditions and Key Takeaways

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Amidst the significant geopolitical shifts in the Middle East, a crucial but underreported dynamic is Iran's growing influence over Iraq's economy and political landscape. Tehran can’t afford a replay of the 1980s, with a muscle-flexing, nationalist Iraq challenging their 1,600km shared border. And so, over the past two decades, Iran has strategically positioned itself, amidst the backdrop of US military withdrawal, to become a dominant force in Iraq.

In the last three years, Iran has executed a strategic takeover of Iraq's political and security systems, leveraging its influence to divert Iraq's substantial oil wealth. Despite losing the 2021 elections, Iran-backed factions maneuvered into power, notably influencing the selection of the prime minister and dominating the governance of the world's 5th largest oil producer. This ascension to power was orchestrated through calculated actions by Iran's Revolutionary Guard, aligned judges, and militia-affiliated politicians, significantly impacting Iraq's oil economy, freedoms, and intelligence services to cement their dominance. This transition has transformed Iraq into a resource-rich, militia-controlled state, exceeding the capabilities of Iran's other proxy networks as the economic powerhouse of Iran’s partner forces.

Since the invasion of Gaza, views of the US have significantly worsened, with 94% of Arabs taking a negative view of the American position in the war. Conversely, only 27% of Arabs evaluate the Iranian position in the war as negative while 48% view Iran’s position positively. This widespread disapproval of US policy towards Palestine and the high perception of Israel as a threat highlight significant challenges for regional diplomacy and underscore the complexities of Middle Eastern geopolitics.

Iraq has historically been a buffer against Iran's regional ambitions. However, the reduction of US military presence and the complexity of influencing Iraq without exacerbating anti-American sentiments or destabilizing the region further complicate this role. In contrast, Iran has entrenched its influence, highlighting a strategic recalibration in the region.

American Foreign Policy in Iraq

Saddam’s Era of Utility

Initially, during Saddam's ascent to power, the United States observed his maneuvers with a degree of ambivalence, recognizing him as a counterbalance to the rise of Islamic radicalism following Iran's Islamic Revolution. Saddam's decision to wage war against Iran was seen through the prism of containing Tehran's revolutionary fervor, a move that inadvertently aligned with American interests.

Saddam's Sunni regime, known for its brutal suppression of dissent and particularly of Shia majority aspirations, managed to maintain a semblance of stability within Iraq. This stability was recognized by American intelligence, which noted Saddam's ability to blunt potential threats through a combination of ruthless power and strategic ethnic politics. This assessment was encapsulated in a declassified CIA report, which highlighted the unique relationship between Saddam and the Iraqi Shia population, suggesting a personal compact based on a mix of respect for his leadership and the economic benefits his regime provided.

On the other hand, if Saddam is assassinated or overthrown in a coup, we believe the Shias will not automatically support his successor. In our view, the Shias have something of a personal compact with Saddam. It is his charisma that they respect and his economic policies that they have benefited from so far [redacted].

The Iraqi experience suggests that Iran’s ability to successfully export its revolution is limited. Saddam’s ruthless use of power combined with astute ethnic politics have succeeded in countering radical appeals from Tehran for a Shia revolution. At the same time, Iraqi tactics are probably not transferable to the Gulf—none of the Gulf regimes has an internal security service as ruthless or effective as Iraq. A strong Iraq, however, will serve as a check on Iranian ambitions, thus furthering US objectives in the Gulf so long as a radical clerical regime is in power in Iran.

Iraq’s Shias: Saddam Blunts a Potential Threat, Declassified CIA Report

Saddam’s Unravelling

However, Saddam's aggressive regional ambitions, particularly his invasion of Kuwait, marked a turning point in US-Iraq relations. This act of aggression was perceived as a direct threat to the regional balance of power and to American strategic interests, particularly the flow of oil from the Gulf. The subsequent US-led military response in the Gulf War under President George Bush Sr. was a demonstration of commitment to maintaining order in the Gulf region. Through meticulous consensus-building with international allies, the US sought to repel the Iraqi invasion and restore Kuwaiti sovereignty, thereby reinforcing a world order that would not tolerate aggressive territorial expansion.

This period of American foreign policy towards Iraq reflects a complex interplay of strategic interests, regional dynamics, and the challenges of dealing with a regime that, while serving as a bulwark against Iranian expansionism, also posed its own set of threats to regional stability and international norms.

The Iraq War and its Fallout

The 2003 invasion of Iraq, led by the United States and United Kingdom, marked a pivotal moment in the nation's history, ending the Ba’athist regime of Saddam Hussein. Initial reactions among Iraqis were mixed, with optimism for a new beginning tempered by the reality of Saddam's brutal dictatorship. This optimism, however, faced a critical blow when the US administration decided to disband the Iraqi military and remove all Ba’ath party members from their positions, a move that plunged Iraq into years of chaos and civil strife. Various armed groups emerged, contesting power and territory, and targeting both coalition forces and the nascent post-Ba’athist Iraqi state.

A brief period of relative calm in the early 2010s was disrupted by the rise of the Islamic State group, which, at its zenith, controlled significant portions of Iraq. It wasn't until 2017, with the support of a US-led and separate Iranian coalition, that Iraqi forces managed to reclaim much of the territory once held by the extremist group. Today, Iraq finds itself in its most stable condition since 2003, albeit still grappling with sporadic and localized violence. The country remains divided, and its people confront deep challenges that the Iraqi state struggles to address effectively.

”We were happy at first when the Americans came. Now they should keep out, no one wants them around”

Public opinion in Iraq has evolved significantly since the invasion. Initial polling in Baghdad showed a nearly even split in perceptions of the invasion's impact. Over time, however, a noticeable shift has occurred in the Iraqi public's sentiment. Today, only 35% view the coalition's entrance in 2003 positively, while 63% of Kurdish respondents saying that life is better now. Among Arabs, 48% of Sunnis say that life was better under Saddam, while amazingly 71% of Shias say life was better or the same under Saddam.

Formal US Policy Today is Noncommittal

In the years following the 2003 invasion of Iraq, the United States' military presence peaked at approximately 150,000 troops. Today, this number has decreased to around 2,500. This downsizing is in line with changing perceptions among the American public and veterans alike, over 60% of whom now believe the Iraq war was not worth the costs involved. Such sentiments underscore a broader re-evaluation of America's engagement strategy in the region coupled with American energy independence.

The current U.S. foreign policy, as outlined in the National Security Strategy of October 2022, advocates for a move away from military-centric approaches that have dominated American actions. By focusing on practical steps rather than grandiose schemes of reshaping the political landscape, the U.S. hopes to contribute more effectively to the long-term stability and growth of the Middle East.

Support De-Escalation and Integration in the Middle East

Over the past two decades, U.S. foreign policy has focused predominantly on threats emanating from the Middle East and North Africa. We have too often defaulted to military-centric policies underpinned by an unrealistic faith in force and regime change to deliver sustainable outcomes, while failing to adequately account for opportunity costs to competing global priorities or unintended consequences. It is time to eschew grand designs in favor of more practical steps that can advance U.S. interests and help regional partners lay the foundation for greater stability, prosperity, and opportunity for the people of the Middle East and for the American people. October 2022, National Security Strategy

Iran’s Regional Influence

Iran's regional influence extends through a network of proxies and alliances. This influence is rooted in its strategic use of both financial incentives and ideological alignment, especially in conflict-ridden or politically unstable regions.

In Yemen, Iran's backing of the Houthi militia is a clear example of its strategy to extend its influence. By offering $100 per month to join the Houthi forces, Iran taps into the dire economic conditions in Yemen, where over 80% of the population lives below the poverty line. Comparatively, Iran's support for Hezbollah in Lebanon is substantially higher, with members of Hezbollah’s military wing reportedly receiving around $1,300 per month. This discrepancy in pay between the two groups reflects the varying strategic importance and operational costs associated with each proxy.

The role of Martyr Soleimani is pivotal and highly strategic in the Palestinian issue. In this regard, he promoted the Palestinian Resistance from using light weapons to employing very important weapons such as ballistic missiles, advanced drones, and important fighting technologies, he added.

We can also introduce and describe martyr General Soleimani as the central authority in the operations of the Resistance in Palestine because he was the initiator of tunneling in Gaza and transferring arms to Palestine in certain ways, the analyst added. Mehr News, Iran State Media on Qassim Soleimani’s role in training Hamas.

The Iranian Revolutionary Guard (IRG) oversees the financing and training of these foreign militias. The Revolutionary Guard's involvement in these regions is not just military but also deeply political, aiming to create and sustain alliances that align with Iran's regional ambitions and ideological stance. Iran's approach in Yemen and Lebanon is part of a broader pattern of influence across the region, where it supports various groups to enhance its geopolitical reach and counterbalance the influence of rival powers, notably Saudi Arabia and the United States. However, this strategy of proxy warfare and regional intervention also attracts criticism and contributes to the complex dynamics of Middle Eastern geopolitics.

Tehran’s Capture of Iraq, Muqawama مقاومة

From 2019 to 2023, Iran-backed militias, collectively known as the resistance movement muqawama (مقاومة), have significantly influenced Iraq's political, military, and judicial landscapes, reflecting a deep entrenchment of Iranian influence. The sequence of events began with the muqawama achieving a form of state capture by securing government funding for the militia medley the Popular Mobilization Forces (PMF). However, challenges emerged, notably the U.S. elimination of key muqawama figures like Qassim Soleimani in January 2020 (and Abu Mahdi al-Muhandis, the head of the pro-Iran Kata'ib Hezbollah militia) and the setback in the 2021 elections where Moqtada al-Sadr's cross-ethnic nationalist Shia bloc outperformed Iran-backed factions, signaling a potential shift in Iraq's political balance. Despite these challenges, the muqawama adeptly navigated the political terrain, leveraging judicial maneuvers by strategically placed Judge Faiq Zaydan, who issued rulings that obstructed the formation of a government excluding muqawama factions. This judicial activism led to a muqawama appointed prime minister, and underscores Iran's long-term strategy to influence Iraqi institutions and safeguard its interests.

Muqawama control of Iraq’s government—now without even a notional sharing of the spoils with Moqtada al-Sadr—puts the Iraqi militias into a league of their own as the economic powerhouse of Iran’s partner forces. Iran’s longest-serving proxy, Lebanese Hezbollah, and Iran’s newer Yemeni partner, the Houthi movement, are economic minnows compared to the Iraqi state. The Shi`a Coordination Framework-led government’s first budget is the largest in Iraq’s history: $152 billion in annual spending for three consecutive years, a roughly 50 percent increase from the last authorized Iraqi budget from 2021. In contrast, a bankrupt Lebanon’s expected spending was under $2 billion in 2022, and the country went $72 billion further into debt due to massive financial losses since 2021. The Houthi enclave in Yemen also has a measly budget of around $2 billion per year. Iraq’s New Regime Change: How Tehran-Backed Terrorist Organizations and Militias Captured the Iraqi State, CTC

By the end of 2022 and into 2023, the muqawama, under the aegis of Prime Minister Mohammed Shia al-Sudani, embarked on a comprehensive restructuring of Iraq's security and intelligence apparatus, embedding loyalists within key institutions. This purge targeted officials aligned with the West and previous Iraqi administrations, reversing efforts to curtail Tehran-backed militia penetration. The National Intelligence Service, Counter-Terrorism Command, and other critical agencies saw significant leadership changes, ensuring muqawama dominance. These developments, coupled with the establishment of entities like the Muhandis General Company, mark a strategic consolidation of power, enhancing Iran-backed militias' control over Iraq's security, economic, and political spheres, thereby altering the country's trajectory in favor of Iran's regional ambitions.

قال لي سائق تكسي أيراني في دولة أوربية،عندما عرف أني عراقي،الله يخلصكم من نظام الملالي في طهران!أجبته الله يخلصكم انتم اولاً منه.

أجاب،لا ،عندما يتخلص العراق من سيطرة الملالي سيسقط النظام عندنا بالضرورة! قلت لماذا؟قال لأن أقتصاد النظام يتنفس من بغداد!!

رجل بسيط لكنه حكيم

An Iranian taxi driver in a European country said to me, when he learned that I was Iraqi, “May God save you from the mullahs’ regime in Tehran!” I replied, “May God save you from it first.”

He replied: No, when Iraq gets rid of the mullahs’ control, our regime will necessarily fall! I said why? He said because the regime’s economy breathes from Baghdad!!

A simple but wise man. Munqith Dagher, MENA Director of the Washinton Institute for Near East

Gaza Deepens Divide Between the US and Middle East Population

The events starting from October 2023, exacerbated divisions between Arab states and the United States, capitalizing on escalating tensions in the Middle East. Through these efforts, Iran has effectively spotlighted Israel's aggressive stance and contributions to the humanitarian crisis in Gaza. The widespread anti-Israel and anti-America sentiment, particularly in Iraq and Yemen, serves Iran's interests by fostering regional discord aligned with its anti-Western agenda.

Israel and America Seen as the Largest Regional Security Threats

Arab Opinion Index 2022

Arab Public Opinion about the Israeli War on Gaza

Prior to the recent conflict, surveys showed that, 84% citizens across the Middle East, perceive Israel as a threat to regional security and stability, with the United States closely following at 78%. This sentiment underscores the deep-rooted tensions and mistrust that exist towards these nations within the Arab world. Conversely, Iranian policies are viewed as a threat by 57% of respondents, on par with perceptions of Russian policies.

Why is Now The Moment for Tehran?

Several critical but underreported factors are shaping the future beyond the well-publicized issues of Saudi-Israel normalization, the US withdrawal of forces, and Iran's pursuit of nuclear capabilities. This includes Iraq's potential for economic growth and the ripe domestic conditions for Iranian-backed groups to gain ground.

For two decades, Iran found itself sandwiched between formidable US military presence in Iraq and Afghanistan. Now, as the US has completely reduced its military footprint, Iran perceives an opportunity to assert its influence and reorder regional dynamics to its advantage. Keen to avoid a return to the confrontational days of the 1980s when a nationalist Iraq posed a significant challenge along their 1,600km shared border, Tehran is seeking control of it’s Arab neighbor.

Iranians Want Democracy

After the domestic tumult following the death of Mahsa Amini in September 2022, some analysts viewed Iran at a juncture reminiscent of the 1979 revolution. These protests, signaled a deep-seated dissatisfaction with the ruling regime. Tehran has since sought to deflect internal scrutiny by rallying against external adversaries.

A comprehensive survey conducted by GAMAAN in February 2022 (before the protests), involving over 20,000 participants from within Iran, unveils a populace that overwhelmingly favors democratic governance over theocratic rule. With 88% of respondents endorsing democracy as either "fairly good" or "very good", and a mere 28% viewing a religiously governed system positively, the dissonance between the government's ideological stance and public sentiment is starkly apparent. These findings underscore a critical domestic weakness for Iran's Islamic leadership which places the Iranian regime in a precarious position, potentially impacting its regional ambitions and strategies.

Independent, Unsanctioned Iraq Would Overpower Iran in Years

The oil industry is the linchpin of the Iraqi economy, accounting for nearly half of its Gross Domestic Product (GDP) and over 92% of export earnings making the Iraqi economy particularly sensitive to oil market fluctuations. Despite its economic challenges, Iraq is on the cusp of growth opportunities.

It’s obvious that Iraq's economic future lies in diversifying its economy beyond oil dependency, but dealing with corruption and maintaining security are vital. One of the challenges Iraq faces is managing foreign influence, particularly Iran and Turkey, both of which have a substantial military and militia presence within Iraqi borders. While Iraq has the public oil revenue for infrastructure investments, the United Arab Emirates is a crucial ally, being the main source of FDI for Iraq. Iran is Iraq’s largest source of imports.

This geopolitical complexity is further compounded by the need to steer clear of U.S. sanctions to maintain and enhance its economic growth trajectory relative to regional competitors like Iran.

The graph below illustrates that while Iraq's economy is heavily oil-dependent, it is on par with Iran when considering the Michael Beckley national power (GDP * GDP per capita) metric, a measure that combines economic size with wealth per inhabitant. For the first time in decades, Iraq’s GDP is comparable to Iran and also boasts a higher GDP per capita. This power parity will unsettle Tehran deeply. Tehran desperately wants to avoid risking the development of an Iraq that can challenge Iran as it did in the 80’s. Tehran has limited time to act to gain influence over Iraq, and since gaining influence in 2021 the two economies have been growing together.

Iraqi’s viewed Iran as the biggest threat Pre-invasion

Prior to the Gaza invasion, when asked about the primary threat to their own countries, 28% of participants identified Israel, with the United States and Iran cited by 13% and 9%, respectively. Most citizens surveyed see Israel as the biggest threat to their respective countries. However, almost half of Iraqis view Iran as the main threat to their country, so for increased influence, Tehran has used the Gaza crisis to turn the spotlight toward America.

Iraqis Don’t Trust Government and are Looking for Strong Leadership

Despite the Iraqi populations strong opposition to Iranian influence, their low trust in the government and desire for strong leadership combined with high confidence in the military creates a fertile ground for Iranian influence. The situation is further complicated by the government's harsh response to protests foreign interference, where they successfully quelled popular unrest. Additionally, 45% of Iraqis say political reform should happen all at once, while another 45% say it should happen bit by bit. These dynamics provide Tehran with many openings for gaining control of military forces and government administration in Iraq. Tehran has been able to frustrate and derail stabilization efforts in Iraq such that it can manage the development of Iraq in it’s own image. The exhausted Iraqi political elite and population has been worn down over time and increased anti-Israel/US sentiment provides even more opportunity for increased Iranian control.

What Has Tehran Achieved in its Regional Agenda? + Key Takeaways

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The Red Sea shipping crisis is having huge repercussions on global trade, particularly affecting China's freight to the EU. China's economic challenges, compounded by underutilization of factories, have led Beijing to subsidize exports, potentially supporting deflation in developed markets. The US's reduced strategic focus on the Middle East, contrasts with China's continued reliance on the region for energy.

While the focus on Israel and Gaza has intensified, leading to a concentration of violence there, the broader region, especially the economically developed Arab states, has remained relatively stable. However, the frequency of violent events has doubled in some regions of northern Syria and Iraq. These areas have become more volatile, potentially due to the diversion of media attention towards the Gaza conflict, granting parties involved more freedom to operate. It is crucial to closely monitor these dynamics, as well as events on the Lebanon border with Israel as shifts in any of these areas could significantly impact the region's stability and security.

Shipping Crisis is Deflationary for Manufacturers

The Red Sea shipping crisis, has had far-reaching impacts on global trade. The crisis has led to significant disruptions in shipping routes, causing delays in freight movement from key manufacturing hubs. This situation has resulted in prolonged transit times and increased freight costs, to the detriment of supply chain efficiency and reliability.

The world is dependent on US naval power and diplomatic engagements with Iran to defuse tensions and ensure the safety of shipping lanes. While Beijing has made a backdoor deal with Tehran to avoid Chinese vessels getting attacked, escalated shipping costs have impacting trade flow, particularly between China and the European Union.

"China calls on all parties concerned to remain calm and restrained, adhere to dialogue and consultation, promote a political solution, refrain from any acts that aggravate the situation, and do their best to maintain the positive momentum of the political process in Yemen," He reiterated his call for de-escalation "to ensure safety of our seafarers, freedom of navigation and stability of supply chains".
Geng Shuang, China's deputy permanent representative to the UN. China Daily

Macroeconomics: Shifts in Global Investment and Trade

China's economic landscape is currently navigating turbulent waters, marked by a confluence of internal challenges. Compounding China’s economic issues are a significant underutilization of its manufacturing capacity. In response to these domestic economic strains, China has initiated a strategy of export subsidization. This approach, might inadvertently exert deflationary pressures on developed markets, contributing to the mix of inflationary and deflationary trends.

The impact of the Red Sea shipping crisis has been particularly pronounced on China and its manufacturing sector. Research from Morgan Stanley highlights that rates for shipping from China to the US have increase by 18%, whereas those to the EU have surged by over 60% since the crisis began. This sharp increase in shipping costs is placing a downward pressure on Chinese manufacturers, while increasing the costs of goods in the European.

These developments are adding fuel to the fire for two major trends: firstly, the ongoing underutilization and resulting deflationary pressures within the Chinese manufacturing sector; and secondly, a declining inclination towards investment in Chinese manufacturing.

FDI Shifts: China's Challenge, US Gain

The current global economic landscape, marked by the ongoing US-China trade war initiated in 2018 and recent geopolitical developments, has significant implications for China's manufacturing sector. China's increasingly complex international relations, especially its alignment with Russia and the tensions over Taiwan, have contributed to a perception of investment risk in the country. This perception has been compounded by internal factors, including the government's response to the COVID-19 outbreak and Xi Jinping's extensive anti-corruption drive targeting high-profile political and business figures.

China is still a middle income economy that requires FDI to progress along the technological curve. As such, the "investors' riot" of 2023 has to be reversed, or else China may find itself stuck in the dreaded middle income trap. Chart below is quite telling. Marko Papic, Chief Strategist Clocktower group

These factors have collectively influenced a notable shift in foreign direct investment (FDI), diverting it from China to other developing markets and domestically in the United States. Conversely, the US and its allies have witnessed a surge in manufacturing investment. This shift reflects risk aversion towards China and a strategic pivot by investors towards more stable and predictable markets.

This FDI divergence has broad implications. For China, it threatens its growth model reliant on foreign capital for technological advancement. The US, however, could leverage domestic investment to mitigate inflationary pressures in global trade and support economic growth.

Underutilization of Chinese Factories

China's manufacturing industry, particularly its automotive sector is operating at only 59% capacity. In response, the Chinese government implemented export subsidies in the second half of 2023 to maintain factory operations, a move that will contribute to deflationary pressures in global markets. This situation presents a complex interplay of economic forces. While China's subsidization efforts aim to sustain its manufacturing output, they also have the potential to exert downward pressure on goods prices. This dynamic could offset the impact off logistics crises by supporting Chinese factories to lower pricing while reducing it impact for consumers in the EU.

Microeconomics: Higher Inventory and Worse Cashflow

On a microeconomic level, the crisis has led to increased freight costs, prompting importers to negotiate lower prices from Chinese suppliers and adjust prices for end-users in markets like Europe. The resulting scenario is a unique juxtaposition of deflation in China and inflation in Europe, on top of part shortages for EU manufacturers.

Now that freight prices are increasing, importers from China are doing 2 things: 1) asking Chinese suppliers more discounts (5 to 7%) 2) slowly increasing prices to end users You see where we are going? Deflation in China, inflation in Europe. Marco Castillo, X

Microeconomic Case Study

This case study focuses on the microeconomic impact caused by a month-long delay in a shipment from China. Originally due for delivery in early January, it's now expected in early February, attributed to disruptions in the Red Sea shipping routes.

For the European Customer:

• Initial Scenario: 30-day inventory costing $100,000.

• Post-Delay Scenario: Inventory extended to 60 days, doubling the cost to $200,000.

• Additional Financial Burden: The delay necessitates an extra $100,000 in capital to maintain the inventory.

For the Chinese Factory:

• Expected Payment: $100,000 post 30 days of delivery.

• Effect of Delay: Same amount, but delayed by an additional 30 days, leading to a cash flow gap.

• Financial Strain: Factory needs to manage its debts and cash flow for an extended period without expected revenue.

Should such shipping delays become a regular occurrence, both parties - the customer and the factory - would need to recalibrate their supply chain strategies. This may involve exploring alternative shipping methods, revising inventory management practices, and enhancing liquidity management strategies to adapt to longer transit times. While an initial adjustment phase of about 5-6 months could stabilize the supply chains, the ongoing challenges of increased capital requirements and extended cash flow gaps could continue to exert pressure on the financial health of both EU importers and Chinese exporters.

Air Strikes on Houthi’s are a Media Band-Aid

The recent U.S. and British air strikes against Houthi forces in Yemen, while a significant response to months of attacks on Red Sea shipping, won’t bring meaningful relief. President Biden emphasized, the intent is to demonstrate a firm stance against threats to global navigation and personnel.

Targeted military attacks are inherent limited against a determined adversary. While the Pentagon reports a notable impact on the Houthis' operational capacities, these strikes are unlikely to offer a resolution to the underlying regional conflicts. They serve as a symptomatic treatment, without necessarily altering the broader geopolitical dynamics that fuel such hostilities. The crisis in the Red Sea region predominantly affects European and Chinese interests, and the US lobbing a few missiles into Yemen is a rather low effort means of looking busy.

China Depends on Middle East More Than US

The United States attained energy independence around 2019, marking a significant transition from its peak energy dependence in 2005. This development has contributed to a reduced strategic emphasis on the Middle East, with the U.S. instead concentrating on the escalating competition with China (see excerpt from the National Security Strategy below).

Support De-Escalation and Integration in the Middle East

Over the past two decades, U.S. foreign policy has focused predominantly on threats emanating from the Middle East and North Africa. We have too often defaulted to military-centric policies underpinned by an unrealistic faith in force and regime change to deliver sustainable outcomes, while failing to adequately account for opportunity costs to competing global priorities or unintended consequences. It is time to eschew grand designs in favor of more practical steps that can advance U.S. interests and help regional partners lay the foundation for greater stability, prosperity, and opportunity for the people of the Middle East and for the American people. October 2022, National Security Strategy

The Red Sea crisis, primarily affects trade between China and the European Union. Additionally, nearly half of China's oil imports originate from the Middle East, highlighting Beijing's reliance on the region for its energy needs. While the Middle East is no longer critically vital to American energy interests, it is a means of applying pressure to global markets. China doesn’t have the military power to safeguard its interests in the Middle East so it relies heavily on diplomatic efforts, with the ongoing crises likely causing considerable concern in Beijing.

Conflict Data: Currently Contained, Possibility of Regional Disruption

The outbreak of violence in Israel and Gaza in October has not only heightened tensions in these areas but also influenced the broader regional conflict dynamics. This analysis delves into the current trends across different Middle Eastern countries, highlighting the complexity and varying nature of these conflicts.

Israel, Palestine, and Lebanon: Escalation Risks

The escalation of the Israel-Gaza conflict has significantly increased violent incidents within Israel, the Palestinian territories, and Southern Lebanon, with Gaza emerging as a central focus of military engagements. This situation indicates a potential for the conflict to spread regionally, especially given Lebanon's proximity to Israel and the involvement of Hezbollah.

Israel, facing this heightened tension, has conveyed to Washington that without a long-term border agreement with Lebanon, it might escalate military actions against Hezbollah. Lior Haiat, an Israeli foreign ministry spokesman, emphasized Israel's preference for a diplomatic solution but did not rule out independent action if necessary: "If a diplomatic solution will not be possible, we will have to act on our own.”

Despite Hezbollah's receptiveness to diplomatic discussions, their commitment to rocket attacks in support of Gaza persists. A senior Lebanese official familiar with Hezbollah's thinking stated to Reuters, "Hezbollah is ready to listen," while noting their rejection of U.S. negotiated proposals. The situation remains precarious as diplomatic efforts continue amidst a backdrop of military readiness and regional instability.

Israel is demanding that Hezbollah retreat north of the Litani River in Lebanon to create a security buffer for northern Israeli citizens. Hezbollah will refuse. At that point the war will probably spread. Iran will support Hezbollah, increasing conflict throughout Syria and Iraq where supply lines run.

Neither the U.S. nor Israel has fully accepted a world in which a nuclear-armed Iran, backed by Russia and China, manages to dominate the region. But if the U.S. looks to force Israel to accept that world, then Israel may refuse to accept Hezbollah looming over it at the same time.

In other words, the U.S. is demanding that Israel refrain from confronting Iran directly. But Israel will interpret this demand as permission to attack Hezbollah. Matt Gertken, BCA

GCC and Stable Countries Stay Stable

Contrary to historical patterns, especially following past conflicts with the Houthis in Yemen, the economically developed Arab states, including Saudi Arabia, the United Arab Emirates, Qatar, Kuwait, Oman, and Bahrain, have experienced a period of stability. Egypt, Jordan and Turkey are also experiencing no increases in violent events. This stability is significant, given the region's history of conflict spillover following major disturbances. The current absence of escalation in these states is a positive sign, indicating effective governance and diplomatic measures in maintaining internal and regional peace.

“Saudi Arabia has had one objective, which is to prevent this from escalating into a wider regional war,” said Tobias Borck, an expert on Middle East security at the Royal United Services Institute. “It has attempted over the last few years to bring its intervention in the war in Yemen to a close, including through negotiations with the Houthis and actually from all we know from the outside, [they] are reasonably close to an agreement.” POLITICO

Less Violence in Yemen and Iran

Conversely, Yemen and Iran demonstrate a different trajectory. Despite Yemen’s historical role as a focal point for regional conflicts, there has been a decrease in violent events. This reduction indicates regional militant efforts have been redirected to the Israel-Gaza area. However, violence in Yemen will undoubtably increase with incoming G7 attacks.

Increased Attacks in Syria are Opportunistic, not Escalatory

The ongoing conflict in Syria, which has ravaged the country since 2011, has escalated since the October attacks. The Asad regime, with the backing of Russian forces, is exploiting the current distractions caused by the Israel-Hamas war to intensify their military operations against opposition-held territories in northwest Syria. This tactic allows them to conduct increasingly indiscriminate attacks with less international scrutiny and condemnation. Notably, violence in the Damascus region, and near the Israeli border has not increased.

Less Discriminate Targeting of Opposition-Held Areas

Northwest Syria, particularly the Idlib province, remains the last significant stronghold of opposition forces. The Syrian government, is intensifying its efforts to root out opposition elements from this region. Recent artillery and air strikes have led to a surge in civilian casualties. Since the escalation of attacks in early October, the number of violent events in the Idleb and Aleppo regions has doubled on a per week basis.

The Asad regime and Russia's military strategy in northwest Syria, under the cover of the Israel-Hamas conflict, represents a concerning development in the Syrian crisis. However, this appears to be opportunistic attacking rather that an escalation of regional conflict.

Conflict in Iraq Contained to Kurdish-Turkish Region

Iraq presents a complex scenario where overall conflict levels have slightly increased, but regional disparities are evident. Baghdad, historically a center of unrest, has seen a noticeable reduction in violent incidents. In contrast, Northern Iraq, particularly the regions around Erbil and Duhok, are experiencing a 50% increase in the frequency of violent events.

This increase in Northern Iraq is predominantly driven by tensions between Turkish military forces and Kurdish factions, including the PKK. The conflict here is increasingly drawing in regional players and could potentially have broader implications for the stability of the local region.

Suppression of Kurds

As an ethnic minority striving for statehood, Kurdish groups have historically shown solidarity with Israel and a friendly stance towards the United States. This alignment and Kurdish militant separatist movements has often led to local opposition. In 2022, the Central Iraqi government passed legislation making normalization of relations with Israel illegal. This law restricts the semi-autonomous Kurdish region in Northern Iraq from forging diplomatic ties with Israel.

The Kurdish areas in northeastern Syria and northern Iraq are facing a complex and escalating conflict. The intensifying clashes between Kurdish groups, particularly the PKK, and Turkish military incursions represent a critical risk. The Iraqi government has struggled to prevent Turkish military incursions into its territory. In the backdrop of a semi-autonomous Kurdish government in Northern Iraq and the establishment of a self-governing Kurdish region in Syria, Turkey is aggressively acting against Kurdish insurgent groups. This aggressive stance stems from Turkey's concerns about potential territorial claims or separatist movements within its southeastern borders, prompting a forceful response to suppress Kurdish rebellions. This situation, is tangentially related to the Israel-Gaza conflict, and could see increased fighting due to the distraction created by the conflict in the Levant.

Less Attacks on US bases in Iraq After Withdrawal

Since mid-2019, Iran-backed militias in Iraq have targeted U.S. bases and convoys. These militias have strategically varied their attacks, balancing between exerting pressure and avoiding heavy retaliation. Following the reduction of U.S. troops in December 2021, their focus has shifted to other targets, including secular establishments and Turkish forces.

While the violence in Iraq has significantly reduced, the Iraqi government faces significant challenges in establishing its central security authority. There are several semi-legitimate militia groups, some of which are backed by external actors like Iran. These militias often play a prominent role in Iraq's security landscape. Furthermore, external powers such as Turkey, Iran, and the United States operate within Iraqi territory with limited intervention from Baghdad. Recent weeks have seen all three foreign nations conducting airstrikes on targets within Iraq. Despite these actions, the Iraqi government's responses have been largely limited to calls for cessation, highlighting limitations of its control over foreign intervention and national security. These events involving foreign powers in Iraq and Syria have been limited to a handful of cases. While they create headlines and stoke frustrations, they aren’t yet moving the needle on net violence.

• Iraq vows to take Iran to UN after attack on Israeli ‘spy base’

• Turkey bombs Kurdish militants in Syria and Iraq

• U.S. drone strike killed a senior Iran-backed militia member in Baghdad, Iraqi officials privately signal they want US forces to stay

Prospects and Risks

Overall, the current conflict trends in the Middle East exhibit a peculiar balance. While the focus on Israel and Gaza has intensified, leading to a concentration of activities there, the broader region, especially the economically developed Arab states, has remained relatively stable. However, the ongoing Kurdish conflicts in northern Iraq and northeastern Syria emerge as wildcards that could disrupt this balance. It is crucial to closely monitor these dynamics, as shifts in any of these areas could significantly impact the region's stability and security.

Amidst this transformation, the battle for copyright has emerged as a critical factor for media publishers to secure their place in the attention spans of consumers. The New York Times' case against ChatGPT stands at ground zero of these developments, highlighting the urgent need for clear guidelines and fair practices in the use of AI in content creation and distribution. The unfolding legal battles and strategic partnerships in the industry are reshaping the landscape, making it imperative for media companies to adapt and innovate while fiercely protecting their intellectual property.

The Battle Over AI and Copyright

In a landmark case that could redefine the boundaries of artificial intelligence development and copyright law, The New York Times has launched a federal lawsuit against tech giants OpenAI and Microsoft. Filed in December 2023, the lawsuit alleges unauthorized use of copyrighted content for training advanced AI models, including OpenAI's GPT-3 and Microsoft's Bard. This high-profile case not only challenges the legal tenets of fair use but also raises profound ethical questions regarding AI development.

The NYT Case: A Landmark in Copyright and AI Development

The lawsuit accuses the defendants of copyright infringement under U.S. law, particularly 17 U.S.C. § 106. The crux of the case revolves around the NYT's claim to exclusive rights over its literary works, which it alleges were used to train and distribute the defendants' AI models. The complaint highlights potential financial impacts and threats to future business models, including AI licensing, vital for funding journalism globally. The NYT emphasizes the extensive human and financial investment in reporting critical global events, underscoring the stakes of this case.

Central to the NYT's lawsuit is the pursuit of fair compensation for its content and the fostering of a responsible AI ecosystem within a healthy news landscape. The complaint details instances of alleged verbatim use of NYT content, comparing it to other search engines' approaches. It also addresses the purported preferential use of NYT-sourced content in AI training, indicating potential market destabilization for journalism.

The Constitution and the Copyright Act recognize the critical importance of giving creators exclusive rights over their works. Since our nation’s founding, strong copyright protection has empowered those who gather and report news to secure the fruits of their labor and investment. Copyright law protects The Times’s expressive, original journalism, including, but not limited to, its millions of articles that have registered copyrights….

The Times objected after it discovered that Defendants were using Times content without permission to develop their models and tools. For months, The Times has attempted to reach a negotiated agreement with Defendants, in accordance with its history of working productively with large technology platforms to permit the use of its content in new digital products (including the news products developed by Google, Meta, and Apple)…

These negotiations have not led to a resolution. Publicly, Defendants insist that their conduct is protected as “fair use” because their unlicensed use of copyrighted content to train GenAI models serves a new “transformative” purpose. But there is nothing “transformative” about using The Times’s content without payment to create products that substitute for The Times and steal audiences away from it. Because the outputs of Defendants’GenAI models compete with and closely mimic the inputs used to train them, copying Times works for that purpose is not fair use. Case 1:23-cv-11195 Document 1 Filed 12/27/23

Key Allegations

The New York Times (NYT) raises four major complaints centered around copyright infringement during the development and use of generative AI models:

1. Unauthorized Reproduction of NYT Works During GPT Model Training

The NYT alleges that OpenAI used millions of copyrighted NYT works, including from the website and third-party datasets, in building training datasets for GPT models. Common Crawl, a significant dataset in GPT-3's training, is highlighted as a primary source of this content. It's described as a comprehensive snapshot of the internet, with www.nytimes.com being one of the most represented sources. The GPT models, including the speculated larger GPT-4, are believed to have been trained on extensive data including NYT content.

Common Crawl is a significant dataset in GPT-3's training, is essentially a 'copy of the Internet' made available by a non-profit organization. OpenAI claims fair use of open source databases however Common crawl’s terms of use are in contradiction with that assertion:

"You also acknowledge and agree that all information, data, text, scripts, web pages, web sites, software, html page links, open data APIs, metadata or other materials (collectively, the "Crawled Content ") may be subject to separate terms of use or terms of service from the owners of such Crawled Content."

2. Incorporation of NYT Works in GPT Models

The lawsuit claims that the GPT language models have "memorized" many NYT works, encoding them into their parameters. This is evidenced by the models producing near-verbatim outputs of significant portions of NYT works upon prompting. For instance, a Pulitzer-prize winning series by The Times on predatory lending was allegedly recited verbatim by the AI models.

3. Unauthorized Display of NYT Works in Product Outputs

NYT contends that generative outputs from products like ChatGPT display NYT content by showing memorized copies or derivatives of their works. ChatGPT, for example, is said to produce summaries and texts closely resembling NYT articles that would typically be locked behind a paywall.

4. Unauthorized News Dissemination via Search Applications

The complaint extends to synthetic search applications like Bing Chat, which are said to display extensive paraphrases or excerpts of NYT content. These applications are accused of creating natural-language substitutes for NYT articles, reducing the need for users to access the original sources, thereby impacting the NYT's audience and revenue.

Prayer for Relief

As the legal battle between The New York Times and technology giants OpenAI and Microsoft unfolds, a crucial segment of the lawsuit, known as the "Prayer for Relief," merits special attention. This part of the litigation is where the NYT explicitly outlines the specific remedies and resolutions it seeks from the court. The requests made in this section are pivotal in understanding the depth and seriousness of the allegations, as well as the broader implications for the media, technology, and legal landscapes. The Prayer for Relief is a window into the NYT's strategic goals in the lawsuit, encapsulating its efforts to protect its copyrighted materials and set precedents in the rapidly evolving domain of artificial intelligence and copyright law.

Monetary Compensation: The NYT is seeking various forms of financial compensation. This includes statutory damages (set amounts of money defined by law), compensatory damages (to cover losses or harm suffered), restitution (repayment for unjust gains), disgorgement (forcing the defendant to relinquish unjust profits), and any other financial relief permissible under law.

Permanent Injunction: The NYT is asking the court to permanently prohibit the defendants from continuing the unlawful and infringing activities that were alleged in the lawsuit.

Destruction of Infringing Materials: Under 17 U.S.C. § 503(b), the NYT requests an order for the destruction of all AI models and training sets (like GPT or other Language Learning Models) that include copyrighted works from The Times.

Legal Costs and Attorneys’ Fees: The NYT seeks an award to cover the costs and expenses incurred during the lawsuit, as well as the fees paid to their attorneys, as allowed by law.

Additional Relief: The NYT also requests any other relief that the court may consider appropriate, just, and fair in the context of the case.

The Ripple Effect

OpenAI and Microsoft's Defense: Both OpenAI and Microsoft have refuted the allegations, standing firm on the principle of fair use. They contend that their use of The Times's content falls within legal parameters, essential for the progress of AI technology. This defense opens a complex debate over where the line is drawn between fair use and copyright infringement in the age of AI. The allegations are only days old so this will be an important factor to monitor in the coming weeks.

Implications for AI Development: The outcome of this lawsuit could be a turning point for AI research and development. A victory for The New York Times might set a precedent, making it harder for AI companies to use copyrighted material without explicit consent. This could slow AI progress or increase costs as companies might have to negotiate rights for content usage. Conversely, if OpenAI and Microsoft succeed, it could reinforce the scope of fair use, potentially accelerating AI advancements.

The Ripple Effect: Elon Musk's X: Amidst this legal battle, Elon Musk's X (formerly Twitter) has revised its terms to prohibit data scraping, a move likely aimed at protecting its data from being used to train AI models. The new terms explicitly ban scraping or crawling without prior written consent, a stark shift from the previous stance that allowed crawling in line with robots.txt instructions. This change, especially the restriction on bots other than Google's, signifies a tightening grip on how public social media data is used in the AI arena.

As this lawsuit unfolds, it has become a watershed moment in the discourse around AI, copyright, and ethics. It not only challenges existing legal frameworks but also compels the tech industry, legal experts, and creators to reevaluate the intersection of AI development and intellectual property rights. Regardless of the outcome, this case is set to have far-reaching implications on how we approach AI training and the balance between innovation and the protection of creators' rights in the digital age.

Axel Springer Partners with OpenAI

In a groundbreaking move that contrasts sharply with ongoing legal disputes, global news publisher, headquartered in Berlin, Axel Springer has announced a collaborative partnership with OpenAI. This venture, unveiled on December 13, represents a strategic alignment between a major news organization and an AI technology leader. Unlike the contentious lawsuit involving The New York Times and OpenAI, this deal exemplifies a mutually beneficial relationship between AI development and content creators. Axel-Springer has effectively addressed all of the NY Times claims within this commercial agreement.

Compensation for Training Data

OpenAI has agreed to compensate Axel Springer for using its content, including archived material, to train its sophisticated language models. While the financial details remain undisclosed, this arrangement is a multiple-year, non-exclusive deal, signaling a sustainable and potentially replicable model for AI and journalism collaborations.

Incorporation of Axel-Springer works into ChatGPT

Under this agreement, when users pose questions to ChatGPT, the AI chatbot will provide summaries of relevant news stories from Axel Springer's brands, including Politico, Business Insider, Bild, and Welt. Remarkably, these summaries will incorporate material from subscription-based articles, citing the original publication as the source and offering links to full articles. This integration not only brings breaking news into the ChatGPT experience but also aims to drive traffic and subscription revenue towards Axel Springer's publications.

Favorable Position for Axel Springer Content

Reuters reported that source familiar with the deal indicates that Axel Springer's content will receive a "favorable position" in ChatGPT search results. This strategic placement is intended to enhance user access to quality journalism while simultaneously boosting Axel Springer's digital footprint and financial returns.

Axel Springer's Vision

Axel Springer CEO Mathias Doepfner articulated the company's ambition to harness AI in journalism. The goal is to elevate the quality, societal relevance, and economic viability of journalism through AI integration, marking a significant shift from traditional news publishing paradigms.

Earlier, OpenAI had struck a similar deal with the Associated Press, focusing on leveraging AI technology without displaying content directly. News Corp is also reportedly in advanced discussions for a similar arrangement, indicating a growing trend of news organizations actively engaging with AI companies.

EU Media Companies Are More Protected than American Ones

The willingness of European companies like Axel Springer to collaborate with AI platforms like ChatGPT can be better understood by examining the differences in legal protections between European and American laws, especially in the context of database rights and copyright directives.

Database Rights in the EU

EU Database Rights: In the European Union, there are "sui generis" database rights, as part of the European Database Directive. These rights are specifically designed to protect the significant investment made by a database creator in assembling, verifying, and presenting the contents of a database. They grant the database maker exclusive rights to prevent the extraction and/or re-use of substantial parts of the database. This legal framework is unique to the EU and is not found in American law.

US Law: In the United States, there is no direct equivalent to the EU's sui generis database rights. Protection for databases in the US is generally afforded under copyright law, but this only extends to the creative elements of the database (such as annotations or novel methods of organization). The raw data itself, especially if it is considered factual information, is not protected in the same way as in the EU. Thus, the legal environment in the US is generally more permissive for the use and aggregation of data in databases.

European Copyright Directive vs. American Copyright Law

EU Copyright Directive (Articles 15 and 17): The European Copyright Directive, particularly Articles 15 and 17 (formerly known as Articles 11 and 13), focuses on protecting press publications and ensuring fair remuneration for online content use. Article 15 allows publishers to obtain fair and proportionate remuneration for the digital use of their press publications by information society service providers. Article 17 deals with the use of copyrighted content by online content-sharing platforms, requiring them to obtain licenses for the content and to filter out unauthorized uploads.

American Copyright Law: US copyright law does not have provisions directly equivalent to Articles 15 and 17 of the EU Copyright Directive. While it provides broad protection for original works of authorship, the US approach is more focused on fair use, which allows limited use of copyrighted material without permission for purposes like criticism, commentary, news reporting, and education. This fair use doctrine creates a more flexible environment for the use of copyrighted materials in the US compared to the EU.

Impact on Axel Springer's Collaboration with ChatGPT

Understanding these legal differences helps explain why a company like Axel Springer might be more open to collaborating with AI platforms. In the EU, the stronger database rights and the new Copyright Directive could provide Axel Springer with a greater degree of control and assurance over how its content is used and monetized. Collaborating with ChatGPT under a formal agreement allows Axel Springer to leverage AI technology while ensuring compliance with European legal standards and securing fair compensation for the use of its content.

In contrast, the legal environment in the US might not provide the same level of protection or control for content creators, making companies in the US potentially more cautious or seeking different terms in their collaborations with AI platforms.

ChatGPT as a Content Platform

The landscape of information dissemination has undergone seismic shifts over the past few decades, driven by the advent of the internet, mobile technology, and social media. These shifts, while democratizing access to information, have also led to an overwhelming surplus of content. This has created an evolution from traditional media to the current era of information saturation and the emergent reliance on aggregators like Substack and AI platforms like ChatGPT as solutions to navigate this deluge.

The Digital Revolution in Publishing

The combination of computers, Google, Kindle, and the Internet revolutionized traditional publishing. Traditional publishers, once constrained by the logistics of physical newspaper and book distribution, found in digital platforms the means to reach broader audiences at significantly lower costs. This digital proliferation not only expanded reach but also democratized access, allowing for a more diverse set of voices to be heard. However, this ease of access and distribution also sowed the seeds for future challenges of information oversaturation.

The Rise of Microbloggers and Social Media Influencers

The personal phone, coupled with platforms like Instagram, TikTok, and YouTube, ushered in the era of the microblogger and social media influencer. Individuals leveraged these tools to create content, reach vast audiences, and, in many instances, achieve celebrity status. This period marked a significant power shift from traditional media houses to individual content creators, highlighting the power of personal branding and niche content.

The Challenge of Information Overload

As the internet became increasingly saturated with content, the challenge is increasingly shifting from accessing information to filtering it. The analogy of "sipping from a fire hose" aptly describes the overwhelming nature of trying to stay informed in the current digital landscape. Users are bombarded with an unending stream of data, making it increasingly difficult to find relevant, trustworthy, and high-quality content.

The Emergence of Aggregators and AI Platforms

In response to this information overload, we are witnessing a mean reversion to platforms like Substack and AI tools like ChatGPT. Substack offers a curated experience, allowing users to subscribe to specific writers or topics, thereby filtering the noise and focusing on trusted sources. ChatGPT, on the other hand, represents a more advanced solution. As an AI platform, it not only aggregates information but also processes, summarizes, and personalizes it. ChatGPT's ability to assist in various tasks, from rewriting emails to providing research support and copywriting, positions it as a powerful personal assistant in the digital age.

OpenAI is the Best, But Retention is Still Uncertain

AI tools like ChatGPT, despite their groundbreaking capabilities, still face challenges in user retention and daily engagement compared to established apps such as YouTube, Instagram, TikTok, or WhatsApp. This aspect of user behavior is crucial to understand in an era where technology adoption is rapidly changing.

ChatGPT, with its innovative approach, initially attracted a vast number of users, fueled largely by the hype surrounding its capabilities. This phenomenon mirrored the initial buzz generated by Meta's Threads app. The surge in interest was primarily driven by curiosity – a desire to explore and understand what these new tools were all about. However, for many of these users, their engagement was fleeting. They were not necessarily looking to permanently incorporate these tools into their daily routines but were instead drawn in by the novelty and the widespread conversation surrounding these technologies.

This pattern of onboarding, characterized by a spike in initial usage followed by a decline, highlights a critical challenge for emerging AI applications. While they capture attention and interest at launch, converting that initial curiosity into long-term, sustained usage is a more complex endeavor. It underscores the importance of not only innovating and introducing new technologies but also ensuring that these tools can effectively integrate into and enhance the everyday lives of users.

Impact on Database owners and AI Developers

The integration of Artificial Intelligence (AI), especially with the development of frontier models, is revolutionizing media. This technological leap is not just transforming the tools of trade but is also reshaping market dynamics. Key players, from large entities like Axel Springer and The New York Times to smaller organizations, are finding themselves caught between innovation and copyright protection.

As we stand at the crossroads of a rapidly evolving AI landscape, two distinct futures are emerging, each with profound implications for market leaders and the broader industry. The advent of frontier AI models, characterized by their vast scale and complexity, is not merely a technological revolution; it's reshaping the very fabric of how businesses operate and compete.

In this dichotomy, two possible worlds emerge: one where market leaders successfully integrate AI to reinforce their positions, and another where AI platforms like OpenAI become central to everything, reshaping markets in their image. Monitoring this situation closely is not just advisable; it's imperative for any business looking to thrive in the coming decades.

Key Takeaways

Below we unravel the implications of the AI revolution on industry giants, the challenges faced by smaller entities, and the strategic adaptations necessary for survival and success in this new era. To fully grasp the magnitude of these changes and to gain insightful forecasts on how this revolution will shape future industry, join us behind the paywall and upgrade to a paid subscription.

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Central to the ongoing debate in various industries is the control over business data assets and the creation of competitive moats. Consumers often find themselves with limited options for protection, necessitating legislative intervention in certain sectors. While some industries may see standard-setting by industry bodies, others attract legislative action due to heightened political scrutiny. Consequently, businesses need to stay vigilant and adapt to the emerging trends in their respective industries so they can skate to where the puck is heading. Managing control over data pipelines demands a nuanced approach, blending a gentle touch with strategic incentivization. For businesses that retain control in their industry, this presents a significant advantage. However, for those in industries where control is shifting away, it's prudent not to resist the tide unless a business holds substantial market influence. Striking this balance requires traditional business acumen, where building moats, refining offerings, and devising strategies align with the changing industry dynamics.

B2B Data Relationships Defined by Contracts, Not Government Regulations

The Privacy Acts of New Zealand and Australia governing the handling of personal data in New Zealand. It focuses on the privacy principles related to the collection, use, and disclosure of personal information. The Act doesn't explicitly define 'data ownership'. Instead, it provides a framework for how personal data should be managed and protected, with a strong emphasis on privacy rights and responsibilities.

In both NZ and AU, while there are comprehensive laws and guidelines about the privacy and security of personal data, 'data ownership', especially in the context of non-personal or operational data often found in industrial or IoT settings, is not explicitly defined. This lack of clear delineation means that data ownership is determined by contractual agreements between parties.

Lack of Contractual Definition Creates Risk

For Industrial IoT (IIoT) systems, where the focus is primarily on non-personal data, the question of data ownership can be quite different from consumer IoT contexts.

Many companies, sell proprietary IoT devices equipped with proprietary control systems. Not having contracts to explicitly define data ownership terms for the IoT assets, and the data generated by them creates significant risks:

1. IP and Data Ownership Disputes: Ambiguity in contracts regarding the ownership of data collected via proprietary systems could lead to legal challenges.

2. Compliance with Privacy Laws: Handling data without explicit consent and clear terms might result in breaches of privacy laws.

3. Customer Relationships: Uncertainty or disputes over data rights could affect customer trust and business relationships.

Who has a claim to data in various scenarios?

This can be a multifaceted and complex issue, with different entities having claims based on their roles and contributions:

Data Ownership vs. Control: While one party may physically possess the data, this does not automatically confer ownership (or title) rights. Possession allows for control over the data, but ownership (or title) pertains to legal rights over it. Usage rights, which follow the data through copying and transmission, can blur the lines between possession, control, and ownership.

Asset Owner's Claims

The owner of the asset (such as a building or vehicle) from which the data is generated may have a legitimate claim to owning the data. This perspective is grounded in the principle that the data, being a by-product of the owned asset's operation or usage, inherently belongs to the asset's owner. For instance, a company owning a fleet of vehicles might claim ownership of data generated by those vehicles, even if the data is collected and initially processed by a device provider. The argument here is that the value derived from the asset (and hence the data it generates) should accrue to the asset's owner, not merely to the entity that collects or processes the data. This claim can be particularly strong if the asset owner is also responsible for maintaining the operational environment in which the data is generated.

Argument for Data Ownership by Hardware Providers

There's a viewpoint that the entity investing in aggregating, processing, and making data usable owns the data. For instance, in the case of a smart thermostat, the homeowner may not own the data regarding their usage of the device. Instead, it's the company that aggregates and processes this data (e.g., a home automation company) that owns it, especially if there's significant investment involved. The value derived from this data, like market intelligence or product differentiation, further supports this notion of ownership.

1. Investment in Proprietary Technology: Hardware provider invests significantly in developing proprietary hardware and control systems. This investment goes beyond the physical devices; it encompasses the innovation and intellectual effort in creating systems that can generate, collect, and process data in unique and valuable ways.

2. Data Processing and Enhancement: The value of raw data from IoT devices is often limited until it is processed and transformed. Hardware providers proprietary systems not only collect data but also enhance it, turning it into actionable insights. This process of transformation, where data is given context and meaning, adds significant value.

3. Monetization and Cost Recovery: Hardware provider uses the data to develop new products and optimize services, this monetization strategy is a way to recover the investments made in technology development. The ability to monetize this data is crucial for sustaining and advancing technological capabilities.

Tesla’s Data Control and Ownership: Learnings for Hardware Providers

It's instructive to look at industry leaders like Tesla for benchmark practices. Tesla's approach to data control and ownership, particularly with their electric vehicles and energy products, offers valuable insights into effective strategies that can be applied in other sectors, including industrial IoT.

“Tesla, like all other automakers, has a policy that spells out what it can and cannot do with the data it gets from customers’ vehicles, including location information. This states that while the company does not sell customer and vehicle data, it can share that data with service providers, business partners, affiliates, some authorized third parties, and government entities according to the law.” WHO ACTUALLY OWNS TESLA’S DATA? IEEE Spectrum

Contractual Agreements

Tesla’s terms of service and user agreements clearly outline data ownership and usage rights. This includes how vehicle data is collected, used, and shared, and the rights reserved by Tesla. Like Tesla, Hardware providers contracts should explicitly define data ownership in B2B Contracts and SLAs. This clarity is vital for managing expectations and legal compliance, especially in multifaceted industrial ecosystems.

Nature of Data

Tesla uses operational data from its vehicles to improve performance, safety, and customer experience. This data is treated as proprietary and is crucial for continuous product development. In IIoT, operational data like machine performance or environmental conditions would be considered proprietary. If generated by unique systems or algorithms, this could justify exclusive ownership or rights, mirroring Tesla's approach.

Data Usage and Sharing

Tesla shares data across its network for broader benefits, like autopilot improvement and safety enhancements, while maintaining control over how this data is used. A similar model can be applied for Hardware provider, where data sharing amongst stakeholders (manufacturers, suppliers, customers) is balanced with ownership rights.

Tesla’s Privacy Notice

Tesla’s privacy notice details how customer data is handled. It provides customers with a clear understanding of their data rights and Tesla’s obligations. Transparency in data handling, coupled with explicit consent mechanisms, is vital in IIoT. This not only builds trust but ensures compliance with privacy laws.

Forcing Data Sharing with Legislation

There is a push for forced data sharing in the automotive sector, epitomized by the evolving debate over the ownership and accessibility of vehicle-generated data. A pivotal moment came in 2015 when the U.S. Congress established that data in a vehicle's event data recorders belong to the vehicle owner, acknowledging their rights over certain data types. Yet, this development merely scratches the surface of a larger, unresolved issue: who owns the myriad data produced by today's connected vehicles? This question, central to the right-to-repair movement, is not just about ownership or privacy; it significantly affects the competitive dynamics in the automotive service industry. When manufacturers like Tesla and Rivian have direct access to vehicle data, it potentially biases the market in favor of their service networks, challenging independent repair shops. This scenario has stirred up considerable debate and has led to legislative initiatives like the REPAIR Act, aiming to democratize access to vehicle data and level the playing field for all service providers.

Drivers Own Safety Event Data Records

The evolving landscape of data ownership, particularly in the context of connected vehicles, has become a focal point in recent discussions. A notable milestone occurred in 2015 when Congress legislated that the data stored in a vehicle's event data recorders is the property of the vehicle owner.

“Event data recorder (EDR) means a device or function in a vehicle that records the vehicle's dynamic time-series data during the time period just prior to a crash event (e.g., vehicle speed vs. time) or during a crash event (e.g., delta–V vs. time), intended for retrieval after the crash event. For the purposes of this definition, the event data do not include audio and video data.” 563.5 of title 49, Code of Federal Regulations

This decision marked a significant acknowledgment of the owner's rights over certain types of vehicular data. Despite this, the broader issue of who owns all of the data generated by today's connected cars is still a matter of contention.

At the heart of this debate is the question of whether data should be considered a form of property, and if so, who should hold these property rights. The logical assumption might be that the vehicle owner, as the user and creator of this data, should possess these rights. However, manufacturers often maintain effective control over this data through a combination of contractual terms and digital locks.

Setting aside the complex issue of ownership, the crucial point in the right-to-repair debate hinges on ensuring that vehicle owners have guaranteed access to the data generated by their vehicles. This aspect is central to understanding and navigating the intricate web of data ownership in the era of connected cars.

Repair Data Sways Servicing Choices

Access to vehicle data is not just a matter of ownership or privacy; it also directly impacts the competitive landscape in the automotive service industry. When carmakers have live access to the data generated by their vehicles, it positions them to potentially preference their own service providers or dealerships. This scenario can create an uneven playing field where independent repair shops might not have the same level of access to the data they need to provide efficient and competitive services.

‘governments will be keen to prevent a monopolistic situation and consumers will not want to be locked into something with no choice’. Australian Automotive Aftermarket Association executive director Stuart Charity

The REPAIR Act

Right to Equitable and Professional Auto Industry Repair Act” or the “REPAIR Act

The "Right to Equitable and Professional Auto Industry Repair Act," sponsored by Rep. Neal P. Dunn, was introduced on February 9, 2023, and is currently under the purview of the House Energy and Commerce Committee. Aimed at reforming the automotive repair industry, this act has undergone several committee meetings, with the most recent action being its forwarding to the full committee by a voice vote on November 2, 2023. The provision outlines a prohibition on motor vehicle manufacturers from withholding data, critical repair information, and tools. It mandates that:

1. Prohibition of Withholding Data and Tools: Motor vehicle manufacturers are prohibited from using technological or legal barriers to restrict access to:

   • Vehicle-generated data by the vehicle owner or their designee.

   • Critical repair information and tools needed by the vehicle owner, their designee, or entities like aftermarket parts manufacturers, motor vehicle equipment manufacturers, remanufacturers, or repair facilities.

   • The use of chosen vehicle towing or service providers by the vehicle owner or their designee.

   • The production or offering of compatible aftermarket parts by relevant manufacturers and repair facilities.

2. Requirement to Provide Data to Owners: Manufacturers are required to:

   • Provide unrestricted access (free of fees, licenses, or decryption devices) to vehicle-generated data for vehicle owners or their designees from the enactment date of the Act.

   • If using wireless technology or telematics systems, make available vehicle-generated data directly and wirelessly to the vehicle owner and their designees through a standardized access platform, starting no later than one year after the final rule publication.

   • Provide unrestricted access to critical repair information and tools at a fair, reasonable, and nondiscriminatory cost, effective from the enactment date.

This provision aims to ensure that vehicle owners and repair entities have fair and unimpeded access to necessary vehicle data and repair resources, fostering a more competitive and consumer-friendly automotive repair market.

Implications of REPAIR Act

The introduction of the REPAIR Act, could have several implications for Tesla's business model, particularly concerning its data control and service moat. The REPAIR Act represents a significant shift in the automotive industry’s data control landscape. For Tesla, it poses challenges to its current service model and data exclusivity but also opens opportunities for innovation and new partnerships.

Broader Access to Vehicle-Generated Data

The REPAIR Act mandates motor vehicle manufacturers to provide unrestricted access to vehicle-generated data to vehicle owners or their designees. This could significantly diminish Tesla's exclusive control over the data generated by its vehicles. The act seems to go beyond just facilitating repairs and maintenance, potentially opening up all vehicle-generated data for broader use, which could be seen as overly broad by manufacturers like Tesla.

Impact on Tesla's Service Moat

Tesla's business model includes a significant service moat, partly built on exclusive access to vehicle data. The REPAIR Act could erode this advantage by allowing third-party repair services access to the same data, intensifying competition in servicing and repairs. The ability for vehicle owners to choose service providers might lead to a more competitive market, potentially affecting Tesla’s service revenues and customer retention.

Challenges in Data Monetization and Innovation

By broadening data access, the act could impact Tesla's ability to monetize vehicle data uniquely. However, it could also foster innovation, as wider access to data might lead to new services and products in the automotive ecosystem, including Tesla's potential participation in these new markets.

Cybersecurity and Data Privacy Considerations

The bill allows for cryptographic protections for vehicle data and systems, which aligns with Tesla’s strong focus on cybersecurity. The requirement for notifications when vehicle data is accessed addresses privacy concerns, but it also adds a layer of transparency that Tesla will need to integrate into its systems.

Potential for Increased Collaboration

The act could encourage collaboration between Tesla and third-party service providers and parts manufacturers. This could lead to more diverse and possibly more economical repair and maintenance options for consumers. Tesla might leverage this to establish partnerships or certification programs for third-party services, maintaining quality control while complying with the new regulations.

Tesla and Rivian Trying to Undermine the REPAIR Act

Leading American electric vehicle manufacturers Tesla and Rivian are supporting a pact between carmakers and automotive repair organizations, which is being criticized as an attempt to undermine legislation aimed at making car repairs more accessible. The automotive industry has been in conflict with service groups and right-to-repair advocates over access to telematic data, essential for repairing modern, computerized cars. Advocates argue that increased access to this data would lower repair costs and extend vehicle longevity, crucial for electric vehicles (EVs) due to the environmental impact of manufacturing their batteries.

The proposed REPAIR Act in Congress seeks to give car owners and their chosen mechanics access to telematic data. However, the auto industry, benefiting financially from this data, argues that manufacturers should control it to ensure vehicle safety. An automotive industry trade group, the Alliance for Automotive Innovation, announced an agreement on data sharing with repair groups, which Tesla and Rivian supported. Major repair industry organizations, however, were not consulted on this agreement and have criticized it for not effectively improving car repairability.

Previously, agreements, like the 2002 pact with the Automotive Service Association and a 2014 memorandum of understanding following Massachusetts' right-to-repair law, aimed to give independent mechanics access to vehicle diagnostic and repair information. However, these agreements did not include telematics, leading to current challenges with access to real-time vehicle data.

Critics argue that the new agreement doesn't significantly change telematic data access and may exempt Tesla and Rivian from sharing any data due to their direct-to-customer business model. The voluntary nature of the agreement further weakens its impact, lacking enforcement mechanisms. This situation has led to calls for stronger legislation to guarantee access to repair data and ensure fair competition in the automotive repair industry.

The Massachusetts Data Access Law and the REPAIR Act under consideration in Congress — which would also require manufacturers to give vehicle owners direct, over-the-air access to telematic repair data via a standard platform — would carry the force of law. By contrast, “there’s no distinction about what happens if this MOU is violated,” Hanvey said. Grist

Data Sharing Across Industries

The introduction of the REPAIR Act in the automotive sector, particularly its implications for data sharing and access, presents a stark contrast to the current landscape in the Industrial IoT industry. Here's a comparison of how this bill, if it becomes law, might differently impact these two industries:

Automotive Industry (Under REPAIR Act)

1. Mandatory Data Sharing: The REPAIR Act would require auto manufacturers like Tesla to provide unrestricted access to vehicle-generated data, not only for repairs but also potentially for wider applications.

2. Increased Competition in Servicing: With easier access to vehicle data, independent repair shops and third-party service providers could compete more effectively with auto manufacturers' service centers, potentially reducing the latter's service revenues.

3. Consumer Empowerment: Vehicle owners gain more control and choice over who services their vehicles, leading to potentially lower costs and increased service quality due to market competition.

4. Collaboration and Innovation: The opening up of vehicle data could spur innovation and new service offerings from third parties, potentially leading to collaborations with auto manufacturers.

5. Cybersecurity and Privacy: Auto manufacturers would need to balance open data access with robust cybersecurity measures and transparency in data usage.

Industrial IoT

1. Data Ownership and Access: Currently, data ownership and access in Industrial IoT is primarily governed by contractual agreements rather than broad legislative mandates. Manufacturers often maintain tighter control over their systems' data.

2. Limited Third-Party Servicing Competition: Without legislative mandates similar to the REPAIR Act, the competition from third-party service providers is often limited by the proprietary nature of the systems and the data they generate.

3. Controlled Innovation: Manufacturers in the Industrial IoT space have greater control over the innovation and development of new services, as they maintain exclusive access to the data and systems.

4. Focused on B2B Relationships: The industry is largely B2B-focused, where negotiations and agreements are tailored to specific business needs, as opposed to the broader consumer-focused mandates seen in the REPAIR Act.

5. Security and Privacy by Design: The industry can implement data security and privacy measures tailored to specific business agreements and customer needs, without the need for broad regulatory compliance.

John Deere, Change is Coming but Delayed

John Deere in the US, signed a memorandum of understanding with the American Farm Bureau Federation (AFBF) to ensure farmers have the right to repair their own farm equipment, which sets a precedent that could influence trends in the Industrial IoT sector, including in countries like Australia.

Key Aspects of the John Deere Case:

• Self-Repair Rights for US Farmers: The agreement allows US farmers to repair John Deere tractors themselves, granting access to necessary tools and software.

• Collaboration for Access to Tools and Software: John Deere committed to working with the farm lobby to ensure access to diagnostic tools and software, enabling farmers to choose their repair methods.

• Protecting Intellectual Property and Safety: The agreement balances farmers' repair rights with the protection of John Deere's intellectual property and equipment safety considerations.

• Regular Evaluation and Engagement: John Deere agreed to meet with the AFBF biannually to assess progress and resolve issues, formalizing a process for ongoing dialogue.

• Access to Diagnostic and Repair Codes: The memorandum includes access to essential resources like operator manuals, service manuals, and diagnostic tools.

• Direct Purchase of Diagnostic Tools: Farmers can directly purchase diagnostic tools from John Deere and receive support in ordering parts.

Implications for the Industrial IoT Industry

• Trend Towards Self-Repair Rights: The John Deere case could catalyze a movement in the IIoT industry, where users may demand similar rights to repair and maintain their equipment.

• Legal and Regulatory Developments: Australia’s Productivity Commission’s recommendation to change right-to-repair laws indicates a global shift towards enhanced repair rights. This could lead to legislative changes affecting IIoT manufacturers.

• Balancing Innovation with Consumer Rights: As seen with John Deere, IIoT manufacturers might need to find a balance between protecting their intellectual property and innovation while accommodating consumers' repair rights.

• Potential for New Service Models: This shift could encourage IIoT companies to develop new service models, possibly involving partnerships with independent service providers or offering diagnostic tools and software directly to consumers.

• Increased Focus on User Empowerment: Just as the John Deere case empowers farmers, a similar trend in the IIoT sector could lead to more empowered end-users who have greater control over the maintenance and repair of their equipment.

While the MOU represents a step towards addressing the right-to-repair issues, it's important to critically evaluate its potential as a genuine solution or as a strategic move by John Deere to delay formal legislation and maintain a competitive advantage in the repair market. The John Deere agreement in the US signifies a significant shift in manufacturers' approach to repair rights, with potential repercussions in the IIoT industry.

How OEMs’ can Ensure Access to Data

Central to the ongoing debate in various industries is the control over business data assets and the creation of competitive moats. Consumers often find themselves with limited options for protection, necessitating legislative intervention in certain sectors like automotive. While some industries may see standard-setting by industry bodies, others attract legislative action due to heightened political scrutiny, like farming. Consequently, businesses need to stay vigilant and adapt to the emerging trends in their respective industries so they can skate to where the puck is heading. Managing control over data pipelines demands a nuanced approach, blending a gentle touch with strategic incentivization. For businesses that retain control in their industry, this presents a significant advantage. However, for those in industries where control is shifting away, it's prudent not to resist the tide unless a business holds substantial market influence. Striking this balance requires traditional business acumen, where building moats, refining offerings, and devising strategies align with the changing industry dynamics.

To ensure ongoing access to data from sites where IoT devices are installed while keeping customers satisfied OEMs need to implement strategic measures. These strategies should balance customer autonomy and rights with the OEMs need for data access, analytics and monitoring. Here are some recommendations:

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Canberra is aggressively chasing the future with the recent signing of the Technology Safeguards Agreement (TSA) between Australia and the United States marking a pivotal development. This agreement facilitates the launch of US space vehicles from Australian soil, significantly boosting Australia's capability in space technology and launch services. With this TSA, Australia not only deepens its ties with the US in space technology but also creates an environment that attracts more investment and innovation in its space sector.

In contrast, New Zealand's space industry, while having its own TSA with the United States, could face stiff competition from Australia, especially if New Zealand does not engage in similar or parallel initiatives like AUKUS Pillar II. Without active participation in such agreements, New Zealand risks lagging in technological advancements and strategic partnerships, potentially losing its edge to Australia's burgeoning space sector. As Australia advances with the support of AUKUS-related initiatives, New Zealand's space industry must navigate these changing dynamics carefully to maintain its competitiveness and attractiveness for future space ventures and investments.

AUKUS Pillar II License: Liberal Trade of Defense Technology

In a recent forum in Sydney, with senior officials from Australia, the UK, and US, discussions centered around easing restrictions on arms, dual-use technology, and information exchanges. The concept they proposed was to facilitate a near license-free trade environment and to simplify ITAR provisions amongst the AUKUS nations. The three countries are changing policy in unison. The first steps toward this end are being taken with the US preparing to introduce an AUKUS Pillar II License in the National Defence Authorisation Act which is due late 2023/early 2024.

Implementing AUKUS Pillar II

The specific areas of advanced capabilities included within AUKUS Pillar II are cyber, artificial intelligence, quantum technologies, undersea capabilities, hypersonics, counter-hypersonics, electronic warfare, innovation, and information sharing. The roadmap for AUKUS Pillar II involves several critical steps:

1. Establishing Working Groups: Seventeen trilateral working groups focusing on specific areas of advanced capabilities will drive the initiative forward, emphasizing collaborative project development and implementation.

2. Sharing Technology and Expertise: The mutual exchange of military technology and expertise is expected to hasten the advancement of these capabilities, creating opportunities for joint ventures and cross-national collaborations.

3. Enhancing Interoperability: Efforts to ensure seamless operational compatibility among the AUKUS forces will require alignment in training, communication systems, and procedures.

4. Boosting Research and Development: Increased investments in R&D are anticipated, possibly involving joint research institutions and collaborative programs to foster technological breakthroughs.

5. Creating a Trilateral Innovation Ecosystem: The initiative aims to cultivate an environment that encourages interaction between government, industry, and academia, potentially leading to groundbreaking innovations and synergies.

The implementation of AUKUS Pillar II marks a pivotal moment in defense collaboration and technology advancement. As these initiatives unfold, they will likely catalyze significant policy and investment shifts, not only within the participating countries but also globally. AUKUS will set the stage for a new era in defense capabilities.

AUKUS Pillar II License

Officials in Sydney recently discussed that the US is preparing to introduce an AUKUS Pillar II License. Based on the broader objectives of the AUKUS agreement and the typical characteristics of defense-related licenses, we can infer some potential features of the AUKUS Pillar II License:

1. Scope of Technology: The license would likely cover a wide range of defense and dual-use technologies, including those related to undersea capabilities, quantum technologies, artificial intelligence, cyber defense, hypersonic technologies, and electronic warfare.

2. Simplified Export Controls: One of the main goals of the AUKUS Pillar II initiative is to facilitate easier transfer of technology between the United States, the United Kingdom, and Australia. Therefore, the license might offer a streamlined process for exporting these technologies, reducing bureaucratic hurdles.

3. Enhanced Information Sharing: The license might include provisions for increased sharing of sensitive information and technology among the AUKUS nations, particularly in areas underpinning advanced military capabilities.

4. Compliance with International Regulations: Despite the simplification of trade procedures, the license would still need to comply with international arms control agreements and non-proliferation treaties.

5. Cybersecurity and Data Protection Measures: Given the sensitivity of the technologies involved, the license would likely incorporate strict cybersecurity and data protection guidelines to safeguard against espionage and unauthorized access.

6. End-Use Monitoring and Restrictions: There would likely be strict controls on the end-use of the technologies and equipment transferred under this license, to ensure they are used only for intended purposes and do not fall into unauthorized hands.

7. Collaboration in Research and Development: The license might include provisions for joint R&D efforts, sharing of testing facilities, and collaborative innovation projects.

8. Legal and Regulatory Frameworks: The license would need to be embedded within the legal and regulatory frameworks of each country, respecting their sovereign laws while facilitating cooperation.

The AUKUS Pillar II License represents a step in defense collaboration, aiming to enhance the collective technological capabilities of the participating nations while maintaining a balance with global security concerns and international law.

There’s a New Launch Pad Down Under

With the upcoming AUKUS Pillar II License facilitating restricted arms trade and technology exchange among the AUKUS partners, Australia is positioning itself at the forefront of a range of technologies. Additionally, Australia recently signed its own TSA with the US which will open space launch programs down under.

Australia's Aggressive Moves In Space

Australia has capitalized on the opportunities presented to it by AUKUS, and recently signed a Technology Safeguards Agreement (TSA) on the 25th of October with the United States. This agreement, symbolizing deepening ties between the two countries, enables the launch of US space vehicles from Australian soil and fosters technology sharing. Equatorial Launch Australia (ELA) has been a notable beneficiary, and is preparing to finalize contracts with US rocket manufacturers for launches from the Arnhem Space Centre in the Northern Territory.

The precise demand for Australian launch sites from American launch companies remains unclear. The ELA statement included an illustration of four small launch vehicles from ABL Space Systems, Astra, Phantom Space and Vaya Space, as well as Rocket Lab’s Neutron medium-lift rocket.

Of those companies, the only one that ELA had previously identified as a prospective customer is Phantom Space. In April, the two companies said they were expanding a previously undisclosed memorandum of understanding with plans for a “multi-launch contract” for Phantom’s Daytona rocket. That rocket has yet to make its first flight although Phantom’s website states it is “booking launches for 2023.” Spacenews

Australia's strategic advancements in the space sector, particularly through the AUKUS Pillar II License and the Technology Safeguards Agreement (TSA) with the United States, signify a monumental leap in its defense and aerospace capabilities.

The recent developments, align with the Australian Government's ambitious goal to triple the size of its space sector from an estimated AUD$4 billion in 2016 to AUD$12 billion by 2030. This expansion is supported by over AUD$2 billion in civil space sector investments since 2018, and an additional AUD$17 billion allocated for developing defense space capabilities as part of the 2020 Force Structure Plan. The TSA paves the way for U.S. commercial space launch vehicles to operate from Australian soil. This agreement not only enhances Australia's capacity in earth observation, space tracking, and satellite operations but also solidifies its role in global partnerships like the Five Eyes intelligence alliance. By fostering these international collaborations and heavily investing in its space sector, Australia is poised to become a pivotal player in the global space industry, bolstering its technological, economic, and strategic standing on the world stage.

Our focus on innovation also extends to space, where we look forward to tomorrow's signing of a space Technology Safeguards Agreement that creates the potential for new space-related commercial opportunities while providing the legal and technical framework to protect sensitive US space launch technology and data in Australia consistent with our shared non-proliferation goals. We also welcome progress in negotiations of a bilateral space framework agreement, and encourage further joint commercial investment across all sectors, including space situational awareness and commercial space stations. Joint statement from Prime Minister Albanese and President Biden

Regulatory Challenges in NZ Space

New Zealand, while deliberating its role in the AUKUS alliance, observes neighboring Australia making significant strides in defense and space capabilities. In New Zealand's space technology industry, the intersection of defense technology and commercial ventures presents unique challenges and opportunities. While New Zealand has a Technology Safeguards Agreement (TSA) with the United States for space launch vehicles, companies like Rocket Lab face stringent restrictions on conducting R&D activities locally. This limitation hampers technological progress and workforce development within New Zealand's space sector. The Australian space industry on the other hand will have much more open access to US technology. As a publicly traded entity, Rocket Lab's primary obligation is to its shareholders, driving it to operate in environments that offer the most favorable conditions for growth and innovation.

The TSA inhibits local development

A crucial aspect of New Zealand's TSA with the United States includes a commitment that New Zealand will not develop or acquire missile technology control regime category I rocket systems without prior consultation with the US government. This clause significantly curtails New Zealand’s ability to independently develop certain technologies, aligning its space sector closely with US interests and regulations. The TSA's constraints pose a strategic challenge for New Zealand’s space tech industry, particularly for companies aiming to innovate and expand in the field of rocket systems. This limitation not only affects the scope of research and development activities but also impacts New Zealand’s stance in the global space technology arena.

Balancing International Commitments and Local Innovation

New Zealand's commitment to the TSA necessitates a delicate balance between adhering to international agreements and fostering local innovation within the allowed parameters. Companies like Rocket Lab, operating under the umbrella of these restrictions, must navigate a complex landscape where their growth strategies are intertwined with regulatory compliance and international diplomacy.

Operational Strategies within TSA Boundaries To work within these constraints, New Zealand’s space tech sector needs to:

1. Focus on Non-Restricted Areas: Prioritize development in areas not restricted by the TSA, leveraging New Zealand’s unique strengths in the space sector. Encourage innovative approaches within the regulatory framework in areas like satellite technology, Earth observation, and space tracking.

2. Outsource Restricted Development: The US office for Rocket Lab conducts the development for the restricted technologies such as engines. Operations in Australia will have more R&D flexibility going forward too.

3. Strategic Collaboration: Engage in strategic partnerships that align with the TSA’s stipulations, ensuring compliance while seeking growth opportunities.

The Technology Safeguards Agreement with the United States presents both challenges and opportunities for New Zealand’s space technology sector. Companies like Rocket Lab, while operating within these limitations, have the potential to explore and expand in complementary areas of space technology, however they will be required to expand development operations outside of New Zealand to keep innovating in core rocket systems.

Companies Will Offshore Without Some Form of AUKUS Tech Sharing in NZ

Rocket Lab, a global leader in launch services, has been quick to adapt to the changing regulatory dynamics. The company, which has roots in New Zealand, announced the establishment of a wholly-owned subsidiary in Australia, Rocket Lab Australia in February 2023, to support the expansion of Australia’s national space capabilities. This move is a strategic response to the Australian government's commitment to tripling the size of its space sector by 2030, backed by substantial investments.

New Zealand's hesitation in deepening its ties with AUKUS and its space and defense initiatives poses a significant risk, particularly to its space industry. Without active participation in agreements similar to the AUKUS Pillar II or tangential initiatives, New Zealand risks losing out on technological advancements and strategic partnerships. Companies like Rocket Lab, with a strong presence in New Zealand, may increasingly shift their focus towards more supportive and integrated markets like Australia and the US. This could relegate New Zealand's role in such companies to lesser value-added functions like manufacturing, maintenance, and localized launches.

Should this trend continue, New Zealand’s space sector could face a reduction in innovation and technology transfer, impacting its global competitiveness and attractiveness for future investments. The country will also miss out on being part of cutting-edge developments in areas like quantum technologies, AI, and advanced cyber capabilities, which are at the forefront of the AUKUS Pillar II initiatives.

New Zealand stands at a crossroads

To maintain and grow its space sector, it must consider more proactive engagement in global defense and space alliances. This might involve seeking partnerships or agreements that parallel the AUKUS framework, fostering an environment conducive to technological innovation and investment. As Australia shows, such involvement can catalyze significant growth and positioning in the rapidly evolving global space industry. For New Zealand, the time to act and carve its path in this dynamic landscape is now.

Frontier Models are Basic Platforms

First off, it is worth putting frontier models in context for business. In the rapidly evolving landscape of Artificial Intelligence (AI), frontier models are in a category of their own. While numerous powerful AI models have become accessible through open-source platforms, it's the frontier models that are set to redefine the AI paradigm. These advanced models are not just iterations of existing technology; they represent a leap into a future dominated by a few global entities capable of sustaining the massive capital and resource investments required for their development.

The Race for Scale

Unprecedented Scale and Complexity: Frontier models are distinguished by their sheer scale and complexity, which demand vast computational resources and sophisticated development processes. This scale isn't just about size; it's about the ability to process and learn from an exponentially larger set of data, leading to more nuanced and accurate AI capabilities.

An Arms Race for AI Dominance: As outlined in the article "AGI: Scale Is All You Need," the development of frontier models is akin to an arms race, with scale being the critical factor. Model size has increased by 17.6x each year for the last decade. Expanding AI model sizes put extraordinary pressure on 1) AI Hardware Performance, 2) AI Model Efficiency and 3) AI Infrastructure Scaling. Companies are rapidly scaling up their AI models, betting on the premise that larger, more complex models will unlock new capabilities and opportunities, potentially leading to Artificial General Intelligence (AGI).

The Dominance of Global Giants: Developing these frontier models is not just a technical challenge but also a significant financial undertaking. Only a handful of global companies have the financial muscle and technical prowess to compete in this arena. This concentration of capability leads to a scenario where AI's future is shaped by a few major players, each vying for technological supremacy.

The Implications of Scale: The race for scale in AI development has far-reaching implications. It's not just about who can build the biggest model; it's about who can effectively harness such a model to solve complex, real-world problems. These will come from use cases built on top of many of these frontier platforms. This race will likely lead to breakthroughs in various fields, from healthcare to autonomous systems, fundamentally altering the technological landscape.

Navigating the Future

Strategic Partnerships and Collaborations: For companies outside the circle of these global giants, collaborations and building on top of their platforms is vital. Engaging with leaders in AI can provide access to frontier technologies, enabling smaller players to leverage these advancements for their own competitive advantage.

Investing in Complementary Technologies: Companies must also invest in complementary technologies and infrastructure that can support the integration and application of these frontier models. This includes cloud computing, data analytics, and cybersecurity.

Standalone AI Does Not Create Value

Despite considerable investments and high expectations, many companies find themselves grappling with the harsh reality that AI alone doesn't automatically translate into business success. A 2019 survey revealed that 40% of businesses failed to realize the anticipated benefits from their AI investments, highlighting a crucial lesson: Like the business IT revolution in the second quarter of the last century, AI is not a standalone solution for value creation but a tool that must be strategically integrated into broader business processes and objectives.

Understanding AI's Role in Business

The allure of AI has captivated many, yet its standalone implementation often falls short of delivering tangible business benefits. This disconnect highlights the need for a more nuanced understanding of AI's role in value creation.

The Necessity of Complementary Assets: Like any transformative innovation, AI requires a supportive ecosystem to flourish. This necessity extends beyond the technology itself to include compatible products, technologies, or services. Just as mobile phones require network connectivity and airlines need airports, AI needs an enabling environment to unlock its potential.

Embedding AI for Customer Value: The true power of AI emerges when it is intricately woven into complementary offerings. This integration ensures that AI not only functions efficiently but also enhances the overall value proposition to the customer.

The Limited Reach of Standalone AI: Companies lacking the capabilities or resources to offer these complementary elements may find their ability to leverage AI constrained. Without a holistic approach, AI's promise remains unfulfilled.

The crux of AI-driven value lies in the broader ecosystem - market access, hardware sensors, data, and technical expertise. Understanding and investing in these areas is crucial for businesses to fully leverage AI. Success with AI demands more than just adopting the technology; it requires a strategic vision to integrate AI. To move beyond the hype, businesses must critically assess how AI fits into their broader strategy and ecosystem, ensuring that it complements and enhances their core offerings.

IT is a Cost, AI Creates Value

In today's digitized world, the dilemma of 'Buy it or Build it' resonates strongly, especially when juxtaposing Information Technology (IT) and Artificial Intelligence (AI). While IT forms the backbone of modern enterprises, often categorized as a necessary yet undifferentiated operating cost, AI emerges as a transformative General-Purpose Technology (GPT) that unlocks value from data, enhancing product offerings and competitive edge.

The Strategic Crossroads: AI vs. IT

IT: Essential but Standardized: IT services, encompassing infrastructure like servers, networks, and software, are indispensable for business operations. However, they represent a baseline requirement, a cost of doing business that, while critical, offers limited differentiation. Many companies, irrespective of size, rely on external IT service providers for efficiency and cost-effectiveness, as the value lies in stable operations rather than innovation.

AI: A Catalyst for Value Creation: AI stands in stark contrast to traditional IT. It’s not just a tool but a driver of innovation, capable of analyzing vast datasets to reveal insights, optimize processes, and even predict market trends. AI's ability to transform data into actionable intelligence makes it a source of competitive advantage, rather than just a cost center.

Outsourcing AI vs. Outsourcing IT

Outsourcing IT – A Practical Necessity: For most businesses, outsourcing IT is a practical decision driven by cost, efficiency, and access to specialized expertise. It's a model that works because IT needs, while complex, are relatively standardized across industries.

Outsourcing AI – A Double-Edged Sword: The decision to outsource AI through a Data Analysis Intermediary (DAI) is more nuanced. On one hand, external AI providers offer advanced capabilities and expertise that may be too costly or complex to develop in-house. On the other hand, AI’s strategic value is closely tied to a company's unique data and specific operational needs. Outsourcing AI risks losing control over these critical strategic assets.

The Balance of Innovation and Control: The key in AI adoption is balancing innovation with strategic control. While outsourcing can accelerate AI integration and bring immediate benefits, building in-house AI capabilities can offer long-term strategic advantages, ensuring that the value derived from AI is unique and tailored to the company's specific needs.

The 'Buy it or Build it' question for AI in business strategy is not just about technical capability but about sustaining competitive advantage. While IT services can be efficiently outsourced as operational necessities, AI demands a more considered approach. For businesses looking to not just survive but thrive in the AI era, the focus should be on how to best leverage AI to extract unique value from their data and operations. Whether through outsourcing for speed and expertise or investing in in-house development for strategic control, the ultimate goal is to harness AI as a tool for innovation, growth, and market differentiation.

Buy it or Build it: Downsides of Outsourcing AI

1. Intensive data sharing needed: Maximizing AI benefits requires sharing sensitive information about products and assets, where the DAI lacks expertise.

2. Net zero competitive advantage: Using data, a DAI will enhance services for competitors, which offers no unique advantage to to the data owner.

3. Creates dependence on a black box:  A DAI’s influence over a companies systems will create a strategic dependency on opaque technology.

4. Data Science as a sole offering: Data owners generally already have the necessary market access, sector expertise and often data infrastructure. AI models are all open source and don’t offer a standalone competitive advantage. DAI’s in some industries will look more like undifferentiated data management and analysis services which use open source tools.

DAI Exception, Sensitive Industries

Data Analysis Intermediaries (DAIs) are emerging as vital players in sectors where direct data exchange is mired in conflicts of interest, such as the pharmaceutical industry. Their role as neutral intermediaries enables them to navigate sensitive data landscapes, particularly where direct transactions between data sources (like clinics) and end-users (like pharma companies) are problematic. However, while DAIs will become a ‘must have’ for companies in restricted industries to remain competitive, they will provide a 'net zero' competitive edge when servicing multiple clients within the same industry.

The Neutral Middleman in High-Stakes Industries

In industries like pharmaceuticals, direct data transactions between clinics and pharma companies can be fraught with ethical and legal complexities. DAIs step in as neutral parties, bridging this gap without the direct conflict of interest that might plague clinics or pharmaceutical companies. The company Prospection exemplifies this intermediary role by purchasing health data from clinics and turning it into actionable insights for pharmaceutical companies. This arrangement allows for data utilization without direct conflict, ensuring that sensitive health data is used ethically and responsibly.

The Value Proposition of DAIs

1. Expertise in Data Processing and Analysis: DAIs specialize in deciphering complex data sets, a task that requires a unique blend of technical skill and industry knowledge. This expertise allows them to extract meaningful patterns and insights that would be challenging for companies to achieve internally.

2. Customized Insights for Targeted Strategies: The insights provided by DAIs are highly customized. In the case of Prospection, the analysis can reveal specific market needs, effectiveness of drugs, and patient outcomes, enabling pharmaceutical companies to tailor their strategies effectively.

3. Cost-Effective Solution for Data-Driven Decisions: For many companies, particularly in specialized sectors like healthcare, developing in-house data analysis capabilities can be prohibitively expensive. DAIs offer a cost-effective alternative, providing high-quality insights without the need for significant internal investment.

DAIs play a pivotal role in the data ecosystem. They act as the crucial link between data collection and its practical application. By analyzing raw data, they transform it into strategic insights, thereby enabling companies to make informed decisions. Prospection stands out as a case study in the healthcare sector. By purchasing data related to drug usage and health condition markers, they apply sophisticated analytical methods to uncover patterns and trends. These insights are invaluable for pharmaceutical companies, helping them refine their marketing strategies and optimize drug development.

The Double-Edged Sword of DAI Services

1. Net Zero Competitive Edge: While DAIs offer valuable insights, their service to multiple clients within the same industry can lead to a 'net zero' competitive advantage. If all competitors have access to similar insights from the same DAI, the competitive edge that such insights might offer is essentially neutralized.

2. Dependence on External Insights: Reliance on DAIs for critical data analysis can lead companies to become overly dependent on external sources for strategic decision-making. This reliance can limit internal development of data capabilities and market differentiation.

Strategic Implications for Companies Using DAIs

1. Balancing External Insights with Internal Capabilities: Companies need to leverage the insights provided by DAIs while also investing in their internal data analysis capacities. This dual approach ensures diversity in strategic data use and reduces over-reliance on external sources.

2. Differentiating Through Customized Application: To overcome the 'net zero' competitive challenge, companies need to apply DAI-provided insights in unique ways, integrating them into broader, customized strategies that differentiate them from their competitors.

DAIs can offer a crucial service in complex markets like pharmaceuticals, acting as neutral intermediaries in scenarios where direct data exchange is not feasible or ethical. However, their role as providers to multiple industry players can equalize the competitive landscape, necessitating innovative and strategic application of their insights. Companies will need to balance the use of DAIs with the development of internal capabilities and ethical considerations, ensuring that they maximize the value of data while maintaining competitive differentiation and regulatory compliance.

Key Takeaways

Read more

If you haven’t already, take a look at our piece last week that puts the strategic technology competition into context:

The Big Glut in Chip Production

Zhao Haijun, the co-chief executive of SMIC, recently highlighted a significant shift in the global semiconductor landscape. He pointed out that "geopolitical factors" are leading to the duplication of supply chains and construction efforts in the industry. This shouldn’t come as a surprise to folks in the industry. This situation, as Zhao noted, results from a rapid buildup of production capabilities over the past few years, now facing the challenge of finding a market for the increased output.

Zhao Haijun, SMIC’s co- chief executive, said on Friday that “geopolitical factors” were causing “duplication of construction and supply chains”.

“From a global perspective, there will be excess production capacity,” he said, “and it will take a lot of time to slowly digest the production that has been built hastily in recent years.” Financial Times

This observation aligns with recent developments in the Chinese semiconductor sector. Before recent bans, Chinese chip equipment companies had little incentive to innovate or develop cutting edge technologies. They operated in a market that was efficiently catered to by foreign firms, with no strategic compulsion to excel in the domain. However, the imposition of bans changed this dynamic.

From April to September, there was a conspicuous surge in Chinese imports of chip-making equipment. From a modest figure of $1.5M in April, imports climbed steeply to an impressive nearly $4M by September. This sudden spike has undeniably boosted businesses in the US, Japan, and the Netherlands, where major semiconductor capital equipment manufacturers are based. Chinese fabs, eager to secure equipment ahead of bans, have been on a buying spree, accumulating significant volumes of foreign chip-making equipment.

Yet, this influx of foreign machinery might be a double-edged sword for China's semiconductor ambitions. While Chinese firms are stocking up on foreign tech, they could inadvertently be closing the doors on their domestic chip equipment manufacturers. The longevity of chip-making equipment, which can be operational for up to 15 years, means that once a chip manufacturing facility is equipped, there is little room for replacements or additions for many years.

The ideal scenario for countries like the US would be for China to become heavily reliant on foreign chip making technology. This would not only assure consistent demand from China for many years but would also stifle the growth of potential competitors in China's domestic market. For burgeoning Chinese equipment makers, this presents a daunting challenge. The road to matching global leaders in semiconductor machinery is already steeped in complex technical challenges. If domestic sales opportunities diminish, these firms will struggle to gather critical operational data needed to refine and optimize their machines.

China Falling Further Behind on Datacenter Scale

The United States currently holds a leading position in the global hyperscale data center market, hosting over half of the world’s capacity in this sector. Out of more than 800 major data centers worldwide, 53% are located in the U.S. Europe accounts for 16%, China for 15%, and the rest of the world makes up the remaining 16%.

AI winter in China: In the context of China's tech industry, there's a notable divergence in the fortunes of different sectors. While China's large-scale tech companies, or Hyperscalers, have been navigating through restrictions effectively, leveraging scale and inventory, the country's AI startups have been struggling. A significant portion of the funding for AI startups, sometimes up to 80%, is typically allocated to computing resources. The restrictions on American chip technology have severely impacted venture capital investments in China's AI sector. From a high of $30 billion in 2018, AI venture capital in China has plummeted to just $2 billion in 2023. In contrast, the U.S. reached its peak AI venture capital investment of $120 billion in 2021, which has since reduced to $50 billion in 2023.

GPU boom in the US: Even though some Nvidia chips remain accessible to China, the country is still trailing behind the US in scale. Data on Taiwan’s exports of computer parts, including GPUs, highlights this disparity. While the U.S. has seen a substantial increase in Taiwanese computer parts imports – up 50% year-over-year in April and 100% in May – exports from Taiwan to China have decreased by 30% year-over-year in these same months.

China chips good, tech bad: This trend underscores the broader impact of U.S. technology restrictions on China. These bans have compelled Beijing to redirect significant resources towards its semiconductor industry. This shift, however, has had the unintended consequence of depriving the burgeoning AI sector of critical investments and resources in the short term.

Global cloud services growing: Global spending on cloud infrastructure services reached over $68 billion in Q3, marking an 18% year-on-year increase and a $10.5 billion growth from the same quarter last year. This surge represents the fifth consecutive quarter of significant growth in the cloud market. Despite economic and political challenges, generative AI technology is playing a key role in driving this expansion. The quarter-on-quarter growth was notably high at 5%, the most substantial since 2021, excluding typical Q4 peaks.

Cloud services are an important leverage point to keep open to China: While the U.S. is considering limiting China's access to American cloud computing services, a complete ban would be counter productive due to the strategic advantage it offers. U.S. cloud services, particularly those using high-end GPUs not available in China, could give Chinese IT and AI companies using them a competitive edge over local firms while increasing reliance on US services. Consequently, Beijing will need to focus on enhancing its domestic cloud infrastructure to mitigate reliance on foreign providers, balancing technological progress with strategic security.

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No design arounds in new restrictions

The new October 2023 export controls are tighter for AI chips and semiconductor equipment going into China by 1) closing technical loopholes to only allow 5-year-old GPUs, over 10x less powerful than the leading edge and 2) to control exports to additional ‘countries of concern’ akin to arms controls. It will be unlikely that Nvidia can design around the new controls in a meaningful way. Huawei’s best GPU already exceeds the limitations of the restrictions, so fabricating this chip locally will be China’s best option, alongside older Nvidia chips to meet local demand.

For a deeper analysis of this topic, refer to our previous post here (Arms Controls for Advanced AI Chips)

US is well ahead in AI

The US currently has a multi-year lead on China in AI owing to starting earlier, more VC investments, depth of talent and AI hardware advantages. Entities in the US publish 70% of the most cited AI papers, and US AI unicorns hold almost 80% of the total enterprise value of AI unicorns globally.

For a deeper analysis of this topic, refer to our previous post here (AI Technology Too Important to Lose)

The Chip Choke strategy has morphed into a Mow the Grass strategy

Large platforms like the entire industrial base of a powerful country are adaptive and resistant to narrow strategic targeting. The ‘Chip Choke’ strategy initiated by President Trump has morphed into a ‘Mow the Grass’ strategy, which cuts off threatening or high value targets. This has the unintended consequences forcing Chinese innovation in chip manufacturing; however, it also diverts China’s resources into catching up. China, which once aimed for complete technological dominance, now finds itself having to selectively focus on key technologies.

Too early to say the restrictions have failed. China chips boom while AI suffers

While China’s Hyperscalers have managed through restrictions with scale and inventory, AI startups have floundered. Up to 80% of raised capital for an AI startup can go into compute resources, and without access to American chips, AI VC in China has become suicidal. China AI VC has shrunk over 90% from its peak of $30B in 2018 down to $2B in 2023, while the US peaked at $120B in 2021 and is down to $50B in 2023.

For a deeper analysis of this topic, refer to our previous post here (China Tech Ban Defensive Tactics)

Beijing’s policies that hinder China’s tech sector are a feature of Chinese policy making, not a bug

While China had ambitions to be a world leader in tech, it seems they have recalibrated their approach to prioritize domestic stability and preservation of culture.

“I think among the richest men in China, few have good endings.” Jack Ma 

Panic buying of chip making equipment will support Q3 earnings of equipment suppliers

Chinese imports of chip-making equipment rose from $1.5M in April, to $4M by September. This sudden spike will boost business for chip capex companies in the US, Japan, and the Netherlands.

Cloud services are an important leverage point to keep open to China

Washington is contemplating restricting Beijing's access to cloud computing services offered by American enterprises. However, reliance on U.S. cloud services provides the strategic option to disrupt Chinese companies’ operations instantaneously. Chinese IT and AI firms that leverage U.S. cloud services using the most high-end GPUs (unavailable in China) might gain a competitive edge over their domestic counterparts. In that situation, it could be in Beijing’s interests to promoting domestic cloud infrastructure and services. Relying on foreign cloud providers poses not just technological, but also strategic risks for China.

Read our previous piece for a background on the controls:

Key Takeaways

• NVidia A800/H800 Can’t be Sold to China Anymore: NVidia responded to the October 2022 ban by developing AI chips tailored for the Chinese market, the A800 and the H800, ensuring it remained just beneath the performance benchmarks. The new October 2023 restrictions closes this loophole, which blocks the NVidias A800 and H800. Chinese companies will be limited to much older chips, like NVidias V100, which was released in 2017 based on 12nm, and is many times less powerful that the A100 and H100.

• NVidia Probably Won’t be Designing Around these Sanctions: While companies like Nvidia may contemplate introducing China-specific chip designs to maneuver around these regulations, the constraints imposed by the performance density rule make this almost impossible. However, if there is a way, NVidia will find it.

• Diverse Chip Combinations as a Solution: Chinese companies are merging three or four older-generation chips to emulate the capability of Nvidia's top processors. This approach requires AI systems, where NVidia has a huge multi-year lead on Chinese counterparts. However, given that NVIDIA chips possess an impressive lifespan – with a 5-year span from launch to peak popularity – Chinese enterprises maintain a good lifetime with their acquired A800 and H800 models.

• Continued Progress Required Systems, Algorithms AND Hardware: While China may face challenges in developing competitive hardware, algorithms offers a pathway for development. However the big behemoth in the room is model size, which has increased by 17.6x each year for the last decade. Expanding AI model sizes put extraordinary pressure on 1) AI Hardware Performance, 2) AI Model Efficiency and 3) AI Infrastructure Scaling. Losing out on any of those fronts will kill an AI company’s competitive edge. For growth, software alone isn’t enough.

• Chinese GPU designers will turn to local fabs: In the immediate future, Huawei appears to be the front-runner for local chip designs. Huawei has successfully produced a 7nm ASIC using SMIC. The 2019 Ascend 910 from Huawei already surpasses existing regulations, implying that a homegrown successor would likely outpace anything Nvidia is permitted to deliver to China. While the immediate outlook appears bleak for sanctions Chinese GPU companies, with the unwavering support from the Chinese state, these firms have the opportunity to pivot to domestic production alternatives.

• Chinese Hyperscalers can access chips unlike start-ups: Well-established corporations like Alibaba or Tencent have the financial muscle and strategic agility to navigate these challenges. The scarcity of GPUs benefits the major cloud players on a relative basis while posing challenges for smaller firms who lack the scale and inventory to access hardware. This is in contrast to the U.S., where startups have easy access to the necessary hardware, fostering innovation and the development of new models.

• National priorities and lack of hardware will thin out Chinese AI: As the nation grapples with limited AI chip resources, priority will undoubtedly be given to projects of national significance. Those deemed non-essential might find themselves sidelined or abandoned altogether. This stringent resource allocation, encompassing both financial investments and compute power, underscores the necessity for China to adopt an extremely streamlined approach to resource management. While such a strategy may keep them in the race, it concurrently risks thinning the depth and diversity of their AI ecosystem.

• Chinese AI startups face a glaring capital crunch: Instead of fueling AI innovations, the bulk of China's tech risk capital is channeled into chip development, leaving the AI sector to be largely dominated by hyperscalers. This landscape presents an almost absurd risk for venture capitalists. The majority of funds raised by AI startups in are immediately consumed by the pressing need to purchase GPUs and critical infrastructure. Without these essential components, startups can't even take their first steps. AI funding in China soared to a remarkable $30B in 2018 but has witnessed a precipitous decline since, with projections standing at a mere $2B for 2023. Meanwhile, the U.S. AI startup ecosystem thrives, consistently securing over $30B annually since 2018 and reaching an astounding peak of $66B in 2021. The gap is widening.

Chip Choke Trumps the Credit Crunch

Beijing continues to prioritize investments in its semiconductor industry amidst the technological rivalry with the U.S., rather than unleashing broad economic stimulus measures. This prioritization demonstrates the willingness to safeguard economic security, possibly at the expense of short-term economic growth.

China's economic revival remains sluggish. While China unleashed a 4 trillion yuan stimulus post the 2008 financial crisis, there are no signs indicate a bazooka approach now, with local governmental debts and slowing tax revenue growth being barriers. The country's tax revenue was 13.8% of its GDP in the previous year, a decline of nearly 5% since 2014.

On Tuesday, 24th October, the government significantly increased its headline deficit, marking the largest in three decades, and introduced a sovereign debt package deviating from its conventional fiscal support model. This one trillion yuan ($137 billion) boost marks a departure from the 3% cap on the deficit-to-GDP ratio. Notably, instead of the massive "bazooka" stimulus seen in previous downturns, the current budget increase, equivalent to approximately 0.8% of GDP, remains modest. The emphasis of the stimulus remains on construction, specifically targeting post-flood recovery and disaster prevention, aligning with Xi's dual objectives of economic growth and security.

Amid budgetary limitations, Beijing emphasizes sectors like domestic semiconductors and electric vehicle production, preparing another $40 billion dollar semiconductor fund. Recently, Beijing declared expanded tax benefits for semiconductor and machine tool sectors, allowing a 120% tax deduction on R&D expenses for five years. We remind readers of our assessment that for China to develop an indigenous supply chain at current 5nm technology levels could take to the end of the decade.

Beijing's prioritization of chip investments ($40B on one technology) compared to broader stimuli ($137B across many sectors) underscores its significance in the eyes of Chinese leadership. Given the transformative potential of AI in bolstering productivity and military power, this could be decisive for China's long-term trajectory. In the absence of foreign cutting-edge chips, a looming question is whether China's AI evolution can remain competitive, ensuring significant productivity and military enhancements even when reliant on dated chip technology.

Defensive Tech Tactics

Under tech restrictions, Chinese companies will need to innovate and effectively mix AI chips, run efficient AI programs on less efficient supercomputers, and design good enough domestic GPU accelerators. Consequently, the current restrictions on AI chips and chip manufacturing technology may mean that Beijing has to press pause on it’s global technology leadership bid, but may not pose an existential threat.

“I definitely think it’s true that the interventions that have been taken so far on the export controls, are likely to have a seismic impact on China's ability to train the next generation of frontier models. Fundamentally all training depends on these chips, Nvidia GPUs and each generation is way more powerful than the previous.” Mustafa Suleyman, founder of DeepMind

Tactic 1: Mix and Match the Foreign Chips

U.S. sanctions have prompted Chinese tech firms to hasten research for advanced artificial intelligence (AI) capabilities without depending on American semiconductors. An analysis by the Wall Street Journal indicates that companies, including Huawei, Baidu, and Alibaba, are exploring methods to maximize the performance of their existing chips without relying solely on the newest models. Additionally, they are experimenting with combining various chip types to diversify their hardware dependence.

Strategic Resource Allocation in Chinese Tech Giants

After February this year, companies such as ByteDance, which already have significant cloud computing stakes, increased their orders with NVIDIA. ByteDance, for example, placed orders worth over $1 billion on GPUs. Meanwhile, firms that had already stocked up on A100s, like Alibaba and Baidu, are now limiting the use of these advanced foreign chips, reserving them for more intensive computational tasks. Baidu has even paused using its A100s for departments like its self-driving unit to allocate them for the development of its ChatGPT equivalent, Ernie Bot. 

NVidia A800/H800 Can’t be Sold to China Anymore

The US banned leading edge NVidia chips from being sold to China in October 2022. However, driven by the allure of short-term profits, NVidia responded to the BIS constraints strategically. The tech giant developed AI chips tailored for the Chinese market, the A800 and the H800, ensuring it remained just beneath the performance benchmarks set by the U.S. Commerce Department. This crafty move allowed the A800/H800 to substitute the A100/H100 in data centers, bypassing the newly imposed restrictions with comparable performance for AI training workloads.

The new restrictions with the “Total Processing Performance” (TPP) and “TPP Density” metrics solves this loophole, which blocks the NVidias A800 and H800. It also means a range of other chips from Intel and AMD are banned too, see SemiAnalysis table below for examples of chips that are allowed and banned. Chinese companies will be limited to much older chips, like NVidias V100, which was released in 2017 based on 12nm, and is many times less powerful that the A100 and H100.

NVidia Probably Won’t be Designing Around these Sanctions

The debate surrounding the concept of "performance density" in the context of chip export controls is intricate. Recent suggestions have surfaced, proposing the expansion of the processor area as a means to dilute performance density, thus potentially bypassing regulations. However, experts have countered this line of thought, arguing that such design modifications would severely compromise chip performance, effectively nullifying the intent behind such design alterations. Specifically, while companies like Nvidia may contemplate introducing China-specific chip designs to maneuver around these regulations, the constraints imposed by the performance density rule make this almost impossible. Adopting strategies such as incorporating blank silicon to artificially inflate the chip's size won't pass muster, as regulations account for such tactics. Essentially, any hardware adhering to these stipulations won't be efficient enough to run large transformers, rendering the design workaround futile. This highlights the stringent nature of the "performance density" criteria, ensuring chip manufacturers can't sidestep regulations without sacrificing the chip's core functionality and efficiency.

Diverse Chip Combinations as a Solution

Chinese companies are now merging three or four older-generation chips to emulate the capability of Nvidia's top processors. This methodology, however, can be expensive and slow. This scenario has motivated some enterprises to fast-track the creation of techniques for training expansive AI models across an assortment of chips. Giants like Alibaba, Baidu, and Huawei have been documented trying various combinations of A100s, older Nvidia chips, and Huawei Ascends to optimize performance while managing costs.

AI systems, where NVidia has a huge multi-year lead on Chinese counterparts, requires engineering out a diverse set of problems. AI accelerator systems address challenges like the "memory wall problem", the gap between computational speed and memory accessibility. Distributing tasks across multiple accelerators presents its own set of challenges, including communication limitations. Addressing these challenges might require multiple years for Chinese companies to develop systems that provide a combination of more strategic deployment methods, and a rethinking of AI accelerator designs to balance computational and memory needs. Or alternative implementations of AI models entirely.

Given that NVIDIA chips possess an impressive lifespan – with a 5-year span from launch to peak popularity – Chinese enterprises maintain a good lifetime with their acquired A800 and H800 models.

In 2023, all eyes were on NVIDIA’s new H100 GPU, the more powerful successor to the A100. While H100 clusters are being built (not without hiccups), researchers are relying on the V100, A100 and RTX 3090. It is quite remarkably how much competitive longevity NVIDIA products have: the V100, released in 2017, is still the most commonly used chip in AI research. This suggests A100s, released in 2020, could peak in 2026 when the V100 is likely to hit its trough. The new H100 could therefore be with us until well into the next decade! State of AI Report

Tactic 2: More Efficient AI Models

Innovation isn't always about sheer power—it's about using resources effectively. While the U.S. often emphasizes maximizing resources, other nations have thrived by focusing on efficiency. History provides ample evidence of this dynamic.

The Japanese Case Study: Vehicles and Appliances

During the latter half of the 20th century, the Japanese auto industry disrupted the global market with a unique proposition: highly efficient, reliable, and affordable vehicles. Instead of the gas-guzzling behemoths popular in the U.S. where fuel was cheap, brands like Toyota and Honda introduced models that were fuel-efficient and required fewer repairs. Similarly, in the realm of home appliances, Japanese companies like Daikin took the lead in air conditioner innovation. While American manufacturers focused on raw cooling power due to cheap electricity, Japanese models were designed with energy efficiency and compactness in mind. This strategic emphasis on efficiency propelled Japanese brands to the forefront of the global market, with their products being synonymous with reliability and value. 

The Algorithmic Era and AI's Evolution

Algorithms are sets of rules driving operations, allowing AI systems to utilize computational resources to analyze data. While processing more data is one method, there's a trend of refining these algorithms to achieve results with fewer resources. One study showed that “every nine months, the introduction of better algorithms contributes the equivalent of a doubling of computation budgets”. When compared with Moore's Law, where computer power doubles every two years, it's evident that efficient algorithms will contribute more to the rate of change of AI than raw compute power. However, multiplied out over the long term the world leaders will develop both hardware and software.

Currently, the industry overfits to exploring AI techniques that work well on existing chips, i.e Nvidia GPUs/Google TPUs running variants of transformers. With the AI Accelerator sanctions on China, one interesting result might be that China forks silicon and explores a different idea-space in AI techniques than the rest of the world. After all, the brain and the signals propagating on it look nothing like our current hardware/software architectures either.

China will invest heavily in compute in memory, neuromorphic computing, or some other analog approach. Currently, none of these approaches show promise in transformers or diffusion models, but that says nothing of new model architectures. Semianalysis, Wafer Wars

Continued Progress Required Algorithms AND Hardware

Understanding this is important when examining the trajectory of Chinese firms in the AI sector. While they may face challenges in developing competitive hardware, the nature of algorithms—which can be replicated—offers a pathway for development. However, model size throws a spanner in these gears. To summarize the pace of development:

1. Moore’s Law: transistor density 2x every 2 years.

2. Around every year, AI algorithms become 2x more efficient to run.

3. AI accelerator systems get about 1.8x better performance every year.

Taking the AI accelerator improvements (which already include Moores law) and AI algorithm efficiency gets us 3.6x improvement every year. However the big behemoth in the room is model size, which has increased by 17.6x each year for the last decade. So subtracting out efficiency improvements means that one would have to 14x chip capacity to keep pace with model development. Now, that’s not entirely true because companies can reallocate resources to focus on major projects but the point is that expanding AI models put extraordinary pressure on 1) AI Hardware Performance, 2) AI Model Efficiency and 3) AI Infrastructure Scaling. Losing out on any of those fronts will kill an AI companies competitive edge.

For continued growth, China needs to invest in algorithm development and consider new designs for AI accelerators, rooted in their own chip innovations. Software alone won't be enough.

Tactic 3: Design and Produce Chips Domestically

“Huawei is committed to building a solid computing power base in China – and a second option for the world,” Meng Wanzhou, Huawei CFO

Local Designs Better than Available Foreign Chips: Ramping Up Local Production

Despite the international restrictions on AI chips, China's semiconductor industry is showing resilience and innovation. A notable highlight is Baidu AI Cloud's unveiling of the "Kunlun" 2nd generation 7-nm general GPU. Kunlun's 2nd gen chip has also successfully replaced foreign-made chips in quality inspections, slashing costs by up to 65%. Furthermore, the R&D for the 3rd generation is underway, with mass production targeted for 2024, aiming to cater to the domestic high-end demand.

The short-term path forward is with Huawei. Huawei has taped out a 7nm ASIC on SMIC’s N+2 process node. It is a successor to the Ascend 910 that Huawei launched back in 2019. We hear this chip utilizes chiplets and contains HBM. China stockpiled millions of units of HBM from SK Hynix and Samsung this year. It is not clear where these are being deployed, because there are no high-volume chips domestically produced in China that can utilize these HBM stacks. The only logical conclusion is that these were imported for Huawei’s upcoming chip.

Hawuei’s Ascend 910 from 2019 already breaks the current regulations, so a domestically produced successor would also beat anything Nvidia can legally ship into the country. While some would argue SMIC is not capable, the fact is that their old 14nm was already used to make an exascale supercomputer. The new N+2 node (7nm) is approaching 20,000 WPM of capacity, which is enough for millions of accelerators at even 50% yields. Furthermore, China is rapidly approaching capabilities of manufacturing HBM domestically at CXMT, but more on that in a bit. Semianalysis, Wafer Wars

Comparative Analysis with Nvidia

While it's heartening for Chinese semiconductor manufacturers, it's essential to maintain a comparative perspective. Top Chinese AI chips are broadly analogous to Nvidia chips that were state-of-the-art five years ago. Certain benchmarks have demonstrated Huawei's Ascend 910 matching the performance of Nvidia's V100 in AI workloads. Yet, Nvidia's H100, which China currently cannot access, is a powerhouse, outperforming the older V100 by over 13-fold.

Effect of Entity Listing Biren and Moore

Recent U.S. trade sanctions have put two of China's leading tech companies, Biren Technology and Moore Threads, under immense pressure. These companies, both having the potential to challenge tech giants Nvidia and Advanced Micro Devices (AMD) in the field of graphics processors, now face significant hurdles in their race to the top. Notably, Huawei's Ascend range and Biren's BR100 chips have emerged as promising contenders.

U.S. Sanctions and their Impact

The severity of the U.S. sanctions has led to strong reactions from both Biren Technology and Moore Threads. Biren has called for a re-examination of the U.S. government's decision, while Moore Threads emphasizes its adherence to relevant laws and regulations.

But the new sanctions aren't the first challenges Biren has faced. In October 2022, TSMC, suspended shipments for Biren. Given that Biren designs processors specifically for AI and high-performance computing (HPC) applications, this halt was a significant blow. Mere weeks after the suspension from TSMC, reports emerged suggesting that Biren Technology was preparing to lay off a third of its workforce.

The Silver Lining: Domestic Innovations and Strategic Moves

While the immediate outlook appears bleak for Biren and its counterparts, there's a potential silver lining. With the unwavering support from the Chinese state, these firms have the opportunity to pivot to domestic alternatives. SMIC, with its 14/7nm capabilities, stands out as a viable option for GPU fabrication. Turning to SMIC not only provides an avenue to sidestep current supply chain challenges but also has the added benefit of bolstering domestic Chinese semiconductor capabilities. As these companies transition towards utilizing local fabs, TSMC might witness a shift in demand. This move is not just about surviving current challenges but could mark a strategic realignment, bolstering China's domestic tech industry and reducing its reliance on external players.

China's Mitigation: Scale and Centralization

The centralized and large-scale approach China adopts in many of its technological endeavors could be its trump card:

“On August 30, Alibaba Cloud announced the official launch of its Zhangbei Super Intelligent Computing Center, with a total construction scale of 12 EFLOPS (12 quintillion floating-point operations per second) AI computing power, which will surpass Google’s 9 EFLOPS and Tesla’s 1.8 EFLOPS. The new construction is now the largest intelligent computing center in the world able to provide powerful intelligent computing services for AI large model training, automated driving, spatial geography and other AI exploration applications.”

However Google is already planning a supercomputer that is double the size of Alibaba’s and announced in May a 26 EFLOP supercomputer made with NVidias H100’s or Cerebras’ (US) planned project of 36 EFLOPS in the UAE. Chinese companies still lack the scale of compute of their American counterparts.

Gaping Weakness, Early Stage Start ups

While Chinese tech giants like Alibaba have the resources to maintain a somewhat competitive scale, budding AI startups in China will struggle to find their footing amidst these dynamics. Well-established corporations like Alibaba or Tencent have the financial muscle and strategic agility to navigate such challenges. In China, the scarcity of GPUs benefits the major cloud players on a relative basis while posing challenges for smaller firms who lack the scale and inventory to access hardware. This is in contrast to the U.S., where startups have easy access to the necessary hardware, fostering innovation and the development of new models.

Furthermore, as the nation grapples with limited AI chip resources, priority will undoubtedly be given to projects of national significance. Those deemed non-essential might find themselves sidelined or abandoned altogether. This stringent resource allocation, encompassing both financial investments and compute power, underscores the necessity for China to adopt an extremely streamlined approach to resource management. While such a strategy may keep them in the race, it concurrently risks thinning the depth and diversity of their AI ecosystem. In comparison, the US and its allies, with their expansive technological ecosystems, benefit from a more holistic and layered approach. This multifaceted ecosystem not only aids in fostering innovation but also offers a robust safety net against potential technological or geopolitical shocks.

Chinese AI startups face a glaring capital crunch, painting a stark contrast with their American counterparts. Instead of fueling AI innovations, the bulk of China's tech risk capital is channeled into chip development, leaving the AI sector largely to be dominated by hyperscalers. This landscape presents an almost absurd risk for venture capitalists. The majority of funds raised by AI startups in China are immediately consumed by the pressing need to purchase GPUs and critical infrastructure. Without these essential components, startups can't even take their first steps. In a telling trend, AI funding in China soared to a remarkable $30B in 2018 but has witnessed a precipitous decline since, with projections standing at a mere $2B for 2023. Meanwhile, the U.S. AI startup ecosystem thrives, consistently securing over $30B annually since 2018 and reaching an astounding peak of $66B in 2021. The gap is widening, and it's crucial to ponder its implications for the global AI landscape.

Coming for Cloud

Amid escalating tensions in the tech sphere, the US government is now pondering various measures to restrict Chinese companies' access to American cloud computing services. These measures range in severity, these options include:

• Banning US companies from providing cloud computing services to Chinese companies. This would be the most drastic option, and it would likely have a significant impact on the global cloud computing market.

• Requiring US companies to obtain a license before providing cloud computing services to Chinese companies. This would allow the US government to vet Chinese companies and to block those that pose a security risk.

• Requiring US companies to store data from Chinese companies on servers that are located in the United States. This would make it more difficult for the Chinese government to access this data.

With US companies controlling over 65% of the cloud services market this is a huge point of leverage for the US.

Implementing monitoring systems might involve a multi-tiered approach.

1. Continuous data flow analysis to detect any anomalous or potentially hazardous operations. Advanced AI algorithms could be deployed to recognize patterns that are inconsistent with routine operations.

2. Real-time notifications could be integrated, alerting stakeholders of flagged operations immediately.

3. Automated protocols to block risky AI could be established, wherein high-risk activities could be paused or halted pending manual review.

China's use of US cloud services presents a potentially strategic concern for both nations. In times of escalated geopolitical tensions, the US, serving as the host nation for these cloud services, could technically restrict or cut off access to vital cloud resources for Chinese entities. Such a move would be significant: disabling access to storage, processing capabilities, or other cloud functionalities could severely hamper operations of businesses or even essential services that are reliant on these platforms.

For China, the potential for such disruptions might serve as an impetus to further develop and rely on domestic cloud solutions. By bolstering its indigenous cloud capabilities, China could mitigate risks associated with foreign dependency.

These controls were strategically crafted to address, among other concerns, the PRC’s efforts to obtain semiconductor manufacturing equipment essential to producing advanced integrated circuits needed for the next generation of advanced weapon systems, as well as high-end advanced computing semiconductors necessary to enable the development and production of technologies such as artificial intelligence (AI) used in military applications.

Advanced AI capabilities—facilitated by supercomputing, built on advanced semiconductors— present U.S. national security concerns because they can be used to improve the speed and accuracy of military decision making, planning, and logistics. They can also be used for cognitive electronic warfare, radar, signals intelligence, and jamming. These capabilities can also create concerns when they are used to support facial recognition surveillance systems for human rights violations and abuses. Commerce Strengthens Restrictions on Advanced Computing Semiconductors, Semiconductor Manufacturing Equipment, and Supercomputing Items to Countries of Concern

AI Creates Military Advantage

The way wars are fought has been continually evolving throughout history. From cold steel and gunpowder to tanks and jet fighters, each technological advancement has brought its own set of strategic implications. However, nothing seems to be reshaping modern warfare quite like the integration of Artificial Intelligence (AI). Based on recent analyses, AI’s involvement in war goes beyond strategy and tactics—it influences the very psychology of conflict.

A New Era of Warfare

Recent events and studies elucidate that AI's role in warfare is not just restricted to enhanced strategies or advanced tactics. It's an influencer, subtly modifying the very psyche of conflict and decision-making. This was evident in the recent skirmishes in Ukraine, where AI-empowered drones, armed with Intelligence, Surveillance, and Reconnaissance (ISR) capabilities, furnished real-time data, paving the way for informed tactical decisions. Such advancements, like the Lethal Autonomous Weapons Systems (LAWS) and Drone Swarms, are prime examples of how AI fundamentally alters combat dynamics, making traditional forms of engagement seem archaic.

Furthermore, the role of AI in cyber warfare can't be understated. Both defensively and offensively, AI algorithms can counter cyber threats or exploit vulnerabilities at unprecedented speeds. In logistics, war-gaming, electronic warfare, and even medical care on the battlefield, This isn't limited to battles alone. Training modules augmented by AI are creating a new generation of soldiers, further emphasizing the symbiotic relationship between man and machine in future combat scenarios.

‘AI can be a force multiplier, enabling security teams not only to respond faster than cyberattackers can move but also to anticipate these moves and act in advance’. Cyber AI: Real defense Deloitte report

The Push to Redefine the Metrics of Military Power

Will Roper, Former Assistant Secretary of the Air Force for Acquisition, Technology and Logistics, commented on the Pentagon’s hardware-centric mindset. Traditional metrics, like the number of ships or planes, still dominate budgetary discussions. However, as Roper pointed out, the real measure in today's world lies in the digital power of these assets. From sensors and algorithms to intelligent munitions, the "digital capabilities" are what determines a force's real strength.

“Ships, airplanes, tanks and ground troops still matter, but what matters more is their digital capabilities: sensors to detect enemy forces, algorithms to process data, networks to transmit information, command-and-control to make decisions, and intelligent munitions to strike targets. Roper said the DoD should be focusing on “decision superiority… but its not the way the budget is built” Four Battlegrounds, Paul Scharre

Transferring AI Into Military Power

Historically, the U.S. Department of Defense (DoD) was at the forefront of technological innovation, with groundbreaking advancements like GPS, microprocessors, and the early internet. This dominance in the 1960s and '70s solidified the military's role as a pacesetter in the realm of Research & Development (R&D). However, recent shifts in R&D expenditure trends suggest a significant transition. The lion's share of innovation is now emanating from the private sector, rendering the DoD more of a consumer than an instigator of cutting-edge technologies.

The implications of this transformation are twofold. On the one hand, the DoD stands to benefit from the burgeoning technological dynamism of the private sector, potentially allowing them to capitalize on innovations without the accompanying R&D expenditure. Yet, on the other hand, the DoD finds itself in uncharted waters. Without the leverage to steer the direction of technological innovation, the DoD is faced with the Herculean task of adapting and integrating these external advancements rapidly. The pressing concern is that any failure in this 'spin-in' mechanism might see the U.S. military side-lined from pivotal technological shifts, thus undermining its global supremacy.

The DoD's notorious slow pace of tech implementation, rooted in its industrial-era metrics and mindset, poses a significant challenge. In an era where the yardstick of military might is shifting from sheer numbers to digital prowess, the DoD's budgetary and operational focus requires a recalibration from waterfall to agile. For the DoD to truly harness the potential of AI and other innovations, a cultural and strategic overhaul is imperative.

However, No Single Technology is a Panacea

Reflecting upon the Gulf/Iraq Wars provides a lens to envisage AI's potential role. The technological dominance displayed by the coalition forces, chiefly the U.S., in these conflicts demonstrated the shift from traditional to technologically advanced warfare. Drawing parallels, just as precision-guided munitions and advanced communication systems were game-changers then, AI promises a similar revolution now. The essence lies in the data acquisition, cognitive advantage and unwavering decision making that AI brings, which might redefine military metrics in the future.

After the U.S. and its coalition partners achieved a swift victory in the initial stages of these conflicts, showcasing their technological and operational dominance, the nature of the war changed. As the conflict in Iraq became protracted, especially during the insurgency phase, a form of stasis set in. Local militias and insurgent groups adapted to the advanced technology and tactics of the U.S. forces. These groups leveraged asymmetric warfare, urban environments, and the element of surprise to negate the technological advantage the U.S. held. Improvised explosive devices (IEDs), guerrilla tactics, and blending into civilian populations proved that even the most technologically superior force could be challenged by adaptive and determined adversaries. The transition from a conventional war to a counter-insurgency required the U.S. and its allies to recalibrate their strategies, emphasizing the reality that pure technological power does not guarantee an enduring victory in complex terrains.

The rapid ascent of China as a technological powerhouse underscores a new era where the U.S. and its allies face a near-peer adversary that is not only catching up but, in some domains, outpacing them. Much like Japan's meteoric rise in the early 20th century, China's trajectory in the realms of AI, quantum computing, and advanced missile systems has redrawn the strategic landscape. The challenges are twofold: not only does the West have to successfully integrate and adapt to AI warfare, but it must also anticipate and counter similar or even superior capabilities from China. It's a dynamic reminiscent of the intense naval competition between the U.S. and Japan during WWII, but with an added layer of complexity. While AI has the potential to revolutionize military strategy and tactics, its ubiquity and accessibility mean that dominance is no longer guaranteed by mere adoption. The key will lie in mastery, constant innovation, and the agility to deploy AI effectively in a rapidly evolving battle environment. The stakes are higher, and the margin for error, thinner than ever before.

The Paradox of Innovation and Strategy

The role of innovation in the strategic realm is paradoxical. At face value, the longer the lifespan of a technical innovation, the better its performance should be. But this isn't always the case in strategy. Utility and performance might seem synonymous for scientists and engineers, but this equation changes dramatically when innovations are subject to strategic countermeasures.

As soon as a groundbreaking innovation emerges, adversaries will begin finding ways to neutralize or circumvent it. This reality challenges the conventional wisdom of pursuing the most optimal or elegant solutions. Instead, there's value in suboptimal but rapid solutions that give adversaries less time to react. Similarly, suboptimal but resilient innovations can weather attempts to undermine them more effectively. Technology strategy values adaptability and speed. Competition among global powers will have to strive to be adaptable, be fast, and keep the opponent guessing.

AI Creates an Economic Windfall

The transformative potential of Generative Artificial Intelligence (AI) is set to usher in an economic paradigm shift. As sectors ranging from banking to retail anticipate profound shifts in productivity and revenue, it's imperative to grasp the total addressable market (TAM) of AI. In this first section we optimistically explore the opportunities for AI's financial prospects, anchored in its automation capabilities, labor productivity growth, and its imminent role in reshaping industries globally.

Numerous research firms are eagerly dissecting the transformative effects of Artificial Intelligence (AI). Amidst the cacophony, voices like Goldman Sachs have distinguished themselves. The numbers for generative AI are nothing short of astonishing:

• Generative AI could raise annual US labor productivity growth by just under 1.5% per year over a 10-year period following widespread business adoption.

• Generative AI could eventually increase annual global GDP by 7%, equal to an almost $7 trillion increase in annual global GDP over a 10-year period.

• Generative AI will be disruptive to jobs: “We find that roughly two-thirds of current jobs are exposed to some degree of AI automation, and that generative AI could substitute up to one-fourth of current work.”

• AI investment could approach 1% of US GDP by 2030 if it increases at the pace of software investment in the 1990s. (That said, US and global private investment in AI totaled $53 billion and $94 billion in 2021, a fivefold increase in real terms from five years prior.)

McKinsey produced a report on generative AI's potential impact, summarized in bullet points:

• Generative AI's potential economic contribution ranges from $2.6 trillion to $4.4 trillion annually.

• Four main sectors to benefit: customer ops, marketing and sales, software engineering, and R&D.

• Banking could see gains of $200 billion to $340 billion yearly; retail may benefit by $400 billion to $660 billion annually.

• Generative AI can automate tasks that occupy up to 60-70% of workers' current time.

• Half of today's work could be automated between 2030 and 2060 due to generative AI.

• Labor productivity might grow by 0.1% to 0.6% yearly until 2040.

• Combined with all tech, productivity could rise by 0.2% to 3.3% annually.

The Low-Hanging Fruits: Information-Based Systems

In the world of AI, the first to reap rewards are often the systems that rely primarily on information processing, without the need for complex real-world interactions. Examples include chatbots, recommendation systems, or financial forecasting tools. Here, the I/O is streamlined: data is readily available in digital form, and the output is typically a digital action, like sending a message or recommending a song. The economic advantages are clear. The real complexity emerges when AI attempts to interact with the physical world, such as driving a car, controlling a drone, or performing a surgical procedure. This interaction demands not just data processing but also the accurate collection of real-time data and the ability to act on that data through various actuators. Information-based AI startups might offer quicker returns given their ease of integration and scalability. While real-world AI applications represent a longer-term bet, with potentially higher returns, but accompanied by increased risks and longer maturation periods.

If You Can Pay People $5/hour Why Would You Adopt AI?

Adoption is also likely to be faster in developed countries, where wages are higher and thus the economic feasibility of adopting automation occurs earlier. Even if the potential for technology to automate a particular work activity is high, the costs required to do so have to be compared with the cost of human wages. In countries such as China, India, and Mexico, where wage rates are lower, automation adoption is modelled to arrive more slowly than in higher-wage countries.

Symbiotic Military-Commercial Development

The symbiotic potential between the Department of Defense (DoD) and corporate giants, presents an exciting future canvas for technological advancements. Historically, as with the development of the internet and GPS, military innovations have often been groundbreaking and well-resourced. If the Department of Defense were to pass down these advancements to the commercial realm, we could see a revolutionary leap in civilian tech, with Tesla's vehicles or Boeing's aircrafts benefiting from defense-grade AI and navigation systems. This becomes all the more compelling when considering the DoD's appetite for tackling long-term investments and complex challenges like real world AI implementations, areas where the private sector often exercises caution due to associated risks. Through this partnership, the DoD provides the rigorous research and development foundation, while companies like Tesla and Boeing provide scalability and widespread application.

AI Matchup: Contested Leadership

Both McKinsey and Goldman Sachs present a compelling picture of its transformative potential, especially the productivity boost to developed economies. While predicting a precise 10-year trajectory remains elusive, their projections suggest an impact to the tune of trillions on the global economy, serving as a valuable base case. These figures could swing higher or lower depending on a myriad of factors. Beyond numbers, the geopolitical implications of AI's ascendancy are profound and multifaceted. But it is clear that missing out on AI will be a critical failure of any nation, exemplified by the US effectively elevating advanced AI chips to similar controls as military weapons. We explore the ripple effects of these dynamics in the next newsletter.

In evaluating global AI leadership, there is a quadrant of vital elements: Data, Algorithms, Hardware, and Talent. Data drives AI, and as more devices gather it, AI systems sharpen their accuracy. Algorithms transform this data into meaningful insights, while high-powered hardware ensures processing. Yet, these systems are only as potent as the human experts behind them, underscoring the competition for top AI talent. Algorithms are universal and easily replicated, so the edge often lies in proprietary data and advanced hardware. Nonetheless, the bridge between these technical facets and real-world utility is human expertise, and the institutions that channel these assets into tangible applications play a decisive role in AI leadership.

The current AI landscape presents a nuanced picture. While the U.S. publishes around 30% more papers than China, the latter is rapidly narrowing this academic chasm. However the US produces 70% of the most cited papers worldwide, while China only produces 20%. Remarkably, when considering publications in the CNKI (China National Knowledge Infrastructure, a leading Chinese academic database), China's output is a whopping five times that of the U.S.

However, there's a significant shift in the AI sector's dynamics. Before 2010, academic institutions spearheaded 80-100% of large-scale AI outcomes. By 2020, this plummeted to below 10%, with startups and private enterprises wielding commercially-driven agendas stepping into prominence. Analyzing the startup ecosystem, the U.S. has 292 AI "unicorns" (startups valued over $1 billion) with a cumulative worth of $4.6 trillion. In contrast, China boasts 69 such firms, valued at $1.4 trillion. Thus, while China's academic contribution is vast, its commercial translation lags behind the U.S. ecosystem. Expert consensus suggests China's Large Language Models (LLMs) trail by roughly two years.

The breadth and depth of tech available to the U.S. DoD courtesy of its private sector necessitates integration for defense applicability. The People's Liberation Army (PLA) starts with a weaker commercial foundation. Yet, the malleability of China's state-centric economic approach could funnel resources to projects that are identified as important. The U.S. holds the upper hand in algorithms, and notably, hardware. But, China's relentless pursuits in hardware, talent development and the transferability of algorithms make the U.S. advantages marginal. However if dramatic changes were executed on the U.S. hardware control regulations, this gap would become far more pronounced. This begs that question: Can China underpin its AI trajectory by ensuring access to top-tier hardware?

China is not ‘Ahead’ Regulating Generative AI

A stark distinction between the U.S. and China is evident in China's LLM approval mechanism; overseen by the Cyber Security Administration, it mandates model-specific evaluations. This translates to formidable barriers for public-facing, consumer-centric solutions, like chatbots. Conversely, business-focused applications, such as corporate productivity tools, may encounter a more lenient regulatory environment. Further compounding the issue, there's a discernible hesitance among Chinese consumers towards SaaS subscription models. However, this doesn't preclude the potential for military innovations within China. 

China's new domestic generative AI legislation raised questions about its integration with the existing censorship system. However, a recent draft by the National Information Security Standardization Technical Committee (TC260) provided clarity on the regulation of AI-generated content. This draft provides explicit guidelines for AI model training and moderation, addressing both universal concerns like algorithm biases and China-specific content.

Key provisions include:

1. Training: AI models use diverse corpora (text and image databases) for training. TC260 asks companies to diversify these databases and evaluate their quality. Any source with over 5% "illegal and negative information" should be excluded from training.

2. Moderation: AI firms are urged to employ moderators who can enhance content quality per national policies and external complaints. Considering that content moderation is already a significant workforce component in companies like ByteDance, human-driven censorship is expected to grow in the AI era.

3. Prohibited Content: Companies are instructed to identify keywords indicating unsafe or banned content. Political content against "core socialist values" and "discriminative" content, such as religious or gender-based biases, fall under this scope. AI models must then undergo tests to ensure less than 10% of their outputs breach these rules.

4. Subtle Censorship: While the standards focus on implementing censorship, they also advocate against overt censorship. For instance, rather than flatly rejecting prompts containing "Xi Jinping," AI should be calibrated to handle questions about the Chinese political system without blatant evasion.

These guidelines are non-binding recommendations but are expected to shape future regulations. Large tech firms in China, like Huawei and Alibaba, have influenced these standards, indicating the industry's aspirations concerning regulation.

In summary, as global AI regulation discussions evolve, China's approach provides insights into potential content moderation methods and possible AI-era censorship strategies. However the rapid progress in regulation in China is not a gold standard for AI safety but an attempt to control the technology within the acceptable bounds of Chinese propaganda.

US Opportunity Adventurism is Unwavering

There's gold in them thar hills!

Regulation: it’s a term that has shaped the trajectory of numerous industries, particularly in the realm of emerging technologies. While many stakeholders argue that regulatory clarity is paramount for innovation, a retrospective look at sectors like cryptocurrency presents a strong counter-narrative.

Innovation Comes Before Regulation

Cryptocurrency, in its infancy, thrived amidst the mist of regulatory uncertainty. From Bitcoin's initiation in 2009 to the explosive proliferation of altcoins, the crypto space was characterized by rapid growth and dynamism, often unencumbered by clear regulatory guidelines. For many innovators, the lack of definitive regulations didn't deter them; instead, it provided an expansive playground where boundaries were yet to be drawn. The message was clear: innovation doesn’t necessitate regulation.

"We want to give the industry time to evolve. We want to give it time to mature. But we also need to protect investors and consumers." Gary Gensler November 2022

AI Investors Will do it for the TAM

Fast forward to the current digital landscape, where Artificial Intelligence (AI) has captivated the attention of venture capitalists. For these investors, AI represents an unmatched opportunity in the software era. Amidst a backdrop of software downsizing and high interest rates there are also TINA (there is no alternative) effects on VC’s. Even in the absence of a meticulously defined regulatory landscape, the potential of AI ensures that risks will indeed be taken, and funds will flow generously into the domain.

The U.S. tech environment thrives, while Chinese startups face the brunt of technological sanctions and limited access to chips. China's tech giants, however, show greater resilience against these sanctions. While Beijing has the means to bolster startups, doing so could disrupt the natural market-driven forces of innovation, a topic we explore in the next newsletter.

Baptists and bootleggers

However, the U.S. start-up ecosystem faces unique challenges in this respect. The concept of 'Baptists and bootleggers' – a coalition of moralists and profit-driven entities pushing for the same regulatory outcome for different reasons – has raised concerns of regulatory incompetence. Such inconsistencies can potentially hamper the growth trajectory of burgeoning tech companies while enriching established ones.

The latest restrictions target the shipment of advanced semiconductors from the U.S. to Chinese data centers. Moreover, companies attempting to evade these rules by rerouting shipments through third countries will now face additional scrutiny, as these nations are brought under U.S. licensing requirements. However, the complexity of this issue goes beyond the restrictions themselves, as it involves a multitude of concerns raised by various stakeholders, ranging from the wide scope of the restrictions to potential repercussions on U.S. tech leadership and global collaborations. This article delves into the key takeaways and implications of these escalating measures and their potential ramifications on the global tech landscape.

As of writing it has been less than 24hrs since the new rules were published, we will continue to monitor the situation and update our views.

Key Takeaways

• AI plays a pivotal role in contemporary technology, influencing geopolitical and economic strategies for nations. See our piece from a few weeks ago on AI in Great Power Competition for more information.

• The U.S. is increasingly cautious about exporting semiconductors to China, recognizing their dual-use potential in AI and military applications.

• In October 2022, the U.S. restricted China's access to sub-14nm equipment and chips, along with prohibiting U.S. entities from supporting semiconductor development in China.

• Stakeholders raised concerns about the broad scope of the restrictions, advocating for international consensus, potential harm to U.S. tech leadership, lack of allied controls, and collateral damage to global collaborations.

• Yesterday, the Biden administration reinforced these controls by adding specificity to the manufacturing equipment restrictions, targeting shipments of advanced semiconductors to Chinese data centers, including countries that are under arms export controls to the AI chip ban and scrutinizing third-country shipments to China. The expansion of controls aims to prevent China from obtaining critical semiconductor manufacturing equipment and advanced ICs.

• The new rules include tiered controls for advanced integrated circuits (ICs), exemptions for consumer chips, and measures to address circumvention. The new restrictions are tighter at the leading edge and prevent leakage while not expanding on lagging edge or consumer technologies.

• U.S. export controls aim to limit China's access to advanced technology while avoiding complete cutoff, allowing room for US suppliers in China. However, Chinese companies may still increasingly turn to domestic options for critical technology, aligning with Beijing's strategic objectives.

Arms Controls for Advanced AI Chips

The latest AI chip restrictions, bear a striking resemblance to arms control measures in several aspects. Firstly, they showcase a deepening concern within the U.S. government about the strategic implications of advanced AI capabilities. Just as arms control agreements aim to limit the proliferation of weapons with the potential to disrupt global security, these restrictions target AI capabilities that can significantly impact military decision-making, electronic warfare, and intelligence operations. This demonstrates a growing recognition of AI's role in shaping modern warfare and the need to curtail its spread.

Secondly, the tiered approach introduced in these controls is akin to arms control regimes that categorize weaponry based on their potential threat. By classifying AI chips into different tiers and imposing stricter regulations on the most potent ones, the U.S. is essentially applying a risk-based assessment, mirroring how arms control treaties treat weapons of varying destructive capabilities.

Additionally, the expanding list of countries subject to these controls, particularly the "unfriendly" ones, is reminiscent of arms embargoes. This broader reach reflects a concerted effort to prevent third-party countries from facilitating China's access to advanced AI technology, mirroring the intent behind arms embargoes on rogue nations.

Furthermore, the emphasis on the potential misuse of AI in surveillance systems for human rights violations adds a humanitarian dimension to these controls, aligning them with the ethical considerations often seen in arms control discussions.

Overall, these AI chip restrictions signal a shift toward treating advanced technology as a strategic asset akin to conventional arms, highlighting the evolving nature of geopolitics in the digital age.

The Escalating Measures

October 2022 Restrictions: Last year, the U.S. government made clear moves to limit China's progress in supercomputing and AI by restricting its access to sub-14nm equipment and corresponding chips. This initiative also extended to prohibit U.S. entities from supporting semiconductor development within China's borders.

Public Comments and BIS Responses: Navigating a Complex Landscape

Despite these controls, there have been challenges. Entities like Huawei and SMIC found ways to break through the ‘sub-14nm barriers’, and companies such as Nvidia sought design-around solutions to navigate the tight regulations.

For background information re recommend readers review out previous posts on The Huawei SMIC Breakthrough and The NVidia Design Around.

However, the true complexity emerges from the myriad of concerns raised by stakeholders, ranging from the broad scope of the restrictions to potential threats to U.S. tech leadership. Through the Bureau of Industry and Security (BIS) responses, it becomes evident that there's a delicate balance at play: addressing national security concerns while acknowledging the integral role of global trade partnerships. Several issues came to light in the latest BIS responses to public comment:

• Broad Application Concerns: Some stakeholders felt the October 7 IFR was unnecessarily expansive, preferring established multilateral controls such as the Wassenaar Arrangement. However, BIS argues that the broad scope is crucial to navigate the increasingly intertwined realms of China's commercial and military sectors.

• Call for Multilateralism: The unilateral nature of the controls raised eyebrows, with advocates pushing for international consensus. BIS's response hinged on the urgency of national security, necessitating swift and independent action.

• The Potential Own-Goal: Concerns about the U.S. potentially sidelining itself from global tech advancements by imposing these controls were raised. BIS countered, emphasizing that the controls aim for security, not supply chain disruption.

• Allied Apathy: The noticeable lack of similar controls from U.S. allies was brought up as a potential weak point. BIS highlighted adjustments made to maintain collaboration capacities with these allied countries.

• Collateral Damage: Stakeholders raised concerns about potential impediments to global health and environmental collaboration. BIS's licensing policies aim to be lenient where risks are minimal, safeguarding these collaborative endeavors.

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The New Rules

October 2023 Restrictions: The Biden administration, just a year after the first round of restrictions, has further reinforced these controls. The fresh restrictions target the heart of China's AI capabilities by curtailing the shipment of advanced semiconductors from the U.S. to Chinese data centers. Companies looking to sidestep these rules by rerouting shipments through third countries would face additional scrutiny, as these nations will now also come under U.S. licensing requirements.

These controls were strategically crafted to address, among other concerns, the PRC’s efforts to obtain semiconductor manufacturing equipment essential to producing advanced integrated circuits needed for the next generation of advanced weapon systems, as well as high-end advanced computing semiconductors necessary to enable the development and production of technologies such as artificial intelligence (AI) used in military applications.

Advanced AI capabilities—facilitated by supercomputing, built on advanced semiconductors— present U.S. national security concerns because they can be used to improve the speed and accuracy of military decision making, planning, and logistics. They can also be used for cognitive electronic warfare, radar, signals intelligence, and jamming. These capabilities can also create concerns when they are used to support facial recognition surveillance systems for human rights violations and abuses. Commerce Strengthens Restrictions on Advanced Computing Semiconductors, Semiconductor Manufacturing Equipment, and Supercomputing Items to Countries of Concern

Advanced Computing Chips Rule (AC/S IFR)

Advanced Computing Chips Rule (AC/S IFR) Document

The AC/S IFR retains the stringent PRC-wide licensing requirements imposed in the October 7, 2022, rule and makes two categories of updates:

• First, adjusting the parameters that determine whether an advanced computing chip is restricted;

• Second, imposing new measures to address risks of circumvention of the controls.

The AC/S Interim Final Rule (IFR) continues the licensing measures from the October 7, 2022 mandate, with a core focus on advanced integrated circuits (ICs) exports, especially those used in datacenter AI. The objective is to prevent possible regulatory sidestepping by the People’s Republic of China (PRC) and associated entities. In essence, BIS is refining its controls to be more specific and targeted.

Parameters that determine whether an advanced computing chip is restricted;

Based on public comments, recent technological developments, and analysis of the prior rule’s national security impact, the AC/S IFR removes “interconnect bandwidth” as a parameter for identifying restricted chips. The rule also:

• Restricts the export of chips if they exceed either of two parameters:

  • (1) The preexisting performance threshold set in the October 7 rule; or

  • (2) A new “performance density threshold,” which is designed to preempt future workarounds.

• Requires a notification for the export of certain additional chips with performance just below the restricted threshold. Under new “License Exception Notified Advanced Computing (NAC),” following receipt of notification for exports and reexport to Macau and destinations identified as subject to a U.S. arms embargo (including the PRC), the U.S. government will determine within 25 days whether the transaction may proceed under the license exception or instead require a license.

As part of these updates, we are also introducing an exemption that will permit the export of chips for consumer applications.

This change anticipates potential loopholes where multiple less powerful chips might be combined to match the capacity of restricted ones. To measure a chip's total performance, factors like the 'MacTOPS' rate, the 'bit length of the operation', and the 'applicable die area' are pivotal.

Performance Density Threshold Calculations

The document provides instructions on how to calculate the 'Total processing performance' (TPP) for integrated circuits. The formula for TPP factors in the 'MacTOPS' (the theoretical peak number of Tera operations per second for a specific computation) and the 'bit length of the operation'. A convention is adopted where one multiply-accumulate computation is counted as two operations. The total TPP for an integrated circuit is the sum of the TPPs for each processing unit on it. Finally, 'Performance density' is calculated by dividing the TPP by the 'applicable die area'.

We are sharing these calculations for real world chips with our close contacts and will release more information for free subscribers soon.

The updated regulations for ICs are categorized into two main sections, 3A090.a and 3A090.b, based on their performance metrics. We are calling them Tier 1 and Tier 2 chips for simplicity:

Tier 1 Chips

• Classified as Export Control Classification Number ECCN 3A090.a

• The IC is regulated if it has a 'total processing performance' of 4800 or more.

• Alternatively, it's also regulated if it achieves a 'total processing performance' of 1600 or more, combined with a 'performance density' of 5.92 or more.

Tier 2 Chips

• Classified as Export Control Classification Number ECCN 3A090.b

• The IC is regulated if its 'total processing performance' is between 2400 and 4800, and its 'performance density' is between 1.6 and 5.92.

• Additionally, if the IC has a 'total processing performance' of 1600 or more and its 'performance density' is between 3.2 and 5.92, it will also be under this control.

In summary, these updated parameters broaden the range of controlled ICs compared to the previous October 7 IFR. This expansion aims to regulate even those ICs below the initial thresholds but which can still aid in training advanced military-grade AI.

Consumer Chips Exemption

In recognition of the consumer market's different dynamics, an exemption for chips designed for consumer applications is now in place. This is consequential as it represents a shift toward focusing on critical military technology, not all technology. This keeps open critical streams of revenue for US chip companies.

New measures to address circumvention of controls

• Establishes a worldwide licensing requirement for export of controlled chips to any company that is headquartered in any destination subject to a U.S. arms embargo (including the PRC) or Macau, or whose ultimate parent company is headquartered in those countries, to prevent firms from countries of concern from securing controlled chips through their foreign subsidiaries and branches.

• Creates new red flags and additional due diligence requirements to help foundries identify restricted chip designs from countries of concern. This will make it easier for foundries to assess whether foreign parties are attempting to circumvent the controls by illicitly fabbing restricted chips.

• Expands licensing requirements for export of advanced chips, with a presumption of denial, to all 22 countries to which the United States maintains an arms embargo (including the PRC) and Macau.

• Imposes license requirements for export of advanced chips, with a presumption of approval, to these same additional countries, in response to reporting that countries of concern have used third countries to divert or access restricted items. This will provide greater visibility for compliance monitoring and enforcement.

• Creates a notification requirement for a small number of high-end gaming chips to increase visibility into shipments and prevent their misuse to undermine U.S. national security.

• Includes a request for public comments on multiple topics, including risks associated with infrastructure as a service (IaaS) providers, the application of controls on deemed exports and deemed reexports, additional compliance guidance that could be provided to foundries receiving chip designs, and how to more precisely define key terms and parameters in the regulation.

To mitigate indirect PRC acquisitions, the rule expands its oversight to specific country groups. Notably, there's now a monitoring mechanism for select high-end gaming chips to ensure their appropriate use.

BIS had introduced a graded control system based on the potential threat of the ICs. The most potent ICs face stricter licensing requirements, while less potent ones have certain allowances but with conditions attached, especially concerning their destination. Additionally, the U.S. government maintains a close watch on exports of chips hovering just below the restricted performance mark.

Tier 1 Chips banned in ‘Countries of Concern’

To prevent the PRC from acquiring advanced ICs via indirect routes or by accessing datacenters with these ICs, BIS is extending controls of Tier 1 chips to certain countries classified as D:1, D:4, and D:5. This a measure to combat China's use of third-party countries to bypass U.S. export restrictions.

For a comprehensive list of D:1 - D:5 countries refer to the BIS document here. The list generally includes countries subject to arms controls: Afghanistan, Belarus, Burma, Cambodia, Central African Republic, China (PRC), Cuba, Cyprus (now exempt), Iran, Iraq etc.

Tier 2 Chips can be exempt from ban on ‘Countries of Concern’

Items eligible for License Exception Notified Advanced Computing (NAC) are defined as those under Tier 2 (including ICs that are designed or marketed for use in a data center) and specific ICs under Tier 1 (not designed or marketed for use in a data center). These less powerful ICs, which could still be used for training large AI systems, can be exported to places in the D:1, D:4, or D:5 groups. However, if these are exported to Macau or a D:5 country, there must be prior notification.

Mitigating Subsidiary Parallel Imports

The new restrictions expand licensing requirements for export of advanced chips, with a presumption of denial, to all 22 countries to which the United States maintains an arms embargo (including the PRC) and Macau. Creates a notification requirement for a small number of high-end gaming chips to increase visibility into shipments and prevent their misuse to undermine U.S. national security.

Creates new red flags and additional KYC due diligence requirements to help foundries identify restricted chip designs from countries of concern. This will make it easier for foundries to assess whether foreign parties are attempting to circumvent the controls by illicitly fabbing restricted chips.

Imposes license requirements for export of advanced chips, with a presumption of approval, to these same additional countries. This will provide greater visibility for BIS for future compliance monitoring and enforcement.

What to Watch for Next

Preparation for Adaptability: To remain responsive to changing landscapes, licensing requirements for advanced chip exports have been revamped. This ensures that the rules adapt to emerging challenges while preserving national security. Gina Raimondo, the secretary of commerce, said the changes had been made “to ensure that these rules are as effective as possible” and that she expected the rules to be updated at least annually as technology advanced.

Cloud Computing Monitoring: Given the rising importance of cloud computing, the rule calls for public insights. BIS is seeking comments from Infrastructure as a Service (IaaS) providers (Amazon, Google, Microsoft) and other relevant stakeholders about further regulations, especially concerning know your customer KYC requirements that would help in addressing uses that pose national security or foreign policy threats.

Expansion of Export Controls on Semiconductor Manufacturing Items Interim Final Rule (SME IFR)

Export Controls on Semiconductor Manufacturing Items

Key changes made from the October 7, 2022, rule include:

• Imposes controls on additional types of semiconductor manufacturing equipment.

• Refines and better focuses the U.S. persons restrictions while codifying previously existing agency guidance, to ensure U.S. companies cannot provide support to advanced PRC semiconductor manufacturing while avoiding unintended impacts.

• Expanding license requirements for semiconductor manufacturing equipment to apply to additional countries beyond the PRC and Macau, to 21 other countries for which the U.S. maintains an arms embargo.

More Clarity on the Technology Level of Equipment

The Export Control Classification Number (ECCN) for manufacturing equipment have undergone revision by incorporating the term “systems designed for” and removing “systems capable of” to hone in on the controls. The term “systems capable of” was swapped as BIS recognized its potential to unintentionally encompass tools utilized for older generation logic ICs. The choice of “designed for” offers precision in controlling systems dedicated to crafting cutting-edge logic ICs.

For instance, SMIC is able to access DUV – a tool crafted for 14nm but capable of achieving 7nm albeit with compromised yield.

Getting Nitty Gritty with Technical Details of Equipment

BIS has added items under ECCNs 3B001 and 3B002, and associated software and technology for fabricating logic ICs with non-planar transistor architecture or with a production technology node of 16/14 nanometers or less.

Although these items are not yet formally controlled under a multilateral regime, the urgency and criticality of the U.S. national security concerns have motivated unilateral control pending adoption through the Wassenaar Arrangement. BIS have been getting some technical advice because they have added some real specificity to the new restrictions, some examples of the technical details are:

• added to control equipment designed for wet chemical processing and having a largest ‘silicon germanium-to-silicon etch selectivity’ ratio of greater than or equal to 100:1.

• equipment designed for dry etching, including isotropic dry etching as specified (3B001.c.1.a) and anisotropic dry etching as specified (3B001.c.1.b and c.1.c)

• Note 2 is added to inform the public of the types of etching that are included in the scope of 3B001.c.1.b, e.g., etching using RF pulse excited plasma, plasma atomic layer etching, and plasma quasi-atomic layer etching

• equipment designed for wet chemical processing and having a largest ‘silicon germanium-to-silicon etch selectivity’ ratio of greater than or equal to 100:1

• The items added to 3B001.d.3, d.4, d.5, and d.8 include advanced fabrication equipment designed for metal deposition of the barrier layer, liner layer, seed layer, or cap layer of metal interconnects.

• control of equipment designed for ALD or chemical vapor deposition (CVD) of plasma enhanced low fluorine tungsten films. This equipment is critical in filling voids in advanced-node device structures with higher and increasingly narrow aspect ratios, which minimizes resistance and improves performance

Enhanced Visibility into Semiconductor Equipment Distribution

Even if approved, adding a license requirement for destinations in Country Group D:5 (which includes countries such as Afghanistan, Belarus, China, Iraq, Libya, Syria, Russia, and Venezuela) will provide greater visibility into the flow of semiconductor manufacturing equipment, associated development and production technology and software, as well as specially designed parts, components and assemblies therefor to other countries and their intended end uses.

Control Equipment That Makes the Equipment That Makes the Chips

Furthermore, the modifications address systems employed in the creation of other equipment, indicating a layered approach to control. The definition of ECCN 3B001 has been updated from the below to add the text in bold to include equipment that makes the equipment that makes the chips… some nested logic…

3B001 Equipment for the manufacturing of semiconductor devices or materials “and equipment for manufacturing semiconductor manufacturing equipment”, as follows (see List of Items Controlled) and “specially designed” “components” and “accessories” therefor.

Additions to the Entity List

Entity List Addition

• BIS is adding to the Entity List two PRC entities and their subsidiaries (a total of 13 entities) involved in the development of advanced computing chips that have been found to be engaged in activities contrary to U.S. national security and foreign policy interests. These entities will also be subject to restrictions on foreign-produced items made with U.S. technology.

• Foundries producing chips for these listed parties will need a BIS license before the foundries may send such chips to these entities or parties acting on behalf of these entities as a result of applying the “footnote 4” Entity List foreign direct product rule designation.

The entities are Shanghai Biren Intelligent Technology and Moore Threads Technology Co. Biren is a fabless semiconductor design company. The company was founded in 2019 by Lingjie Xu and others, all of whom were previously employed at NVIDIA or Alibaba. Moore Threads specializes in graphics processing unit (GPU) design, established in October 2020 by, Zhang Jianzhong, the former global vice-president of Nvidia and general manager of Nvidia China. This send a clear message that us US aims to contain the ex-NVidia AI chip knowledge in China.

These entities are involved in the development of advanced computing integrated circuits (ICs). As described in an upcoming amendment to regulations regarding advanced computing items and supercomputer and semiconductor end use, advanced computing ICs can be used to provide artificial intelligence capabilities to further development of weapons of mass destruction, advanced weapons systems, and high-tech surveillance applications that create national security concerns. Entity List Additions

Feedback and Fallout

“We are evaluating the impact of the updated export controls on the U.S. semiconductor industry. We recognize the need to protect national security and believe maintaining a healthy U.S. semiconductor industry is an essential component to achieving that goal. Overly broad, unilateral controls risk harming the U.S. semiconductor ecosystem without advancing national security as they encourage overseas customers to look elsewhere. Accordingly, we urge the administration to strengthen coordination with allies to ensure a level playing field for all companies.” SIA Statement on New Export Controls

A Bit of a Bummer for NVidia

Nvidia has been considerably impacted by these changes. The company revealed that their data center revenue, which includes not just AI-enabling chips but other products as well, sees 20-25% of its generation from China. Analysts believe that while the rising global demand for Nvidia chips in the AI sector could provide an opportunity to offset these losses by redirecting to other markets, concerns over the performance constraints on a broader range of Nvidia chips have caused the company's stock price to dip by approximately 5% on a given Tuesday.

Revisions to the "Validated End User" List

In an effort to adapt to the changing landscape, the U.S. Department of Commerce also recently has made adjustments to its "validated end user" list, which specifies the recipients of certain technological exports. This allows giants like Samsung and SK Hynix to continue supplying some U.S. chipmaking tools to their factories in China. I would speculate that installing kill switches on equipment functioning in a Korean fab in China might be incorporated within this new framework.

China’s Grand Plan Faces Challenges

China is making aggressive strides in the technology arena. A plan rolled out by authorities, inclusive of the Ministry of Industry and Information Technology (MIIT), aims to amplify China's collective computing power by more than 50% come 2025. The ambitious target is to reach 300 EFLOPS. While this could be feasible, the path to this goal may rely on costly and inefficient technology, lacking the innovative edge of American designs. See our piece from a few weeks ago on AI in Great Power Competition for more information.

Getting the Enemy High on Your Supply

“If you give a man a fish, you feed him for a day. If you teach a man to fish, you feed him for a lifetime.” Applied in reverse. "If you take a mans fish, you starve him for a day. If you take away a man's ability to fish, you starve him for a lifetime."

Or more specifically “If you take a nations commodities, you weaken them for a day. If you take away a nations manufacturing technology, you weaken them for a lifetime.” Zen on Tech, Sept 8th

History is littered with examples of inducing foreign dependence on domestic goods. Today, US policy makers are finally recognizing these dynamics and understanding that broader restrictions incentivize the designing out of US technology in the Chinese supply chain. Chinese AI companies are increasingly limited in their options for sourcing domestically. The strategy appears to be for the U.S. to continue supplying Chinese firms with mid-range technology – good enough to be useful but not advanced enough to threaten U.S. technological leadership. By doing this, if U.S. suppliers provide tech options that are more cost-effective than what's available domestically in China, it creates a dependency, challenging the growth and sustainability of the indigenous supply chain.

With fewer top-tier domestic options like Biren and Moore Threads, Chinese AI firms will continue to be tethered to foreign suppliers. If these U.S. suppliers offer tech that's more cost-effective than what's available from China's indigenous sources, it further undermines the local supply chain, engendering deeper dependencies.

Dr. Doug Fuller of the Copenhagen Business School claims that Chinese semiconductor equipment firms have increased their share of China’s domestic market from 8.5 percent in 2020 to 25 percent in the first 10 months of 2022, though these sales were overwhelmingly concentrated at legacy nodes and far from the state of the art. In Chip Race, China Gives Huawei the Steering Wheel: Huawei’s New Smartphone and the Future of Semiconductor Export Controls

Since 2018, U.S. policies have made it challenging for China to fully realize its tech ambitions. While the U.S. has imposed severe costs, pushing China towards self-reliance in semiconductors, it hasn't yet pulled the plug entirely. The Huawei saga is a testament to this. First, the U.S. allowed Huawei to stock up on American chips before implementing restrictions. Then, there was a leeway given to Chinese firms to accumulate equipment from the U.S., Netherlands, and Japan, before broader sales restrictions came into effect. Even with these restrictions in place, China continues to acquire key technology and expertise.

In essence, the lessons from history remain relevant. By controlling the supply of essential commodities or technologies, it's possible to create dependencies that can be leveraged for strategic advantage. However, given Beijing’s strategic awareness of this dynamic, we anticipate that Beijing will force Chinese AI and infrastructure companies to purchase domestic options.

Historical Context & Lessons from Past Conflicts

To understand the current conflict, it helps to look into its historical context. Israel's strategy in Gaza has never aimed at achieving a decisive, all-encompassing victory. While Israel has the military superiority over Hamas, a complete overthrow could pave the way for an even more radical group to take over Gaza. Moreover, Israel hadn’t wished to shoulder the burden of governing Gaza post-conflict. This led to Israel's “mow the grass” strategy - a periodic targeting of Palestinian militant leaders and high value targets to maintain manageable violence levels.

Most broadly, though, this is a story of deterrence. Israel never strived for a decisive victory in Gaza. While it could militarily defeat Hamas, Israel could not overthrow Hamas without risking the possibility that a more radical organization would govern Gaza. Nor did Israel want to be responsible for governing Gaza in a postconflict power vacuum. As such, Israel’s grand strategy became “mowing the grass”— accepting its inability to permanently solve the problem and instead repeatedly targeting leadership of Palestinian militant organizations to keep violence manageable. Rand, Lessons from Israel's Wars in Gaza

This approach was evident during "Operation Protective Edge" in 2014. A seven-week military campaign in response to rocket attacks from Gaza saw extensive airstrikes by the IDF and a ground operation targeting Hamas's tunnel network. The conflict led to the deaths of over 2,100 Palestinians and 72 Israelis. An Egyptian-mediated ceasefire marked its conclusion, but the operation underscored the fragile relationship between Israel and Palestine.

Beyond Deterrence: Israel's Empowered Position Against Hamas

“Iron Dome is a blessing because it buys Israel time, but Israel needs an excuse for why they are killing Palestinians in operations. . . . When Iron Dome works so well and so few Israelis die, Israel loses the justification for the operation” —Senior Israeli policymaker, Rand, Lessons from Israel's Wars in Gaza

The current conflict highlights the intertwined relationship between military technology and strategy. Israel's Iron Dome, for instance, has been a significant game-changer. Its efficiency, while shielding Israel against missile threats, has paradoxically reduced Israel's justification for operations due to decreased Israeli casualties.

Operation Protective Edge further exemplified the importance of technological advancements and their implications on warfare. During this operation, The Israeli Defense Forces (IDF) confronted the limitations of precision firepower, especially in dense urban terrains. The operation revealed that airpower alone couldn't achieve broader strategic goals, such as deterring Hamas.

Ground warfare insights from the operation also emphasized armored vehicles and Active Protective Systems (APS). Prior to the operation, Israel's defense investments leaned heavily towards intelligence and airpower, occasionally overlooking heavy armor's significance. However, post-operation assessments saw the IDF valuing APS more, not only for their protective abilities but also as strategic assets influencing battlefield decisions.

Before Protective Edge, the IDF invested in intelligence and airpower, often at the expense of particularly heavy armor platforms, while after it, the IDF is once again investing in armored vehicles. Active Protective Systems (APS) protected vehicles from rocket-propelled grenades and anti-tank guided munitions and had other indirect benefits on the battlefield, shifting the ways the commanders maneuvered and serving as an intelligence-gathering system. Rand, Lessons from Israel's Wars in Gaza

In sum, the conflict between Israel and Hamas underscores the balance between military technology and strategy. The introduction of advanced defense systems like the Iron Dome poses both opportunities and challenges, shaping the region's evolving geopolitics. And now with the loss of 1,300 Israeli lives and a newly reinforced fleet of armored vehicles, Israel stands stronger in its social credibility and hard power capability to dismantle Hamas.

THEREFORE, WHEN we think of the new Barak tank and the technology it has brought to the forefront, it’s worth considering it as part of this history. Wars and the kinds of weapon systems that are put into action are not fought in a vacuum. It is a common refrain that militaries learn to fight the last war, not the next one. In this case, Israel’s technology is trying to anticipate the next one. Jerusalem Post

Peace Illusion: Hamas Surprise Attack

In an unforeseen and meticulously orchestrated operation, Hamas stunned Israel with a surprise assault, reminiscent of the surprise that Egypt and Syria laid upon Israel during the Yom Kippur War 50 years prior. "Hamas employed a unique intelligence strategy that hoodwinked Israel over recent months," revealed an insider to Reuters. They created a public facade of reluctance towards confrontation while secretly preparing for this large-scale operation.

A False Dawn of Peace

The reluctance was evident when Hamas refrained from joining the smaller Islamic Jihad group in rocket attacks on Israel. This restraint was seemingly interpreted by Israeli leadership as Hamas's pivot towards prioritizing the well-being of Gazans over repetitive rocket attacks. In response to the perceived truce from Hamas, Israel reciprocated by permitting a growing number of Gazans to work within its borders, creating an illusion of a pathway to peace and prosperity.

Israel promptly reciprocated the de facto Hamas ceasefire by allowing thousands of Gazans to work in Israel—first 17,000, then 20,000, with the potential for many more. Their earnings were changing the lives of 100,000 family members with the possibility of even wider benefits. What was happening on the ground seemed to open a path toward tranquility for Israel and a degree of prosperity for Gaza.

Evidently it was all a delusion. Hamas, just like Arafat’s PLO, is willing to do everything for Palestine—and nothing at all for Palestinians. Edward Luttwak

The Shocking Assault

However, this apparent tranquility was shattered by Hamas's meticulously planned assault. Despite the hopes of burgeoning peace ties with other Arab nations and a potential deal with Saudi Arabia, Israel's political oversight of Hamas's intentions inadvertently lowered the nation's guard. Saturday’s assault laid bare Israel's security vulnerabilities. Hamas militants, with basic tools like bulldozers, and paragliders, breached Israel's billion-dollar security barrier on the Gaza border.

The Middle East Forum’s [Jonathan] Spyer called the attacks a failure of intelligence across the board, at both the strategic and technical level.

On the tactical level, Hamas “succeeded in knocking out the monitoring system at an early stage, using drones and weapons dropped from drones. There were facilities close to the border responsible for watching real time developments, and these were destroyed and disabled … I‘m sure there will be ways put in place to make sure that doesn’t happen again.” Breaking Defense

Additionally, a wave of rockets overwhelmed the famed Iron Dome missile defense system. Most alarmingly, Israel's elaborate surveillance apparatus – comprised of drones, cameras, and cyber tools – was rendered inefficient, as Hamas either bypassed or overloaded it. The aftermath had experts and citizens alike questioning the conspicuous absence of Israeli surveillance drones. As tech journalist Assaf Gilead stated somberly, the ones who were supposed to command those drones were no longer alive.

Rethinking Technological Dependence

While the immediate focus post-assault pivots towards repelling Hamas militants and rescuing hostages, the long-term view delves into the lessons derived from this attack. Was Israel's heavy reliance on technology its downfall? Some analysts contend that technology wasn't the primary issue. They emphasized a "failure of imagination" and an underestimation of the opponent.

Since Hamas took over as a governing faction in Gaza, Spyer said, Jerusalem has treated them as if they are more interested in ruling [Palestine] than in fighting Israel — an assessment that now appears to have been incorrect. Breaking Defense

As Israel reckons with the aftermath, the episode underscores the age-old lesson: while technological advancements are crucial, they cannot replace human vigilance, intuition, and understanding of ever-evolving geopolitical landscapes. It highlights the reality that risk of military surprise is likely to be an enduring factor in the 2020s, which is extremely consequential for global dynamics.

Bilal Saab, Senior Fellow and Director of the Defense and Security Program at the Middle East Institute, put it bluntly: “Over reliance on tech always has its drawbacks. But the problem here wasn’t tech. There was a failure of imagination, first and foremost, and total disrespect of the opponent.”

Similarly, Byron Callan, an analyst with Capital Alpha Partners, warned about jumping to conclusions about technology when people are involved.

“We don’t know if there was human intelligence warning of an impending attack, and warnings can be ambiguous. This doesn’t mean that technical surveillance in the form of space [and] air surveillance, signal intelligence, and cyber-network penetration has been devalued,” Callan wrote in a note to investors. “Rather, it again underscores the value of human sources and human assessments. It also means that the risk of military surprise is likely to be an enduring factor in the 2020s.” Breaking Defense

Cyber Attacks, an Increasing Role

Nation Security Agency senior cybersecurity advisor Rob Joyce explained yesterday [9th October] at a security conference in Sea Island, Georgia:

“One of the big worries, of course: is there a cyber component at this point? I’d say not yet.” 

That being said, Joyce did acknowledge the U.S. had observed “small denial-of-service” attacks and warned that he expected “significant events” in the future. 

Joyce isn’t alone in expecting the conflict to worsen, with Risk consulting, markets, and emerging business leader at PwC, Siddharth Vishwanath, also warning that the war is “Escalating in the physical world, and it is likely [to] escalate into a full-blown cyber warfare.”  Technopedia

Recent developments in the Israel-Hamas conflict have highlighted the evolving landscape of cyber warfare. While traditional forms of warfare include land, sea, and air battles, the digital realm has now become a prominent battleground. The conflict has prompted nations and non-state actors to reassess their approaches to cyber threats, blurring the lines between physical and digital warfare.

The Israel-Hamas conflict serves as a stark reminder that the rules of engagement in cyberspace are still being written. The world is witnessing a paradigm shift in the way nations respond to cyber threats, blurring the boundaries between the digital and physical realms of warfare. The age of cyber warfare is upon us, and its implications for global stability are profound and complex.

Over the weekend, President Biden said he’d tasked his intelligence team “to make sure Israel has what it needs.” Matthew Olsen, assistant attorney general for the Justice Department’s national security division, confirmed at the conference that the US was working to understand if Iran played any part in the attack and whether Israeli and other intelligence had any inklings of the plans in advance.

So far, cyber operations themselves have played little role in the onslaught, said Rob Joyce, director of cybersecurity at the National Security Agency. At the conference, he cited only minor denial of service attacks and web defacements, but noted that this could change. “There will be others that pull into this fight. It just won’t be Hamas,” he said, without naming specific groups or countries.

Joyce said he also expected to see hacktivist action from unaffiliated hackers. While less technically sophisticated, they’ve still displayed a “very substantial capability” to threaten information flows, company finances and even critical infrastructure, he said. Bloomberg

Hard Power Response to Cyber Incursions: Israel's Changing Paradigm

In an evolving global landscape where warfare has expanded to cyberspace, the question of proportionate response to cyber threats becomes increasingly pressing. The Israeli military's airstrikes on 14th and 19th May 2021 against the supposed cyber bases of Hamas in Gaza highlighted a novel approach, marking a continued shift from soft power diplomacy to kinetic force in retaliation to cyber threats.

Crossing Cyber-Physical Boundaries: Israel's Paradigm Shift

Historically, states responded to cyber threats with soft power tactics, mainly including covert cyber offensives or diplomatic channels. The nature of cyber threats, being largely non-physical with few resulting in direct loss of life, led to this restrained approach. Israel's consecutive airstrikes against Hamas's cyber bases in 2019 and 2021 signifies a bold move away from this conventional wisdom.

While international laws governing cyber warfare are still in infancy, many states have benefited from the grey areas within cyberspace. This unrestricted freedom allows states to pursue foreign policy agendas covertly.

On the 14th and 19th of May 2021, the Israeli military conducted consecutive airstrikes against houses in the Gaza Strip that were allegedly home to Hamas cyber operations. The announcement came via the Israeli Airforce Twitter account, and closely mirrored the Israeli military’s bombing of Hamas cyber bases in 2019. Despite a two-year lapse between the attacks, Israel remains the only nation-state to have responded to cyber threats or cyber attacks through conventional military force. International concerns around the establishment of this precedent largely revolve around the perennial issue of how states can respond proportionately to cyberattacks. New Precedents in Cyberwarfare: Israel’s Airstrike of the Hamas Cyber Base, Bronte Munro

Cyber's Physical Manifestations: A Look at Stuxnet

The 2009 Stuxnet malware attack against Iran's nuclear facilities marked a significant shift in the cyber warfare landscape. What was primarily seen as a digital threat suddenly showcased its potential for tangible, physical destruction. Israel's airstrikes against Hamas further underscores the country's intent to blur lines between physical and digital realms, challenging the norms of cyber warfare.

Setting a Dangerous Precedent?

With over 50 significant state-related cyber incidents recorded in 2021, the normalization of kinetic responses to cyber threats could spell a volatile future for international relations. The risk of misguided retaliation, given the inherently challenging nature of attributing cyber attacks, increases the potential for widespread conflict.

Hamas's Cyber Operations: From Gaza to Turkey

Despite the constrained conditions within the Gaza Strip, Hamas's cyber activities persist. The group's cyber capabilities, while still in development, are not to be underestimated. Notably, Hamas's operations aren't restricted to Gaza. Being targets for the Israeli mow the grass strategy, Palestinian leadership has set up cyber operations in Turkey. The Turkish government, has provided a safe haven for Hamas leadership, potentially facilitating a base for planning cyber operations. Beyond Turkey, Hamas continues to receive support from Iran and Qatar, ensuring its cyber capabilities remain a threat in the region. This shift in cyber operations underscores the challenges of addressing digital threats through traditional force, as cyber initiatives are geographically unrestricted.

Hamas’s cyber capabilities, while relatively nascent and lacking the sophisticated tools of other hacking groups, should not be underestimated. It comes as a surprise to many security experts that Hamas—chronically plagued by electricity shortages in the Gaza Strip, with an average of just ten to twelve hours of electricity per day—even possesses cyber capabilities. Israel’s control over the telecommunications frequencies and infrastructure of the Gaza Strip raises further doubts about how Hamas could operate a cyber program. However, in 2019, Israel deemed the offensive cyber threat to be critical enough that after thwarting an operation, the IDF carried out a strike to destroy Hamas’s cyber headquarters, one of the first acknowledged kinetic operations by a military in response to a cyber operation. However, despite an IDF spokesperson’s claim that “Hamas no longer has cyber capabilities after our strike,” public reporting has highlighted various Hamas cyber operations in the ensuing months and years.

This dismissive attitude toward Hamas’s cyber threat also overlooks the group’s operations from outside the confines of the Gaza Strip. Turkish President Recep Tayyip Erdoğan and his AKP Party share ideological sympathies with Hamas and have extended citizenship to Hamas leadership. The group’s leaders have allegedly used Turkey as a base for planning attacks and even as a safe haven for an overseas cyber facility. Hamas maintains even more robust relationships with other state supporters, namely Iran and Qatar, which provide financing, safe havens, and weapons technology. With the assistance of state benefactors, Hamas will continue to develop offensive cyber and information capabilities that, if overlooked, could result in geopolitical consequences. The Cyber Strategy and Operations of Hamas, Atlantic Council

The Way Forward

As cyber threats persist and evolve, the international community faces a crossroads. On one hand, the unchecked potential of cyberspace offers countries opportunities to achieve foreign policy objectives covertly. On the other, the precedence set by kinetic responses to cyber threats threatens global stability. As more state and non-state actors delve into the realm of cyber warfare, establishing international norms and laws becomes imperative. Israel's approach, involving a mix of soft and hard power, offers a glimpse into the future of cyber warfare, one thing is clear: the age of cyber warfare is upon us, and the rules of engagement are still being written.

Cyber Aggression Against Israel in Current War

Israel stands as a hub for cybersecurity innovations, with its cybersecurity sector comprising over 400 international R&D centers and domestic companies that contribute over $3.5 billion in yearly exports. However, despite its prowess, the nation remains vulnerable to both cyberattacks and the spread of disinformation. Amid the intensifying conflict between Israel and Hamas, cyberattacks in Israel have surged. Key incidents include:

1. Billboard Hacks: Pro-Hamas messages and images were displayed on Israel’s smart billboards, as reported by Check Point Software Technologies.

2. Texts & Scams: Israelis received threatening texts and WhatsApp messages originating from Yemen and Afghanistan. Additionally, there were crypto scams masked as pro-Israel aid appeals.

3. Industrial System Attempts: There's been a spike in efforts to access Israel’s industrial systems, largely from Iran, Syria, and the pro-Russia hacktivist group Killnet. (These arracks are technically challenging and require sophistication).

4. Remote Learning Disruptions: A video of an armed man interrupted a high school video conference, prompting warnings from Israel's Ministry of Education.

5. DDoS Attacks: Many Israeli websites, including that of the Jerusalem Post, faced distributed denial-of-service attacks, causing temporary outages.

6. Critical Infrastructure Concerns: Experts fear more sophisticated attacks targeting critical infrastructure, potentially with assistance from Iranian hackers.

7. Disinformation: Examples include false claims about the compromise of Israeli water supplies.

Responses and Background Israel, being a prime target in Middle Eastern cyberattacks, has mobilized its tech community in response. Initiatives include:

• Israel Tech Guard: A volunteer group from the tech community has been formed to assist in finding hostages and missing persons using online post clues, despite the distressing nature of some content.

• Protection of Key Services: Volunteers are also bolstering security features for essential services, like missile-alert apps, and creating databases, websites, and apps for aid coordination and location services.

• U.S. Support: The U.S. has promised "surging" cyber support for Israel, possibly in the form of communications links, replacement equipment, and crucial intelligence.

Who's Behind the Cyberattacks?

The recent cyberattacks targeting Israel emerge from a diverse set of actors, each with its own motivations and objectives. Here's a breakdown:

1. Hacktivists Seeking Notoriety or Pursuing Values: The group AnonGhost has taken a pro-Palestinian stance and is known for its DDoS attacks and attempts to target essential infrastructure and APIs. Most notably, they claimed responsibility for the alleged breach of the Israeli Red Alert missile warning platform. Hacktivism erupts in response to Hamas-Israel war, TechCrunch

   

2. State-Sponsored Actors: Iran, Russia, and China: While not explicitly mentioned, these nations have historically demonstrated advanced cyber capabilities and have been implicated in cyber offensives. The possibility of state-backed actors participating either directly or indirectly, by supporting other hacker groups, cannot be ruled out. Microsoft Digital Defense Report 2023

   

3. Organized Militant Groups: Hamas has been associated with cyber warfare efforts against Israel in the past. For instance, there have been allegations of Hamas disseminating malicious imposter versions of Israeli missile alert applications. The Cyber Strategy and Operations of Hamas, Atlantic Council

The cyber landscape in the Israel-Hamas conflict is multifaceted, with various actors playing roles driven by a combination of geopolitical objectives, ideological motivations, and the allure of chaos and notoriety. The amalgamation of independent hacktivists, state-sponsored actors, and organized militant groups creates a complex web of threats that Israel must navigate.

Hacking Palestinian Infrastructure

Various threat actors, both siding with Israel and taking a neutral or anti-Palestine stance, are emerging as key players in this digital warfare. While cyber elements are involved in disrupting Palestinian services, Israel’s kinetic warfare and control over Palestinian infrastructure are playing much larger roles in the current conflict.

Among the most notable actors is the Indian Cyber Force. The group have claimed to have successfully disrupted several websites. Among their targets are the Ministry of Transportation, governmental webmail services, the e-commerce platform U Buy, and the official Hamas website.

Meanwhile, the hacktivist group ThreatSec, which says it has “attacked Israel” previously, claimed it targeted Alfanet, an internet service provider based in the Gaza Strip. In a post on Telegram, the group claimed to have taken control of servers belonging to the company and impacted its TV station systems.

Doug Madory, director of internet analysis at monitoring firm Kentik, says that Alfanet was inaccessible for around 10 hours on Saturday, October 7—before the hacktivists posted their claim. The ISP’s systems have since been back online and communicating with the wider world. “Some of their services could still be broken,” Madory says, pointing to an Alfanet TV website and a web portal that were inaccessible on Sunday evening.

In response to a request for comment from WIRED via Facebook Messenger, Alfanet shared a statement in Arabic saying that communications were cut off due to “the complete destruction” of its headquarters. “Crews are working with all their might to restore service after the bombing of the headquarters and the main tower, despite the difficult and dangerous circumstances,” the message says via machine translation. The company did not comment on the role of a cyberattack, if any, in the outage. The Israel-Hamas war erupts in digital chaos

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Cutting Off the Money to Hamas

Recent developments have put the spotlight on the role of cryptocurrencies in financing terrorist activities. While traditional funding mechanisms remain a significant source for Hamas, it seems that the flexibility, anonymity, and global reach of cryptocurrencies are presenting a new frontier for financing channels.

The Multi-Faceted Funding Machine

Researchers have pointed out that while cryptocurrency is a tool in Hamas's financial arsenal, it's by no means the only one. Traditional means like smuggling cash across the Gaza-Egypt border still remain in place. Moreover, Iran stands out as a stalwart supporter, with estimates suggesting Tehran channels around $100 million to the Hamas annually.

Iran already provides both Hamas and the Palestine Islamic Jihad (PIJ) with at least $100 million dollars a year, and it openly proclaims its intention to destroy Israel. Israel’s War on Hamas: What to Know, CFR

However, as Joby Carpenter, an expert on cryptocurrency and illicit finance at ACAMS, notes, “Crypto is another string in their bow.” Matthew Price, a former IRS investigator now with Elliptic, echoed this sentiment, stating that using crypto is “much easier than smuggling cash over Egypt’s border.”

The Challenges for Israel

Recent incidents have highlighted the difficulties both the U.S. and Israel face in cutting off foreign funding to these groups. PIJ and Hamas managed to amass significant weaponry and equipment, leading to the most notable breach of Israeli borders since the 1973 Yom Kippur War. The exact role of crypto in these operations remains uncertain. While significant funds were observed moving through digital wallets associated with these groups, the specific amounts seized by Israeli authorities and their exact use in operations are not yet known.

On Tuesday, Israeli police announced a move to freeze crypto accounts linked to Hamas. These accounts were allegedly used for soliciting donations on social networks. This is a part of a sustained effort to dismantle the “financial infrastructure in cryptocurrencies used by terror entities.”

The Mechanisms and Magnitudes

Cryptocurrencies operate by allowing users to instantly transfer tokens between digital wallets, usually held on a crypto exchange. This bypasses traditional banking mechanisms, and while it offers numerous benefits, it's this very feature that makes it attractive for illicit activities. Previous reports from the U.S. Treasury Department have highlighted this risk, citing instances where terror groups like the Islamic State and al Qaeda received donations via crypto.

Recent data from Elliptic, a leading crypto research entity, reveals that digital wallets associated with PIJ received roughly $93 million in crypto between August 2021 and June the following year. In the same period, Hamas-related wallets garnered about $41 million, as per data from BitOK, a Tel Aviv-based crypto analytics firm. The charts below show the role of crypto in the Ukraine-Russia war for comparison.

Controversies Around Binance

Further complicating the picture is the role of established crypto platforms. Binance, a company founded in Shanghai and operating out of the Cayman Islands is one of the world's leading cryptocurrency exchanges. Binance was sued by the US Commodity Futures Trading Commission (CFTC) for various violations, including potential money laundering activities. Internal correspondences from Binance suggested a lenient stance towards suspicious transactions, even when linked to entities like Hamas.

In the evolving landscape of international finance and digital currencies, it's clear that regulators, governments, and crypto platforms have a shared responsibility. With terror entities seeking newer and more efficient ways to fund their operations, a multi-pronged and coordinated approach is essential to safeguard global security and economic integrity.

In March, the US Commodity Futures Trading Commission (CFTC) sued Binance for a series of violations. The lawsuit, one of many, even implied that Binance engaged in activity that could be perceived as criminal, including money laundering. Thus, for example, it was written that in February 2019, after the company received information about "Hamas transactions" on the platform, the head of compliance at the company, Samuel Lin, explained in an internal correspondence that "it's fine", terrorists usually send "small amounts" since "large amounts constitute money laundering", A colleague of his replied that he "could barely buy an AK47 (Kalashnikov assault rifle) with $600." Regarding other customers from Russia, Lin noted in another correspondence from February 2020 that "they are here for a crime” The Israeli police froze Hamas Cypto Accounts

Takeaways

The financing landscape of terrorist organizations is rapidly evolving, with cryptocurrencies emerging as a notable avenue for illicit fund transfers. This shift towards digital currencies, particularly due to their anonymity and ease of use, poses significant challenges for national and global security efforts. Regulatory bodies in the US are ramping up measures to exert control over domestic cryptocurrency exchanges and extend influence over foreign-based ones where feasible. In cases where direct oversight isn't possible, strategies like exclusion are could be considered. While cryptocurrencies like Bitcoin provide several legitimate utilities, their potential misuse cannot be overlooked. As a result, the global financial community should brace itself for heightened scrutiny and regulation in the crypto space.

Impact on Financial Markets

In recent days, as the geopolitical stage has seen a surge in hostilities, financial markets have been reacting with some very specific patterns.

Defense and Cybersecurity Stocks on the Rise

The axiom "buy the invasion" seems applicable, especially with defense stocks. Since last Friday, both Israeli and US cybersecurity stocks have seen an upward trend by 5-10%. Notably, US firms like Palantir and Crowdstrike and Israeli companies such as Checkpoint and Cyberark are part of this trend. The positive response, however, seems short-lived, with already visible signs of the growth plateauing. Additionally, the iShares US Aerospace & Defense ETF has climbed by 5% since the inception of the ongoing conflict. However, we caution against expecting this surge to sustain.

Our previous articles highlighted the escalating defense spending and its positive revenue implications for defense companies (see here). The rise in cyber breaches heightens the risk and public awareness of attacks, potentially boosting cybersecurity stock performance. Simultaneously, conflicts lead to increased usage of ammunition, benefiting defense manufacturers, especially those in the US. However, while this event is significant, it alone won't drive fundamental shifts in these sectors, barring wider conflict escalation. Instead, it complements a broader trend of increased defense spending and fits into the overarching macroeconomic context.

Oil Market in Flux

BCA's stance on petro-state instability outlines a complicated landscape. It indicates that both Russia and OPEC might curtail oil production, leading to a rebound in oil prices. Furthermore, the Saudis are unlikely to assist the Biden administration while the US-Iran engagement continues. This dynamic scenario, with Iran's oil production being the sole growth, indicates that a potential oil shock is looming, especially with Iran's nuclear program still active.

A reminder to everyone that Israel-Palestinian conflicts this century have not been market relevant. I am open minded that this can change, but thus far "what happens in the Levant, stays in the Levant" has been a reality. - Marko Papic

In a different part of the world, talks between Venezuela and the U.S. are progressing. The focus is on providing Caracas with sanctions relief by permitting foreign oil firms to take Venezuelan crude oil as debt repayment, conditional to resumed talks with opposition in Mexico. Earlier, there was a U.S. proposal to ease sanctions on Venezuela's oil sector, contingent upon the nation moving towards a free election.

In summary, the current global tensions have cast a complex and evolving shadow over the financial markets. With defense and cybersecurity stocks rising and the oil market navigating a web of geopolitical influences, stakeholders across the globe remain watchful and anticipatory.

Possible Conflict Expansion

In a rapidly digitized world, cyber threats are taking center stage in conflicts and political upheavals. The recent increase in cyber attacks related to Israel's situation and the Russia-Ukraine conflict has demonstrated how geopolitics now spill over into cyberspace, affecting not only governments but also major corporations.

Increasing Cyber Conflict: Impacts for Australian and New Zealand Organizations

Hamas-Israel Conflict and Its Implications for AUNZ Organizations

The recent escalation in the Hamas-Israel conflict has increased the potential for ideologically-motivated actors to target AUNZ organizations with DDoS attacks in the upcoming month. Over 30 groups ideologically aligned with various countries, including Russia, Ukraine, India, Pakistan, and Bangladesh, have redirected their social media channels towards the conflict. And over 70 DDoS attacks were reported against targets in various countries. Several points indicate a heightened risk for AUNZ organizations:

• Association with sectors like financial services, energy and utilities, government, education, healthcare, media, and airports.

• Presence in or partnerships with Israel or nearby regions.

• Connections to political reactions to the conflict, e.g., think tanks, universities, or businesses where key members have public opinions about the situation.

Potential Threats to AUNZ Organizations

• Pro-Russia hacktivist groups that previously targeted AUNZ may amplify their campaigns, exploiting the ongoing conflict.

• DDoS remains the predominant mode of attack, but website defacement and hack-and-leak strategies might also be employed.

• While AUNZ's condemnation of Hamas might place them in the crosshairs, there's a higher strategic priority for other regions at the moment.

• Currently, there's a minimal chance that AUNZ entities will face destructive attacks linked to the conflict, but this can change rapidly.

Cyber Threat Landscape in Australia and New Zealand (AUNZ)

Recent analyst briefings have highlighted a growing concern regarding pro-Russian cyber groups, which are expected to intensify their cyber campaigns targeting Australia and New Zealand. This escalation is largely due to these nations' political stances and their public condemnations, such as that of Hamas.

CyberCX, a prominent cybersecurity firm, has flagged two particular groups as being especially active during the current conflict. These include one group responsible for a recent outage of Australia's Department of Home Affairs website and the pro-Russian Anonymous Sudan group, known for at least 24 DDoS attacks on Australian entities.

Record-Breaking DDoS Attacks

Despite being a relatively low-brow form of cyberattack, DDoS attacks are notorious for their potential to inflict significant harm. This was recently demonstrated when Google Cloud experienced a record-breaking DDoS assault in August. This attack, which peaked at an astounding 398 million requests per second (RPS), employed a novel "Rapid Reset" method. To put it into context, this attack was seven and a half times larger than any prior known DDoS attack, which had peaked at 46 million RPS in 2022.

Google wasn't the sole victim. Both Cloudflare, a top cloud delivery network, and Amazon Web Services (AWS) reported similar large-scale DDoS attacks, with RPS figures of 201 million and 155 million, respectively.

The Cyber Front of the Russia-Ukraine War

The conflict between Russia and Ukraine, which ignited in 2022, set a new precedent in terms of cyber warfare's role in military campaigns. CrowdStrike Intelligence has tracked a range of cyber activities linked to Russia throughout the conflict. These activities span from intelligence collection and attempts to sway public sentiment to deploying harmful attacks on government and commercial networks.

While Russia has been integrating cyber capabilities into its military strategies for years, often deploying DDoS attacks, the 2022 activities underscore the nation's willingness to employ a diverse set of tools in pursuing its objectives.

The intertwining of geopolitics and cyber warfare suggests that in modern conflict, the digital domain is critical. As nations and corporations continue to bolster their digital defenses, understanding these cyber threats is paramount.

Physical Element

In the volatile atmosphere of the Middle East, Israel finds itself navigating through an intricate maze of regional powers, each with its distinct stance and capabilities. While Israel faces resistance challenges within the confines of Gaza, another looming threat, Iran, takes center stage. The Iranian foreign minister's recent admonition for Israel to cease its offensive in Gaza is not to be taken lightly. Coupled with the caution of potential involvement from Hezbollah — which would inevitably spell catastrophe for Israel — this development is disconcerting. Particularly alarming is Iran's threats; its recent ascent to a de facto nuclear power status considerably broadens its strategic options and influence in the region.

However, it's noteworthy that Hezbollah's posture indicates a calculated restraint, at least for the time being. This restraint is attributed, in part, to the presence of U.S. military assets in the region. Although Hezbollah vocalizes its preparedness for confrontation, the organization has primarily called for reduced conflict. Yet, any action by Hezbollah, even if perceived as limited, holds the potential for unforeseen escalations. Misinterpretations and miscalculations could amplify the situation, especially if strikes inadvertently harm Israeli forces or civilians “The potential for miscalculation is exceptionally high.”

During the 2006 Lebanon War, Hezbollah had an arsenal of about 15,000 missiles, the most sophisticated provided by Iran and Syria, and wreaked havoc on the north of Israel. Today, Hezbollah has an arsenal of missiles believed to be ten times that, which are both more accurate and can travel greater distances. The entirety of Israel would then be vulnerable to missile attacks. Thus, there is every possibility of the war spreading, and the terrible bloodshed and tragedies (especially to the civilian populations) that will follow will make any kind of talks more fraught and more distant than in the past. In addition, Palestinian militants in the West Bank could rise up with violence at any moment, though this would be more likely if Israel were to launch a major ground attack and re-occupy Gaza. That would then raise the question: confronted by a three-front war, would Israel then target Iran in hopes of pressuring it to call off its minions? Israel’s War on Hamas: What to Know, CFR

BIS is Quiet on Chip Restrictions

Anticipation has been building regarding an imminent announcement from the U.S. Bureau of Industry and Security (BIS) on further China bans, which were hinted at last week for a release on October 7th. The recent developments in Israel have likely introduced an unexpected delay in this disclosure. The escalating situation in the Middle East might be diverting the attention of key decision-makers, thereby postponing other significant international policy announcements.

Exclusive: US warned China to expect updated export curbs in October - Reuters

The Commerce Department, which oversees export controls, is working on an update of export restrictions first released last year. The update seeks to limit access to more chipmaking tools in line with new Dutch and Japanese rules, other sources said, and to close some loopholes in export restrictions on artificial intelligence (AI) chips…"The PRC has been expecting an update around the one year anniversary, based on conversations with administration officials," the U.S. official said... The original rules were published Oct. 7, 2022. Reuters

The October 2022 Restrictions

The regulation set out to restrict China's access to sub-14nm equipment, any sub-14nm chips for supercomputers or AI purposes and barring any US citizens, or companies from supporting semiconductor development in China.

The October 2023 Restrictions

Huawei/SMIC announced production at the 7nm technology node which has sparked a flurry of activity. Particularly, a group of Congress committee members wrote to BIS demanding further action outlined below.

At the minimum the new restrictions will target trade leakages in AI chips, manufacturing equipment and possibly support services. It is also possible that the Biden administrations implements some of the legal whack-a-mole policies described in the letter to BIS.

The Case for the Scalpel: Strategic Sensitivity

As we have described previously Biden's apparent softness is influenced by his re-election ambitions and desire to prevent tensions from exploding prior to the election. China is well aware of this dynamic and so far has been unwilling to reciprocate with the US outreach and visits from senior officials. Based on the fact that the US administration gave Beijing warning, it seems like Biden is trying to soften the announcement for Beijing, while also pursuing national interest under pressure from Republican lawmakers.

The Biden administration warned Beijing of its plans to update rules that curb shipments of AI chips and chipmaking tools to China as soon as early October, a U.S. official said, a policy decision aimed at stabilizing relations between the superpowers. Reuters

The current tech bans have not prevented China from developing in areas of national security. However if new restrictions aimed at resolving these issues are overly expansive it could trigger a crisis and start the countdown clock on Beijing's chip stockpiles. The US is still dependent on China for critical inputs and the administration will want to see the EU take steps to de-risk from China before initiating escalatory trade action. If the US administration was perceived by the EU as triggering a crisis it would undermine the creation of a united front with US allies.

We wrote in September about the possible leverage points the US could target in order to challenge China's semiconductor and broader tech sectors. The Scalpel - high-likelihood areas for US intervention include:

• Nvidia's modified AI chips: An extension of restrictions on AI chips to include NVidias chips, modified for the Chinese market. Given the prior WSJ reporting on this, there is a high probability of this being passed.

• Targeted manufacturing equipment bans: Aimed at the equipment involved in the production of the specific Huawei 7nm chip, policy makers might target some of the specific masks, photoresists, metrology and etching equipment used at the high end outlined by SemiAnalysis. Such a policy would be detrimental for China's semiconductor fabs, while also affecting international equipment manufacturers.

• Bans on after sales support and spare parts: These would have marginal impact on Non-Chinese companies while making operation and maintenance of SMIC’s DUV machines more difficult over time.

There is no doubt that U.S. export controls, a messy and inefficient tool being used in unintended ways, have produced more harm than benefit to its national security. In addition to pushing Chinese companies forward in the innovation cycle, the controls have also meant the progressive ‘designing out’ of U.S. technology in China. 

This has already resulted in billions of dollars in lost revenue for U.S. tool makers, undercutting their R&D budgets, their future market growth, and — potentially — their competitiveness. U.S. semiconductor product companies like Nvidia, AMD, Intel, and Qualcomm have all lost market share in China, as Chinese companies favor domestic sources, and will continue to do so. Other U.S. companies like Micron have become the target of Chinese retaliation, and are also facing billions in lost revenue and market share. Even Apple has come under pressure, due to informal restrictions on government use of iPhones….

The saga so far has, then, exposed that no one in the U.S. government appears to know how to do a cost-benefit analysis of the overall impact of export controls on China, and assess the U.S.’s national security gains. That is the ultimate meaning of the Mate 60. Paul Triolo, Senior Associate, Trustee Chair in Chinese Business and Economics

The Case for the Chainsaw: No Way Out

US Companies are getting blocked from China’s market while China replaces leading foreign made chips and massively increases it production volumes of legacy chips. After Huawei/SMIC announced production at the 7nm technology node using “14nm” DUV equipment, it's becoming evident that the traditionally influential market held by western companies in China is shrinking. China has transitioned from courting the US semiconductor industry to replacing it.

For background information on the Huawei/SMIC 7nm production and the Apple bans see our previous article here.

While it will take time for tech giants like Nvidia and Qualcomm to be designed out by China, older technologies, such as catalogue components, are at risk of being replaced by domestic options. This is a shift in the semiconductor landscape, with China transitioning from seeking US expertise to actively replacing it, and semiconductor equipment sales to China potentially jeopardizing US and international tech firms. With some US companies losing out in the Chinese market it could hint at diverging industry perspectives where the US semiconductor industry may have less cohesion in lobbying against the "Chip Choke".

All this threatens the foreign companies that have advocated stabilizing trade ties between China and the west. As recently as July, US semiconductor chief executives made pilgrimages to Washington to argue against new restrictions on China. Now their market share is at stake. If the Chinese market looks lost, American companies have no reason to lobby for access to it.

And as their chips are replaced by local versions, they may question whether the west’s decision to keep supplying China with chipmaking tools and chemicals is really in their interest.” Chris Miller, author of Chip War

US Companies Getting Blocked From China’s Market

China banned its government officials from using iPhones and other foreign devices at work, aiming to decrease dependence on foreign tech and boost cybersecurity. This move could hit up to 5% of Apple's iPhone sales in China, potentially costing the company around $4 billion in revenue. China is Apple’s third-largest market, accounting for 18% of total revenue last year. The ban poses a significant hurdle for Apple in one of its primary markets.

State Subsidies Replaces Foreign Chips in the leading edge

SMIC, under sanctions, has been providing 7nm chips to Huawei, another sanctioned company, actions that are well over the line. Despite early indications that SMIC's production efficiency for these chips is subpar, it may represent China's symbolic message that "US sanctions are ineffective".

to produce Huawei’s chips, SMIC has used DUV lithography machines rather than more advanced EUV tools, which it is barred from buying. Foreign chipmakers such as TSMC and Intel learnt how to produce 7nm chips with DUV machines years ago, before turning to more efficient EUV tools. SMIC’s manufacturing costs are thus probably only competitive because the Chinese state is footing the bill. The company’s 7nm chip is, then, far from an unprecedented breakthrough. Chris Miller, author of Chip War

State Subsidies Increase Production Volumes of Old Chips

China is making non-market driven purchases in stockpiling chip making equipment, as the country did in 2017 after the ZTE bans, and before the Huawei bans. That would be the natural response if Beijing saw large restrictions coming.

China Expanding Production of Older Tech. In retaliation to the US sanctions, China has fortified its older technology chip production. Beijing's $140 billion investment and SMIC's strategic refocus are evidence of this. While their main revenue streams come from older technology chips, SMIC has witnessed significant growth, with its revenue soaring past $7 billion in 2022. SMIC's revenue is a mere tenth of TSMC's, while the difference in wafer shipments is only half: 7.1M wafers for SMIC compared to 15.2M for TSMC. This indicates a lower average selling price for SMIC and a predominance of older chip technology sales. While the global chip industry (except for AI) is experiencing a cyclical downturn in sales Chinese fabs are buying Western chip making equipment like there’s no tomorrow. Zen on Tech

Chip Chainsaw Massacre: Coming to a Theatre Near You

Post-election, the president will have more room to maneuver to enact tighter restrictions on national security grounds. However, given the pressures outlined in this article, the Chip Choke could soon evolve into the Chip Chainsaw Massacre. Those familiar with our writing will recognize our perspective on the cycle of escalation that will be difficult to escape.

Should China manage to circumvent current restrictions on AI chip and manufacturing technology, their success could alter the global power dynamics substantially. Such advances would, in turn, likely prompt the US to escalate its technological restrictions on China, leading to a cyclical pattern of tensions between the two nations. China’s Options for Chip Security

Even if stringent bans aren't declared in the current phase, we expect them to materialize eventually:

• Ban all manufacturing equipment and software for 28nm and below: The would be an expansion of the October 2022 bans. This would severely impact revenues and valuations for US and Japanese equipment makers given they obtain a large portion of their revenue from older equipment sales to China. This has been advocated for by prominent voices in US think tanks.

• Ban Chinese-produced chip exports: This would be harder to target, as the older chips that are made in China are mostly sold within China, however a ban could target Western products that have Chinese chips assembled into them.

In this volume, we navigate the intricate web of artificial intelligence at the heart of global great power competition. Unraveling the vast potential and tangible realities of AI, we offer a comparative analysis of the U.S. and China's positions in this technological race. With AI poised to redefine economic, military, and societal landscapes, this assessment aims to shed light on the strategic decisions and repercussions in the larger context of geopolitical dynamics.

Promise of AI

• Economic Growth: Generative AI offers the potential for a 1.5% annual boost in U.S. labor productivity over a decade, and a 7% rise in global GDP.

• Military Advancements: AI's role in defense encompasses Lethal Autonomous Weapons Systems, Drone Swarms, logistics, electronic warfare, and even battlefield medical care. Moreover, AI training modules are forging a new era of military personnel.

• Accelerated Scientific Breakthroughs: AI’s ability to process immense data and make predictions is set to revolutionize scientific research in material/molecule discovery, design and optimization.

AI's Real-World Challenges

• Diffusion and Application: AI's true challenge lies in real-world applications, requiring both data interpretation and actionable insights in real-time. The first sectors to reap rewards will be ones that rely on information processing, without the need for complex real-world interactions

• Civilian-Military Tech Exchange: The private sector is the new epicenter of AI innovation, with the U.S. DoD adopting, rather than creating, these advancements. However, with DARPA’s history of high risk research, a two-way transfer between the DoD and tech giants could spur unprecedented innovations in both military and civilian realms.

• AI Chip Landscape: While Nvidia is the current AI chip market leader, evolving software and system-level dynamics provides opportunities for other companies like Google, to capture value in multiple areas of the technology stack.

The U.S. vs. China in AI

• Current AI Landscape: The U.S. leads in data and algorithms, but China's surge in hardware and talent indicates a growing rivalry. Despite China's academic contributions, its commercial execution remains behind the U.S.

• Impact of Sanctions: Following U.S. sanctions, China will have to defensively innovate to shield its AI sector. Major Chinese cloud players may be resilient to GPU scarcity though huge inventories, whereas smaller entities will struggle. Meanwhile in the U.S, easy hardware access for startups spurs innovation.

• Algorithm and Compute Power: Efficient algorithms might drive AI progress, but long-term leadership will require prowess in both software and hardware. China’s AI chips mirror Nvidia’s from five years ago, the challenge is not just in creating superior chips but building a holistic ecosystem.

AI in the Context of Great Power Competition

In assessing the trajectories of the U.S. and China within the realm of artificial intelligence (AI) and technology, several compelling narratives emerge. At present, given the framework of restrictions, the U.S. holds a slight edge in the AI competition. This advantage stems from the nation's hardware advantages and efficient allocation of resources, fostering a dynamic ecosystem conducive to technological innovation and entrepreneurship.

China's strength lies in its scale, centralization, and commitment to promoting indigenous technology. Such a strategy allows for the rapid deployment of resources on projects of national significance. The big players in China, the 'hyperscalers', benefit from this approach, however they have failed to amass the vast computational power of their American counterparts. Furthermore, Beijing’s strategic approach might leave smaller entities—like nascent AI startups—scrambling for a foothold.

Drawing lessons from history, the 1970s—despite its economic challenges—saw the U.S. birth tech titans like Microsoft, Apple, and Intel (1968). These entities later provided the West with an unforeseen strategic advantage against the Soviet Union during the Cold War. Two factors, however, make this competition uniquely intense. Firstly, China's economy is large, having surpassed the U.S. in terms of purchasing power parity and inching closer on a current dollar basis. This economic might affords China a clout the Soviets never enjoyed. Secondly, China's unique blend of state-driven centralization and private sector creates an environment capable of innovation. This duality poses a significant challenge, as China's private sector is dynamic enough to potentially rival the innovative spirit of the West. 

The U.S.' strategic deterrence in the ongoing AI and tech competition with China hinges on preventing China's dominance in key tech sectors and reducing reliance on it for essential commodities, while concurrently imposing systemic costs on China's tech development. Through sanctions against companies like Huawei, the U.S. hampers individual entities but also signals to the broader Chinese tech landscape its readiness to thwart significant technological leadership bids. Each time the U.S. increases sanctions on China, Beijing responds with more state support. This approach drains China's resources, forcing them into defensive technological investments. Conversely, while the U.S. struggles toward stability in tech supply chains, it has intensified efforts in cutting-edge technologies and global partnerships to consolidate its technological leadership. This duality seeks to balance immediate security with sustained innovation.

In sum, while the U.S. benefits from an efficient, entrepreneurial ecosystem, China's massive scale and fusion of state and private sectors present a formidable counter. The U.S. is better situated to innovate and breach the new frontiers of compute and AI while Chinese resources are funneled into catching up. However, when new approaches or applications emerge, Beijing has the resources and coordination to replicate foreign advances domestically. The key question remains: will the U.S's agile innovation or China's centralized resource-driven approach create the decisive advantage? The unfolding of this competition promises to shape the global AI landscape and, by extension, the strategic geopolitics of the 21st century.

However, this trajectory and these relative strengths are contingent upon China’s continued access to US chip making equipment from 90nm down to 14nm as is currently the case. If that were to change, and the U.S. was able to convince its allies and force its private sector to expand the restrictions up to 28nm, the implications for the Chinese AI industry would be dire.

Dive into the full report for our comprehensive analysis

Zen On Tech Newsletter V17 Oct 2023

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In an evolving landscape, the competition in the semiconductor space is heating up. As China pushes relentlessly to establish its prominence in the chip sector while it’s economy struggles, the U.S. is re-evaluating its export restrictions and gearing up for potential strategic moves. This article delves deep into China's determination to leapfrog its technological constraints, the U.S.'s profit-driven maneuvers, and the high stakes political chess game that's unfolding.

China's chip aspirations are more than just a quest for innovation – they're a testament to the nation's drive to cement its place in the world. While Huawei flaunts its 7nm chip, and Beijing amplifies its investment in the semiconductor industry, a looming shadow of U.S. restrictions and economic hurdles persist. On the other side of the Pacific, American corporations, with an eye on immediate profits, are navigating this intricate geopolitical terrain, epitomized by Nvidia's tactical dance around licensing rules. Yet, with the upcoming U.S. elections, the tech warfare could experience a seismic shift, with policy decisions holding the potential to reshape the industry's landscape.

Whether it's China's aggressive investments, the U.S.'s corporate strategies, or the impending political decisions – the chips, quite literally, are up in the air.

China is Determined to Catch up

Despite the fanfare around Huawei's latest 7nm chip, it's important to temper expectations and view it for what it truly is: not a "breakthrough," but rather a resumption of progress in an industry already capable of such feats. Huawei had the know-how to design 7nm chips even before the imposition of trade restrictions. Additionally, SMIC had the equipment and tools to be manufacturing 7nm chips at a low yield well before the restrictions. Huawei Defies U.S. Sanctions While Beijing Bans Apple; the 1-2 Combo

Beijing continues to prioritize investments in its semiconductor industry amidst the technological rivalry with the U.S., rather than concentrating on broad economic stimulus measures. This decision aligns with President Xi Jinping's goal of safeguarding economic security amidst rising U.S. tensions, possibly at the expense of short-term economic growth.

In August, medium to long-term loans to households in China, including mortgages, plummeted by approximately 40% year-on-year. The markets were expecting the People's Bank of China to lower interest rates this week but they refrained. The yuan's recent decline against the dollar, reaching its lowest since 2007, may have influenced this decision, as further rate cuts could exacerbate the currency's fall and spur capital flight.

China's economic revival remains sluggish, particularly with a two-year property market downturn and disruption from its zero-COVID policy. Efforts, like softening real estate regulations, haven't had significant impacts. While China unleashed a 4 trillion yuan stimulus post the 2008 financial crisis, there are no signs indicate a similar approach now, with local governmental debts and slowing tax revenue growth being barriers. The country's tax revenue was 13.8% of its GDP in the previous year, a decline of nearly 5% since 2014.

Chip Choke Trumps the Credit Crunch

The government has been cautious about direct payments to households, leading to concerns about potential deflation and prolonged low growth amid a fragile job market. Amid budgetary limitations, Beijing emphasizes sectors like domestic semiconductors and electric vehicle production, reportedly preparing another $40 billion dollar semiconductor fund. Recently, Beijing declared expanded tax benefits for semiconductor and machine tool sectors, allowing a 120% tax deduction on R&D expenses for five years. We remind readers of our assessment that for China to develop an indigenous supply chain at current 5nm technology levels could take to the end of the decade. The latest round of subsidies and increased focus could shift that goal-post closer, and we will continue to update our forecasts.

US Companies are Determined to Make Money

While Beijing's focus remains on reinforcing its semiconductor sector, the U.S. is considering tightening export restrictions on key artificial intelligence (AI) chips.

As pointed out by various sources, the implementation of these restrictions has been porous. The Bureau of Industry and Security's licenses, ambiguities in technical standards, and vulnerabilities like leaked manuals, indicate that the sanctions, are leaky. These loopholes aren't just administrative oversights; they hint at deeper issues, including potential lobbying pressures from U.S. firms that stand to lose from stringent controls. The U.S. is at a crossroads—either to abandon these controls or rectify them. Huawei Defies U.S. Sanctions While Beijing Bans Apple; the 1-2 Combo

American firms, driven by the allure of short-term profits, have a strong incentive to maximize sales today, even if it means navigating complex regulatory waters. The creativity of companies in U.S. allied nations should not be underestimated. These entities have historically showcased their knack for adhering to the letter of Bureau of Industry and Security (BIS) regulations, whilst often sidestepping their true intent.

A recent example of this intricate dance is Nvidia's maneuver following the introduction of licensing rules that affected its A100 chips. The A100, a potent chip rolled out two years ago, is pivotal for data centers, facilitating large scale AI computations. Alongside the A100, Nvidia's advanced H100 chips, released this year, also fell under the new licensing rules.

Nvidia's response to these constraints was both swift and strategic. The tech giant developed an AI chip tailored for the Chinese market, the A800 and the H800, ensuring it remained just beneath the performance benchmarks set by the U.S. Commerce Department. This crafty move allowed the A800/H800 to substitute the A100/H100 in data centers, bypassing the newly imposed restrictions with comparable performance for AI training workloads.

The new restrictions being contemplated by the department would ban the sale of even A800 chips without a license, according to the people familiar with the matter. U.S. Considers New Curbs on AI Chip Exports to China, WSJ

The administration is aware of this and sources close to the situation have indicated to the WSJ that the U.S. Commerce Department is contemplating even tighter restrictions. If these considerations materialize into policy, Nvidia's A800/H800 chip sales to China would also require a license.

US Policy Makers are Determined to Win… After Election Season

Maintaining the current level export controls poses a significant threat to America and its allies’ long-term economic and national security.

The US government and its allies could stop the Chinese semiconductor industry in its tracks. Here are some steps that could be taken to ensure that China does not develop the ability to mass-manufacture the sorts of chips needed for high-end military applications in the coming years…

Half measures will not work, but a full-scale assault will make it so the cost of replicating the semiconductor supply chain domestically is neigh on impossible. While we aren’t advocating for any of these specifically, it is clear the west can still stop China’s rise if decisive action is taken. SemiAnalysis

Amidst the drama, some pundits have been calling for tighter restrictions immediately. As Matt Gertken has frequently noted, the president controls foreign policy and Biden's apparent softness is influenced by his re-election ambitions and desire to prevent tensions from exploding prior to the election. China is well aware of this dynamic and so far has been unwilling to reciprocate with the U.S. outreach and visits from senior officials.

If Biden is re-elected [without congress being controlled], his hands are tied at home, that’s where he would have the ability to use the presidential powers aboard. And worst case scenario, it hurts the economy, that would hurt the democrat party. They don’t necessarily want him to do that, but at this stage Biden is worried about his legacy, he’s worried about going down in history as an American president who defended U.S. interests. That’s the same phenomena with Trump. These are also very old men, they’re going to be in their 80’s. So they’re not only at the end of their terms in office, they’re at the end of their lives. This is an environment where they could make visionary or apocalyptic or radical decisions and that’s going to cause more disruption for the financial markets. Matt Gertken, BCA Research’s Chief Strategist, Geopolitical Strategy and US Political Strategy

The post-election period will see the U.S. intensifying its protectionist agenda. However, China’s lack of cooperation is becoming more obvious in the near term and Biden can’t let that go unanswered without hurting his own credibility.

The Scalpel or the Chainsaw

The U.S. is not without leverage when it comes to challenging China's semiconductor and broader tech sectors. High-potential areas for U.S. intervention prior to the election include:

• Nvidia's modified AI chips: An extension of restrictions on AI chips to include NVidias chips modified for the Chinese market could result in a significant drop in Nvidia's lofty stock value. Given the prior WSJ reporting on this, there is a high probability of this being passed, which creates downside risks to NVDA.

• Targeted manufacturing equipment bans: Aimed at the equipment involved in the production of the specific Huawei 7nm chip, policy makers might target some of the specific masks, photoresists, metrology and etching equipment used at the high end outlined by SemiAnalysis. Such a policy would be detrimental for China's semiconductor fabs, while also affecting U.S. and Japanese equipment manufacturers but it depends on how it is structured.

• Bans on after sales support and spare parts: These would have marginal impact on Non-Chinese companies while making operation and maintenance of SMIC’s DUV machines more difficult over time.

After the election the president will have more room to maneuver and could take a heavy handed approach to trade policy with China:

• Ban all manufacturing equipment and software for 28nm and below: The would be an expansion of the October 2022 bans. This would severely impact revenues and valuations for U.S. and Japanese equipment makers given they obtain a large portion of their revenue from older equipment sales to China. Chinese companies have anticipated this and are buying older equipment like there is no tomorrow. China is making non-market driven purchases in stockpiling this equipment with the expectation that there will be no response from the U.S. administration. If that gains publicity, it could force Biden’s hand.

• Chinese-produced legacy chip exports: This would be harder to target, as these older chips are mostly sold within China, however a ban could target Western products that have Chinese legacy chips assembled into them.

  

Vietnam's strategic position is complex. Its proximity to China and historical ties, make them weary acquaintances. And now the gravitational pull of the U.S. economy - compounded by China’s assertive expansionism - pull Vietnam towards a closer alliance with the U.S.

The Vietnam war ended in 1975 victory for the communists. Vietnam ended the war as a formidable fighting force capable of threatening the Peoples Republic of China. Since the war's end, Vietnam and China have had recurring conflicts over borders, fishing rights, and regional influence, initially involving military confrontations which have gradually subsided over time.

Vietnam is aiming to strike a balance by aligning with both China and the U.S., however the competing interests of Vietnam and China are evident. Vietnam's burgeoning electronics industry, its abundant rare earth mineral resources, and its pivotal position in Asia's trading channels make it a prime candidate for foreign investments seeking alternatives to China. Additionally, China's actions in the South China Sea not only challenge Vietnam's territorial rights but also negatively affect the Vietnamese public’s perception of China. This aggression drives Vietnam to seek support from the U.S., to strengthen its negotiation power with China. Winning Vietnam's alliance will come at an economic and strategic cost for China via reduced control over global manufacturing, rare earths and the South China Sea.

However, this tightrope needs to be viewed with caution by the Vietnamese leadership. The north of Vietnam witnesses preferential investments from Chinese firms, while American companies are inclined towards the south, driven by geographical and strategic motivations. Notably, the south has been the epicenter of anti-Chinese sentiments. To maintain harmony, the Vietnamese authorities will need to invest significant effort in fostering national cohesion and control.

What Singaporeans need to understand better is that, under present circumstances, there may be no sweet spot we can occupy that will keep both the Chinese and the Americans simultaneously happy. There is no silver bullet, and it is a fool's errand to look for one.

Neither can we just lie low and hope for the best. You may not look for trouble but trouble may come looking for you. And trouble is all the more likely to seek you out if either side thinks you are, or can be, intimidated.

We must have the courage to pursue our own national interests. Sometimes our national interests may lead us to tilt one way, sometimes the other. But it must always be our national interest that guides us and nothing else.

Both the Chinese and Americans may not be too happy with us for pursuing our own interests. But Singapore does not exist to give joy to American or Chinese hearts. So long as neither side is so unhappy that it dismisses us as unredeemable, we can live with their unhappiness and manage it. Straights Times

China’s Expansionist Behavior Invites Opposition, Seeds of a Westphalian System

While Beijing is nestled in the Bohai Sea, China has no buffer zone between its most economically successful coastal provinces that house Shenzhen and Shanghai and the vast ocean. This geographic vulnerability is a driving factor behind China's maritime behavior. While China’s 9 dash lines and expansionist behavior seems like the perfect way to ‘lose friends and alienate people’, Beijing views it as vital for ensuring operational space, establishing early warning systems, and executing anti-access/area-denial and deterrence tactics. This reasoning parallels the current reasoning of Moscow in maintaining a buffer zone on it’s Western border. And as events in the Western Pacific unfold I encourage readers to ponder that reality.

The South China Sea is a buffer-zone for the southern Chinese mainland. China’s control of the region will allow it to create a military barrier from which it can challenge any future military threat. For example, any trade blockade, by any state or a coalition of states, against China could only be achieved through dominance of the South China Sea. A strategic analysis of the South China Sea territorial issues, Japanese Naval College

Vietnam is not alone in these challenges, just about all ASEAN nations have had run-ins with China on this issue. Chinese ships have very recently been obstructing Philippine vessels trying to resupply their BRP Sierra Madre military base. China defended its actions by stating the vessels had trespassed without permission.

I was at the recent Australian Strategic Policy Institute (ASPI) conference in Canberra featured Ignacio Madriaga, Undersecretary for Strategic Assessment and Planning, Philippines Department of National Defense. Madriaga emphasized that from the Philippine perspective, deterrence is already missing the mark with China's deviation from established UNCLOS norms. He adeptly highlighted China's use of four "AIs" in its strategy

AI-1: Artificial Islands: Constructing man-made islands to gain control over crucial maritime pathways. These islands not only serve as strategic footholds but are also equipped with military installations, extending China's capabilities to project power and influence in the region.

AI-2: Alternative Interpretation of international norms: Manipulating international norms to their advantage, exemplified by the contentious 9-dash line. This line is a delineation that China uses to claim vast swathes of the South China Sea, well beyond what is internationally recognized in the UNCLOS framework.

AI-3: Aggressive Interaction: Engaging in confrontational behaviors, such as shadowing and obstructing Philippine ships. Beyond mere intimidation, these actions underscore China's aim to exercise de facto control over contested waters..

AI-4: Artificial Intelligence: Deploying cyber warfare techniques, including espionage operations targeting regional adversaries, cyberattacks against critical infrastructure, and disseminating disinformation to shape the narrative in China's favor.

Madriaga concluded that China has been attempting to slowly change the status quo, and that the response needs to be another AI, All Inclusive. This shift in narrative brings rise to a Westphalian maintenance of the balance of power between states. The Philippines doesn’t care about anyone’s strategy to contain China, all they care about is thwarting China’s hegemonic ambition in the region.

In what this paper argues is a provisional solution, the US has acted as guarantor to regional stability providing a military umbrella which does not offer an enduring resolution to the problem, and indeed risks rapid escalation particularly in the wake of any military miscalculation.

Recognising that the current strategy lacks coherency and unity of effort, the paper then sets out an alternative, collegiate and blended approach. The core of this strategy is based on the need to compel China to accept the rules based international system. The strategy seeks to avoid threatening Chinese sovereignty but re-emphasises the validity of International Law and the application of rules based convention. A strategic analysis of the South China Sea territorial issues

Vietnamese are More Hawkish Than Japan and S. Korea

The Asia-Pacific region presents a kaleidoscope of views towards China's rising economic clout. Australia, for instance, largely sees China's economic growth as a boon. In contrast, India and Vietnam’s sentiments are largely skeptical, with only a small fraction deeming China's ascent as advantageous for their nation.

Vietnam shares a unique relationship with China, characterized by both cooperation and competition. As China's economy has surged, Vietnam has increasingly viewed this ascent as a double-edged sword. On one hand, China's economic activities bring opportunities for trade and investment. On the other hand, there's a prevailing sentiment in Vietnam that the countries are in a zero-sum competition, especially in sectors like manufacturing and exports. With both nations vying for a slice of the global market, Vietnam often finds itself in direct competition with its massive northern neighbor.

The predominant concern in the Asia-Pacific region, including Vietnam, revolves around China's expanding military strength. Vietnam, alongside South Korea and Japan, is wary. All three countries have had military confrontations with China in the last century and ongoing territorial disputes in the East and South China seas. In Vietnam's case, nearly all surveyed citizens believe China's escalating military prowess could pose a threat to their nation.

China Tech? Not in ‘Nam

Vietnamese sources state the belief that Huawei products are being exported at below market prices to “supervise the world”. Vietnam shunned Huawei from their telecommunications networks while bringing in Ericsson and developing their own domestic competitor to Huawei. The Vietnamese are deeply suspicious of Chinese technology and will put domestic sovereignty ahead of cost.

While China's economic trajectory has been wavering, Vietnamese exports to China have been stagnating since 2020.

US-Vietnam Relations Erodes China’s Position

During Bidens recent trip to Hanoi, the U.S. was elevated to the highest diplomatic rank, Comprehensive Strategic Partnership. This elevation came after Vietnam's diplomatic interaction with Australian Prime Minister Anthony Albanese, resulting in various agreements and the release of Australian citizen Chau Van Kham. Vietnamese news sources state that Australia is set to follow in becoming a Comprehensive Strategic Partner of Vietnam.

Put it in perspective, this propels the US into the rarefied pantheon of Việt Nam's close partners - China (which Việt Nam set up Comprehensive Strategic Partnership in 2008), Russia (2012) , Japan (2014), India (2016), Republic of Korea (2022), and Singapore. Indonesia, Australia set to follow - other than Việt Nam's special friendship with its two Indochina neighbours Laos and Cambodia along with the Latin American fraternal partner Cuba. vietnamnews.vn/

Several collaborations were announced with companies such as Boeing, Microsoft, and Nvidia. Emphasis was placed on sectors like cloud computing, semiconductors, and artificial intelligence. Key stakeholders from industries, including Google and Intel, also participated in discussions. Among the agreements, notable mentions include a $7.8 billion agreement with Boeing, the establishment of semiconductor hubs in Ho Chi Minh City, and AI projects with Nvidia and Microsoft. The semiconductor hub is set to be in South Vietnam - in the event of conflict, operations in Hanoi and the shipping lanes in the Gulf of Tonkin could be strongly influenced by China.

"The semiconductor partnership in particular has the potential to help Việt Nam's export-oriented economy rise further up the value chain. Higher-value industrial activity will improve Việt Nam's productivity, which is key to the next stage of its extraordinary growth story.” Nick Ferres, Chief Investment Officer at the Singapore-based Vantage Point Asset Management. vietnamnews.vn

Any benefits to U.S. owned companies will be small, they will take time to ramp up and will only mitigate a portion of the downside geopolitical risk from worsening relations with China. However it is important to note is that Vietnam is adopting U.S. technology rather than Chinese.

Export Growth Driven by Phones, Chips to Come

In looking at the type of products being exported by Vietnam, it becomes very clear that Vietnam’s export boom has been driven by phone manufacturing and assembly. Vietnamese phone exports to the U.S. have been accelerating since 2012, exports to China followed a few years later. Other exports from Vietnam such as semiconductor devices are slowly picking up speed and we expect the growth in Vietnamese exports to broaden to other products.

Phone manufacture in Vietnam is predominantly done by Samsung with over 80% share, followed by Apples contract manufacturer Foxconn. Notably Huawei doesn’t have a manufacturing footprint in Vietnam. Xiaomi only starting shipping made in Vietnam phones in 2022, out of North Vietnam. Vietnams phone export boom has come at the expense of Chinese factories. Vietnam's economic advancements, such as VinFast's listing on Nasdaq, highlight the growing relevance of Vietnams tech sector and their direct competition with Chinese companies in the global markets.

China and Vietnam Have Conflicting Economic Interests

1: Vietnam and China Occupy the Same Position in the US Supply Chain

While China's economic trajectory has been wavering, with growth rates dwindling to just above 3% and challenges like plummeting real estate values and rising youth unemployment, it presents a unique opportunity for countries like Vietnam. As US imports from China have decreased, reaching $771B in Q2 2023 from a peak of $879B in Q2 2022, nations like Vietnam, are stepping up to fill the gap. Notably, US imports from Canada and Mexico have surpassed those from China, reflecting a significant change in trading dynamics.

We interpret these trade shifts as a transition in consumer spending from goods to services, dovetailing with a cyclical downturn in the devices sector and a strategic move towards onshoring or friend-shoring. China, with its export economy focused on electrical devices and in geopolitical competition with the US, stands vulnerable to these potential slowdowns. Even though a potential rebound in the electronics market might temporarily elevate US imports from China, the momentum towards diversifying supply chains to regions like ASEAN, including Vietnam, is set to continue.

2: Vietnam’s Rare Earth Opportunity = China’s Loss of Leverage

The Biden administration made REE’s a key focus of the Vietnam trip per the following White House briefing:

Diverse and Securing Critical Mineral Supply Chains:  A bilateral Memorandum of Understanding strengthens technical cooperation to support Vietnam’s efforts to quantify its Rare Earth Elements (REE) resources and economic potential, attract quality investment for integrated REE sector development, and meet high environmental, social, and governance standards. White House briefing

China's decision to control exports of certain rare earths, citing national security, has triggered a global reaction. Although China has a dominant position in rare earth production, its previous attempt to leverage this against Japan backfired, reducing its global market share from 97% to 60% within a decade (Zen on Tech V15). The US is also actively encouraging nations like Australia and Canada to increase their production of rare metals. As the US fosters stronger ties with emerging markets in the Indo-Pacific, it aims to harness their untapped mineral resources.

Extracting mineral resources from their vast reserves is perhaps one of the most feasible ways for Vietnam to generate tax revenue. It will be hard for China to stand in the way of Vietnam making the most of their resources.

3: Vietnam Wants Freedom to Operate Within it’s EEZ

China has sought to tap into marine resources in the South China Sea, which the Vietnamese people deemed egregious economic theft. Yet, in the current balance of power Vietnam has limited capability to defend its regional interests without collaboration with other nations and the backing of the US.

In 2014, riots broke out at industrial parks near Ho Chi Minh City, with protesters looting and damaging Chinese factories. The Associated Press reported that around 20,000 people had participated in initial peaceful protests in Binh Duong province. The unrest began after Beijing placed an oil rig, Haiyang Shiyou 981, in water 70 miles within Vietnam's exclusive economic zone (EEZ).

Is Vietnam a Reliable Partner for the US?

Just a week ahead of Biden's visit to Vietnam, a Chinese delegation visited Vietnam:

"Highlighting the tradition of friendship and mutual assistance between the two Parties, the two countries and the two peoples, Trong expressed appreciation for the Chinese people's help to Vietnam's revolutionary cause and socialist construction and national development over the period, as well as the contributions of Chinese senior leaders, particularly Party General Secretary and President Xi Jinping, to the development of Vietnam-China relations in recent years." e.vnexpress.net/news

Vietnams government is ideologically similar to the CCP and they score very low on personal freedom indices that we value in democracies. However they are deeply suspicious of China because of their long history of Chinese rule and recent history of territorial disputes. Vietnam is primarily concerned with sovereignty, territorial integrity and economic prosperity. We argue that Vietnam will aim to extract territorial concessions out of China vis a vis international norms by partnering with regional allies and the U.S. Vietnam will step in to economically engage with the West as the U.S. ‘de-risks’ from China. Unless China can craft a strategy of engaging with Vietnam we see this as negative for Chinese manufacturing.

If conflict were to break out in the region over Taiwan, Vietnam would likely try to avoid getting involved. Their focus would be on securing maritime trade and their northern border with China. However North/South tensions is a risk that needs careful attention both in a hot conflict and in the structure of competition.

What Can China offer Vietnam?

The primary challenges facing China in deepening ties with Vietnam are rooted in historical distrust, territorial disputes in the South China Sea, and competition for market share and resources. For China to bring Vietnam closer into its orbit and away from the US, it will need to compromise on it’s ambition. Here we outline potential paths it could consider:

1. Economic Incentives:

   • Trade Concessions: Vietnam and China are both part of the RCEP, so China could propose favorable terms or preferential access to its domestic market.

   • Infrastructure Development: Extend the Belt and Road Initiative (BRI) more comprehensively into Vietnam, financing and aiding in key infrastructure projects. Vietnam is in dire need of infrastructure and utilities upgrades but they will be wary of Chinese influence and do it on their own terms.

   • Investment: Encourage Chinese companies to invest more heavily in Vietnam.

2. Technological Collaboration: While Vietnam is wary of Chinese tech, especially in the telecom sector, China could offer partnerships in other tech arenas like green technology. Knowledge transfer agreements where Chinese institutions collaborate with Vietnamese ones, helping to build technological capacity in Vietnam. This would cost Beijing leverage over global manufacturing while Chinese companies learn how to outsource manufacturing. Xiaomi recently opened a factory in Vietnam, but this is a minor investment. We expect that anything that China invests into Vietnam will be non-critical so as not to erode Chinas influence over global manufacturing.

3. Strategic and Defense Concessions: China could ease its aggressive stance in the South China Sea, recognizing Vietnam's EEZ and reducing military installations and patrols. This would significantly improve trust between the two countries but at a cost of strategic influence for China.

4. Energy and Natural Resources: Offer partnerships in clean energy development. Mutual recognition of each country's rights to certain rare earth minerals and resources.

5. Soft-Power: Cultural and people-to-people ties, diplomacy, joint collaboration for regional stability and development, address the trust deficit, open channels for constant dialogue and dispute resolution.

However, the reality is that Vietnam's trajectory, both economically and geopolitically, seems to be tilting towards the US and other like-minded democracies. As such, China's efforts to bring Vietnam closer might face challenges. The situation requires adept diplomacy, mutual respect, and consistent efforts to build trust over time.

SMIC, under sanctions, has been providing 7nm chips to Huawei, another sanctioned company, actions that are well over the line. Despite early indications that SMIC's production efficiency for these chips is subpar, it may represent China's symbolic message that "U.S. sanctions are ineffective,".

"Huawei is testing the US red line now. If there's no response from the US, Huawei will see it as a green light, and its suppliers might follow SMIC's footsteps, undermining US sanctions," Lin Tsung-nan, electrical engineering professor at National Taiwan University.

The Challenge of Enforcing U.S. Sanctions on China's Turf

The aim of the Trump era Huawei ban is to restrict any manufacturer, from leveraging U.S.-made equipment in its production processes to create products for Huawei. However, the challenge lies in the execution and enforceability of such a ban on Chinese suppliers. While the United States can exert control and influence on its own soil, or through international trade, attempting to dictate how already-sold equipment is used within China's borders presents significant obstacles. Direct enforcement of such a ban within another country is near impossible.

Where the U.S. does retain significant control is within its borders and with its own (and to a lesser extent, allied) exports. Thus, a more feasible and enforceable strategy would involve curbing or monitoring the export of sensitive machinery or technology to China, like the Biden administration October 2022 ban. By managing what equipment enters China, the country can influence how China's tech sector operates, without overstepping into direct intervention within China's internal affairs.

“Covenants, without the sword, are but words and of no strength to secure a man at all.” Hobbes, Leviathan.

One could argue that sabotage, particularly via compromising industrial control systems, could be a way to disincentivize Chinese suppliers from selling to Huawei. Our previous research shows that it would be possible for the U.S. to target Western industrial control systems operating in Chinese fabs (China's Options for Semiconductor Security). Such actions come with considerable ramifications and could escalate tensions further however this route has been walked before. Blocking control system software updates and replacement parts would be another means to make this more challenging for Chinese manufacturers

“It [Stuxnet, an industrial control system virus used against Iranian nuclear material enrichment facility] bought us time. First, it was to get across from one administration to the next without having the issue blow up. And then it was to give Obama a little more time to come up with alternatives, through the sanctions,” Cyber-attacks "bought us time" on Iran: U.S. sources | Reuters 

China's Semiconductor Reality

“We should actually be pretty cautious in how we interpret this…Huawei has a great job of publicizing this but I don’t think we should conclude that it means something that it doesn’t necessarily mean. We shouldn’t over-estimate the impact of this news… Absent great data on yield and cost and volume, it definitely doesn’t mean that SMIC will have an easy pathway toward 5 nanometer.” Chris Miller, author of Chip War: The Fight for the World’s Most Critical Technology.

Doug Fuller, a prominent China tech observer and author, took to X to shed light on China's chip manufacturing landscape. A few of his observations include:

• The success story of China's semiconductor industry might be more of a myth.

• SMIC's chip yield rate is less than 10%, a stark contrast to Taiwan's TSMC which had 80-94% for its 7nm chips four years back.

Fuller points out that his sources indicate that the yield rate of SMIC’s process is less than 10% (using Western equipment). This dismal performance starkly contrasts with Taiwan's TSMC, which boasted yield rates of 80-94% for its 7nm chips nearly four years ago. The Chinese government has stepped in to subsidize this low-performing sector, making it economically viable only because the state is absorbing the high costs.

We've delved into China's journey towards semiconductor independence (here). We estimate that eliminating Western technology from their supply chain up to 5nm could cost China over $60B and may take them until the decade's end. By that time, the allied supply chain will have advanced by several generations.

Strategizing Sanctions: What Works Best?

“If you give a man a fish, you feed him for a day. If you teach a man to fish, you feed him for a lifetime.” Applied in reverse. "If you take a mans fish, you starve him for a day. If you take away a man's ability to fish, you starve him for a lifetime."

Or more specifically “If you take a nations commodities, you weaken them for a day. If you take away a nations manufacturing technology, you weaken them for a lifetime.”

Sanctions are a powerful geopolitical tool used by nations like the U.S. to influence or penalize adversaries. However, their effectiveness and fairness are debated, especially in the tech arena involving AI and semiconductors. Using the "teach a man to fish" analogy, there's a dilemma: should the U.S. restrict the end product or the means of production? The former may produce immediate results (Huawei decapitation), but the latter could have more profound long-term effects. Paul Scharre suggests that while the U.S. aims to control China's chip-making abilities, completely cutting off access may backfire by fueling China's domestic growth.

“The US government, meanwhile, has been slow to develop a strategy for competing in AI hardware. Like a drunk in a bar fight, the United States threw the first punch in a global chip war with no plan for how to finish the fight. Some of the U.S. government's actions are sensible but others have been self defeating. Restricting China's access to manufacturing equipment and software design tools necessary to manufacturing leading edge chips makes sense. The United States and its allies should aim to keep China reliant on foreign chips supplies, retaining the ability to cut off China's access to chips if needed. Yet actually cutting off access to chips, as the United States did with 5G chips for Huawei and with advanced AI chips nationwide, should be a rare move. Denying China the ability to import chips turns China's $400 billion of semiconductor buying power inward, fueling the growth of their domestic semiconductor industry, which is the exact opposite of what Washington should want.” - Paul Scharre, Four Battlegrounds

Moreover, as pointed out by various sources, the implementation of these restrictions has been porous. The Bureau of Industry and Security's licenses, ambiguities in technical standards, and vulnerabilities like leaked manuals, indicate that the sanctions, are leaky. These loopholes aren't just administrative oversights; they hint at deeper issues, including potential lobbying pressures from U.S. firms that stand to lose from stringent controls. The U.S. is at a crossroads—either to abandon these controls or rectify them.

Apple’s China Conundrum

To add to the drama, in the last week, China banned its government officials from using iPhones and other foreign devices at work, aiming to decrease dependence on foreign tech and boost cybersecurity. This move could hit up to 5% of Apple's iPhone sales in China, potentially costing the company around $4 billion in revenue. The ban might also tarnish Apple's brand image in the country. China is Apple’s third-largest market, accounting for 18% of total revenue last year. While the long-term effects are uncertain, Apple faces bearish challenges like losing market share to local competitors like Huawei and Xiaomi (revenue ↓) while adjusting its supply chain out of China (costs ↑). The ban poses a significant hurdle for Apple in one of its primary markets.

Several agencies have begun instructing staff not to bring their iPhones to work, people familiar with the matter said, affirming a previous report from the Wall Street Journal. In addition, Beijing intends to extend that restriction far more broadly to a plethora of state-owned enterprises and other government-controlled organizations, said the people, who asked not to be identified discussing a sensitive matter. https://www.bloomberg.com/news/articles/2023-09-07/china-plans-to-expand-iphone-ban-to-some-state-backed-firms-in-blow-to-apple

The U.S. Policy Stance: Work in Progress

As the Biden Administration and Congress start looking into the new Huawei phone, and US media like the Washington Post report on how much PRC media and netizens mocked Commerce Secretary Raimondo, is it possible that the trolling could be good for scoring cheap nationalist points but ultimately cause a lot more pain for Huawei and SMIC? Bill Bishop, Sinocism

The U.S. faces the challenge of aligning national security interests with the complexities of global trade. Jake Sullivan's "small yard, high fence" philosophy indicates a preference for a targeted approach, addressing genuine security threats without implementing a sweeping disconnection from China's technological landscape. Nonetheless, the perceived leniency, as illustrated by the collaboration between SMIC and Huawei, brings into question the administrations dedication to safeguarding its national priorities.

“I’m going to withhold comment on the particular chip in question until we get more information about precisely its character and composition… What it tells us, regardless, is that the United States should continue on its course of a ‘small yard, high fence’ set of technology restrictions focused narrowly on national security concerns, not on the broader question of commercial decoupling.” Jake Sullivan during a White House briefing

Mike Gallagher's stance (below) underscores a more stringent methodology, pushing for a cessation of tech exports to entities that either violate U.S. regulations or pose security risks. While this viewpoint might steer U.S. policy towards tighter controls, it's worth noting that aggressive measures might inadvertently hand China a nationalist victory, framing them as resilient underdogs against U.S. pressure. Furthermore, this could prompt China to hasten its technological progression, or forge ties with other global players, potentially contesting U.S. technological supremacy.

"This chip likely could not be produced without US technology and thus SMIC may have violated the Department of Commerce’s Foreign Direct Product Rule… The time has come to end all U.S. technology exports to both Huawei and SMIC to make clear any firm that flouts U.S. law and undermines our national security will be cut off from our technology." Mike Gallagher, Chair of the House Committee on the Chinese Communist Party

Central to this debate is not just restricting end products, but more critically, the means of production, which will be the real game-changer in this geopolitical tech tussle.