The Gaussian Copula Function

Recipe for Disaster: The Formula That Killed Wall Street

By Felix Salmon 02.23.09

In the mid-'80s, Wall Street turned to the quants—brainy financial engineers—to invent new ways to boost profits. Their methods for minting money worked brilliantly... until one of them devastated the global economy.
Photo: Jim Krantz/Gallery Stock

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A year ago, it was hardly unthinkable that a math wizard like David X. Li might someday earn a Nobel Prize. After all, financial economists—even Wall Street quants—have received the Nobel in economics before, and Li's work on measuring risk has had more impact, more quickly, than previous Nobel Prize-winning contributions to the field. Today, though, as dazed bankers, politicians, regulators, and investors survey the wreckage of the biggest financial meltdown since the Great Depression, Li is probably thankful he still has a job in finance at all. Not that his achievement should be dismissed. He took a notoriously tough nut—determining correlation, or how seemingly disparate events are related—and cracked it wide open with a simple and elegant mathematical formula, one that would become ubiquitous in finance worldwide.

For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.

David X. Li, it's safe to say, won't be getting that Nobel anytime soon. One result of the collapse has been the end of financial economics as something to be celebrated rather than feared. And Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees.

How could one formula pack such a devastating punch? The answer lies in the bond market, the multitrillion-dollar system that allows pension funds, insurance companies, and hedge funds to lend trillions of dollars to companies, countries, and home buyers.

A bond, of course, is just an IOU, a promise to pay back money with interest by certain dates. If a company—say, IBM—borrows money by issuing a bond, investors will look very closely over its accounts to make sure it has the wherewithal to repay them. The higher the perceived risk—and there's always some risk—the higher the interest rate the bond must carry.

Bond investors are very comfortable with the concept of probability. If there's a 1 percent chance of default but they get an extra two percentage points in interest, they're ahead of the game overall—like a casino, which is happy to lose big sums every so often in return for profits most of the time.

Bond investors also invest in pools of hundreds or even thousands of mortgages. The potential sums involved are staggering: Americans now owe more than $11 trillion on their homes. But mortgage pools are messier than most bonds. There's no guaranteed interest rate, since the amount of money homeowners collectively pay back every month is a function of how many have refinanced and how many have defaulted. There's certainly no fixed maturity date: Money shows up in irregular chunks as people pay down their mortgages at unpredictable times—for instance, when they decide to sell their house. And most problematic, there's no easy way to assign a single probability to the chance of default.

Wall Street solved many of these problems through a process called tranching, which divides a pool and allows for the creation of safe bonds with a risk-free triple-A credit rating. Investors in the first tranche, or slice, are first in line to be paid off. Those next in line might get only a double-A credit rating on their tranche of bonds but will be able to charge a higher interest rate for bearing the slightly higher chance of default. And so on.

"...correlation is charlatanism"
Photo: AP photo/Richard Drew

The reason that ratings agencies and investors felt so safe with the triple-A tranches was that they believed there was no way hundreds of homeowners would all default on their loans at the same time. One person might lose his job, another might fall ill. But those are individual calamities that don't affect the mortgage pool much as a whole: Everybody else is still making their payments on time.

But not all calamities are individual, and tranching still hadn't solved all the problems of mortgage-pool risk. Some things, like falling house prices, affect a large number of people at once. If home values in your neighborhood decline and you lose some of your equity, there's a good chance your neighbors will lose theirs as well. If, as a result, you default on your mortgage, there's a higher probability they will default, too. That's called correlation—the degree to which one variable moves in line with another—and measuring it is an important part of determining how risky mortgage bonds are.

Investors like risk, as long as they can price it. What they hate is uncertainty—not knowing how big the risk is. As a result, bond investors and mortgage lenders desperately want to be able to measure, model, and price correlation. Before quantitative models came along, the only time investors were comfortable putting their money in mortgage pools was when there was no risk whatsoever—in other words, when the bonds were guaranteed implicitly by the federal government through Fannie Mae or Freddie Mac.

Yet during the '90s, as global markets expanded, there were trillions of new dollars waiting to be put to use lending to borrowers around the world—not just mortgage seekers but also corporations and car buyers and anybody running a balance on their credit card—if only investors could put a number on the correlations between them. The problem is excruciatingly hard, especially when you're talking about thousands of moving parts. Whoever solved it would earn the eternal gratitude of Wall Street and quite possibly the attention of the Nobel committee as well.

To understand the mathematics of correlation better, consider something simple, like a kid in an elementary school: Let's call her Alice. The probability that her parents will get divorced this year is about 5 percent, the risk of her getting head lice is about 5 percent, the chance of her seeing a teacher slip on a banana peel is about 5 percent, and the likelihood of her winning the class spelling bee is about 5 percent. If investors were trading securities based on the chances of those things happening only to Alice, they would all trade at more or less the same price.

But something important happens when we start looking at two kids rather than one—not just Alice but also the girl she sits next to, Britney. If Britney's parents get divorced, what are the chances that Alice's parents will get divorced, too? Still about 5 percent: The correlation there is close to zero. But if Britney gets head lice, the chance that Alice will get head lice is much higher, about 50 percent—which means the correlation is probably up in the 0.5 range. If Britney sees a teacher slip on a banana peel, what is the chance that Alice will see it, too? Very high indeed, since they sit next to each other: It could be as much as 95 percent, which means the correlation is close to 1. And if Britney wins the class spelling bee, the chance of Alice winning it is zero, which means the correlation is negative: -1.

If investors were trading securities based on the chances of these things happening to both Alice and Britney, the prices would be all over the place, because the correlations vary so much.

But it's a very inexact science. Just measuring those initial 5 percent probabilities involves collecting lots of disparate data points and subjecting them to all manner of statistical and error analysis. Trying to assess the conditional probabilities—the chance that Alice will get head lice if Britney gets head lice—is an order of magnitude harder, since those data points are much rarer. As a result of the scarcity of historical data, the errors there are likely to be much greater.

In the world of mortgages, it's harder still. What is the chance that any given home will decline in value? You can look at the past history of housing prices to give you an idea, but surely the nation's macroeconomic situation also plays an important role. And what is the chance that if a home in one state falls in value, a similar home in another state will fall in value as well?

Here's what killed your 401(k) David X. Li's Gaussian copula function as first published in 2000. Investors exploited it as a quick—and fatally flawed—way to assess risk. A shorter version appears on this month's cover of Wired.

Probability Specifically, this is a joint default probability—the likelihood that any two members of the pool (A and B) will both default. It's what investors are looking for, and the rest of the formula provides the answer.	Survival times The amount of time between now and when A and B can be expected to default. Li took the idea from a concept in actuarial science that charts what happens to someone's life expectancy when their spouse dies.	Equality A dangerously precise concept, since it leaves no room for error. Clean equations help both quants and their managers forget that the real world contains a surprising amount of uncertainty, fuzziness, and precariousness.
Copula This couples (hence the Latinate term copula) the individual probabilities associated with A and B to come up with a single number. Errors here massively increase the risk of the whole equation blowing up.	Distribution functions The probabilities of how long A and B are likely to survive. Since these are not certainties, they can be dangerous: Small miscalculations may leave you facing much more risk than the formula indicates.	Gamma The all-powerful correlation parameter, which reduces correlation to a single constant—something that should be highly improbable, if not impossible. This is the magic number that made Li's copula function irresistible.

Enter Li, a star mathematician who grew up in rural China in the 1960s. He excelled in school and eventually got a master's degree in economics from Nankai University before leaving the country to get an MBA from Laval University in Quebec. That was followed by two more degrees: a master's in actuarial science and a PhD in statistics, both from Ontario's University of Waterloo. In 1997 he landed at Canadian Imperial Bank of Commerce, where his financial career began in earnest; he later moved to Barclays Capital and by 2004 was charged with rebuilding its quantitative analytics team.

Li's trajectory is typical of the quant era, which began in the mid-1980s. Academia could never compete with the enormous salaries that banks and hedge funds were offering. At the same time, legions of math and physics PhDs were required to create, price, and arbitrage Wall Street's ever more complex investment structures.

In 2000, while working at JPMorgan Chase, Li published a paper in The Journal of Fixed Income titled "On Default Correlation: A Copula Function Approach." (In statistics, a copula is used to couple the behavior of two or more variables.) Using some relatively simple math—by Wall Street standards, anyway—Li came up with an ingenious way to model default correlation without even looking at historical default data. Instead, he used market data about the prices of instruments known as credit default swaps.

If you're an investor, you have a choice these days: You can either lend directly to borrowers or sell investors credit default swaps, insurance against those same borrowers defaulting. Either way, you get a regular income stream—interest payments or insurance payments—and either way, if the borrower defaults, you lose a lot of money. The returns on both strategies are nearly identical, but because an unlimited number of credit default swaps can be sold against each borrower, the supply of swaps isn't constrained the way the supply of bonds is, so the CDS market managed to grow extremely rapidly. Though credit default swaps were relatively new when Li's paper came out, they soon became a bigger and more liquid market than the bonds on which they were based.

When the price of a credit default swap goes up, that indicates that default risk has risen. Li's breakthrough was that instead of waiting to assemble enough historical data about actual defaults, which are rare in the real world, he used historical prices from the CDS market. It's hard to build a historical model to predict Alice's or Britney's behavior, but anybody could see whether the price of credit default swaps on Britney tended to move in the same direction as that on Alice. If it did, then there was a strong correlation between Alice's and Britney's default risks, as priced by the market. Li wrote a model that used price rather than real-world default data as a shortcut (making an implicit assumption that financial markets in general, and CDS markets in particular, can price default risk correctly).

It was a brilliant simplification of an intractable problem. And Li didn't just radically dumb down the difficulty of working out correlations; he decided not to even bother trying to map and calculate all the nearly infinite relationships between the various loans that made up a pool. What happens when the number of pool members increases or when you mix negative correlations with positive ones? Never mind all that, he said. The only thing that matters is the final correlation number—one clean, simple, all-sufficient figure that sums up everything.

The effect on the securitization market was electric. Armed with Li's formula, Wall Street's quants saw a new world of possibilities. And the first thing they did was start creating a huge number of brand-new triple-A securities. Using Li's copula approach meant that ratings agencies like Moody's—or anybody wanting to model the risk of a tranche—no longer needed to puzzle over the underlying securities. All they needed was that correlation number, and out would come a rating telling them how safe or risky the tranche was.

As a result, just about anything could be bundled and turned into a triple-A bond—corporate bonds, bank loans, mortgage-backed securities, whatever you liked. The consequent pools were often known as collateralized debt obligations, or CDOs. You could tranche that pool and create a triple-A security even if none of the components were themselves triple-A. You could even take lower-rated tranches of other CDOs, put them in a pool, and tranche them—an instrument known as a CDO-squared, which at that point was so far removed from any actual underlying bond or loan or mortgage that no one really had a clue what it included. But it didn't matter. All you needed was Li's copula function.

The CDS and CDO markets grew together, feeding on each other. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that number had skyrocketed to more than $62 trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.

At the heart of it all was Li's formula. When you talk to market participants, they use words like beautiful, simple, and, most commonly, tractable. It could be applied anywhere, for anything, and was quickly adopted not only by banks packaging new bonds but also by traders and hedge funds dreaming up complex trades between those bonds.

"The corporate CDO world relied almost exclusively on this copula-based correlation model," says Darrell Duffie, a Stanford University finance professor who served on Moody's Academic Advisory Research Committee. The Gaussian copula soon became such a universally accepted part of the world's financial vocabulary that brokers started quoting prices for bond tranches based on their correlations. "Correlation trading has spread through the psyche of the financial markets like a highly infectious thought virus," wrote derivatives guru Janet Tavakoli in 2006.

The damage was foreseeable and, in fact, foreseen. In 1998, before Li had even invented his copula function, Paul Wilmott wrote that "the correlations between financial quantities are notoriously unstable." Wilmott, a quantitative-finance consultant and lecturer, argued that no theory should be built on such unpredictable parameters. And he wasn't alone. During the boom years, everybody could reel off reasons why the Gaussian copula function wasn't perfect. Li's approach made no allowance for unpredictability: It assumed that correlation was a constant rather than something mercurial. Investment banks would regularly phone Stanford's Duffie and ask him to come in and talk to them about exactly what Li's copula was. Every time, he would warn them that it was not suitable for use in risk management or valuation.

David X. Li
Illustration: David A. Johnson

In hindsight, ignoring those warnings looks foolhardy. But at the time, it was easy. Banks dismissed them, partly because the managers empowered to apply the brakes didn't understand the arguments between various arms of the quant universe. Besides, they were making too much money to stop.

In finance, you can never reduce risk outright; you can only try to set up a market in which people who don't want risk sell it to those who do. But in the CDO market, people used the Gaussian copula model to convince themselves they didn't have any risk at all, when in fact they just didn't have any risk 99 percent of the time. The other 1 percent of the time they blew up. Those explosions may have been rare, but they could destroy all previous gains, and then some.

Li's copula function was used to price hundreds of billions of dollars' worth of CDOs filled with mortgages. And because the copula function used CDS prices to calculate correlation, it was forced to confine itself to looking at the period of time when those credit default swaps had been in existence: less than a decade, a period when house prices soared. Naturally, default correlations were very low in those years. But when the mortgage boom ended abruptly and home values started falling across the country, correlations soared.

Bankers securitizing mortgages knew that their models were highly sensitive to house-price appreciation. If it ever turned negative on a national scale, a lot of bonds that had been rated triple-A, or risk-free, by copula-powered computer models would blow up. But no one was willing to stop the creation of CDOs, and the big investment banks happily kept on building more, drawing their correlation data from a period when real estate only went up.

"Everyone was pinning their hopes on house prices continuing to rise," says Kai Gilkes of the credit research firm CreditSights, who spent 10 years working at ratings agencies. "When they stopped rising, pretty much everyone was caught on the wrong side, because the sensitivity to house prices was huge. And there was just no getting around it. Why didn't rating agencies build in some cushion for this sensitivity to a house-price-depreciation scenario? Because if they had, they would have never rated a single mortgage-backed CDO."

Bankers should have noted that very small changes in their underlying assumptions could result in very large changes in the correlation number. They also should have noticed that the results they were seeing were much less volatile than they should have been—which implied that the risk was being moved elsewhere. Where had the risk gone?

They didn't know, or didn't ask. One reason was that the outputs came from "black box" computer models and were hard to subject to a commonsense smell test. Another was that the quants, who should have been more aware of the copula's weaknesses, weren't the ones making the big asset-allocation decisions. Their managers, who made the actual calls, lacked the math skills to understand what the models were doing or how they worked. They could, however, understand something as simple as a single correlation number. That was the problem.

"The relationship between two assets can never be captured by a single scalar quantity," Wilmott says. For instance, consider the share prices of two sneaker manufacturers: When the market for sneakers is growing, both companies do well and the correlation between them is high. But when one company gets a lot of celebrity endorsements and starts stealing market share from the other, the stock prices diverge and the correlation between them turns negative. And when the nation morphs into a land of flip-flop-wearing couch potatoes, both companies decline and the correlation becomes positive again. It's impossible to sum up such a history in one correlation number, but CDOs were invariably sold on the premise that correlation was more of a constant than a variable.

No one knew all of this better than David X. Li: "Very few people understand the essence of the model," he told The Wall Street Journal way back in fall 2005.

"Li can't be blamed," says Gilkes of CreditSights. After all, he just invented the model. Instead, we should blame the bankers who misinterpreted it. And even then, the real danger was created not because any given trader adopted it but because every trader did. In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust.

Nassim Nicholas Taleb, hedge fund manager and author of The Black Swan, is particularly harsh when it comes to the copula. "People got very excited about the Gaussian copula because of its mathematical elegance, but the thing never worked," he says. "Co-association between securities is not measurable using correlation," because past history can never prepare you for that one day when everything goes south. "Anything that relies on correlation is charlatanism."

Li has been notably absent from the current debate over the causes of the crash. In fact, he is no longer even in the US. Last year, he moved to Beijing to head up the risk-management department of China International Capital Corporation. In a recent conversation, he seemed reluctant to discuss his paper and said he couldn't talk without permission from the PR department. In response to a subsequent request, CICC's press office sent an email saying that Li was no longer doing the kind of work he did in his previous job and, therefore, would not be speaking to the media.

In the world of finance, too many quants see only the numbers before them and forget about the concrete reality the figures are supposed to represent. They think they can model just a few years' worth of data and come up with probabilities for things that may happen only once every 10,000 years. Then people invest on the basis of those probabilities, without stopping to wonder whether the numbers make any sense at all.

As Li himself said of his own model: "The most dangerous part is when people believe everything coming out of it."

Semi-conductor business

The semiconductor industry

Under new management

Chipmakers were suffering even before the global economic downturn. Recession is heightening the pain and highlighting changes in structure and ownership

Apr 2nd 2009 | DRESDEN | From The Economist print edition

AFP

MOST tourists come to Dresden to view the city’s architectural wonders. Beautifully rebuilt, the Frauenkirche (Church of Our Lady), for instance, reveals no hint that its huge cupola once crumbled after a rain of British bombs. But the capital of the German state of Saxony also has more contemporary attractions—at least for technically inclined travellers. It is the hub of one of Europe’s biggest technology clusters. Silicon Saxony, as the region has come to be called, boasts 1,500 high-tech firms employing 43,000 people, most of them in the semiconductor industry.

Yet industrial tourists had better hurry. Recently Silicon Saxony has taken some hits that have weakened its foundations. On April 1st Qimonda, a maker of memory chips and the cluster’s largest employer, mothballed its factory, having been forced into insolvency earlier this year. Its last hope is to be bought by an outside investor lured by money from the Saxon government. Inspur, a Chinese computer-maker, is among those expressing interest in Qimonda, which has developed some cutting-edge technology.

At Dresden’s other big “fab”, as chip-fabrication plants are called, is an indicator of another change that may prove just as damaging. There is a new logo at the entrance: visitors are no longer welcomed to AMD but to Globalfoundries. AMD, a maker of microprocessors for personal computers (PCs), decided last year to spin off its fabs into a separate company and to sell a majority stake to investment funds controlled by the government of Abu Dhabi. A good deal of production, some fret, may eventually move from Dresden to the Gulf.

The likely death of Qimonda and the birth of Globalfoundries have turned Silicon Saxony into an industrial showcase of a very different kind. It is a visible token of how hard recession around the world has hit the semiconductor industry, which had already been weakened by one of its periodic downturns. Just as important, it demonstrates the longer-term upheavals in the industry. The semiconductor business is becoming less vertically integrated and more concentrated. And its centre of gravity is shifting eastwards.

Despite a few signs that the worst may be over—Asian chipmakers’ share prices soared recently after shortages were predicted—the industry is still in the midst of the longest slump in its 50-year history. If market researchers are right, it will shrink again in 2009 before resuming growth in 2010. iSuppli, one such forecaster, thinks that revenues will fall by more than 20% this year, to $205 billion (see chart 1). Other observers have been making similarly gloomy predictions.

To understand why the semiconductor industry has been so pummelled, think of integrated circuits (ie, chips) not as tiny pieces of silicon engraved with millions of transistors, but as an essential resource. Before long every man-made object will come with at least one embedded microchip (see chart 2). Jerry Sanders, AMD’s founder, once called chips “the crude oil of industry”. This seems apt: integrated circuits have become the grease of the information economy. The flip side is that chipmakers have come to depend increasingly on the health of the rest of the economy.

The chip cycle

However, the industry’s own economics are also to blame. Even without the world’s wider troubles, these would have caused problems. In explaining how, Dan Hutcheson, chief executive of VLSI Research, a consultancy, likens semiconductor manufacturing to a different industry: farming. Investment decisions have to be made long before products can be sold. Chip farmers have to spend billions and wait years before they can start etching circuits onto “wafers”, those thin disks of semiconductor material, the size of pizzas, which are sliced into hundreds of chips at the end of the production process.

This goes a long way towards explaining why chipmakers, like farmers, have a tendency to oversupply the market, particularly if they sell memory chips, an undifferentiated product (like winter wheat). Even if prices fall below costs, they have an interest in keeping their fabs humming, in order not to lose their heavy upfront investment and to recover the variable costs. What is more, they are caught on a “technology treadmill”, in the words of Mr Hutcheson. Competition forces them always to employ the latest technology, which both increases output and puts pressure on prices.

Finally, just as in agriculture, governments further fuel this innate tendency to oversupply. In prestige, national security, industrial policy or just a desire to create jobs, politicians have always found a reason to support their semiconductor industries, mostly with cash. Silicon Saxony, for instance, has received more than €1.5 billion (nearly $2 billion at today’s exchange rate) from the state of Saxony alone, much of it to coax AMD into investing.

Asian governments have been the most active. Thanks to Taiwan’s industrial policy, more than half of the world’s chips are now made there. Support from the South Korean government made Samsung and Hynix the world’s biggest makers of memory chips; they supply about 50% of this segment. China seems intent on turning its semiconductor companies into market leaders at almost any price, above all Semiconductor Manufacturing International Corporation, or SMIC. All this explains why of the 40 fabs under construction in 2007, 35 were in Asia, three in America and only two in Europe.

Not surprisingly, at times supply far outstrips demand. From 2002 until last year Asian makers of memory chips, especially, invested as if capital were free—which explains why everybody is now bleeding money. In July 2007 the price of a DRAM (dynamic random access memory) chip with a capacity of 512 megabits was more than $2. In early April it was about 50 cents. Smaller makers cannot cope. Qimonda, for instance, piled up losses of about €1.5 billion between October 2007 and June 2008. Its revenues were only €1.3 billion.

Given the scale of the losses and the screaming from other industries, governments look less inclined to help this time. Even Taiwan is having second thoughts about an ambitious plan to save its memory-chip industry, announced only last month. The idea is to merge and bail out the country’s six makers of memory chips, which have lost $12.5 billion in the past two years and accumulated $11 billion in debts.

Even if Taiwan were to let these firms fail, which is highly unlikely, supply would still exceed demand, according to iSuppli. Global sales of memory chips will not start growing again before next year. And growth will not reattain its 2006 rate before 2015.

Whatever happens to Qimonda and its Taiwanese rivals, the current crisis is sure to speed up two seemingly contradictory long-term trends in the industry. It is consolidating, in that the manufacture of chips is becoming concentrated among fewer companies. At the same time, it is splitting up, in that more companies are specialising in design, and contracting out or quitting the making of chips. Both developments are mainly the consequence of what has come to be called “Moore’s Second Law”, an economic counterpart to a better known observation by Gordon Moore, one of the founders of Intel, the world’s biggest chipmaker by revenue.

The original Moore’s Law is usually summarised thus: the number of transistors on a chip doubles every 18 months. In fact Mr Moore first predicted this would happen every year and later changed his forecast to every two years; the average has become his law. Mr Hutcheson points out that Mr Moore made more than a purely technical prediction. He also stated that the cost of an integrated circuit would stay the same, a halving of the cost per transistor with every doubling of the number.

This has turned out to be essentially correct, but progress has come at a high price. The ever more sophisticated equipment required to make semiconductors has been getting dearer with every iteration of Moore’s Law. The most advanced chips are built using 32-nanometre technology, meaning that transistors are now so tiny that more than 4m can fit on this full stop. Lithographic tools for transferring Lilliputian circuitry onto a wafer cost up to $50m a pop. To reach the economies of scale needed to make such investments pay, chipmakers must build bigger fabs.

Rising fixed costs give rise to Moore’s Second Law: as the cost of transistors comes down, the cost of fabs goes up, albeit not at quite the same rate. In 1966 a new fab cost $14m. By 1995 the price had risen to $1.5 billion. Today, says Intel, the cost of a leading-edge fab exceeds $6 billion, including all the preparatory work. And the Taiwanese Semiconductor Manufacturing Company (TSMC) has built two “GigaFabs” for between $8 billion and $10 billion each, which would buy you four nuclear power stations. The output of such monsters depends on the mix of products, but they each could easily churn out 3 billion chips a year.

These ever-increasing costs and the need for specialisation have caused the industry to splinter, says Derek Lidow, iSuppli’s chief executive. Originally, all chipmakers were vertically integrated, meaning they designed the chip, built the tools to make them, ran the fabs and added the necessary connectors. As costs went up and certain activities became more and more complex, they were spun out to spread expenses and know-how. Semiconductor equipment, design software and packaging have long been done by separate companies. But the past ten years have seen the rise of “fabless” firms, which merely design integrated circuits.

Now established chipmakers can no longer afford to develop their own manufacturing processes or even to run their own fabs. To share the pain, IBM, Samsung and others have teamed up to use chipmaking technology jointly. Some firms, such as Texas Instruments, have chosen to go “fab-lite”, meaning that they have their own fabs only for certain chips. Others, such as AMD, have spun off manufacturing completely (although AMD’s decision had much to do with a lack of cash after it bought ATI, a maker of graphics chips, for $5.4 billion in 2006).

Hence the rise of “foundries”, the smelters of the information age. These are essentially contract manufacturers. Although far from household names, they are huge companies, churning out about one quarter of the world’s semiconductors. The biggest, TSMC, has a manufacturing capacity greater even than Intel’s. Its revenues grew at an annual average rate of 13% for several years, topping $10.6 billion, before falling by almost a third in the last quarter of 2008.

TSMC also illustrates a corollary of Moore’s Second Law: even the biggest chipmakers must keep expanding. Intel today accounts for 82% of global microprocessor revenue and has annual revenues of $37.6 billion because it understood this long ago. In the early 1980s, when Intel was a $700m company—pretty big for the time—Andy Grove, once Intel’s boss, notorious for his paranoia, was not satisfied. “He would run around and tell everybody that we have to get to $1 billion,” recalls Andy Bryant, the firm’s chief administrative officer. “He knew that you had to have a certain size to stay in business.”

Grow, grow, grow

Intel still appears to stick to this mantra, and is using the crisis to outgrow its competitors. In February Paul Otellini, its chief executive, said it would speed up plans to move many of its fabs to a new, 32-nanometre process at a cost of $7 billion over the next two years. This, he said, would preserve about 7,000 high-wage jobs in America. The investment (as well as Nehalem, Intel’s new superfast chip for servers, which was released on March 30th) will also make life even harder for AMD, Intel’s biggest remaining rival in the market for PC-type processors.

Two other long-term developments also point towards further concentration of chipmaking. The first is technological change beyond that ordained by Moore’s Law. Fully automated “lights-out” fabs are in operation. Within a few years fabs will be producing wafers with a diameter of 450mm, up from 300mm now, making them even more productive. “When the industry goes to 450mm and this happens at 22 or even 11 nanometres, it is conceivable to have one factory handle all our needs as a company,” says Mr Otellini. He adds, however, that Intel would never put all its eggs in one basket.

The other development is the maturing of the industry. Its annual growth has slid from double digits in the mid-1990s to an average of around 5% since then. And since 2004 the profitability of chip firms has dropped steadily as many chipmakers have lowered prices to expand their markets. In the future, only three types of semiconductor firm will make a decent return, predicts Mr Lidow: those with unique intellectual property; those happy to make commodity chips; and those with enough cash to achieve unprecedented scale.

How far will consolidation go? High-ranking executives at leading firms, who prefer not to be quoted, give similar answers. In the long run, they say, there will be only three viable entities, at least at the leading edge of chipmaking: Samsung in memory chips, Intel in microprocessors and TSMC in foundries. The rest will be “nationalistic” ventures in need of regular government bail-outs.

Yet such predictions may be a little off the mark. Largely because of that nationalism, the semiconductor industry is unlikely to end up as a bunch of near-monopolies. The Taiwanese are unlikely to let the South Koreans rule the memory roost. The newly founded Taiwan Memory Company (TMC), which is to take over the six local firms, could become the core of a global memory giant. It will hook up with Elpida Memory, Japan’s sole maker of memory chips. TMC is also said to be interested in Qimonda.

BloombergPrecious pizza

As for microprocessors, in the fast-growing market for netbooks and other mobile devices, Intel has to do battle with many “fabless” firms, most of which build chips based on designs by ARM, a British company. What is more, after spinning off manufacturing, “our customers no longer have to ask: is AMD able to invest in the next generation of manufacturing?” says Dirk Meyer, the firm’s chief executive. And Abu Dhabi’s investment in Globalfoundries is part not just of its preparations for the post-oil age, but also of a long-term plan to create a “global” alternative to foundries in Taiwan and mainland China. The company will build a fab in New York state and perhaps one day in the Gulf state.

Whatever the precise number of firms, the semiconductor industry will be highly concentrated and much of it will be dominated by Asian companies. Does this matter? From a purely economic standpoint, probably not much. The industry’s extreme capital-intensity is certainly a barrier to entry, and in theory a market with only a few suppliers is ripe for rigging. But chipmakers are unlikely to be able to extract a disproportionate rent or restrict supply—or even to try. For one thing, the industry has a history of intense competition. This is especially fierce among Asian national champions, for which prestige plays a big role. More important, the global production network of the information-technology industry is much too interdependent. If foundries, for instance, took a much larger piece of the pie, others in the value chain, such as chip designers, would find it hard to survive.

From a political perspective, the shift towards Asia could matter much more—especially for Europe. Although America has lost much of the “back end” of chipmaking—the packing and testing—to Asia, it still is the home of many leading-edge fabs, notably those run by Intel. Intel’s finances, thanks to its dominance, are still healthy, but the big European chip firms such as STMicroelectronics (revenues of $9.8 billion in 2008), Infineon Technologies ($6 billion) and NXP Semiconductors ($5.4 billion) are struggling. NXP has just announced a financial restructuring to lighten its debt burden of nearly $6 billion.

Worse, over the past ten years Europe’s market share in semiconductors has dropped from more than 23% to about 15%, according to Future Horizons, a consultancy. A recent report by the European Semiconductor Industry Association (ESIA), a lobbying group, listed some of the reasons for this erosion: the appreciation of the euro, much more generous subsidies in other regions and lagging R&D spending. If governments do not act soon, the report concludes, chipmakers will continue to migrate elsewhere and put Europe’s competitiveness at risk.

Although sophisticated chips are an essential ingredient of many European exports, from cars to medical equipment, the answer is unlikely to be a splurge of taxpayers’ money. A lot has already been spent on manufacturing, to create jobs. But this approach will work even less well in the future. Trying to draw level with Asia in chipmaking would be futile.

What is more, although there has been a lack of spending on research, the real problem has been a lack of successful commercialisation. What Europe’s semiconductor industry—and its technology sector as a whole, for that matter—badly needs is a better environment for entrepreneurs, says Dan Breznitz of the Georgia Institute of Technology, a specialist in the global IT industry. Because Europe’s semiconductor industry has been dominated by big, hierarchical companies, fabless firms are still rare. In Israel, by contrast, with its newly entrepreneurial culture, they have multiplied. Europe, argues Mr Breznitz, is still too focused on manufacturing.

Europe could stage a comeback, some say, should an old idea finally take off: “mini-fabs”—small, flexible and agile production units. Such a revolution has happened before, in steel: giantism once seemed insuperable, yet today plenty of steel is made in “mini-mills”, which use scrap as raw material. Might the foundries of the information age one day be under a similar threat? Maybe. But experts are right to be sceptical: transistors may get ever smaller, but in chipmaking scale rules.

NYTimes article on Shanzai phones

April 28, 2009

In China, Knockoff Cellphones Are a Hit

By DAVID BARBOZA

SHENZHEN, China — The phone’s sleek lines and touch-screen keyboard are unmistakably familiar. So is the logo on the back. But a sales clerk at a sprawling electronic goods market in this Chinese coastal city admits what is clear upon closer inspection: this is not the Apple iPhone; this is the Hi-Phone.

“But it’s just as good,” the clerk says.

Nearby, dozens of other vendors are selling counterfeit Nokia, Motorola and Samsung phones — as well as cheap look-alikes that make no bones about being knockoffs.

“Five years ago, there were no counterfeit phones,” says Xiong Ting, a sales manager at Triquint Semiconductor, a maker of mobile phone parts, while visiting Shenzhen. “You needed a design house. You needed software guys. You needed hardware design. But now, a company with five guys can do it. Within 100 miles of here, you can find all your suppliers.”

Technological advances have allowed hundreds of small Chinese companies, some with as few as 10 employees, to churn out what are known here as shanzhai, or black market, cellphones, often for as little as $20 apiece.

And just as Chinese companies are trying to move up the value chain of manufacturing, from producing toys and garments to making computers and electric cars, so too are counterfeiters. After years of making fake luxury bags and cheap DVDs, they are capturing market share from the world’s biggest mobile phone makers.

Although shanzhai phones have only been around a few years, they already account for more than 20 percent of sales in China, which is the world’s biggest mobile phone market, according to the research firm Gartner.

They are also being illegally exported to Russia, India, the Middle East, Europe, even the United States. “The shanzhai phone market is expanding crazily,” says Wang Jiping, a senior analyst at IDC, which tracks technology trends. “They copy Apple, Nokia, whatever they like, and they respond to the market swiftly.”

Alarmed by the rapid growth of counterfeits and no-name knockoffs, global brands are pressing the Chinese government to crack down on their proliferation, and are warning consumers about potential health hazards, like cheap batteries that can explode.

Nokia, the world’s biggest cellphone maker, says it is working with Beijing to fight counterfeiting. Motorola says much the same. Apple Inc. declined to comment.

Even Chinese mobile phone producers are losing market share to underground companies, which have a built-in cost advantage because they evade taxes, regulatory fees and safety checks.

“We’re being severely hurt by shanzhai phones,” says Chen Zhao, a sales director at Konka, a Chinese cellphone maker. “Legal cellphone makers should pay 17 percent of their revenue as value-added tax, but shanzhai makers, of course, won’t pay it.”

So far, however, China has done little to stop the proliferation of fake mobile phones, which are even advertised on late-night television infomercials with pitches like “one-fifth the price, but the same function and look,” or patriotic appeals like “Buy shanzhai to show your love of our country.”

Last month, the Ministry of Industry and Information Technology did warn consumers about the hazards of shanzhai phones, saying “their radiation usually exceeds the limit.” China’s consumer protection agency says faulty mobile phones were the No. 1 consumer complaint last year.

A few weeks ago, a 45-year-old man in south China was severely burned after his cellphone exploded in his shirt pocket, according to state-run news media.

But that hasn’t seemed to affect sales of black market phones, which typically sell at retail for $100 to $150. In the spirit of what is called “shanzhai” — which suggests rebels or bandits and which applies to counterfeit products of all kinds — many consumers are willing to take a risk on a cheap item that looks stylish.

“I saw iPhone pictures on the Web; it’s so cool. But it costs over $500 — too expensive,” says Yang Guibin, 30, an office worker from Chongqing. “So I decided to buy a shanzhai iPhone. I bought it in a digital market here; it looked exactly like the iPhone.”

Some experts say they believe the shanzhai phenomena is about being creative, Chinese style.

“Chinese grass-roots companies are actually very innovative,” says Yu Zhou, a professor at Vassar College. “It’s not so much technology as how they form supply chains and how rapidly they react to new trends.”

While the phones may look like famous brands, companies actually add special features like bigger screens, dual-mode SIM cards (which allow two phone numbers) and even a telescopic lens attachment for the phone’s camera.

Since it is the SIM card that makes a phone run in China, as in most places other than the United States, all you have to do is insert a valid SIM card into a shanzhai phone and it works.

All this innovation comes from an industry that only took off in 2005, after Mediatek, a semiconductor design company from Taiwan, helped significantly reduce the cost and complexity of producing a mobile phone.

Using what experts call a turnkey solution, Mediatek developed a circuit board that could inexpensively integrate the functions of multiple chips, offering start-ups a platform to produce a low-cost mobile phone.

The industry got another boost in 2007, when regulators said companies no longer needed a license to manufacture a cellphone.

That set off a scramble by entrepreneurs in this electronics manufacturing center. Counterfeiting and off-brand knockoffs flourished. Tiny companies would buy a Mediatek chip loaded with software, source other components and ask a factory to assemble them.

Marketing strategies were simple: steal. Designs and brand names were copied identically or simply mimicked. (Sumsung for Samsung or Nckia for Nokia.)

Tapping into the supply chains of big brands is easy, producers say. “It’s really common for factories to do a night shift for other companies,” says Zhang Haizhen, who recently ran a shanzhai company here. “No one will refuse an order if it is over 5,000 mobile phones.”

The people who make fake iPhones admit it’s a shady business.

“We are a kind of illegal producer,” says Zhang Feiyang, whose company, Yuanyang, makes an iPhone clone. “In Shenzhen there are many small mills, hidden. Basically, we can make any type of cellphone.”

The competition is already forcing global brands to lower prices, analysts say. And new Chinese brands are emerging, like Meizu, a would-be Apple that has opened stylish stores here.

“Our phone is even better than the iPhone,” says Liu Zeyu, a Meizu salesman in Shenzhen. “Our goal is to create a phone that makes Chinese proud.”

Chen Yang contributed research.

Shanzhai

Mobile-phone culture

The Apparatgeist calls

How you use your mobile phone has long reflected where you live. But the spirit of the machines may be wiping away cultural differences

Dec 30th 2009 | From The Economist print edition

Illustration by James Fryer

TECHNOLOGIES tend to be global, both by nature and by name. Say “television”, “computer” or “internet” anywhere and chances are you will be understood. But hand-held phones? For this ubiquitous technology, mankind suffers from a Tower of Babel syndrome. Under millions of Christmas trees North and South Americans have been unwrapping cell phones or celulares. Yet to Britons and Spaniards they are mobiles or móviles. Germans and Finns refer to them as Handys and kännykät, respectively, because they fit in your hand. The Chinese, too, make calls on a sho ji, or “hand machine”. And in Japan the term of art is keitai, which roughly means “something you can carry with you”.

This disjunction is revealing for an object that, in the space of a decade, has become as essential to human functioning as a pair of shoes. Mobile phones do not share a single global moniker because the origins of their names are deeply cultural. “Cellular” refers to how modern wireless networks are built, pointing to a technological worldview in America. “Mobile” emphasises that the device is untethered, which fits the roaming, once-imperial British style. Handy highlights the importance of functionality, much appreciated in Germany. But are such differences more than cosmetic? And will they persist or give way to a global mobile culture?

Such questions bear asking. It is easy to forget how rapidly mobile phones have taken over. A decade ago, there were fewer than 500m mobile subscriptions, according to the International Telecommunication Union (ITU). Now there are about 4.6 billion (see chart). Penetration rates have risen steeply everywhere. In rich countries subscriptions outnumber the population. Even in poor countries more than half the inhabitants have gone mobile. Dial a number and the odds are three to one that it will cause a mobile phone, rather than a fixed-line one, to ring somewhere on the planet.

As airtime gets cheaper, the untethered masses tend to use their mobiles more. In early 2000 an average user spoke for 174 minutes a month, according to the GSM Association (GSMA), an industry group. By early 2009 that had risen to 261 minutes, which suggests that humanity spends over 1 trillion minutes a month on mobiles, or nearly 2m years. Nobody can keep track of the flood of text messages. One estimate suggests that American subscribers alone sent over 1 trillion texts in 2008, almost treble the number sent the previous year.

Now a further mobile-phone revolution is under way, driven by the iPhone and other “smart” handsets which let users gain access to the internet and download mobile applications, including games, social-networking programs, productivity tools and much else besides. Smart-phones accounted for over 13% of the 309m handsets shipped in the third quarter of 2009. Some analysts estimate that by 2015 almost all shipped handsets will be smart. Mobile operators have started building networks which will allow for faster connection speeds for an even wider variety of applications and services.

All alike, all different

Yet these global trends hide starkly different national and regional stories. Vittorio Colao, the boss of Vodafone, which operates or partially owns networks in 31 countries, argues that the farther south you go, the more people use their phones, even past the equator: where life is less organised people need a tool, for example to rejig appointments. “Culture influences the lifestyle, and the lifestyle influences the way we communicate,” he says. “If you don’t leave your phone on in a meeting in Italy, you are likely to miss the next one.”

Other mundane factors also affect how phones are used. For instance, in countries where many people have holiday homes they are more likely to give out a mobile number, which then becomes the default where they can be reached, thus undermining the use of fixed-line phones. Technologies are always “both constructive and constructed by historical, social, and cultural contexts,” writes Mizuko Ito, an anthropologist at the University of California in Irvine, who has co-edited a book on Japan’s mobile-phone subculture.

Indeed, Japan is good example of how such subcultures come about. In the 1990s Americans and Scandinavians were early adopters of mobile phones. But in the next decade Japan was widely seen as the model for the mobile future, given its early embrace of the mobile internet. For some time Wired, a magazine for technology lovers, ran a column called “Japanese schoolgirl watch”, serving readers with a stream of keitai oddities. The implication was that what Japanese schoolgirls did one day, everyone else would do the next.

The country’s mobile boom was arguably encouraged by underlying social conditions. Most teenagers had long used pagers to keep in touch. In 1999 NTT, Japan’s dominant operator, launched i-mode, a platform for mobile-internet services. It allowed cheap e-mails between networks and the Japanese promptly signed up in droves for mobile internet. Ms Ito also points out that Japan is a crowded place with lots of rules. Harried teenagers, in particular, have few chances for private conversations and talking on the phone in public is frowned upon, if not outlawed. Hence the appeal of mobile data services.

The best way to grasp Japan’s mobile culture is to take a crowded commuter train. There are plenty of signs advising you not to use your phone. Every few minutes announcements are made to the same effect. If you do take a call, you risk more than disapproving gazes. Passengers may appeal to a guard who will quietly but firmly explain: “dame desu”—it’s not allowed. Some studies suggest that talking on a mobile phone on a train is seen as worse than in a theatre. Instead, hushed passengers type away on their handsets or read mobile-phone novels (written Japanese allows more information to be displayed on a small screen than languages that use the Roman alphabet).

Might the Japanese stop talking entirely on their mobiles? They seem less and less keen on the phone’s original purpose. In 2002 the average Japanese mobile user spoke on it for 181 minutes each month, about the global norm. By early 2009 that had fallen to 133 minutes, then only half the world average. Nobody knows how many e-mails are sent, but the Japanese are probably even more prolific than text-crazy Indonesians, who average more than 1,000 messages per month on some operators. No wonder that Tokyo’s teenagers have been called the “thumb generation”.

Handy if you’re thrifty

Illustration by James Fryer

Others are quiet, too. On average Germans—who are fond of saying that “talk is silver, silence is golden”—spend only 89 minutes each month calling others for Handy-based conversation. This may be a result of national telephone companies on both sides of the Berlin Wall having exhorted subscribers for years to “keep it short” because of underinvestment in the East and rapid economic growth that overtaxed the network in the West. Germans are also thrifty, suggests Anastassia Lauterbach of Deutsche Telekom. For longer calls, she says, consumers resort to much cheaper landlines.

In contrast, Americans won’t shut up. Their average monthly talk-time is a whopping 788 minutes, though some of this is a statistical illusion because subscribers also pay for incoming calls. Yet talk is cheap: there is no roaming charge within the United States. Americans are often in their cars, an ideal spot for phone calls, especially in the many states where driving and talking without headsets is still legal.

The chattiest of all are Puerto Ricans, who have by far the highest monthly average in the world of 1,875 minutes, probably because operators on the American island offer all-you-can-talk plans for only $40, which include calls to the mainland. This allows Puerto Ricans to chat endlessly with their friends in New York, but may also have arbitrageurs routing cheap international phone calls through the island.

Just how people behave when talking on a mobile phone is a question of culture, at least at first, according to Amapro Lasén, a sociologist at Universidad Complutense in Madrid. In the early 2000s she studied phone users in the Spanish capital, in Paris and in London. Mobiles were a common sight, but Parisians and Madrileniens felt freer to talk in the street, even in the middle of the pavement. Londoners, by contrast, tended to gather in certain zones, for instance at the entrances of tube stations—the sort of place Ms Lasén calls an “improvised open-air wireless phone booth”.

In Paris people openly complained when bothered by others talking loudly about intimate matters, but complaints were rare in London. In both places, people tended to separate phone and face-to-face conversations, for instance by retreating to a quiet corner. But subscribers in Madrid often mixed them and even allowed others to take part in their phone conversations. The Spanish almost always take a call and most turn off voicemail.

For Ms Lasén, who has lived in all three cities, such variations reflect how people traditionally use urban space. In London, she says, the streets are mainly for walking, “like the bed where the river flows”. Paris, however, is a place to stroll, the home of the flâneur. In Madrid people inhabit the streets to talk together. As for their aversion to voicemail, the Spanish consider it rude to leave a call unanswered, even if it is inconvenient. This may be the result of a strong sense of social obligation towards friends and family.

Elsewhere, too, culture and history may help determine whether people talk in public or take a call. The Chinese often let themselves be interrupted, fearing that otherwise they could miss a business opportunity. Uzbeks use their mobiles only rarely in public, because the police might be listening. And Germans can get quite aggressive if people disobey the rules, even unwritten ones. In 1999 a German man died in a fight triggered by his ill-mannered Handy use.

Economics and other hard factors also shape habits. Olaf Swantee, the head of Orange’s mobile business, notes that pricey handsets are less popular in Belgium than in Britain because Belgian operators have long been barred from subsidising phones, a strategy widely used on the other side of the Channel. Italy, however, exhibits both low subsidies and many high-end handsets. Subscribers there do not want to spend much on airtime, but are keen to buy a flashy phone.

China is distinct because of economics and relatively lax regulation. Many consumers use shanzhai (“bandit”) phones, produced by hundreds of small handset-makers based on chips and software from Mediatek, a Taiwanese firm. Knock-offs are common, with labels such as “Nckia” and “Sumsung”. Other innovative manufacturers have developed specialised phones, for instance handsets that can respond to two phone numbers, or models with giant speakers for farmers on noisy tractors.

Elsewhere the physical environment determines which kinds of handsets prevail, says Younghee Jung, a design expert at Nokia, the world’s largest maker of handsets. In hot India, for instance, men rarely wear jackets, but their shirts have pockets to hold phones—which therefore cannot be large. Indian women keep phones in colourful pouches, less as a fashion statement than as a way to protect the devices and preserve their resale value. It also makes for a noteworthy contrast with Japan, says Ms Jung. If women there keep phones in a pouch and decorate them with stickers and straps, that has nothing to do with economics, but reflects the urge to personalise the handset. Phones are highly subsidised in Japan and the resale value is essentially nil, so it is not unusual to see lost units lying in the gutter.

In some countries it is a common habit to carry around more than one phone. Japanese workers often have two: a private one and a work one (which they often turn off so bosses cannot get them at any hour). “I have one phone for work, one for family, one for pleasure and one for the car,” says a Middle Eastern salesman quoted in a study for Motorola, a handset-maker. Having several phones is often meant to signal importance. Latin American managers, for instance, like to show how well connected they are: some even have a dedicated one for the boss.

As this example suggests, softer factors may influence the choice and design of hardware, even for networks. If coverage in America tends to be patchy, it is not least because consumers seem willing to endure a lot and changing operators is a hassle. Elsewhere the reverse is true. Italians demand good reception on the ski slopes, the Greeks on their many islands and Finns in road tunnels, however remote. If coverage is poor, subscribers will switch.

Paradoxically, however, it is in Italy and Greece that people are especially worried about the supposed health risks of electromagnetic fields. A 2007 survey commissioned by the European Commission found that 86% of Greeks and 69% of Italians were “very” or “fairly” concerned about them, compared with 51% in Britain, 35% in Germany and only 27% in Sweden. It may be that people fret when they lack reliable information—or that in some countries local politicians stir up fears.

Whatever the reasons, the public reaction explains why phone masts in Italy are often disguised, for instance as the arches of a hamburger restaurant, as a palm tree or even as the cross on a famous cathedral. In Moldova, by contrast, such masts are monuments to prosperity. “Every time we put up a mast, they had a party. It connected them,” says Orange’s Mr Swantee.

Yet digital technologies change quickly, and so do attitudes towards them. Will such differences between cultures persist and grow larger, or will they diminish over time? Companies would like to know, because it costs more to provide different handsets and services in different parts of the world than it would do to offer the same things everywhere.

Enter the Apparatgeist

Illustration by James Fryer

A few years ago such questions provoked academic controversy. Not everybody agrees with Ms Ito’s argument that technology is always socially constructed. James Katz, a professor of communication at Rutgers University in New Jersey, argues that there is an Apparatgeist (German for “spirit of the machine”). For personal communication technologies, he argues, people react in pretty much the same way, a few national variations notwithstanding. “Regardless of culture,” he suggests, “when people interact with personal communication technologies, they tend to standardise infrastructure and gravitate towards consistent tastes and universal features.”

Recent developments seem to support him. When Ms Lasén went back to London, Paris and Madrid a few years later, phone behaviour had, by and large, become the same in the different cities (although Spaniards still rejected voicemail). Yet it is not just the Apparatgeist that explains this, argues Ms Lasén. In all three cities, she says, people lead increasingly complex lives and need their mobiles to manage them. Ms Ito agrees. American teenagers now also text madly, in part because their lives are becoming almost as regulated as those of the Japanese.

This convergence is likely to continue, not least because it is in the interest of the industry’s heavyweights. Handsets increasingly come with all kinds of sensors. Nokia’s Ms Jung, for instance, is working on a project to develop an “Esperanto of gestures” to control such environmentally aware devices. Her team is trying to find an internationally acceptable gesture to quieten a ringing phone. This is tricky: giving the device the evil eye or shushing it, for instance, will not work. Treating objects as living things might work in East Asia, where almost everything has a soul, but not in the Middle East, where religious tenets make this unacceptable.

In the long run most national differences will disappear, predicts Scott Campbell of the University of Michigan, author of several papers on mobile-phone usage. But he expects some persistence of variations that go back to economics. In poorer countries subscribers will handle their mobile phones differently simply because they lack money. Nearly all airtime in Africa is pre-paid. Practices such as “beeping” are likely to continue for quite a while: when callers lack credit, they hang up after just one ring, a signal that they want to be called back.

A few differences may remain within borders, suggests Kathryn Archibald, who works at Nokia and tries to understand consumers in different parts of the world. Only a few countries, mainly in Africa and Asia, still need special cultural attention when designing a phone (which is why some models in India double as torches). “We see more differences within countries than between them,” she says.

Nokia breaks down phone users into various categories, rather than by geography. “Simplicity seekers” barely know how to turn on their phones and use them only in case of trouble. At the other end of the spectrum, “technology leaders” always want the latest devices and feel crippled without their phones. “Life jugglers” need their handsets to co-ordinate the many parts of their lives. Ms Archibald says Nokia’s aim is to offer the right handset to each such group.

But when it comes to content—the services offered via the phones and the applications installed on them—Nokia pays considerable attention to local culture. In India and other developing countries the firm has launched a set of services called “Life Tools”, which ranges from agricultural information for farmers to educational services such as language tuition. In many rich countries, by contrast, handsets come bundled with a subscription to download music. “We need to operate globally, but be relevant locally,” concludes Ms Archibald.

All this raises a question: as differences fade, are people becoming slaves to the Apparatgeist? “Because of our evolutionary heritage, we want to be in perpetual contact with others,” argues Mr Katz. Just as technology allows people to overeat, it now lets them overcommunicate. If this is a problem now, imagine what would happen if telepathy become possible. The thought is not entirely far-fetched: researchers at Intel, a chipmaker, are devising ways to use brain waves to control computers. A phone that can be implanted in your head may be just a few years away—at which point the Germans will no longer be able to call it a Handy.

MediaTek, Mobile Phone Platforms, and Industry Vertical Disintegration

MediaTek and mobile-phone chips

Fabless and fearless

How a Taiwanese firm became one of the world’s fastest-growing chipmakers

Aug 6th 2009 | HSINCHU, TAIWAN | From The Economist print edition

ImaginechinaThe many guises of the chipset

MOST technology firms fall into one of two brackets: those that sell individual components, such as Intel, a chip giant, and those that offer finished products, such as Apple of iPhone fame. MediaTek sits somewhere in between: it sells most of the innards of mobile phones in a single package, but not the phones themselves—a strategy that has made it one of the world’s fastest-growing chipmakers. On August 4th it said its second-quarter profits were 80% higher than a year before, at NT$9.16 billion ($277m).

Although no household name, MediaTek makes products used by most consumers in rich countries. The Taiwanese firm is a “fabless” chipmaker, meaning that it only designs its chips, while subcontracting production. It started life in 1997 making chips for CD-ROM drives, and eventually took to building the brains of all sorts of consumer devices. Today MediaTek is the leader in these markets, equipping more than 50% of DVD players, for instance.

Yet these have become commodity businesses with low margins. So in 2004 MediaTek expanded into higher-value territory by making the bundles of chips, or “chipsets”, on which mobile phones rely. Being a latecomer, the firm opted to sell processor-, radio- and other sorts of chips together with the necessary software. This “total solution” makes it much easier for phonemakers to produce handsets.

MediaTek’s technology has revolutionised the manufacture of mobile phones in mainland China. A handset firm there used to need 20m yuan ($2.9m), 100 engineers and at least nine months to bring a product to market. Now 500,000 yuan, ten engineers and three months will do. As a result, Chinese handset-makers now number in the hundreds. Many churn out shanzhai (or “bandit”) phones: knock-offs of established brands, labelled “Nckia” or “Sumsung”. Others are true innovators, making handsets with big speakers or with two slots for SIM cards, so that one handset can be called on two different numbers.

This has thrust MediaTek’s revenues from $1.2 billion in 2004 to nearly $2.9 billion in 2008, when it sold about 220m chipsets to China. It became the world’s third-biggest fabless chipmaker by revenue in the first quarter of this year, behind America’s Broadcom and Qualcomm.

So far MediaTek only makes chips for low-end phones. Other developing countries, which already import 40% of all handsets made in China, are a huge opportunity, says Jon Erensen of Gartner, a market-research firm. But the firm is even more ambitious: later this year it will start selling technology for smartphones. Whether MediaTek can compete with Qualcomm and ST-Ericsson, Europe’s new champion for wireless chips, remains to be seen. Of the well-known handset brands only LG, a South Korean electronics giant, sells phones with MediaTek chips inside.

A more fundamental question is to what extent the industry structure spawned by MediaTek’s chipsets and software in China will spread across the globe. Lawsuits will thwart blatant knock-offs in rich countries. All the same, the barriers to entry for new handset-makers are getting ever lower. And Western consumers like variety as much as Chinese ones.

Japan's chuken kigyo

Japan's technology champions

Invisible but indispensable

A host of medium-sized Japanese electronics firms have developed dominant positions in many areas of technology. Can they keep them?

Nov 5th 2009 | TOKYO | From The Economist print edition

Illustration by Gary Niell

Correction to this article

ABOUT 40 nuclear reactors are under construction around the world, designed by half a dozen companies from America, China, France, Japan and Russia. But to obtain a huge, solid-steel vessel to contain the radioactivity, all must turn to a single firm, Japan Steel Works, on the northern island of Hokkaido. Though smaller or welded vessels exist, only the Japanese company has the technology to forge the critical $150m part from a single 600-tonne ingot.

Few companies find themselves in such a privileged position. But Japan Steel Works is only the most visible example of an insufficiently appreciated feature of corporate Japan. The country has a host of medium-sized firms that dominate specialised global markets. Some of these are in simple engineering: Shimano earns around $1.5 billion a year by supplying 60-70% of the world’s bicycle gears and brakes; YKK makes around half the world’s zip fasteners by value, and used to control far more. But it is in the arcane corners of electronics, engineering and materials-science that Japanese companies reign. The technologies are largely invisible to consumers, but the firms enjoy outsize market shares because they are essential for making particular products.

For example, around 75% of motors for hard-disk drives in computers come from a firm called Nidec; 90% of the micro-motors used to adjust the rear-view mirror in every car are made by Mabuchi. Often the products are components, materials or equipment used to make other equipment: TEL makes 80% of the etchers used in making an LCD panel; Covalent produces 60% of the containers that hold silicon wafers as they are turned into computer chips.

A choice: Japanese or Japanese?

In some instances the companies’ only real rivals are also Japanese, making the country indispensable even if there is more than one supplier. Shin-Etsu has 50% of the market for the photomask substrate, used to place patterns on semiconductors, but the other producers—Covalent, NSG, AGC and Tosoh—all hail from Japan too. Japanese companies have a similar grip on, for example, bonding material for integrated circuit packages and the lithography machines (called steppers) to make LCD panels. So far, despite their dominance, most have avoided antitrust trouble.

Whereas big Japanese electronics companies such as Panasonic, Sharp and Sony have been losing market share to rivals from China, South Korea and Taiwan, these smaller, less well known Japanese firms continue to dominate niches upon which the global technology industry depends. The Japanese even have a term for them: chuken kigyo (strong, medium-sized firms). It doesn’t matter if the brand on the casing says Apple, Nokia or Samsung: the innards are stuffed with Japanese wares. According to an official at Apple, the company depends on Japanese firms for vital components because few suppliers elsewhere can live up to its rigorous standards.

“They may not be the sexiest products, but you can’t make a semiconductor chip or an LCD panel without them,” says Alberto Moel, an expert on high-tech manufacturing with Monitor Group, a consulting firm, in Tokyo. Japanese companies serve more than 70% of the worldwide market in at least 30 technology sectors worth more than $1 billion apiece, according to the Ministry of Economy, Trade and Industry (METI). They range from certain films to diffuse light used in LCD screens (where they have the whole of a market worth more than ¥270 billion, or $3 billion) to multilayer ceramic capacitors that regulate the current in electrical equipment (77% of ¥540 billion).

Japan’s technological prowess is a reminder of the country’s industrial strength at a time when it is struggling to overcome nearly two decades of economic stagnation and is poised to lose its place as the world’s second-largest economy to China. It is also an answer to decades of criticism by Western management experts who breathlessly argued that the country’s business culture, from a rigid labour market to weak shareholder rights, was holding companies back. Corporate Japan must have been doing something right after all.

Of course, some foreign companies can boast similar supremacy in global markets. Microsoft’s Windows operating system is on more than 90% of the world’s 1 billion or so personal computers, of which around 80% are powered by Intel chips. And chips designed by ARM, a British firm, dominate the market for application processors, which run software on smart-phones. Germany’s Mittelstand, the closest Western equivalent of the chuken kigyo, also boasts many smallish world-beaters. In much the same way as the Mittelstand, Japan’s chuken kigyo is not simply a part of the national economy, but the core of its industrial structure. It enables the country’s bigger, well-known electronics firms to exist, as well as meeting foreigners’ essential needs. Strikingly, doubts are growing about Japanese companies’ ability to maintain their enviable position—but for now their grip remains mostly firm.

Treasure in small things

The best example of Japan’s technical strength is hard to see: a capacitor. With some being as small as a grain of salt, a magnifying glass is needed. They store electricity in a circuit and are a basic building-block of many electronic devices. They cost somewhere between a quarter of a cent and 20 cents each, but a mobile phone may need 100 of them and a PC 1,000. A Japanese company called Murata has 40% of the global market.

Though the profitability of Murata’s capacitors is hard to know, the company’s overall margins are typically about 50%, estimates Macquarie, an investment bank. Japan’s total market share (other suppliers include TDK and Taiyo Yuden) is 80%. But that is down from around 90% at the start of decade. Ground has been lost to ambitious foreign rivals such as Samsung Electro-Mechanics of South Korea and Yageo of Taiwan.

Other Japanese companies boast similar strengths. Nitto Denko claims to have more than 20 market-leading products, mostly for making LCD displays. Covalent also has several; it controls, for example, 70% of the market for carbon brushes in electric motors. Mitsubishi Chemical commands a near monopoly in red phosphorescent materials used to make natural-white LED light bulbs. Shin-Etsu enjoys the top spot for certain silicon wafers for semiconductors. Kyocera leads in several integrated-circuit components.

The process of making computer chips illustrates Japan’s dominance. Among the many steps are four in which the Japanese are indispensable: wafer processing; thin-film formation; coating, lithography and developing; and contact and packaging. Japanese companies rule the markets for essential components in all four stages and equipment in three of them (see chart 1).

Electronics manufacturers everywhere turn to Japanese makers for these sorts of tools and components because of their high quality and reliability, explains T.W. Kang, a Korean semiconductor expert who recently retired from the board of NEC Electronics. No one wants to have a car dashboard malfunction because of an inferior part that cost only a few pence.

Many technology products have become commodities, but certain components have not, since they require continual innovation. So entry barriers to the business of making them remain high, and although the margins on the final goods have deteriorated, the margins on specialised, high-end components are still juicy.

Japan’s technology champions share certain characteristics. They invest handsomely in research and development (R&D). Many have factories abroad for basic products but keep the high-end stuff at home—in a “black box”, they like to say. They often own their supply chains: chip companies that might use crystal components generally grow their own. Some firms even make the very machines they use, in order to control costs, remain independent of suppliers and maintain a deep understanding of their technology.

When asked what is the main reason for their success, executives invariably gush about the quality of their customers. The response initially sounds scripted, or perhaps typically humble. Of course, good customers impose strict standards, forcing suppliers to raise their game. But there is more to it than that. As Susumu Kohyama, the boss of Covalent, points out, the components, tools and materials in which Japanese firms excel are highly customised. It is only by working closely with clients over many years that suppliers gain insight into their future technical plans and are trusted to learn about thorny problems that a clever supplier might solve. Once firms become technology leaders, it is harder to unseat them.

Moreover, the knowledge about the technology is tacit, not formal. It cannot be transmitted by writing a manual or reading a patent application. Rather, it accumulates by working with colleagues over many years. This poses a barrier to entry for rivals. It is also why firms try to maintain lifetime employment in specialised high-tech sectors, though it is ebbing elsewhere in the economy.

This belief that the strength of the company is stored in the collective mind of employees—rather than in the share price of the moment—also helps explain why Japanese companies disdain mergers and acquisitions. Firms resist takeovers, rather than viewing them as the natural combinatory process of business, as in the West.

Ironically, the very success of Japan’s hidden technology champions is in part due to changes in the industry that have hammered Japan’s big electronics firms. Companies anywhere can buy the machines, chemicals and know-how to get into the manufacturing business, so the leading Japanese brands have suffered. But the country is also home to the firms that supply those very machines, chemicals and know-how. As the giants have struggled, the chuken kigyo has thrived.

The foreigners are coming

Impressive as it is, however, Japanese firms’ continuing dominance is not guaranteed. They conquered their markets partly by adopting and improving on foreign (largely American) technology, first with low cost, then better quality and finally with technical superiority. Along the way, they developed close relationships with their customers, gaining intimate knowledge of—and then satisfying—their precise needs. A technical edge and customers’ trust amounts to a formidable barrier to entry. The question now is whether China, South Korea and Taiwan could do to Japan what Japan did to America.

Worries about the sustainability of Japan’s lead stem chiefly from a belief among some executives and officials that Japanese firms are not doing as much as they could to realise the value of their technology. Hiroaki Okamoto, the director of R&D at Shin-Etsu, even believes the industry is in crisis. “We know that Korean and Taiwanese firms might catch up. There are so many competitors in Japan, no one is really making much money” on certain products. Lower margins mean that Japanese companies have less money to invest in R&D. “This lets Taiwanese, Chinese and Korean companies compete.”

That said, market dominance is a pretty strong starting position. Some executives believe that when a narrow market is shared by a few firms, they should consolidate. They also rue the inwardness of Japanese firms that resist co-operating with others. Jun Saito, a researcher at the University of Tokyo, notes that Japanese tax law actually discourages partnerships from forming. Mr Moel of Monitor believes that the firms could generate new revenue opportunities if they were more outward-looking and managed the technology better.

The very attributes of Japanese business that led to its technical dominance also risk holding it back. The lack of shareholder pressure that lets companies focus on long-term projects removes the market discipline to boost performance and cull weak projects. Vertical integration ensures supply and quality, but leads companies into non-core areas better done by others. Lifetime employment keeps knowledge in-house, but firms lose flexibility, employees lose labour mobility and fresh ideas can be stifled.

“Frankly speaking, the changes are starting now,” confides a manager at Taiyo Yuden. South Korean products are good, he says. “We see others coming after us. If we don’t do anything, they will run over us. So we’re struggling to find a new way.”

What is Japan’s response? If possible, more innovation. In substrates for integrated circuits—the foundations for chips and other components—this has worked (see chart 2). Between 2002 and 2007 Japan’s market share collapsed, from 75% to 34%, as Taiwanese firms doubled and South Korean firms quadrupled their presence. So the Japanese moved to higher-value products, focusing on substrates for microprocessor units (MPUs). The 3% of substrates for MPU applications shipped in 2007 accounted for 30% of the market’s value.

However, innovation alone may not always help. High volume also counts for a lot. Japan went from making half of the world’s solar panels to less than 20% over the past four years. Although it continues to make the best-performing ones, the industry has largely shifted to China. Furthermore, the best technology is less prized in the fastest-growing markets—poor countries like China and India that want basic products. Japanese makers of mobile phones have the world’s most sophisticated devices but their market share abroad is virtually nil.

A warning to the chuken kigyo is the experience of two big firms, Canon and Nikon, against ASML, a Dutch company, in the market for steppers, the tools used to make computer chips. In 1990 ASML had less than 10% of the market, while the two Japanese firms dominated it. Yet today ASML controls 65%. Japanese executives raise the matter to decry corporate complacency. How did ASML win?

“We were too small to compete with Nikon and Canon directly,” explains Willem Maris, who devised the strategy as the boss of ASML from 1990 to 2000. The Japanese had far more resources and did everything in-house. So ASML redesigned the product to make it modular, which let it farm out work to specialists. For instance, Carl Zeiss, a German company, made precision lenses. This ultimately enabled ASML to innovate faster and surpass the Japanese, says Mr Maris.

Illustration by Gary Niell

ASML’s openness took a more literal form, too. “When a machine at Samsung broke down, 20 Japanese would come over and place a tent over it, so no one could see exactly what they did,” he says. ASML took the opposite approach, and showed customers the problem and how it would be fixed. Today, Nikon and Canon remain as closed as ever—and separate, even though merging their stepper businesses would make sense.

Old skills, modern times

Japan’s technical success has its roots in old strengths. Its excellence in fine ceramics harks back to its expertise in pottery. Its brilliant steel forgings are a vestige of ancient swordmaking. Japanese will say this reflects their culture of monozukuri (making things) and kaizen (continuous improvement). But not all of Japan’s customs serve it well. Its tradition of resisting outsiders—be they foreigners or other companies—today risks undermining it.

To help overcome the reluctance among companies to share technologies or join forces, in July METI established the Innovation Network Corporation of Japan. Packed with people from business, it acts as a sort of national private-equity fund, with assets and credit guarantees totalling $9 billion. It aims to invest in promising intellectual property, with the idea of creating spin-out companies or encouraging consolidation.

“They never merge,” laments a METI official, who fears more companies will go the way of Nikon and Canon in steppers. “We can’t lose that,” he says about Japan’s technical dominance. In the past, Japan’s closed approach made sense, admits Mr Kohyama, the boss of Covalent. But not today. “We have to think a lot more openly,” he implores.

Japan’s hidden champions will probably need to unite in some form to maintain the financial and technical strength they need to stay dominant. They will also have to be wary of antitrust watchdogs, even if they have largely avoided them hitherto. The American authorities are investigating makers of optical drives (used in computers and DVD players) and Japanese trustbusters tend to focus on a merger’s effect on the domestic market although it would create a strong global supplier.

As for Japan Steel Works, its technical superiority is legendary. Even today it makes samurai swords using time-honoured techniques. Yet its absolute dominance in nuclear-containment vessels is coming to an end, as rivals from China, South Korea and elsewhere emerge.

“In the not too distant future we’re going to have at least five options,” notes Aris Candris, the boss of Westinghouse, which builds reactors. “Unfortunately none of them are from Pittsburgh”—where Westinghouse is based and which used to be the centre of America’s steel industry. The lesson is clear: once the expertise is lost, it is hard to regain.

Correction: we originally wrote that Westinghouse was based in Philadelphia. In fact it is based in Pittsburgh. Sorry. This was corrected on November 6th 2009.