The Trump Administration recently barred American companies from selling any new products to SMIC (OTC:SMIC.Y), China's largest contract chipmaker, without special government licenses. In a letter introducing those new restrictions, the U.S. Department of Commerce claims exports to SMIC posed an "unacceptable risk" of being diverted to "military end use."

SMIC claimed it wasn't notified about those new restrictions, and declared it "has no relationship with the Chinese military and does not manufacture for any military users." Nonetheless, shares of TSMC (NYSE:TSM), SMIC's larger Taiwanese rival, immediately surged on the news.

Cargo freight containers painted with the American and Chinese flags.

Image source: Getty Images.

Is SMIC really a threat?

SMIC is China's largest chip foundry, but it's tiny compared to TSMC, which generated over eleven times as much revenue last year.

SMIC is also much smaller than the foundries at TSMC's two largest peers, Samsung and Intel. Samsung directly competes against TSMC and SMIC by producing chips for fabless chipmakers, while Intel mainly produces its own first-party chips.

SMIC also remains far behind all those foundries in the "process race" to create smaller and faster chips, which are measured in nanometers. SMIC's most advanced foundries can only manufacture 14nm chips, putting it two full generations behind TSMC, which started producing 10nm chips in 2016 and 7nm chips in 2017.

As a result, the world's top fabless chipmakers, including Qualcomm (NASDAQ:QCOM) and AMD, outsource the production of their most advanced chips to TSMC, which only produces its top-tier chips in Taiwan.

Why did the U.S. sanction SMIC?

Based on those facts, SMIC doesn't seem like a major threat to TSMC or the U.S. However, the expansion of the trade war into a tech war under the Trump Administration -- which blacklisted hundreds of Chinese firms -- is pushing China to accelerate its investments in domestic chipmakers. Escalating political and military tensions between China and Taiwan are also exposing China's dependence on TSMC-manufactured chips.

A wafer of chips being manufactured.

Image source: Getty Images.

TSMC and SMIC both stopped accepting chip orders from Chinese tech giant Huawei in response to U.S. sanctions earlier this year. Huawei accounted for 14% of TSMC's revenue and about 20% of SMIC's revenue last year.

As a result, SMIC now receives government funding equivalent to about 40% of its annual revenue, according to the OECD. China's state-backed funds also recently boosted their investments in SMIC's Shanghai plant.

Therefore, the U.S. is likely sanctioning SMIC to hamper its recovery and prevent it from catching up to TSMC, Samsung, and Intel in the process race. But citing "military use" as a justification for those sanctions seems weak -- especially since SMIC mainly manufactures low-end to mid-range chips for consumer electronics instead of high-end military hardware.

Will SMIC's pain generate gains for TSMC?

The sanctions against Huawei already cost SMIC a fifth of its revenue, and it will lose even more revenue if American chipmakers pull their orders.

SMIC generated 21.6% of its revenue from U.S. chipmakers last quarter. One of its top customers is Qualcomm, for which it produces lower-end Snapdragon chipsets. SMIC only generated 9% of its revenue from its "newer" 14nm/28nm processes -- which are old by TSMC's standards -- and the rest from even older processes.

By comparison, TSMC generated 36% of its revenue from its top-tier 7nm chips last quarter. 16nm chips accounted for 18% of its revenue, while 28nm chips accounted for another 14%. TSMC manufactures some of its lower-end chips in China, so American chipmakers like Qualcomm could shift some of their production within China from SMIC to TSMC in response to the new sanctions.

However, SMIC's total revenue from U.S. chipmakers last quarter would only equal less than 2% of TSMC's total revenue last quarter. So even if TSMC absorbs all of SMIC's U.S.-based orders, it wouldn't offset its recent loss of Huawei's orders.

The risks could outweigh the rewards

SMIC's loss of U.S. orders might generate minor short-term gains for TSMC in China, but it could also prompt the Chinese government to boost its investments in SMIC, push Chinese chipmakers to divert their orders from TSMC to SMIC, and hit TSMC's Chinese plants with new restrictions.

All of those actions could throttle TSMC's growth in China, which accounted for a fifth of its revenue last year. Those longer-term headwinds could easily cancel out any near-term tailwinds from the sweeping sanctions against SMIC -- which merely exacerbate trade tensions between the U.S. and China.

 
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.