circuitboard.jpgHere's one industry that China will not be leading any time soon. China's domestic chip manufacturers have struggled for years to shake off their also-ran reputation and live up to the Chinese government's promotion of semiconductors as a high-value strategic sector.

But China's chip industry is now facing its biggest hurdle yet as the global downturn hits sales of low-cost electronics goods, which is the area where Chinese chip makers have made most inroads.

Lift the lid on an iPod, Amazon's Kindle or any other high-end electronic gear and you will find that the high-value components are all made by western chip manufacturers like Qualcomm, Freescale or Novatel Wireless. But take the electronic guts out of a cheap Made in China toy or a no-name MP4 player, and you will find a motley collection of unbranded Chinese chips.

That very failure failure to differentiate is what is hurting Chinese chip makers so hard and it caused nearly 60% of China's semiconductor manufacturing capacity to sit idle in the Q1 of this year.

The firm predicts a big shake-out is likely and says companies must merge and resize manufacturing operations if they want to survive.

Many chip makers are turning to production cuts and layoffs amid increased competition and a sharp drop in demand in one of the most severe downturns the industry has seen in years.

ISuppli told the Wall Street Journal that China's goal of establishing a strong semiconductor production industry is in “serious jeopardy.”

“The establishment of a technologically strong Chinese semiconductor industry was considered an essential element of China's long-term domestic economic and technological independence,” iSuppli director and chief analyst for semiconductor manufacturing Len Jelinek said.

He added that the plan has failed because global sales had evaporated before internal demand could grow to match demand from the rest of the world.

More on China's chips in these stories.