* Merger deal awaiting regulatory approval - sources
* Deal to complete as early as year-end - sources
* Merged firm will still face challenges in tech - analysts (Adds details, quotes)
By Lee Chyen Yee and David Lin
HONG KONG/SHANGHAI, Dec 1 (Reuters) - China's second- and third-largest contract chipmakers Shanghai Hua Hong NEC and Grace Semiconductor have agreed to merge in a sector in need of a consolidation and technology upgrades, sources said on Thursday.
Chinese chipmakers, including domestic leader Semiconductor Manufacturing International Corp , Grace and Hua Hong, have lagged leaders Taiwan Semiconductor Manufacturing Co Ltd , United Microelectronics Corp and Global Foundries in technology and sales.
"China needs better technology and savvy people to become competitive in the foundry sector. They need to strengthen integrated circuit design and lift their market share," said KGI Securities analyst Ricky Liu in Taipei.
"Hua Hong NEC and Grace will have greater capacity when they merge, but they need more than that to compete, especially since the semiconductor industry is seeing slowing growth in shipments and falling average selling prices," he said.
Hua Hong NEC Electronics Co Ltd, set up in 1997 and whose shareholders include state-backed Hua Hong Group and Japan's NEC Corp, owns two eight-inch fabs with a capacity of 60,000 wafers per month.
Grace Semiconductor Manufacturing Corp, which began operations in 2003, was started by Winston Wong, son of late Taiwan plastics tycoon Wang Yung-ching, and Jiang Mianheng, son of former Chinese president Jiang Zemin.
Grace, whose investors include Hong Kong tycoon Li Ka-shing's Hutchison Whampoa Ltd and Cheung Kong (Holdings) Ltd, has an eight-inch fab with a capacity of 40,000 wafers per month.
PRECURSOR TO MERGER
Both chip companies have jointly invested in a higher-technology 12-inch semiconductor project with a capacity of about 10,000 wafers per month, a move that analysts say paves the way for the merger.
Industry sources said the key assets of both companies were worth about $1 billion.
"The deal is about to close and will probably happen by year-end," said a source close to the matter, declining to be identified as he was not authorised to speak to the media.
Grace and Hua Hong NEC declined to comment.
"The merger will be good for both companies as their products and production lines don't really overlap and they complement each other," said Vincent Gu, a senior analyst at research firm iSuppli in Shanghai.
China's companies have succeeded in certain areas of the technology sector. PC maker Lenovo Group Ltd has climbed to the world's No.2 spot, and Huawei Technologies Co Ltd has emerged as the second-largest telecommunications equipment provider globally.
But the country's chipmakers are performing poorly compared with global competitors.
Analasys said Taiwan's TSMC was already utilising 28-nanometre technology at its fabs, but Chinese chipmakers were nowhere near, with SMIC's technology migration slowing as its 65nm revenue contribution declined.
More advanced 28nm technology packs more power within the same chip area than older 40nm, boosting processing speed and reducing power consumption, while larger wafers allows more chips to be manufactured from a single wafer, reducing production costs.
China's largest contract chipmaker SMIC has been beset by problems, such as poorer technology and management uncertainties at a time when global semiconductor sales are faltering amid global economic woes.
Global revenue for the semiconductor market is expected to decline 0.1 percent in 2011 to $299 billion, research firm Gartner said in September, as consumers moderate purchases of electronic products. (Editing by Chris Lewis)