Special Report
Highlights Taiwan remains the epicenter of global geopolitical risk, as highlighted by the past week’s significant increase in saber-rattling around Taiwan and across East Asia and the Pacific. Tensions may subside in the short run, as the US and China resume high-level negotiations. But then again they may not. And they will most likely escalate over the long run. Investors should judge the Taiwan scenario based on China’s capabilities rather than intentions. China’s intentions may never be known but it is increasingly capable of prevailing in a war over Taiwan. Before then, economic sanctions and cyber attacks are highly likely. The US has a history of defending Taiwan from Chinese military threats. Washington is trying to revive its strategic commitment to Asia Pacific. But US attempts to increase deterrence could provoke conflict. The simplest solution to Taiwan tensions is for a change of party in Taiwan. This would require an upset in the 2022 and especially 2024 elections. China may try to arrange that. Otherwise the risk of conflict will increase. A sharp economic slowdown in China is the biggest risk for investors, as it would not only be negative for the global economy but also would threaten domestic political stability, discredit the gradual and non-military approach to incorporating Taiwan, and boost nationalist and jingoistic pressures directed against Taiwan. Feature Chart 1China's Confluence Of Internal And External Risks China faces a historic confluence of internal and external political risks. This was our key view for 2021 and it continues to be priced by financial markets (Chart 1). The latest example of these risks is the major bout of saber-rattling over Taiwan. The US sent two aircraft carriers, and the UK one carrier, to the waters southwest of Okinawa for naval drills with Japan, Canada, the Netherlands, and New Zealand. Related drills are occurring across Southeast Asia, including Vietnam, Singapore, Malaysia, and others. Meanwhile the Chinese air force let loose its largest yet intrusion into Taiwan’s air defense identification zone (Chart 2). The US assured Japan that it would defend the disputed Senkaku islands, while Japan said that it would seek concrete options – beyond diplomacy – for dealing with Chinese pressure. Chart 2China’s Warning To Taiwan Chart 3Market Response To Saber-Rattling Over Taiwan Strait Yet, at the same time, a diplomatic opening emerged between the US and China. A virtual summit is expected to be scheduled between Presidents Joe Biden and Xi Jinping. The Biden administration unveiled its review of US trade policy toward China, with mixed results (i.e. imply a defensive rather than offensive trade policy). China offered to join the Trans-Pacific Partnership trade deal (the CPTPP). All sides exchanged prisoners, with Huawei’s Meng Wanzhou back in China. In the short run global investors will cheer attempts by the US and China to stabilize relations. But over the long run tensions over Taiwan suggest the underlying US-China strategic confrontation will persist. We do not doubt that global risk appetite will improve marginally on the news, including toward Chinese and Taiwanese assets (Chart 3). But investors should not mistake summitry for diplomacy, or diplomacy for concrete and material strategic de-escalation. The geopolitical outlook is gloomy for China and Taiwan. Grand Strategies Collide US grand strategy forbids countries from creating regional empires lest they challenge the US for global empire. China has the long-term potential to dominate the eastern hemisphere. The US now quite explicitly seeks to counter China’s growing economic, technological, military, and political influence. China’s grand strategy forbids countries from interfering in its domestic affairs and undermining its economic and political stability. This could include eroding its territorial integrity, jeopardizing its supply security, or denying its maritime access. The US still has considerable capabilities on this front, particularly due to its control of the oceans and special relationship with Taiwan, the democratic island that China claims as a province but that the US supplies with arms. Historically, the Kingdom of Tungning (1661-83) exemplifies that a rival political and naval power rooted in Taiwan can jeopardize the security of southern China and hence all of China (Map 1). Taiwan’s predicament is geopolitically unsustainable and the difference between the past 72 years and today is that Beijing increasingly has the military means of doing something about it. Map 1Why Taiwan’s Status Quo Is Geopolitically Unsustainable China seeks to establish maritime access, expand its navy, and improve supply security. This process points toward turf battles with the US and its allies and could easily lead to conflict over Taiwan, the East and South China Seas, and other strategic approaches to China. It could also lead to conflict over technological access. The latter is an economic and supply vulnerability that relates directly to Taiwan, which produces the world’s most advanced computer chips. The Chinese strategy since the Great Recession, under two presidents of two different factions, has been to take a more assertive stance on domestic and foreign policy, economic policy, territorial disputes, and supply security. This hawkish turn occurred in response to falling potential GDP growth, which ultimately threatens social stability and the survival of the political regime. Hong Kong was long the symbol that the western liberal democracies could coexist with the Chinese Communist Party. China’s reduction of Hong Kong’s political autonomy over the past decade violated this understanding. Taiwan is now increasingly concerned about its autonomy while the West is looking to deter China from attacking Taiwan. China is willing to wage war if the West attempts to make Taiwan’s autonomous status permanent through increased military support. The US strategy since the Great Recession, under three presidents of two different parties, has been to raise the costs on China for its increasingly assertive policies, particularly in acquiring technology and using economic and military coercion against neighbors. The US is increasing its use of sanctions, secondary sanctions, tariffs, export controls, cyber warfare, and regional strategic deterrence. Hence the policy consensus in both the US and China is more confrontational than cooperative. The Biden administration is largely maintaining President Trump’s punitive measures toward China while trying to build an international coalition to constrain China more effectively. Meanwhile the Xi administration is refusing to hand over power to a successor in 2022, so there will not be a change in Chinese strategy. The US is politically divided, a major factor in Beijing’s favor. China is politically unified, particularly on the question of Taiwan. But one area of national consensus in the US is the need to become “tougher” with respect to China. President Trump’s policies and the COVID-19 pandemic reinforced this consensus. The number of Americans who would support sending US troops to Taiwan if China invaded has risen from 19% in 1982 to 52% today – meaning that the country is divided but fear of China is driving a shift in opinion.1 Chart 4Taiwan Strait Risk Shoots Up To 1950s Levels And Beyond The China Cross-Strait Academy, a new think tank with pro-mainland sympathies, has produced a Cross Strait Relations Risk Index that goes back to 1950 and utilizes 59 factors ranging from politics and diplomacy to military and economics. It suggests that tensions have reached historically high levels, comparable to the 1950s, when the first and second Taiwan Strait crises occurred (Chart 4). Beware Chinese Economic Crisis – Or Concerted US Action Tensions across the Taiwan Strait began to rise in 2012 when the Communist Party adopted a more hawkish national policy in response to potential threats to its long-term rule arising from the Great Recession. The 2014 “Sunflower Protests” in Taiwan and “Umbrella Protests” in Hong Kong symbolized the rise in tension as Beijing sought to centralize control across Greater China. Support for the political status quo in Taiwan peaked around this time, although most Taiwanese still prefer the status quo to any final decision on the island’s status, which could trigger conflict (Chart 5). China’s militarization of rocks and reefs in the South China Sea throughout the 2010s gave it greater control over the strategic approaches to Taiwan. Since 2016, we have argued that geopolitical risk in the Taiwan Strait would rise on a structural, long-term basis for the following reasons: (1) China’s economic downshift triggered power consolidation and outward nationalism (2) Taiwanese opinion was shifting away from integration with the mainland (3) the US was attempting a strategic shift of focus back to Asia and countering China. Underlying this assessment was the long-running trend of rising support for independence and falling support for unification with China (Chart 6). Chart 5Taiwanese Favor Status Quo Indefinitely Chart 6Very Few Taiwanese Favor Reunification, Now Or Later China’s crackdown on Hong Kong from 2016-19 escalated matters further as it removed the “one country, two systems” model for Taiwan (Chart 7). China continues to insist on this solution. In 2013 and again in 2019, Xi Jinping declared that the Taiwan problem cannot be passed down from one generation to another, implying that he intended to resolve the matter during his tenure, which is expected to extend through 2035. Whether Xi has formally altered China’s cross-strait policy is debatable.2 But his use of military intimidation is not. The US policy of “strategic ambiguity” is debatable but the historical record is clear. In the three major crises in the Taiwan Strait (1954-55, 1958, and 1995-96), the US has sent naval forces to the area and clearly signaled that it would defend Taiwan against aggression.3 However, in diplomatic matters, the US has constantly downgraded Taiwan: for instance, transferring its United Nations seat to China in 1971, revoking its mutual defense treaty in 1980, and prioritizing economic cooperation with China in recent decades. The implication is that the US will not stand in the way of unification unless Beijing attempts to achieve it through force of arms. China’s conclusion from US behavior must be that it can definitely overtake Taiwan by means of economic attraction and diplomacy over time. For example, Beijing’s assertion of direct control over Hong Kong took 20 years and ultimately occurred without any resistance from the West. By contrast, a full-scale attack poses major logistical and military risks and potentially devastating costs if the US upholds its historic norm of defending Taiwan. China’s economy and political system could ultimately be destabilized, despite any initial nationalistic euphoria. Taiwan’s wealth (and semiconductor fabs) would be piles of ash. Of course, Taiwan is different from Hong Kong. The Taiwanese people can believe realistically that they have an alternative to direct rule from Beijing. If mainland China’s economic trajectory falters then the option of absorbing Taiwan gradually will fall away. Today about 30%-40% of Taiwanese people believe cross-strait economic exchange should deepen (Chart 8). Only one period of Taiwanese policy since 1949, the eight years under President Ma Ying-jeou (2008-16), focused exclusively on cross-strait economic integration and deemphasized the tendency toward greater autonomy. If China’s economic prospects dim, then Beijing will become more inclined toward the military option, both to distract from domestic instability and to prevent Taiwan from entertaining independence. Chart 7Taiwanese Oppose "One Country, Two Systems" Chart 8Taiwanese Not Enthusiastic About Cross-Strait Economic Integration Chart 9Taiwanese Identify Exclusively As Taiwanese, Not Chinese Most likely China already has the capability to fight and win a war within the “first island chain,” including over Taiwan, especially if US intervention is hesitant or limited. But any doubts will likely be dispelled in the coming years. As long as China’s military advantage continues to grow, Beijing will increasingly view Taiwan as an object that it can take at will, regardless of whether economic gradualism would eventually work. The Taiwanese increasingly view themselves as distinctly Taiwanese – not Chinese or a mix of Taiwanese and Chinese (Chart 9). The implication is that it may be too late for China to win over hearts and minds. However, Beijing will presumably want to see whether Taiwan’s pro-independence Democratic Progressive Party (DPP) can be dislodged from power in the 2024 elections before making a drastic leap to war. Taiwan, like the US and other democracies, is internally divided. President Tsai Ing-wen’s narrative of Taiwan’s democratic triumph over authoritarianism is not only applied to the mainland but also directed against Taiwan’s own Kuomintang (KMT).4 The country is unified on its right to expand economic and diplomatic cooperation with the West but it is starkly divided on whether the US should formally ally with Taiwan, sell it arms, and defend it from invasion (Chart 10A). Kuomintang supporters say they are not willing to fight and die for Taiwan in the face of any invasion (Chart 10B). American policymakers complain that Taiwan’s military structure and policies – long managed by the KMT – are not seriously aimed at preparing for asymmetric warfare against Chinese invasion. Chart 10ATaiwan Divided On Whether US Should Increase Military And Strategic Support Chart 10BTaiwan Divided On War Sacrifice The international sphere also matters for Beijing’s calculus. If the US remains divided and distracted – and allies curry favor with China – then China will presumably continue the gradualist approach. But if the US unifies at home and forges closer ties with allies, aiming to curb China’s economy and defend Taiwan’s democracy, then China may be motivated to take military action sooner. If the US and allies want to deter an attack on Taiwan, they need to signal that war will exact profound costs on China, such as crippling economic sanctions, a full economic blockade, or allied military intervention. But the West’s attempts to increase deterrence could spur China to take action before the West is fully prepared. Unlike the US in the Cuban Missile Crisis, China cannot accept a defeat in any showdown over arms sales to Taiwan. Its own political legitimacy is tied up with Taiwan, contrary to that of the US with Cuba. Given the lack of American willingness to fight a nuclear war over a non-treaty ally, the probability of China launching air strikes would be much higher (Diagram 1). Diagram 1Game Theory Of A Fourth Taiwan Strait Crisis The US is not trying to give Taiwan nuclear arms, or other game-changing offensive systems, although the US has sent marines and special operations forces to help train Taiwanese troops. It is up to Beijing when to make an ultimatum regarding US military support.5 Ultimately the US still controls the seas and China depends on the Persian Gulf for nearly half of its oil imports. This is a good reason for China not to invade Taiwan. But if the US imposes an oil blockade, then the US and China will go to war – this is how the US and Japan came to blows in World War II. The danger is that China assesses that the US will not go that far. Will Biden-Xi Summit Reduce Tensions? Not Over The Long Run True, strategic tensions could be calmed in the short run. The US is restarting talks with China and setting up a bilateral summit between Presidents Biden and Xi. The two sides have exchanged prisoners (e.g. Meng Wanzhou), held climate talks, and Beijing has offered to join the Trans-Pacific Partnership. The US Trade Representative is suggesting it could ease some of President Trump’s tariffs under pressure from corporate lobbyists. The Biden administration is also likely to seek Beijing’s cooperation in other areas, such as North Korea and Iran. Biden has an urgent problem with Iran and may need China’s help constraining Iran’s nuclear program. However, none of the current initiatives change the underlying clash of grand strategies outlined above. A fundamental US-China reengagement is not in the cards. China is adopting nationalism and mercantilism to deal with its slowing potential growth, while China-bashing is one of the few areas of US national consensus. Specifically: Democracy over autocracy: The Biden administration cannot afford to be seen as smoothing the way for Xi Jinping to restore autocracy in the twentieth National Party Congress 12 months from now. China doubles down on manufacturing: China is not making liberal reforms to its economy to lower trade tensions but rather doubling down on state-led manufacturing and technological acquisition, according to the US Trade Representative.6 The US trade deficit is surging due to US fiscal stimulus. Biden will maintain or even expand high-tech export controls. Climate cooperation is limited: The US public does not agree that it should exchange its homegrown fossil fuels for Beijing’s renewable energy equipment, and the US and EU are flirting with “carbon adjustment fees,” which would be tariffs on carbon-intensive goods imports from places like China. Meanwhile China just told its state-owned enterprises to do everything in their power to secure coal for electricity and ordered banks to lend more to coal companies. North Korea is already a nuclear-armed state, which China condoned, despite multiple rounds of negotiations with the West. No agreement on Iran: If China helps force Iran to accept restrictions on its nuclear program, then that could mark a substantial improvement. But China has made long term commitments to Iran recently and probably will not backtrack on them unless the US makes major concessions that would undermine its attempts to counter China. The Taiwan conundrum undermines trust. If China can be brought to help the US with historic deals on North Korea or Iran, it will expect the US to stand back from Taiwan. The US may not see it that way. A failure to do so will appear a betrayal of trust. Consider China’s bid to join the Trans-Pacific Partnership. China’s state-driven economic model is fundamentally at odds with the TPP. It only takes one member to veto China’s membership, and Australia and Japan would defer to the US on this issue. The US is only likely to rejoin the TPP, which requires Republican support in Congress, on the basis that it is a vehicle for countering China. Even if the TPP members could be convinced to accept China, they would also want to accept Taiwan, which Beijing would refuse. Ultimately if China’s membership is vetoed, then it will conclude that the West is not serious about economic integration. China will be excluded and will be more inclined to pursue its own solutions to problems. China possesses or is close to possessing the capability of taking Taiwan by force today. We cannot rule it out. Taiwanese Defense Minister Chiu Kuo-cheng just claimed it could be attempted as early as 2025. Other estimates point to important Chinese calendar dates as deadlines for Taiwan’s absorption: 2027 (centenary of the People’s Liberation Army), 2035 (Xi Jinping’s long-term policy program), and 2049 (centenary of the People’s Republic of China). The truth is that any attack on Taiwan would not be based on symbolic anniversaries but on maximizing the element of surprise, China’s military capabilities, and foreign lack of readiness and coordination. Given that China’s capabilities are in place, or nearly in place, and nobody can predict such things precisely, investors should be prepared for conflict at any time. Investment Takeaways Chart 11Taiwanese Dollar Strengthened Since Trump The Taiwanese dollar has rallied since the escalation of US-China strategic tensions in 2016. The real effective exchange rate is now in line with its historic average after a long period of weakness (Chart 11). The trade war and COVID-19 have reinforced Taiwan’s advantage as a chokepoint for semiconductors and tech exports. If we thought there was no real risk of a war, we would not stand in the way of this rally. But based on geopolitical assessment above, the rally could be cut short at any time. Taiwanese equities have also rallied sharply for the same reasons – earnings have exploded throughout the pandemic and semiconductor shortage (Chart 12). Equities are not overly expensive on a cyclically adjusted price-to-earnings basis. But they are meeting resistance at a level that is slightly above fair value. Again, the macro and market fundamentals are positive but geopolitics is deeply negative. We remain underweight Taiwan. China’s willingness to try to stabilize relations with the US is an important positive sign that global investors will cheer in the short run. However, with the US economy fired up, and China’s export machine firing on all cylinders, Chinese authorities apparently believe they can maintain relatively tight monetary, fiscal, and regulatory policy, according to our Emerging Markets Strategy and China Investment Strategy. This will lead to negative outcomes in China’s economy and financial markets. The domestic economy is weak and animal spirits in the private sector are depressed. Retail sales, for example, have dropped far beneath their long-term trend (Chart 13). Chart 12Taiwanese Stocks Not Exactly Cheap Chart 13China: Consumer Sentiment Weak The regulatory crackdown on the property sector could trigger an economic and financial crisis (Chart 14). Chinese onshore equity markets were ultimately not able to sustain the collapse in sentiment this year that hit offshore equities even harder. China’s technology sector will continue to struggle under the burden of hawkish regulation, while Chinese stocks ex-tech have long underperformed the broad market (Chart 15). Chart 14China's Huge Property Sector Looking Wobbly Chart 15Beware Financial Turmoil In Mainland China We maintain the view that Chinese authorities will ease policy when necessary to try to prevent deleveraging in the property sector from triggering a crisis ahead of the twentieth national party congress. A look at past five-year political rotations suggests that bank loans will be flat-to-up over the coming 12 months and that fixed asset investment will tick up (Chart 16). But as long as policymakers are reluctant, risks lie to the downside for Chinese assets and related plays. Chart 16National Party Congress 2022 Requires Overall Stability Chart 17GeoRisk Indicators Flash Warnings China’s shift from “consensus rule” to “personal rule,” i.e. reversion to strongman rule or autocracy, permanently increases the risk of policy mistakes. This could apply to fiscal and regulatory policy as much as to cross-strait policy or foreign policy. It is appropriate that our geopolitical risk indicators for China and Taiwan are rising, signaling that equities are not yet out of the woods (Chart 17). Over the long run China is capable of staging a surprise attack and defeating Taiwan. We have argued that the odds are small this year but that some crisis is imminent – and that the risk of war will rise in the coming years. This is especially true if China cannot engineer a recession to get the Kuomintang back into power in 2024. However, from a fundamentally geopolitical point of view, any attack is bound to be a surprise and hence investors should be prepared. The three main conditions for a conflict over Taiwan are: (1) Chinese domestic instability (2) an American transfer of game-changing offensive weapon systems to Taiwan (3) a formal Taiwanese movement toward independence. The likeliest of these, by far, is Chinese instability. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 See Dina Smeltz and Craig Kafura, "For First Time, Half Of Americans Favor Defending Taiwan If China Invades," Chicago Council on Global Affairs, August 26, 2021, thechicagocouncil.org. 2 See Lu Hui, "Xi says ‘China must be, will be reunified’ as key anniversary marked," Xinhua, January 2, 2019, Xinhuanet.com. For a less alarmist reading of Xi’s recent speeches, see David Sacks, "What Xi Jinping’s Major Speech Means For Taiwan," Council on Foreign Relations, July 6, 2021, cfr.org. 3 See Ian Easton, "Will America Defend Taiwan? Here’s What History Says," Strategika, Hoover Institution, June 30, 2021, hoover.org. 4 See Tsai Ing-wen, "Taiwan and the Fight for Democracy," Foreign Affairs, November/December 2021, foreignaffairs.com. 5 See Gordon Lubold, "U.S. Troops Have Been Deployed In Taiwan For At Least A Year," Wall Street Journal, October 7, 2021, wsj.com. 6 Office of the US Trade Representative, "Fact Sheet: The Biden-Harris Administration’s New Approach To The U.S.-China Trade Relationship," October 4, 2021, ustr.gov.
