Preparing for cross-Strait relations to stay on the brink

• China’s unprecedented large-scale military exercises near Taiwan signify a foreboding change of the status quo, and are not a one‑off incident.

• Targeted economic sanctions on Taiwan will cause some pain, but EIU expects the the island’s paramount electronics sector to be spared, which will avoid wider disruptions to headline growth.

• Limited disruption of air and sea routes near Taiwan will become more likely, presenting supply-chain risks for companies with regional operations.

We expect China’s ratcheting up of pressure on Taiwan following a visit by Nancy Pelosi—the US Speaker of the House of Representatives (lower house of Congress, the US legislature)—in early August to cause a longer-term shift in the security paradigm in the Taiwan Strait. The drills do not signal an imminent war—China is not ready for that—but do represent a clear change of the status quo. However, beyond the implications for trilateral relations between Taiwan, China and the US, what do these developments mean for Taiwan’s economy, as well as its ties with the US?.

Import bans: inflicting more political pain than economic gain

As expected, China’s retaliation for Ms Pelosi’s visit has includes targeted economic sanctions. These include bans on thousands of Taiwanese citrus and seafood imports, alleging covid‑19 contamination—a common tactic used by China against countries with which it has diplomatic disputes, such as Australia and Canada. China also banned natural sand exports to Taiwan, probably to harm the island’s construction sector.

The limited scope of these measures highlights limitations in China’s ability to retaliate economically against Taiwan in response to Ms Pelosi’s visit. The targeted goods are not major Taiwanese export categories, nor do they constitute a significant portion of cross‑Straits trade. Although Taiwanese farmers and fisherman will suffer in the short term, we ultimately expect them to find alternative markets for their goods, with the effects of this longer-term diversification helping to insulate Taiwan from future economic pressure (probably mirroring the experience of many agricultural producers in Australia and Canada, who were once over‑reliant on the Chinese market). Taiwan also imports less than 1% of the natural sand, according to data from Taiwan’s Bureau of Mines, suggesting a shallow impact on broader industrial and investment prospects as a result of these moves.

These limitations are reflective of the nature of cross‑Straits good trade, which are overwhelmingly dominated by shipments of semiconductors and other intermediate electronics equipment and machinery. As Taiwan’s top export market, China is one of the most important destinations for these shipments—and more than half of Taiwan’s US$188.1bn worth of exports to mainland China and Taiwan were electronics parts, according to Taiwan’s Ministry of Finance. Restricting this goods trade could inflict catastrophic damage to Taiwan’s economy, but at a pyrrhic cost for China, given the latter’s overwhelming reliance on Taiwanese inputs for its own electronics sector. As a result, we expect China to continue to shy away from this strategy, particularly as its own economic self‑reliance campaign struggles to cut Taiwanese producers out of its domestic technology supply chain.

This does not suggest that China’s economic retaliation will come without any cost. An immediate concern for Taiwan’s ruling party, the Democratic Progressive Party (DPP), will be the fact that these restrictions could undermine electoral support among rural constituencies ahead of the November local elections. We had already expected the opposition, led by the Kuomintang (KMT), to retain its control over a majority of Taiwan’s counties and municipalities. There is a risk that these movements could push voters further away from the DPP (although regardless of the electoral outcomes, we would not expect this to prompt adjustments to Taiwan’s overall economic or foreign policy).

A greater economic concern for Taiwan is that multinational companies may begin to see the island as a high‑risk investment destination. Lingering covid‑19 restrictions, including a four‑day quarantine (in a hotel for non‑residents) already have hurt Taiwan’s competitiveness. Regular Chinese military activity may create the impression that Taiwan is dangerous, prompting multinationals to shift operations to lower-risk countries in the region. Sustained Chinese military exercises have the potential to disrupt commercial air and sea traffic routes, given Taiwan’s position along one of the world’s busiest shipping lanes. About half of the world’s container ships and 88% of the largest such vessels passed through the Taiwan Strait from January to July, according to Bloomberg data. Future Chinese military activities pose risks of disruption in ways that may (mildly) affect the competitiveness of Taiwanese supply chains, as well as the normal operations of the Taiwanese shipping and logistics industries.

 Lawfare risk

China’s upcoming 20th Party Congress, to be held in late 2022, will provide some clarity on the future direction of cross‑Strait dynamics. New Chinese legislation targeting “secessionist” activities—separate from the existing 2005 Anti‑Secession Law—could provide greater legal justification to sanction any person or organisation in China that “supports Taiwan independence”. Multinational firms should consequently carefully examine their language in how they refer to Taiwan, particularly in their external messaging activities (including advertisements, marketing and retail activities; for example, whether Taiwan is referred to as a “country” via company websites). Imaginative workarounds might become more necessary. The model used by many airlines that categorise destinations by regions and cities, instead of countries, could be instructive.

Even more concerning would be legislation providing new grounds for pursuing unification by force. Jingoistic voices in the Chinese state media have already mooted this idea. At a minimum, such legislation would indicate that China increasingly sees peaceful unification as a remote possibility, rather than its primary goal in cross‑Strait relations.

A diplomatic balancing act between China and the US

We expect US‑Taiwan ties to deepen, as made evident by another trip in mid‑August by a bipartisan group of US lawmakers to the island as another show of US support. This will cause China to further double down the normalisation of its military exercises, in ways that change the status quo. Chinese military aircraft, for instance, have repeatedly crossed the unofficial “median line” between China and Taiwan in recent weeks—a show of force that was previously done only rarely, as a sign of purposeful provocation. The Taiwanese president, Tsai Ing‑wen, will come under pressure on how to respond to China’s erosion of this status quo.

This will also come at a time as misalignment on “Taiwan policy” in the US becomes more evident, as an increasingly pro‑Taiwan stance in the US Congress (the legislative branch) pushes the US administration under Joe Biden (the executive branch) to adopt a less cautious approach to US‑Taiwan ties. The bipartisan Taiwan Policy Act of 2022 (which is currently making its way through the US Congress) would aim to overhaul US‑Taiwan relations in ways that strengthen the US‑Taiwan relationship, such as by enhancing Taiwan’s profile in various multilateral financing institutions; directing the US government to engage with their Taiwanese counterparts in more formalised settings; and rescinding US guidelines on prohibiting Taiwanese officials from displaying symbols of sovereignty.

The act will not change the unofficial status of US‑Taiwan ties, but will inflame it regardless. This will particularly be the case as the US president, Mr Biden, remains wary of “looking weak” on China, giving him limited room to push back on these provisions. A future flash point will be negotiations around formal US‑Taiwan trade talks. Although these developments are only rumours at this point, the initiation of formal trade negotiations (which may go beyond the scope of US‑Taiwan trade and investment talks in June) would probably prompt a strong Chinese response, in ways that could exacerbate the risks and uncertainty currently facing cross‑Strait supply chains.

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