Taiwan caught in the middle of US-China power struggle

The “One China” policy maintains that there is only one sovereign state that includes Taiwan. Pelosi’s visit to Taipei was seen to undermine this policy, with the House Speaker telling President Tsai that the US “will not abandon Taiwan.¹

In response, Beijing announced live-fire drills in the vicinity of Taiwan which ended on 10 August. This was a worrying development given that China has previously refused to rule out using military force to gain control of Taiwan, as expressed in an official government paper.² Furthermore, China implemented a halt on exports of sand to Taiwan and imports from Taiwan of citrus fruits and some types of fish. Having overtaken the US to become Taiwan’s largest export partner in 2004 (see Chart 1), China has the potential to damage the Taiwanese economy through trade restrictions.

Chart 1. Taiwanese exports to China and the US (% of total Taiwanese exports)

Source: Taiwan Bureau of Trade and EFGAM calculations. Data as of August 2022.

However, the restrictions that have been introduced are minor, with fish and citrus fruits ranking 27th and 43rd respectively out of Taiwan’s exports to China in 2021.³ Taiwan’s main export to both China and the US is semiconductors. The chip market is of huge importance and is one which Taiwan dominates (see Chart 2). On top of accounting for 63% of global semiconductor production in 2020, Taiwan accounted for 92% of the production of the most advanced semiconductors.⁴ Put plainly, China could not afford to limit the flow of chips arriving from Taiwan and the US could not afford to create a situation in which its own supply of chips from Taiwan was compromised. The signing of the CHIPS act by US President Joe Biden, the day before Chinese military drills were halted, highlighted the push from the US to become less dependent on Taiwanese chips.⁵ This process will take time, however, and it seems unlikely the situation will escalate to a military conflict before it is complete.

Chart 2. Semiconductor foundry market share, 2020

Source: TrendForce and EFGAM calculations. Data as of March 2021.

In addition, any restriction on the flow of chips from Taiwan to China would be a political own goal. The Chinese economy has lacked momentum in 2022, with growth looking likely to come in below the official government target of 5.5% and urban unemployment currently at its highest since August 2020. Multiple Taiwanese companies operating in China and employing Chinese citizens rely on Taiwanese chips as a key part of their production line. With President Xi expected to secure a third term in power during the Communist Party’s 20th National Congress in November, the Chinese authorities will be keen to avoid any further slowdown in Chinese economic growth.

In fact, both President Xi and President Biden have benefitted from recent events in terms of their respective domestic support. President Xi has used Pelosi’s visit as an excuse to showcase China’s strength and dedication to its One China principle via the military drills around Taiwan. Similarly, President Biden, whose popularity had been declining before Pelosi’s visit, also sent a signal of US strength in not appeasing China. Furthermore, the response has reaffirmed the US’ willingness to support other Asian countries such as Japan in their respective territorial disputes with China over islands in Asia.⁶ This could play an important role in the China-US battle for geopolitical influence in the Indo-Pacific area. The response has seen Biden’s ratings climb to a two-month high in approval polls, though they remain at a low absolute level ahead of the midterm elections in November (see Chart 3).

Chart 3. President Biden approval rating survey (%)

Source: Reuters, Ipsos and EFGAM calculations. Data as of August 2022.

It is also of note that President Biden and President Xi were acquainted long before Biden became the US President. In 2013, President Xi referred to Biden, who was Vice President to Obama at the time, as an “old friend”.⁷ Despite current elevated tensions between the two countries, the two Presidents are planning to meet face-to-face for the first time since Biden became President at the next G20 meeting in November.⁸ The meeting will be closely watched, with the potential to agree on a de-escalation between the two countries.

In summary, a proxy war between the US and China over Taiwanese independence would have negative economic consequences, straining supply chains, elevating inflation, and damaging growth. Nonetheless, this is not the current baseline scenario. China remains hesitant to impact the Taiwanese economy through restrictions on semiconductor trade, as this would also have negative implications for the Chinese economy. At the same time, the US does not want to push China into any form of economic blockade on Taiwan before it has secured its own domestic semiconductor supply chains. This reduces the risk of near-term escalation of the conflict. The US Department of Defence still maintains that China will not take Taiwan militarily within the next two years.⁹ Furthermore, war would not play into the hands of either President given their own domestic situations and their upcoming elections.

¹ http://go.pardot.com/e/931253/condemned-by-china-2022-08-03-/25rm5/89305378?h=QvBddFDbK6EUNOrUXRVYECqfTN55OIjqVsIUq6ll910
² http://go.pardot.com/e/931253/S5d3941ddc6d08408f502283d-html/25rm8/89305378?h=QvBddFDbK6EUNOrUXRVYECqfTN55OIjqVsIUq6ll910
³ Taiwanese Bureau of Trade
⁴ http://go.pardot.com/e/931253/bal-semiconductor-supply-chain/25rmc/89305378?h=QvBddFDbK6EUNOrUXRVYECqfTN55OIjqVsIUq6ll910
⁵ http://go.pardot.com/e/931253/chips-and-science-act-of-2022-/25rmg/89305378?h=QvBddFDbK6EUNOrUXRVYECqfTN55OIjqVsIUq6ll910
⁶ http://go.pardot.com/e/931253/-BRIE-2021-696183-EPRS-BRI2021/25rmk/89305378?h=QvBddFDbK6EUNOrUXRVYECqfTN55OIjqVsIUq6ll910)696183_EN.pdf
⁷ http://go.pardot.com/e/931253/dent-xi-jinping-peoples-republ/25rmn/89305378?h=QvBddFDbK6EUNOrUXRVYECqfTN55OIjqVsIUq6ll910
⁸ http://go.pardot.com/e/931253/nearly-three-years-11660318437/25rmr/89305378?h=QvBddFDbK6EUNOrUXRVYECqfTN55OIjqVsIUq6ll910
⁹ http://go.pardot.com/e/931253/isit-official-says-2022-08-08-/25rmv/89305378?h=QvBddFDbK6EUNOrUXRVYECqfTN55OIjqVsIUq6ll910