Trade ties have helped to maintain peace and stability across the Taiwan Strait, and the wider region, over the last few decades. As those ties untangle, Global Insight assesses what’s at stake.

In December, the Kiel Institute for the World Economy, a German think-tank, published a new study that attempted to quantify the impact of a ‘hard decoupling’ between China and Germany. Based on the same methodology it used in early 2022 to assess the impact of Germany decoupling from Russian gas following the latter’s invasion of Ukraine, the study modelled a ‘Cold War 2.0 scenario’ in the event that China invades Taiwan. It concluded that the German economy would shrink by five per cent in the first year – comparable to the hit from the global financial crisis and the Covid-19 pandemic – while the longer-term loss would be 1.5 per cent per year.

In such a scenario, the world economy would fragment into three distinct blocs: the Group of Seven, or ‘the West’; China and its allies, notably Russia; and others, including Brazil and Turkey that are termed neutral. All direct trade relations between the first two blocs are cut.

But the study also compared the shock with a scenario in which trade relations remain intact, albeit at a much-reduced level. It calculated a similar loss of prosperity in the long term as in the scenario in which trade abruptly ceased – at around 1.5 per cent of economic output per year – but without the sharp slump endured in the first months and years. The study’s authors concluded that it would therefore be preferable to start reducing exposure to China now, rather than wait for a ‘much more costly “cold turkey” hard decoupling dictated by geopolitical events’.

Ursula von der Leyen, President of the European Commission, refers to such an approach as ‘de-risking’ without ‘decoupling’ from China – terminology that has since been adopted by the US. In other words, diversifying supply chains away from China without cutting economic ties altogether.

Beijing has accused Taiwan’s governing party, the Democratic Progressive Party (DPP), of pursuing such an approach by obstructing and limiting trade exchanges and cooperation across the Taiwan Strait for its own political interests ever since it first came to power in 2016. This, argues China, is in direct contravention of the free trade agreement between the two governments – the Economic Cooperation Framework Agreement (ECFA) – signed in 2010.

The ECFA was based on upholding the 1992 Consensus, which defines both sides of the Taiwan Strait as ‘One China’. But, while this definition was accepted by the Taiwanese government signatory at the time – the Kuomintang (KMT) party – it’s rejected by the DPP.

Matters came to a head in the run-up to January’s election in Taiwan when China’s Ministry of Commerce (MOFCOM) accused Taipei of imposing trade barriers, launched a trade investigation and ultimately concluded that Taiwan had violated the rules of both the ECFA and the World Trade Organization (WTO).

From 1 January, Beijing suspended tariff cuts on 12 products under the ECFA and subsequently signalled that other agricultural and industrial products could be next. ‘There’s probably plenty of speculation of what those trade actions mean from a political signalling perspective’, says Charles Zhan, Special Projects Officer on the IBA International Trade and Customs Law Committee and a partner and Head of International Trade at Moulis Legal in Canberra. ‘The action that was taken in response to what Beijing considered to be a breach of those obligations was under the ECFA. That itself is an example of China de-escalating and containing the situation within a framework that’s between Beijing and Taipei, instead of taking that to an international level.’

The alternative view, and the one adopted by the DPP, is that the MOFCOM probe was politically rather than economically motivated and was actually an attempt at economic coercion. The DPP emphasised that, as fellow WTO members, China and Taiwan could discuss the trade dispute at any time through the mechanisms and framework of the WTO, if China was acting in good faith.

Dalton James Albrecht, Co-Chair of the IBA International Commerce and Distribution Committee and counsel with EY Law in Toronto, agrees with the DPP’s argument. ‘The tariff suspension was an attempt to say to the Taiwanese, “if you want independence then it’s going to come at an economic cost”’, he explains. ‘And a blockade in the Straits would be an incredible economic cost.’

As an international trade law specialist, Albrecht acted for many Chinese manufacturers in Taiwan in the 1990s. ‘China is trying to turn the screws economically because, firstly, they can, and secondly, that’s what Taiwan reacts to’, he says. ‘In my experience, the Taiwanese are very independent but, at the same time, very business-like and very practical. They are free market people, and they know who’s “buttering their bread”.’

The costs of war

Despite the tariff cuts and the regular deployment of Chinese military planes and vessels close to the island nation, Taiwanese voters seemingly ignored the threats and elected pro-sovereignty DPP candidate Lai Ching-te as the next president.

The world watched closely, with the potential ramifications of the result stretching way beyond the Taiwan Strait. Senior analysts had cited the 2024 election as an event that could ultimately trigger a conflict between Taiwan and mainland China. With China’s rising economic and military heft, Taiwan’s burgeoning sense of national identity and fractious relations between Beijing and Washington, many international commentators have speculated that the conditions for a crisis are now in place.

Beijing described Lai as a ‘troublemaker’ and a ‘separatist’ in the run-up to the election, asserting that the vote was a ‘choice between war and peace’ – the DPP’s electoral rivals, the KMT and the Taiwan People’s Party (TPP), favour closer ties with China. But, with self-described ‘realistic Taiwan independence activist’ Lai in office for at least the next four years, there’s a question as to whether China really wants a war.

Nikkei Asia has estimated that a Chinese invasion of Taiwan would destroy world trade to the tune of $2.6 trillion. Central to this estimate is the impact on the global semiconductor industry, with approximately 60 per cent of all microchips – and more than 90 per cent of the more advanced types – made in Taiwan. Bloomberg Economics has estimated that the final price tag of a war over Taiwan could be as high as $10 trillion. This would dwarf the financial blow dealt by the war in Ukraine, the Covid-19 pandemic and the global financial crisis.

‘The fact that China is so much more integrated with the world economically, and has positioned itself as the powerhouse of the world economy (and wants to continue to be that powerhouse), means it is very unlikely to act in the same way as a major power like Russia’, says Zhan. ‘I don’t think China wants a war and I don’t think there will be a war in the short term because of those reasons.’

The outbreak of conflict in Gaza and Ukraine are reminders of how long-simmering tensions can erupt into conflict. It shouldn’t be surprising that all stakeholders in a potential Taiwan conflict are already moving to hedge against the risk.

Some commentators, meanwhile, are drawing an analogy between China and Russia. Their argument is that the West’s failure to stop Russia from annexing Crimea in 2014 emboldened the Russians to initiate a war against Ukraine in 2022, and that China’s posturing towards Taiwan could similarly be a prelude to a military initiative against the island.

In all of the Kiel Institute study’s simulated scenarios, the costs for China in relation to its ‘Cold War 2.0 scenario’ were significantly higher than they were for Germany. China is well aware of this, says Albrecht. He adds that Chinese President Xi Jinping will have carefully monitored how the US and its European allies reacted to the invasion of Ukraine.

‘They’re watching everything’, he says. ‘If the Western world, not just the US but the rest of the Western world, hadn’t provided armaments and supported Ukraine, both economically and militarily, I think China would have already invaded Taiwan by now. That’s because they wanted to do it for years, but they needed to build up their military first because they worried about the US counterforce.’

Albrecht believes that if the US continues to ‘weaken internationally’, which he sees as probable given the unclear outcome of the country’s presidential election in November, ‘then that could be a real tipping point in terms of Taiwan’. The risk is heightened by the possibility of a second term as US president for Donald Trump, who has vowed to cut off US aid for Ukraine.

Albrecht points to two reasons why the US would wish to avoid a war in Taiwan – firstly because they would struggle to simultaneously fund a war in Taiwan and support Ukraine, and secondly because the US needs the microchips produced in Taiwan.

A less predictable response by Western governments, but one that Beijing must take seriously, is the possibility that Chinese state assets around the world could be seized, frozen and even potentially used to support Taiwan. Beijing need only consider the growing clamour in support of the moral and practical case for using the nearly $300bn in frozen state assets belonging to Russia to help fund Ukraine’s defence.

Harvard Law School’s Laurence Tribe and Robert Zoellick have argued that international law authorises governments to transfer those funds to a harmed party as a proportional countermeasure against an invader. Their contention is founded on the US International Emergency Economic Powers Act, which they argue authorises the Biden administration to transfer Russian state assets to Ukraine even without action by Congress or a court order.

Elsewhere, the Estonian government is pressing ahead with legislation allowing it to confiscate Russian assets frozen by sanctions. ‘If Russian assets are seized and Mr Tribe is right that, under international law, the US can just dispose of those assets and pay them out to Ukraine, that would have a major impact on China’, says Albrecht. ‘China has a lot of assets all over the world so, if they thought they might lose those assets, that might be the one thing that dissuades them.’

Trade’s latest buzz words

A Chinese blockade in the Taiwan Strait and subsequent sanctions would prove hugely disruptive to global supply chains, as approximately half of the world’s container ships pass through the shipping lane every year. This includes the export of critical Taiwanese semiconductors.

Although China has been working to develop its own domestic semiconductor chip industry, its companies are still lagging several generations behind their most advanced Taiwanese counterparts. Albrecht highlights that, up until now, ‘a lot of components involving labour intensive manufacturing often came from China. But a lot of the more advanced technology was being transferred to China from Taiwan. So, practically speaking, the economies were pretty integrated’.

That situation is changing as Taiwan ‘de-risks’ and diversifies its supply chains away from China. According to Taiwan’s Investment Commission, China’s share of Taiwan’s outbound foreign direct investment has declined from 84 per cent in 2010 to 34 per cent in 2022. In particular, the shift of semiconductor production away from China has become more pronounced since the Covid-19 pandemic.

The US has been ‘de-risking’ from China since Donald Trump’s presidency and, in summer 2022, the Biden administration and lawmakers passed the Creating Helpful Incentives to Produce Semiconductors and Science Act, which included $52bn to strengthen semiconductor manufacturing in the US. ‘Some of my clients are starting to look at reorganising their supply chains, with the obvious one being microchips’, says Albrecht. He says that, between US incentives and efforts to encourage chip production in Canada, there will be ‘a pretty big impact on Taiwan’s economy, which isn’t going to help them if there is a war’.

The new buzz words in global trade are: ‘re-shoring’, meaning the return of the production and manufacturing of goods to a company’s original country; ‘near-shoring’, referring to the outsourcing of business operations and processes to companies located nearby; and ‘friend-shoring’, whereby manufacturing and sourcing are carried out in countries that are geopolitical allies. These concepts are helping businesses increase their resilience and optimise the processes of manufacturing and distribution along the supply chain. ‘Chip production is being near-shored if it can because obviously the Western world needs the microchips, and most of them were being produced in Taiwan’, says Albrecht. ‘From a trade perspective, it’s part of this broader trend of near-shoring that we’re seeing, as the threat of war is having a major impact on some of the Taiwanese companies and on trade flows.’

One consequence of this is the trend towards regional trade blocs. An example of friend-shoring, the trend represents the realignment of trade networks along geopolitical lines. For example, since the 2020 signing of the US-Mexico-Canada Agreement, itself an expansion of the North American Free Trade Agreement, Mexico has seen its share of US imports surge. ‘Mexico is receiving increasing investment […] it’s doubling and even tripling in some sectors’, says Albrecht. ‘There’s no industrial park availability because demand for industrial parks in Mexico has increased by 20 per cent, year-on-year, between 2022 and 2023. But China is also behind a lot of these industrial parks. So, what we’re seeing is China reacting to this friend-shoring and trying to invest in areas that are near or friendly to North America or other Western countries.’

Zhan agrees that critical manufacturing infrastructure and technology is being near-shored or friend-shored, and that China is as active in that space as any other country. ‘China is continuing to push forward its development in clean energy industries like electric vehicles (EVs) [and the] renewable energy sector as well as the semiconductor sector, which is a continuing battle’, he says. ‘China will have to do what it can to try to secure those investments, whether it is from Taiwan or elsewhere, to build up its own self-reliance in key sectors. So, we will continue to see those battles for supply chain and manufacturing capacities in a political context.’

Favouring the status quo

In October 2023, then UK Foreign Secretary James Cleverly warned China that an invasion of Taiwan could collapse the Chinese economy. With the cost of invasion so prohibitively expensive and the lessons from Russia’s campaign in Ukraine playing out in real time, Beijing may well prefer to continue influencing Taiwanese politics through its strategy of economic coercion.

‘The economic coercion certainly shows what China’s intentions are, and I think it’s affecting Taiwan’s economy’, says Albrecht. ‘Although I wouldn’t say I have clients fleeing Taiwan, many are leaving and trying to move their operations and look for alternative sources for critical products like microchips. And that’s the whole point of near-shoring and friend-shoring. So, there is a huge economic impact resulting from the Chinese pressure.’

The election in January of Lai, while no doubt frustrating for Beijing, may offer some hope that a military conflict can be avoided. Lai won the presidency with 40.05 per cent of the vote, which was the lowest percentage for a winning candidate since 2000. In addition, the DPP failed to retain control of Taiwan’s parliament, the Legislative Yuan, winning 51 seats compared to the KMT’s 52.

This will probably hinder Lai’s ability to pursue some policies that require legislative approval, such as higher military spending in the face of China’s assertiveness. Of even more significance to Beijing, perhaps, was the performance, and rise, of a third political party: the TPP.

‘Although the TPP only got 26.5 per cent of the vote, they still increased from five to eight seats in parliament, so they are improving’, says Yuka Kobayashi, Professor of China and International Politics at the School of Oriental and African Studies within the University of London. ‘They were really appealing to the younger generation but scored quite weakly with the older generation and I think they will learn from that and, in the 2028 elections, they will be a force to be reckoned with.’

With the DPP losing ground in the legislature, and KMT party representatives still holding a large number of seats, Beijing will see a growing opportunity to influence Taiwan without the need to resort to force.

But the increasing de-globalisation of international commerce, which has accelerated in recent years due to the ongoing trade wars and the invasion of Ukraine, looks set to continue. ‘Regional trade blocs are a real trend and that’s making the world a poorer place’, says Albrecht.

In 1998, three years before China joined the WTO, then US President Bill Clinton described trade as a force for change in China, ‘exposing China to our ideas and our ideals, and integrating China into the global economy’. Zhan says that while there’s strong rhetoric in the US that those assumptions have failed, ‘from a trade perspective […] the economic reality is that those goals are, at least partly, achieved’.

Such integration may not have led to the ‘unstoppable momentum towards greater political freedom and progress on human rights’ predicted in 2005 by then UK Prime Minister Tony Blair. But China has transformed economically and, in many sectors, is a thriving market economy, says Zhan. ‘China has not changed completely, nor as much as some may have expected or hoped, but trade definitely has a very positive impact and will continue to have that impact in encouraging peace and stability and development in the region and globally’, he adds.

Stephen Mulrenan is a freelance writer and can be contacted at smulrenan@lextelpartners.com