Last week's Taiwan visit by US House Speaker Nancy Pelosi and the military drills by China, in response, have brought long-standing geopolitical risks to the fore for global investors.
However, the telegraphed nature of China's response should allay concerns that a major crisis is underway. Furthermore, the precedent from the last actual crisis in the Taiwan Strait, in 1995-96, suggests that the clear demonstration of how costly a war would be for all concerned should lead to an ultimate de-escalation.
And for emerging market investors, the valuation of the largest stock in the index, TSMC, already reflects a good deal of concern, with its forward PE on a 25% discount to the 5-year median. Few cared when we discussed these risks in 2021 and TSMC was valued at a substantial premium.
China's response to Pelosi's provocation
Pelosi was the most senior US official to visit since one of her predecessors, Newt Gingrich, in 1997. The scale of military drills conducted by China in response is also without precedent over this time frame.
Compared to that era:
China is economically and militarily stronger and President Xi Jinping enjoys more concentrated power than Jiang Zemin.
The US is even more polarised, with both Democrats and Republicans seeing domestic political benefit in taking the most hawkish position on China.
All US allies are more sensitive to the geopolitical challenge of China in light of Russia's invasion of Ukraine, NATO now defines China a "systematic challenge", the Quad has been re-established, and Japan and South Korea's military spend is increasing.
Concerns have ranged from supply chain disruption at a time of accelerating global inflation, the potential for human error to trigger a hot military conflict, and greater dysfunction in relations between China and the US impacting trade, security, climate, and pandemic management.
However, the precedent from the last Taiwan Strait Crisis in 1995-96 is that the spectre of a costly war ultimately drives de-escalation. And the aftermath of that crisis established the "strategic ambiguity" in US foreign policy which has since served both the US and China well:
Establishing unencumbered supply chains for US allies like Japan, South Korea, and Taiwan, seeing pro-US politicians flourish in Taiwan, but at the same time.
Allowing China to build up its military capability and maintaining the "One China" policy, without ever exposing the limits of that military in a hot conflict on multiple fronts.
Putting the rationality and internal pressures of each leader to one side, when comparing Russia-Ukraine with China-Taiwan, there is no land border which makes for a quicker invasion, a sympathetic or partly subdued population near that border, and opposing multinational forces are already stationed nearby with a track record of coordination.
And it is not even clear that the events of the last week amount to a crisis. China telegraphed the start (and finish) of its drills and (so far) there is little counter-escalation from Taiwan or US. The drills and the diplomatic rhetoric from China convey the cost involved in any hot military conflict and the outrage it wishes to project over any interference in Taiwan but in a manner that serious US policymakers would surely consider entirely predictable.
China-Taiwan-US status quo
The status quo in terms of the risks surrounding China, Taiwan, and the US can be summarised in the following ten points — our previously published reports on these points are linked. The key question is what, if anything, has changed as a result of the events of the past week?
China is extremely sensitive over Taiwan. This has been the case since the communists won the Chinese Civil War in 1949, and close relations between Taiwan and the US has prompted three crises in the Taiwan Strait (1954 and 1958, both under President Eisenhower, and 1996-96 under President Clinton).
President Xi Jinping is committed to reunification of Taiwan but, since becoming Chinese Communist Party General Secretary in 2012 and President in 2013, has oscillated between relatively conciliatory and abrasive rhetoric. The looming 20th National Congress of Party in November 2022, during which he should be re-elected General Secretary or newly elected as Chairman, weaves sensitivity over Taiwan in with political succession.
China is projecting its power across its coastal waters with increasing ambition, and across its Nine-Dash Line with belligerence, with its growing naval assets, armed vessels and reclaimed islands. This has led to clashes over the past decade from Vietnam to the Philippines.
While all non-China powers with which China has territorial disputes rely on implicit and explicit US security cover, to differing degrees, they also are deeply integrated into China's supply chain. Imports from China equated to 36%, 15%, 11%, 9%, and 7% of GDP in Vietnam, Malaysia, Philippines, Thailand, South Korea, respectively, in 2019.
Note that during Pelosi's stopover in South Korea, recently elected pro-US President Yoon Suk-yeol decided not to meet her.
China is a key exporter of all manufactured goods to the US, accounting for close to 20% of total US imports, and a key trading partner globally, accounting for over 15% of global trade.
While relations have been cooling for some time, pre-dating President Trump's trade tariffs, reference to a cold war between China and the US, along the lines of the US-USSR Cold War (1947-1991) are misplaced because of the largely disconnected economies of those two protagonists.
China is the largest regional military power, measured by military spend, but, in military spend and naval power, it is outweighed by the regional deployment of the US and by the combination of the US and allies such as those in the Quad (US, Japan, India, Australia).
Since President Carter terminated US diplomatic recognition of Taiwan in 1979, the US has pursued a policy of "strategic ambiguity" over exactly to what extent the US would respond in the event of Chinese military action in and around Taiwan, neither explicitly supporting Taiwan independence nor China reunification.
The US has at least two arms — the President and the Congress — that handle its foreign policy, and they can act as inconsistently on the issue of China-Taiwan as they can on others, eg the Trans-Pacific Partnership trade agreement or the Iran Nuclear Deal.
Currently, both President Biden and the Democrats in Congress are scoring poorly in opinion polls prior to mid-term elections in November.
Nancy Pelosi's visit to Taiwan, against the wishes of President Biden, is not the first instance of the US Congress contravening the President and triggering an escalation of tension with China over Taiwan.
After President Carter terminated US diplomatic recognition of Taiwan in 1979, in order to prioritise cultivating relations with China, the US Congress passed the Taiwan Relations Act, which institutionalised the supply of military hardware to Taiwan — while maintaining "strategic ambiguity".
And it was the US Congress that effectively enabled the visit of Taiwan President Lee Teng-hui and triggered the Third Taiwan Strait Crisis in 1995 (see below).
Taiwan is the key global exporter of cutting-edge technology semiconductors, with TSMC accounting for over 50% of third-party foundry revenues. The majority of its capacity, and all of its leading edge capacity, is located in Taiwan.
Even its under-construction Phoenix-Arizona plant in the US will operate 5nm lithography at launch, in 2024, by which time its most advanced Taiwanese fabs will operate 3nm.
Taiwan's next general election is in 2024, at which point incumbent President Tsai Ing-wen, who champions Taiwan nationalism, reaches her two-term limit and will not contest.
Non-committal voters make up the largest group (46%), with the incumbent President's DPP supported by 31% and the main opposition KMT at a three-decade low of 14%.
Over 82% of the electorate support some form of the status quo, with very little support for either a quick move towards independence (5%) or reunification (1%).
A History of Taiwan Strait Crises
The First (1954) and Second (1958) Taiwan Strait Crises occurred in the aftermath of the Chinese Civil War (1945-49) between the communists, who emerged victorious, and the nationalists, who retreated to Taiwan under Chiang Kai-shek and sought closer relations with the US (under President Eisenhower).
The Third Taiwan Strait Crisis (July 1995 to March 1996) was triggered, by the visit of Taiwan Lee Teng-hui to the US, after votes in the US Congress forced a reluctant US State Department to issue him a visa, and continued until the first direct presidential election in Taiwan.
In response, China, under President Jiang Zemin, mobilised troops in the coastal province of Fujian, and conducted months of missile and live ammunition tests and exercises involving naval vessels and amphibious assault units.
In its counter-response, the US, under President Clinton, deployed naval ships to the Taiwan Strait, initially an amphibious assault ship in July 1995, followed by a first aircraft carrier group in December 1995, and then a second one in March 1996.
The immediate aftermath of the crisis appeared as a double setback for China: the credible threat of a US military response prompted a climbdown and the Taiwanese electorate overwhelmingly supported presidential candidates more in favour of independence (winning 75% of votes) than pro-reunification mindset (15%).
However, within two years, President Clinton had pledged the "Three No's": no to Taiwan independence, no to "two Chinas", and no to Taiwan membership of international organisations. The Third Taiwan Strait Crisis had not worked out so poorly for China after all.
China's share of global trade and military spending is far greater than in 1996. It remains to be seen whether China's latest demonstration of force around Taiwan has credibly demonstrated to the US, Japan, South Korea and other allies, its potential for disrupting sea and airborne trade around Taiwan and the costs to militarily defeat it.
TSMC valuation already reflects a lot of risk
Taiwan Semiconductor Manufacturing Company, TSMC, is the largest single stock in the MSCI EM index and has a 6.3% weight. Taiwan, overall, has a 14.2% weight, second only to China-HK (31.7%).
The spike in China-Taiwan-US friction compounds existing global growth concerns.
However, with forward 12-month PE of 13.8x, about a 25% discount to the 5-year median, a good deal of risk is, perhaps, already reflected.