Economic impact of yet another Taiwan Strait crisis

Geopolitical tensions in the Taiwan Strait have risen after U.S. House Speaker Nancy Pelosi visited Taiwan. There is no surprise that Beijing announced economic retaliations and military drills. What is uncertain is that the Taiwan Strait, one of the world's most important lanes for marine shipping and air cargoes, is now a riskier place today due to ongoing live military exercises. Any disruption is bound to create bottlenecks and supply chain disruptions feeding inflationary pressures.

The focus of economic sanctions is on food, but it only affects 0.2% of Taiwan's exports. It means the import ban is extremely targeted without touching semiconductors that Mainland China clearly needs. But the live military drills surrounding Taiwan are more worrisome, especially if it becomes regular. Persisting activities can force ships and planes to reroute, detour or cancel their trips.

With the worrisome development in the Taiwan Strait and the sinking trust between China and the US, the mild global market reaction seems incomprehensible. The reality is global investors are closely watching the growth prospect of the US and Mainland China, and the focus is relatively limited to Taiwan. Capital outflows have stepped up from Taiwan's equities, but the scale is not comparable to April when the FED hiked for the first time. In short, the market is hardly pricing a crisis in the Taiwan Strait and certainly nothing like the Ukraine-Russia war.

Even if the world manages to avoid another military conflict, there are still important risks related to continuing military drills, which are larger than the 1996 Taiwan Strait crisis. First, the economic size of Mainland China and its trade flows with the world are much larger nowadays. Second, Taiwan has become a critical producer of semiconductors and ICT products, especially advanced chips.?

There are two sectoral implications to the above. A "de facto" blockade by Mainland China's regular military exercises would create bottlenecks in fast-growing sectors dependent on semiconductors, such as high-performance computing, internet of things, data centers and electric vehicles. Consumer electronics will also suffer, but the falling demand and higher inventory level should buffer the shock. The Taiwan Strait is also an important route for energy imports by Japan and Korea.

Therefore, a potential Taiwan Strait crisis is part of the bigger scene in the US-China strategic competition. Any further escalation can have very negative consequences for Taiwan, Asia, and the world. It includes supply chain disruptions and renewed inflationary pressures. Another consequence is that the ongoing supply chain reshuffling sets to accelerate. Mainland China is bound to face more headwinds to move up the tech ladder in key industries, especially semiconductors. The US will put more pressure on key suppliers to ban exports to China and develop production in its own market with industrial policy tools, such as the CHIPS Act and a push for friend-shoring.

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