5 October 2018

Taiwan Confronts the Costs of Economic Integration With Mainland China

Taiwanese electronic firms are still more advanced than mainland China's in developing most cutting-edge technologies, but they are increasingly linked to mainland supply chains.

This integration could help Beijing move up the production value chains, compromising Taiwan's competitive advantage.

U.S.-China trade tensions will likely increase production costs and push Taiwanese-owned, low-end manufacturing companies to move away from China and into Southeast Asian states.

Though Taiwan will continue to struggle to form regional, multilateral free trade agreements, it could see more success pursuing bilateral deals with the mainland's biggest rivals.

Taiwan is caught in the middle of the escalating trade war and larger strategic competition between mainland China and the United States. And the clash is threatening the self-governing island's export- and tech-oriented economy, which relies heavily on the mainland's supply chains for assembly, export opportunities and market access. (This is particularly true for its electronic and semiconductor industries, which together account for about 25 percent of the island's gross domestic product.)

Adding to Taiwan's economic troubles is Beijing's two-pronged campaign to diplomatically isolate the island and poach its businesses and talent, all in the hopes of eventual reunification. Together, these threats are increasing Taipei's desire to rely less on the mainland's economy, to diversify its trade and investment relationships with its neighbors, particularly India and those in Southeast Asia, and to establish more free trade agreements. In the past, these efforts have had mixed results, but the current economic and strategic pressure will likely harden Taipei's resolve in the coming months.

Deepening Connections

Over the past two decades, disputes over sovereignty have contributed to a volatile political relationship between Taiwan and mainland China. But at the same time, trade and investment links between the two have grown. Taiwanese investments into the mainland have steadily increased since Beijing opened up access in the early 1990s. Because of a similar culture and language, and the mainland's huge market potential and cheap labor, many capital-rich Taiwanese businesses relocated to the mainland. Today, China accounts for over 40 percent of Taiwan's exports, of which 80 percent are intermediary goods that are assembled in China before being sold domestically or exported.

These developments have had the added effect of nurturing China's economy during its reform and transformation era. The Taiwanese business community not only serves as a top capital source for once cash-strapped China but has also become an important means through which Beijing could influence the island and forge cross-strait connections.

And as such links grew, Taiwan found it had few options besides mainland markets and production. The island's economy was plagued by years of stagnation, low wages and productivity throughout the 2000s, and it continues to face high-tech competitors in South Korea. Indeed, during the global financial crisis of the late 2000s, former Taiwanese President Ma Ying-jeou's administration removed a host of restrictions on investment in key high-tech sectors on the mainland, contributing to an even heavier dependence on the mainland economy and creating new cross-strait supply chains in those industries.

As Taiwanese electronics firms outsource to mainland China, they are keeping higher value-added work — such as the development of semiconductors, chips and other key electronic components — at home. But a significant portion of these components are supplied to Chinese, Taiwanese or foreign firms in China. As much as 90 percent of Taiwanese-branded computers, laptops and mobile phones are produced outside the country, with a majority being produced in mainland China.

The Consequences of Linking Supply Chains

While the mainland and Taiwan have both benefited from their interconnectedness in economic terms, the relationship has spurred increasing debate within Taiwan about its impact on the island's de facto independence. The mainland's relatively high-skill, low-cost labor and integrated supply chains offer Taiwanese businesses competitive advantages, but they also open up the opportunity for China to interfere with Taiwan's internal politics and, in a more extreme scenario, to challenge its industrial development.

Beijing's ultimate imperative is reunification, so it has been careful in applying serious economic pressure on Taiwanese businesses on the mainland. But it has increasingly leveraged its economic influence to try to shape Taiwan's internal politics in its favor, as it did during Taiwan's presidential election in 2012.

Moreover, a heavy reliance on overseas production is eroding the Taiwanese incentive to innovate and allowing mainland competitors to gain knowledge as China pushes to move up the value chain. This drive threatens Taiwan's competitive advantage in lower-end technology sectors. In particular, Beijing has been moving aggressively to develop a more self-reliant semiconductor industry, as outlined in its signature Made in China 2025 project.

These developments could have several implications for Taiwan. China has ramped up its efforts to absorb talent and technological capability, and Taiwan is a target due to Beijing's reunification goal and its strategic intention to move up the semiconductor value chain. And Beijing's capital- and state-led efforts are expected to boost China's tech industry, putting Taiwanese companies in a race to climb the ladder of cutting-edge technology.

Of course, as the ZTE case has illustrated, Beijing is still perhaps a decade away from its goal of achieving greater technological independence, while Taiwan holds a leading position in the most advanced technologies, such as integrated circuit design, fabless integrated circuits and foundries. But the mainland's efforts to climb the value chain with products such as solar panels and smartphones have rapidly eroded Taipei's advantages in those global markets.
Taiwan Strives to Diversify

As the U.S.-China trade war threatens to disrupt supply chains and as China amplifies cross-strait tensions while growing more technologically competitive, Taiwan has urgently emphasized the development of economic relations beyond the mainland, which the island has pursued in one form or another for the past several decades.

Since taking office in 2016, Tsai has implemented her "New Southbound Policy" to ramp up connections with and investment in Southeast Asian states and India — an extension of similar goals held by two previous administrations. Her government has also accelerated its longtime quest for free trade agreements, hoping to better integrate Taiwan's economy on a global level. This was a goal in the 2000s as well, as the proliferation of regional free trade agreements threatened to undermine Taiwan's competitive advantage in the Asia-Pacific.

But the previous diversification policies didn't yield much progress, since Beijing's ever-growing and outperforming economy meant China remained the most lucrative place for investment. And Taiwan's attempts to join multilateral free trade agreements, such as the Regional Comprehensive Economic Partnership between the 10 members of the Association of Southeast Asian Nations (ASEAN) and the Trans-Pacific Partnership, didn't yield much success due to the island's political status and the concerns of some countries that they would risk backlash from Beijing.

In the two years since Tsai took office, Taiwanese investment in Southeast Asia has moderately picked up but still fell short of what the island was investing in those regions in the late 1990s and early 2010s. Most of the current investments are concentrated in the retail and financial sectors, indicating that they are primarily oriented to capture those growing markets instead of directing markets away from mainland China. Moreover, Taiwan has so far made few electronics investments in Southeast Asia (with a few in Malaysia and Indonesia and some most recently in Thailand). After two decades of developing sophisticated, well-functioning supply chains for items such as semiconductors, Taiwanese businesses are less than eager to relocate and abandon the growing domestic Chinese market.
What's Different Now

But Tsai's conviction of the need to diversify Taiwan's economy is strong, and things may change this time around. Many countries in the ASEAN, such as Vietnam, Indonesia and the Philippines, are developing strong economies of their own, working to move up the value chain and moving factories out of China. Inspired by their success, Taipei will likely work hard to keep up. Additionally, even as Taiwan remains an unlikely candidate for regional free trade agreements in the short term, its quest for bilateral free trade agreements with the United States and, to some extent, India may get new momentum as Washington challenges the current state of cross-strait relations.

All these developments, combined with the protracted U.S.-China strategic competition that could disrupt critical supply chains and with a mainland government that is increasingly challenging Taiwan's autonomy, will drive Taipei to focus on its goal of disengaging its economy from the mainland, despite the barriers to that objective.

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