Potential Taiwan conflict will hit these 3 countries the hardest, EIU report says

Japan, South Korea and the Philippines will be hardest hit in the event of a conflict between Taiwan and China, according to a report by the Economist Intelligence Unit.

EIU defines a conflict as a “full-conflict scenario, involving direct military participation by China, Taiwan and the U.S.” and based on the presumption of an escalation by China.

To be clear, the EIU assesses the risk of a direct Chinese military assault on Taiwan as “very unlikely.” But should it occur, the three economies will be “most vulnerable” due to their proximity to the Taiwan Strait and heavy trade ties with China, but more importantly, because these three countries are U.S. treaty allies.

China sees self-ruled Taiwan as a breakaway province that should be reunified with the mainland. Chinese President Xi Jinping has previously said China will “strive for the prospect of peaceful reunification,” but “will never promise to give up the use of force.”

Taiwan sees itself as a sovereign state and separate from China, having ruled itself since the Nationalist government fled there from the mainland in 1949 following a protracted civil war. Tensions between Taiwan and China’s governments have risen over the years, and high-level U.S. politicians’ visits to Taiwan have drawn Beijing’s ire.

The report pointed out that Japan, South Korea and the Philippines host U.S. bases, which highlights their vulnerability to a preemptive Chinese attack, should China choose to go to war.

“We expect U.S. participation to activate that country’s regional security alliances, carrying direct
implications for Australia, Japan, New Zealand, the Philippines and South Korea (as well as other countries that host U.S. bases, such as Thailand and Singapore).”

Spokespersons for China’s embassy in Singapore and the Taipei Representative Office in Singapore were not immediately available when contacted by CNBC.

The U.S. does not have a mutual defense treaty with Taiwan and is not obligated to defend the island. However, the 1979 Taiwan Relations Act states the U.S. “will make available to Taiwan such defense articles and defense services” as may be necessary to “enable Taiwan to maintain sufficient self-defense capabilities.”

The EIU also named a few “severely exposed markets”: Australia, Malaysia, Thailand and Vietnam, as well as Hong Kong.

Particularly for Hong Kong, the EIU highlights that it is exposed to less risk from physical devastation than from the repercussions of likely economic, investment and financial prohibitions on China.

Hong Kong, a former British colony, returned to Chinese rule in 1997. The Asian financial hub is governed under a “one country, two systems” principle, giving it more autonomy than other mainland Chinese cities.

The report said that in the event of a conflict, and if sanctions are applied to both China (and Hong Kong by extension), this would prompt an exodus of a significant share of the city’s population and capital flight, as well as a steep decline in inbound capital flows.

As for Australia, Malaysia, Thailand and Vietnam, the EIU assessed that the risks they faced are due primarily to their extensive trade links with China; their dependence on semiconductors from Taiwan; and the importance of global trade flows to their local economies.

In addition, both Malaysia and Vietnam would be exposed to a potential conflict with China if cross-strait hostilities spilled over and ignited a conflict in the South China Sea. Malaysia and Vietnam both have competing claims with China in the contested waterway.

Separately, the EIU assessed that Australia will be severely exposed should a conflict break out, as the country is more actively engaged in regional security issues, which suggests it could play a more direct role in any cross-strait conflict.

Furthermore, its participation in the AUKUS pact and deployments of warships to the South China Sea indicates a “strong interest in deterring (and punishing) violations of the Asian security status quo.”

AUKUS is a security alliance involving Australia, the United Kingdom, and the United States, which seeks to boost intelligence cooperation and collaboration on advanced capabilities among them.

Domestically, Australia also does have “souring popular and official perceptions of China, which could create enough domestic political momentum for the country to respond strongly in the event of a war over Taiwan.”

Australia and China have been locked in trade tensions since Canberra supported calls for an international inquiry into how Beijing handled the coronavirus pandemic.

Taiwan, being the economy at the center of it all, will suffer the most severe consequences in the event of a cross-strait conflict, sending shocks that will ripple through the global semiconductor industry.

The Economist in March estimated that Taiwan produces 60% of the world’s semiconductor chips alone, and 90% of the most advanced chips.

The EIU said a conflict will cut off Taiwan’s foundries, and at best, air and maritime links will be disrupted. At worst, Taiwan’s chipmaking facilities would be completely destroyed.

In both cases, the impact will be felt both upstream and downstream.

Producers of advanced chipmaking equipment will not be able to get their goods into Taiwan’s foundries, and finished chips from Taiwan will not be able to be exported, affecting customers who rely on these finished chips for their products, like smartphones and automobiles.

Other markets will also be impacted by a conflict over Taiwan.

The EIU report assessed “exposure to imported Taiwanese chips” as a risk for economies in Asia, and found that Japan led the region, with 47.6% of its total chip imports from Taiwan. Singapore and Malaysia rounded off the top three, depending on Taiwanese chips for 40.5% and 27.2% of their total chip imports, respectively.

The EIU acknowledged that China itself is a major semiconductor exporter, but said that in the event of a cross-strait conflict, sourcing from the Chinese market will be difficult, due to disrupted logistics and likely prohibitions from the U.S. and others.

While there have been efforts to diversify semiconductor production to other parts of Asia and the U.S., the EIU thinks these efforts will likely “span years” and require huge sums of capital investment.

What this means is that there is limited immediate recourse for businesses or policymakers, in the event of any lost Taiwanese production.

Taiwan’s importance in the global trade landscape is unlikely to change soon, the EIU said, and given its competitiveness in production, logistics and transportation networks, the current level of diversification will only provide companies with “limited insulation” should a conflict break out.

In light of this, “strategies on how to prepare for a conflict in the Taiwan Strait will probably need to focus on risk mitigation, rather than outright risk avoidance,” the EIU said.