Macro Battleship with Christopher Wood

With all the focus on the US-China trade negotiations, it is easy to forget about Taiwan and the long-running cross-Strait dispute. But there was an interesting New Year speech on Taiwan made by Chinese President Xi Jinping on Jan. 2 which is worth highlighting. Xi called on Beijing and Taipei to start talks on unification and the adoption of “one country, two systems” in Taiwan, laying out steps to settle the 70-year-old division between the two sides. He stated: “The problem of Taiwan existed because the Chinese nation was weak and in chaos, but it will end along with national rejuvenation.”

 

China’s Bid to Bring Taiwan into Unification

Xi also said Taiwanese independence should not be tolerated and representatives from both sides should “start in-depth democratic consultations for a cross-Strait relationship and the future of the Chinese nation, and reach transitional arrangements for the peaceful development of cross-Strait ties” (see South China Morning Post article: “Chinese President Xi Jinping urges Taiwan to follow Hong Kong model for unification”, Jan. 2, 2019).

Xi stated that the political division across the Strait “cannot be passed on from generation to generation”, which along with dropping the two-term limit, suggests that he’s committed to resolving the Taiwan issue while he’s in power.

Xi also upped the ante in his New Year speech by stating that the political division across the Strait “cannot be passed on from generation to generation”. This is a warning that the current status quo is not long-term acceptable to Beijing, a significant development given Xi’s term in power no longer has term limits.

The National People’s Congress passed in March 2018 the constitutional amendment to abolish the two-term limits on presidency and vice-presidency. This suggests he is intent on resolving the Taiwan issue during his period in power. Meanwhile, Tsai’s defiant response to Xi’s speech, made just hours after the speech, was that “Taiwan will never accept one country, two systems, and that the majority opinion in Taiwan is also against it”.

 

A Loss for Pro-Independence Party is an Opportunity for Xi

Xi’s more assertive tone may in part represent Beijing’s desire to take advantage of the main political development in Taiwan last quarter. That was the unexpectedly heavy losses suffered by the ruling (more pro-independence) Democratic Progressive Party (DPP) in the local city elections held in late November. The party ended up in charge of just six of Taiwan’s 22 cities and counties. By contrast, the opposition (more pro-Beijing) Kuomintang won 15 cities and counties, including the traditional DPP stronghold of Kaohsiung.

The defeat was sufficiently crushing for President Tsai Ing-wen to step down as leader of the DPP, which has prompted speculation that she may not be the DPP presidential candidate for the next presidential election due to be held in January 2020. Meanwhile, Beijing has undoubtedly seen the outcome as an endorsement of its strategy of not talking to the DPP government ever since Tsai refused to acknowledge Beijing’s preferred formula of One China, Two Systems in her inauguration speech in May 2016.

 

Taiwan’s Reliance on China

Even allowing for the natural tendency to vote anti-incumbent in mid-term elections, the results have renewed the focus on the lack of progress in cross-Strait relations and the resulting negative economic consequences for the domestic Taiwan economy, including an ongoing brain drain.

An estimated 2 million Taiwanese businessmen and their families live in China. Meanwhile, China accounts for more than 40% of Taiwan’s exports, of which 80% are intermediate goods assembled in China before being sold domestically or exported.

Worryingly, a survey conducted in May 2018 found that 88% of Taiwanese office and factory employees are interested in working overseas, including in the mainland. Such data will only encourage Beijing in its continuing efforts to entice more Taiwanese to move. For example, the Taiwan Affairs Office of the State Council announced in Feb. 2018 a package of 31 measures designed to give greater access to Taiwanese companies and individuals on the mainland.

Still, the reliance of Taiwanese companies on China as a production centre has become a perceived risk in the context of the current US-Sino trade dispute. This has raised hopes in Taiwan for manufacturing “reshoring”. The country’s National Development Council announced at the end of November a scheme to facilitate the return of companies. The plan, which includes the provision of industrial land, began on Jan. 1 and will run for an initial period of three years. However, there is massive skepticism about the prospects of this initiative. One obvious problem is sourcing skilled labour.

The environmentally aware DPP had been committed to close down all of Taiwan’s four nuclear power plants, which currently account for 10% of electricity supply, by 2025.

Another issue is the lack of available power supply, as well as the related need for new investments to satisfy environmental-impact concerns. The environmentally aware DPP had been committed to close down all of Taiwan’s four nuclear power plants, which currently account for 10% of electricity supply, by 2025. Yet there are no concrete plans in place on how to replace them beyond vague talk about “renewables”.

The Executive Yuan approved a draft revision to the Electricity Act in early December to abandon that 2025 deadline as a result of one of the referendums voted on in the local elections, where a majority (59.5% of valid votes) voted in favour of repealing the related paragraph of the electricity law which stated that all nuclear-based power plants “shall wholly stop running by 2025”. In what looks like a classic fudge, Premier Lai Ching-te has stated that the revision “does not change the goal of transforming Taiwan into a nuclear-free homeland, but rather eliminates a specific deadline for achieving that objective”.

From a macroeconomic perspective, the export sector has slowed as the downturn in the technology sector has become more visible, with total exports declining by 3% YoY in US-dollar terms in December and total electronics exports contracting by 9.9% YoY (see following chart). This slowing trend has already been signaled by foreigners selling a net NT$355 billion worth of Taiwan stocks last year (see following chart) while the Taiex Electronics Index was down 19% at the end of 2018 from its peak reached in late January 2018 (see following chart).

As ever in aging Taiwan, there is scant ability for the domestic economy to offset the external weakness. Still, the Tsai government will now come under pressure to do more to stimulate domestic demand, given the poor election results. Real GDP growth is forecast to slow to 2.4% this year, down from an estimated 2.6% in 2018.

Taiwan total export growth and electronics exports

Taiwan total export growth and electronics exports

Source: CEIC Data

Cumulative foreign net buying of Taiex stocks

Cumulative foreign net buying of Taiex stocks

Source: CEIC Data, Taiwan Stock Exchange

Taiex Electronics Index

Taiex Electronics Index

Source: Datastream

From a stock market valuation perspective, Taiwan’s tech sector trades at 14.0x 2019 earnings based on forecast earnings decline this year of 2%, according to consensus estimates. This is slightly above the historical 10-year average forward PE of 13.8x. The same universe has an attractive forecast dividend yield this year of 4.6%.

All of the above is a reminder to investors that the cross-Strait issue cannot be ignored altogether. With the base case remaining that Donald Trump will agree to a trade deal with China within the 90-day period prior to the March 1 deadline, the cross-Strait issue is unlikely to precipitate a crisis in the near-term.

That said, such an assumed Sino-US deal on trade will not resolve the national security concerns of the hawks in Washington, with their growing focus on China as a “strategical rival”. An example is the perceived threat to American technological superiority represented by Huawei’s pending rollout of so-called 5G in the telecommunication space. This is why longer-term risk for Taiwan’s democracy is that it becomes a political football in an era of growing US-China rivalry.