The US and China are Joined at the (C)Hip — in Taiwan

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Question: “If Taiwan were attacked by China, do we (the US) have an obligation to defend the Taiwanese?”

President George W Bush: “Yes we do… and the Chinese must understand that. The United States would do whatever it took to help Taiwan defend

Presidential CNN Interview, April 25, 2001

From the position of Chinese people’s nationalism, 1.3 billion people on the mainland would not agree to Taiwan’s formal independence. The Communist Party would be overthrown by the people if the pro-independence issue was not dealt with.”

                   Chinese President Xi Jinping , Feb 20,2016

To begin with, semiconductors… are building blocks of modern information-dependent military systems.

            Ming-chin Monique Chu. The East Asian Computer Chip War, p276

There are a number of countries in this world, some quite large, whose sudden disappearance (by tsunami, earthquake, nuclear attack – pick your imaginary catastrophe) would have a relatively trivial effect on the global economy. Taiwan, aka the Republic of China with a relatively modest population of some 24 million, is not one of those countries. Dubbed Formosa or “the Beautiful Island” by Portuguese sailors in 1544, most people probably could not find Taiwan on a map. But were Taiwan to suddenly vanish or be significantly damaged by some catastrophic event, the global economy would go into a tailspin.

Taiwan – The Silicon Island

Why is little Taiwan so important to the US, Chinese and world economies?  The short answer is because so many of the world’s semiconductor chips are made there and so many ancillary services related to computers and computer chips are provided there.

Taiwan is a crucial global node in what is sometimes referred to as “hard tech”. Taiwan stops and whole parts of the global economy stop. Legendary tech investor Marc Andreesen once said software would eat the world. But the fact is no chips, no software, no dinner. For example, Apple has a substantial part of the chips in its iPhone made in Taiwan by Taiwan Semiconductor (TSM). Taiwan shuts down and expect to wait a year for an iPhone. At least.

In 1949 by sending the Seventh Fleet into the Taiwan Straits the US interfered in the Chinese civil war. Stopping the spread of Communism was the motive. That’s all ancient history now. Today, it’s all about economics and nationalism. But…it so happens, when it comes to Taiwan, from an economic point of view the US and China are in this together.

Semiconductor companies can be divided into three categories, i.e., 1) Integrated Device Manufacturers or IDMs, 2) pure play foundries or fabs (the words are interchangeable) and 3) fabless chip design companies. Vertically integrated IDMs fabricate their own chips in their own foundries. Fabless companies design their own chips but leave the manufacturing, i.e., chip fabrication, to others, notably pure play foundries. This fabless/foundry model has been very successful for a growing number of companies. Foundries cost billions of dollars to build and must run at full capacity to be used efficiently. It makes economic sense for only the largest firms to have their own.

Intel (INTC), Texas Instruments(TI) and Samsung (005930:KS) are IDMs . Their foundries, Samsung excepted, are mostly in the United States. IBM (IBM) used to be an IDM but it paid $1.5 billion to Global Foundries (A US-based company owned by the Emirate of Abu Dhabi) to take its foundries off its hands. There is a long list of fabless companies including Qualcomm(QCOM), Nvidia (NVDA), Apple (AAPL), Avago (AVGO), Xilinx (XLNX),and MediaTek (2454,TW). These companies are in the chip design business, not the chip manufacturing business. Each company uses different foundries in different locales and all are somewhat secretive. But it is safe to say as a group global fabless companies depend on Taiwanese foundries.

According to IC Insights, Taiwanese foundries accounted for 73% of sales of all pure play global foundries in 2015. Of that Taiwan Semiconductor alone accounted for 59%.  These companies’ foundries are physically located mostly in Taiwan, not China or other Asian countries.

Both the US and China are heavily dependent on Taiwan to keep the crucial semiconductor industry going. China is a major importer of Taiwanese semiconductor chips, a substantial portion coming in as parts of American products sold by say Apple or Nvidia and some sold directly to Chinese firms. Recreating the Taiwanese foundries in the US or China would take years and cost tens of billions.  Not only that, according to IC Insights, China-based foundries technology-wise are at least two generations behind the most advanced Taiwanese and other non-Chinese foundries.

The reader may ask how did such important economic assets get physically located in such a geopolitically precarious place like Taiwan?  Lower labor costs of course have favored Taiwanese manufacturing as they have for all Asian companies. But labor costs may not be the principal reason and are diminishing in importance today. There seem to be a multitude of reasons accounting for the location of hard tech in Taiwan. First, technology runs ahead of politicians. By the time the U S figured out what was going on in Taiwan and how successful the fabless/foundry model would be, it was probably too late. Second, Taiwan has been a de facto American ally.  As such, the US has wanted to encourage the growth of the Taiwanese economy. Third, the Taiwanese government singled out the pure play chip foundry business for significant initial support, which helped Taiwan Semiconductor get its start. Finally, credit must be given to the industrious nature and high level of engineering skills of the Taiwanese people. Besides being highly capital intensive, chip fabrication is one of the world’s most complicated and difficult manufacturing processes. The Confucian work ethic, which in some ways is alleged to be a hindrance to creativity, may be a great asset in providing the discipline required for chip fabrication. It is probably no accident that other Confucian influenced countries, notably Korea, Singapore, Japan and China itself, also can boast of foundries. It is probably no accident that India, which has no shortage of brilliant engineers but does not inherit this Confucian discipline, is not in the foundry business.

Foundries are not the only tech activity in which Taiwan excels. Foxconn (2454.TW) and Pegatron (4938:TW) which ,among other things, assemble the Apple phones – in China. And then there is MediaTek which is a major fabless semiconductor company actually headquartered in Taiwan. And there is a whole host of companies involved in design, masks (used in chip fabrication) and chip testing and packaging.

The Semiconductor Industry is the Foundation for Both a Strong Modern Economy and a Strong Modern Military

I do not pretend to be an expert on the US and Chinese militaries’ dependencies on the global semiconductor industry. Except to say that there is a great deal of dependence and by implication that means Taiwan. The major tech breakthroughs today come from the global civilian tech sector and are used by the military. Spin-on, as Dr. Chu (quoted above) calls it. China has announced a major effort to build a state of the art semiconductor industry. As mentioned it is still far behind now but it is pouring money into this, attempting to buy Western computer related companies, encouraging US semiconductor companies to invest directly in China and — what is of great interest for this blog—attempting to gain technology one way or another from Taiwan.

A lot of the Chinese efforts takes place in secret. I refer the interested reader to Dr. Ming-chin Monique Chu’s book, referenced above.

The One China Policy Is a Brilliant Diplomatic Solution

The One China Policy is a brilliant diplomatic artifact which serves both the US and China very well. Under this policy introduced in 1979 by US President Jimmy Carter and China’s Deng Xiaoping, the US recognizes the Peoples Republic of China as China’s government, not the Republic of China as the Taiwan government is still called.  In practice, the One China Policy is shorthand for the Status Quo, whereby in turn for recognition, (PRC) China does not interfere in Taiwanese affairs, or worse, try to invade the island. The people of Taiwan get to keep their democracy and personal freedoms. And the fabs on the Silicon Island humm away.

The current One China/ Status Quo enables China to maintain face and assert its historical claim over the island under what is called the One China Principle. Taiwan had been part of Imperial China since the 17th century but was lost to Japan in 1895. It was returned to the Republic of China in 1945 and became a refuge for Jiang Jieshi (Chiang Kai-Shek) and his Guomindang Party in 1949.

In my opinion, the US should discourage independence movements in Taiwan (and also in Hong Kong.) In its waning years the Qing Dynasty (1644-1911) suffered one humiliation after the other, the loss of Taiwan and Hong Kong being two of many. A cyclical pattern of rising then falling dynasties is a familiar one in Chinese history. The China of today is the rising phase of its latest cycle and wants to recover peripheries lost in the late Qing cyclical down phase. Hong Kong, Macau, Tibet, and Xinjiang have been recovered, to China’s satisfaction if not that of all their inhabitants. Mongolia proper and (maybe) past Qing claims to parts of today’s Russia have been written off. But Taiwan remains.

Besides the fact that the Chinese military is not yet up to taking on the American Seventh Fleet, invading Taiwan from China’s perspective does not really make sense even in the unlikely event the US did not choose to intervene. What would the Chinese get from invading Taiwan other than restored national pride? It would get a Crimea situation– but one a hundred times worse. Unlike Taiwan’s, Crimean assets are not so important for the world economy. From a global economic viewpoint, it makes very little difference who controls Crimea. But it makes a huge difference if political control of Taiwan is suddenly transferred to the Peoples Republic of China.  Taiwan’s major asset is brains, not natural resources.  But would the brains stay? Would China wind up with empty fabs, a world boycott and thousands of patent disputes in courts around the world? Would China not be better off by continuing its current policy of attracting Taiwanese talent and investment in semiconductors?

A permanent solution of the Taiwan problem is not possible today.  A more formal Hong Kong style Basic Law/One Country Two Systems solution has not tempted Taiwan. Taiwan has been “off the Chinese reservation” for too long. It is free and democratic whereas China is a one party, state controlled country. The somewhat ambiguous One China /Status Quo compromise “kicks the can down the road” until such time things change and the government of Taiwan and the Peoples Republic of China can work out a deal satisfactory to both. Keep in mind that, just as with Hong Kong, every year the overall economy of Taiwan becomes more and more integrated with that of China. China can wait.

It hardly needs mentioning that from a global investor perspective, maintaining the One China /Status Quo is a highly desirable state of affairs. And for the intermediate future, it is in the best interest of both the US and China.

Fortunately, if belatedly, President Trump seems to have figured this out.

The US and China are Joined at the (C)Hip — in Taiwan