• Jan

The risks of Taiwan proxy escalation


Let me outline first that the intent of this article is not to steer any more heat that already is within the air of the current geopolitical sphere or to speak of any events as a "must to happen", it is merely to outline potential risks and also rough possibilities on whether it would make strategic sense for the proxy conflict in Taiwan to happen at least from the perspective of either the eagle or the dragon.


It should be as well highlighted, studying strategic reasoning is a very delicate process that requires a lot of research and is usually never laid out well in public media. And since public media is where the majority get information on what "countries" or their representative administrations might be thinking (which is far from the truth often due to intentional deception or propaganda) it often leads to wrong conclusions for geopolitical observers. Objectivity is an absolutely needed characteristic to asses situations correctly, removing biases as much as possible and therefore necessary.


It requires a balanced and objective view from both sides of participating powers (as observer) to see the real chances of proxy conflicts and when or how they might happen. Since from my view the chances for escalation are significant enough to talk about it and prepare risk-averse scenarios for markets ahead (since after the fact 3 months later there is only limited value to do that), the article will address some points of view and potential directions in markets in case of an event.



Turning the tables


One might ask what would The dragon gain from launching an escalation and plunging its own relationship with the global economy upside down? When I was discussing with a few low-key fellas in 2018 why there is potential for upcoming conflict between Ukraine and Russia, the question always bounced back to from majority: "It will not happen, because the consequences for Russia would be too large to outweigh the benefits of launching the escalation". The point I was arguing was, that this is only seemingly true if you do not understand the depth of situation on how the Kremlin sees the Ukraine situation because if truly everything is laid out the chances of launching such escalation becomes much higher, especially if such situation is placed within historical context and that Russia might see Ukraines and NATO encirclement as an existential threat, whether justified or not it does not matter. That is how its administration perceives it and such a view could impact the actions taken.


For a realistic geopolitical view (and projection of actions into future) it is always very important to see the picture from each side as clearly as possible (and study it in depth objectively on both sides), even if completely conflicting. History often serves you much clearer view because emotions and subjective blind spots can be more easily removed when it comes to assessing strategic actions and creating forecasts. To many observers, it was seemingly unlikely for Ukraine escalation to happen only because they were operating with limited information (as typical geopol hobbyist does) and a non-wholistic picture of the situation (lack of hours spent on research), but most importantly not placing it within the historical contexts which would provided that indeed the escalation chances were higher, they are easy to ignore because foreseen consequences are harsh and it is human nature to downplay such situations for sake of optimism in gloomy situations.


Keep in mind, as a market participant if you want at least somewhat anticipate the situation ahead and pull the plug on the positions is a significant edge in markets, since those events cause major damage to the markets. To explain why the majority of market participants or geopolitical observers are always deers into headlights within such events, lets point out some of critical mistakes (using my observations):


-Lack of historical research:


Without significant historical research, no live situation will ever make much sense, especially geopolitics can be quite extreme, which can easily trigger emotional responses from observes, which is even more of a reason to have a historical backbone. There is only so much one can make sense of from observing real-time situations without being able to place them into the right context. Context is everything, history is key. The typical market participant is lacking enough historical research and typically goes where the social or mainstream media flows go. Whether the noise is the strongest, is where typical opinions will consolidate.


-Lack of information from mainstream media:


A large portion of market participants will get their feed of situational awareness from the media one way or the other. Very few think for themselves. Hence, the majority are always one step behind. In mainstream media, proxy escalations especially those very dangerous (Taiwan being more problematic than Ukraine for triggering superpower-to-superpower conflict) ones are typically not discussed ahead of, or if done, those articles, videos or stories circulate very very rarely. Certainly not frequent enough if the strength of the signal is compared to the amount of media exposure it gets, the balance is much more tilted toward silence. And there is a good reason why so, to not steer the pot of bees further that is already steered up by itself.


-Optimism of significant doom situations overpowers rationalism:


It is in human nature to remain optimistic and downplay the chances of escalations happening in the geopolitical landscape. But as someone exposed to markets or the economy itself it pays a lot to be realistic in such a case, even if that means playing the dark card with an as higher chance of happening than most in public might be willing to give it (if there are objective reasons for it of course, not just due to pessimistic nature).


-Lack of objectivity and strategic assessment of each participant:


Without being completely objective, seeing the situation as each country sees it from their point of national security issues, it is impossible to ever predict the responses of countries in advance correctly. One has to always see (to as much extent with somewhat limited info) as possible what the leadership of each country is trying to achieve, which typically is within long-term strategic advantage and interest of the country, even if its short term doesn't make sense.

Let me repeat, to get geopolitics right ever in advance, one has to assess the long-term strategic sense for each country by itself. Each country tries to play the game in what benefits it the most in long run. It is just that many countries overestimate their abilities which often actually makes them pull decisions that are leading them to long-term ruin instead of being a benefit. Therefore assessment of strength correctly and vision both are needed, but that is only after a fact. We as observers do not need to project that each country around the globe responds as a completely rational player that truly gets every move done right. It is often that leadership of the country pulls the worst possible moves, due to the wrong assessment of the situation.

To project geopolitical moves as good as possible, one task therefore should be not trying to think of each country as a completely rational and top-notch player, but trying to put yourself into the shoes of that participant and trying to figure out what they are thinking about, and how they see the situation. This is how to get it to figure out as close as possible, in terms of what moves will be triggered.


The summary of the above is, to get things right ahead in geopol and to protect yourself in markets, you need to be capable of always thinking for yourself and being a black sheep on forming your own views, based on the objective assessment of situations. Chances are no one else will serve you the complete picture on every aspect, the probability of happening, the markets impacted and the directions were taken.



Back to "turning the tables":


If we apply the same to the China-Taiwan proxy situation and if some of the facts are assessed it doesn't take much to draw similar conclusions. The chances for escalation to happen are not negligible at all.

The subtitle "turning the tables" stands for a situation where two major powers such as US-Russia or US-China face some sort of indirect passive confrontation, and often secondary power within such a challenging situation is often seen to escape the situation being dictated by the dominant power (US) which could lead to long term ruin or large negative consequences (losing large sums of territory, capital, competitiveness...), in such case secondary power might use the start of proxy escalation as an escape plan. A route on the way out is to take control of the situation at least somewhat under its own hands more than it would be if things are left to flow within the set direction of the plan that the dominant power has set (which typically is long-term erosion trough the cold war). Hence turning the tables.


In all cases, especially within a globalized economy launching proxy conflict is always a huge cost for a secondary superpower to do it, but if justified as a "necessity" its chances of happening are higher than many observers would credit it to (regardless of cost). Hence secondary superpowers will always have massive costs associated to launching such proxy conflict, but that doesn't mean its chances are neglectable just because of economic or human lives cost. There is the big picture in play, the long-term view which is why in some cases the event still have a follow-trough, regardless of the obvious costs of isolation as it was the case for the Russian economy.


So you might be asking, what situation is China facing that would justify from the view of CCP a launch of escalation on Taiwan, even though it's obvious to everyone that the Chinese economy would face massive consequences as a result of it (just as Russia did)?

Who would be crazy enough to replicate such a large cost event, when prior reference is so clearly displayed to everyone and the consequences that Russia faced for launching the Ukraine proxy escalation?

Again to find the answer to that, it is all about the cost equation of short-term vs long-term cost. How much China can lose by not using the "turn the tables" approach if the US keeps dictating the terms for the upcoming decade and preventing the plan of Chinese administration and execution of doctrines such as China 2025, the One belt One Road initiative, and the geopolitical encirclement that has been formed in 2020 pro-US Asian quad alliance.


As usual to understand geopolitics and potential moves of countries well, one has to understand the cost-benefit equation dynamics and the angle that each administration operates with. The countries and their actions are deployed often just as businesses make decisions, even if the expense of human lives is taken as a potential cost, unlike the businesses which typically are not facing such challenges.




Holding the key negotiating card: TSMC




One of the reasons if the Chinese administration decides to use "turn the tables" approach but without the intent of launching global confrontation, but rather just to decrease the scale of US cold war pressure, it might be to grab the strongest negotiating card which is the TSMC. Taiwan's small but not-so-small globally important company is critical for the US economy as it produces a larger chunk of advanced semiconductor chips. If the US economy was to be dislocated away from having such resource it could provide China with some negotiating powers, although that would depend highly on just how serious the issues in the US economy would get as a result of that (and how unable US was to displace internal production by launching domestic production within 1-3 years), or if the US would not be willing to just eat the consequences which it just might without reasoning any negotiations. If US was to impose semiconductor sanctions and dislocating Taiwans chips from Chinese tech companies, it could create even more incentive for Chinese administration to take hold of TSMC and reverse the course. If the US economy faces significant challenges because TSMC is unable to export the chips to the US and this creates a stall on the production of too many items, the cascade of shortages could actually impact economic growth at a large scale, how large it is difficult to estimate for someone who does not understand those industries inside out, but we could assume it would be significant especially if enough time is dragged out (1 plus year). It would not be too difficult for the navy to block the exports completely at which point the US is held under a sitting duck situation in terms of semiconductor chips, unless it decided to escalate the situation of encircled Taiwan if it were to come to this.


Semiconductor transactions between US/Taiwan/China:

From a strategic point, there are a few reasons why getting a hold of TSMC might make sense from the dragon's side:


-Creating a supply chain and productivity slump for the US economy


-Able to negotiate for sanctions liftoff and removal (tit for tat)


-Stalling progress of the US tech sector while having more time to catch up by itself in a technological race that both US and China are engaged in



What type of escalation could possibly happen?


Based on my rough overview of situation those two seem most likely scenarios, outlined below, (although i could be completely missing some additional maneuvers in play due to lack of situational overview):


-Naval Blockade:


Since the Chinese navy is very large it has the capacity to fully surround Taiwan's key ports and trade routes, it can place a stranglehold on the economy as one of potential tactics used if it would want to escalate the pressure. This would result in a classic siege approach where to avoid the losses of military human or resource capital, the encirclement of trade routes would be used combined with the prolonged embargo to either push economic damage on US due to TSMCs export ability collapsing or to put political pressure on Taiwan to change its course in strategic alliances. Therefore applying pressure both on US and Taiwan at same time. Strategically this route would be the least costly and has a higher chance of being deployed (in my opinion), at least from conceptual risk/reward analysis. This way China would avoid being the trigger of aggression since it would toss the ball to the side of Taiwan and the US in terms of how they would wish to respond, which would make it even more likely that the response could be economic sanctions rather than the military response from either Taiwan on US directly. However, since every country or city has limited capacity to stay isolated under the siege, time (internal resource inventories) would become key factor after a while to determine further actions.



-Conquest:


No matter what form of the action takes place, it is likely that western nations would respond to the aggressive actions of China similar to how the response was to the Russia/Ukraine situation in terms of sanctions, and disruptions of trade, it is not highly likely that any of US alliance nations within Asia or US would need to respond militarily. Hence that side of the equation on response is much more likely that Taiwan might be left to fight off aggression on its own in such a case (since it might be difficult to supply encircled islands anyways through outside resources). Therefore before figuring out if action on Taiwan would result in global conflict escalation, a much more probable scenario to worry about is actually the imposition of sanctions on the Chinese economy. Either way, the result is the same whether China decides to move through a non-aggressive naval blockade or trough a contest with military assault in my view. The western and pro-US alliance nations in the region will not be willing to escalate militarily as a counter-move due to too high risks and consequences, sanctions would make far more likely scenario. Direct confrontation would therefore most likely only begin if China would be willing to escalate against the region in the first place, not the other way around.

This risk/cost/benefit analysis for the conquest scenario only really matters from the CCP's perspective and how the leadership might justify it. Considering how difficult and costly the raid on islands can be historically speaking, it is within larger possibilities that to reduce huge costs in human and resource capital for China to use the naval blockade route as the primary way first. But if time is of the essence (to conquer Taiwan's political leadership and change its direction), and resulting of the siege as fast as possible then that obviously blockade could more likely turn into conquest, and assault could be more probable. However historically speaking using similar (and not so similar) situations, when a blockade is an option it is exercised first before things move into secondary motion states unless the time is running out for the aggressor. Please keep in mind, this is not to place judgments on any nations as aggressors since none of the events have happened, this is only speaking about possibilities if such actions were to take place, how the alliances within the Pacific or South China Sea region might see it.



Outside support for Taiwan?


Would the US navy help to resolute conflict? There is no clear answer to that, obviously from the point of writing this article is the answer of being a no, because if we take for granted a yes then the consequences and directions taken would be highly unpredictable and it would go against everything written in the article. This is only about laying out more likely or potential scenarios if we take under the assumption that the US would not get involved militarily directly and not risk a direct conflict with China, as this is the only somewhat orderly way of where the future moves on the chessboard can be predicted and the implications it might have to global economy.




Historical context and current economic situation for China



It shouldn't require much introduction to say that China does not have a strong history of being the external aggressor or the power trying to mitigate direct proxy confrontations. If anything China historically deployed covert methods to subdue proxy nations without the need to fight as much as possible. This goes hand in hand with Sun Tzu's methods of "achieving victory fast without using the weapon" to be the goal of a good strategist. This somewhat decreases the chances for a very escalatory situation, but of course only to some extent.


The policy and actions of current leadership as well somewhat support that vision, which is to avoid any escalatory movements if possible as they do not go well hand in hand with the historical framing of how China or the great panda wants to be portrayed. This is especially the case in the current situation because Chinese prosperity is completely tied into the globalization project (led by US since end of cold war), which can only exist if China is seen as peaceful non-adversary power. The fragility of Chinese supply chains is significant if this story was to end with globalization breaking down within Asian region. If China was to cut the globalization project by itself (not intentionally necessarily) trough actions on Taiwain it could find itself cornered into very difficult situation out of which there is only one escape route: trough further full regional escalation.


Its economy is highly globalized (huge net energy importer and large product exporter) and in need of global trade to remain functional, the situation where the trade breaks up, and the inflow of dollars ends would be catastrophic as the export sector would be unable to adjust to that in short term. The leadership is most likely well aware of just how significant a situation this could lead to for the entire economy. Everything depends on the functionality of trade, and an end to this could be an end to the economy as it exists today, not just the Chinese economy but even global economy and its status of globalization of trade. If severe sanctions were to be imposed and flow of Chinese products ends it would lead to a large surge of inflation for global consumers, and asymmetric shortfalls in many resources that China exports for the global industry.


The risks are far higher than what Russia was facing in terms of decision-making in 2021 when the Kremlin was assessing the potential for launching a Ukraine assault because the Russian economy has more self-sustainable resources and is less dependent on capital inflows than China. Basically Russian trade is less dependent on globalization than Chinese is, especially because beinghuge net energy importer is possibly the weakest exposure that any country can have.

In other words, even if Russia's economy is completely isolated, the economy while it would shrink significantly can still sustain theoretically (minus a surge in inflation), unlike China, where the reduction of growth and shortages of resources (energy especially) would be potentially so significant that the losses and damages would be unimaginable and unacceptable for political leadership or the population. Historically those are very dangerous situations because due to net economic and sustainability deficits the countries sometimes start to respond with very harsh moves, due to being cornered into an existential crisis.

Because of that in my view, Russia-Ukraine's situation is by no means as problematic as China-Taiwans could be in near future if things were to escalate through proxy conflict in a similar manner.


This means that the need for China to sustain the framework of a globalized economy is very important and not to ruin this through any unwanted actions, but at the same time, the challenging situation that it is stepping into within the US as its adversary is going to push it towards the path of where "taking means into own hands" becomes an option. So keep this in mind, of all that was said above, yes while it seems like as "impossible" for China to launch any action due to how severe a situation it would find itself in (not militarily but economically), that in itself does not discredit the potential of actions as impossible. In such cases, countries think three steps in advance, meaning how to engage in proxy conflict in Taiwan while at the same time securing that there is no shortfall in resources as a key question that CCPs leadership and military command might be asking themselves today if there was a need to use Taiwan card. This means if the situation looks dire by taking action, how to make it not so, by implementing surprising (Pearl Harbour-style) events to ensure no shortfalls happen.


Only to say above, because the typical mistake geopolitical observers make (when making predictions for future events) , is they think the strategic assessment is all about looking on one side of the equation, that is only looking at current visible risks. "If advancing on Taiwan is too risky due to economic consequences, the actions cannot happen in the first place as the Chinese leadership is not crazy to do so." That is not a real-politic approach to the situation.

Both sides of the equation need to be established, which means that leadership might find enough reasons to take action if there are higher risks for not taking the action than taking the action in the first place. That is at the end how a large chunk of geopolitical escalations happen in the first place. It is weighing the risks of 0 action and the already expected path, versus the risks of taking action but yielding more control over the situation as a reward, while potentially shifting the risks even deeper. The deeper the current projections of 0 action risks are showing, the more likely the future actions might be to "turn the tables" stated initially on the article.


All of this leads us to a very contradictory situation where history clearly says that China will most likely not engage itself in any proxy escalations and probably wants to avoid it at all cost. The economic situation as well confirms it since its position in globalized supply chains requires things to function well and smoothly. But at the same time, becoming a superpower number one which the leadership has very passively set as its goal requires pushing back against the cold war suppression agenda of the US, which invalidates all the above two points, as long as leadership can ensure if such actions were to take place that they would happen in very controlled and as highly win-able conditions as possible. Similar to how Japan justified its actions in 1941.


As we can see the conclusion is very unclear and both sides can be argued as possible scenarios (avoid/engage) from the contextual analysis, considering that we do not know what is going through the minds of the Chinese leadership and contextual analysis is the closest possible projection that can be used in the first place.



Agent provocateur?



Does it make sense from the eagle's perspective to engage the dragon in proxy conflict, or rather to do all it is possible to avoid creating proxy escalation?


Well regardless of what one might think, we can see that actions over the past few years indicate that the eagle indeed is doing a lot to escalate:


-Increased arms sales and security dialog,


-all of sudden (after many years for first time) visits of high US officials,


-discussions about giving Taiwan special status and not adhering to the wishes of the dragon,

-creating technological-semiconductor sanctions which tighten the need for the dragon to stay close or get even closer to Taiwan,


-and many more.


There is a significant stack on the side of confirmation rather than vice versa, to de-escalate.


We are already witnessing the breakup of US-China trade from many angles, it is just not noticeable to many, because it is happening at rather slow speed and at same time in so many different areas at once. If the US is serious about the complete breakup of trade, and there is no further quid-pro-quo trading relationship in near future for those two nations, then the last thing the US would want is to keep China strong and let it shift its trade to other nations in distant future (say 15 years). Disempowering the strength of China, in fact, might be what the eagle is going after, as the US re-shores its manufacturing back in its homeland, while engaging China into proxy conflict and draining its power might be one of the goals. This angle provides additional insight to why the situation is not as innocent and might be more tilted to the escalation, or to at least try provoking one.




Historical context and reference (1940s Japan)



There is one situation that carries some references to the current situation between US and China, which was the US-Japan situation after 1935. There are a few reasons why certain situational conditions are shared and might matter. And yes while I know this can trigger emotional responses from readers when reading about such comparisons, i believe that objectively certain conditions are shared and can contribute to shaping policy-making decisions in a similar manner . Some of those are:


-Japan was short of key industrial resources such as energy or iron (China is a major importer as well)


-Japan was major industrial power (China is as well), which makes it critical to ensure resource supply else economy could face long term stagnation or even collapse


-the US was encircling Japan through embargo and sanctions (China has been currently encircled through counter US-Asian alliances as well formed by the US, and partial sanctions/tariffs were deployed already since 2016s, which include capital, semiconductors and other sanctions)


-Japans war drills and spending increase (while trying to avoid conflict diplomatically) preparing for major military spending and exercise increases few years ahead of the conflict (China has been doing similar over past year especially in relation to Taiwan). Japan was signaling major preparation for war even though it was not publicly discussed much as high probability scenario, similar to how current events are taking place within US-China and China-Taiwan situation.


There is a lot more to list, but the above four in my view are key that are essential for economic well-being or survival and can contribute the most pushing the country on the brink of conflict if the security of resources or its trade was to be threatened, whether actions justified or not it does not matter, strictly from no-action/action perspective it matters for predictive projections.



Implications for markets and consumer




Let's address how the potential sanctions in case of Taiwan escalation would reflect for global consumer.


Ukraine's proxy escalation and the result of sanctions have led to a large increase in global inflation. Typically proxy conflicts are not highly inflationary, if we look at ones over the past 100 years, but they can be if resulting actions tear up the global trade, due to major sanctions as we have seen with the Ukraine conflict. This means that it's not the dislocation of resources output from the invaded proxy country that is the issue for global inflation, but the trade or capital sanctions applied against the superpower engaged in such conflict and the dislocation of output that this superpower brings to global markets its what matters. Hence if such sanctions were to follow with Taiwan escalation we would see rising inflation as result, but different kinds of inflation. Let's break down where the significant difference is between Ukraine proxy conflict-induced inflation versus the potential Taiwan proxy conflict-induced inflation.


The difference is in speed (a fast hike of CPI consumer-driven inflation vs slower PPI industrial or services inflation) and the end impact (industry vs consumer). Ukraine escalation is a slow hike of industrial-driven inflation primarily, while Taiwan event most likely would result being a faster inflation hike impacting consumers primarily (but industry as well) if it was to happen. Obviously, taken into consideration that the sequence of actions and sanctions outlined in the article actually happens in the case of Taiwan escalation to a similar extent to how they happened within the Ukraine situation (deployment of heavy sanctions). Because in the end, it's not the escalation in itself that causes a large surge in global inflation its the sanctions and dislocation of the large economies out of the market that spiral global inflation higher. Conflict in itself only applies regional country-to-country inflationary pressures, global spill comes mostly from sanctions.


While Russia is a major primary resource producer and exporter, most of which are needed for industrial use, the consequences of dislocations of them from the market are more passive and take time to impact consumers significantly (industry feels it much quicker than consumer). The price hikes that end consumer sees (such as electricity spikes and food hikes due to fertilizer shortages from gas being cut off) is all seen only after several months if not an entire year and then some. Therefore global economy has not even chewed on the real consequences of the Russian sanction imposition as those will only be seen within 2 years to the maximum effect, once inventories of Russian resources in Eurasian markets dry out.


Meanwhile, potential Chinese sanctions if they were to happen would result in a different kind of inflation, which is direct consumer inflation, reflected trough CPI index. China exports vast amounts of industrial products and deflation through the productivity to the global economy, if sanctions would remove this out of circulation, the inflationary impacts would be felt straight away without much delay, unlike with Russian sanctions. Meaning if Chinese products are pulled from the market, the consumer in Europe and US, or Asia would see shortages of items on shelves due to an imbalance of products (and inability to create manufacturing capacity quickly in any developed nation). Since most of the countries do not store for several months of Chinese goods supply, eventually sooner or later inventories would run dry and large corporations would have to adjust their prices quickly for the shortfall of products, to the upside of course.


This inflation would show up very quickly, and its results would most likely last more than 3 years until the manufacturing production would forcefully start to relocate within the developed economies to make up for the shortfall of the output, most likely the US since EU and Asia would both face energy shortages if such event was to happen.

Prices in stores for many products would therefore increase significantly, and many jobs would be lost across the globe due to industries and companies that rely on Chinese trade to function losing their market share, which could lead to a large unemployment surge both in US and Asia.

Additionally, because there is so much Asian capital tied to the growth story of China, if there was a significant geopolitical escalation, the capital would quickly start to find its way out of Asia and into the US, where large capital outflows (all nearby Chinese economies) could create a huge capital route, weakening of currencies and credit markets, leading to additional inflationary surges and reduction of industrial production within the Asian region. The consequences would be felt on all corners and would be especially significant within Asia.


As one can notice, the risks are significant and cannot be underestimated. The impacts would last many years before the global economy would be able to absorb all the damage and restructure to meet the break-even point once again. One country only would benefit in such a case (long term), the US that is, if manufacturing would be on-shored once more due to trade breakup, since both EU and Asia would most likely be unable to sustain manufacturing (to some extent) on their ground either due to geopolitical disruption or trade dislocation or just the energy shortages due to both continents lacking its own energy supply (ex Russia).



Energy routes and safety of global trade



One of the biggest arteries of global trade goes through the South China Sea. What happens if large escalation starts taking place, followed by disruption of geopolitical ties, and trade breakup between all those nations positioned around South China Sea, and sanctions are imposed, completely shaking up the global trade as we know it today?


The consequences of that are not by any means seriously discussed publicly (outside of certain national defense institutions of US and China), as the picture is too bleak to be put out to the public most likely. Or it might be matter of national security secret (tactical maneuvers) for advantage in such a situation hence the public is not well informed for that reason, it could be few different things as the reason for it.


If there were to be a dislocation of trade in the such a large high value area, along with energy supply chains becoming majorly disrupted, the direct result would be a major surge in global energy and industrial product prices, as Asia, US and Europe would suddenly become disconnected to some extent, and even Asian economies within their closest proximity (those positioned near the South China Sea) would all of sudden find it difficult to secure the supply chains without disruptions to the trade. It would be a mess at major scale.

In simpler terms we would see crude oil prices going higher 50%, as well as technological and industrial products much of which is produced within Asian region (S. Korea, China, Japan).


Since a lot of industrial products would become disrupted in their transport and export capacity (if sanctions were to be deployed) and energy flows would get disrupted (tankers avoiding the South China Sea) the bid on those resources would increase worldwide. The consumer and industry would ensure the rally on those prices, and countries would eventually have to step in between to artificially hamper the demand, to control prices from rallying further, basically force creating a recessionary environment in order to avoid shortages everywhere. Which is basically what are already see being deployed in current 2022 environment.

Think about it within what FED and central banks are doing to monetary policy currently by creating a tight liquidity environment (by raising rates) to reduce demand and prevent further inflation rise by hampering the demand, the same actions would happen in case of Taiwan escalation but not just in monetary and capital space, but rather a physical commodity space (industrials, energy, and other resources).


It should also be noted, that if energy sanctions were to be imposed, China being net energy importer would cause a potential drop in oil prices if a large amount of demand was to be dislocated from the market. One might argue that this goes against what was said above to see crude oil prices to rally. Well, perhaps that might be a quick short-term effect, in mid-run by all means if that was to happen energy security would be forcefully taken by China more likely than not, hence ensuring the Persian gulf flows or Saudis flows are secured as having no energy supply would be out of question probably.

There is also a big if, it is assuming that from all the sanctions applied energy sanctions would be one of them, which might not be the case. Either way, this article only lays out scenarios on if that was to happen, and what would follow, not specifically on what exactly should or has to be happening in sequence. In other words, sanctions on trade goods would be the most likely scenario, while energy sanctions would be a less likely secondary scenario, although still probable enough to consider projection analysis.



Quad alliance formed in 2020 on image below (counter China encirclement):


The major problem is, that a large chunk of economies positioned within the sphere of China belongs to the pro-US alliance (either freshly formed quad alliance or older softer alliances formed over past 20 years), which in such a case of escalation would trigger the most likely same response as what European economies did when it came to Ukraine proxy escalation (following the orders from US), which is the direct imposition of sanctions and blockade of trade against China. This especially might be the case for the strongest economies which are able to stand on their own and absorb the damage of dislocated flows better, such as Japan, Australia, and India. Other smaller countries might be much more careful in choosing sides in such cases, especially if they do a large chunk of total trade % with China as part of their net imports/exports. Either way, the entire region would quickly find itself pushed against the wall, sides would have to be chosen, remaining neutral and playing both sides would become very difficult. This means countries would face being sanctioned by US and international order if still doing the trade with China, or suffering major trade deficits because all of sudden their export market would collapse if deciding to boycott the trade. The choice between bad and worse.


The issue is, no matter what country we focus on, the entire South China Sea and nearby regions are heavily trading with each other, and creating an escalatory geopolitical environment in such a region would have massive disruption to trade flow one way or the other. Even just two countries dislocating and pulling back trade due to following the US sanctions suggestions and policies would eventually trigger a cascade for other trading partners.


As countermeasures to any sanctions imposed if they were to come, China would/could possibly respond by blocking their resource exports (especially to quad alliance nations) as well, pushing the entire Asian region into resource and item deficits, sending prices of certain things very high (fertilizers, ore, rare earth materials...). The implications of that would be felt across the entire globe, this would be by no means just isolated to Asia. The consequences would be substantially harsher than anything seen from the Ukraine proxy conflict and the impact of Russian trade dislocation due to the amount of total global GDP contribution of the South Asian region versus the Russia-EU itself.

The net result would be higher global inflation (5% plus), higher energy prices, shortages of industrial items, some of which already mentioned above.


The issue overall is that Taiwan escalation could create a cascade due to how tight the major global trade routes are positioned within the South China Sea and nearby seas and geopolitical positioning towards the US of many countries, the response could be a breakup not just on the geopolitical side, but also on the trade side. The consequences for China could be large, since, unlike Russia, China is a major net energy and capital importer and would likely face issues on how to secure the energy and capital inflows to keep the economy functioning, and face the additional question of where to bring all of the factory exports to if sanctions are imposed? There are no nations besides US and EU market that can absorb the Chinese industrial and consumer items at the scale. With other words, the industrial output would have to undergo significant shrinking process and shutdowns if such thing was to happen. Which means the growth engine of the world, or so called factory of the world would being to shut down partially.


Unlike Russia which had some initial luck in finding export markets for their resources partially, it is highly unlikely some economy would all of sudden show up to gobble the exports of Chinese industrial output all of sudden, hence situation would most likely leave all of that supply hanging dry in Chinese warehouses. The capital inflows into the economy would therefore collapse as well. Since China similar to many other emerging nations are in need of dollar inflows to finance growth, a cut on dollar flows would create issue on debt repayments (real estate sector), the trustworthiness of credit markets (no access to debt financing), and most importantly the weakening of currency (inflation rise for consumer trough energy cost increase) while the USD would strengthen as result of capital flight.


The Chinese situation is especially fragile because if the currency was to weaken fast significantly as a result of all actions above, as a large energy importer the costs would increase at the same time (similar to what we have seen happening to Turkey past years), if such energy was to be imported under petro-dollar status denominated in a much stronger dollar and weaker yuan. This, of course, brings us to another point, that China would in such a case ensure the supply from one of the only non-petrodollar nations - Iran would be ensured and secured at all costs (which is why the recent 400 billion USD deal was made between China and Iran). To ensure the energy gets imported by avoiding as much as possible not being priced in strong inflationary USD.



However, that is why the whole situation is even more dangerous than it seems (and different to Ukraine proxy conflict) because it could force China to justify taking on nearby other countries which are rich in energy exports, especially if Iranian supply somehow fails to deliver (unlike Russia which has plenty of internal resources), to ensure the energy imports keep flowing into China at all costs if there was a rationale to begin Taiwan escalation.


This means securing the crude oil exports of Iran, and probably forcefully taking the Persian gulf by ensuring this supply route is not disrupted (to ensure sanctions on Iran do not become problem of having access to its energy), and potentially trough finding its way towards Indonesian coal resources one way or the other, and even Australians energy coal/gas supply.


This is not a fictional scenario, it is the playbook that Japan partially implemented in 1935-40 when it faced a similar issue to what China is/could face in such a situation which is resource and energy starvation or at least insecurity if it was to be encircled trough sanctions of its nearby countries, and especially the US.

Securing the industrial resources and energy for Japan was critical, hence Indo-kina expansion. It is the resource deficit situation that Japan faced that makes previous historical situation somewhat similar to the situation China might face under such scenario, therefore creating a real chance of cascading offensive maneuvering within South Asian region in similar fashion to how Japan went about it. But obviously all of this is if anything happens around Taiwan in first place, not to get too far ahead.



It should be added that the above scenario of strong escalation could/would only happen (in my view) if certain variables would at once support its chances:


-Iranian crude oil gets sanctioned and the Persian gulf oil supply gets disconnected for access to China


-China gets sanctioned by majority of Asian countries, dislocating its trade and making it more risk-prone (less to lose), cost of no-action becoming higher than taking action of what was mentioned above


-energy and food shortages are ongoing in China a year or two ahead of the actual Taiwan event (making a need to secure resources much more likely)


Therefore the whole issue of the Taiwan conflict is, that if it begins, it might not stop just there, especially if the US finds reasons to pull the navy away to avoid confrontation and potential nuclear exchange, hence leaving China an open route to "island hopping". It is especially because of the seriousness of the situation that to some extent US administration does not have a common policy of expressing what would be done if Taiwan escalation begins. The situation is so complex that it is difficult to draw red lines.




"Imposing sanctions would be insanity for US consumers, hence it will not happen"



We have already seen from the recent example of the European union, that consumers were not taken into account whatsoever when it came to implementing strategic decisions in response to Russian actions. Even though it is quite clear how significant the price the European consumer will pay for the imposition of sanctions on Russian energy, the sanctions still went through. Nor the consumer nor the agricultural or industrial experts were asked if sanctions should go trough, the decisions were all made from the top. This is important to understand, as geopolitics will often override all sane cost/efficiency rules often at a huge expense.


Therefore using the argument that "sanctioning Chinese trade products and exports will never happen because the damage to the inflation of consumers worldwide would be too high on the US, EU and Asian economies" is a soft argument, as it is likely to be ignored by the administrations of majority pro-western countries if the push came to shove around Taiwan. This is again an important piece of the puzzle to keep in mind if things started to heat up.


As a decade-long observer of geopolitics, I see this mistake being made time and time again, where people are not aware of the agendas of countries and underestimate just how likely the dangerous and costly actions are to be taken. They assume if something is "crazy" it's impossible to happen, yet placed within the right context its chances might just be very high. I have seen some argument from many arguing against my point that Ukraine will likely start stepping towards NATO sooner than later and discredit it as an "impossible" scenario, yet here we are a few years later:




Global equity markets and their reaction to potential proxy escalation (SP500 specifically)


If you agree to the points made above in the article, then as a potential investor in equities (if that is the case) one might be wondering if the bottom is in equities or not right now as of 2022 or early 2023. There are many ways to argue the point for why the equities could still have further leg lower in the upcoming recession next year based on the earnings miss-es which will increase over the next few months for corporations and businesses, to energy issues in Europe, to growth slump across the globe, all of which is already quite clear and probably has not been priced in fully yet. But if you do agree with the assessment that chances for a Taiwan event are not negligible, then one has to be prepared for much lower prices in global equity markets, which includes the SP500-SPY index as the focus of this subsection.


Let's keep a few key factors in mind, which in the case of the event would be priced in a such manner most likely:


-20% plunge in equities in early few months, because of an event not being priced in (it is impossible to price such events in ahead) and the fact that the chain reaction following could be as one specified above, resulting in tremendous global economic damage. A 20% selloff would not be too out of whack to see.


-Long-term negative pressure for equity markets (capped rallies).

While a short-term reaction following the fear response in markets would not be too surprising to see, the more important focus should be on the prolonged consequences that high inflation and trade breakup would lead to businesses and consumers. It would increase the chances that global equity markets would stagnate and be unable to rally too much throughout at least 2 to 4 years. Range-bound market chances would increase significantly with escalation and sanctions happening. In my view very important adjustments that investors should make and already think about the prospects of that ahead. While many might be thinking about inflation or recession for the next year of 2023, many might also expect this recession to end within a year along with inflation sooner or later disappearing. None of that would happen if Taiwan escalation would happen, the chances of a much more prolonged recession and inflationary environment would increase significantly, and equity markets would therefore more likely struggle for a long time, especially because very few in market consensus have priced this as a possibility so far into the current price. And if that was to happen, mind that every mainstream market analyst would have told you "yes but no one could have seen that coming".


-Very long-term picture (3 years after the event), strongly bullish SPY (manufacturing boom):

If such an event was to take place, followed by sanctions, the result would be the relocation of US manufacturing from Asia back to inshoring. This includes industrial (low/mid-end) and technological (semiconductors). To achieve that major boom and influx into the building of factories either in nearby Mexico or similar proxy countries would be needed, or directly on US land. Either way, it would be bullish for capital inflows.


Conclusion

It goes without saying that I do not hold the above views as highly likely scenarios or something that must happen by any means. It is just a layout of if certain events do align in just the sequence outlined above, the chances for further significant events actually can increase and become more probable. But until the primary drivers are set in the motion (or without it) it remains a low probability scenario (especially larger escalation).


More important than identifying probabilities of Taiwan escalation or broader Asian escalation is actually to set realistic scenarios on what (sectors, economic activity, resources, etc) will be impacted if it happens so one can anticipate and prepare for it ahead. The article is after all written from the perspective of economic and market participants as the rest of the material on the blog.

The focus should not be on identifying whether the probability of something happening is higher or lower by 5% (because that is not practical for observer), but rather on what the sequence of events is likely to be (both from US and Chinese side), using historical and situational conditions as a guide.


On the image below the amount of products for US and EU markets coming from China is significant, in case of disruption the effects would be felt quickly.



From the market perspective standpoint, and economic exposure, the net result would likely be (based on my very rough estimates and potential likely scenarios):


-Higher global inflation (5% plus):


Reduction of trade with China would increase global inflation by a good degree without a doubt. As a major deflation exporter over the past 20 years of cheap labor and goods, if those were to be pulled away due to sanctions, the result would be direct consumer inflation, which would be most likely seen much faster (1 month) than results of Ukraine based industrial inflation on resources (6 months). It wouldn't be unimaginable to see a 5% increase in CPI prints, especially because direct consumer goods would be hit to a good extent since Chinese exports are a major share in most developed countries. If you are in a camp of "peak inflation" in 2022 and "there is no chance it could get higher", well its best to remain open-minded because there are risk scenarios that could infact spark another leg higher.

And that includes the scenario of a recession happening in 2023 where the inflation as consequence comes down, it could still remain elevated for a long time in case if Taiwan event would happen. It would be hard to imagine 2% inflation in 2025 when/if both Ukraine and Taiwan proxy conflicts have had a follow-trough.


-Higher global energy prices:


Disruption to tankers in Asian waters, the uncertainty of supply chain flows, and potential secondary issues to Persian gulf matters could see prices of energy rally. Even though dislocating Chinese oil demand seems on paper bearish for prices, in reality, the chances of escalation and disruption to the smooth energy flows would more likely cause significant upward pressure in my view, even if plenty of Chinese demand gets removed from the market bid.


-Shortages of industrial items:


If trade was to be sanctioned and capital flows would start to suffer, the industrial output would shrink and might stop to large extent. This would cause tons of US and EU consumers to get left without Chinese goods which represent a large amount of industrial and nonindustrial product share in their internal markets. Prices for consumers would therefore increase in general and specialized stores. We would see literal shortages of products (by 30% perhaps) on shelves of the majority of stores, but especially tech, industrial and non-food related stores.


-Earnings plunge for major US corporations such as Amazon, Google, Walmart:


If trade was to dislocate, a large chunk of especially Amazon sold items come out of Chinese factories. No doubt the earnings would take an instant plunge in the next quarter, since a lot of those represent high-margin products for Amazon, the impact could be quite significant to stock prices and as well employment of thousands of workers. The same would be the case for Walmart and even Google which is dependent on growing economic conditions somewhat as well, or especially might see a decrease in users from Asia if the geopolitical situation was to escalate with the technological "wall of China" being deployed. Shrinking of earnings and labor force for many US corporations in such case would be almost impossible to avoid.


-Semi-stop on electronic and higher-tech production:


If TSMCs production was to be heavily disrupted due to proxy escalation in Taiwan and semiconductors would be disrupted in export, the technological production in Asia and US, or any region in the world for that matter would decrease by good extent. Especially higher-end tech products would potentially completely stop in their production for months, and low-tech products might have lowered output by a certain % since those would not be as impacted. Taiwan produces large amount of high-tech needed chips.

This would impact the earnings of many major tech companies in the US and Asia (NVDA, MU, AAPL,...), and impact the prices of those final products to go significantly higher due to sudden shrinkage on output capacity. Due to the fear of the public of this situation lasting long, it actually might cause a frenzy buying of tech products to stack on them (similar to what we have seen in 2020 crunch on small scale). Short-term frenzy buying, but long-term drought because eventually supply would shrink too much and prices increase at the same time too high, reducing the public interest.

Keep in mind that while prices of many tech items which US companies produce would increase by a large amount in such cases, the product output for those companies would still collapse and would most likely not make up for the shortfall. In other words, the collapse in supply output would be much stronger than the forced pick-up in demand would be to justify the very high price buying of tech items. The consumer does not need new iPhone every year, it is an optional purchase. Therefore stocks of those companies would take large declines, considering it would take years to offset Taiwan chip production somewhere else before stock prices would recover again.


-Significant capital outflows from the Asian region and collapse of currencies (Asian tigers 90s style):


If trade was to be largely disrupted followed by capital outflows due to fear, the currencies would take a plunge. It would not be surprising to see a 20% decline in all major Asian currencies. To place it within the context, both EUR and RUB have plunged 20% around the months of Ukraine proxy escalation, it wouldn't be out of the norm to see the same happening to Asian currencies as well if such an event and similar responses were to follow. This would in total strengthen the dollar once more, push bonds higher on the US side, and further ramp the pressures on global markets.




While the article might look like too straightforward almost to the point of being provocative, that is not intended whatsoever, since it is written from the objective and neutral point with no bias. It is just one of those situations where things have to be called as they are in order to better prepare ahead.

The conclusions drawn are based on consideration of where the relationship between the US and China is heading, and what the likely future scenarios might have for those two nations, which is where Taiwan comes right in between, like a child participating in the struggle of two parents in the middle of a broken marriage.

0 comments

Recent Posts

See All