- The semiconductor sector would be the most vulnerable should cross-strait tensions further escalate.
- In our base case, we assume that mainland China's future military drills around Taiwan will be less intense than the recent exercise, with no further expansion of trade restrictions.
- Worsening geopolitical disputes would hit Asia-Pacific more broadly, and reverberate through global supply chains.
The worsening geopolitical dispute among mainland China, Taiwan, and the U.S. is casting a pall over the long-term business and economic prospects of Taiwan. Prolonged tensions would reverberate to the rest of Asia-Pacific and exacerbate constraints in global technology trade flows.
Mainland China's recently concluded military drills around Taiwan are unusually intense, sparked by the visit of a high-level U.S. official to Taipei. Should elevated tensions endure, the downsides to credit conditions could be significant. Given Taiwan's role as major producer of chemicals, semiconductors, and other technology components, supply-chain disruptions could be costly. Taiwan's corporate creditworthiness would deteriorate.
Another Weight On Asia-Pacific Credit Conditions
Besides the unprecedented military drills across the Taiwan Strait, mainland China also imposed trade restrictions on Taiwan. Specifically, the export of natural sand from mainland China, and the import of some fish and fruits from Taiwan have stopped. While the direct and immediate economic consequences of these developments are limited, the intertwined trade and economic ties among mainland China, Hong Kong, and Taiwan underline susceptibility to escalating geopolitical challenges. This adds yet another headwind to the region's credit conditions.
In our base case, we assume that cross-strait relations between Taiwan and mainland China will not deteriorate toward a major military or economic conflict. This is further underlined by the recently released white paper by mainland China's state council, which discusses reunification. We also envisage no further intensification of trade restrictions between Taiwan and mainland China.
Persistent tensions could lead to a sharp deterioration in risk sentiments (both business and consumers). This would hurt Taiwan's export-reliant economy and fiscal position. With mainland China functioning as Taiwan's largest trading partner, a widening scope of trade bans would have knock-on impacts on the island's economy.
That said, a cutoff from Taiwan's technology would also hit mainland China's manufacturing economy hard, and in turn global supply chains. For example, Taiwan accounts for 92% of global production for the process nodes that power the world's most advanced machines.
Meanwhile, regular military drills across the Taiwan Strait could cause serious disruptions to one of the world's busiest shipping routes. Higher cargo insurance premiums or undertaking of longer shipping routes to avoid military drills would be costly for Taiwan's exporting corporates, compressing profit margins.
Corporates Have Low Flexibility To Manage Risks From Rising Cross-Strait Tensions
So far, the hike in tensions between mainland China and Taiwan has not imposed material costs on rated Taiwan-based corporate entities. We expect inconveniences stemming from likely higher costs for shipping delays and temporary increases in freight rates and insurance premium, or higher compliance costs.
Were the situation to escalate, most rated Taiwanese companies have limited flexibility to manage the risk of transportation and production disruptions. In our view, semiconductor companies could face the highest risk, since the bulk of their capacity is located in Taiwan. While companies like Taiwan Semiconductor Manufacturing Co. Ltd. (TSMC) are building fabrication plants in the U.S. and Japan, overseas capacity will remain limited over the next few years. As of end-2021, 90% of TSMC's wafer capacity was located in Taiwan.
Other technology supply companies, such as electronics manufacturing service companies, are also vulnerable an escalation of tensions. For example, the majority of Hon Hai Precision Industry's production is located in mainland China. Component and material supply to mainland China from Taiwan and other regions, such as Japan and the U.S., could face restrictions. This will eventually hurt output.
Fears Of Tensions Will Accelerate Supply-Chain Diversification, Raising Costs
Taiwan exports components that are critical for the production of downstream information technology, electric vehicles, and consumer electronics, in addition to other chemicals and metals. For example, in the second quarter of 2022, Taiwanese companies had a 64% share of the global semiconductor foundry market. Most of these intermediate goods go to mainland China for further assembly before shipping to other shores. Mainland China accounted for about 40% of Taiwan's exports in 2021.
Rising geopolitical tensions could accelerate supply-chain diversification away from Taiwan and mainland China. Diversification efforts have been under way since the beginning of the trade and tech dispute between the U.S. and mainland China in 2018. All major sectors in Taiwan are increasing their capital spending and production capacity in India, southeastern Asia, Mexico and the U.S. The aim is to lower their dependence on production in Taiwan and mainland China and boost their access to local end-markets.
Such initiatives could raise financing costs amid higher long-term uncertainties for Taiwanese producers. Risks of supply-chain diversification include weakening economies of scale and higher production costs, impeding progress and margins for rated corporates. While most companies can pass through additional costs in the initial stage because their clients need the capacity outside mainland China urgently, the long-term storyline is unclear. Slower-than-expected realization of cost efficiencies despite infrastructure investments in new locations could lead to margin compression.
Taiwan Financial Institutions And Insurers Have Low Exposure To Mainland China
In our base case, we assume a limited impact to the Taiwanese financial services sector. Capital markets have mostly stayed calm. While some corporate borrowers will be hit by the imposition of trade restrictions by mainland China, the overall impact is absorbable by the financial services sector.
As with other sectors, the story would be different in the event of widening trade restrictions or military activity. A weaker macroeconomic environment and falling asset quality for vulnerable corporate clients would burden credit profiles. The damage would be more pronounced for banks than insurers and non-bank financial institutions. That said, buffers are sturdy. The ratio of nonperforming loans to total loans of Taiwanese banks stood at less than 0.2% as of end-June 2022.
The profit contribution of operations in mainland China and Hong Kong account for less than 10% of the overall financial services sector. Furthermore, this contribution has been decreasing in the past few years. Currently, six out of 36 domestic Taiwanese banks have large exposure to mainland China (over 50% of its net worth) due to their subsidiaries in mainland China or own investments and credit exposure. However, this remains far below the 100% net worth limit set by the Taiwanese financial regulator.
Direct Economic Impact Is Limited: Indirect Hits Could Grow
Besides the military drills and trade bans, mainland China may be tightening enforcement of existing rules on the labeling of Taiwanese exports, e.g., forbidding the use of "Taiwan" or "Republic of China (ROC)".
The direct, immediate economic consequences of these developments are likely to be modest. The impact of the military exercises on commercial shipping should be short term. Also, the macroeconomic effect of the food import bans should be small: total food exports make up less than 1% of Taiwan's shipments to mainland China. The labeling rules should not be difficult or costly to adhere to. Indeed, Taiwan's stock market and currency have so far shrugged off concerns about the economic impact.
However, the indirect and longer-term economic impact is likely to be significant, for Taiwan, mainland China, economies in the region, and possibly the rest of the world.
- The increase in tension, risk of further military exercises, and possible change in the status quo are likely to hurt economic sentiment and activity, especially in Taiwan. The rise in friction and risk is likely to weigh on investment and consumption in Taiwan. In our view, it should also reduce foreign investment into mainland China and its international economic interaction more generally, with negative consequences for long-term growth. Economies such as Hong Kong with significant dependance on economic interaction with Taiwan and/or mainland China will feel the most spillover impact of these consequences.
- The rise in the risk of disruption to shipping in the Taiwan Strait could lead to diversion and re-routing of ships, thus raising costs and causing delays, with global implications. The Strait is used heavily by shippers, not just for cargo originating in mainland China and Taiwan: according to Bloomberg, in the first seven months of 2022, 48% of the world's operational containerships passed through the Strait.
- The heightened tension between mainland China and the U.S. is likely to add to existing pressure for broader political and economic decoupling. Economic decoupling between mainland China and developed economies has so far remained modest. But the continued worsening of political ties is likely to accentuate economic decoupling as firms on both sides respond to changes in the political climate and risk perceptions about producing and operating in different places. This will weigh on productivity and growth in mainland China and the Asia-Pacific region, as well as in the U.S.
Persistent Tensions Could Undermine Economic Support For Government Ratings
The limited negative impact of the recent developments on the Taiwanese economy also means that immediate impact on the government's rating metrics are modest.
Nevertheless, geopolitical risks to the ratings will remain elevated at least in the next few months as U.S.-China tensions are likely to remain high. Approaching key political events in both countries limit policymakers' room to repair ties. The chance remains that policy initiatives in both countries, aimed at their respective constituents at home, could exacerbate strains in the bilateral relationship. Accidents involving military assets in the South China Sea could become less unlikely with intensification of exercises in the region. Mainland China's recently announced decision to cut communications with the U.S. military make escalations more likely if an accident occurs.
Longer term, should heightened geopolitical risk perceptions dampen investor confidence in Taiwan, economic growth prospects may weaken. The island's economic growth trend has been relatively strong for its income level, and this is a significant support for our government rating. In the unlikely event that investor confidence is affected so strongly that we no longer consider Taiwan to be an economic outperformer, support for our ratings on the government could weaken materially.
It's also possible that increased geopolitical risks could become persistent to the northeast region. If this results in significantly weaker investment trends, it would undermine economic support for our ratings on governments in the region. Consistently strong economic growth has been an important credit support for East Asian governments. We consider several economies in the region outperformers among their peers at similar income levels. Slower investment growth could erode some of this growth advantage, which could also weaken other government rating metrics.
This report does not constitute a rating action.
S&P Global Ratings Australia Pty Ltd holds Australian financial services license number 337565 under the Corporations Act 2001. S&P Global Ratings' credit ratings and related research are not intended for and must not be distributed to any person in Australia other than a wholesale client (as defined in Chapter 7 of the Corporations Act).
|Primary Credit Analyst:||Eunice Tan, Hong Kong + 852 2533 3553;|
|Corporates:||Andy Liu, CFA, Hong Kong + 852 2533 3554;|
|Economics:||Louis Kuijs, Hong Kong +852 9319 7500;|
|Sovereign:||KimEng Tan, Singapore + 65 6239 6350;|
|Rain Yin, Singapore + (65) 6239 6342;|
|Financial Services:||Andy Chang, CFA, FRM, Taipei +886-2-2175-6815;|
|Credit Research:||Terry E Chan, CFA, Melbourne + 61 3 9631 2174;|
|Christine Ip, Hong Kong + 852 2532-8097;|
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