Abstract

The ongoing U.S.-China trade war and ensuing high-tech conflicts are regarded as Taiwan's most crucial opportunity to slow down its progressively increasing economic dependence on China. The impact of the U.S.–China trade tensions on Taiwan are important to analyze because of Taiwan's relatively unique political and economic relationships with the United States and China, especially since the latter views Taiwan as its “breakaway province.” The regression results indicate that Taiwan's outward investment to China is significantly affected by Taiwan's lagged investment and exports to China, and the gap in the economic growth rates between Taiwan and China. Policy implications are provided for Taiwan to alleviate its economic dependency on the Chinese market and the negative impact from the U.S.-China trade war.

1.  Introduction

This paper analyzes the possible impact on Taiwan within the context of the U.S.–China trade war, especially in the midst of high-tech tension between the two countries, as Taiwan is a part of China's supply chain. The focus on Taiwan is unique and necessary because of its relatively special political and economic relationships with both the United States and China. After being defeated by the People's Republic of China (referred to as China hereinafter) in the Chinese Civil War, the Republic of China (referred to as Taiwan hereinafter) retreated from mainland China to Taiwan Island in 1949 and began a military stand-off between Taiwan and China. In essence, Taiwan is an island that lacks natural resources such as crude oil and minerals, and is therefore relatively dependent on international trade for its economic growth. Since 1994, China has replaced the United States as Taiwan's largest export destination; and both China and the United States are Taiwan's two most important and indispensable trade partners, with a share of 41.2 percent and 11.8 percent, respectively, in Taiwan's total exports in 2018.

Nevertheless, Taiwan has been a political entity that is not widely recognized by the international community since its membership in the United Nations was replaced by China in 1971. China has also claimed Taiwan as its “breakaway province” and denied the full sovereignty of the Taiwanese government, despite the close economic ties between the two countries. Figure 1 indicates the geographic locations of China and Taiwan, whereby Taiwan is a small island across the Taiwan Strait, ranging about 130 to 220 kilometers from the nearby coastline of China's Fukien Province. The geographic proximity has raised certain insecurities in view of China's expanded military in terms of scale and technological advancement. Furthermore, in the last three years, seven out of Taiwan's remaining 22 diplomatic countries has switched allegiance to China.
Figure 1.

Geographic layout of Taiwan and China.

Figure 1.

Geographic layout of Taiwan and China.

Note that, for decades, Taiwan has managed to maintain certain political-economic-military alliance with the United States. After the termination of official diplomatic relations with Taiwan's government, the United States, with its global strategic planning in the Cold War context, established official diplomatic relations with China by acknowledging the “One China Policy.”1 From the viewpoint of the U.S. geopolitical strategic plan in Asia, however, Taiwan is a critical part of the first island chain, and because of concern over Taiwan's lack of effective self-defense capability, the United States has continued to provide military arms sales to Taiwan. Nevertheless, China is openly critical whenever this kind of U.S.–Taiwan interaction occurs.

To expand their markets and profits, quite a number of Taiwanese corporations have invested more than US$ 60 billion for the last three decades (excluding portfolio investments or investments via third areas) in China, an amount that is far larger than Taiwanese investment to other countries or regions. Market and profit-seeking, including some privileges provided by China, are the obvious economic arguments for Taiwan's corporate investments in China. Other studies, however, such as Tanner (2007) show that there are also possibly hidden political motivations: China uses its large domestic market to attract Taiwan's investments as it can progressively increase Taiwan's dependence on China for exports and its economic development. This in turn can be potentially used to extract political concessions from Taiwan in the future.

In short, Taiwan is claimed by China as a province that will be taken back and unified. Although the United States is unlikely to allow this “unification” because of its global strategic planning, the U.S. diplomatic acknowledgment2 restricts itself from openly supporting the government of Taiwan. Taiwanese companies have invested in China since the 1980s in their search for lower production costs (in both labor and land) and to maintain their profits. China has become Taiwan's largest trade partner and destination of outward investment, with economic incentives to make Taiwan's economic development more dependent to China as a political bargaining chip since China has never given up its claim on the territory of Taiwan.

The current U.S.–China trade war originated from the United States’ complaint about China's unfair trade-related practices. The objective of this paper is to systematically analyze the impact of this war on Taiwan through Taiwan's increasing economic ties with China and the political attitudes of the United States and China toward Taiwan.

The paper is organized as follows: Section 2 provides a more comprehensive illustration of various possible outcomes for Taiwan under the U.S.–China trade war. The regression model of Taiwan's outward investment in China is discussed and estimated in Section 3. Section 4 provides policy implications for Taiwan's government to navigate a safer route in the midst of the U.S.–China trade war and convert the “challenges” into “opportunities” to improve the value-added and employment of domestic industries and expansion of foreign trade markets. Section 5 concludes.

2.  Taiwan in the turmoil of U.S.–China trade war

The imposition of higher tariffs on U.S. imports from China is attributed to its huge trade deficits with China (Center for China and Globalization 2018) in line with growing economic protectionism and anti-globalization sentiments (Moeller 2018; Thiebaut 2018; Havráneková and Dvorský 2019). Some media3 and research institutes (e.g., KPMG Economics & Tax Centre 2018) do not deem that there will be any positive results from this trade war. Trade disputes between the United States and China are not new, however, as they have emerged since the 1990s (Noland 1996), although the relationship appears to have deteriorated after China's accession to the World Trade Organization (WTO) in 2001, and a “trade war” between the two countries resulted due to the trade imbalance between the U.S. and China in the mid-2000s (Woo 2008). The future development of the U.S.–China trade war is further discussed extensively in Chong and Li (2019) who focus on the role of value-added to China's exports.

With 2018 GDP at US$ 590 billion, and GDP per capita at US$ 25,026 (or US$ 53,023 in PPP),4 Taiwan is known as one of the four “Asian Tigers” that experienced relatively significant economic growth and development achievement in the 1960s and 1970s. Since the 1980s, Taiwanese industries have faced tremendous challenges due to more stringent domestic environmental regulations and higher labor costs. Industrial transformation is needed, but the necessary research and development (R&D) may require a long gestation period to deliver the economic impact of quality patents. Many Taiwanese companies then chose an easy and quick way to reduce the financial burdens of such transformations by making outward investments5 to other countries where regulations are more lax and labor costs are lower, especially in China, which had just implemented economic reforms and needed foreign investments. With Taiwan's geographic, cultural, and ethnic proximities with China, despite tense military conflicts between them, the lucrative emerging Chinese market and the attempt to seize first-comer advantage drove many Taiwanese companies to invest heavily in China. China later surpassed the United States and became Taiwan's largest trading partner in 1994. Hence, in terms of the economic growth and development of Taiwan, the “China factor” is one important variable that cannot be neglected.

Despite progressively increasing trade between the cross-strait areas, certain specific trade restrictions are imposed by both governments. Investments from China to Taiwan were prohibited until 2008, and even as of 2018, the amount of China's investments to Taiwan amounted to only US$ 197 million,6 under intense monitoring by Taiwan's authorities. On the other hand, Taiwan's exports and investments to China need also to be approved by relevant authorities but with fewer restrictions that are more or less on par with direct investments from foreign countries. Therefore, based on data availability, in this paper, we use Taiwan’ exports and outward investments to China to respectively describe the major “trade” and “investment” factors between Taiwan and China.

It is important to note that Taiwan's trade and investments with China could also include the concept of a “triangular trade” in which most Taiwanese products exported to Europe or North America are assembled in China with intermediate goods imported from Taiwan, and then exported therefrom. In other words, certain Taiwanese products are partly manufactured in China and sold to third-country markets around the world. No doubt the incentives of the “world's factory” did attract many companies, including Taiwanese ones, to establish manufacturing facilities in China for costs reasons. However, for Taiwan's case, as Figure 2 illustrates, the ratio of Taiwanese products produced in China (including in Hong Kong) is higher than the one for those produced in Taiwan during the years of 2015, 2016, and 2017.
Figure 2.

Production locations of Taiwan's export orders

Note:Left axis indicates cumulative shares of export orders produced by areas; right axis indicates ratios of production in Taiwan or China (including Hong Kong). ASEAN-6 includes Indonesia, Malaysia, the Philippines, Singapore, Thailand, and Vietnam.

Figure 2.

Production locations of Taiwan's export orders

Note:Left axis indicates cumulative shares of export orders produced by areas; right axis indicates ratios of production in Taiwan or China (including Hong Kong). ASEAN-6 includes Indonesia, Malaysia, the Philippines, Singapore, Thailand, and Vietnam.

One of the positive impacts from the recent U.S.–China trade conflict is the mitigation of the ratio for Taiwan's orders produced in China from 56.74 percent in November 2018 to 50.40 percent in August 2019. This benefited Taiwan's domestic value-added and employment. Considering the large share of China in Taiwan's orders produced overseas, it is imperative to seize this opportunity to increase and improve Taiwan's domestic manufacturing capacity.

In sum, the basic picture for Taiwan under the context of U.S.–China trade conflict is that Taiwan has substantial economic dependency but a tense political and military stand-off with China; while the economic, political and military cooperation with the United States is indispensable. Many Taiwanese products are assembled in China and exported from there to the United States or other regions, are thus regarded as Chinese products and will face the new tariff rates imposed under the trade war. This will further decrease the comparative advantage of Taiwan's products, and, also in turn, reduce Taiwan's exports to China. However, if the challenges are handled wisely, the investments of China-based manufacturing sites of Taiwanese companies may be shifted back to Taiwan, thereby re-establishing and improving domestic manufacturing capacity and, in turn, improving domestic employment opportunities. To ensure the inventory of products in the United States or other regions, “order transference” or trade diversion could be expected, whereby orders originally given to Chinese companies are now transferred to non-Chinese companies (including Taiwan's companies).

In the short-term, the U.S.–China trade conflict is not likely to end anytime in the near future. The following section will provide a more comprehensive illustration of Taiwan's situations under the context of U.S.–China trade war.

2.1  Challenges to Taiwan's foreign trade in the context of U.S.–China tensions

The initial increase in tariffs by the U.S. government would decrease the trade advantages of Chinese products exported to the U.S. market, which often incorporate Taiwanese intermediate goods, especially in the case of electronic products. Taiwan is heavily dependent on international trade to maintain the momentum of its economic growth because of its shallow-dish nature with limited domestic market scale. After 2000, Taiwan experienced two major economic recessions, both due to a sharp decrease in orders from foreign buyers: the 2001 “dot-com bubble” and the 2008–09 global financial crisis. According to national statistics (monthly data) from Taiwan's Bureau of Foreign Trade, Ministry of Economic Affairs, Taiwan's total trade volume, in December 2018, reached US$ 52.46 billion, a decline of 0.8 percent (on a year-on-year [YoY] basis), while Taiwan's total exports declined by 3.2 percent to US$ 28.56 billion.

Further as exhibited in Figure 3, the shares of Taiwan's major export destinations are 41.2 percent for China (including 12.4 percent for Hong Kong), followed by 11.8 percent for the United States. It is thus obvious that Taiwan's international trade is largely dependent on China and the United States. The U.S.–China trade war further clouded the future economic outlook while politically, picking of sides has become a dilemma.
Figure 3.

Taiwan's top export destinations, 2011–18, as shares of Taiwan's total exportsUnit: %

Note:ASEAN (6) are the six countries located in South East Asian region: Indonesia, Malaysia, Philippines, Singapore, Thailand, and Vietnam.

Figure 3.

Taiwan's top export destinations, 2011–18, as shares of Taiwan's total exportsUnit: %

Note:ASEAN (6) are the six countries located in South East Asian region: Indonesia, Malaysia, Philippines, Singapore, Thailand, and Vietnam.

The lack of a general international identity for Taiwan creates certain barriers for it to access and utilize functions of international organizations such as the UN and/or its economic affiliations, which prevents Taiwan from being more active when confronted with international incidents that can affect it, such as trade conflicts. As for the U.S.–China trade war, Taiwan must be careful not to have its export “made in Taiwan” products mistaken as “made in China”—as it will be disadvantaged by the tariffs imposed on China's exports to the United States. According to an estimation made by Singaporean DBS Bank (Ma 2019), the Phase I 25 percent tariff (by May 2019) on US$ 200–billion worth of China's exporting commodities exerted little influence on Taiwanese products assembled in and exported from China. The impending 25 percent tariff increase on the rest of US$ 300–billion worth of imports from China (Phase II) will damage the trade advantage of Taiwanese products significantly. Consequently, the study forecasted a decrease in Taiwan's 2019 GDP growth rate by about 1 percent, should the United States fully implement the proposed tariffs on another US$ 300–billion worth of commodities. This is because Phase II's US$ 300–billion worth of commodities are more directly related to Taiwan's exports to or products manufactured in China, such as consumer electronics. This forecast has not been realized, partly because the tariffs of Phase II have not yet been fully implemented.

In addition, by examining Figure 4, we see that Taiwan's exports to China expanded from US$ 83.96 billion to US$ 96.76 billion, with a meager growth rate of about 15.2 percent for the period 2011 to 2018. Nevertheless, a more detailed examination indicates that the share of electrical products in total exports has increased from 30 percent in 2011 to 47 percent in 2018. The share of machinery products, meanwhile, increased from 9 percent to 11 percent for the same period, so one could discover that the export of electronics from Taiwan to China grew by 80 percent over the period 2011 to 2018, indicating that the export of electronic products to China solely stands at a considerable importance for Taiwan.
Figure 4.

Distribution of export to China of Taiwanese products, 2011 and 2018 (%)

Figure 4.

Distribution of export to China of Taiwanese products, 2011 and 2018 (%)

Under the mode of triangular trade, however, Taiwan exports intermediate goods to China for further processing or assembling into final products that are then exported from China. China is the largest exporter to the United States in terms of consumer electronics, which undoubtedly includes products with parts and materials from Taiwan. The tariff imposed by the United States would therefore negatively affect China's exports as well as Taiwan's exports of parts and components to China for the manufacture of the affected exports to the United States, thereby eroding the competitiveness of certain Taiwanese products. Worst still, Taiwan's alternative export destinations are limited due to the lack of multilateral and/or bilateral free trade agreements with other major trading nations; should China's exports dip, this would lead to a decrease in imports from Taiwan.

For the recent decade, in general, Taiwan's trade volume from China indicates an increasing trend until 2018:Q4. However, the ongoing U.S.–China trade conflicts may have caused China to face a certain economic slowdown whereby China's exports to the United States in the first half of 2019 declined by 26 percent (YoY). At the same time, Taiwanese exports to the United States increased by 12 percent, indicating that trade has been diverted from China to Taiwan. For example, as Nicita (2019) indicates, China's exports of office machinery to the United States fell by almost US$ 10 billion in the first half of 2019, while Taiwan benefited from such “trade diversion” as increasing exports to the United States by US$ 4.5 billion. The profits of Taiwanese companies operating in China may be negatively affected, however, since these products would be deemed as “made in China” and will therefore be subjected to the higher tariff rate when exported to the United States. On the other hand, manufacturing products and exporting to the U.S. market from Taiwan or selling products to the Chinese market may be rather “safe” from the impact of the U.S.–China trade war. Therefore, Taiwanese corporations abroad will have to decide whether to expand investments in Taiwan domestically or other countries such as Southeast Asian countries, the United States, EU, or India to avoid the negative effect of exporting Taiwan-made goods in China to the United States.

2.2  Danger of Taiwan's relatively high dependency on trade with China

In Figure 5, we see that Taiwan's exports to China experienced a rather steep decline from June to December 2018. This led to a decrease in total export growth despite unchanged or even mild growth in the exports to other major trade partners, due to Taiwan's high dependency on trade with China. In one of the famous conflict cases in the U.S.–China trade war—the arrest of Huawei's CFO in December 2018—the U.S. intention to drag or even prevent the global business expansion of 5G wireless networks of Chinese telecommunications equipment and consumer electronics manufacturer, Huawei, affected Taiwan negatively through its impact on Huawei's supply chain in which some Taiwanese high-tech device manufacturers are incorporated.7 When the arrest was publicized, Taiwan's stock market faced a sharp decline, including a decrease of stock prices of some top Taiwanese high-tech companies supplying parts or materials to Huawei. This is due to the concerns of Huawei's potential slowdown or even termination of business expansion that would lead to fewer orders to Taiwanese suppliers. Considering Taiwan's high dependency on trade with China, losing orders from large Chinese companies would indeed be quite a setback for Taiwan's economic development. In detail, the maximum economic impact from the shutdown of all supply chains (overseas and domestic) by Huawei is estimated as 3.5 percent; taking the overseas number alone, it is still equivalent to the 0.5 percent of Taiwan's GDP. Considering Taiwan's shallow-dish economic nature, both percentage numbers could cause heavy damage to Taiwan's economic growth.
Figure 5.

Trend of Taiwan's exports (YoY) to major trade partners

Note:CN&HK = China and Hong Kong; US = United States; JP = Japan; ASEAN6 = Indonesia, Malaysia, Philippines, Singapore, Thailand, and Vietnam.

Figure 5.

Trend of Taiwan's exports (YoY) to major trade partners

Note:CN&HK = China and Hong Kong; US = United States; JP = Japan; ASEAN6 = Indonesia, Malaysia, Philippines, Singapore, Thailand, and Vietnam.

The high dependency on trade with China may also reduce the impact of signed free trade agreements (FTAs). For example, the Taiwan–Singapore FTA signed in 2013 and effective in 2014 accounts for about 6 percent of Taiwan's trade share, whereas other FTAs with Taiwan in sum contribute about 5 percent. The danger is that if Taiwan loses export market share in China, in the short term, there is no single alternative market or country that can substitute the volume of trade that Taiwan has with China. Hence, trade stagnation could be severe and joining major regional trade pacts has often been difficult.

As a part of China's supply chain and with its heavy reliance on trade with China, Taiwan's direct hit from the U.S.–China trade war in the short term could be the weakening of the competitiveness of Taiwanese products due to the high tariffs—because most Taiwanese products are assembled and shipped from China, thus would be deemed as Chinese products from the U.S. perspective.

As China is likely to continue growing into a more stable economic entity, other WTO members are demanding that it abide to WTO rules. It has been argued that the inefficiency of the Dispute Settlement Unit of the WTO has led countries like China to passively utilize the WTO mechanism. In the future, along with recent the U.S.–China trade war, it is expected that the emphasis of intellectual property rights would be more direct and the center of aggressive negotiations between the United States and China. Taiwan, to a certain degree, is also a “victim” of China's disregard of intellectual property rights. Hence, a stronger push of an agenda on intellectual property rights escalated by the U.S.–China trade war would be an opportunity for Taiwanese enterprises or individuals to better safeguard their intellectual property rights.

On 15 March 2019, China passed a new Foreign Investment Law with the aim (claimed by officials) to improve the business environment for foreign investors and ensure that foreign invested enterprises participate in market competition on an equal basis.8 If Taiwanese companies could be treated with the regulations of such newly-passed foreign investment law, as stated by a high ranking Chinese Official, they may still enjoy benefits by investing in China and could continue expanding their businesses there. However, it is suggested that Taiwanese companies should not simply ignore the uncertainties in Chinese administration which would still easily and willfully re-interpret any statement, especially when it is not written in established legal regulations.

2.3  Potential brain drain to Taiwan by China to partially avoid the impact from technical sanctions due to the trade war

Recently, some major Chinese technology companies such as Huawei are putting efforts to master the techniques of 5G, which is being heavily opposed by the United States as the latter is concerned over the “first-comer advantage” of Chinese enterprises. A handful of Taiwanese well-known companies are participants of the supply chains of the above Chinese tech companies, implying that currently, the relations between these Taiwanese and Chinese companies are relatively complementary.

The termination of the supply of core materials such as the sanction on the supply of silicon chips to Chinese telecommunications equipment and systems company ZTE in April 2018, could leave Chinese firms at a disadvantage in trading, especially in core high-tech parts. China may either solicit more companies from Taiwan or other countries to join the supply chain to replace the original suppliers from the United States and/or further expand its own R&D. Once these endeavors have successfully generated patents, Chinese companies could be more “self-sufficient” to manufacture the final products, further reducing the participation of foreign companies in its supply chain. However, improving technological advantage requires more R&D, which is a rather long-term endeavor. In the short run, China may spare no efforts to attract talent from Taiwanese companies with advanced technology, thereby accessing the intellectual property rights of these corporations. Two significant examples are the tailored “31 Preferential Policies for Taiwanese” and the “26 Measures” announced in February 2018 and November 2019, respectively.9 Both preferential measures attempt to attract the immigration of Taiwan's talents and enterprises, especially those with patent rights and necessary skills, as well as recruitment of students (even high school students) with excellent academic performance.

2.4  Shifting trend of Taiwanese FDI

According to Taiwan's official statistical data, foreign direct investment (FDI) to Taiwan often fluctuates significantly. For example, FDI to Taiwan increased from US$ 4.80 billion in 2015 to US$ 11.04 billion in 2016, and then dropped to US$ 7.51 billion in 2017. One of the major reasons could be the relatively unstable political tensions between China and Taiwan, especially the potential risks of military conflict, making foreign investors hesitate when it comes to making major investments in Taiwan, despite Taiwan's solid infrastructure and relatively high quality of human capital. This is nothing new, since the “1996 Taiwan Strait Crisis” also hindered Taiwan's inflows of FDI, which dropped from US$ 2.93 billion in 1995 to US$ 2.46 billion in 1996. As for the recent U.S.–China trade war, after the “Taiwan Assurance Act” passed by the House of Representatives and increased frequency of U.S. naval ships cruising through the Taiwan Strait, China started to make strong statements while inflows of FDI into Taiwan dropped by 19 percent (YoY). This may once again suggest that analyzing Taiwan's development in the context of a U.S.–China trade war could not be exercised without political considerations.

On outward investments, in Table 1, from 2006 to 2018, the average share of Taiwan's outward investment to China in total Taiwanese outward investment is around 60.65 percent, ranging from 37 to 84 percent annually. This is an indication of Taiwan's overconcentration of outward investment to a single country. During the mayhem of the U.S.–China trade war, a significant decrease on Taiwan's outward investment to China from January to September 2019 can be seen. This may be the start of a diversification of Taiwanese outward investment, thereby lowering its dependency on China's market, which would be beneficial if effective strategies are used to develop business opportunities and expand other new markets.

Table 1.
Taiwan's approved annual outward investment from 2006 to 2018 Units: million US$; %
YearAmount to foreign destinations (1)Amount to China (2)Total amount (3) = (1)+(2)Share to China (4) = (2)/(3)
2006 4,315 7,642 11,958 63.91 
2007 6,470 9,971 16,441 60.65 
2008 4,466 10,691 15,158 70.53 
2009 3,006 7,143 10,148 70.38 
2010 2,823 14,618 17,441 83.81 
2011 3,697 14,377 18,073 79.55 
2012 8,099 12,792 20,891 61.23 
2013 5,232 9,190 14,422 63.72 
2014 7,294 10,277 17,570 58.49 
2015 10,931 10,965 21,897 50.08 
2016 12,123 9,671 21,794 44.37 
2017 11,573 9,249 20,822 44.42 
2018 14,295 8,498 22,792 37.28 
Jan.–Sep. 2019 5,455 2,822 8,277 34.09 
YearAmount to foreign destinations (1)Amount to China (2)Total amount (3) = (1)+(2)Share to China (4) = (2)/(3)
2006 4,315 7,642 11,958 63.91 
2007 6,470 9,971 16,441 60.65 
2008 4,466 10,691 15,158 70.53 
2009 3,006 7,143 10,148 70.38 
2010 2,823 14,618 17,441 83.81 
2011 3,697 14,377 18,073 79.55 
2012 8,099 12,792 20,891 61.23 
2013 5,232 9,190 14,422 63.72 
2014 7,294 10,277 17,570 58.49 
2015 10,931 10,965 21,897 50.08 
2016 12,123 9,671 21,794 44.37 
2017 11,573 9,249 20,822 44.42 
2018 14,295 8,498 22,792 37.28 
Jan.–Sep. 2019 5,455 2,822 8,277 34.09 

Source:Directorate General of Budget, Accounting and Statistics (DGBAS), Executive Yuan, Taiwan, R.O.C.

Prior to 2015, the investment amount by Taiwanese companies in China is far larger than the amount invested in all other foreign countries (Table 1). After 2016, however, the trend shifted conversely. Studies such as Guo et al. (2018) and Carvalho et al. (2019, p. 2) suggested that “some important emerging countries not directly involved in the [U.S.–China] trade conflicts would benefit from the shift in demand to sectors where they have comparative advantages.” Some Taiwanese companies have accordingly shifted their investments from China. These investments may be motivated by the decreasing production volumes of major Chinese companies, which are being accused by western countries of possible national security concerns. However, uncertainties remain and the costs of re-establishing production lines in China may be relatively high for companies that have returned to the domestic market in Taiwan, and hence they are unlikely to shift back to China in the short run.

3.  Research methods and estimated results

In this section, we use the political economic approach of combining regression of statistical data and qualitative analysis. The objective of the regression is to show the relationship between Taiwan and China over a period of 27 years. This is to better understand the determinants of Taiwan's outward investment utilized in China by focusing on variables regarding investment, trade, and political economy. Based on the availability of data, a time series analysis on Taiwan's export and outward investment to China is adopted to illustrate the so-called complicated trade and investment relationship between Taiwan and China.

For selected variables, we use the Chinese governmental annual data of Taiwan's outward investment utilized in China (FDITWt)10 as the dependent variable. Although Taiwan has been investing in China since 1980s (Chen 1996), only the data from the period of 1989–2018 is available. Due to annual fluctuations in FDI, a three-year moving average is adopted to smoothen out such fluctuations. For example, according to China's official statistics on utilized Taiwan's outward investment, shown in Figure 6, the amount fluctuated considerably, ranging from US$ 470 million in 1991 to US$ 3,970 million in 2002, and then to US$ 1,390 million in 2018. Furthermore, these investments are often not immediately utilized upon approval, implying that a regression based on the raw data of Taiwan's outward investment may be less efficient and possibly misleading. Using a three-year moving average, the time period used for regression is from 1991to 2018.
Figure 6.

Taiwan's outward investment utilized in China, 1991–2018Unit: billion US$

Figure 6.

Taiwan's outward investment utilized in China, 1991–2018Unit: billion US$

The independent variables are discussed herein. The variable Time (which is 1991–2018) is included because of the possibility of upward or downward time trend. The one-period lagged dependent variable of Taiwan's outward investment to China (FDITWt−1) is a crucial independent variable and likely to influence the dependent variable FDITWt positively, meaning that the more Taiwan's outward investment is utilized in China from the previous year, the more Taiwan's investment will be utilized in China in this year because of the logic of path dependence. Next, the one-year lagged Taiwan's exports to China TWEXPt−1 is used to represent the variable trade. The magnitude of TWEXPt−1 ranges from US$ 700 million (in 1989) to US$ 137,900 million (in 2018), which increased by about 200-fold over the period analyzed. Its direction of influence on the dependent variable FDITWt is unclear due to potential substitution effects between exports and outward investment. An intercept dummy variable (D2009) is set to have the years after 2009 (including 2009) as 1 and years prior to 2009 as 0 because the Chinese government in November 200811 announced the Chinese Economic Stimulus Program by investing over RMB 4 trillion (roughly US$ 586 billion by the official exchange rate of 2008) to mitigate the impact of the global economic crisis and boost its industrial upgrade. The intercept dummy variable set for China's participation to WTO in 2001 is considered less relevant for influencing Taiwan's outward investment to China because Taiwan had been investing in China for over 30 years (from the 1980s). Hence, whether this “program” encourages Taiwanese companies to invest more in China will be examined. Another independent variable, is the difference between the one-year lagged GDP growth rates of China and Taiwan (CN_TWt−1), is included to see how Taiwan's investment is influenced by China's relatively higher economic growth. It is predicted that the larger the growth rate gap, the more Taiwan's outward investment would be attracted and utilized in China in the subsequent years. Additionally, two slope dummy variables calculated by D2009 multiplied by FDITWt−1 and/or TWEXPt−1 are also included to evaluate the possible interactive influences of China's stimulus program and lagged Taiwan's investment and/or exports on the attraction of Taiwan's outward investment to China.

The Ramsey Regression Equation Specification Error Test (RESET) is adopted to examine possible misspecification. The null hypothesis of RESET is that the model is correctly set, and therefore, if the test result is significant, it indicates that the null hypothesis will be rejected, and the model may miss some important variable(s) or it is mis-specified. The RESET results for the model is unable to reject the null hypothesis. Hence, the specification of the model will proceed.

Additionally, the unit root test is performed to examine the stationarity of time series variables. The null hypothesis is “the tested variable has the unit root.” It is found that variable CN_TWt−1 is stationary by significantly rejecting the null hypothesis; while variables FDITWt−1 and TWEXPt−1 are non-stationary with order 1 (i.e., I(1)). Moreover, there is a long-term cointegration existing in these two non-stationary independent variables. To mitigate such effects, which often exist in time series data, the approach of Fully Modified Ordinary Least Squares (FMOLS) is applied because it is designed to provide sound estimates of regressions containing variables with cointegration (Phillips 1993).

The basic regression model is set as following:
FDITWt=C+β1Time+β2FDITWt-1+β3TWEXPt-1+β4CN_TWt-1+β5D2009+β6D2009×FDITWt-1+β7D2009×TWEXPt-1+ɛt,
(1)
where C is the constant term. Time, which is t, has 1992 = 1, 1993 = 2, and 2018 = 27. The dependent variable FDITWt is Taiwan's outward investment (excluding portfolio investments) utilized by China in the year t and FDITWt−1 is the one-year lagged dependent variable. For other independent variables, TWEXPt−1 is Taiwan's export to China in the year t − 1, CN_TWt−1 is the difference in the economic growth rates of China and Taiwan. To better reflect major policy changes, D2009 is the intercept dummy variable, which is set to value 1 after the year 2009, and 0 otherwise. Furthermore, the interactive dummies of D2009 × FDITWt−1 and D2009 × TWEXPt−1 are considered to allow possible changes of the slopes. Finally, ɛt is the error term with the usual assumption of being normally, independently and identically distributed.

The regression results of equation (1) by adopting the FMOLS approach is shown in Table 2.

Table 2.
Estimated results of FMOLS regression models
VariableModel 1Model 2Model 3
Time 43.57607* 21.29751 46.36411 
 (23.77257) (18.16863) (22.43699) 
FDITWt−1 0.743847*** 0.780734*** 0.733104*** 
 (0.059975) (0.053545) (0.057456) 
TWEXPt−1 −20.48726*** −16.22366*** −20.52284*** 
 (4.845476) (3.904792) (4.770759) 
CN_TWt−1 65.81632*** 62.34965*** 63.55137*** 
 (13.66288) (13.63892) (13.26665) 
D2009 −624.0701 −162.7140 −461.9849 
 (604.2843) (526.0658) (510.2404) 
D2009 × FDITWt−1 0.437694 − 0.561236** 
 (0.272497)  (0.245223) 
D2009 × TWEXPt−1 3.705022 7.732869 − 
 (5.532749) (5.008509)  
782.0106*** 738.8277*** 779.0880*** 
 (176.1131) (174.3522) (174.8739) 
R2 0.862677 0.854563 0.858215 
Adjusted R2 0.809274 0.808635 0.813440 
VariableModel 1Model 2Model 3
Time 43.57607* 21.29751 46.36411 
 (23.77257) (18.16863) (22.43699) 
FDITWt−1 0.743847*** 0.780734*** 0.733104*** 
 (0.059975) (0.053545) (0.057456) 
TWEXPt−1 −20.48726*** −16.22366*** −20.52284*** 
 (4.845476) (3.904792) (4.770759) 
CN_TWt−1 65.81632*** 62.34965*** 63.55137*** 
 (13.66288) (13.63892) (13.26665) 
D2009 −624.0701 −162.7140 −461.9849 
 (604.2843) (526.0658) (510.2404) 
D2009 × FDITWt−1 0.437694 − 0.561236** 
 (0.272497)  (0.245223) 
D2009 × TWEXPt−1 3.705022 7.732869 − 
 (5.532749) (5.008509)  
782.0106*** 738.8277*** 779.0880*** 
 (176.1131) (174.3522) (174.8739) 
R2 0.862677 0.854563 0.858215 
Adjusted R2 0.809274 0.808635 0.813440 

Note:***Statistically significant at the 1 percent level; **statistically significant at the 5 percent level; *statistically significant at the 10 percent level.

The directions of coefficients of each independent variable presented in each model are consistent. Model 3 is selected for further interpretation because it has the highest adjusted R2 value among all the three models.

In model 3, FDITWt−1, TWEXPt−1, CN_TWt−1, and D2009 × FDITWt−1 are statistically significant; whereas D2009 and the time trend are not.2 The results show that Taiwan's outward investment utilized in China from the previous year (FDITWt−1) does positively influence the subsequent investments (FDITWt) to China.

By examining model 3, note that increases of Taiwanese exports by US$ 1 million to China in the previous year (TWEXPt−1) decreases FDITWt by US$ 20.5 million. The reason may be due to the fact that Taiwanese companies in general are relatively smaller businesses and have limited fundraising capacity compared with major international enterprises. This implies that these corporations have relatively limited capability to simultaneously make exports and investments to other countries or regions. The other possible reason is that some of the trading relationships between Taiwan and China's companies are transforming from “complementary” to “competitive,” especially in the supply of mobile phones and semiconductors. Economic rationality based on comparative advantage and national security concerns from the Taiwanese authorities imply that simultaneous exports and outward investment to China without certain interventions are unlikely to occur.

The larger the gap between growth rates of China and Taiwan (CN_TWt−1) in the previous year is, the more Taiwanese investment will flow into China the following year. Hence, the economic growth of China would significantly attract Taiwan's outward investments. Thus, though the Chinese Economic Stimulus Program implemented by Chinese government in 2009 itself may not have attracted more Taiwanese investment in China for all the years after 2009, China's subsequent economic growth would nevertheless have a positive impact on Taiwan's outward investments to China.

The intercept dummy variable (D2009) is statistically insignificant in all three models. However, in model 3, the interactive term D2009 × FDITWt−1 is statistically significantly at the 5 percent level, which may reinforce Taiwan's outward investments to China. This means that the stimulus program implemented by China in 2009, although not totally effective for attracting Taiwanese investment by itself, does generate some positive impact in form of increasing the slope of dummy variable in regression model 3.

The estimated regression results indicate that Taiwan's outward investments to China could be influenced by factors such as investment in previous years, trade, and China's relative economic growth rates. Taiwanese companies that have already made considerable investments in China may not be able to easily and totally withdraw their invested capital in a rather short period and further investments would continue, which would lead to further and continuous investment in China and show the intertwined and seemly inseparable economic and trade relationship between Taiwan and China.

4.  Proposed policy implications

From our analysis, due to Taiwan's political and diplomatic situation in the international arena, there are not many proactive options Taiwan can immediately adopt when facing the impact of the current U.S.–China trade conflicts. If nothing is done, however, the negative impact to Taiwan is also inevitable. Hence, the proposed policy implications are presented to avoid as much as possible the negative consequences from the extensively wide-ranging trade conflicts because Taiwan would lack the ability to offset the impact.

4.1  Regional trade agreement participation

In November 2019, China officially formed a broader Asia Pacific trade pact, Regional Comprehensive Economic Partnership, which consists of 15 (originally 16, but India dropped out at the last moment) countries including those that China once reluctantly interacted with, such as Japan and Korea. This leaves Taiwan little opportunity to develop further interaction with countries of East Asia such as joining the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) since China may request its allied countries who are CPTPP members to veto Taiwan's application.

Instead, the Free and Open Indo-Pacific Strategy proposed by the United States may be another opportunity for Taiwan. The New Southbound Policy, initiated in 2016 by Taiwan's government, may foster more practical interactions with India and ASEAN countries, Australia, and New Zealand, forming a more solid political economic and pragmatic relations between Taiwan and South and Southeast Asia regions could be feasible. In addition, India's huge emerging economy could provide opportunities for Taiwan's investments. Under the current U.S.–China trade conflict, promoting trade and investment with India is supported by Taiwan's government (via the New Southbound Policy); furthermore, Taiwan has few political and economic disputes with India. Moreover, there is abundant Indian human capital and talent in high-tech industries, which may satisfy the R&D needs of some of Taiwan's most competitive enterprises.

4.2  Promoting value-added of Taiwanese industries

Aside from regional trade agreements, bilateral free trade agreements would be an alternative trade pact for Taiwan. Nevertheless, it is still difficult for the United States to sign the Trade and Investment Framework Agreement (TIFA) with Taiwan. One of the major barriers of signing the TIFA hinges on the import of American pork-related products. The Taiwanese government approved the import of American beef products under certain restrictions governing food safety in 2014. The import of pork remains unresolved. One of the main reasons causing this difficulty is because the Taiwanese domestic market consumes seven times more pork products than beef, making pork a more important import. Hence allowing the import of U.S. pork products into Taiwan would be one of the perquisites for the United States to sign TIFA with Taiwan. Therefore, the upgrade of domestic pork products in terms of value-added to increase the comparative advantages of domestic produced pork and its related products is essential for Taiwan should the TIFA be signed.

Moreover, Taiwan's official statistics show that the ratio of the service industry to Taiwan's GDP has exceeded 62 percent for the recent decade and employs around 60 percent of all employees. In terms of the size of the companies, over 97 percent of Taiwanese companies are small and medium-sized enterprises, providing nearly 70 percent of jobs. Unfortunately, most Taiwanese firms in the service industry have a rather limited capacity to promote R&D or innovation for enhancing the value-added of their products or services to avoid being easily replaced by foreign ones with higher cost effectiveness. Considering that R&D could be a long-term endeavor, it may seem to urgent for the government to help facilitate Taiwanese domestic firms to invest in R&D, especially with the ongoing U.S.–China trade conflicts since time is not on Taiwan's side.

5.  Conclusions

Taiwan shares a special and complicated political, economic, and military relationship with both the United States and China. The empirical regression results support that Taiwan's outward investment is influenced by its own lagged dependent variable, Taiwan's exports to China, and the gap of economic growth rates between Taiwan and China, in which the larger the gap, the more Taiwanese investment will flow into China. The effect of the U.S.–China trade war on Taiwan is not purely economic. It also has political and military impacts. Currently, some Taiwanese companies are expanding their investments to Taiwan, as well as to India, ASEAN countries, and/or even EU and the United States, leading to investment diversion from China.

The second effect would be changing U.S. foreign policy toward Taiwan, in which regulations for interaction between the United States and Taiwanese officials and military arm sales to Taiwan are relaxed. The third effect would be China's “retaliation” toward Taiwan via an “economic weapon”—such as prohibiting Chinese citizens traveling as groups to Taiwan for tourism and providing preferential economic incentives to Taiwanese citizens, companies, and talent, as well as oppressing Taiwan's diplomatic activities (to reduce the number of countries with official diplomatic relations with Taiwan). Even though Taiwan has a great opportunity to establish its domestic supply chain by utilizing additional FDI from advanced economies while reducing its dependency to China, the process of slowly obliterating Taiwan's economy should not be completely ignored. That is to say, clinging to either the United States or China too much should be discouraged, and instead, simultaneous promotion of increasing domestic value-added of domestic industries and expansion to new foreign markets should be the policy focus.

As the U.S. government accuses China of manipulating exchange rate currencies, the U.S.–China trade war is unlikely to be a short-term conflict as the United States is expanding its conflicts to high-technology and currency manipulations, which in turn could severely damage the macro economy. We may witness a global shifting of international trading based on pure economics to a more politically motivated stance using tit-for-tat strategies. For example, Korea and Japan are starting their own version of a trade war based on historical issues rather than economic arguments. Although this may benefit Taiwan in its exports of related products in the short term, any potential trade conflict between Taiwan and its trade partners will have a negative impact on Taiwan, as it lacks the tools to counter such a conflict.

Taiwan should consider choosing a path to avoid or minimize direct impacts from the U.S.–China trade war as much as possible. As mentioned above, Taiwan's diplomatic status is rather weak, which makes it difficult to sign FTAs with other countries. Hence, these suggestions may be passive in nature but are relatively pragmatic options in order to sustain Taiwan's international exports. Solutions such as attempting to actively apply to join any possible regional trade agreements to showcase Taiwan's willingness to uphold the principles of free trade, as well as the promotion of value-added to Taiwan's domestic industries and R&D to enhance firms’ resilience, and the expansion to other potential foreign markets other than the United States and China, are suggested. Nonetheless, it should once again be noted that these policy implications may not be realized if international political attitudes toward Taiwan, especially from China, are rather unfriendly, especially in the midst of the U.S.–China trade war.

Notes

*

I am grateful for insightful comments on an earlier draft from the anonymous reviewers, Wing Thye Woo, Zhang Miao, Tat Wai Tan, and other participants of the Asian Economic Panel Meeting “The Global Trade System in Disarray: Fixing Design Flaws and Adjusting to a Multi-Polar War” held at Sunway University, Kuala Lumpur, Malaysia, 29–30 March 2019. This work is supported in part by the National Cheng Kung University within the framework of the Higher Education Sprout Project by the Ministry of Education of Taiwan, R.O.C. The usual disclaimer applies.

1 

The “One China Policy” is a diplomatic policy asserting that there is only one sovereign state under the name “China.” For decades the Republic of China Government (Taiwan) and the People's Republic of China (PRC) Government (China) have been fighting for legal representation of the sovereign state “China.” After 1971, most countries in the world (including the United States) regard the PRC as sovereign state China's legal representative. The PRC Government regards the “One China Policy” as meaning that there is only one sovereign state “China” and Taiwan is an inseparable part of this sovereign state.

2 

The 1979 Joint Communique of the United States of America and the People's Republic of China (Normalization Communique) indicated that ``the Government of the United States of America acknowledges the Chinese position that there is but one China and Taiwan is part of China.'' For details, please see ``U.S.-PRC Joint Communique (1979),'' American Institute in Taiwan, www.ait.org.tw/our-relationship/policy-history/key-u-s-foreign-policy-documents-region/u-s-prc-joint-communique-1979/.

3 

South China Morning Post (2019) “All-out trade war between China and the United States leaves no room for optimism,” 16 January 2019, https://www.scmp.com/comment/insight-opinion/united-states/article/2182088/all-out-trade-war-between-china-and-us-leaves (accessed 26 October 2019).

4 

Most of the data are obtained from Taiwan's Directorate General of Budget, Accounting and Statistics (DGBAS), Executive Yuan. However, the data of GDP (PPP) per capita is obtained from the IMF. As for 2018, Taiwan's Gross National Income (GNI) is US$ 601.2 billion, GNI per capita is US$ 25,501, and GNI (PPP) per capita is US$ 54,029.

5 

Instead of “foreign direct investment,” the term “outward investment” is used by Taiwan's government due to the constitutional issues that regard the area of mainland China as the territory of the Republic of China and hence, the investment in mainland China is not deemed as investments in “foreign” countries.

6 

Data acquired from the Department of Taiwan, Hong Kong and Macao Affairs, Ministry of Commerce of the People's Republic of China. See http://tga.mofcom.gov.cn/article/sjzl/taiwan/201901/20190102828082.shtml [in Chinese].

7 

Huawei is the largest manufacturer of equipment of 5G wireless networks, with global market shares of 30–35 percent in base stations and 40–45 percent in fiber optic communication equipment. Some major Taiwanese companies like TSMC and Foxconn Technology Group are suppliers of intermediate goods for Huawei's products.

8 

China Briefing, 17 October 2019, “China's New Foreign Investment Law: A Backgrounder,” https://www.china-briefing.com/news/china-new-foreign-investment-law-backgrounder/ (accessed 1 November 2019).

9 

XINHUANET, 30 May 2018, “All 31 preferential policies for Taiwan to be implemented: spokesperson,” http://www.xinhuanet.com/english/2018-05/30/c_137218238.htm (accessed 5 November 2019) and South China Morning Post, 4 November 2019, “Beijing extends sweeteners for Taiwanese weeks before Taipei election,” https://www.scmp.com/news/china/politics/article/3036194/beijing-extends-sweeteners-taiwanese-weeks-taipei-election (accessed 5 November 2019).

10 

The data of Taiwan's outward investment to China is acquired from the Ministry of Commerce of the People's Republic of China, which are the amounts “utilized,” not just “approved.”

11 

New York Times, 10 November 2008, “China Unveils Sweeping Plan for Economy,” https://www.nytimes.com/2008/11/10/world/asia/10china.html (accessed 30 January 2019).

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