Scenarios of Sino-US Tensions Around Taiwan – Investment Strategy Lombard Odier

Key points

• US House Speaker Nancy Pelosi’s visit to Taiwan has raised the risk of a more rapid disengagement or outright confrontation between the US and China.
• Prolonged or regular maneuvers in the Formosa Strait would seriously disrupt Taiwan’s trade with the rest of the world and global supply chains.
• Here we present three 3–5-year scenarios for the evolution of Sino-US tensions around Taiwan, largely based on protracted but one-off military maneuvers around the island that cause intermittent disruptions to trade flows.

US House Speaker Nancy Pelosi’s visit to Taiwan and China’s bellicose response lead to our medium-term outlook for US-China relations and stability in the Formosa Strait. Beijing appears to have opted for carefully calibrated responses to risky military operations aimed at physically disrupting Ms. Pelosi’s visit. However, in the longer term, investors face a higher risk of an accelerated disengagement or even outright conflict between China and the US.

Following the confirmation of Ms. Pelosi’s visit to Taiwan, China announced “direct munitions” military maneuvers in six areas around Taiwan’s main island (some of which were deliberately intended to violate territorial waters and in Taiwan’s view) and effectively closed them to air traffic and civil navigation for four days from August 4 to 7. China also launched other types of military exercises today and imposed a series of economic restrictions, such as a ban on citrus and fish imports from Taiwan.

From our perspective, Beijing has clear intentions to actively test Taiwan’s maritime territorial claims and the boundaries of Air Defense Identification Zones (ADZs) in the foreseeable future. The White House insists on the fact that the visit will in no way change the US policy of “one China” (as distinct from the one China policy). However, it seems to us that it will be difficult to change Beijing’s growing perception that the visit is part of Washington’s long-term strategy to remove existing commitments to support bilateral relations between the two countries. Beijing has good reason to prevent repeat visits by top officials from other G7 countries and to publicly condemn Ms Pelosi’s refusal to heed public warnings and constraints on its political calendar (ie, presidential promotions). Chinese Communist Party by the end of next autumn). China’s response will inevitably reflect an escalation of measures taken during the third Straits of Formosa crisis in 1995-1996.

Although China’s big moves will come once Ms. Pelosi leaves Taipei (which certainly helped relieve markets last night), it’s too early at this point to predict exactly what they will be and how long they will last. These uncertainties, downplayed by markets at the moment, are troubling because they suggest a possible isolation or blockade of Taiwan, which could be the next step in strategic escalation between China and the US. Although military maneuvers may be temporary in nature, they could easily become prolonged or routine, significantly disrupting Taiwan’s trade with the rest of the world. It should be noted, however, that the combined naval forces of the United States and its allies operating in the region will have the effect of limiting the extent of Chinese activities in accordance with the patterns of these efforts.

With these facts and food for thought in mind, we can sketch three possible scenarios for the evolution of Sino-US tensions around Taiwan over a roughly 3-5 year horizon:

1. Scenario A (most likely): Military maneuvers lasting one to two years (or less) around Taiwan, without major direct military confrontations, are likely to cause intermittent disruptions to trade flows through the Formosa Strait and the waters and airspace around it. between China and Taiwan or between China and the United States. A third strait model similar to the Formosa crisis, but on a more aggressive scale, would offer some strategic flexibility depending on the outcome of elections in the United States in 2024, while reducing the risk of Western sanctions against China. States and Taiwan or a New Mutual Strategic Understanding in the Middle Ages. The cost to the global economy would further disrupt global supply chains, and risk a sudden escalation into a dangerous conflict and a rapid disconnect between China and the United States. The overall strategic position will be maintained, but the long-term outlook remains highly uncertain. Markets will face volatility as sentiment shifts towards the risk of a head-on confrontation between the US and China.
2. Scenario B (less likely): A less (and more dangerous) scenario is Beijing’s deliberate move to impose an “isolation” or blockade of Taiwan, leaving China to decide who can enter the area around Taiwan. The difference between isolation and blockade is that in the former case, most trade and commerce flows are allowed except those deemed inappropriate by Beijing. In either case, Taiwan would have strong incentives to resist the move militarily, and the United States and its allies would respond with economic sanctions or military action, even at the risk of direct armed conflict with China. For example, an attempt by China to restrict the flow of arms or energy exports from the United States to Taiwan could come up against a reaction from Taiwanese military forces, who believe they have nothing to lose. In this scenario, the disruption of global supply chains would be more than lasting but one-off military maneuvers, and the rift between the US and China would be almost final. In western countries.
3. Scenario C (probability in this case is still very low, but not negligible): A less extreme but more dangerous scenario is a rapid escalation into “open war” over the strait between the US and China, with the latter trying to assert political control of Taiwan through a settlement. This scenario would expose the entire global economy to massive shock waves, as it would lead to a complete restructuring of global supply chains and the collapse of multilateral governance structures.

For now, we assume that China is reluctant to change its military posture around smaller islands like Kinmen, Matsu, and Pradas, knowing that the cost of subsequent Western sanctions may outweigh the small benefit of strategic signals sent to Taiwan, the United States, and the United States. their allies. In other words, the attempt to seize these islands makes sense only as a prelude to an “open war”, which China still wants to avoid in our view.

Different configurations of outcomes are possible given the high degree of uncertainty surrounding the approach of the United States and China, but we believe they will ultimately move toward one of the three scenarios outlined above in the medium term. Needless to say, a verbal confrontation between the two countries followed by very short military maneuvers would be a much more desirable outcome. However, considering China’s demand in this scenario, this scenario is not feasible for us at present.

Ultimately, we are of the view that an open war in the Formosa Strait is unlikely in the medium term, although China’s reaction to Ms. Pelosi’s visit could open the door to a more significant escalation toward such an outcome. If the strategic position can be maintained despite trade disruptions, the impact on the global economy will certainly be negative, but more than surmountable. Collateral damage from escalating tensions around Taiwan could be a setback in Sino-US talks on the elimination of tariffs and delisting of Chinese companies in the US, as well as restrictions on secondary sanctions imposed on Russia. These relatively modest setbacks have already been largely priced in by markets.

Two meetings organized by the Association of Southeast Asian Nations (ASEAN) this week should give an indication of future developments in Sino-US tensions, with the foreign ministers of the two countries concerned expected to attend them. Another signal that could prove useful is a tentative agreement between Presidents Biden and Xi on the principle of a one-man summit by the end of the year. A breakthrough in this regard could strengthen the prospect of eventual expansion. In any case, we will keep a close eye on developments in this file and provide updates as needed.

China’s military maneuvers around Taiwan

Sources: Xinhua, Flanders Marine Institute, Australian National University, Bloomberg