GeoLegal Weekly #20 - China, Taiwan and the Biggest Force Majeure Ever?
China kicks off big war games against Taiwan, a chokepoint for the global semiconductor industry & on-ramp to massive sanctions. Plus a pretty exhaustive list of legal consequences of escalation.
A few years ago, I was getting ready for a private meeting with the then-President of Taiwan. Despite a firmly business casual culture, we nonetheless had a policy of always wearing ties for meetings with heads of state. Deciding what to wear hinged on a critical judgment: Is Taiwan actually a state?
While you won’t catch me in a tie much these days, I knew I had to wear one regardless. But the question of Taiwanese statehood is even more complicated today than it was just a few years ago. And, I have a strong suspicion it will get dangerously more complicated in the years ahead, as China’s “Operation Joint Sword” demonstrated this past week. To understand the intended intimidation of this war game, you can check out this video released by the Chinese government.
Taiwan is responsible for the manufacture of nearly half of the world’s advanced semiconductors and could possibly be an on-ramp to a US-China war - or massive sanctions that would shock both economies. While I am less alarmist about war than others, I think the risk of China blockading Taiwan, as it simulated last week, is significant. What would it mean?
Bloomberg estimates the cost of a Chinese blockade of Taiwan alone would be 5% of global GDP, or $5 trillion, in the first year. And given the ambiguity of Taiwan’s legal status, there are a host of questions about what the diplomatic and military response of the US and Taiwan’s other allies might be, increasing the uncertainty around the risks and legal landscape for private actors trying to fulfill routine contractual obligations. Toward the end of this newsletter, we go into exhaustive detail on legal considerations for companies.
To make sense of what’s going on, I spoke with Sale Lilly, senior policy analyst focused on China at The RAND Corporation in my (newish) hometown of Santa Monica. We discussed how to think about this week’s military exercises. Sale stressed the war games were not necessarily an escalation, just run of the mill saber-rattling. He highlighted that it’s not predetermined that China will retake Taiwan some day - and certainly not by a specific moment in time. Rather, China will do what it takes to make sure it does not lose Taiwan, which is a different thing. While some in the military community point out particular dates by which China might try to retake Taiwan by force, those dates point to when China will have certain military capabilities, not necessarily intention. For one of the most substantive interviews I’ve done to date - where we get into crisis management planning and the like - click here or watch below.
The upshot of the above interview, then, is that the chance of full-scale war between China and Taiwan (and potentially the US) is not as high as one might think. But the chance of a major disruptive event - like China implementing a blockade or a customs inspection regime of Taiwan - is rising.
Necessary Background
I go into a decent amount of depth on business and legal risks related to the Taiwan issue toward the bottom of this note and if that’s all you’re here for, you can skip over the political backdrop. But I think it’s pretty important to refresh our understanding of the issues at stake.
The People’s Republic of China (“China”) has long regarded Taiwan as a fundamental part of its country and uses its leverage to gain such acknowledgement from other countries through its “One China Policy.” China insists it will never renounce the use of force to reunify Taiwan with China. China tries as hard as it can to block countries from having official diplomatic relations directly with Taiwan and opposes its membership or observership in as many international organizations as it can (and even where Taiwan participates, China insists it be referred to as “Taiwan Province of China” (IMF) or “Chinese Taipei” (Olympics) or other similar formulations).
The Republic of China, which is what Taiwan calls itself, and President Lai Ching Te’s Democratic Progressive Party, consider Taiwan an independent and sovereign nation, even if official state policy does not. Part of the reason for the war games was this passage of Lai’s recent inauguration speech:
The Republic of China and the People’s Republic of China are not subordinate to each other. All of the people of Taiwan must come together to safeguard our nation; all our political parties ought to oppose annexation and protect sovereignty; and no one should entertain the idea of giving up our national sovereignty in exchange for political power.
The situation is ambiguous and many Taiwanese prefer it that way. According to the Election Study Center, National Chengchi University, almost all of Taiwan’s population prefers the murky status quo to any change in status or attempt of change in the near term as you can see below.
The US has long had a position of “strategic ambiguity” about whether it would defend Taiwan if China attacked. The US generally accepts “one China” (of which Taiwan is part) but simultaneously sells a tremendous amount of military equipment to Taiwan to defend itself (even though delivery is backlogged).
This is an ambiguous equilibrium yet one asset markets are comfortable enough with to shrug off last week’s war games. But the landscape is shifting.
What’s Changing
There are a lot of things happening simultaneously that are compounding risk over Taiwan’s fate. China’s President Xi Jinping has fully consolidated power and is ramping up the military machinery that would increase the odds of success of a Taiwan invasion (though success is far from certain). China has stepped up asymmetric provocations and attacks on Taiwan considerably - for instance, there are nearly two million cyber attacks on Taiwan per month, done to project a cost on Taiwan for empowering independence-oriented leaders. And China has tightened its grip on Hong Kong politics indicating a resolve to settle outstanding questions of political independence faster than many expected. This also undermines the basis for China and Taiwan to theoretically agree on a “two system / one country” model - making the eventual use of force for occupation more likely.
Taiwan continues to elect presidents from the pro-independence party, which further sours relations with the mainland. US President Joe Biden has broken with norms to say the US would defend Taiwan in an attack but the White House has also walked back such a commitment (which feels to me like unstrategic ambiguity!) China saw former House Speaker Nancy Pelosi’s visit to Taiwan a few years ago as a major provocation.
Business and Economic Implications
China, Taiwan and the US have business interdependence that has provided a stabilizer in the relationship. But emerging consensus in the US that tariffs on Chinese imports makes for good politics and economic policy; and Xi’s evident preference for political control over economic growth suggests this stabilizer is deteriorating. Furthermore, as the US and Western countries have started to restrict China’s access to next generation technology, China has begun to invest in technological independence that will make Taiwan less important over time, as the Atlantic Council notes:
Taiwan’s advantage over China is likely to slowly erode. Beijing has opened dozens of semiconductor fabrication plants in recent years, and many others are under construction—sometimes with Taiwanese companies involved in the building. While the ban on sales of high-end chip-making equipment will slow China’s efforts to produce the most advanced chips, Chinese companies will still make advances, as the recent unveiling of an advanced chip in a new Huawei Technologies Co. smartphone made clear. In addition, as Chinese production of legacy chips surges at its new factories, Taiwan’s smaller chip makers may begin to lose market share on the mainland…Taiwan’s essential place in the China market may weaken over time.
As a result, Taiwan’s semiconductor powerhouse TSMC is making significant investments in the US, like $40bn in plants in Arizona. It will take a long time for either China or the US to replace the scale and yield of TSMC in the event something catastrophic were to happen to the company in the course of a conflict. And everyone who depends on semiconductors - which is pretty much everyone - would bear the downside cost, with Taiwan accounting for 46% of advanced chip market share according to Bloomberg.
As a representative scenario, let’s say we woke up tomorrow and China declared that Taiwan must begin to follow PRC law, leveraged potentially by a blockade - like the one they simulated last week - to get the island to submit and companies to follow suit. The US would almost certainly first respond with increased sanctions. The impact of carving China out of the global economy would make Russian sanctions look like child’s play.
The US already has sanctions on lots of Chinese firms–whether because they are believed to be arming Russia, engaging in human rights violations, dealing with other sanctioned entities such as Iran, committing IP theft in either civilian or dual use technologies etc. But thus far, the major nodes of China’s connections with the rest of the world have remained untouched–its biggest banks, its central bank and the repositories of its foreign reserves (State Administration of Foreign Exchange, China Investment Corporation), and its broad access to the dollar payment system.
These are all vehicles and networks similar to those that the US and EU have incrementally but decisively targeted over the course of the Russia-Ukraine war. The incremental approach was likely chosen because Russia was much more enmeshed in global financial networks than Iran, Libya, Sudan, or North Korea. And China is much more connected to the world’s financial and real economies than even Russia is, meaning that the financial disruptions from sanctions (or even speculation that these might be in the works) could add to the economic hit from the interruption of goods supply chains. There could be second and third order consequences here as markets fret about known and unknown unknowns.
Here is a non-exhaustive list of sanctions question based on (and extrapolating from) the Russian example:
What will happen to China-linked assets held by investors in the US (or in the West more broadly)?
Will those assets be tradeable and if so, with which counterparties
What will the price impact of trading restrictions be and will it affect leveraged players?
Will Chinese entities be allowed to withdraw money from Western financial vehicles
Will they try to front-run potential asset freezes?
Will this have an impact on the liquidity or solvency of key intermediaries or counterparties?
Will they appeal in Western courts against such measures?
Is there an adequate resolution regime that can deal with these questions?
Those last two questions bring us to our geolegal analysis.
Geolegal implications
I could spend all day fear mongering on the economic consequences of cutting China out of the world economy. But since this is a geolegal analysis, I want to spend the balance of this weekly thinking about legal implications of the plausible catastrophic scenario above.
First, there’s an interesting question about whether fallout between China and Taiwan would be covered under general force majeure clauses in JVs and supply contracts. As Nikkei covers here, there’s a question of whether Taiwan escalation-specific contract clauses are needed given confusion over whether Taiwan is actually part of China or not, based on the “One China” policy ambiguity. Similarly, escalatory actions short of war - like restricting trade - may not give businesses the same contract outs as actual war. Nikkei provides an example of how this is being dealt with by novel clauses, for example that:
neither party would be liable for failure to perform the terms of a supply contract in the event of a "national or regional emergency or other geopolitical event(s) over the Taiwan Strait and/or the South China Sea which restricts freedom of navigation through these waters under customary international laws.”
The most interesting part of the Nikkei article to me is the fact that including such a provision in your contracts could be considered a political statement today that would be interpreted negatively by Chinese customers or the Chinese government given the sensitivity of the issue. We don’t often see such clear examples of “geolegal” decision-making as that!
Second, there’s a question about insurance and reinsurance policy coverage, which normally excludes war-related losses. Insurers are already tightening up policies and raising costs against directly ensuring Taiwan exposures. Insurance Insider cites “1.75%-2% per annum for a one-year risk” compared to “0.35% on a 15 year risk in the region” two years prior. Indirect exposures for organisations, and those who insure them, is however a real consideration. Business interruption and contingent business interruption insurance policies could respond to the knock-on impacts of a conflict. This raises questions both about stress-testing your existing policies for how they would respond in such scenarios and also preparing for the broader economic shock to your market and the resilience of your insurers in the event that a China scenario swamped insurers with outsized claims.
Third, there’s an interesting question around language and maps. Companies will need message discipline in how they describe and represent the island in any escalated scenario. Casually referencing the wrong term or geographic boundary in public can trigger massive backlash from any or all sides. For instance, Vietnamese audiences may never see the Barbie movie because Barbie’s map to the “Real World” included dashes perceived as favoring China’s interpretation of a long-running sea dispute.
Finally, there’s a whole host of questions companies would need to ask in the event of an elevated dispute. Dan Currell, who is an advisor to Hence and a lawyer that is also a fellow at the National Security Institute, helped develop the below. In doing so, we sought to represent how complicated the situation would be - and to demonstrate that preparing answers to such questions can take place in advance.
Let’s say we woke up to China declaring that mainland law would apply to Taiwan and third party companies would be held liable for any violations. Beyond the fact that the US would respond with sanctions, companies would need to consider at least the following questions:
Jurisdictional context
Do we have a China/Taiwan legal entity?
Are we doing business in China/Taiwan under local law?
Do we have real property in China/Taiwan?
Do we have employees or contractors in China/Taiwan?
Are we doing business with suppliers or customers in a way sufficiently integrated to constructively qualify as doing business in China/Taiwan?
Do we sell or buy sensitive technologies or export-restricted goods to either Taiwanese or Chinese entities, or entities that sell into or buy from China/Taiwan?
Do we have data that resides in China/Taiwan - on servers or otherwise?
Do we have the PII of China/Taiwan residents?
Do we have loans from China/Taiwan-based banks/FIs?
Are we (or our subs or major contractors) listed on the public markets in China/Taiwan?
Contracts
Do any contracts bar us from doing business in China? At what point does Taiwan become part of China for those purposes? (Also see export restrictions below, same issues.)
Do we have integrated suppliers or customers who will require or request that we not attest that we are following Chinese law in Taiwan?
Could following Taiwanese requirements put us in breach of any contract provisions?
Will this drop the valuation of our Taiwanese business in a way that will impact viability provisions in our contracts?
Data Privacy/Security
Is our Taiwan-domiciled data treated differently under the national data security / privacy law of China?
Is the PII we have related to Chinese nationals (employees, customers, contractors etc.) held in a way that complies with Chinese law?
Advertising / Marketing Law
Are our advertisements and communications in Taiwan compatible with Chinese law?
Would changing our ads/comm’s violate Taiwan’s laws?
Employment
Do we have labor contracts in Taiwan that would be violated by applying Chinese labor law?
Do we have material suppliers or customers who would have the same problem?
Would Chinese law regard any of our contractor relationships in Taiwan to be employment relationships?
Are there labor standards that conflict between Taiwan and China - i.e. where standard practice in Taiwan would put us in violation of Chinese rules/law?
Are there obligatory employee benefits in China that we would need to offer to Taiwanese employees?
Finance & Securities
Could following Chinese mandates put us in breach of any loan/financing covenants?
Do we do business with Taiwan-based banks/FIs that might be vulnerable/shaky because of China’s actions?
Will this drop the valuation of our Taiwanese business in a way that will impact covenants in our financing arrangements?
What risks do we need to disclose in our next securities filing (assuming publicly traded)?
Should we consider changes to our capital structure to reduce exposure to this volatility?
Export Restrictions
When does Taiwan become China for purposes of export restrictions - i.e., selling products into Taiwan?
If China’s export restrictions now apply to Taiwan, are we exporting from Taiwan anything that wouldn’t be allowed to sell out of China? Are our suppliers? Are our customers?
Tax and Tariffs
Does compliance with Chinese and Taiwanese law at the same time obligate us to pay double tariffs/double taxes?
Does paying Taiwanese taxes violate Chinese law?
Does paying Taiwanese tariffs violate Chinese law?
Environmental
Does Chinese law have a higher environmental standard (e.g., emissions, waste, etc.) than Taiwan, and can we realistically meet it?
Are product regulations (GMO, carcinogens, etc.) different in China than Taiwan?
Political
China’s law requires companies of a certain size to have a CCP committee - do we need to create one in our Taiwanese entity?
That’s it for this week on the essay.
Public Service Announcements
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Second, if you find yourself with a few free moments and want to see me sans tie featured in the Financial Times on General Counsels and geopolitics, you can.
-SW & KS