The Cost of Conflict: Economic implications of a Taiwan military crisis

Navigating economic security in an increasingly interconnected world

In this deeply interconnected world of today, Europe should look toward East Asian countries such as Japan, Taiwan, and South Korea for best practice examples of industrial policy to increase prosperity and security. East Asian countries have distinct ways in which governments and industries work together to fortify the economy for this new age of great power competition. Today’s world is much more economically interdependent than many people believe and merely focusing on trade figures is not the right way to look at it. At the EU Institute for Security Studies (EUISS) and at the Hague Center for Strategic Studies (HCSS), the focus of Joris Teer’s work is on helping governments and companies to conduct risk assessments for determining feasible geopolitical risk premiums. Setting up semiconductor manufacturing in Arizona instead of Taiwan may not be the most cost-efficient way. So why is it done? It is an upfront cost to have guaranteed supply if a crisis occurs in East Asia. Governments and companies are both faced with the question of how much should be paid for our geopolitical risk premium and how this can be carried out in a smart way without inadvertently competing with like-minded countries or creating subsidy races between collaborative nations. The analysis presented assesses war scenarios and the impact they could have on supply chains, trying to craft policies on the basis of this knowledge.

Lessons learned from the Russian invasion of Ukraine

Europe’s experience of the situation with Russia and the crisis in Ukraine is a great lens through which to understand the new problems of the world. The underestimated economic costs that the Ukraine crisis brought about have impacted Europe significantly. Around April or May 2022, the Azovstal steel factory in Mariupol became a symbol for the war because Ukrainian soldiers were sheltering here for 82 days while they were bombarded by the Russian military. It is also a symbol for what can be called “geopolitical breaking points,”—when tensions between two competing parties reach such a high level that normal trade comes to a halt. In this case, key commodities could no longer be produced at this factory, which not only produced steel, but also neon gas, which is used in the production of semiconductors. In fact Ukraine’s various facilities were responsible for 50% of the world’s neon production.

One lesson that should be learned from the war in Ukraine is that in this time of deep economic interdependence, war-related disruptions can destroy a lot of value. What really hurt the European economy was the dependence on Russian gas and Putin's decision to reduce the gas supply to Europe, resulting in soaring energy prices. According to Bloomberg, the Ukraine crisis and the resulting compensation schemes have already cost the EU 1,000 billion (1 trillion) US dollars (in 2022 alone). Even though tensions were rising leading up to this war, European leaders failed to recognize the need to diversify their energy supply. While the dependance of gas imports from Russia was about 20% in 2011 or 2012, this figure rose to around 45% at the eve of the Ukraine war, despite the seizure of Crimea in 2014. In hindsight, paying a geopolitical risk premium to reduce the dependence on Russia would have been favorable, but now it is too late.

An analysis of semiconductor supply chain dependencies in East Asia

Another important case where tensions could result in a crisis is East Asia. The supply chain to look at in this region is semiconductors and the critical raw materials used for their production, as opposed to gas in the case of Russia. Semiconductors are essential for the production of wind turbines, medical technologies and defense equipment. From a Western perspective, looking at the supply chain of semiconductors, the weaponization of interdependence of front-end manufacturing is not the main concern. Front-end production is dominated by companies from the U.S., Taiwan, and South Korea, as well as Japan and Europe. However, China has become increasingly strong in the area of back-end fabrication and the front-end production of foundational chips. Estimates range between 29% and 40% of total back-end manufacturing of semiconductors in China. While a chip may be designed in the U.S. and the front-end production done by Taiwanese parties, the back-end manufacturing of a lot of chips still happens in China, which provides them with significant leverage. In the supplemental layer that is supporting the semiconductor value chain, there is even less risk because equipment mostly comes from European and American companies, and Japan is also a big player for wafers and processed chemicals. The real problem lies at the bottom of the value chain. Many of the specific raw materials semiconductors are made of come from China. According to estimates by the U.S. Geological Survey, China mines 97% of all germanium. Around 68% of rare earths are extracted in China, and around 90% of rare earths are refined in China. For permanent magnets, China’s dominance ranges between 85% and 90%. Japan is also able to produce these, but on a different scale. Furthermore, while 70% of all cobalt comes from the Democratic Republic of Congo, many mines are either majority-invested or owned by Chinese companies, or Chinese companies exploit those mines. Subsequently, most of the cobalt is transported to China, where refining takes place.

Why should this particular value chain be looked at? Critical raw materials and semiconductors can be described as the oil of the 21st century. Critical raw materials are the skeleton of the world's economy—without them it is very difficult to produce anything because they are needed for semiconductor production. Semiconductors are the central nervous system of the world economy and global manufacturing—without them the discussed critical goods cannot be manufactured. This can be described as different countries or regions in the world controlling different building blocks of a structure that we are trying to build together. It must be recognized that some parties see this from the point of view where collaboration allows for the most efficient outcomes and so the behavior is economically “rational” and therefore continued collaboration is the only possible course of action, while other parties see this very differently. Prior to the Ukraine war, many European economists and energy experts said that Russia would never weaponize gas delivery because it would be irrational from an economic perspective of mutual benefit, ignoring other national incentives. And so there are two issues that we must come to understand. Number one is the world is more interconnected than many believe, and number two is that some leaders are once again prioritizing a sense of national glory or hard security considerations over mutual economic gain. The two consequences of this are that if a crisis hits, war-related disruption destroys a lot of value, and two, this subsequently puts countries at odds with each other, so they start weaponizing economic interdependence during a crisis. These are the two problems that we are now faced with. East Asia and Taiwan are of particular interest, because East Asia has become the global manufacturing hub in the world. Over 75% of all front-end manufacturing and more than 70% of the back-end manufacturing of semiconductors is carried out here. A lot of the resources for antibiotics and other vital medicine also come from China, which is a painful dependency. 35% of all manufactured goods are produced in China, meaning that a conflict in this region would have much greater effects than the current conflicts are having. The analysis presented in this seminar is based on reports compiled for the Dutch Parliament and other reports to create a comprehensive picture of what the cost of conflict would be for the EU and provide policy recommendations. It was written on the basis of what we call a “military crisis stress test.”

Stress test analysis of invasion and blockade scenarios of Taiwan by China

The most extreme scenario that was looked at in the stress test analysis is an invasion of Taiwan by China. China's rapidly proceeding military modernization and other powerful trends makes this scenario a possibility. While China’s and Taiwan’s defense spending was the same in 1991, in 2021 China spent 21 times more on defense than Taiwan. China's military intimidation of Taiwan in 1995/1996 was easily stopped when U.S. President Bill Clinton sent two aircraft carrier battle groups to the Taiwan Strait. Nowadays, there is more reluctance on the part of the U.S. to put highly valuable military assets close to China’s shore at times of high tension, indicating a new power balance in the region. In this war scenario we basically assume that China’s goal is still reunification with Taiwan but that it no longer has faith in “reunification” through peaceful means, and Beijing has decided that an invasion is a more likely path to success rather than a blockade. We assumed that the Chinese invasion will be unsuccessful. Yet, the economic fallout will still be enormous because the East China Sea and the South China Sea would turn into a no man's land where two great powers contest each other. Trade within the region becomes incredibly dangerous and therefore close to impossible. This scenario basically entails the grinding to a halt (or downright destruction of) of Taiwan’s semiconductor industry. If not because of active damage to the fabs, then because of the fact that Taiwan is around 95% dependent on energy imports. Maritime energy imports would no longer be possible. Subsequently, many electronic applications and medical devices that use semiconductors and are produced in China cannot be produced anymore which causes shortages in critical sectors. If the war zone ranges all the way up to Japan and South Korea, their imports of LNG and oil may also be affected. They are responsible for 60-75% of memory chips and Japan produces 90% of photoresist—what happens if airspace and maritime space are both inaccessible? If we think about the idea of essential building blocks that each party needs to supply its critical sectors, trade will most likely come to a halt to a large extent due to the war-related disruption, leading to global shortages of critical goods. A war will be accompanied by a sanctions effort. The pressure of the United States on its allies will be enormous. Most likely there will be a sanction spiral similar – but more extreme - than the one we are seeing now between the West and Russia. Even if China could still supply the West with medical devices, medicine and other goods, would it still want to at a time of war?

A more likely, but still quite extreme scenario is a blockade, which we called “Strangling the Porcupine.” The relatively short military exercises by China around Taiwan following the Nancy Pelosi visit already caused disruptions such as cancellations of some passenger flights to Taiwan and redirection of some maritime traffic to resupply Taiwan. Since China’s military exercise in May 2024 after the inauguration speech of the Taiwanese president was titled “Joint Sword-2024A,” it is likely that there will be further exercises. Unlike an invasion, the implementation of a blockade is very difficult to predict. An invasion scenario will see all sorts of large-scale preparations in China for months, indicating that an invasion is possible. In a blockade scenario, a “regular exercise” can suddenly be transformed into something permanent. It is much more insidious and less devastating as well, but still economically devastating. In addition to the direct effects of this blockade—for example on semiconductor manufacturing in East Asia—one must keep in mind that this may be answered by a U.S. Navy blockade of the Strait of Malacca, which China uses to import a lot of its energy. This scenario will set off a chain reaction that is not as extreme as the invasion scenario, but it would still affect critical sectors around the world.

Finally, there is a slightly less intense scenario where China conducts exercises, goes away, and exercises again for a longer period. Even if semiconductor manufacturing is interrupted only for a very short time, if there are energy shortages the impact might be long lasting. One example of this actually occurring is when there was a blizzard in Texas and the energy supply to semiconductor manufacturing facilities of Samsung and NXP was interrupted for one day. Restarting the process took one month. If there were a two-week exercise around Taiwan during which supply into Taiwan comes to a halt, semiconductor production could come to a halt, causing possibly causing a semiconductor shortage, than perhaps worse than the one we experienced in 2020-2022.

The importance of joint efforts among like-minded countries

Regarding economic security, the world consists of potential breaking points. Once a crisis erupts, decoupling is not gradual anymore—it is sudden and extreme. The war in Ukraine was such a breaking point in our relations with Russia and being unprepared cost us dearly. There is a risk of East Asia being another breaking point. Prior to a conflict unfolding, top level leader meetings of like-minded countries are needed to assess reverse dependencies where China is specifically dependent on other countries and discuss appropriate sanctions before they are necessary. In December 2021, a European Council meeting took place where the European leaders announced that there would be massive consequences in case of an invasion of Ukraine by Russia, but no details of the sanctions were stipulated. Threats are a lot more credible if they are detailed and precise. Having learned the lessons from the Ukraine war, this is where Europe can take an active role.

Also, like-minded countries that do not have an economy as enormous as the U.S. should be much faster in precisely identifying critical goods that need to be reshored. For example, medicine is incredibly vital, and yet Japan, Europe and other like-minded countries have failed to take the necessary steps to ensure local production capacity. Europe is already seeing shortages right now and these are nothing compared to what the situation would be like if a crisis erupted in East Asia. While the U.S. has the advantages of an enormous economy and a hierarchical government and is pursuing reindustrialization across the board, other like-minded countries should build a system to help support mutual reindustrialization within each other's countries. Demand in one country can be used to stimulate production in a like-minded country. For example, the Netherlands could consider procuring permanent magnets for their wind turbine production from Japan—a like-minded country—instead of China, but currently the tenders are mainly based on price, making purchases of magnets from China more attractive . Finally, we should work on our strategic indispensability. We need to build up our strengths within critical value chains so that our economic deterrence efforts vis-à-vis China become more credible.

Q＆A

Q:
Taiwanese firms have made efforts to move semiconductor production overseas, such as TSMC’s investment in Arizona or in Kyushu. However, these efforts so far do not include leading-edge chips. How do you expect Taiwan’s overseas investment to develop in the future?

Joris TEER:
Taiwan is trying to strike a balance between accommodating its partners that see a risk in having semiconductor production concentrated in Taiwan while at the same time remaining strategically relevant. When I visited Taiwan in June 2023, I heard that Taiwan is diversifying, but total TSMC capacity in the U.S. would still be less than 5% and investments in capacity building outside of Taiwan in total are less than 10% of TSMC's production capacity. Even though new projects have been announced for Japan and the U.S.—including leading-edge chips—I expect that the combined investments will still be below 20%. I suppose Taiwan will continue its overseas investments with a focus on security of supply, ensuring that the U.S. military and the European automotive industry have access to the particular chips they require. However, the chips needed for the broader world economy will for a large part still come from Taiwan.

Q:
The approach of combining military and geoeconomic insights that you presented is very unique. Regarding the Taiwan crisis, there are two theories. One is that some ships to Japan or Korea will be stopped, leading to a stop of transportation and disruption of memory chip production in Korea and Japan. The other theory says that while rerouting may incur costs, by using a different route Japan and Korea may sustain their sea lanes. Which is correct?

Joris TEER:
What I stress to companies is that a multidisciplinary effort is needed to create a thorough risk analysis. Governments are used to inviting experts from think tanks to assist with military analysis, but for most companies this is a new approach. By including those experts in meetings with people in charge of different departments—such as human resources, supply chain management and procurement, asset management, or legal matters—new questions concerning each respective field will come up in the discussion, which is extremely important. While conducting mock attacks regarding cyber security (i.e., table top exercises) is common practice at most companies, for some reason supply chain stress tests are not carried out, even though these war scenarios likely are far more disruptive.
Regarding the resupply of South Korea and Japan, the situation is different from Taiwan. While war-related disruption would make it very difficult to sail through, Japan can indeed be reached from the other side and for Korea rerouting would also be physically possible, albeit more difficult. Therefore, this was kept open in the scenario presented. However, longer routes will also lead to disruptions, and an increase of prices and insurance costs.

Q:
How do European researchers, governments, or industries think about East Asian economies, or an East Asian crisis, as it might relate to their own national security?

Joris TEER:
As for the semiconductor clustering in Taiwan, to some extent the interests of Europe and the U.S. diverge from those of Taiwan itself. Especially from the U.S. there is pressure to diversify the semiconductor value chain. The U.S. compensates this with subsidies to TSMC, but there is an awkwardness because Europe and the U.S. are afraid of a crisis in East Asia and are therefore trying to have less manufacturing based in East Asia. On the other hand, from Japan's point of view, there is an interest in maintaining business, commerce, and production in Japan, for both commercial and geopolitical reasons. The primary objective should be to remove essential manufacturing on which the EU and Japan depend from China—and Russia—and diversify the dependence on Taiwan to strengthen resilience. This can be done by working together and redirecting procurement policies of governments and companies toward like-minded countries like Japan in the case of permanent magnets.

Q:
In Japan, there is some joint action between industries and the government. But how should individual companies prepare for this kind of crisis?

Joris TEER:
First, running military crisis stress tests is essential. Only by running such tests can companies identify hidden strategic dependencies, which can end up being the most dangerous. Second, investing in economic intelligence capabilities is also crucial. Overall, businesses should employ a much more geopolitical country strategy and not only consider production costs in a particular country, but also tensions, taking into account which countries are likely to side with which great power in the event of a conflict and what implications that decision would have. Finally, one of the key points is that Europe should learn from East Asia. In East Asian countries there is a closer relationship between business and the government, resulting in a much stronger industrial policy, which is where Europe is behind.