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Emerging tail-risk: An invasion of Taiwan

Summary:
I am not in the habit of peddling conspiracy theories, but this is inadvertently becoming a Halloween tradition. Last Halloween, I wrote about how China could control Taiwan without firing a shot (see Scary Halloween story: How a weak USD could hand China a major victory). This year, a new geopolitical tail-risk is materializing for investors and for global stability. China’s People’s Daily recently published a “Letter to Taiwan’s Intelligence Organs” warning Taiwanese intelligence agencies against supporting President Tsai Ing-wen’s resistance to China’s unification efforts (article in Chinese here, Facebook summary in English here). People’s Daily on Thursday urged intelligence agencies in Taiwan to stay away from the “fatal track” of seeking Taiwan’s independence, which only leads to

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I am not in the habit of peddling conspiracy theories, but this is inadvertently becoming a Halloween tradition. Last Halloween, I wrote about how China could control Taiwan without firing a shot (see Scary Halloween story: How a weak USD could hand China a major victory). This year, a new geopolitical tail-risk is materializing for investors and for global stability. China’s People’s Daily recently published a “Letter to Taiwan’s Intelligence Organs” warning Taiwanese intelligence agencies against supporting President Tsai Ing-wen’s resistance to China’s unification efforts (article in Chinese here, Facebook summary in English here).

People’s Daily on Thursday urged intelligence agencies in Taiwan to stay away from the “fatal track” of seeking Taiwan’s independence, which only leads to self-annihilation and is doomed to fail.
 

In the released Message to Taiwan’s Intelligence agencies, the Chinese mainland firmly opposed those independence-seeking diehards of the blind to allay their tiger-riding behaviors, and advised them to get a clear understanding of the situation and get back to the correct track, the only correct way of stopping them from dead ends.
 

“Don’t say I didn’t warn you,” said the message.
 

The message also reiterated that the Chinese mainland and Taiwan island share the same blood and same culture, and the mainland always welcomes variety of cooperation through different channels and encourages exchanges and dialogues with people of insight in Taiwan.

The warning was little noticed by most Western media. What was ominous was the phrase, “Don’t say I didn’t warn you” (勿谓言之不预也). Similar language was used by China when it launched military offensives in the past. It used that phrasing when it issued a “surrender or die” ultimatum to the nationalist garrison in Beijing in 1949. it warned American-led forces in Korea not to approach its Yalu River border in 1950; it warned India before attacking in 1962; and it issued a similar warning before the invasion of Vietnam in 1978.
 

Emerging tail-risk: An invasion of Taiwan

This is not a drill.
 

A newly triumphal China

The Chinese Communist Party held its plenum last week. Deliberations were behind closed doors, but if there is a theme to this year’s session, it would be what Vice Premier Liu said in a recent speech, “Now the bad things are turning into good ones.”
 

The new swagger is shown by China’s latest PMI, which has bounced back strongly compared to the rest of the world.
 

Emerging tail-risk: An invasion of Taiwan

The new assertiveness is just part of a long-lived effort by Beijing to flex its geopolitical muscles. Arguably, it began when China established bases on artificial islands in the South China Sea to assert its claim in the region. It is also manifested in China’s increasingly coercive “wolf warrior” diplomacy, which Wikipedia explained as “an aggressive style of diplomacy purported to be adopted by Chinese diplomats in the 21st century. The term was coined from a Rambo-style Chinese action movie, Wolf Warrior.”
 

The result of the “wolf warrior” style can be seen in a Pew Research Center poll of attitudes on China and Xi Jinping. The recent surge in negative ratings is remarkable, especially among Asian trading partners like Australia and South Korea.
 

Emerging tail-risk: An invasion of Taiwan

China has already abrogated the “one country, two systems” principles in Hong Kong. What’s next?  A move against Taiwan?
 

The bloodless coup

A year ago, I detailed how China could dominate Taiwan in a bloodless coup (see Scary Halloween story: How a weak USD could hand China a major victory). A Bloomberg article detailed Taiwan’s financial vulnerability. The Taiwanese were putting too much of their savings into life insurance products:

Taiwan’s chief financial regulator is urging people to stop using life insurance as a way to make money and he points to his own family as part of the problem.
 

The widespread use of life insurance as a wealth-management product has made Taiwan into the most insured market in the world. But it has also created a level of competition and reckless offers that threaten the stability of an industry with $876 billion in assets, the Financial Supervisory Commission Chairman Wellington Koo said in an interview Monday.
 

“Insurance isn’t the same as savings. It’s not a wealth management product,” Koo said. “You shouldn’t take out an insurance policy instead of a wealth management product just because your bank only offers 1% on your savings.”
 

The problem is one Koo is personally aware of. The 60-year-old readily admits he and his wife, Taiwan’s deputy economics minister Wang Mei-hua, have nine high-return fixed term insurance policies between them. He says they were taken out on his behalf by his mother on the advice of staff at her local bank.

Here is the problem. The liabilities of Taiwanese life insurance is denominated in TWD, but they don`t have enough investment opportunities in Taiwan. The WSJ reported that they have instead invested mostly in US corporate debt.

Asia’s insurance behemoths, particularly in Taiwan, pose a growing risk to the U.S. corporate-bond market after a multiyear binge on greenback debt.
 

Insurers in Asia’s more developed economies have promised returns far greater than their government-bond markets can provide, and they need to hold far more assets than their domestic bond markets can satisfy.
 

That has left them fishing for other sources of returns, most notably in the U.S. corporate-bond market. South Korea, Japan and Taiwan’s holdings of U.S. dollar corporate bonds have more than doubled to over $800 billion in the past five years, according to the International Monetary Fund’s global financial stability report, published last week.
 

Corporate bond markets in the U.S. and the eurozone are 81% and 41% of the size of their life insurers’ total assets, respectively. In Korea, Taiwan and Japan, the respective figures are 10%, 8% and 4%.

While all Asian life insurers have foreign exposure, Marketwatch observed that the size of Taiwan`s exposure dwarfs all others. Taiwanese life insurers’ financial stability came to US$540 billion in foreign assets, that’s nearly Taiwan’s US$600 billion in GDP.
 

Emerging tail-risk: An invasion of Taiwan

While some of the foreign currency exposure is hedged, much of the hedge book risk is borne by CBC, Taiwan’s central bank. In effect, any significant depreciation in the USD could collapse the Taiwanese financial system, not just because of life insurers’ exposure, but the implicit cheap hedge provided by the CBC. What’s more, the CBC has actively suppressed the TWD by providing this hedge.
 

Imagine the following scenario. The PBoC begins to sell its USD holdings to buy TWD assets, which drives up the TWDUSD exchange rate. The Taiwanese financial system gets strained. At what point does it implode? 
Once Taiwan’s financial system collapses, a friendly China state-owned financial company graciously steps in to offer a lifeline by buying the life insurers and banks at pennies on the dollar. A Chinese SOE now owns the Taiwanese financial system, and Beijing is in control of Taiwan’s entire financial system – all without firing a shot.
Taiwan’s GDP is roughly $600 billion. The PBoC’s assets are about $3 trillion. What price will Beijing pay to get Taiwan back?
 

The military option

Instead of a soft takeover of Taiwan, Beijing could opt for the hard military option. As the Chinese economy grew, it was inevitable that spending on the People’s Liberation Army (PLA) would dwarf Taiwanese military spending. Indeed, Taiwan’s Ministry of Defense reported in 2013 that China had developed a plan to invade Taiwan by 2020 at the 18th National Congress. Moreover, the 100-year anniversary of the Communist Party in 2021 will raise pressure on Xi to show progress towards “unification”.
 

Emerging tail-risk: An invasion of Taiwan

Beijing seems to be entering a new phase in its military actions. In the past, PLA warplanes have probed Taiwan’s air defenses but stopped at the “median line” separating Taiwan and the Mainland that served as an unofficial boundary. In recent months, PLA fighters have sortied in numbers, and ignored the median line as it became more assertive in its sorties.
 

What is China were to invade? DEFCON Warning Systems reported that repeated Pentagon wargames have usually resulted in victories for the Chinese side.

The Red Team, composed of experts on the Chinese military, aims to use all available forces to capture Taiwan, the island 90 miles off the coast that China regards as a renegade province and that it has repeatedly vowed to retake, by force if necessary.
 

The Blue Team, made up U.S. military personnel with operational experience — fighter pilots, cyber warriors, space experts, missile defense specialists – must try to defeat the Chinese invasion.
 

It doesn’t generally go well for the Blue Team.
 

“It’s had its ass handed to it for years,” David A. Ochmanek, a former deputy assistant secretary of defense for force development and now a defense analyst at Rand, told RealClearInvestigations. “For years the Blue Team has been in shock because they didn’t realize how badly off they were in a confrontation with China.”

The assault would begin with airstrikes on American bases in the region.

;If China felt that the U.S. would intervene, military planners from the Pentagon and Rand who have gamed out scenarios believe a war over Taiwan would most likely begin with a massive attack by advanced Chinese missiles against three American targets: its bases on Okinawa and Guam, its ships in the Western Pacific, including aircraft carrier groups, and its air force squadrons in the region. 

The initial landings would be conducted by airborne troops. When the paratroopers have secured beachheads, the follow-up force would then come by sea.

“They are giving off a lot of signals about how this campaign would unfold,” Lyle J. Goldstein, a China and Russia specialist at the Naval War College in Rhode Island, told RCI. “They’re talking a lot about airborne assault in two varieties, by parachute and by helicopters. It’s what’s called vertical envelopment. Amphibious assault is old school. It may be necessary but it’s not the main military effort.  The new school is to bring lead elements over by air, secure the terrain and then bring in more forces over the beach. The intensity and scale of training in the Chinese military now for airborne assault is, to me, shocking.
 

“There would be 15, maybe 20 different landings on the island, east, west, north, and south, all at once, some frogmen, some purely airborne troops,” Goldstein continued, saying he was expressing his own views, not official assessments of the U.S. “The Chinese high command would watch these bridgeheads to see which of them is working, while the Taiwan command is looking at this amid decapitation attempts and massive rocket and air assaults. The Chinese would seize several beachheads and airports.  Their engineering prowess would come into play in deploying specialized floating dock apparatuses to ensure a steady flow of supplies and reinforcements—a key element. My appraisal is that Taiwan would fold in a week or two.”

While Taiwan’s military appears to be impressive on paper, its actual capabilities are suspect. Foreign Policy reported that a recent suicide revealed “the disastrous logistics of an undersupplied army”: Taiwan’s Military Has Flashy American Weapons but No Ammo,

As Taiwanese politicians showcase flashy U.S. weapons bought with taxpayers’ money, the logistics inside the military remain so abysmal that a young army officer killed himself after being pressured to buy repair parts out of his own pocket.
 

Huang Zhi-jie was a 30-year-old lieutenant in the Taiwanese army. Initially serving in the airborne troops as an enlisted soldier, Huang was so committed that he requested officer training—normally considered more work for little reward—and was later commissioned as a lieutenant in charge of a maintenance depot of the 269th Mechanized Infantry Brigade. Huang was supposed to be the model soldier of which Taiwan desperately wanted more: a young, college-educated volunteer who chose to serve the country out of his own volition, at a time when the military was still facing difficult transition from conscription to an all-volunteer military.
 

But on the night of April 16, Huang hung himself on a dark staircase by his base’s mess hall. Initially his death was not even reported in the Taiwanese media, until Huang’s mother took to Facebook in a long open letter appealing to President Tsai Ing-wen for an investigation.
 

In an emotional press conference, Huang’s mother alleged that her son was subjected to hazing by his superior officers, and that he was pressured to procure tools and spare repair parts out of his own pocket. Screenshots of private messages, receipts, and photos of items purchased by Huang were shown to the public as proof. For some time before Huang’s death, the novice lieutenant was desperately trying to make up for the shortages in his depot by buying a variety of items like repair hammers and fire buckets from the civilian market. Huang’s brother even used a U.S. website in Arizona to purchase a pair of spark plug gap gauges for him that used imperial measurements instead of metric ones.

The shocking part of this incident is it occurred at one of Taiwan’s frontline military units, indicating a lack of readiness among Taiwanese forces.

Even worse, the 269th Mechanized Infantry Brigade isn’t some rear-echelon unit but a major combat formation strategically stationed around the outskirt of Taoyuan City, northern Taiwan. It is expected to bear the brunt of ground fighting to stop any invading Chinese troops from reaching the basin of Taipei, Taiwan’s capital. If the 269th is in such bad material shape, how about the rest of the Taiwanese military?

An article in The Economist came to a similar conclusion about military readiness in Taiwan.

Alas, Taiwan’s preparedness and its will to fight both look shaky. “The sad truth is that Taiwan’s army has trouble with training across the board,” says Tanner Greer, an analyst who spent nine months studying the island’s defences last year. “I have met artillery observers who have never seen their own mortars fired.” Despite long-standing efforts to make the island indigestible, Taiwan’s armed forces are still overinvested in warplanes and tanks. Many insiders are accordingly pessimistic about its ability to hold out. Mr Greer says that of two dozen conscripts he interviewed, “only one was more confident in Taiwan’s ability to resist China after going through the conscript system.” Less than half of Taiwanese polled in August evinced a willingness to fight if war came.

America’s response

Should China decide to invade, how would Washington react? The DEFCON Warning Systems article stated that the cost to American forces would be high, and at a level not seen since the Vietnam War.

“We’re playing an away game against China,” Rand’s Ochmanek said. “When bases are subjected to repeated attacks, it makes it exponentially more difficult to project power far away.”
 

“The casualties that the Chinese could inflict on us could be staggering,” said Timothy Heath, a senior international defense researcher at Rand and formerly a China analyst at the U.S. Pacific Command headquarters in Hawaii. “Anti-ship cruise missiles could knock out U.S. carriers and warships; surface-to-air missiles could destroy our fighters and bombers.”

Much depends on the outcome of the election. President Trump has shown himself to be very transactional in his approach to foreign policy. Would he commit to defending Taiwan under such a scenario? An article in The Atlantic cast Trump as someone in the “Paul Kennedy” school in his conduct of American foreign policy.

When Trump’s first book, The Art of the Deal, was atop best-seller charts in the late 1980s, second on the list was a scholarly work called The Rise and Fall of the Great Powers, by the Yale professor Paul Kennedy. That book warned that the U.S. could not sustain a policy of global supremacy indefinitely while its relative wealth continued to fall. The U.S. had risen to dominance in the aftermath of Europe’s implosion after World War II, but, Kennedy argued, this was an abnormality.
 

The challenge for America, he wrote, was to bring into balance its means and its commitments. In effect, whether it liked it or not, America was moving from being the only power that mattered to the greatest power in a world of them. The book, published in 1987, came out just before the fall of the Soviet Union and America’s unipolar moment of glory. Its central warning, however, has boomeranged back into relevance.
 

Trump may have no idea that he is revealing any of this; he may not even agree with the things he is revealing. Yet he is revealing them nonetheless. “He’s a Paul Kennedy, Rise and Fall of the Great Powersperson,” Fiona Hill, Trump’s former senior director on European and Russian affairs at the National Security Council, told us, before adding: “Though I doubt he ever read the book.”

Trump’s America First philosophy has inadvertently asked some very good and uncomfortable questions about the direction of American foreign policy in the post-World War II era. 
After decades of international adventures that have left the U.S. overstretched, overwhelmed, and overburdened, it was Trump who blurted out the uncomfortable truth: American foreign policy was failing, and had been for decades.
Through a combination of hubris, ignorance, instinct, and ego, he pointed at the reality and demanded to know why it was being allowed to continue. Why was America still fighting wars in the Middle East and elsewhere? Why wasn’t it partnering with Russia against Islamist jihadists? Why was China allowed to abuse the rules of the game? Why were American workers losing their jobs to poorer countries? And why were so-called allies in Europe allowed to place high tariffs on American produce while American workers paid for their defense? Were these countries even allies at all?
Joe Biden, on the other hand, is a long-time member of a foreign policy establishment. He would be in favor of engagement with America’s allies and recently denounced Xi Jinping as a “thug”. Reading between the lines of the Democratic Party platform, I interpret it to mean that a Biden White House would commit to coming to the aid of Taiwan in case of attack.
Democrats’ approach to China will be guided by America’s national interests and the interests of our allies, and draw on the sources of American strength—the openness of our society, the dynamism of our economy, and the power of our alliances to shape and enforce international norms that reflect our values. Undermining those strengths will not make us “tough on China.” It would be a gift to the Chinese Communist Party…
Democrats believe the China challenge is not primarily a military one, but we will deter and respond to aggression. We will underscore our global commitment to freedom of navigation and resist the Chinese military’s intimidation in the South China Sea. Democrats are committed to the Taiwan Relations Act and will continue to support a peaceful resolution of cross-strait issues consistent with the wishes and best interests of the people of Taiwan.
That said, a retreat from Taiwan, regardless if it’s voluntary or involuntary, would send shockwaves around the world. It would brand America as a fading global power, in the manner of Britain and France after the Suez Crisis of 1956.

Threat assessment

Let me make this clear, an invasion of Taiwan is not my base case scenario, but it does represent a significant tail-risk for investors and for global stability. 
As we enter November, the weather in the South China Sea becomes too unpredictable to support an immediate invasion. However, China’s “Don’t say I didn’t warn you” warnings have been followed up by military action several months later. 
There are some milestones to watch. Keep an eye on how the Oracle and Walmart proposed purchase of in TikTok’s US operation is resolved in the coming days. That transaction requires approval from the US Committee on Foreign Investment after the election, but within a November 12 deadline. The next hurdle is China’s approval to allow ByteDance sell TikTok’s U.S. platform.
Notwithstanding the details of the TikTok deal, also monitor the TWDUSD exchange rate for a possible Chinese attack on the Taiwanese financial system. As well, watch for reports of that satellite reconnaissance indicating possible PLA buildup of forces in preparation for an attack.

Hedging against an attack

For investors, the consequence of a Chinese invasion of Taiwan would be a horrific risk-off episode. However, hedging against such an outcome can be problematic. The behavior of conventional risk-off havens such as the USD, JPY, and gold is dependent on how any potential conflict unfolds. The JPY may not be a safe haven in light of Japan’s geographic proximity. USD assets, such as Treasuries, may serve as a counterweight to risky assets to stocks, but it depends on the level of American involvement in the conflict. Similarly, gold prices may spike during wartime, but it tends to be inversely correlated to the USD, and a USD rally could pose a headwind for gold prices.
A better hedging vehicle that acts well in a war, but may not create a drag on portfolio returns is the Aerospace and Defense industry. The long-term relative performance of this group is characterized by a stair-step pattern of relative uptrend, followed by a period of consolidation. These stocks were battered in the last year by the difficulties experienced by Boeing and its 737 Max. From a technical perspective, the relative return of this group against the S&P 500 has exhibited a positive RSI divergence, which is constructive.
Emerging tail-risk: An invasion of Taiwan
In the ancient Chinese text, The Art of War, Sun Tzu wrote that a general could win by arraying his forces to exploit his enemy`s weaknesses. That way, he can achieve victory without bloodshed if it becomes evident that the enemy will collapse before any fighting begins. Watch the preparations for war, and be prepared to hedge accordingly. That way, you won’t be surprised by developments.
Don’t say I didn’t warn you.
About Cam Hui
Cam Hui
Cam Hui has been professionally involved in the financial markets since 1985 in a variety of roles, both as an equity portfolio manager and as a sell-side analyst. He graduated with a degree in Computer Science from the University of British Columbia in 1980 and obtained his CFA Charter in 1989. He is left & right brained modeler of quantitative investment systems. Blogs at Humble Student of the Markets.

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