Treasure Island? Any Chinese attempt to capture Taiwan would be a high stakes gamble

According to Chairman Xi Jinping, the “reunification” of Taiwan with the Chinese mainland would fulfill the wishes of his country’s 1.4 billion citizens. Whether the Chinese people genuinely feel this way is unclear — like in Russia, conducting representative opinion polls in China is impossible — but there is little doubt that the government in Beijing sees Taiwan, with its significant microchip production capacity, as an increasingly attractive target. As a result, the task of developing a sanctions regime capable of deterring the world’s second-largest economy from embarking on such an aggressive step has become a necessary task for Western countries.

Why China needs Taiwan

Possessing Taiwan — if it could take the island cost free — would be advantageous for China when it comes to the country’s international trade, 60% of which is conducted by sea. China’s income and physical security depend on maritime routes, as it remains a net importer of food and energy. Even the Belt and Road initiative cannot eliminate China's maritime dependency, as ships must navigate through chains of islands belonging to various states, many of which are U.S. allies capable of blocking China's ocean access at any moment. A Taiwan under Beijing’s control would ensure that Chinese ships are no longer at risk of being trapped in coastal waters.

Control over these waters is also critically important for military strategic reasons. In the 1980s, former Chinese premier Deng Xiaoping's reforms moved the country’s financial and industrial centers to the coast, and development has been concentrated in these areas ever since, placing them in the strike zone of any potential attack from the east. Dean Cheng, a senior advisor to the China program at the United States Institute of Peace, wrote in 2022 that, “Placing surface-to-air missiles, radars, and aircraft with radar detection and guidance systems on Taiwan will allow Beijing to improve awareness of air and sea space in the central Pacific Ocean. This will significantly complicate attacks on China's economic center and provide much earlier warning of any sea or air attack. It will also increase the chances of intercepting cruise and ballistic missiles.”

Given Taiwan's technological prowess, particularly its leadership in the microchip market, Beijing also has economic interests at stake. Taiwan produces 60% of the world’s most advanced semiconductors, with Taiwan Semiconductor Manufacturing Corporation (TSMC) alone accounting for more than half of the global revenue of chip manufacturers. These enterprises are difficult to relocate, and if the plant remains undamaged during an invasion, China will likely attempt to utilize it.

This would grant Chinese businesses independence from external suppliers, a crucial goal that has been set for 2025. With the deadline for import substitution programs approaching, the return of Taiwan would significantly contribute to achieving these objectives, thus bolstering the ruling party, according to analysis from the Center for Economic and Policy Research (CEPR).

“In recent years, SMIC — a direct competitor to Taiwan's TSMC — has been actively developing in China, with former TSMC engineers heavily involved in its progress,” notes China expert Mikhail Korostikov. However, SMIC still significantly lags behind its rival in terms of quality. While TSMC has already mastered the production of 5-nanometer and 3-nanometer chips, China's SMIC can only comfortably produce 7-nanometer chips. Producing 5-nanometer chips comes at enormous cost and resource expenditure, and 3-nanometer chips are currently beyond its capability.

TSMC operates nine factories in Taiwan producing wafers for microprocessors (12-inch, 8-inch, and 6-inch) and five facilities for backend development. Additionally, the company has factories in China, the U.S., and Japan. TSMC also plans to invest in constructing a European Semiconductor Manufacturing Company plant in Dresden, Germany, with a launch date scheduled for around 2027.

Acquiring Taiwan's microchip production would not only reduce China's reliance on imports but also increase the world's dependence on China. This dependency would last for at least a few years before other countries could achieve production of comparable quality semiconductors from their own manufacturers, an effort the U.S. is already pursuing.

Possible sanctions

Given the size of the Chinese economy and its involvement in international relations, imposing truly harsh sanctions on Beijing if it decides to occupy Taiwan seems unfeasible, as such measures could harm the economic standing of the entire world. Instead, sanctions are likely to be targeted, focusing on vulnerable areas — and the range of such measures is limited.

One option in the West's arsenal is the “freezing” of reserves, a tactic already tested on Russia. China's foreign exchange reserves total $3.2 trillion (as of the end of June 2024), with 95% of this held in foreign currencies. While the exact composition of these reserves remains undisclosed, analysts estimate that about 89% are in G7 currencies. In addition to state reserves, China's banking sector holds international assets worth $1.5 trillion, most of which are also in G7 currencies. Thus, coordinated actions by the G7 could inflict significant damage on China, while the developed countries themselves would suffer much less, as only 2% of their reserves are stored in yuan.

Another measure previously applied to Russia is disconnecting the Central Bank of China and at least four of its largest commercial banks from the SWIFT international payment system. Currently, Chinese banks handle international transactions worth $6 trillion annually.

Freezing foreign exchange reserves and simultaneously disconnecting from the international banking system pose a risk of creating currency shortages, which could lead to a decline in the yuan's exchange value. In response to such sanctions, Beijing may impose controls over the foreign exchange market and exchange rates. However, to stabilize the balance of payments, authorities may have to allow the yuan to depreciate. This would likely result in higher import prices and inflation but could support exporters and mitigate the impact of sanctions on them.

Personal sanctions also cannot be ruled out, along with restrictions on companies or entire sectors, such as the defense industry and related economic spheres.

Implementing large-scale trade restrictions would be challenging. China is the largest supplier of goods to both the U.S. and the EU. Chinese goods constitute approximately 20% of all imports in Europe and 18% in the U.S. By comparison, before the war, Russia was the EU's third-largest supplier, with a share barely one-third the size (7.7% of all imports, and these primarily oil and gas rather than in manufactured goods). Russia was only America’s twentieth-largest trading partner.

However, China is not merely a supplier; it is also a significant market, ranking third for both the U.S. (after Mexico and Canada) and the EU. “They are very closely intertwined,” Korostikov emphasizes.

Simultaneously, China has pivoted towards the East, with Southeast Asian states emerging as its largest export market, surpassing the U.S. and Europe as of November 2023. In the past year alone, Chinese companies have invested a record $16.2 billion in Saudi Arabia, a marked increase from a base of just $1.3 billion in 2022.

Trade sanctions could involve revoking China's most-favored-nation status in the WTO, which would increase tariffs on Chinese goods and reduce their competitiveness. This could deal a significant blow to the Chinese economy, leading to a decline in exports that could impact approximately 100 million jobs. That's the number of people in China who depend on external demand, with nearly 45 million relying on G7 countries as a buyer of last resort. With restrictive import measures from China, most of these jobs could be at risk, at least temporarily.

However, an ongoing trade conflict between the U.S. and China began years ago, with America already imposing restrictions on the export of strategically important goods, such as chips and military technologies, to China. If the conflict escalates, the range of goods affected and the severity of measures could increase as well. At its extreme, measures might include a complete embargo on bilateral trade. However, even with Russia, on which the U.S. relies much less for trade, a complete trade embargo was not feasible. As is evident from that example, goods can be supplied via routes that bypass sanctions.

How China is preparing

“In China, they closely monitor, analyze, and write articles on Russia's anti-sanction policy,” notes Korostikov. Chinese economists conclude that it is necessary to control the circulation of their currency and establish their own infrastructure for information exchange between banks. “In this regard, China is doing much better than Russia, thanks to the CIPS system — an analog of SWIFT — used in more than a hundred countries worldwide.”

China has also started purchasing record amounts of gold, accumulating reserves valued at $170 billion.

China aims to play an increasingly important role in the international supply chain while relying more on its own strength. This is the essence of the “dual circulation” concept announced by Xi Jinping in 2020, which aims to boost domestic market consumption and attract foreign investment. The long-term goal is to minimize the Chinese economy's dependence on foreign markets and technologies.

“What was previously produced and sent to the United States is now being redirected to the domestic market through various stimulation measures,” explains Korostikov. “Before the pandemic, this strategy worked relatively well. However, after the pandemic, growth has been weak; people are buying less and saving more, so the policy can't yet be deemed successful.”

Another plan called “Made in China 2025,” which was launched in 2015, aims to transform China from a “world factory” producing low-quality, cheap goods using its lower labor costs and supply chain advantages, into a supplier of high-value goods and services. The first of three planned steps will conclude next year. However, China has not yet fully achieved this transformation. The program has incurred significant costs for the economy and strained relations with trading partners, who have also begun prioritizing their own producers. Additionally, the Chinese firms that received support have not always used it efficiently.

Experts largely conclude that such steps do not constitute preparations for war. “China is currently acting on the assumption that tensions with the United States and the West are quite serious and are unlikely to decrease in the near future,” says Scott Kennedy, an expert on China's economy at the Center for Strategic and International Studies (CSIS). “At the same time, this is still quite different from preparing for a real war and what would follow it.”

Korostikov agrees: “None of these measures are being introduced with the expectation of an imminent attack on Taiwan. I don't believe we will see such an attack in the next 5-10 years,” he said.

In addition, China's economy is slowing down, meaning that the authorities have fewer and fewer tools at their disposal to mitigate the economic damage from sanctions.

Bonuses for Russia

“It will be the best day in Vladimir Putin's life if China attacks Taiwan,” Korostikov believes. “China would be cut off from natural gas supplies from Australia and the U.S., and access for oil tankers from Iran and the Persian Gulf countries through the Strait of Malacca would likely be blocked. The only place to make up for these losses would be Russia. A golden shower will pour on Vladimir Putin. It will be in yuan, though, but that's not a big problem. Russia will simply buy even more of everything from China.”

After the hypothetical attack on Taiwan — or possibly even before it — China and Russia might agree to form a military alliance. Currently, no such formalized structure or mutual obligations exist. “Then an active transfer of military technologies between the countries may begin,” Korostikov reasons. However, he emphasizes that “the probability of this is extremely low, because the Chinese leadership is very rational.”