Scared Strait: Understanding the Economic and Financial Impacts of a Taiwan Crisis
Following Russia’s invasion of Ukraine and Beijing’s demonstrations of force against Taiwan since 2022, Western governments and corporate boardrooms have increasingly debated the likelihood, timing, and methods of a possible invasion or blockade of Taiwan by the People’s Republic of China (PRC).
Yet the real economic and financial dimensions of a potential cross-strait conflict remain underemphasized in this policy discourse. All realistic scenarios of PRC aggression will induce fast-moving and unpredictable dynamics, many of which would manifest before the outbreak of hostilities. The Taiwan Strait is central to global maritime trade, and Taiwan is the world’s most advanced and critical semiconductor manufacturing hub. For its own part, China remains an important manufacturing and trade partner for advanced and developing economies. As such, any crisis or conflict in the Taiwan Strait would impose substantial costs on China, the United States and its allies and partners, and the global economy.
Over the past year, the CSIS Freeman Chair—along with experts from the CSIS Economics Program and CSIS Japan Chair—organized a series of closed-door Taiwan scenario exercises with members of the private sector, including hedge funds, venture capitalists, private equity, pension funds, investment banks, and multinational corporations (MNCs) from various industries. Unlike traditional tabletop exercises or war games, which often (and perhaps necessarily) hold the global economy constant or otherwise use formal models to estimate the economic impact of a Taiwan crisis, these CSIS scenarios seek to understand firm psychology by asking private sector actors to approximate how they would navigate and respond to various geopolitical shocks in the Taiwan Strait, ranging from an accidental collision to a full-scale invasion.
While the magnitude and pattern of economic and financial impacts depend on the precise nature and sequencing of events, the results from these exercises nonetheless provide some broad parameters for how investors and companies make decisions in an environment of uncertainty and imperfect information. Here are some main takeaways from these exercises.
- Market actors are getting better at understanding Taiwan-related risks. Since Representative Nancy Pelosi’s visit to Taiwan in August 2022, investors and MNCs have developed a more sophisticated awareness of cross-strait dynamics. They have already priced in or planned for some risk and will not overreact to events that fall within their assessed baseline range. This would even include large-scale PRC military actions that are judged to be temporary in nature, such as the People’s Liberation Army (PLA) exercises in the wake of Pelosi’s Taiwan visit, which did not elicit a severe market response largely because events played out in ways that the private sector predicted. Assuming that Beijing reacts to the upcoming elections in Taiwan in ways that are broadly in line with expectations, market reactions will be relatively subdued.
- Investors are already souring on China (at the margin). Many of the scenario participants state that even if a narrower crisis can be de-escalated or averted, it is only a matter of time before a larger crisis emerges, so better to leave the Chinese market sooner than later.
- Investors and companies have internalized a view that the Chinese leadership under Xi Jinping might be less open to negotiation or compromise during a crisis than previous Chinese leaders. The same, however, goes for assessments of the domestic political constraints on the White House, which is operating in an environment of intense scrutiny from Congress and the public at large.
- Many investors believe that China’s political and regulatory environment has already become more problematic, and so the opportunity cost of exiting their China positions is decreasing.
- Novel and unpredicted scenarios drive volatility. More fluid and severe market activity follows events that depart from baseline expectations or novel situations where financial firms and MNCs anticipate severe financial disruptions—even those that fall short of extreme scenarios such as a blockade or invasion of Taiwan.
- Markets might react well in advance of actual physical disruptions or shortages, and if uncertainty were high enough, might shift into “flight to safety” mode even if some experts believed that de-escalation was likely. Even for firms with a more accurate understanding of this de-escalation, their behavior would be influenced by the perceived costs of being late to exit.
- Consider, for example, a possible collision between a Chinese and Taiwan fighter jet, a scenario that has a higher probability than more extreme scenarios. Even assuming such a scenario would be resolved diplomatically, as was the case in the 2001 collision between a PLA interceptor and a U.S. Navy signals intelligence aircraft, negative market reactions would occur almost immediately. In such a scenario, negative market reactions would occur almost immediately. “Fast money” hedge funds would be among the first to react, potentially selling off large portions of their China and Taiwan exposure and proactively dumping their holdings of Chinese companies listed on U.S. stock exchanges in anticipation of sanctions. MNCs with dependencies in China, would see a noticeable market sell-off as investors anticipate a possible continuation or expansion of the crisis. All of this might occur in the opening hours of an early-stage crisis before it even becomes clear if it will escalate.
- Uncertainty about the United States reaction also drives volatility. Uncertainty about U.S. actions in a developing crisis, including military responses, would likely amplify early market reactions. Perceptions of differing responses to the crisis in other key capitals, such as Japan and Australia—or perceptions that other U.S. allies assess a lower risk of conflict or are unsupportive of the U.S. response—would exacerbate this uncertainty.
- The threat of sanctions matters. Clear and credible signaling from the United States, along with key allies such as Japan and the major European economies, that PRC use of force would be met with sweeping and united financial sanctions, export controls, and other steps, would accelerate these reactions in the financial markets.
- The conflict is the sanction. At the same time, if military conflict occurred, or was perceived to be imminent, the financial market responses would far exceed the impact of financial sanctions, at least in the near term. China, and the global economy, would pay a severe price for a conflict over Taiwan, regardless of whether the major economies were united in imposing sanctions.
- Real economy impacts would be slower to emerge. For impacts on the real economy to reach the level of financial market responses, there would likely need to be a blockade or combat between U.S. and Chinese forces, or other such dynamics that would lead to actual damage to physical capital, threats to the safety of employees, capital controls, or disruptions of supply chains.
- Impacts to the real economy from financial distress would only be substantial if the crisis and uncertainty were prolonged.
- While all lose in a conflict, China might lose more. If an acute Taiwan crisis were resolved diplomatically and both sides deescalated, the scarring effects would be larger for China and Taiwan than Western markets, because of concerns that the status quo ante could not be restored, and another crisis could occur.
- At a certain point, market participants would consider geopolitical uncertainties too high relative to expected profits and China could become "uninvestable," which some investors have already said is the case. The risks of such a shift in foreign investor sentiment increase as China's economic performance appears to weaken.
A consistent finding from these scenario exercises has been that there is an understanding gap between government and private sector, with both making guesses or assumptions about what the other would do during moments of uncertainty. Perhaps such a gap can never be bridged, but future CSIS work will attempt to narrow the band of ignorance and misunderstanding.
Jude Blanchette holds the Freeman Chair in China Studies at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Gerard DiPippo is the senior geoeconomics analyst at Bloomberg Economics. He previously was a senior fellow in the CSIS Economics Program. Christopher Johnstone is senior adviser and Japan Chair at CSIS.