China-Taiwan Showdown Involves Politics, PCs

By Glenn Smith

A politically savvy jingle in China goes: Visit Beijing, and you discover you're nobody. Visit Shanghai, and you learn you're poor. Visit Taiwan, and you relive the Cultural Revolution.

Translated, it doesn't rhyme, nor is it fully up to date. A week ago Saturday, Taiwan's "cultural revolution" – an allusion to the real Cultural Revolution that derailed China in the 1960s – was dealt a severe blow.

President Chen Shui-bian resigned as Chairman of the Democratic Progressive Party (DPP) after his party suffered a humiliating defeat in a legislative election. The opposition KMT, or Nationalist Party, won by a landslide, taking 81 seats, compared to the DPP's 27, out of the body's total of 113 seats.

"This is the worst defeat since the founding of the DPP," Chen said, after the vote was counted. Analysts say the KMT's victory shows that Taiwan's citizens want an end to bitter partisan fighting that marked Mr. Chen's two terms in office, and they are alarmed by his plan to hold a referendum on a bid for the island to enter the United Nations under the name Taiwan rather than the usual Republic of China. The Bush Administration called Chen's referendum "provocative," and China sees it as nothing short of sedition. More uncertainty looms ahead, as Taiwan will elect a new president on March 22.

So why should you care?

Here's why. Because if things fall apart and a Tom Clancy scenario unfolds in the Taiwan Strait you can forget about upgrading your PC or laptop for a while. The hundred miles of shallow seas separating Taiwan and China happen to be the most important yet most precarious link in the global ICT supply chain.

So much is at stake for information technology companies – not to mention the global economy – that one of the founders of the island's semiconductor industry, Robert Tsao, former head of United Microelectronics Corporation, the second largest IC foundry in the world, began placing full-page advertisements in major newspapers asking the DPP to abandon political behavior that could be viewed as antagonistic toward China.

This is a rare move for one of Taiwan's normally apolitical technological and industrial elite. "If you look back, you'll see that business leaders avoided being linked to either party, and tried to cooperate with government policy," said Andrew N. C. Yang, Secretary General of the Chinese Council of Advanced Policy Studies (CAPS) and faculty at National Sun Yat-sen University, Taiwan.

"Now they are being proactive and speaking out," Yang added. "They see the negative U.S. reaction [to President Chen's actions] on one hand, while they see no advantages on the other. Much is at stake, and they want to preserve the status quo in Taiwan and China relations to avoid a possible disaster."

An uneasy relationship

For decades, diplomatic relations between Taiwan and China have been a geopolitical version of the ultimate "COPS" rerun. There is a sloppy domestic dispute that flares every few years, often before a Taiwan election and always whenever the word "independence" is uttered by a politician. The world watches, like officers in uniform, bored yet vigilant about possible weapons in the house.

Taiwan's next presidential election is on March 22, and President Chen has attached a public referendum on UN entry to the ballot.

"China sees the Chen referendum as another identifiable, incremental step towards independence," said Rupert Hammond-Chambers, president of the Washington-based U.S.-Taiwan Business Council. "To the Chinese it is another illustration of the thin edge of the wedge – [with Taiwan] continuing to make not one big step and formally declare independence but instead continuing to take smaller steps that chip away at the legacy fabric."

To Beijing, this is tantamount to sedition. In fact, on March 14, 2005, sensing that pro-independence President Chen might embark on such an adventure while China is straddled with the onerous task of playing nice during the build up to the 2008 Summer Olympics, Beijing passed an Anti-Secession Law.

This spy-versus-spy battle of wits has been going on since 1949 when Chiang Kai-shek fled China with his troops and established a provisional government in Taiwan. China, oddly enough, believes the island is its territory as promised by Roosevelt, Churchill and Stalin – and Generalissmo Chiang for the Republic of China [ROC] -- in the 1943 Cairo Declaration.

Yet if ever there is a last chance that the Taiwan-China dysfunctional duet could miss a beat, then this is it.

Even a minor slip could send the NASDAQ plummeting. "What you have is not just a China-Taiwan bilateral trade relationship that surpassed $100 billion last year," said Hammond-Chambers. "China's export machine is driven by the complex intertwined relationships with Taiwan's suppliers on Taiwan and Taiwan manufacturers based in China clustered around major Taiwan ODM/OEMs who are exporting from China to the global market -- the U.S., Europe and increasingly the Middle East."

Hundreds of billions of dollars in world trade depend on this Taiwan-China relationship.

Somehow the genius of globalization -- Adam Smith's "Invisible Hand" – has located the workshops of the digital age on opposite sides of the Taiwan Strait. But, there is a twenty year technology gap between them. In effect, tiny Taiwan is the ODM/OEM brains and gargantuan China is the dumb, assembly brawn. Neither can exist without the other.

Made in China, designed in Taiwan

Consider these trade statistics:

China already surpasses the U.S. as the world's leading exporter of ICT (information and communication technology) products. In 2004, China's export totaled $180 billion versus $149 billion for the U.S, $139 billion for the EU and $124 billion for Japan, according to the Organization for Economic Co-operation and Development (OECD).

Yet the Made-in-China label is misleading because most of these electronics goods were designed by a Taiwan company, then assembled by the Taiwan company's factory in China before being shipped abroad. Taiwan manufacturers virtually own many ICT product categories, and their global market penetrations are startling if not unfathomable.

Taiwan is the world's number one volume supplier of motherboards, WLAN NIC cards, VoIP routers, laptops, DSL customer premises equipment, cable modems, IP phones, PDAs, VoIP terminals, LCD monitors, switches, WLAN access points, color tube monitors and large LCD panels.

For all of these products, Taiwan commands more than half of the global market share's dollar value, according to data from Taiwan's Institute for Information Industry (III), part of its national Market Intelligence Center (MIC).

Take, for example, motherboards. In 2006, Taiwan commanded a 99.0 percent world share, and one company, Hon Hai Precision, made most of them. That same year 86.2 percent of the world's notebooks were built by Taiwan companies, one of which, Quanta Computer, sometimes commands as much as three quarters of production.

But Hon Hai Precision, Quanta and other Taiwan ICT companies manufacture their products in China.

Of Taiwan's total ICT output of $89.6 billion in 2006, only 4 percent was made in factories on the island. Instead the bulk – 85 percent – was made in China.

For Taiwan, ICT assembly is just so '80s. The Taiwan government readily grants approval to Taiwan companies seeking to manufacture in China, the only exceptions being TFT-LCD lenses and semiconductors.

Two of Taiwan's science-based industrial parks – one in northern Hsinchu and the other in southern Tainan – are strategically clustered zones for semiconductor production. Here one finds the world's two largest IC foundries, the number one ranked, Taiwan Semiconductor Manufacturing Company (TSMC) and the aforementioned, number two, UMC. Next come more than a hundred fabless chipmakers – design houses that rely on dedicated foundries to make their chips. Then, further downstream, there are packagers and testers.

This industrial model – called vertical disintegration -- was created in Taiwan in the 1980s to maximize flexibility between product generations and demand cycles. Still, Taiwan has more fabs, and even IDMs – vertically integrated chip makers that do everything in-house, from design, fabrication, packaging and testing. All told, there are eleven 12-inch wafer and 21 8-inch wafer fabs on the island. On Taiwan sits 19 percent of the world's IC production capacity, and in 2006, $42.9 billion worth of ICs were produced here.

For a decade, China has been playing catch up, and foreign firms have poured in money and expertise to assure themselves a piece of the action.

Until recently, Taiwan's government has prohibited its own semiconductor makers from joining the fray.

Robert Tsao, of UMC, somehow ran afoul of this policy. Or maybe he was just at the wrong place at the wrong time, a victim of an overwrought political climate.

How politics shape PCs

Taiwan wasn't always this way.

In the early 1980s, a motorcycle ride down any alley in any city would reveal claques of housewives, snapping electronic components together by hand and tossing them into plastic buckets. These semi-finished parts found their way to small factories that dotted the countryside, where PC clones with XT and AT motherboards were made. Everything ended up loaded into ships at Keelung or Kaohsiung.

Taiwan's era of local assembly was short-lived, and soon companies like Acer, then known as Multitech, were building factories in Malaysia, Thailand and Vietnam. By offshoring to Southeast Asia, Taiwan's industry thrived into the mid-1990s as its cost of labor rose.

Investing in factories in China would remain forbidden for ICT companies, but quasi-legal for makers of umbrellas, bicycle parts and low-tech goods, as long as the investment was under a corporate entity in a third country, then typically Hong Kong.

In 1988, Taiwan elected its first native born president, Lee Teng-hui, appointed by Chiang Ching-kuo, who inherited the presidency from his father Chiang Kai-shek.

In a sense, this forever ended the deceased Generalissmo Chiang's dream of reclaiming the mainland that he had lost, but instead of pleasing China it stirred deeper fears of Taiwan drifting towards political independence.

Things remained quiet, with China watching President Lee's every move, as he pursued diplomatic initiatives to expand the handful of countries – totaling 23 today – that still recognized the ROC government after it lost its UN seat in October 1971.

But, in the summer of 1995, President Lee's alma mater Cornell University invited him to speak, and when U.S. officials granted him a visa, China saw it as a serious breach in the triangular Taiwan-China-U.S. protocol.

Beijing went ballistic. Taiwan and the U.S. were issued warnings in words and missiles. Within days, Beijing announced a series of missile tests to be held July 21 and 26, north of Taiwan's Pengchiayu Island. The PLA mobilized forces in neighboring Fujian Province and stationed Jian-8 aircraft uncomfortably near its coast. Later, in August, China announced provocative joint sea-air military exercises. China's saber rattling continued for eight months, until mid-March 1996 when yet another round of missiles tests was conducted near shipping lanes off Taiwan's two main ports – Keelung and Kaohsiung – which control 70 percent of the island's shipping volume.

This last move was seen as a threat to voters in Taiwan's first presidential election on March 23, 1996. Undeterred, voters chose Lee as the first elected president on Chinese soil, giving him a term of another four years.

Throughout the hostilities, the U.S., in accordance with the 1979 Taiwan Relations Act, demonstrated its commitment to defend Taiwan against Chinese aggression.

The USS Nimitz was dispatched from across the Pacific to patrol the Taiwan Strait in the weeks before the March 1996 election. Nearby, the U.S. Seventh Fleet had six ships monitoring the live fire exercises at that time.

Finally, tensions faded.

For Taiwan, it was a test of resolve. Its stock market crashed, its currency plummeted, but the Third Taiwan Strait Crisis, as the events of 1995/1996 are known, had little impact on the technology industry.

Taiwan was still dotted with electronics factories, and more than two-thirds of Taiwan's output was made on the island, with the rest manufactured in Southeast Asia.

But this home-spun scenario changed with China, as illogical as it might seem, becoming the offshore destination for Taiwan factories.

China assumes Taiwan's role

By 2000, only half of Taiwan's ICT products were made locally, and this has since declined to a mere 4 percent. Meanwhile, Southeast Asia, which had accounted for 31 percent of Taiwan production in 2000, has seen its share slip to 10 percent.

Hands down, in terms of production share, the new leader is China, which has grown from an insignificant manufacturing partner to a major stakeholder with a 85 percent share during the decade since the Third Taiwan Strait Crisis.

Visit Taiwan's industrial parks today, and one doesn't see low-slung concrete buildings surrounded by parking lots crammed with thousands of 100cc motorcycles. Instead one spies glass-and-steel offices with a handful of BMWs and Mercedes near the front door and SUVs and mid-priced sedans in the employee lots.

Taiwan's industrial parks are centers for administration, R&D and engineering. The labor-intensive tasks have been delegated to workers in China.

This result is counter-intuitive. How did this come about?

"In 1995 and 1996," says CAPS' Yang, "there was a brief period of uncertainty, but the U.S. intervened and therefore confidence was restored." Was the Taiwan government's ban on China investment lifted? "No," he added. "There has been no change, and China investment still goes through third countries such as the Cayman Islands."

Yang's explanation is that Taiwan's ICT customers – the world's leading high-technology companies – were being wooed by China with investment incentives and promises of market access. Taiwan's businesses are "interdependent and integrated" into the operations of these customers, and as they moved into China, Taiwan's ICT makers had no choice but to follow.

Taiwan and China share a common language, history and culture, and given their proximity, its hardly surprising that their economies are deeply linked Yet this was accomplished without the governments of either side formally acknowledging the other side's existence, let alone their partner's overwhelming importance.

"The situation is unique," says Yang. "Between Taiwan and China, the politics are always confrontational, but there are extremely high levels of economic integration from which they each side benefits. Their economies of both will suffer if there is a disruption, and this is a source of great pressure for their leaders."

LCD panels represent core Taiwan strength

In the migration of Taiwan's technology manufacturing to China, the last men standing are TFT-LDC lenses and semiconductors.

Taiwan's leading panel suppliers -- AU Optronics, Chi Mei Optoelectronics, Chunghwa Picture Tubes and HannStar Display – build their lenses in local fabs and for the most part assemble them in China. TSMC, UMC and other chip makers have fabs up and down the island, but 52 percent of their output goes to China, and increasingly it is packaged and tested there by Taiwan or Chinese companies.

Tze-Chen Tu, general director of the Industrial Economics & Knowledge Center (IEK), at Taiwan's Industrial Technology Research Institute (ITRI), said that every country wants to keep its first-tier industries at home, and that technology transfers are banned if thought harmful to economic or national security.

"We don't like to see them go but even when Taiwan companies shift manufacturing to China, they come back for design and for critical components," said Tu.

Taiwan companies still need prior approval before investing (via a third country) in manufacturing facilities in China.

The general rule for all Taiwan companies is that the investment cannot exceed 40 percent of the enterprise's total valuation.

"Actually, we would like to swap out our 8-inch wafer plants by transferring the technology to China, and by then rebuilding them as 12-inch wafer fabs here," Tu said. "Environmental regulations [for new plants] are getting tougher and tougher in Taiwan, but by changing out existing fabs we would quickly receive approval by our EPA."

China would welcome such a deal, and it is already the world's largest purchaser of used semiconductor equipment, Tu added.

Yet Taiwan did loosen its rules a notch in April 2006. By December, Taipei approved a two-year old request by TSMC to build a 8-inch wafer fab in Shanghai.

New guidelines allow Taiwan semiconductors to operate an 8-inch wafer fab [.18 micron] in China, but only if the company continues to operate a state-of-the-art, 12-inch wafer fab on the island.

USTBC's Hammond-Chambers adds, "What the government regulation in Taiwan states is that when a license is given – and TSMC is the only one that has been granted one – they have to construct, complete and ramp up to full production a 12 inch facility in Taiwan before they can start shipping 8-inch equipment over to the mainland. In addition, they cannot buy new equipment for the mainland facility, they must move the equipment over from Taiwan."

A push for peace

That, no doubt, was cold comfort to UMC's Tsao, who just months before had been indicted on charges of flaunting these rules. He Jian Technology was founded in 2002 by former UMC employees, and Tsao allegedly provided "management assistance" for a 15 percent stake.

Facing a possible two-year jail term, Tsao resigned as chairman at UMC, but nearly two years later, on October 26, in Hsinchu District Court, he was acquitted of all charges.

Tsao began blogging shortly thereafter. Topping his home page is a banner beseeching the KMT's Ma Ying-jeou and DPP's Frank Hsieh – front-running candidates in the upcoming March 22 election – "to work together to draft a Cross-Strait Peaceful Coexistence Law, to resolve tensions between Taiwan and China, and to ease domestic political strife on Taiwan." Tsao's photo graces the page, and he signs as "an ordinary citizen concerned with national affairs".

Included are four essays that Tsao has penned, and a key message is his recommendation that President Chen scrap plans for a referendum on Taiwan's entry into the U.N. When not blogging, Tsao indulges a more expensive hobby – placing front page political ads in Taiwan's major newspapers.

Tsao's new career as political blogger has outraged President Chen, who has called the techno-statesman everything short of traitor. But momentum seems to be gathering behind Tsao's cross-strait business stance.

KMT presidential candidate Ma – in a complete reversal from the KMT's standoffish policy of past decades – has called for broad liberalization of Taiwan's business relations with China, and even for the inauguration of direct chartered flights between the two territories.

The DPP's candidate Hsieh is equally pro-business, promising immunity to Taiwan companies guilty of illegal investment in China. He suggests that investment restrictions be softened so that Taiwan technology companies are at parity with their counterparts from the U.S., Europe and other Asian countries.

Even so, current events bear eerie parallels with the events that sparked the Third Taiwan Strait Crisis.

Between now and March 22, Taiwan politics will push forward behind their own coded shields. There will be the issue of U.N. membership [independence], there will be a presidential election [democracy] and President Chen will push U.S. authorities for a landing visa [diplomatic recognition] for an upcoming flight to Guatemala.

Is the CIA retasking its satellites to observe PLA troop movements in Fujian? Is the U.S. naval fleet redeploying to nearby waters? Probably not.

"There won't be any brinksmanship in coming months," said CAPS' Yang. "Five or six years ago, there was a restructuring of the fleet in the North Pacific to enhance naval and military presence in the region and that sends a clear enough signal to Beijing.

"The stakes are getting higher," said Yang, referring to the hundred of billions of dollars in trade across the Taiwan Strait. "Both sides have clear and abundant knowledge of how to avoid a conflict and of how to further their political and economic interests."

USTBC's Hammond-Chambers said that the "massive economic integration" between Taiwan and China is reason enough to believe they won't go to war.

"That is a compelling case," he said. "It is certainly the public position of the US Taiwan Business Council to encourage further economic integration as a threat reducer."

"There is a guy who works for SEMI, the semiconductor association, who wrote a book called The Silicon Shield… he took the position that the United States would always come to Taiwan's side in the event of a conflict given the importance of Taiwan's chip manufacturing to the U.S. economy."

But, asked how China would react if Taiwan pushes its luck with the U.N. referendum, Hammond-Chambers demurred. "I don't think it will even get that far. In that instance, given the Chinese rhetoric over the past few decades, there would certainly be conflict. There would be some sort of military exchange. The Chinese, for myriad reasons, cannot allow Taiwan, at least at this juncture any way, to drift towards independence… The Chinese Communist Party, looking for ways to demonstrate to its people that it is the legitimate power, cannot allow Taiwan to drift. It cannot."