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Wednesday, February 01, 2006
Calling China's Taiwan Bluff
Politics not economics is usually the first concern for most investors considering investing in Taiwan. For the next couple of years, both lead to a window of opportunity for investors with nerve and foresight.
There is little doubt that for the leadership of the Chinese Communist Party, Taiwan is a bone in their throat - a constant irritant - and most likely an obsession for some hard-line factions determined to bring Taiwan back into the fold of the motherland. So sensitive is the issue that an uproar ensued when Google deleted the words "Taiwan, a province of the People's Republic of China" during a recent routine update of its online map of Taiwan.
Even so, any noise that Beijing will take near term military action against Taiwan is likely a bluff for five reasons.
First, any military conflict with Taiwan would surely cancel the Beijing's showcase 2008 Olympics. This would be a devastating setback for China's leadership and people.
Second, Beijing's approach of working quietly to support more friendly political factions within Taiwan seems to be working. In the municipal elections held on December 3rd, the so called "Pan Blue" coalition, composed of parties more flexible regarding reunification with China than the ruling party, captured 17 out of 27 seats building on the coalition's success in the 2004 legislative election. In addition, Taiwanese President Chen Shui-bian's term will end in 2008 and Beijing is betting on a less strident and independent successor.
Third, although China is rapidly modernizing its military forces, U.S. treaty obligations to Taiwan in the event of an invasion cannot be discounted. In addition, President Chen, citing China's expanded missile program in his annual New Year's Day address, called for the legislature to approve plans to purchase more weapons from the U.S. to offset the buildup.
Fourth, a 2005 joint statement by the Japanese and U.S. governments that both countries had a "common strategic objective" to "encourage the peaceful resolution of issues concerning the Taiwan Strait through dialogue," raises the possibility of Japanese intervention making the military option even more risky and improbable.
Lastly, the economic integration of Taiwan into China is moving ahead at a breathtaking rate. Cross-Straits trade has doubled since 2000 to reach $62 billion in 2004, about 1 million Taiwanese have re-located to work in China, and Taiwanese companies now account for about 65% of hardware output from the mainland.
My view is that while calls for independence have at least temporarily been muted, the desire for a high degree of autonomy from China is still strong. There may be one China but there are three systems - China, Hong Kong and Taiwan. Perhaps the best solution is for China and Taiwan to formally agree to a long period of Taiwanese autonomy to see if China's system evolves into a more open, transparent system with rule of law and democratic institutions.
Taiwan with a population of 23 million and an area of 14,000 square miles (half the size of Ireland) is a remarkable success story. However, but Taiwanese companies will need to constantly innovate, make Taiwan a major R&D center and build strong consumer brands to avoid the it's economy from being swallowed by the mainland.
If you can get over the political risk and are ready to call China's bluff, Taiwan's stock market represents good value though you should expect some volatility. In his New Year's Day address, President Chen also called for Taiwan to maintain and nurture a separate identity and renewed his pledge to have a new constitution in place before he leaves office in 2008. Concerns about the remarks impact on China relations led the next day to Taiwan stocks day falling 1.3% but the next day the market promptly bounced back 2% to reach a twenty month high as investors focused on economic fundamentals. The laptop maker Wistron alone rose the daily 7% limit to an all time high.
Taiwan's stock market was up only 6% in 2005 lagging Asian markets such as Japan, up 42% and South Korea, up 54%. One company that had a great year is Taiwan Semiconductor (NYSE: TSM) which was up over 35% and still looks like a buy. It has a return on equity of 16%, a strong balance sheet and a low level of institutional ownership.
If you want more diversification, you should invest in the iShares Taiwan (EWT) exchange-traded fund. It has a 23% exposure to the semiconductor industry and Taiwan Semiconductor accounts for 14% of its holdings but it includes significant exposure to technology hardware, materials and banks.
In 2005, Japan, Australia and South Korea were the most successful China plays. In 2006, why not take some profits and place a bet on Taiwan, also known legally as the Republic of China.
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