Testimony Before U.S.-China Economic and Security Review Commission

Hearing on “China’s Growth as a Regional Economic Power: Impacts and Implications”

December 4, 2003

Merritt T. (“Terry”) Cooke

Senior Fellow, Foreign Policy Research Institute (Philadelphia, PA) & Managing

Director, GC3 Strategy Inc.

I am honored to have been invited back to provide an update on the analysis I presented to the Commission on August 2, 2001. In the two years since I participated in that public hearing, I have had the pleasure to meet, and work with, many of you on the present Commission in various conferences and security-related forums. I commend you for the intelligence and scrutiny which the Commission continues to bring to bear on a matter of significant security interest to the United States. I am encouraged to see that the Commission’s letter of invitation has framed this panel’s focus on Cross-Strait economic integration and on the implications of this integration dynamic for the Asia-Pacific region and for the U.S. Two years ago, there was scant recognition in public debate on the Cross-Strait situation that such a dynamic was taking place or was relevant to U.S. security interests in the region.

Because the Commission is already familiar with the broad outlines of my perspective and because time for prepared remarks is limited, I will confine myself here to the six specific issues which your letter of invitation asked me to address. I have provided the Commission secretariat with a more extensive statement for the written record which embeds these remarks into the fuller context of my research. I will take this opportunity to remind the Commission that my research does not presume to contribute to rigorous macroeconomic understanding of Cross-Strait economic ties. As I described in 2001, such data are hard to come by and others are better trained at piecing that particular puzzle together. My research is microeconomic and focuses on interviews with CEOs and other strategic-level corporate decision-makers in Taiwan and the U.S. who are directing the investment decisions into the Peoples Republic of China. Also, my research into corporate decision-making, and the technology dynamics which underlie that decision-making, focuses predominantly on Information Technology sectors of the economy.

Question 1: The extent to which Taiwan’s domestic manufacturing sector is being “hollowed out” by China’s economic growth?

My impression is that that this is more a political problem of perception to be fought out on Taiwan’s electoral hustings than it is an economic problem for the Ministry of Economics (MOE) or the Council of Economic Planning and Development (CEPD) to solve technocratically. Fundamentally, the issue of ‘hollowing out’ appears to be a concomitant of success, rather than the fall-out of failure, for Taiwan’s globalizing economy. Two decades of close integration in the global IT supply chain and the consequent rise of per capita income and standards of living have helped usher Taiwan into the ranks of advanced economies. As a newly-minted graduate to this elite level, Taiwan is now being forced to confront some of the standard challenges faced by advanced economies everywhere – lower rates of GDP growth, structural unemployment, susceptibility to global cycles of demand, and pressures on productivity and the production base.

China’s economic rise does exacerbate these challenges for Taiwan, but in few cases does it account solely for them. While Taiwan is involved in a fractious political debate on these issues, I am confident that Taiwan – as an authentic democracy and as a nimble player in the world economy -- will eventually meet this challenge of industrial restructuring and economic transformation as successfully as it has met other, equally daunting political and economic challenges in the past.

Question 2: The manner is which the economies of both China and Taiwan are benefiting from the unique dynamics of Cross-Strait economic relations?

The evidence, while incomplete, points to a clear conclusion for most of the Information Technology sectors: Taiwan, China, and the United States have all enjoyed substantial benefits as the global IT supply chain has extended over the past three years from Hsinchu across the Taiwan Strait to the Yangtze River Delta, the Pearl River Delta and elsewhere in China.

Economies and ecologies do not prosper in the absence of change and adaptation. While China=s emergence into the global IT ecosystem has brought disruptions, the change also appears to be strengthening the global ecosystem as a whole.

Worldwide, consumers have benefited from lower prices for quality IT goods. Meanwhile, U.S. brand companies at the top end of the value chain have consolidated their position and continue to reap the disproportionate return on investments (ROI), because of their brand names. In the middle of the value chain, Taiwan firms are squeezing a new revenue stream from their OEM playbook by replaying it in the Shanghai-Kunshan-Suzhou-Nanjing corridor. At the same time, they are sinking new taproots in Taiwan in fields as diverse as original design manufacture (ODM), manufacturing-related research and high-end production (e.g. advanced TFT-LCDs, O-LCDs, and 12@ wafer production). In China, local firms that have never previously participated in a meaningful way in the global economy are now supporting the low end of the global supply chain with component production and increasingly sophisticated assembly operations.

WTO accession offers the best example of the symbiotic benefits that the United States, Taiwan and China have all enjoyed from an expanded global value chain. Taiwan is now positioned to trade off, incrementally, its dominance of China=s IT export market in return for substantially improved access to the smaller but potentially more profitable market on the mainland. China has gained limited access to high return foreign markets under the tutelage of a Taiwan partner with two decades of experience in those markets. The United States, meanwhile, experiences consumer benefit, a steady supply of vital IT components and products, and a more efficient global pipeline for its own research-led innovation.

In sum, the limited available data shows not even marginal erosion of Taiwan equity control in the overall IT market since 2000. Whatever shifts in leverage may be occurring in the IT sector between Taiwan and China, they appear to be happening gradually and to involve balanced trade-offs in access to the foreign and domestic portions of the economy.

Question 3: The economic and other forces driving the steady flow of investment capital into China from Taiwan?

In the IT realm, the forces driving the steady flow of investment capital are various. To cite a few:

§ China’s large and fast-growing market for mobile telephony is increasingly prompting handset makers and their suppliers to bring production and even R&D closer to their consumer base in the mainland;

§ The low cost of land, factories and labor in China has already forced Taiwan IT hardware Original Equipment Manufacturers (OEMs) to relocate production in order to meet the cost-efficiency demands of their U.S., European, and Japanese brand-name customers;

§ China’s Export Rebate Tax system has been giving mainland chip-producers a cost advantage of 11-14% over their Taiwan competitors;

§ The global nature of today’s capital and venture capital markets is not easily controlled by national entities;

§ The human capital resource in China -- represented by more than one billion brains with adequate, though basic, levels of health and education – is compelling.

Question 4: The impact of China’s economic development on Taiwan’s role in the global supply chain?

In the interest of time, I will highlight one key implication of this question – the relative stability of highly differentiated, high-value supply chains (as still pertain in most IT sectors) as opposed to the instability of far simpler manufacturer-retailer networks characteristic of commodity products like toys, umbrellas, and the like.

With a simple commodity-supply network, an enterprising factory-floor manager in China can first learn a foreign-invested firm’s production methods, and then jump ship to create overnight a competing factory on a lower cost-basis. Offering lower costs in commodity areas not highly-sensitive to considerations of quality of production or speed of delivery, all it takes for an upstart factory to dislodge its more globally-established competitor is a well-targeted letter to a mass-retailer in North America or Europe touting its product’s lower costs.

Highly differentiated, innovation-dependent supply chains behave in fundamentally different ways. This type of supply chain – characteristic of sectors as diverse as brand-name athletic shoes, high performance bicycles, IT hardware, and automotive assembly – has a fundamentally different value-proposition. Rather than rely solely on price, these complex supply-chains are bound together by a more adaptive logic – the formula of “cheaper, better, faster.” Since the binding logic of supply chains rests on three legs rather than one, they tend to be much more stable. This helps account for the stability of Taiwan equity ownership of the IT production sector in China despite the hypercompetitive practices prevalent there.

This distinction helps throw into relief an underappreciated fact about the historical pattern of Taiwan investment into the mainland. While many light industry sectors which Taiwan moved to the mainland in the 1980s and 1990s have been swallowed up by mainland competitors, brand-name athletic shoes and high performance bicycles have remained largely in Taiwan equity hands. If these product sectors, with their relatively lower levels of technology and slower product cycles, could stay in Taiwan control for decades, there is every reason to believe that the various IT hardware sectors will stay even more firmly in Taiwan’s grip in years ahead.

For example, industry sources are now reporting that Wal-Mart is considering its own brand-name line of laptops and notebooks. These would compete with Dell and HP among others, largely on the basis of price. To bring this new line to market, however, Wal-Mart is not turning to upstart suppliers on a cost-basis. Rather Wal-Mart is turning to the same Taiwan OEMs who produce for Dell and HP and appears to be seeking its cost-advantage through leveraging the volumes and efficiencies of its own well-honed retailing model.

Question 5: Whether Taiwan perceives China’s pursuit of regional and/or bilateral Free Trade Agreements, in Southeast Asia for example, as regional economic catalysts or as threats to Taiwanese economic and security interests?

Taiwanese are clearly concerned that China is using its FTA (Free Trade Agreements) and CEPA (Closer Economic Partnership Agreements) initiatives to further constrain Taiwan’s diplomatic space and to encroach on its economic/commercial space. For this reason, China’s FTA discussions with the ASEAN nations of Southeast Asia as well as its recent offer to sign a Hong Kong-like CEPA with Taiwan are met with anxiety and skepticism. Memories of TSMC’s shabby treatment by China’s industry association, protocol snubs for Taiwan officials at APEC gatherings, and audit and inspection harassment of ChiMei’s mainland operations during the last Presidential election in Taiwan are fresh in peoples’ minds. The business community views these initiatives as political posturing rather than as commercial negotiations.

Question 6: The implications of increasing Cross-Strait economic cooperation and interdependence on the U.S.-Taiwan relationship?

I would cite three main implications of Cross-Strait economic integration on the U.S.-Taiwan relationship:

First, it’s a fact that the Cross-Strait IT interaction is being driven by larger globalization trends. With globalization comes stresses of change and adaptation, but Taiwan also gains a higher degree of acceptance and support in an interdependent world, as does China. The U.S. has leadership experience, and models of interdependence, which could be shared with Taiwan and China in this regard.

A second implication relates to the perennial question of who is gaining leverage. The evidence suggests that leverage is not so much in the hands of politicians in either Beijing or Taipei as it is in the hands of Taiwan=s globally-experienced IT firms and their brand-name customers. With a dominant share in China=s export industry, a growing share in China=s local market and strong R&D roots in Taiwan, this is not a zero-sum predicament for either Taipei or Beijing.

A third implication involves democracy trends. As a result of economic integration, Taiwan manufacturers and managers are now bringing millions of Chinese workers into direct contact with global norms of business and a more universal set of values. This development, brought about by sustained commercial interaction, would appear to directly support U.S. policy goals for the resolution of cross-Strait tension through sustained and peaceful interaction.

From this perspective, I conclude with the suggestion that the United States Government attend closely to two key policy questions:

§ Since China is now following a two-track approach (old-style military intimidation coupled with a new strategy of economic blandishment), the U.S. needs to understand on its own terms where each track leads. The facts-on-the-ground of economic integration appear to be beneficial for all concerned but the politics of FTAs and CEPAs are subject to manipulation by China to Taiwan’s detriment.

§ While the security and economic tracks may lead in different directions, they are not disconnected. Increased U.S. policy support for the economic >globalization track,= coupled with guided management of FTA and CEPA politics, is the best path toward Cross-Strait and regional stabilization. This path promotes U.S. security interests by further constraining either/both Taiwan and China from jumping the political/military track.

The old saying about dancing with your enemy captures a truth in the current cross-strait situation. Economic engagement between Taiwan and China will not eliminate the chance of an outbreak of hostilities, but it will reduce that chance. Similarly, as globalization continues to push Taiwan and China into closer economic embrace, U.S. policies on the above two issues can determine whether that embrace becomes mutually comfortable or ultimately injurious to Taiwan.