Mitigating the Trade-Off Risks of Taiwan’s Over-Reliance on its Semiconductor Industry

This article is by Zoë Weaver-Lee, a program assistant at GTI. Originally published by the Global Taiwan Institute in its weekly newsletter, The Global Taiwan Brief, Vol. 6, Issue 18. Used with permission.

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Taiwan’s growing reliance on its semiconductor industry as an asset and international diplomatic tool is widely heralded by strategists, economists, and business professionals alike. Yet, the country’s lack of export diversification, centralized prioritization of resources, and a sober expectation of long-term market dominance present a high-risk environment in which Taiwan is vulnerable to both endogenous and exogenous shocks. There are important trade-offs that policy makers should consider in their efforts to leverage Taiwan’s semiconductor industry for international recognition.

For instance, Taiwan’s extended drought in the first half of 2021 placed severe pressure on both local and national water supplies. Government regulators had to incentivize farmers to skip this growing season and even to halt irrigation altogether in order to divert water to neighboring chip manufacturing processes. The recent drought is but one example of Taiwan’s economic vulnerabilities. However, several steps can be taken within the governmental and corporate policy spheres—such as resource regulations, international partnerships through the private sector, and expanded research and development—which would uphold the value of the crucial semiconductor industry while mitigating the risks associated with over-relying on it.

The Value of Taiwan’s Semiconductor Industry

The importance of the semiconductor industry in Taiwan is now internationally recognized—and for good reasons. Taiwan Semiconductor Manufacturing Company (TSMC, 台灣積體電路製造股份有限公司) alone manufactures 84 percent of the world’s most advanced chips. In many ways, the growth of companies such as TSMC demonstrates the well-deserved success of Taiwanese innovation. It is thus no surprise that policy makers, economists, and strategists have bought into the benefits of the chip industry as a tool for Taiwan’s diplomacy— often arguing that this success story is an opportunity for international recognition and leverage. In recent months, as the global chip shortage has strained the supply chain, Taiwanese companies have been in a unique position to fill the gap. For the first time, it seems, cooperation with Taiwan is needed. Jeremy Huai-che Chiang, writing in a previous issue of the Global Taiwan Brief, even called the shortage a “rare diplomacy gain for Taiwan,” an instance in which the island could demonstrate its “industrial might.”

Taiwan’s strengths as a technologically advanced export economy fit into the strategies of the United States, Japan, and the European Union insofar as they provide crucial equipment and know-how to the global supply chain, and help achieve selective decoupling from China. More specifically, in an effort to reduce global economic dependence on China, the United States is looking instead to build partnerships with Taiwan and protect its interests. The United States Innovation and Competition Act of 2021, passed by the US Senate in early June, highlights several points of potential cooperation with Taiwan: these include democratic governance of technological development, investment in high technology research and development, and the formation of a digital technology trade alliance. [1] Why then should adjustments be made to such a seemingly advantageous environment?

Long-Term Outcomes of Semiconductor Dependence

If there is a lesson to be learned from the water supply shock, it is that Taiwan should not solely depend on the semiconductor industry as a strategic diplomatic tool. Most related to the current situation is the domestic strain on natural resources. As an island, Taiwan is scarce in land, labor, and usable water. As of 2019, TSMC alone reported using 10 percent of Hsinchu’s water supply per day, and outsourced water in the midst of the drought in April 2021. Although the company has committed to various environmentally conscious initiatives to reduce waste and water usage—including the construction of water reclamation facilities— local supply shortages have resulted in a decline of output in other industries, particularly agriculture. When considering the impact of resource depletion, the effects of scarcity on local prices, and narrowing of the market to rely particularly on manufacturing alone, the long-term outlook for defending against shocks is bleak. In Hsinchu alone—where restrictions were not only placed on chip hubs and farms but also on drinking water—other factors such as changes in population, chip demand, and climate could all severely affect the local and national economy.

The lack of diversification in Taiwan’s economy in itself presents several challenges. While it may be argued that Taiwan’s savvy in manufacturing is not limited to chips, the extent to which other product sectors and companies are leveraged as diplomatic tools is incomparable. Taiwan is not the only player in this market, and as the United States and Japan continue to increase focus on research and development—as well as to create sophisticated ecosystems for semiconductor businesses—the market will become increasingly competitive. While Taiwanese support and coordination will be valuable to an extent, there is also an incentive for the United States to “figure out which areas of the supply chain we want here [in the United States]” and to “develop our own capabilities,” according to the German Marshall Fund’s Bonnie Glaser. [2] Additionally, while the price of chips continues to rise and the market is caught in a shortage at present, the risk of uncontrolled inflation in the future, combined with the costs of building foundries to reach supply-demand equilibrium, is particularly volatile. Undiversified economies do not remain stable amid such changes.

As an additional factor to consider, when calculating the possibility of an attack on Taiwan by China followed by control of its industries, there is reason to predict that its chip manufacturing capabilities would not be sustainable. As US-Taiwan Business Council President Rupert Hammond-Chambers argued during a Global Taiwan Institute panel on global chip supply chains, “We are not dealing with Chinese control over semiconductors, we are looking at taking it offline in a short period of time, which would have dramatic consequences.” Of course, in such circumstances, the state of Taiwan’s semiconductor industry would be of secondary importance. Nonetheless, considering that Taiwan’s vibrant semiconductor industry is not guaranteed to survive, economic diversification will serve as mitigation against such developments.

Risk Mitigation in Governmental and Corporate Policy

Taking into consideration the dynamic ecosystem in which Taiwan’s semiconductor industry exists as well as the value it currently holds for international engagements, while also taking heed of the risks associated with a lack of diversification in relation to resources, strategy, and export markets, there are several noteworthy policy options.

(1) Enforce regulations on resource usage.

Governmental regulations regarding resource allocation should include a combination of policies limiting their use, incentivizing measures such as the use of reclaimed water, and enforcing tradable water usage quotas. [3] While the agricultural sector will adapt to the more limited availability of water by necessity, such equilibriums are neither long-term, nor should they be reached through coercion. By adopting a set of standards that account for environmental impact and demand, as well as increasing the value of water, areas such as Hsinchu will be able to avoid frequent destabilization and a future undiversified economy. Additionally, enforcing the use of tradable quotas will ensure an efficient market in which each party achieves either their desired output or receives proper compensation.

(2) Expand company-level partnerships abroad.

As of June 1 this year, TSMC began construction on a USD $12 billion chip factory in Arizona, with plans to open for production in 2024. This project, however, remains one of the few tangible international partnerships at the company level within the Taiwanese semiconductor industry. Given the risks posed by domestic resource strains and possible exogenous geopolitical vulnerabilities, these types of partnerships will be crucial for the future of sustained Taiwanese dominance in the chip manufacturing field. Allowing operations to branch beyond domestic borders will not only diversify resource availability, create employment opportunities for Taiwanese nationals, and manifest a reliance on Taiwan’s technical know-how, but also mitigate the effects of exogenous shocks to the island.

(3) Provide tax incentives and grants for Taiwanese manufacturing abroad.

While company-led endeavors to forge these partnerships will most likely occur organically, it is important to incentivize their development through tax incentives, particularly those available abroad. Promoting the development of Taiwanese manufacturing capabilities on US soil or in partnership with US-based companies will help accomplish Taiwan’s goals of risk mitigation; furthermore, for the United States government, it will also promote the goal of economic decoupling from China.

(4) Provide domestic incentives for research and development.

To address the increasing competition within the semiconductor industry, Taiwanese governmental agencies will need to further invest in research and development. [4] While the domestic market is currently focused on manufacturing, diversifying its role in the supply chain would buffer the industry against price changes, as well as broaden its appeal to international partners. In this regard, an incentive program that establishes a pipeline for Taiwanese students with more diverse degree backgrounds—and that includes more phases of the supply chain—would help in this effort, as well as slow the rate of Ph.D. students that do not return to Taiwan after receiving their degree. [5] Investment into the fields of software and software-hardware integration would help prepare the Taiwanese workforce for shifts in chip demands as well.

Conclusion

While the semiconductor industry in Taiwan has found its rightful place in the center of the global supply chain and international cooperation, overreliance on chips as a new source of political leverage has several potentially detrimental risks. Taiwanese governmental agencies and companies should diversify in order to mitigate shocks posed by strains on natural resources, changes in market competition, exogenous price and population changes, geopolitical factors, and a severe brain drain. To do so, restrictions should be placed on resource use, international partnerships should be made at a company level and encouraged through tax incentives, and domestic research programs must be expanded.

The main point: Encouraging over-reliance on its semiconductor industry as a diplomatic tool poses risks to Taiwan’s relatively undiversified economy. These risks should be addressed through resource regulations, international partnerships through the private sector, and expanded research and development.

(Feature Image from Unsplash)

References:

[1] US Congress, Senate, United States Innovation and Competition Act of 2021, 117^th Cong., 1st sess., 2021, S. 1260, subtitle C, sec. 3121.

[2] US Congress, Senate, Committee on Armed Services, Hearing to Receive Testimony on the United States’ Strategic Competition with China, 117^th Cong., 2021 (testimony of Bonnie Glaser), 41.

[3] Avril C. Horne, Erin L. O’Donnell, Adam J. Lock, David C. Adamson, Barry Hart, John Freebairn, “Environmental Water Efficiency: Maximizing Benefits and Minimizing Costs of Environmental Water Use and Management,” WIREs Water 5, no. 4, 2018.

[4] Genda J. Hu, “Government-Industry Partnerships in Taiwan,” in Securing the Future: Regional and National Programs to Support the Semiconductor Industry (Panel 4: The Taiwanese Approach), 2003, 151.

[5] Shirley L. Chang, “Causes of Brain Drain and Solutions: The Taiwan Experience,” Studies in Comparative International Development 27, 27-43, 1992.