Investment Research
12 December 2016
Flash Comment
A clash between the US and China a rising risk for markets

Even before Donald Trump has put himself in the presidential seat, he has started a
diplomatic crisis with China. By questioning the support of the One China policy,
Trump is using the most sensitive issue for China in his attempt to get concessions
from China in the trade area. However, Trump might be playing with fire here and if
the situation escalates, this could become a risk for markets in 2017.

By accepting a phone call from the Taiwanese President Tsai Ing-Wen 10 days ago,
Trump broke with 37 years of US foreign policy. The US broke diplomatic relations
with Taiwan in 1979 when President Jimmy Carter closed the US embassy in Taipei.

China’s initial response to Trump’s phone call with Tsai was one of composure
given the sensitivity of this issue. However, China seemed to choose to not be provoked
and go into a big fight on words but await the situation further until it knew if it was
just words or a real change of policy. President Xi Jinping did not respond directly, but
chose to reply through critical editorials in the state media.

However, over the weekend, Trump stated on Fox News that, ‘I fully understand the
One China policy, but I don’t know why we have to be bound by a One China policy
unless we make a deal with China having to do with other things, including trade… I
don’t want China dictating to me’. Trump is now very clear in putting a question
mark over support for the One China policy and linking it to concessions in other
areas. The One China policy has been in place since 1972.

This has no doubt infuriated China. It sees the One-China policy as a bedrock in USSino ties and as non-negotiable in any form of deal.

No Chinese leader can afford to look weak in the matter of Taiwan – especially not
going into a year of the 19th Communist Party Congress. The loss of Taiwan to Japan
in 1895 is one of the deepest wounds inflicted during what China calls the ‘century of
humiliation’ by western powers and Japan that lasted from 1939 to 1949 (see below).
Reuniting with Taiwan is a central part of the Chinese narrative towards rectifying the
humiliation.
Following the Trump-Tsai phone call, a headline in the Chinese newspaper Global Times
said that China’s ‘strategic composure’ should not be mistaken as weakness. However,
given the latest development, Beijing needed to respond more forcefully to meet the new
challenge by Trump. In the fairly outspoken state newspaper Global Times today, it said
China should make Trump ‘hit some snags’ to show him it is not ‘easy to bully’. It also
said ‘Trump is naïve to think he can use the One China policy as a bargaining chip’ adding
that, ‘nothing is impossible if the Trump administration goes too far’, see link.
Chief Analyst
Allan von Mehren
+45 45 12 80 55
[email protected]
Important disclosures and certifications are contained from page 3 of this report.
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Flash Comment
Why the Taiwan issue is so sensitive for China
Taiwan is one of the big wounds inflicted on China during what they label the ‘century of humiliation’.
It designates the period of 1839-1949 in which western powers through wars, occupations and
destruction of Chinese cultural treasures broke China’s long history as one of the dominant powers in
the world. The ‘century of humiliation’ is a key narrative of Chinese history taught in schools for the
past 60 years.
The period started with the First Opium War in 1839 in which the United Kingdom attacked China to be
able to sell opium in return for silver. It also forced China into treaties that would benefit UK trade with
China. During the ‘century of humiliation’, China lost Hong Kong, Tibet and not least Taiwan, which
was seized by Japan in 1895 following the first Sino-Japanese war. Prior to this, Taiwan had been in
Chinese hands since the 17th century. Further wounds on China were inflicted during the Japanese
invasion of Eastern China from 1937-45, which included the so-called Nanjing Massacre. In the eyes of
China, the ‘century’ ended when the Communists won the civil war in 1949 and the Nationalists
(Kuomintang) fled to Taiwan. The Western powers supported the Nationalist party and its leader
Chiang Kai-Shek, and while the US has supported the One China policy from 1972, it is still supporting
Taiwan with weapons and has vowed to defend Taiwan in a potential military conflict with China.
Since the end of the ‘century of humiliation’, a key priority in Chinese policy has been to rectify the
humiliations by regaining territory lost during the period and recovering the international standing and
once again becoming one of the great powers of the world. A full reunification with Taiwan is one of
the last outstanding issues in which China has not gotten full rectification. This is still a key Chinese
policy, though and it was underlined in 2005 with the Anti-Secession Law.
Source: Danske Bank Markets

In 1995, US president Bill Clinton triggered a diplomatic crisis with China by
allowing the Taiwanese president to give a speech in the US. It triggered Chinese
missile tests in the waters around Taiwan and the US had to sail in aircraft carriers in
an escalating conflict. Hence, China has demonstrated before just how sensitive this
issue is and a similar escalation could take place over the coming months and
potentially give a hit to market sentiment.

As late as 2005, China passed the Anti-Secession Law, which among other things
stated that China would use ‘non-peaceful’ instruments if Taiwan tried to secede from
China, see link.

A risk in the US-China relation is that Trump has surrounded himself with China
hawks that are very critical of China and in favour of a much tougher stance. By
choosing to use the Taiwan issue as a weapon, they could have miscalculated how to
gain concessions from China. Any sign in China that the Chinese leadership would give
in to the US on this issue or let them be ‘bullied’ would be a very serious matter there.

The next challenge could arise when the Taiwanese president plans to transit via
New York on a visit to Nicaragua in early January before Trump’s inauguration
ceremony. If Tsai meets with Trump aides on her transit, this would add to the
provocation of China.
What could China do?
The US-China relationship is one of co-dependence. Both countries can hurt each other
but not without hurting themselves as retaliatory measures would be taken. For now, China
could choose the following steps to hit back at the US:
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
Punish Taiwan by changing rules for Taiwanese companies in China.

Initiate missile tests in Taiwanese waters as in 1995 in a show of power.

Be more supportive of North Korea. In the Global Times article cited above, it says
China could offer support to US foes and even offer them military assistance.

Put unofficial trade barriers on US companies by making it much harder for them
to do business in China.
12 December 2016
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Flash Comment
In the case of a trade war, China could hit the US by selling US bonds, putting quotas on
exports of rare earth minerals (used in iPhones, wind turbines etc.) of which they have 95%
of the world’s production etc. See Flash Comment: What does Trump mean for China, 9
November 2016.
Similarly, China could be hurt significantly by increases in US tariffs and other trade
obstacles hitting Chinese companies exporting consumer goods etc. to the US. With the US
buying close to 20% of Chinese exports, this would be a big hit to the Chinese export
industry.
A rising risk factor for 2017
While focus has been very much on European politics as a risk factor for 2017, a potential
crisis in the US-China relationship and a possible military escalation in the Taiwan Strait
could be increasingly on the radar screen. Markets are so far calm but if Chinese missile
tests are suddenly performed in the Taiwan Strait, it could result in a sudden hit to
risk sentiment.
With Trump being surrounded by China hawks and not seeming to respect the unofficial
code of conduct in foreign relations, there is a risk that a tit-for-tat development could
unfold. Where this could lead is very hard to say currently. However, it bears watching.
A map of China and the Taiwan Strait
Source: Danske Bank Markets
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Flash Comment
Disclosures
This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske Bank’).
The author of the research report is Allan von Mehren, Chief Analyst.
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Flash Comment
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