The Daily Reckoning PRESENTS: Two weeks ago, a Chinese general stated that if the U.S. intervenes in any conflict with Taiwan, they would be forced to retaliate with nukes. Dan Denning looks at the factors surrounding the situation and wonders if this threat could become a reality...

The biggest risk I see in China right now is not economic, but political. And what's more, China's biggest risk is itself and how it might act if Taiwan pushes for a two-state relationship.

Personally, I don't think the United States is willing to go to war over Taiwan. American interests in the region are more economic than military. For their part, though, the Chinese seem deadly serious about Taiwan. In fact, everyone I talked to in China was unanimous that China would not and could not allow Taiwan independence. China will go to war over Taiwan if it has to. How might that war play out? Dr. Marc Faber sets the stage:

"Wendell Minnick, who is the Jane's Defense Weekly correspondent for Taiwan, sets a likely scenario. According to Minnick, should China ever decide to invade Taiwan, it would unlikely be a large-scale, Normandy-type of amphibious assault, but be by means of a 'decapitation strategy.' Minnick explains that 'Decapitation strategies short-circuit command and control systems, wipe out nationwide nerve centers, and leave the opponent hopelessly lost. As the old saying goes, 'Kill the head and the body dies.' "

If this assessment is accurate, China's Taiwan strategy is not at all different from the U.S. strategy of "shock and awe" in Iraq. It's a variation on the idea of getting inside your adversary's decision cycle. In military terms, it means attacking in unexpected ways and in unexpected places (not strictly military targets). By doing so, you get your opponent off balance. By the time they react to what you've done, you're doing another thing, eventually collapsing their will to resist by the speed and ubiquity of your assault.

The Chinese have played their Taiwan hand beautifully. With the United States engaged in Iraq and dependent on China and Russia to disarm North Korea, it looks to me like a reuniting of Taiwan and the mainland may simply be a matter of time. Whether it's by peaceful means or not remains to be seen.

It also remains to be seen whether the United States considers it more important to support Taiwan's ambitions rather than to make nice with mainland China and its growing economy and huge holdings of U.S. bonds. In his 2005 inaugural address, President George W. Bush said, "It is the policy of the United States to seek and support the growth of democratic governments and institutions in every nation and culture, with the ultimate goal of ending tyranny in our world." An ambitious goal, to say the least, and one that must include Taiwan.

It's hard to imagine, with $124 billion in trade between them and their economic futures now intimately intertwined, that America and China would go to war over Taiwan. But both appear determined to do just that if they feel they have to. Let's hope they don't have to.

There's also the possibility - which would be even more shocking - that the mainland Chinese communist leadership will collapse before China ever attacks Taiwan. How could this happen? In late January 2005, Zhao Ziyang died. Zhao was the leader of the Communist Party in 1989 during the student uprisings in Tiananmen Square. He spent the last 15 years of his life under house arrest for having refused to order a crackdown on the pro-democracy demonstrators. He was mourned by thousands in Hong Kong, where it is still legal to gather in public and support democracy.

In mainland China, nothing of the sort could happen. When I strolled through Tiananmen Square, it was not too hard to notice the plainclothes police who still follow Westerners, in addition to uniformed police. My guide in Beijing made sure to remind me not to bring up the subject in public. Despite outward appearances of prosperity, China is not democratic.

Yet there is a chance that the mainland could become more like Taiwan, and not the other way around. It has to do with the connection between economic prosperity and liberty, but for now, let me quote a friend of mine who currently lives in Taiwan and describes himself as a pro-free-market libertarian:

"Taiwan cannot be free and secure, if China is not free and democratic. And, as China goes, so goes Asia. Whether China becomes a superpower or descends into another period of warlordism, things will not stay as they are (although I have not yet been to the mainland), and the rest of Asia and the world will be impacted, to say the least. It would be difficult for anyone to convince me that China's transition will occur in as sweet a fashion as did the Soviet Union's...I believe that Taiwan is correct to push forward the controversial name changes to state-run industries...Taiwan's only chance is to continually let the world know the true nature of the Chinese beast. It is simply inconceivable how anybody could object to Taiwan's right to self-determination. However, there is a danger in accelerating the Taiwanization of the ROC, namely that there are still very powerful elements within Taiwan that are attached to the idea of a China one and indivisible. More needs to be done to make the emerging pro-independence government broadly representative. Not only because it is right, but because it will make Taiwan stronger internally, it will give China fewer excuses to interfere in Taiwanese affairs, and it will set an example not only for China, but an example to the rest of Asia, how democracy can be reconciled with order...[T]his is perhaps overly kind to the Chinese view, there is some reason for them to fear democracy."

Needless to say, a Chinese invasion of Taiwan would be a shock to financial markets. But given the ways in which the Chinese might accomplish such an invasion, and making the large assumption that the United States will offer only diplomatic resistance, I think the shock would be short-lived and not substantial. In the meantime, the best way to invest in China is to buy the companies doing business with China but that have Western listings.

It's a huge paradox. China has all the artifacts of a modern capitalist economy. And its people and entrepreneurs are a lot more opportunistic than many Americans I know. Yet little is known of the millions Mao killed. And while not as visible, the military is a constant reminder of the coercive nature of the Chinese state. For all its remarkable progress toward free markets, there has been a lot less progress toward freely expressed political thought. Can the government maintain its grip on information? Can it privatize nearly every other sector but keep a tight rein on what people say and publish? I doubt it.

The Chinese I met on my trip were bright, talented, ambitious people. They are also very proud of China. It will be their job to clean up the heinous mistakes of the state over the last 50 years. The Chinese government's war on the family has left hundreds of millions without a traditional support network as they get older. There are no institutions to fill the void. Not the state, which can't afford it. Not the church, which doesn't exist in large enough numbers. And not the family, which was systematically eliminated by the one-child policy.

Then again, Chinese culture is 5,000 years old. Communists can ruin a lot in a short time. Nothing is more destructive than the conceit that you can dispose of hundreds of years of tradition and evolution and replace it with a crackpot, egoistic, planned economy. But Buddhist, Taoist, and Confucian thought and beliefs are still at the heart of China. Not even an all-powerful state could eradicate that. How else to explain that Sun Yat-sen, the father of the Chinese nation, is more popular than Mao? His mausoleum in Nanjing is a shrine of sorts. I went there myself and discussed his legacy with several of the Chinese I traveled with. Mao was feared, but he made China great. Sun Yat-sen is revered, and he makes the Chinese proud.

My prediction: As China moves into center stage in the world economy, its traditional culture and its emerging free-market culture will replace the statist culture. It will be better for China and the world. The state may be planning otherwise, but it can't control what it's unleashed. And for that, we should all be grateful. China is a beautiful place with kind, hardworking people. The real moneymaking there has just begun, and it's spreading throughout Asia like fire in a crowded theater.

Regards,

Dan Denning
for The Daily Reckoning

© 2005 Dan Denning
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Dan Denning is the editor of Strategic Investment, one of the most respected "big-picture" investment newsletters on the market. A former specialist in small-cap stocks, Dan has been at the helm of Strategic Investment since 1999 - where, drawing from his network of global contacts, he has designed an investment strategy that takes into account global political and economic trends. His weekly e-mails and monthly newsletter give investors the most complete picture of what's shaping investment markets, what's coming next, and exactly what to do today You can sign up for a free subscription to the Daily Reckoning here: http://www.dailyreckoning.com. This essay was originally published in The Daily Reckoning.