Taiwan-China trade agreement: A game changer

FORTUNE -- Taiwan finally gets to join the dynamic ring of fiery growth that has typified East Asia for the past decade. The island signed a trade agreement with China on Tuesday that ends its economic isolation and increases the chances for lasting peace in the Taiwan Strait.

Taiwan watched from the sidelines as all of Southeast Asia signed a free-trade deal with China and started trading as a bloc as of January of this year. Now, Taiwan's own deal will allow it to export 539 categories of goods to China with reduced tariffs, worth $13.8 billion annually. In exchange, Taiwan will lower tariffs on half that number of Chinese goods, worth just $2.9 billion.

According to research from the Peterson Institute for International Economics (IIE), the deal will add 4.5% to Taiwan's GDP growth by 2020. Without it, Taiwan wouldn't just stand still -- its economy would contract by nearly 1%.

So it's a good deal for Taiwan. But that doesn't mean everyone in Taiwan is happy about it. Opposition politicians organized a protest that attracted tens of thousands of people to the streets of Taipei last weekend despite a torrential downpour. These anti-free-traders fear that the latest deal -- part of the rapprochement with China begun by President Ma Ying-jeou after his election in 2008 -- will be yet one more step toward Taiwan's loss of independence and its eventual assimilation into the mainland. Some protesters also fear small businesses will be overrun by a flood of cheap imports from China.

What they don't understand is that in order for Taiwan to increase its economic power in the region and to grow its economy, it must not only have this free trade deal but also continue opening up to the economic powerhouse off its shores. A stronger economy strengthens Taipei's position in any eventual talks with the mainland. Isolation weakens it.

And it's also good for U.S. interests in the region, in that a stronger Taiwan means more chances of keeping the peace in the Taiwan Strait. "The geo-economic implications are significant enough to demand strategic attention from the United States," according to Daniel Rosen and Zhi Wang, the authors of the IIE study.

New relationships lead to economic expansion

Since he took office, Taiwan's President Ma has managed to secure 12 economic agreements with the mainland. He allowed Chinese investment into Taiwan, including into the stock market, for the first time. He also opened up direct air and sea links that had been closed since the Communist capture of China in 1949. Instead of a lengthy detour through Hong Kong, the 1 million Taiwanese who invest in and live in mainland China can fly direct on 270 regular weekly flights between Taiwan and 31 mainland cities. The government estimates that 1 million mainland tourists will visit Taiwan this year -- up from 600,000 last year (injecting $986 million in revenue), and up from virtually zero in 2007 before President Ma opened up the Taiwan Strait to cross-Strait trade.

"Better relations with mainland China are good for Taiwan and will reverse the country's marginalization," former American Institute in Taiwan Director Douglas Paal told a conference discussing the trade pact in New York recently.

The Harvard-educated President Ma would next like to widen the free-trade area to include Southeast Asia -- an extension that could raise the total benefits to Taiwan's GDP to 5.7% by 2020, the IIE study found. Further talks between Taipei and Beijing on expanding trade even more are due to begin six months after this agreement takes effect -- and that first requires approval by Taiwan's parliament.

The agreement affects primarily the textile, auto parts, machinery and petrochemical sectors, as well as banking and other services. Taiwanese banks such as Bank of Taiwan, Chang Hwa Bank, and Hua Nan Commercial Bank have been scouting opportunities on the mainland in hopes of being able to apply for banking licenses and operate retail branches as U.S. and other foreign banks now do.

However, the current agreement does nothing to loosen Taiwan's restrictions on semiconductor manufacturers such as TSMC, which currently are prohibited by Taiwan's laws from bringing their most sophisticated technology to China. TSMC has moved its 8-inch wafer manufacturing to China where it's cheaper, but like others restricted by Taiwan laws, it must manufacture 12-inch wafers at home. TSMC's founder Morris Chang told investors when announcing first-quarter earnings this year that business has grown 63% on the mainland since it set up there in 2004, and that TSMC would be expanding capacity at its 8-inch facility in Shanghai this year as business continues to explode.

President Ma has repeatedly said there is no compromise of Taiwan's sovereignty in opening up to the mainland, but that expanding trade ties with China creates both opportunity -- and risk. If Taiwan is going to remain an integral part of a growing region, it's a risk it has no choice but to take.

Sheridan Prasso, a long-time contributing editor at Fortune, is an Associate Fellow at the Asia Society.