China Set to Bump Up Taiwan’s Economy

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When the dust settles over the first half of this awful year, the reopening of negotiations between Taiwan and China may well end up hugely significant after having mostly been overlooked. Taiwan is certain to become the mainland’s first stop abroad, taking over the role that Hong Kong ceased to be able to play after June 1997. If so, Taiwan can expect:

  • To be the recipient of an exponential rise in tourist arrivals from China;

  • To become the first-stop home for mainland Chinese capital moving overseas;

  • To become the first-stop home for mainland real estate investment.

The changes to Taiwan’s economy will be dramatic. The economy is performing surprisingly well in strategic terms compared with how it was before cross-strait relations froze in 2000, and to other potentially similar Asian economies not hampered in the same way, and given the fact that the economy is fractured between an industrial sector that is coping well with the collapse in terms of trade and a slumping domestic economy. That fracture can be traced directly to the failure of Taiwan’s financial system.

It is right there, in the lopsided relationship between Taiwan’s financial system and the opportunities available on the mainland, that the opportunity cost of the last eight years is to be found, and it is right there that the opportunity afforded by the easing of the de facto financial boycott of the Taiwanese financial system by mainland Chinese money will be found.

Strategic Conditions: Still Impressive and Positive

In terms of return on capital, labor productivity and the net cash flows generated by the private sector, Taiwan’s economy has so far survived the deterioration in global trading conditions better than any other Northeast Asian economy. In common with the rest of Northeast Asia (except China), so far this century, the fundamental story has been one of a sharp slowdown in the growth of capital stock, which has halted and to some extent reversed the deterioration in return on capital of the 1990s. By the first quarter of this year, Taiwan’s capital stock of machinery was probably growing by 4.1 percent in nominal terms, and that the return on that capital stock was no worse than stable.

taiwan-capstock

Source: CEIC Data, ColdWater Economics Ltd

The ability to keep return on capital rising modestly since 2002 has been largely bolstered by a sustained rise in real labor productivity – in this the real output per worker adjusted to take into account the changes in deployed capital-per-worker. During the first quarter of 2008 this measure of real labour productivity was up 1.4 percent.

taiwan-realoutput

Source: CEIC Data, ColdWater Economics Ltd

The combination of this relatively robust return on capital and labour productivity picture, coupled with a domestic private sector consumption demand which has remained depressed (private consumption rose only 2.0 percent year on year in real terms during the first quarter) has allowed Taiwan actually to grow its private sector savings surplus to 8.5 percent of GDP in the 12 months to March, up from 8.3 percent in the same period last year. It has also meant that, against considerable odds, capital spending has continued (up 11.1 percent annually in the first quarter in nominal terms, and 5.8 percent in real terms), and employment has continued to grow (up 1.5 percent annually in April, with underlying sequential momentum still positive).

taiwan-privsect

Source: CEIC Data, ColdWater Economics Ltd

This is extremely surprising, since, like the rest of Northeast Asia, the country’s current economic situation is dominated by the deterioration in its terms of trade, to which it has had no significant currency response. As of May, Taiwan’s terms of trade were down 14.8 percent year on year – the sharpest fall since at least 1990, but almost identical to the deterioration afflicting Japan (down 15.4 percent) and Korea (down 15 percent).

taiwan-twi

Source: CEIC Data, ColdWater Economics Ltd

The ability to raise the private savings sector surplus even in the face of a collapse in terms of trade is unique in Northeast Asia, and ought to have resulted in a sustained flow of liquidity into Taiwan’s financial system, which in turn ought to have supported bond yields and broader monetary growth. As we shall see, this has not happened, because Taiwan’s exporters exchanged only 10.3 percent of their export earnings for the NT dollar in the year to May – a record low. This breaks the link between what’s happening in Taiwan’s industrial economy and the monetary economy. And this fracture both describes and accounts for the continued sour relationship between Taiwan’s people and their money, and between Taiwan’s financial system and its economy.

For a glimpse at the disjunction between the financial system and the economy, take a look at Taiwan’s monetary velocity (Gross domestic product/M2). Taiwan has the lowest monetary velocity of any Asian economy, which suggests that the deployment of the deposits in its banking system regularly produces less GDP growth than anywhere else in Asia. What’s more, Taiwan also has the region’s lowest liquidity preference (the proportion of M1 to M2). In bald terms, the Taiwanese keep the region’s highest proportion of money in deposits, not cash, but the banking system uses those deposits in the region’s least economically efficient ways.

Taiwan’s sustained economic success has come about despite, not because, of its financial system.

One of the reasons that Taiwan’s financial system is not improving could be the lopsided economic and financial relationship with China. If so, while China’s boycott of Taiwan’s financial system has not ruined Taiwan’s economy, it has helped hobble it.

But Can You Spot the Strategic Difference?

As far as the overall structure of growth is concerned, Taiwan’s economy compares well with most of its Asian competitors. This raises the question of ‘has China’s financial boycott actually hurt at all?’ After all, why bother about the opportunity cost if the outcome is already favorable relative to neighbouring economies?

And in terms of Taiwan’s direct economic mix, it is difficult to spot any glaring omissions in structure. Consider the similarities in the share of various different industries in Taiwan’s GDP, compared with those in Korea (original NIC running-mate); Malaysia (similar population size) and Hong Kong (formerly first-stop for Chinese investment and tourism).

Contributions to GDP

Taiwan Korea Hong Kong Malaysia Manufacturing 31.8% 30.5% 3.0% 30.1% Financial Services 11.4% 7.0% 17.7% 10.7% Restaurants/Tourism 2.2% 2.2% 3.0% 2.4% Property 9.2% 5.9% 4.5% +10.2% n.a. Construction 2.4% 6.5% 2.5% 3.0%

What’s striking about this is how utterly unwarped Taiwan’s industrial structure seems. In those areas where one might have expected the China boycott to have had a major impact, the data suggests otherwise. Thus financial services, though essentially closed to mainland investment, at 11.4 percent of GDP are already more important than in both Korea and Malaysia. Tourism accounts for only 2.2 percent of GDP, but is that really so different from the 3.0 percent recorded in Hong Kong, or the 2.4 percent recorded in Malaysia? In short, one looks in vain for glaring anomalies of industrial or economic structure recorded in the national accounts.

Current Cyclical Malaise

So far, so good. But despite the unexceptional industrial structure, and despite the unusually positive outcome for the industrial economy so far this year, Taiwan’s domestic economy is in trouble, with no early sign that things are likely to get better. The chart below captures what’s happening to its economic momentum. It shows how Taiwan’s industrial economy remains surprisingly buoyant despite the general sourness of the world economy. In particular, Taiwan, like Korea, has managed to maintain positive export momentum: May’s data shows exports up 11.1 percent year on year in NT dollar terms and 14.0 percent in volume terms.

However, the relatively healthy state of the industrial economy finds no echo in domestic demand data. There, despite employment rising 1.5 percent annually, momentum in wages is sharply negative (they were up just 1.5 percent year-on-year during the first quarter), retail sales are falling (down 0.9 percent in the three months to April), car sales are collapsing (down 15.2 percent in the three months to April), and the construction industry is also suffering (building permits down 17.5 percent in the same period).

May’s consumer confidence reading is the worst since late 2001 and there is no support at all from the monetary side of the economy, where April’s data shows M1 growth as having stalled in YoY terms, and M2 growth to be negligible at 2.1 percent YoY. Loan growth has slowed to 2.2 percent annually and the underlying sequential momentum of loan growth has been negative now for 26 consecutive months. Banks are, if anything, becoming more cautious, and loan/deposit ratios have fallen to 86.2 percent- their lowest level since 2004.

Nonetheless, today’s Taiwanese newspapers report a survey of banking institutions which finds that almost all expect Thursday's CBC monetary board meeting to result in a 0.125 percent rise in benchmark rates.

taiwan-momentum

Source: CEIC Data, ColdWater Economics Ltd

Just when Taiwan could benefit from a properly functioning financial system, it hasn’t got one. Insofar as the stagnation of Taiwan’s financial system has been sustained or encouraged by the mainland Chinese financial boycott, the opportunity cost of the post-2000 cross-straits diplomatic standstill is now being counted in the fragility of Taiwan’s domestic economy.

Finance & Other Service Exports: The Lopsided Relationship

The most obvious difference between Hong Kong and Taiwan, and one likely to reflect the difference in the financial relationship between these two economies and the mainland, shows up in net foreign portfolio investment into both financial systems. At the beginning of 2000 (when my data for Hong Kong starts) both economies had enjoyed net inflows of approximately US$10 billion in the previous year. By the end of last year, the situation had changed shockingly: while the net inflow of portfolio investment into Hong Kong had risen to just under US$20 billion, there had been a net outflow of portfolio investment from Taiwan of slightly less than US$40 billion.

taiwan-netport

Source: CEIC Data, ColdWater Economics Ltd

But I suspect that these balance of payments numbers underestimate the problem. For what they ignore is the extent to which Taiwanese companies themselves routinely and nearly invisibly, but massively, have disinvested. The key statistic for this is the collapse of the proportion of foreign currency earned from exports which is sold for NT dollars and thus enters Taiwan’s financial system. As the chart below shows, over the last 15 years, that proportion has collapsed from over 60 percent to just over 10 percent today. In the 12 months to May, the amount of export earnings which never entered the financial system stood at US$242 billion, of which we can assume that around US$200 billion was used to fund imports. There remains, however, an opportunity -- cost leakage of approximately US$40 billion a year from Taiwan’s banking system.

portion-net

Source: CEIC Data, ColdWater Economics Ltd

Is the mainland’s boycott of Taiwan’s financial industry solely to blame for this? Of course not. However, looking across at the US$10 billion-odd in net Hong Kong dollar positions which Chinese banks routinely have in the Hong Kong banking system, surely suggests that the ending of the boycott, and the emergence of Taiwan’s financial system as the ‘first-stop abroad’ would certainly reverse it. “If mainland Chinese investors are buying into our financial system, shouldn’t we be too?”

And, of course, such a fundamental change in the relationship between corporate Taiwan and the financial system it currently ignores would utterly transform Taiwan’s short and medium term economic prospects. That’s rarely been clearer than right now.

Finally, the second and related opportunity cost which Taiwan has been paying from its lopsided commercial and financial relationship with the mainland is found in the negligible growth Taiwan has managed in its services exports. As the chart below shows, exports of services amount to only 7.9 percent of Taiwan’s nominal GDP, compared with 40.8 percent in Hong Kong. What’s more the growth trajectory since 2000 has been very sharply different: in absolute terms between 2000 and 2007, in US dollar terms Taiwan’s services exports grew 79 percent, from 5.2 percent of GDP to 7.8 percent. Meanwhile, in Hong Kong, services exports grew 106.7 percent YoY, from 23.9 percent of GDP to 40.3 percent.

taiwan-services

Source: CEIC Data, ColdWater Economics Ltd

Michael Taylor is an independent economist at Coldwater Economics