The ascendant Southeast Asian region of 600 million offers Taiwanese banks better prospects than mercurial China

The Taiwanese banking sector booked a net loss in 2015 for the first time in nine years as a feeble domestic economy and China’s slowing growth battered balance sheets. Earnings fell 0.2% year-on-year to NT$319.6 billion (US$9.75 billion), according to the Financial Supervisory Commission (FSC). Although the Chinese operations of Taiwanese banks remained profitable, overall earnings in China fell by nearly 46% to NT$1.97 billion (US$60.1 million). It was the first annual decline since Taiwanese banks expanded into China in December 2010.

What a difference a year makes. As this magazine reported last May, Taiwanese banks recorded record profits in 2014, buoyed in large part by surging offshore business in China. In recent years, Taiwanese banks have sought to escape the doldrums of their saturated home market by pursuing higher-margin offshore lending in China, which has become their largest debtor.

But Taiwanese banks will now have to look elsewhere for growth drivers as risk increases sharply in China, experts say. “China exposure could be too high, especially as China is not transparent,” says Liang Kuo-Yuan, chairman of the Yuanta-Polaris Research Institute, a Taipei-based economic think tank.

The Chinese economy grew by just 6.9% last year – the slowest pace in 25 years and down more than 30% from five years ago. This year Beijing has set a growth target of 6.5% to 7%, though Liang notes that many analysts expect the pace to be slower. “It’s not clear what level of single-digit growth we are seeing in China,” he says.

Meanwhile, renminbi deposits in Taiwanese banks have fallen in recent months, notes Cheng Cheng-mount, president of the Agricultural Bank of Taiwan and one of the island’s leading economists. In February, deposits of the Chinese currency in Taiwanese banks dropped to a 13-month low of 316.8 billion yuan (US$48.6 billion), according to Taiwan’s Central Bank.

“Maybe we need to take a short break from China,” Cheng says, acknowledging that the PRC’s fiscal travails are affecting the bottom line of Taiwanese banks. “In this case, the logical place to go is Southeast Asia, where many Taiwanese businesses have established operations.”

Since Taiwan eased restrictions on doing business with China in 1987, Taiwanese manufacturers have favored investing in their giant neighbor for reasons of cultural and geographic proximity. Yet former president Lee Teng-hui did have some initial success with his “Go South” policy, launched in late 1993 to prevent Taiwan from becoming economically overdependent on China. From 1993 to 1996, Taiwan invested US$15 billion in ASEAN compared to just US$6.5 billion in China, according to Jing Bao-chiun, a research associate at the Lee Kuan Yew School of Public Policy at the National University of Singapore.

With the onset of the 1997 Asian financial crisis, Taiwan shifted its focus decisively to a rising China, Jing noted in a January report in Singapore’s Straits Times. By October 2015, a staggering US$153 billion, 61% of Taiwan’s aggregate overseas investment, went to China.

ASEAN ascendant

With labor costs now soaring in the PRC and the domestic economy sputtering, Taiwanese businesses are rethinking their China-centric strategy. Encouraged by the government, they are tapping the fast-growing economies of Southeast Asia. Through 2014, Taiwan had invested US$84.1 billion in the ASEAN market, according to the Ministry of Economic Affairs (MOEA) Taiwan is also one of the top foreign investors in Vietnam, Malaysia, and Thailand.

In addition, ASEAN has become Taiwan’s second-largest trading partner after China. Bilateral trade between Taiwan and ASEAN totaled US$93.6 billion in 2014, comprising 16% of the island’s overall trade that year, according to Bureau of Foreign Trade statistics.

“ASEAN is benefiting from the changing landscape in China and the inclusion of four member states – Vietnam, Malaysia, Singapore, and Brunei – in the TPP,” says Taipei-based Standard Chartered economist Tony Phoo, referring to the pending Trans-Pacific Partnership trade agreement signed in February by 12 Pacific Rim countries including the United States and Japan. For the high-growth region, which in 2013 overtook China as the world’s top recipient of FDI, “this is just the beginning,” he adds.

“We aren’t leaving China, but we are focusing on Southeast Asia,” says Huang Boyi, president of the Taiwan Academy of Banking and Finance (TABF). “We need to spread out the risk.”

Bank of Taiwan Chairperson Lee Jih-chu, who also heads the Bankers Association of the R.O.C., notes that “ASEAN recently has been catching everyone’s eyes globally because of its rapid economic growth and gradually deregulated market.” The government-owned Bank of Taiwan, which has had a branch in Singapore since 1995, recently established a representative office in Yangon in Burma (also known as Myanmar), and is studying the feasibility of opening a branch in the Philippines.

Lee cites the “demographic dividend” provided by ASEAN’s large population, young labor force, and growing middle class that constitutes an estimated 30% of the people.

At the center of the ASEAN growth story is Vietnam, whose economy is forecast to grow 6.7% this year – the same pace as 2015 – on the back of surging FDI and robust domestic consumption. Globally, only India is expected to grow faster.

Taiwan is now the number-four investor in Vietnam, after South Korea, Japan, and Singapore. In 2015, Taiwanese businesses invested US$674 million in Vietnam, an increase of 43.7% over the previous year. With that surge in investment came opportunity for Taiwanese banks, which last year opened 11 new branches in Vietnam. The country is now home to 31 branches of Taiwanese banks. Globally, only China has more with 43.

For Taiwanese banks, “Vietnam is a natural gateway to Southeast Asia,” says Standard Chartered’s Phoo. “It’s a starting point for a region-wide strategy.”

Underscoring the importance of Vietnam to Taiwan’s financial sector, then FSC chairman William Ming-chung Tseng traveled there last December to meet with Vietnamese regulators. The trip bore fruit. The Vietnamese government promised Tseng to allow Taiwanese investors to own up to 30% of state-owned banks and 100% of local privately owned insolvent banks. In return, it said it hoped for help from Taiwan’s financial services firms in funding Vietnam’s infrastructure projects.

It was no easy win for the FSC, observes Cheng of the Agricultural Bank. “The FSC chairman went to Vietnam because Vietnam’s Central Bank is very conservative,” he says.

With a large, youthful population (51 million people) and rapid GDP growth, Burma is another Southeast Asian country attracting Taiwanese investment. In November 2014, the Taiwan Electrical and Electronic Manufacturers’ Association (TEEMA) announced it would invest NT$14 billion (US$428 million) to develop an industrial park in southern Burma to serve as a manufacturing base for dozens of Taiwanese electronics components makers. Bilateral trade between Taiwan and Burma reached US$328 million in 2014, up 20% from a year earlier, according to government statistics.

To date, Taiwan’s level of investment in Burma remains modest compared with its presence in China, Thailand, Singapore, or Vietnam. But there is significant opportunity for Taiwan in Burma’s underdeveloped finance sector, which was closed to foreign competition for decades under junta rule. Burma “has big growth potential,” says Phoo of Standard Chartered, adding that “recent elections are likely to bring political stability in the medium term.”

In February, a total of 13 banks, eight of them Taiwanese, applied for licenses to operate in Burma. Among the Taiwanese banks, only E. Sun Commercial Bank has received approval thus far. The new round of bank licensing began late last year with the objective of boosting foreign investment in the Southeast Asian country. Burma’s Central Bank has yet to say how many licenses will be granted.

The way forward

As Taiwanese banks expand across Southeast Asia, they will face a number of operational challenges, experts say. Foremost among those will be developing a cross-border platform, says Fitch Ratings analyst Cherry Huang, noting that Taiwanese banks lack global talent with experience in cross-border business. As they seek to acquire local banks, they are therefore at a disadvantage compared to “regional champions” like Singapore’s DBS, which has a deep international talent pool, she observes.  She expects that cost-conscious Taiwanese banks will instead choose to cultivate talent with “more of a regional and global view” internally, a process that could take considerable time.

Furthermore, Taiwanese banks typically are less well capitalized than their global competitors in Southeast Asia. Given that acquisition targets in the region are often not in sound fiscal condition, an acquisition has the potential to weigh heavily on the balance sheet of a Taiwanese bank, Huang notes.

Still, several Taiwanese banks have already made significant inroads into Southeast Asia. Cathay United Bank has more than 60 overseas units in ASEAN countries, including branches in Singapore, Malaysia, Vietnam, and Laos, and representative offices in the Philippines, Thailand, and Burma. In 2013, Cathay became the first Taiwanese bank with a fully-owned Cambodian operation following its acquisition of Singapore Banking Corporation Cambodia.

CTBC Bank, formerly known as Chinatrust, has an even larger presence in Southeast Asia than Cathay. Of its 100 overseas units, many are located in ASEAN countries. During a regional economic forum held in the Philippines last September, CTBC president Daniel Wu told Reuters that ASEAN “has been on our radar screen” in reference to plans to boost overseas banking’s share of the bank’s overall income. In an unusual move for a Taiwanese bank, CTBC also plans to set up a Japanese desk in the Philippines to serve the increasing number of Japanese manufacturers there.

Some observers say China’s enormous size and close economic ties with Taiwan will continue to make it an important market for Taiwanese banks in the future, even if Southeast Asia is the new priority. “I don’t see Taiwanese banks having to downsize operations in China, but the importance of the China market will gradually decline as they build up operations in Southeast Asia,” says Phoo of Standard Chartered. “Longer term, China still has positive prospects. It is one market you cannot afford to ignore as you grow offshore revenue.”

Meanwhile, the risks of China exposure are becoming increasingly clear as banks grapple with customer defaults on a popular derivative product called a Target Redemption Forward (TRF) used to hedge yuan exposure and speculate on currency moves. Those defaults may have caused hundreds of millions or even billions of dollars in losses at Taiwanese banks following the yuan’s precipitous slide last summer. The TRF pays the holder a monthly income provided the yuan remains above a trigger price against the dollar. If the yuan falls, the investor has to pay out.

According to Fitch Ratings, SMEs “are among the most exposed to TRFs” as the derivative products are sold largely to smaller companies aiming to hedge their yuan exposure from cross-Strait trade.

Fitch notes that banks’ disclosures regarding their TRF business are insufficient, making it difficult to accurately gauge the full extent of bank losses caused by the derivatives. The FSC estimates losses to be about NT$4 billion (US$120 million). Last December, however, Fitch conducted a scenario test that found losses could reach up to NT$79 billion – equivalent to about 0.2% of sector assets or 2.6% of sector equity – if the Chinese currency were to fall below 7 Chinese yuan (CNY) to the US dollar. The exchange rate at that time of the test was CNY6.4/USD and is now CNY6.5/USD.

“Banks should be able to absorb the losses, but their returns, which are already low, will be eroded,” says Huang. Fitch predicts the banking sector’s return on assets will be 0.6% in 2016, down from 0.7% a year earlier.

In a January statement, the FSC said it would punish nine banks for inappropriately selling yuan derivative products to clients. Banks named in the statement include Citibank, Standard Chartered, Cathay United Bank, Taipei Fubon Bank, and Bank Sinopac.

Cheng of the Agricultural Bank notes that the FSC is taking a conservative stance on China exposure for now. “They are waiting to see what type of cross-Strait policy Tsai [president-elect Tsai Ing-wen] pursues.” Tsai has said repeatedly that she will uphold the status quo in cross-Strait relations. But it is clear she intends to place greater emphasis on relations with Taiwan’s other Asian neighbors. In September 2015, at an event celebrating the 29th anniversary of the DPP’s founding, Tsai said it “it is a natural choice for us to step up overall relations with ASEAN.”

Under current political conditions, the regulatory cap of 100% on the ratio of a Taiwanese bank’s China exposure to its net assets is not going to be lowered, reckons Huang. “That’s a potential bottleneck” to further expansion of the banking sector in China, she says. “The new president has made it clear it’s essential to diversify risk.”