Ensuring Financial Stability Requires Economic Rebalancing

Taiwan’s economy has demonstrated its resilience during the past two years of the pandemic, thanks to strong demand for the island’s exports. In the long term, however, some reforms to monetary policy are needed as Taiwan faces the dual challenges of a hot housing market and an aging population.

While post-pandemic inflation continues to impact markets and consumption patterns worldwide, Taiwan’s recent high levels of economic growth, driven by a surge in exports, has given the island’s economic policy makers a bit of a buffer. And although central banks around the world are now entering a tightening cycle to address that inflation, a move that tends to reveal stress points in an economy, observers are generally confident about the ability of Taiwan’s housing market – and the economy as a whole – to withstand any resulting monetary pressure.

That said, the massive run-up in Taiwan’s housing prices following the 2008 financial crisis never contributed much to stimulating the economy. As a 2019 study by three scholars at National Chengchi University concluded, “As less than 7% of Taiwan’s population owns two or more houses, the wealth effect contributed only insignificantly to consumption as housing prices surged.” In addition, the report noted, “The reduction of interest rates through the policy of monetary easing caused housing prices to surge and endangered the economy’s stability, further deteriorating income distribution, housing affordability and the consumption ability of the public.”

Another factor holding down consumption is Taiwan’s demographic challenges, primarily its rapidly aging population. The island has the second-lowest birth rate in the world, trailing only Korea. As a result of these various pressures, housing is supported by less and less economic activity.

Japan, which once was also an export-driven economy, offers a picture of the worst-case scenario. The Plaza Accord, a 1985 agreement between five major world economies, including Japan, to appreciate their currencies in relation to the U.S. dollar, caused the Japanese Yen to double in value. External reforms were not matched by corresponding internal reforms to Japan’s closed system of industrial finance, and capital continued to flow into the country’s own real estate market instead of overseas (although it eventually began to flow outward once the scale of the distortions became clear). The resulting real estate bubble famously caused the land under Tokyo’s Imperial Palace to be worth as much as the real estate of the entire state of California.

In many respects, the Japanese financial system was slow to respond even after the stock market crash in 1989, as banks did not act quickly enough to recognize corporate bankruptcies. That year inaugurated what was later termed Japan’s “lost decade,” even though the period turned out to be essentially indefinite.

Those market developments dovetailed with the end of the country’s demographic dividend, which ensured that it never again saw the same growth rates as it had previously enjoyed. Japan was a global outlier at the time, with its fertility rate falling below 1.5 children per woman in 1993. Taiwan, for its part, is now at 1.2, and it is expected to become a super-aged society by 2025.

The basic facts alone may overstate the severity of the situation. Taiwan’s housing vacancy rate has come down from 20% when prices first exploded, to 10%. Regarding demographics, Taiwan has an ability and willingness to import more immigrants, as a portion of its population, than Japan ever did. Furthermore, Taiwan is much more exposed to international trade and capital flows, making its external account management more important than its internal monetary policies.

Taiwan’s demographics are also exposed to regional trends. Even though it does not import Chinese laborers, due to competition on the margins, its own labor pool could to some extent still be considered part of the same regional market. Because China no longer exports nearly as many laborers to countries such as Korea and Japan, Taiwan now finds itself competing with them on price for the same fixed pool of workers from Southeast Asia. A scarcity of imported labor will become an especially acute problem for retirees who depend on personal caretakers.

Schive Chi, former Chair of the Taiwan Stock Exchange and Taiwan Academy of Banking and Finance, is more optimistic about Taiwan’s ability to attract regional labor. Of Taiwan’s current student population, 7.3% has at least one immigrant parent. “These family ties with their original home countries mean that Taiwan does not need to compete for labor only on price,” says Schive, who now serves as a professor of economics at Shih Hsin and Soochow Universities in Taipei.

Overall, Schive says that Taiwan’s economy can be expected to be more resilient than its neighbors’. It has so far experienced lower inflation than other major economies; in fact, bottlenecks in its own semiconductor sector are one of the causes of the inflation happening elsewhere. For this reason, as well as Taiwan’s history of moderate interest rate changes, rate hikes abroad may not necessarily translate into increases in Taiwan. The trade surplus, meanwhile, means the New Taiwan dollar (NTD) may face pressure to appreciate. Otherwise, the Central Bank may continue to accumulate further reserves to push it down.

Over the years, however, such an approach has come to be a source of growing criticism of Central Bank policy. Taiwan already has the world’s fifth-largest reserves, which stood at US$549 billion as of January. That comes out to about US$23,300 per capita, or 80% of GDP.

Last year, four scholars at National Taiwan University wrote The Privilege to be Rich: The Price We’ve Paid for 20 Years of Central Bank Policy (致富的特權: 二十年來我們為央行政策付出的代價), explaining that the low domestic rates, which have led to the current housing situation, are tied directly to reserve accumulation. The Central Bank can only accumulate foreign currency by exchanging it for NTD, which leads to easy money domestically. Although there is no general principle that an increase in the money supply must be used to fund asset price increases, practically speaking, that practice appears to have been the case.

It is hard to say how much dissatisfaction with the Central Bank exists in the financial sector, but it appears to be more than before. “We cannot definitively say that the Central Bank is wrong, but we disagree with its approach,” says Wu Tsong-Min, a professor of economics at NTU specializing in historical perspectives on Taiwan’s economy and one of the authors of The Privilege to be Rich.

Dissatisfaction with the Central Bank’s policy on managing Taiwan’s reserves has been growing in the last few years. Photo: Wikipedia

“Most scholars would agree that there is significant room for improvement in the way the Central Bank manages its reserves,” agrees Schive Chi. “By any standard or reason, the amount of foreign exchange accumulated by the bank is way too large for necessity, and the way that amount is handled is unwise,” he says, referring to how the bank keeps its reserve allocation entirely in cash. This arrangement causes it to forgo returns on investment, even as the global environment now turns inflationary. Schive recommends instead putting part of that money into a sovereign wealth fund, which he says could earn 6-12% annually, instead of the 3% currently being generated.

The points about quantity and allocation are related. To see why, it is important to revisit the history around the time of the Plaza Accord, when the U.S. pressured Taiwan to appreciate its currency below its longstanding level of 40 NTD/USD, to an unknown “equilibrium” level.

The result was somewhat chaotic, as foreign investors were confused about the extent of intended appreciation. “Hot money” (funds from investors seeking short-term returns) poured in, in expectation of further gains. Alarmed, the Central Bank ended up having to defend the currency from further appreciation at 27.5 NTD/USD after it had reached 26 NTD/USD.

Liquid and illiquid capital

The same phenomenon could also give rise to other costs besides policy uncertainty – especially in an economy like Taiwan’s that is open to foreign investment. Suppose foreign investors bring capital into Taiwan, expecting appreciation. Because Taiwan has few government bonds available on the market, this investment goes into the private sector, where it earns returns. If the Central Bank wants to dispel the foreign investors’ expectations and keep the NTD from appreciating, that money must then leave Taiwan again as reserves.

Taiwan thus loses the margin between the cost of the incoming capital and the returns on outgoing capital, kept as cash. Combined with investor uncertainty about the future path of the NTD, the problem of asset allocation may not only create an opportunity cost for the pension system (if the reserves are to be used as retirement savings), but it could also result in a direct percentage cut in Taiwan’s current international cash flows.

The Privilege to be Rich provides more insight on past history than on future solutions. The U.S. is once again becoming uncomfortable with the Taiwan Central Bank’s market interventions, although co-author Wu says that because the U.S. stance on Taiwan’s currency policy has been clear for some time, the risk of mismatched expectations is less than during the reforms of the 1980s. Nevertheless, given that the main source of pressure is external, Taiwan inherently has less control over the situation.

Moreover, one of the strongest conclusions of the book is that certain institutional impediments exist to monetary policy reform. The Central Bank is organized like a state-owned corporation and is expected to earn profits every year, mainly from foreign exchange trading. Currency appreciation would mean that foreign assets lose money. Schive also points out the political barriers to creating a sovereign wealth fund, since the Central Bank would probably not be fully in charge of its management.

All in all, the greatest medium-term threats to Taiwan’s economy still seem more conventional in nature than a financial crisis caused by a long-term domestic consumption squeeze. The current under-capacity in semiconductors could eventually turn into overcapacity, following massive capital investments. A slowdown in China, which accounts for 42% of Taiwan’s exports, could also constrain its growth. It is also particularly worth noting that China’s situation is quite similar to Taiwan’s, with the exception of the recent positive impact on Taiwan of increased U.S.-China competition. The renewed demand for the island’s exports as a result of this situation provides a cushion against any adverse eventualities.

The challenges that remain are more institutional in nature. Now that exporters are no longer competing so fiercely on price, Taiwan can transform itself into a more consumption-oriented economy. To do so, it will need to consider reforms to Central Bank policies and practices, as well as concurrent reforms to its immigration system.

Recognizing the increasing scarcity of manpower in Taiwan, the Ministry of Labor has recently announced a new path for migrant workers to obtain permanent residency. Going forward, the government may need to take a proactive approach, not just relaxing rules on migration but also taking action to more effectively compete for workers.

As competition for Southeast Asian migrant workers increases, Taiwan will need to take a more proactive approach to boost its appeal. Photo: Andrew Chen

The problem with plans to import immigrants to help care for future retirees is similar to that of the overconcentration of housing wealth. If everyone is planning to retire at the same time, current prices may not reflect those that will occur when assets need to become liquid.

Likewise for immigration, where every country in East Asia is facing the same demographic situation. The question for Taiwan is less about the price of immigrant labor as it is whether potential migrants will be available at the time they are needed in Taiwan. Demographics can interact with both personal and public finances in a variety of ways that may not be apparent from simple financial ratios or economic statistics.

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