Is the honeymoon over for Taiwan-China trade?

Institutional Investor, June 2010

Ever since Ma Ying-jeou became President of Taiwan in May 2008 on a platform of warmer relations with mainland China, the island state’s businesses have been enthusing about the benefits that should flow to them from this new cooperative spirit.

The logic is straightforward. Closer ties mean greater ease of access, which is good for tourism and transportation, and should lead to more business in general. In particular, the lifting of long-standing restrictions on investment in mainland China is not only good for Taiwanese investors and entrepreneurs, but ought to galvanise the financial services sector too as banks follows their clients in to new opportunities.

But two years on, much the same language – of promise, of opportunity, of the future – is being used as it was when Ma came to power. “We are on the verge of a major transformation,” says Victor Kung, President of Fubon Financial, but it feels like Taiwan has been on that verge for some time.

In fairness, the picture varies from sector to sector. In aviation, for example, the whole environment has changed beyond recognition. It is less than two years since the first highly symbolic weekend flights from Taipei to Shanghai took place – the first direct commercial services in half a century – yet already there are 270 direct services between Taipei and mainland China each week, with plans to double that capacity to more than 540. This is a vast difference. “It used to be that when I wanted to go to China I would have to fly in to Hong Kong, wait awhile, and transfer to another plane in the direction I just came from. I’d lose a whole day,” says one businessman. “Today if I get a morning flight I can be having lunch in Xiamen or Shanghai the same day.” In terms of business productivity, this marks a significant shift.

Tourism has also had a major lift from Chinese visitors, with a corresponding effect on hotels and real estate generally. These industries are the front line of what is hoped will be substantive changes, and many international fund managers are positioning their funds to take advantage. “Our biggest country position is in Taiwan,” says Peter Sartori, founder of Treasury Asia Asset Management, which runs chiefly Australian institutional money from its offices in Singapore. “We’re a believer in the relationship with mainland China. We think it has improved dramatically in the last couple of years, and we think that’s set to continue. The market hasn’t priced that in yet.”

But in the financial services industry progress feels rather slower. Since 2008, banks have been excited about the prospect of being able to open branches (or turn existing representative offices into branches) on the mainland. This should allow them to serve their clients who have long been going in to China without them; to help new local clients invest on the mainland; and eventually to take renminbi deposits and build a new sustainable business. Banks have for years watched 40% of Taiwanese exports, worth about US$100 billion a year, flow to China but have been unable to serve their customers in their needs on the mainland, instead watching that business go the way of Chinese or international banks. The hope is that this will all now change. But still not one Taiwanese bank has been granted a branch license.

“Everything is more difficult at the beginning,” smiles Kung. “But we do remain very hopeful that once we have a beginning, everything shall move quickly.”

Institutional Investor’s last Taiwan report, in September 2009, featured an interview with Financial Supervisory Commission (FSC)’s Sean Chen – the country’s chief financial regulator – in which he explained the challenges involved in his negotiations with China to build memorandums of understanding to govern banking, insurance and securities. “The most difficult question to answer is when,” he said then. But he did eventually succeed: the MOU was signed in January, and hailed as a landmark.

After that, Taiwan announced new local domestic regulations regarding Taiwanese financial institutions going in to China. But the implementation of these regulations was then held up in the Legislative Yuan, Taiwan’s parliament, for several months, and consequently the FSC has only just started accepting formal applications from local banks to open Chinese branches. The regulator has not set a timeframe for processing these applications, but Kung does not expect to see branches open any earlier than the third or fourth quarter of 2010.

Even then, though, the impact of that breakthrough will depend on still another piece of negotiation, the Economic Cooperation Framework Agreement, or ECFA, which is being hammered out between the governments of Taiwan and China. This is a monumental discussion for Taiwan. “This agreement will set the framework, economically and politically, between Taiwan and China,” says CY Huang, co-founder and president of Polaris Capital. “It’s a very big thing. It will send a strong message to the world to imply a more normal relationship.”

There are numerous complex issues related to this agreement: the opposition Democratic Progressive Party in Taiwan believes it will lead to unification with China, which they fear; some feel it will reduce jobs and salaries and lead to outflows of capital and human resources; there are issues about migration of Chinese workers into Taiwan; and there are complex issues around tax, tariffs, investor protection and intellectual property to be resolved. ECFA is expected to be signed in June, but the whole agreement may yet have to pass through a public referendum before being implemented. It will be closely watched.

From the financial services point of view, banks are keen to see whether ECFA allows new branches to conduct business in renminbi. Under China’s agreements with the World Trade Organization, branches can only apply to do RMB business after three years of operations, of which two must have been profitable; Taiwanese banks are hoping they will be permitted to do RMB business from the outset.

Apart from commercial banks, other financial services players are watching ECFA closely. Eddy Chang, senior vice president of corporate strategy and planning at China Development Financial Holdings, a holding company that includes China Development Industrial Bank and Grand Cathay Securities, says the ECFA will help it to set up venture capital and private equity businesses in mainland China. “We would be able to set up our own office, and we could possibly raise RMB funds, whereas before we could only invest in US dollars.” Naturally, its potential investment targets will change too, to include mainland Chinese companies. Chang is hopeful that many Chinese local governments will invite CDFH to set up venture capital funds in China’s provinces, attracted by the group’s expertise in technology. “By doing so, they can attract Taiwanese high tech companies.”

While waiting for ECFA to be signed, several banks are already looking at joint ventures with Chinese securities companies or asset management businesses. But in the meantime, the most ambitious attempt by a Taiwanese bank to penetrate Chinese banking remains Fubon’s purchase of 19.9% of Xiamen Commercial Bank through Fubon’s Hong Kong subsidiary in 2008. “Last year was the first year of our investment, sending our team over to take over the management – it was a year of a lot of infrastructure building,” says Kung. “We made some organisational changes, tried to implement a new business model, and this year we will be able to start to build up our business more aggressively, especially for Taiwanese institutions in Xiamen and Fujian Province. This will be the year we are able to show some progress in numbers.”

Bankers describe the situation domestically as intensely competitive in Taiwan, but there are signs of enthusiasm from foreign players, again based on the promise of China. Peter Flavel, global head of private banking at Standard Chartered, is particularly enthused about Taiwan following a tax amnesty last year, “giving people an incentive to bring money that was offshore, onshore. There was quite a flow of money back into Taiwan.” Generally, he says, the Taiwan-China story is a story about trade. “Our wholesale bank will be involved in the explosion of trade flows – not just with China but in Northeast Asia – and trade creates wealth that needs to be invested.”

Certainly foreign brokers appear to believe risks are to the upside. Deutsche, for example, has a buy recommendation on each of Fubon Financial, Cathay Financial, First Financial and Yuanta Financial, saying “we expect further ECFA negotiations to support sentiment.” And Sartori says: “The economic benefits for Taiwan are too great for them to put roadblocks up. The Taiwanese economy and stock markets have lagged the region for about two decades because they’ve been hollowed out by Mainland China. We believe that’s changing.”

While banking is a key focus of China-Taiwan negotiations, there is more to the country than financial services. One of Taiwan’s economic mainstays has been technology and electronics, and here too there is a range of opinion: some think that the country’s semiconductor heavyweights like TSMC could be damaged by free trade with China; others are more optimistic. “There’s a concept called Chaiwan,” says Chang. “It’s Taiwan’s technology combined with mainland China’s market.” Certainly, there are some great believers in Taiwan’s tech story overseas. Robert Parker, special advisor at Credit Suisse Asset Management – which manages Sf1.3 trillion worldwide – says Taiwan is one of his key overweights in Asian equities, “because of the technology play.”

For many, access to China for Taiwanese businesses is only half the opportunity; the broader ambition is that Taiwan becomes a servicing hub to help people from all over the world move into China. “Taiwan is the perfect focal point between China and the world,” says Huang. “Taiwan knows China ethnically, culturally, linguistically.” And it’s a two-way street. “Chinese companies growing globally don’t have the right management capability; they could take minority stakes in Taiwanese companies and gain management talent. It goes both ways.”

For 60 years Taiwanese relations with the mainland have been fractious; yet now it appears Taiwan’s whole economic outlook is dependent on making the peace.

BOX: TDRs AND FOREIGN ISSUERS

Taiwan experienced a landmark on its stock markets on May 18 when Integrated Memory Logic, a Silicon Valley electronic chip manufacturer, listed on the Taiwan Stock Exchange – the first foreign initial public offering on the country’s exchange.

While the NT$1.4 billion offering, equivalent to just US$44 million, looks a fairly insignificant sum, this was a triumph for the TSE and its chairman Chi Shive, who has been pushing for foreign listings. IML chose Taiwan over Nasdaq and others because it had low listing costs, high liquidity and accommodative regulation, as well as being more suitable for a small listing than the Hong Kong or Tokyo stock exchanges.

As well as foreign IPOs, Shive has sought to boost so-called Taiwan Depositary Receipts, or TDRs. These generally involve Taiwanese companies overseas opting to raise capital at home, and once again they represent a play on renewed relationships with China. There were four of these listings from 1998 to 2008, then 10 last year and a further four so far in 2010; Shive hopes to see 20 this year.

The revival of interest has to do with a change in policy in which Taiwanese listed companies had a 40% ceiling on the amount of their capital they could invest in China. In that environment, many local companies – and all foreign companies – had little incentive to list in Taiwan since doing so would mean accepting a restriction on their investments in China, which over the last two decades has been an intolerable handicap. That cap has now gone. “The policy was originally designed to attract overseas listed Taiwanese companies to come back,” explains CY Huang at Polaris.

But the IML listing demonstrates that it’s done more than that, and illustrated the appeal of Taiwan’s capital markets for foreign issuers too. They are attracted by strong liquidity, making it a useful place for a second listing in order to diversify the investor base; and by high valuations, with many TDRs trading at a premium to the underlying share in the issuer’s home country.

Listings in Taiwan appear to work best for smaller companies – like IML – that would be swamped or ignored in bigger markets like Hong Kong or Tokyo. “Taiwan is the best market for small and medium cap companies,” says Huang. “In Taiwan the average IPO size is US$10 million to $30 million. You recently saw a cosmetics company raised $790 million in Hong Kong.” Taiwanese investors, he says, “are the richest, most open-minded and receptive. They love concept plays: there is huge liquidity for these offerings.”

Next could be Chinese companies. “Taiwan recently announced a new policy to allow PRC companies to list in Taiwan, so you have the potential for red chips as well,” adds CY Huang at Polaris. [In Hong Kong the term red chips refers to businesses that are legally domiciled outside of China, but in practice do nearly all of their business within it.] “All of these are a demonstration that the Taiwan market is internationalising and opening up, and the more it opens, the more competitive it will be. Taiwan is a new funding hub,” he says.

Yuanta was the lead manager on the IML deal, but this ability to attract foreign issuers – or to persuade Taiwanese who have listed elsewhere to return – is a source of delight to securities houses across Taiwan. “We hope Taiwanese companies that have listed in Singapore, Hong Kong and other places will dual list in Taiwan,” says Eddy Chang at CDFH, which includes within its holding company Grand Cathay Securities, another investment banking group that has benefited. “The government is encouraging these companies to come back and it has rejuvenated the capital market in Taiwan.”

Kung at Fubon – who says the pipeline for TDRs is “very strong” – thinks the rise of TDRs ties in to the drive towards Taiwan become a service centre for China. “Taiwan has certain advantages – for example it is one of the leading stock markets for electronics and technology-related companies – and I think it can expand on that by attracting technology companies not just from Taiwan and China but all over Asia to seek listing in Taiwan,” he says. “It offers the best valuations, the best coverage by analysts, and liquidity.”