Why Taiwan’s shift to China trade has saved it

Institutional Investor, September 2009

Taiwan’s fortunes are shaped by those of two other nations: the USA and China. The trend of recent years has been a shift away from one and towards the other. Where the US has traditionally dominated Taiwanese exports, and remains important today, it is no longer the most important influence on Taiwan’s economy. That, instead, is unquestionably China.

When exports account for 60% of your GDP, as they do in Taiwan – making it the most export-oriented major economy in Asia – then the health of your trading partners matters enormously. And, while the USA has obviously slipped into protracted recession, China is swiftly reviving and is likely to enjoy 8% growth in 2009 in the midst of a global economic crunch. All of which makes the shift in direction of Taiwan’s exports all the more fortuitous today. In 2003, total exports from Taiwan to the USA were US$26.53 billion, 16% higher than the US$22.89 billion to mainland China that year, according to Taiwan’s National Statistics Bureau. By 2008, the US figure was US$30.79 billion – an increase, but less than half of China’s US$66.88 billion, a figure that has trebled in five years.

And it’s not just about exports. On top of that, last year’s change of government to Ma Ying-jeou, who took power in May 2008, brought with it a new attitude to mainland China which is expected to have a major impact on Taiwan’s economy. The administration of Chen Shui-bian, his predecessor, had been characterized by antagonism towards China, a stance that had some ideological support in Taiwan but did not help its economy. Ma’s platform has been for greater warmth between the two states, and it has been reciprocated: When Hu Jintao, China’s president, sent Ma a telegram in late July applauding his election as party chief, it was the first direction communication between China and Taiwan’s leaders since Mao took power in China in 1949.

Already, there have been some visible consequences of this: direct flights have resumed between the two places for the first time in many years, making trade and business easier. Tourism has begun to take off, in both directions, with mainland tourists helping Taiwan’s economy. Direct shipping has also had an effect. But one of the most closely watched areas is in financial services.

This has been one of the sectors that was most obviously impeded by cross-straits tension. China needs Taiwanese exports of things like chips and flat screen components to support its own electrical goods industry which then plays such a large role in China’s export numbers, so it has never objected to Taiwanese factories or the broader involvement of Taiwanese manufacturing with the mainland. But Taiwanese banks have never really been permitted to follow them: seven have opened representative offices but have been unable to upgrade them to branches; there have been restrictions on overall investment in China; and the mutual fund industry has not been permitted to own Chinese stocks, which has driven many local investors to seek funds offshore instead. Taiwanese banks, largely because of this, have had to watch their private clients go offshore to international banks who are able to engage with China.

Central to any change in this situation is a memorandum of understanding (MOU) between Taiwan’s Financial Supervisory Commission and its counterpart in China. This sets a basic framework within which the two groups agree to joint supervision of financial institutions from one location that want to operate in the other; that, in turn, paves the way for the issuance of licenses.

To hear the latest on where that’s up to, see the boxed interview with FSC chairman Sean Chen. But, when concluded, just how much will it really change? Taiwanese banks are making an effort to be pragmatic. “The MOU is merely symbolic, but it’s still a necessary first step in the process,” says Allen Wu, senior vice president at Yuanta Securities, who believes things are “moving in the right direction” for the Taiwanese financial sector but expects further opening to take time. “Even as that happens, not everyone in the financial sector will be able to benefit,” either because they lack a competitive advantage for China or can’t go anyway.

“In our view it’s very important strategically,” says Victor Kung, president of Fubon Financial. “But if people think that just because of the opening then we will see a bottom line effect in the short run, they may be disappointed. Some of these expectations are really somewhat hyped.” There is, too, an important counterpoint to remember: if Taiwanese can open in China, then it follows that Chinese banks will be allowed to open in Taiwan, and there are few more daunting prospects than ICBC or Bank of China – two of the world’s largest banks by market capitalization – turning up on your doorstep. “The concern is they are giants who are going to crush the ants of Taiwan,” says CY Huang, co-founder and chairman of Polaris Capital.

Nevertheless, it’s clearly good news if Taiwanese institutions can expand their business into the world’s most vibrant market.

In parallel with the MOU negotiations is a broader program: the Economic Cooperation Framework Agreement, which would address lowering tariffs, investment protection, intellectual property rights, economic cooperation and trade dispute settlement mechanisms. While these discussions are between China and Taiwan, there is a broader context because it would allow Taiwan to participate in regional free trade agreements such as ASEAN Plus One, which is intended to come into effect among Asian nations next year. As William Dong at UBS puts it: “This would enable Taiwan to remain as an integral part of the Asia economic zone.”

Dong notes that “simply signing the ECFA does not mean that Taiwan’s economic growth will suddenly leap forward. We believe it will really just put Taiwan on a more equal footing with its regional trading partners.”

Indeed, in a way the bigger issue is the risk of not completing it. “If Taiwan is not part of that [ASEAN plus one], it will have to pay additional tariffs and that means it cannot compete at all,” notes Huang. “Investor confidence is very much related to the signing progress of these agreements.” It’s tense, too, though, as there is a concern that agreements like these will turn Taiwan into something of a Hong Kong – a specially administered territory of China rather than the more independent nation most Taiwanese consider themselves to live in.

While banks have yet to see the clear benefits of China cooperation, they’ve also done OK in a difficult environment. “So far it [the banking sector] has held up relatively well,” says Kung at Fubon. “It has long rooted problems – the industry is too fragmented, highly competitive and is therefore eroding its profitability. But as far as this financial tsunami is concerned, we have our share of the losses but they are not big enough to hurt the capitalization of most of the banks.”

Indeed, it looks so good it is actually a little puzzling. As of May 2009, the non-performing loan data for the industry was just 1.6%, only about 10 basis points higher than its historical low. “I don’t know how much credibility investors can give those numbers,” says Matthew Smith, analyst at Macquarie Research in Taipei. “There’s a lot of loan restructuring and rollovers which could in future mean having to take extra provisions. It’s hard to believe that Taiwan of all places could withstand this shock to the global system and not experience any rise in NPLs.”

In particular, there is concern about the health of the semiconductor sector, specifically the D-RAM manufacturers ProMos Technologies and Powerchip Semiconductor. “It’s difficult to see what the endgame is for those two names, unless the government comes up with a plan to put them back on track,” says Smith. “Banks and other creditors already have extended debt repayments for the D-RAM makers and this is going to be a recurring theme, probably next year, when debt comes due and has to be restructured again.”

Kung is concerned. “Certainly D-Ram is the weakest link in Taiwan’s industry,” he says. “We all, and our bank also, have some exposure but the government has come out strongly to try to instill some confidence into the industry.” But he takes comfort from the fact that last year the LCD component industry also appeared a major worry, and has since recovered. “Even during the gloomiest days we have been saying that asset quality is not going to be a major issue this year.”

In sum: so far, so good, but there are causes for both concern and optimism in Taipei today.

BOX: The Fubon approach

For years, the Fubon group tried to find a way around the tricky relations between China and Taiwan, and eventually they managed it. Last year Fubon’s Hong Kong subsidiary purchased a 19.99% stake in Xiamen Bank for RMB230 million, becoming the first major investment by a Taiwanese bank in a mainland one. Despite the low stake, Fubon was entitled to appoint three directors onto Xiamen’s 11-strong board.

The deal was perhaps more symbolically than financially significant. “Xiamen Bank is very small: it only has about $2 billion of total assets [at the time of the announcement they were disclosed as RMB17.7 billion] so obviously if we look at the bottom line the contribution will be very small, almost negligible,” says Victor Kung. “But from a strategic development point of view, it is certainly a very important strategic step for us, because it makes us the first Taiwanese institution to operate a retail branch network in China.”

Getting the acquisition approved required help from the Hong Kong Monetary Authority, which acted as something of a go-between for the Taiwanese and Chinese regulators. But, now the two sides are talking directly, is the Fubon model quickly going to become obsolete? Financial Supervisory Commission Sean Chen notes: “once the MOU is signed by regulators on both sides of the Taiwan strait, I don’t think any reasonable operation would take that road, it’s not necessary.” And Kung himself points out that “once we can go directly, definitely we will go directly as well – it’s not that we have to go through Hong Kong.” That said, the first groups expected to benefit from the MOU are those seven Taiwanese institutions who already have mainland representative offices, because the norm in Chinese MOUs is that representative offices must exist in China for two years before being permitted to become a branch. Fubon is not one of the seven, so it’s possible the Xiamen venture may have to be its flagship mainland presence for a while yet.

BOX: CHEN IN THE HOTSEAT

Sean Chen took on the chairman role at Taiwan’s Financial Supervisory Commission in December, becoming the agency’s sixth head since its creation in 2005. It has been a difficult period to preside over for the former chairman of Sino-Pac Financial Holding, but he can at least take comfort in the fact that Taiwan, and particularly its banking sector, has weathered the global storm well so far.

“In Chinese we say you can find fortune in misfortune,” says Chen, speaking to Institutional Investor in Taipei. “Our major export market, the US, is the country which suffered most from the financial turmoil, But we are also blessed because for the past 10 years we have been shifting our export markets to mainland China – now the largest export market for Taiwanese manufacturers.”

Since Taiwanese banks have been major providers of credit and services to the manufacturers who are exposed to China’s continuing boom, Taiwan’s banking sector continues to look very healthy. Non-performing loans are just 1.6% – much lower than the US, where the level is around 2.5% – and provisions stand at 69.8%. The capital adequacy ratio for Taiwan’s banking sector as a whole is between 11 and 12%, well above the statutory minimum of 8% and again higher than the norm in the US. “Our banking industry, even after the financial turmoil, remains relatively healthy compared to other areas,” Chen says.

But will it stay that way? Apart from that fact that NPL levels look bafflingly low, there are clear headwinds to come (see main story for NPLs and the D-RAM sector). “Personally I’m not so optimistic: I would not say the worst time is behind our back, because this world is too small for us to prosper or suffer alone,” says Chen.

Bankers are also alarmed by the prospects of a law capping interest rates on credit cards. Chen is quick to point out that the US has a similar law that has already passed the House of Representatives, and argues that the mooted Taiwanese law – which would have a floating cap moving with changes in the central bank base rate – is more flexible than the US approach which proposes an outright cap. (“That’s incredible. The US is a free economy!”) He also points out that although the Taiwanese law has passed a first reading of its legislature, in Taiwan any such amendment must go through three readings, and that major discussion will take place first, including the banking industry and consumer protection associations. Nevertheless, he says: “After the financial turmoil in Taiwan as other countries, the administrative and legislative branches are paying more attention to the interests of the consumer,” and he puts the credit card amendments within that context.

Chen is part of the team negotiating the eagerly awaited memorandum of understanding with China (see main story). “There is a French word, rapprochement, building a bridge; it’s a very good word to describe the present situation,” he says. “We have to mend the relationship between Taiwan and China. Any financial institutions which intend to conduct cross-border activities need a blessing from the home and host regulators. But how can they do that? Those regulators have to sit down and talk to each other.” Taiwan has previously signed MOUs with 35 counterparties in other countries; mainland China has more than 50, so there’s no lack of experience in negotiation. “The problem is, for the last eight years, not only the regulators but the governments on both sides of the strait don’t want to sit down and talk.”

Now that they are, things have improved. “We all agree it will be very healthy for the financial institutions on both sides of the strait to set up a financial presence in each other’s territory,” he says. The MOU provides for an agreement for the two regulators to jointly supervise institutions which intend to conduct cross-border activities, and three are under negotiation: for banking, insurance, and securities businesses. “There will be obstacles, but those obstacles will be removed and the MOU can be signed,” he says. “The most difficult question to answer is when.”

Pressed for detail, he says: “Well, frankly speaking, there’s nothing new in the MOU. A very basic MOU should include, first, the intention of cooperation; second, the intention to exchange necessary information; third, how to protect those information exchanges between the regulators; and fourth, the intention for further cooperation. It’s very simple.”

Interestingly, Chen says one reason progress is slow is that for both sides, despite the common language, this is the first time to structure an MOU in Chinese. “There’s a problem,” he says. “After separation, from 1949, the Chinese language changed a bit on both sides of the Chinese strait. So sometimes it takes a lot of time to find a terminology which is acceptable by both sides.”

When the MOU is signed, “it doesn’t mean Taiwanese institutions will be granted a license in China automatically, because they have to prove their institutions have been managed under prudential principles,” he says. But it paves the way.

It is strongly noticeable how Chen’s attitude towards banking consolidation differs markedly from that of his predecessors, who sought actively to encourage consolidation, even to precipitate it. “You should come back to basics and let market forces operate,” he says. “If a financial institution can operate by its own, it can be a niche player and we should allow it to operate in that way.

“We should not give it any guidance that it should be acquired by another institution. That’s not fair.”  That said, “I would expect to see further consolidation – but not in the instant future.”