Taiwan prepares for an economic makeover

Institutional Investor, September 2011

For many years, technology and electronics have dominated the Taiwanese economy. The country’s acknowledged global champions – names like Acer, Hon Hai or Taiwan Semiconductor – all hail from the technology field; electronics-related stocks make up about 65% of the market capitalisation of the Taiwan Stock Exchange. But this may be set to change, and the spur for that change – as with so much in Taiwan today – is China.

Partly, it’s a matter of necessity, because prospects for Taiwan’s electronics industry – or manufacturing generally – are not good in a troubled world economy. “Taiwan has historically been an exporting country,” says Paul Yang, senior executive vice president and chief investment officer at China Development Financial Holding Corporation. “Most of our wealth comes from outbound businesses. These businesses, while still going well, face murky prospects as a result of the uncertainties in the global marketplace.” The US is, after all, still Taiwan’s top export destination, and its slump has heavily hit demand.

Others are more blunt. “The tech sector is losing steam,” says CY Huang, president of FCC Partners and Chairman of the Taiwan Mergers & Acquisitions and Private Equity Council. “The D-Ram industry is losing money, haemorrhaging, while global consolidation is taking place. The TFT-LCD panel industry is losing money because of global overcapacity issues. Symbols of Taiwan like Hon Hai are suffering from a margin squeeze, Acer has lost ground in worldwide notebook sales, and even in the best companies there are problems,” such as smartphone manufactuer HTC being sued for copyright infringement by Apple. “Nobody in the tech sector, from the worst to the best, seems to be immune from this.”

It’s causing some deep reflection. “Taiwan is in a stage of transition, and everyone – government, owners of enterprise – is asking what’s next?” asks Huang. “Where’s our next growth engine?”

The answer may be previously unexceptional industries given a new lease of life by increasingly close ties with mainland China. “What’s promising is that there is a lot of inbound business in Taiwan,” says Yang. “And it’s mainly benefiting from the normalization of relations with China. We’re seeing more of that peace dividend.”

People have been talking about this peace dividend for years – with increasing frustration at the slow pace of its fruition, particularly in financial services – but there do seem to be areas where it is coming through in genuine growth. Tourism is the most obvious example, as mainlanders seek to visit Taiwan; natural knock-on effects from that are hotels and airlines, for example. But there’s actually a broader trend at work.

“What we’ve been suffering from for the last decade is a lack of domestic demand,” says Yang. “A lot of our population, many of them in their prime, are working in mainland China now. And there is soft demand in just about everything, from consumer related products to housing: Taiwan already has one of the highest rates of home ownership in Asia, at 85%. So local services and consumer related industries were soft until this normalization began.”

The arrival of tourists has changed patterns around consumption; so, too, has the return of Taiwanese expatriates who have done well in the mainland and are now keen to come home to invest in their homeland. “It’s a shot in the arm in the local economy,” says Yang. One sees it in a number of ways: Taipei hadn’t had a new five-star hotel for a decade, for example, but has now welcomed two in a year. Better still, any economy driven by domestic consumption tends to feel the effects quickly. “When you have a booming export economy, it takes longer for wealth to trickle down,” Yang says. “With a strong domestic economy, the benefits are really felt.”

The government has highlighted six sectors to try to rejuvenate growth in Taiwan, in varying degrees of success: tourism, and the cultural industry, are clearly seeing progress although little major impact on FDI; agriculture, venture capital and green energy are slow, but there are very positive signs in biotech, which is becoming a clear and sophisticated niche sector in Taiwan, both in terms of the industry itself and listed constituents on the stock market. But Huang – who sees progress in these areas as “pretty pathetic and insignificant,” biotech and tourism apart – agrees with Yang that the future has to lie in a much broader mindset. “One way for more and more Taiwanese companies to transform themselves is to treat China as a domestic consumption market rather than a factory,” he says. “Hong Kong Chinese treat China as a home market. Taiwan, with few exceptions, does not. But people are changing, and those people who are deploying resources cleverly are reaping the fruit.”

Related to this, some see the future of Taiwanese business growth in the services sectors. “I believe the engine for Taiwan’s economic growth is shifting,” says Victor Kung, President of Fubon Financial. “Taiwan’s economic growth has been led by manufacturing growth for 40 or 50 years, since we began to industrialise in the 1960s. But the warming of the cross-straits relationship is a great opportunity for Taiwan to shift into a more services-led growth model, like other mature developed economies.” The premise is that Taiwan will become a major service centre to China. Some of the manufacturing that previously took place on Taiwan will inevitably move to the mainland – it’s already happening, in fact – “but what retains in Taiwan will be the more high value-add services components of the value chain,” Kung says. That will drive the economy and make Taiwan a nicer, less polluted place at the same time, he says.

Kung sees this coming through in some interesting areas: alongside tourism and healthcare, he points to creative industries, noting that at least half of the Chinese pop singers he is aware of are actually Taiwanese. This is an argument that a free culture, without inhibitions on expression, manifests itself in greater creative talent. And Kung is also clear that services, in his definition, doesn’t just mean the service industries like banking (although, with Fubon’s new mainland asset management venture with Founder Securities finally approved on June 30, he is one of the few executives with any positive progress to report on cross-straits banking). Instead, to him services includes the service components within manufacturing – research and development, design and corporate finance.

International analysts have become wise to the same themes. Jenny Lai, head of Taiwan research at HSBC, crunched the numbers in a July 27 report and found that publicly listed Taiwanese companies’ aggregate investment in China since 2005 has reached 12% of their combined net profit, a figure she expects to grow. While that’s not so surprising, she dug further and found that while tech companies have historically accounted for up to 65% of Taiwanese investment in China, investment by non-tech companies grew 75% in 2010 alone. “The gap between tech and non-tech is closing,” she says, noting that the China revenue contribution for Taiwanese non-tech companies on her radar ranged from 23% to the whole lot. It’s coming through in stock market behaviour too. “Investors appear eager to reward Taiwan parent companies for their success in China,” she says.

Two days after Lai’s report, Deutsche’s strategist Joelian Tseng put out a Taiwan report entitled ‘one market, two worlds’, concluding that investors should expect outperformance in non-tech sectors while tech remains under pressure. “Non-tech has delivered a better return on equity and margin recovery than tech,” said Tseng, whose model portfolio is skewed to financials, consumer and property.

If fund managers are rebalancing in line with these ideas, then at the grass roots level of venture capital the same thing is happening. CDFH, a large part of which has been built on early investment in unlisted businesses, already has 26 investments in China, many of which have already gone public, and expects to expand considerably. But China will also change the nature of its portfolio elsewhere too. “The opening of the China market really expands the universe of companies that will be interesting to us,” Yang says. “When China wasn’t opening up, Taiwan was best known for exporting electronics, communication and light industrial goods. Things like services, consumer and pharma businesses were not so interesting to us because our markets are too small. But China opening up changes things dramatically: now some of the best opportunities are service and consumer related, and many of the most successful brands in China are Taiwanese-run.” While the venture capital portfolio at CDFH is around 60% electronics today, Yang expects it to be less than half of the portfolio within five years, with the shortfall made up by services, tourism, hotels, media, consumer staples, pharma and entertainment related businesses.

The balance between a floundering tech sector and growing domestic consumption economy is coming through in reasonable, but not exceptional, macro numbers. The Taiwanese economy fell from 6.6% year on year growth in the first quarter to 4.9% in the second, but that was much better than most economists expected, largely because of this domestic demand spur. The government’s full year forecast is 5.01%. In sum, it’s a picture with some cause for optimism and some for concern, balancing out as a steady but unexceptional growth market.

BOX

Taiwan and the offshore RMB

One of the most extraordinary financial stories of the last two years has been the growth of the offshore RMB market in Hong Kong. The dim sum market – RMB bonds traded outside China – grew from a nascent pilot program to one drawing international issuers from top-ranked names to high yield within a matter of months. Offshore trade settlement volumes continue to grow, and the pace of RMB deposits in Hong Kong ensures the market is underpinned by further demand.

Singapore is striving to become a second offshore RMB centre. But why not Taiwan too? Bankers here hope that’s on its way. “I think the Taiwan government has certainly paid attention to the development of the RMB as an international currency,” says Kung at Fubon. “The Chinese government has relaxed some restrictions on Taiwanese banks getting involved in RMB business, and from the banking industry’s perspective we’d like to see the possibility of Taiwan becoming another offshore RMB centre.” Certainly, it’s in China’s interest to have more than one centre in Asia, since it allows for more efficient pricing and capital flows. Taiwanese argue that they also have the language skills and cultural affinity with China to make Taipei a natural second home for the currency.

In banking generally, progress remains somewhat slow in cross-straits development, with some areas becoming more open for Taiwanese banking groups (opening branches, investing into Chinese banks, general and life insurance, and fund management) but others still restricted (chiefly brokerage).