New president means new approach to China for Taiwan

Institutional Investor, April 2008

When Ma Ying-jeou won Taiwan’s presidential elections on March 22, it marked a significant change of direction with far-reaching consequences for the country – and for investors in it.

Rather than domestic matters, overseas attention has instead been focused on what the new president will do with foreign policy: specifically, relations with China. His predecessor, Chen Shui-bian, had a fraught relationship with Beijing, championing Taiwan’s independence; whatever its ideological merits, that approach impeded flows of business between the two nations, particularly in the financial services sector.

It is likely that President Ma’s approach, which promises a spirit of friendlier cooperation between the two nations, will be reflected in investment flows and greater freedom for Taiwanese businesses in sectors from aviation (Ma has pledged to develop direct flights between China and Taiwan for the first time) to shipping to banking.

The change of leadership has brought a mood of optimism to Taiwanese business, and particularly to its financial services industry. “Imagine you can fly from Taipei to Shanghai in one hour twenty minutes,” says CY Huang, president for Greater China investment banking at Polaris Securities. “How would that change your organisation, the way you do business? You can position Taipei as your headquarters, fly there in the morning and fly back in the evening. Multinational companies may think of positioning Taipei as a hub for doing business with China.” Compared to other hubs – most obviously Hong Kong – land and property are far cheaper in Taipei, plus of course the whole population speaks Mandarin Chinese.

Huang feels much momentum has been lost in recent years. “Some people compare it to China in the 60s, and the Cultural Revolution; we almost had an economic Cultural Revolution,” he says. “We used to be number one among the Asian little dragons… but Taiwan fell into the trap of ideology, with too much politics, forgetting the world is borderless.” Now, though, he is bullish on a vastly changed Taiwan. “Taiwan will develop into something new: people just need to have imagination.”

The area that has perhaps suffered most from cross-straits tension, and which is showing the earliest evidence of change, is financial services. Taiwan’s banks have been prohibited from acquiring institutions in China, and so have only been able to service clients in the country in a very limited way. In addition, Taiwan-managed mutual funds have been unable to invest in Chinese securities, pushing much high net worth money offshore to be managed elsewhere. This is a big loss, because Taiwanese individuals and businesses, lacking the restrictions that are imposed on the banking sector, are among the most active nationalities on the ground in China: they are believed to have around US$150 billion in investments and assets on the mainland. The client base is there, but the banks can’t follow them.

“Lots of Taiwanese, probably millions, have moved to China,” says Allen Wu, senior vice president and head of investor relations at Yuanta Securities. “Although they share the same language, they have different cultures, and Taiwanese businessmen in China need some help from a company that shares their culture.” It’s a clear opportunity for Taiwanese banks, but one that has so far been barred to them. Wu compares the scale of financial institutions in China to those in Taiwan in order to illustrate the cost of this impediment. “Look at their market cap. The largest broker in China is CITIC Securities; their price to book is three to five times. In Taiwan, [similar institutions] are 1.5 to three times. Citic’s market cap is probably 20 times that of Yuanta Securities.”

But change is underway, and indeed was gaining momentum well before the election.  In early March, the government announced it would allow Taiwanese banks or financial holding companies to use their overseas subsidiaries to invest in mainland Chinese banks for the first time.

This move all but formalises a deal that has been talked about for years. Fubon, one of Taiwan’s largest financial groups, has a subsidiary in Hong Kong and has long wanted to use it to acquire a bank in Xiamen, mainland China. The Hong Kong Monetary Authority has acted as something of a go-between for the Taiwanese and Chinese regulators to thrash out the issues involved, and the Taiwanese announcement suggests the deal will finally go ahead.

“This is a major breakthrough,” says Victor Kung, president of Fubon Financial. “I would say a major hurdle now has been cleared, and we do expect that we can finalise and close the investment within a short period of time, definitely before the end of this year,” Kung says.

Fubon is likely to be seen as a test case, viewed closely by both Taiwanese and Chinese regulators, and the results will dictate how future ventures are approved. A lot is at stake. “For Taiwanese banks, we are all very eager to be able to open branches in China and invest into Chinese banks,” Kung says. “We have a lot of clients there – Taiwanese enterprises are a major investor in China and have done very well there.” But until now, “while they are our customers in Taiwan, we are unable to service them when they move to China. Therefore we lose business.”

Even now, banks will only be allowed to hold 20% in a Chinese bank, so the immediate impact to the bottom line is unlikely to be particularly big. But that perhaps disguises the significance of this move. “Since we will be able to deepen our relationship with our clients, we should be able to generate more revenues from our clients in Taiwan as well as in Hong Kong,” says Kung. “That’s strategically very important, perhaps more so than what we can see from just the profit contribution from the Chinese bank.”

Key to this has been the efforts of the regulators – three of them, in Taiwan, China and Hong Kong. “We have been engaging in trilateral negotiations,” says Sheng-Cheng Hu, chairman of the Financial Supervisory Commission. “The process is quite smooth and I hope we will be able to complete the procedure pretty soon.” Hu credits the role of the Hong Kong Monetary Authority in making things happen. “We have a middle-man, a go-between; it was much easier this way,” he says. “I hope that this will allow us to continue other talks and negotiations.”

Still, some believe it is possible to read too much into the Fubon situation. “The only bank to have the muscle to do that is Fubon,” says Huang at Polaris. “It’s a good thing for them, but I don’t think there will be many other examples like that.” But he does think there are other benefits from cross-straits openness. Wealth management, asset management and institutional brokerage, for example, are all more sophisticated in Taiwan than in China today. That expertise, he believes, is exportable. “Taiwan has a model of distributing financial products to the mass population, different from in Hong Kong or Singapore where it is more addressed to the middle and high end level,” says Huang. “China is very rich but they don’t know investment or wealth management. People need to develop a sense of asset allocation and investors need to be educated. Who is the best at that [in the immediate region]? The Taiwanese.”

Domestically, Taiwan’s banking sector has had a volatile couple of years. It has had to deal with a crisis in unsecured consumer lending and credit cards domestically, before running headlong into the global problems with sub-prime lending and the credit markets. “Despite all these difficulties, the growth in the financial sector last year was a nine-year high,” says Hu. “The quality of assets are good, the banks are strong, the overall non-performing loan ratio is just 1.87% and the adequacy rate is over 10%.” The broader economy has stayed strong, with exports up sharply in the second half of last year driven by increased volumes to southeast Asia and Europe. “When the economy is strong the financial sector will remain strong.”

Taiwan’s banks have tended to focus their attention on wealth management; Fubon, for example, doubled both revenue and profit from this business last year and it is not alone in benefiting. “The Taiwanese population is entering into a stage where there will be more retiring people, and the savings pool is accumulating very fast,” says Kung. “In the meantime Taiwanese investors are opening up to the global investment markets, and are becoming more used to putting some of their assets abroad.” When they do so, “they are more willing to have those assets managed by professional investment managers. It creates opportunities for banks and life insurance companies to distribute wealth management products.”

Wu at Yuanta Securities reports growth in three particular areas of investment: insurance-linked products, structured notes, and offshore mutual funds. All of this is to the benefit of wealth management divisions, and he argues that improved cross-straits relations are going to help investors to diversify their portfolios. “People can improve their financial returns and financial institutions can improve their bottom lines.”

The problem is, everybody has the same idea, and wealth management has already become ferociously competitive in Taiwan. In previous years, banks could also rely on credit card and other consumer loan revenue; not any more. The only other area of optimism domestically for Taiwanese banks is in lending to small and medium enterprises. But it’s not enough to support such a crowded local banking industry. “The spread for banking portfolios is terrible,” says Wu at Yuanta. “Most of the banks, if you look at their portfolio, consumer or corporate, the spread is in the range of 2 to 2.5%.”

This leads to calls for consolidation. There are almost 40 domestic banks in Taiwan for a country of 23 million people, even after considerable efforts have been made to reduce the number. Much has been done but clearly more must follow.

“I think we have been making good progress,” says Hu at the FSC. “We have cleaned up our distressed debts; we have had five banks acquired by international institutions, and three turning over their control to foreign funds; it all greatly strengthens our banking sector.”

Specifically, Standard Chartered has bought Hsinchu International Bank, Citigroup bought Bank of Overseas Chinese, ABN Amro purchased Taitung Business Bank, HSBC took over Chinese Bank, and in February Singapore’s DBS Bank said it would acquire the “good bank assets” of Bowa Bank. On the private equity side, Carlyle, Longreach and GE Consumer Finance have all made purchases. Hu says that the foreign share of Taiwan’s banking sector has risen from around 4% to 15.8% as a result of recent acquisitions, and that the work continues. “We still have parties from other international banks who are interested in spending,” he says.

What links all these banks is that they are in varying states of disrepair: either failed, or at the very least troubled. In some cases, like ABN Amro, they had to be paid to take on the institution. So what’s the appeal for foreign banks, particularly in distressed institutions like these? “I think foreign banks come here for various reasons,” says Hu. “One is wealth management. They consider this market to be very attractive. Secondly, they are interested in loans to small and medium businesses. And by coming to Taiwan they can access the region in southeast Asia and China.”

One fly in the ointment came when Temasek, the investment arm of the Singapore state, announced in March that it would pull out of its own investment in a Taiwanese bank, E-Sun. Hu takes a pragmatic view. “We have so many foreign acquisitions – I think in the last few years we have had 18 or 19 – so ultimately one or two will not work well,” he says. “A few years ago Citi participated in a bank, it did not go well, but they have now taken over the Bank of Overseas Chinese. Even though Temasek decided to withdraw from E-Sun, our understanding is it is still interested in this market, and E-Sun has found another participant. These things will happen with so many acquisitions going on; I’m not surprised.”

Kung adds: “It’s only natural to see that some would like to come in and others to get out, but I think the fact that all the foreign banks are interested in Taiwan demonstrates that fundamentally there is still money to be made here.”

One could argue that foreigners buying into banks doesn’t help Taiwan with its consolidation problem: it means there are just as many banks as before, only now with a greater number of able competitors. The counter-argument to this is that these foreign banks, once established, will use their new platforms to buy other small banks, eventually reducing the total number.

One barrier to consolidation is that about half the market remains in state hands. The departing DPP government had a stated policy of wanting to keep only two banks in their own hands; it is not yet clear what the new government’s stance will be on the sale of state assets, but given the global situation this is hardly an ideal time to sell down.

“Because the government banks still have about 50% of banking market share, consolidation cannot avoid being intertwined with government privatisation of the banks,” says Kung. “With the government in transition, I think it is going to be very difficult for anyone to embark on bold moves. But hopefully with the new government in place [it takes power in May] it will do the right thing and push for consolidation by privatising some of the government banks. That’s what we would like to see.”

The situation in brokerages is if anything more extreme. The number has come down – from about 400 brokerage houses in 1990 – but there are still more than 90, with the top 10 controlling more than half of the market share. Here, it’s a bit easier to consolidate. “They are all privately owned companies, so it is pretty easy to consolidate them with each other,” says Wu at Yuanta. Seven of the 10 biggest brokers in Taipei are already part of bigger financial holding companies; “independent brokers will find it difficult to survive in the long run,” he says.

Taiwan has been attracting a lot of private equity investment, perhaps prompted by the relative belligerence of China to private equity money there. “There was a lot of euphoria about China, but when we talk about execution things get stuck,” says Huang. “A lot of money is now turning to Taiwan.” There is much to attract it. For a start, valuations are among the lowest in the region. Secondly, Taiwan acknowledges the need for consolidation in some of its industries, notably financial services, and has therefore welcomed private equity as a means of setting that consolidation in motion. Thirdly, there is a willingness in Taiwan to expand overseas, and an acceptance that in order to do so the money and expertise of foreign partners could be helpful.

Despite this interest, Taiwan has long had to face hefty capital outflows. A recent report from Morgan Stanley said that there was a total $207 billion capital outflow from Taiwan between 2000 and the end of the third quarter of 2007. Clearly, that’s not all coming back, but there is a feeling that the quantum of disappearing cash might reduce. “I wouldn’t say capital outflows will reverse, but there will be capital inflows,” says Huang. The strength of the Taiwanese dollar, which has appreciated strongly, is expected to bring some flows back, and foreign portfolio flows are believed to be increasing on the back of the election and an expected boost to market performance as a consequence.

Taiwan’s stock market has long been reaching out to global investors in an attempt to bring capital back in. In 2007 alone the stock exchange went on roadshows to New York, London, Hong Kong and Singapore; investment forums will follow in New York and London this year. “The world will understand we are making progress towards liberalisation and internationalisation,” says Rong-I Wu, chairman of the Taiwan Stock Exchange. “It increases the attraction for international investors: it’s a transparent gateway to Asian prosperity.”

Taiwan’s markets have much to recommend them in regional terms. They are reasonably large (over US$700 billion in market capitalisation when the 698 companies on the Taiwan Stock Exchange are combined with the 547 smaller companies on the GreTai securities Market second board), and are liquid, topping US$1.2 trillion in trading volume between the two markets in 2007. Consequently foreign ownership of Taiwan’s stocks as a percentage of market capitalisation has more than doubled, to 31.1%, in the seven years to the end of 2007. Two other things add to the attraction: one of the highest average dividend yields in Asia, and low valuations. This all comes within a framework of good regulation and high transparency by regional standards. Taiwan’s various market entities – the two stock exchanges, a depositary and clearing company, and the futures exchange – are to be put into a new holding company this year which then will be listed on the exchange itself, probably in 2009, once the relevant legislation gets through parliament. “One immediate result will be one-stop shopping,” says Wu at the TSE. “And the synergies are very important, making it more efficient, in particular in terms of IT.”

While financial services is interesting, technology is utterly dominant in the Taiwanese economy, accounting for almost half of the country’s listed companies according to Wu, and at one stage representing 70% of the country’s market cap. Clearly, technology is exposed to a slowing US economy. As American consumers become more conservative, that naturally hits consumer electronics. In addition, the strengthening Taiwanese currency is not helping.

So what’s the future? Huang argues there are two approaches: build a brand as the best in the world in a specific, innovative segment, tailor-making products for big companies worldwide; or launch a new business model, as Asustek has done with its new line of $200 personal computers, cheap enough to be used as gifts, halfway between a toy and a sophisticated PC. “You don’t want to be stuck just manufacturing,” Huang says. “You need your own brand, channel, global market or have something truly innovative.”

It’s not all bad: IBM said in January it wanted to hire 300 new staff in Taiwan, many of them in research. An annual survey from Watson Wyatt says high tech compensation is higher than ever in Taiwan, and that turnover in jobs is very high as employees look for the best opportunities. And within some sectors, analysts are positive: Macquarie, for example, has outperform ratings on several manufacturers of TFT LCD chips, used in high definition panel screens.

Nevertheless, the global situation clearly can’t be ignored. Taiwan is looking good by world standards – it has averaged 5.2% growth over the last four years and analysts expect it to grow at 4.5% in 2008 despite global travails. Unemployment is at its lowest level in six years. But much depends on Taiwan building investment bridges with countries outside the United States. “Taiwanese businesses are gradually diversifying their reliance on the US market to the Chinese market and other emerging markets,” says Wu.

The positive view is that China replaces the role the US used to have as an engine for growth. “I think the impact of the US recession will be somewhat mitigated by the China factor,” says Kung.  Areas such as property, department stores, tourism, hotels and leisure should all benefit from closer China links. The negative view, though, is to recall that engagement with China is a two way-street, and that all the newfound political goodwill in Taiwan won’t matter unless the other side is committed to that openness too. On balance, the mood in Taiwan is extremely positive; but change doesn’t come overnight, and there is much more work to be done.