Better ties with China bodes well for Taiwan’s economy

After years of sluggishness and depressed sentiment, signs abound that the worst may be over for Taiwan’s economy.

And the optimism is being reflected in the island’s stockmarket, now at its highest level in seven years. Last month it was the world’s best performing market.

For the uninitiated, the Taiwanese market stands apart from its regional counterparts in its heavy susceptibility to political sentiment. The market is often seen as a barometer of confidence in Taiwan’s somewhat volatile political ties with China and now – with the increasingly close economic ties with the mainland – its economic future as well.

“Strained relations with China have meant that Taiwan has borne all the costs, but few of the benefits of its rapidly developing neighbour,” says Stewart Newnham, a research analyst with Morgan Stanley in Hong Kong.

In Taiwan, like anywhere else, it is difficult to see where politics ends and economics start. With presidential elections scheduled for March 2008, most experts expect the government to try to create favourable conditions in the markets before the polls.

China regards Taiwan as a renegade province and has not ruled out using military means if it declares independence. The ruling Democratic Progressive Party (DPP), which promotes Taiwan’s independence from China, has been blamed for inefficiency and poor governance.

Yet it is believed that regardless of which party wins, Taiwan’s relations with China are expected to improve once President Chen Shui-bian steps down next year.

In the next election, the DPP’s Frank Hsieh will compete with the pro-unification Nationalist Party’s Ma Ying-jeou, who is leading the polls. Ma, the former mayor of capital Taipei, favours better relations with the mainland. Hsieh (pictured, page 12) is also generally regarded as seeking better ties with China.

The consensus view is that Ma would win the elections but the race, if the past is any indication, is expected to be tight in the run-up to the polls. The public has much at stake in electoral politics. In the past, the ruling party often mobilised government funds – pension funds, postal savings funds, among others – to create a semblance of prosperity in the status quo before the elections.

Such policies to prop up the stockmarket generally help drive voters in favour of the incumbent. Indeed, the benchmark index has crossed the 9,000 level and pundits are already predicting that it will surpass the psychologically important 10,000 before the end of the year.

One reason is that the huge rally in the markets of the region, notably China and Hong Kong, had made Taiwanese shares look inexpensive in comparison. And domestic companies are now deriving an ever-larger share of their earnings from their investments in China.

“Taiwanese and Hong Kong shares are trading at about 20 times price to earnings ratio now, which is in the middle of their historical range,” said the leading business daily, Commercial Times, in an editorial on July 8. “While not low by any means, it is only half of their Chinese counterparts.”

Apart from low price levels, it is difficult to find much reason for unfettered optimism in the economy. Interest rates are rising, there is an incipient inflationary pressure, capital outflow has reached worrying levels, the banking system, though much stronger than before, still leaves a lot to be desired, particularly given the island’s aspirations to become a regional financial centre on a par with Hong Kong and Singapore.

In addition, Taiwan continues to lose its competitive edge against China (in terms of manufacturing), South Korea (IT services) and Singapore and Hong Kong (financial services.)

Nonetheless, Taiwan has some good things going for it. After years of negative growth and huge amount of provisioning for non-performing loans, banks are reporting positive earnings. The consumer-banking crisis (a result of high percentage of bad loans in the consumer loan segment, as high as 50%) that jeopardised the system over the past few years has finally come to an end.

Matthew Smith, who tracks domestic banks for Macquarie Securities in Taipei, says that while the profitability of the financial systems continues to be constrained by the fragmented and over-crowded nature of the sector, things are looking much better. “However, the worst is over for the unsecured consumer crisis and the development of the wealth management business is a long-term positive for the top-tier banks,” he says.

Macquarie expects aggregate earnings at the Taiwanese banks to grow by 15% in 2008. Meanwhile, more mergers and acquisitions are expected to take place going forward, though not on the scale that it had seen over the past two years.

Major international firms have increased their presence on the island: ABN Amro, Citigroup and Standard Chartered have all acquired domestic banks.

On July 10, Carlyle Group, a Washington-based investment house, announced it would buy a 35% stake in Tachong Bank. The news comes less than a month after Longreach Group, a private equity firm based in Hong Kong, said it would take a 51% stake in Taiwan’s EnTie Commercial Bank.

This wave of foreign participation is “positive” for their Taiwanese partners and will bring with it some immediate benefits. It will strengthen their capital base and help their risk management skills and business strategy, according to Susan Chu, banking sector analyst at Taiwan Ratings Corporation, a credit-rating agency, which is a joint venture with Standard & Poors.

Yet given the highly competitive nature of the sector, the impact on the whole, Chu says, is “neutral”, unless the foreign partners are able to instill “more discipline” into their banking practices.

For the economy at large, Taiwan’s GDP growth remains stable. Better than expected export figures, particularly to America, Taiwan’s largest trading partner, should boost the GDP figures. Exports, which account for nearly half of Taiwan’s GDP, grew by 8.5% in the first quarter of this year.

Polaris Research Institute, the research arm of one of Taiwan’s largest stockbrokers, expects GDP to grow by about 4.5% in 2007, a shade higher than the government’s forecast of 4.38%. Earnings at listed companies are expected to grow by about 20% in 2007.

A stronger market is expected to help lift domestic consumer sentiment, while weak local currency is likely to boost exports in the long run. And the currency has stopped weakening against the major currencies.

For much of the past year, massive capital outflows have rendered the new Taiwan dollar one of the weakest currencies in Asia. Sharp depreciation of the currency has been a source of concern for the regulators, forcing the central bank to intervene regularly in the markets and raise domestic rates to stem the currency’s slide.

Morgan Stanley’s Newnham says Taiwan’s capital outflow is “structural” and is a result of political impasse between Taiwan and China.

While the central bank is supporting the currency by raising interest rates, he thinks it will be difficult to reverse what he calls the “perennial weakness” of the new Taiwan dollar.

He says it will continue to remain weak unless “there is a breakthrough in Taiwan’s relations with China”, which he does not expect before the end of Chen’s presidency in 2008.

Recently though the currency has rebounded from its lows and has gained some lost ground against the dollar, thanks to the central bank’s well-timed rate hike last month.

This has attracted more global investors into the market, contributing, in no small measure, to the market’s climb. All this may be seen as yet another sign of Taiwan’s resilience.