Taiwan: China's weakness takes a toll Asia Pacific Economic Outlook, Q4 2015

Given the fact that Taiwan’s economy is closely intertwined with that of China—Taiwan’s exports to China and Hong Kong account for 40 percent its total exports—the current weakness in the Chinese economy is likely to affect Taiwan’s growth.

Taiwan_interior-imageThe unexpectedly severe weakness of the Chinese economy is taking a toll on Taiwan. In the second quarter, Taiwan’s real GDP was down 2.0 percent from the first quarter, the sharpest quarterly decline since the fourth quarter of 2008 at the height of the global financial crisis.1 This was due to an unusually sharp drop in exports. Moreover, the decline in exports clearly continued into the early part of the third quarter, with July exports down 11.9 percent from a year earlier and August exports to China and Hong Kong down 16.6 percent.2 Taiwanese exports to China and Hong Kong account for about 40 percent of the country’s total exports. Exports to China and other East Asian economies fell sharply in the first half of 2015, while exports to the United States and Europe, which together account for a little less than 20 percent of exports, fell only modestly. Moreover, the weakness in exports had a spillover effect on business investment which has performed poorly. Thus, even if growth recovers in the third and fourth quarters, it is likely that full-year growth of the Taiwanese economy will be less than half the 3.8 percent growth clocked in 2014.

On the other hand, Taiwan’s consumer sector continued to grow at a steady pace. A combination of lower oil prices, wages rising faster than the very low level of inflation, and continued job growth have contributed to strength in domestic demand. However, as the impact of a weak Chinese economy continues, it could undermine the growth of employment and wages. Still, unemployment is very low right now, productivity is growing at a strong pace, and prices are actually falling. Thus, a continued increase in real (inflation-adjusted) wages seems likely in the coming year. That, in turn, should be helpful in boosting consumer demand. Nevertheless, Taiwan has become increasingly dependent on exports in recent years. Thus, China’s continued weakness will be a source of concern.

Taiwanese banks hold a large volume of loans to Chinese businesses. In fact, China is the largest foreign debtor to Taiwanese banks. If China’s financial system becomes stressed, it could have a negative impact on Taiwanese bank earnings.

China’s weakness influences the Taiwanese economy in several ways. First, Taiwanese exports to China are an integral part of China’s manufacturing supply chain. The weakness in Chinese exports hurts the pipeline through which Taiwan supplies China with components used to make finished products, particularly in electronics. Second, the weakening of Chinese business investment affects Taiwan, as the country supplies China with technology products that are used for investment purposes.

Finally, Taiwan’s financial system is integrated with that of China. Taiwanese banks hold a large volume of loans to Chinese businesses. In fact, China is the largest foreign debtor to Taiwanese banks. If China’s financial system becomes stressed, it could have a negative impact on Taiwanese bank earnings.

The good news

On the positive side, Taiwan has benefitted from the decline in oil prices, thus suppressing inflation to the point where prices are now declining. Not only has this boosted consumer spending power, it has also given the central bank room to devalue the currency without fear of igniting inflation. Consequently, the central bank allowed the currency to depreciate during the summer in an effort to boost the competitiveness of exports—or at least to avoid an appreciation against the Chinese currency as China engaged in devaluation. The Taiwanese currency is now at its lowest level against the US dollar in about six years. Moreover, given that Taiwan is currently experiencing consumer price deflation, it needn’t worry about the inflationary effects of further currency depreciation. As such, when the US Federal Reserve raises interest rates in the next few months and years, Taiwan may be able to avoid raising interest rates and could even choose to cut rates if the economy weakens further. Indeed the central bank has held its benchmark rate at 1.875 percent since 2011.3 Also, given that Taiwan runs a current account surplus (which means that it is, on balance, lending to the rest of the world), Taiwan needn’t worry about the consequences of an increase in capital outflows. As such, the country is in a favorable position in terms of its financial relationship with the rest of the world.

In addition, the government’s finances are in good shape, with a barely perceptible budget deficit of less than 1 percent of GDP, and a debt/GDP ratio of less than 33 percent.4 Thus, the government retains considerable flexibility if it chooses to use fiscal policy to offset the negative impact of weak external demand.

Politics

The current Kuomintang Party (KMT) government will face voters in early 2016, and the latest polls suggest it has an uphill battle to remain in power. The KMT has been friendly with China and has encouraged closer economic relations, especially through its proposal for an unpopular Trade in Services Agreement (TISA) with China. Critics claim that this agreement will make Taiwan too economically dependent on China. They note that Taiwan has lost jobs to China as trade and investment has been liberalized. They complain about Taiwanese companies investing heavily in China. Proponents of the agreement point out that Taiwan is very dependent on the export of manufactured goods, especially IT and telecom goods, and that liberalization of services trade will allow Taiwan to diversify its economy—even if that means more economic interaction with China. If the KMT loses the election, it could have a negative impact on further economic integration with China. This would depend on which opposition party emerges as the most powerful. There is the Democratic Progressive Party which is averse to closer ties with China, and there is the People First Party, which favors closer ties with China.