Taiwan Economy: Near-term Uptick, Longer-term Challenges

Understanding Taiwan’s economic prospects at any given time starts with consideration of the state of the world economy. With export value equivalent to more than 60 percent of Gross Domestic Product, Taiwan is among the world’s most trade-dependent economies. Although its population of 23 million ranks 51st worldwide, Taiwan’s trade volume – an estimated $572 billion last year according to Taiwan’s customs statistics – is the 19th largest. Possessing scant natural resources, the island economy imports virtually all its energy needs and raw materials; on the export side, its manufacturing operations satisfy a large proportion of global demand for semiconductors, flat panel displays, precision machine tools, high-end bicycles, and a wide range of other products. Massive additional production is carried out by Taiwanese-owned factories in China, strengthening the parent companies’ bottom line.

When the world economy is in good shape, Taiwan invariably enjoys boom conditions. In periods of uncertainty such as the international economy has been experiencing recently, the impact is quickly seen on the order books of Taiwan’s exporters.

Last year’s economic performance demonstrates the connection. Before the year began, the leading forecasting organizations were projecting quite healthy economic growth for Taiwan in 2012, in the range of 4-5 percent. But the prolonged European debt crisis, lackluster pace of recovery in the United States, and slowdown in China’s growth combined to cut heavily into overseas sales for Taiwan’s goods – especially for the computers, components, and other information-technology products that represent the core of Taiwan’s manufacturing strength.

Throughout the year, the forecasters kept revising their projections for Taiwan’s growth downward. The latest calculations put final GDP growth for last year at an anemic 1.26 percent, and even that level was achievable only because of a much stronger than expected 3.72 percent growth registered in the fourth quarter. On the trade ledger, Taiwan’s year-end customs figures show a 2.3 percent drop in export value in 2012 from the previous year, to reach $301.1 billion, and a 3.8 percent decline in imports to $270.7 billion. The outlook for 2013 appears far brighter – subject of course to unforeseen changes in conditions in major markets around the world (so far, at least, economists do not view the effects of the sequestration in the United States as likely to put much of a crimp in U.S.-Taiwan trade). The Taiwan government’s Directorate General of Budget, Accounting and Statistics (DGBAS) is currently projecting 3.59 percent economic growth for this year, and most forecasts from think tanks and financial institutions have been within a similar 3.4-3.6 percent band. Where there have been exceptions, the difference has been on the high side, including a 4.2 percent projection by HSBC and 4.23 percent by Taiwan’s Cathay Financial Holding. “Taiwan starts 2013 on a firmer footing on the back of China’s recovery and better-than-expected U.S. growth,” HSBC Greater China said in a report.

Taiwan, in fact, seems poised to be among the best performing economies in the East Asian region this year after China. The International Monetary Fund is forecasting 3.6 percent growth for South Korea, 3.5 percent for Hong Kong, 2.9 percent for Singapore, and 1.2 percent for Japan.

For Taiwan, a current bright spot is its mounting trade with Southeast Asia. Last year when Taiwan recorded decreases in its export shipments to every other major market, its sales to the ASEAN-6 countries of Thailand, Malaysia, Indonesia, Singapore, the Philippines, and Vietnam jumped by an impressive 9.8 percent. The $55.7 billion total equaled 18.5 percent of Taiwan’s overall exports, up from a 16.5 percent share in 2011. Continued expansion of trade with a flourishing ASEAN is expected to reinforce the positive outlook for 2013.

The once rapid growth in trade with China, in contrast, may begin leveling off, due to an import-substitution effect as the PRC develops more of its own sources of supply for goods like petrochemical intermediates and industrial machinery and equipment. In 2012, direct shipments to China accounted for nearly 27 percent of Taiwan’s total export value, but an even more telling figure is the almost 40 percent share taken together by China and Hong Kong, since many of the items sold to the former British colony are later transshipped to the mainland proper.

At the same time as the import-substitution factor plays out, however, some Taiwanese products may gain attractiveness in the China market as a result of cross-Strait trade agreements now being negotiated. The Economic Cooperation Framework Agreement (ECFA) signed by representatives of Taiwan and China in 2010 has so far had limited impact, since only an “Early Harvest” portion covering 539 Taiwanese commodities and 267 products from China has gone into effect. The tariff concessions for the Early Harvest items were also phased in over three years, and only this year reach the zero-tariff level. But the ECFA framework calls for additional agreements – with a pact on trade in services reportedly close to completion, and one covering a broad range of goods due to follow next year.

The trade relationship with the United States, after being eclipsed for a time by the dramatic rise in cross-Strait commerce, now appears to be coming in for greater attention. After a long period of soured government-to-government trade relations due to Taiwan’s restrictions on the import of American beef products on alleged food-safety grounds – regulations that the U.S. side contended were blatantly protectionist and without scientific merit – Taiwan last fall dropped its prohibition on beef containing traces of the leanness-enhancing feed additive ractopamine. That step opened the way for resumption of high-level negotiations under the 1994 bilateral Trade and Investment Framework Agreement (TIFA). Once held routinely on an annual basis, those talks had not taken place since 2007 due to the beef dispute – but they are being conducted this week in Taipei despite continuing U.S. dissatisfaction that the market for pork was not opened at the same time as beef.

The TIFA talks themselves will deal mainly with fairly technical regulatory matters, but some bigger-picture topics are also likely to be raised. Taiwan is known to be interested in discussing the possibility of the two sides entering into a bilateral investment agreement or even a free trade agreement, a goal for which some influential members of the U.S. Congress have recently expressed their support.

A few decades ago, the United States was by far Taiwan’s largest market, at one point taking close to half of all its exports. Now it is second after China (or third if ASEAN is treated as a single market), last year directly absorbing $33 billion worth of Taiwan products for an 11 percent share. Not to be overlooked, in addition, is that many of the Taiwanese goods shipped to China are components and materials that wind up in finished products – mainly made in Taiwan-invested factories – destined for American buyers.

For the United States, Taiwan is the tenth largest trading partner and the sixth largest market for agricultural products. Taiwan’s total imports from the United States came to $23.6 billion last year.

Composition of GDP

Besides the contribution of exports, the primary momentum behind Taiwan’s GDP growth this year is expected to come from improved levels of private domestic investment. After negative growth in that category in both 2011 (down 1.26 percent) and 2012 (minus 1.35), DGBAS forecasts that private investment will rebound by 5.51 percent this year as companies increase capacity to take advantage of the better export opportunities.

The Taiwan government is also optimistic about the potential for attracting China-based, Taiwan-owned enterprises to “come home” with new investments on the island. So far only a handful of such cases have been announced, including projects by Catcher Technology, a leading maker of metal housings for computers, and Eminent Luggage. But a number of large companies are known to be discussing investment opportunities with the Taiwan authorities.

“The differential in production cost between China and Taiwan has narrowed and in some cases disappeared, especially when factored for productivity,” says Gordon Sun, director of the Macroeconomic Forecasting Center at the private Taiwan Institute of Economic Research (TIER). He notes that in Shanghai and some other coastal areas of China, labor and property costs may be even higher than in Taiwan. Rather than move to less-costly locations in the Chinese interior, which may present logistical challenges, some operations may prefer to place more of their resources in Taiwan. Sun says the machinery industry is one of the most likely to select Taiwan as the site for expansion projects.

To induce China-based businesses to return, the government is offering help with land acquisition in special economic zones where investors will be free of certain regulatory restrictions. The benefits will include the right to employ larger quotas of less-expensive foreign labor for the first two years of operation.

Foreign direct investment (FDI) is expected to make up only a small part of the overall private-investment equation. Last year Taiwan’s Investment Commission approved a total of $5.5 billion in foreign investment projects, an improvement over the $3.8 billion in 2010 and $4.9 billion in 2011. Taiwan’s FDI totals, however, continue to be well below the levels attracted by other countries in the region. One reason may be the reluctance of large private equity funds to propose new projects in Taiwan after several highly publicized cases in recent years in which investment applications from PE companies were not approved. Although the reasons for the lack of approval were never explained to the satisfaction of the applicants, the authorities appeared uneasy about the possibility that prominent companies might be delisted from the Taiwan Stock Exchange.

Another segment of the economy expected to do better this year is the banking sector, long plagued by low profit margins due to over-competition within a relatively small market. Recent cross-Strait agreements permitting Taiwan banks to start doing business in renminbi – mainly offering loans to Taiwanese companies with manufacturing plants in China – should present Taiwan’s financial institutions with new and more remunerative lending opportunities.

Other than exports and private investment, strong drivers of GDP growth are likely to be absent in 2013. DGBAS expects private consumption, for example, to see only modest 1.45 percent growth this year. After a disappointing 2012, both private companies and the government were more frugal than usual in handing out annual bonuses this Chinese New Year, and there was no pay raise for civil servants and many private-sector employees this year. In addition, notes TIER’s Sun, at least a million Taiwanese – mostly relatively high-income technical and managerial personnel – are currently living and working in China. “That means they’re making the bulk of their purchases on the mainland rather than adding to local consumption,” he says.

Although the fiscal situation in Taiwan has not been as dire as in many countries that have felt obliged to adopt stringent austerity measures, rising budget deficits are a serious concern. As a result, increased public spending on infrastructure and services to help provide economic stimulus has been ruled out. Instead, government investment is set to decrease this year – dropping by 8 percent on top of a 10.8 percent decline in 2012. Even for many construction projects already approved, the schedule appears to have been slowed down.

As a proportion of GDP, tax revenue in Taiwan is an extremely low 12.8 percent – about half the level in the United States, which is already well below that of Europe. Budgetary pressure has further heightened following the decision in 2010 to lower the top rate for corporate income tax from 25 percent to 17 percent to bring Taiwan more in line with regional competitors for investment Singapore and Hong Kong. In an effort to respond to criticism that a disproportionate amount of the tax burden falls on the salaried class, the government last year reinstituted a capital gains assessment on securities, but the legislature passed only a watered-down version, leading to the resignation of the finance minister, a leading economic reformer.

Other key indicators, however, have contributed to a sense of optimism about 2013. The unemployment rate, which in 2010 stood at more than 5 percent, an unusually high level for Taiwan, has continued to decrease; it is now 4.16 percent and economists consider that it may fall below 4 percent by the end of this year. At the same time, Taiwan has been enjoying relative price stability. Despite hikes in electricity and gasoline prices as the government reduced what were in effect subsidies to consumers by state-owned enterprises, as well as higher vegetable prices following a spate of typhoons, the consumer price index in 2012 rose by a still-modest 1.93 percent and is expected to be even lower this year.

New directions

Since coming into office in 2008, the administration of President Ma Ying-jeou has put much of its emphasis on fostering better cross-Strait relations, looking to closer ties with the booming Chinese market to help spur economic growth in Taiwan. The result has been most evident in the tourism sector. For years, Taiwanese travelers flocked to China for business and sightseeing, but barriers on both sides blocked traffic in the other direction. Now Chinese visitors – mainly in tour groups but recently individual travelers as well – are helping to balance the tourism flow, bringing welcome business to Taiwan’s hotels, restaurants, shops, and tour-bus operators. Of the 7.3 million foreign visitors to Taiwan last year, 2.5 million were mainland Chinese.

Inbound tourism in general, long neglected in favor of manufacturing, is now being promoted more heavily as a non-polluting industry that contributes to easing the over-reliance on exporting. Although Chinese tourists are the most numerous at popular sights such as Sun Moon Lake, Taroko Gorge, and the Taipei 101 skyscraper, Taiwan is also attracting increasing numbers of visitors from Japan, Korea, Hong Kong, and Southeast Asia.

Looking longer-term, the Ma administration has identified a series of objectives as necessary to set the groundwork for Taiwan’s continued prosperity, referring to them as key pillars of future economic development. The most important among them are Trade Liberalization, Industrial Innovation, and Energy Security – each designed to overcome what could otherwise be a serious obstacle to Taiwan’s economic viability.

For Taiwan, trade liberalization is less a matter of lowering tariffs – most of which have been at reasonable levels since Taiwan’s 2002 accession to the World Trade Organization – than of eliminating protectionism in the form of regulatory barriers such as inadequate transparency. As a result of Beijing’s efforts to isolate Taiwan internationally, Taiwan has largely been left out of the wave of trade liberalization that has taken place over the past decade as countries have increasingly entered into bilateral free trade agreements or worked to set up multilateral trade blocs such as the Trans-Pacific Partnership (TPP) that the United States is currently negotiating with 10 other governments. Another such nascent bloc is the Regional Comprehensive Economic Partnership (RCEP) centering around ASEAN and China. If Taiwan remains excluded from such arrangements, it risks seeing its exports become increasingly uncompetitive in other markets.

With its ECFA agreement with Taiwan already in place, China now seems to have less objection to Taiwan concluding trade pacts with other countries. Taiwan expects to complete an FTA with Singapore in the coming months, and another with New Zealand is under negotiation. But those are small economies, and it is unclear whether China’s more open attitude would extend to Taiwan signing free trade agreements with larger trading partners such as the United States or to participating in the TPP and/or RCEP. Also uncertain is whether Taiwan is willing to adopt major regulatory reforms at this stage to demonstrate its readiness to join such undertakings, or whether it would be reluctant to give up any chips before actually engaged in negotiations.

The need to foster more industrial innovation stems from Taiwan companies’ longstanding reliance on contract manufacturing for other corporations. That business model served Taiwan well for many years, but it offers much lower profit margins than marketing unique products under one’s own brand. The government is encouraging companies to engage in more R&D, and the huge government-backed Industrial Technology Research Institute provides support to companies in the private sector. Still, with some exceptions such as the highly successful Taiwan Semiconductor Manufacturing Co., Taiwanese firms are facing an increasing challenge in competing against industrial giants like Korea’s Samsung.

The issue of energy security may be coming to a head later this year as the government has agreed to the opposition party’s calls for a national referendum on whether Taiwan should continue with nuclear-power development. The vote will determine whether a fourth nuclear plant, construction of which is nearing completion after numerous delays, would be allowed to become operational. Japan’s Fukushima disaster of 2011 lent added momentum to what was already a strong anti-nuclear movement in Taiwan.

Risks regarding nuclear safety will need to be weighed against the risk of serious power shortages and substantially higher electricity costs if Taiwan abandons the nuclear option. Nuclear power currently accounts for about 17 percent of the electricity generated in Taiwan, and President Ma has already stated that the existing three nuclear plants will be decommissioned when their authorized 40-year lifespans expire between 2018 and 2025. Without a new nuclear plant or extension of the old ones, it is questionable whether Taiwan has feasible options for meeting its energy needs. Renewable sources such as solar and wind energy are not sufficient to take up that slack, coal-fired plants face opposition on environmental grounds, and heavy reliance on liquefied natural gas (LNG) – which is highly expensive to transport and store – could be so expensive as to undermine Taiwan industry’s competitiveness.

Besides the energy challenge, the new cabinet of Premier Jiang Yi-huah, who took office last month, will have to overcome resistance from various quarters to seek to push through some needed reforms. Among the most pressing:

• Overhaul of the pension system, especially for civil servants, who currently receive far more generous terms than available to private-sector employees. Given the current fiscal crunch, the government finds it difficult to maintain those conditions, but reform risks alienating some of the staunchest backers of the ruling Kuomintang (Nationalist Party).
• Adjusting the rates charged for water usage, which are among the lowest in the world, leading to wastage and providing no incentive for conservation. Scientists say Taiwan may be in for one of its periodic droughts later this year, exacerbating the problem, but consumers are likely to complain vociferously about higher prices, especially after last year’s increases in electricity tariffs.
• Encouraging another round of consolidation in the banking sector, considered to be one of the least efficient areas of the economy and a drag on Taiwan’s development. Of the 38 domestic banks, some of the largest are government-owned, but suggestions about selling off those assets trigger criticism that instead of serving the public interest, the result would be only to increase the power of Taiwan’s large business groups.

Assuming that Taiwan finds answers to its energy and other challenges, however, it has the potential to develop into a prosperous commercial hub for multinational business operations in Asia, a recent American Enterprise Institute study concluded. “Taiwan Inc.: A Home for Global Business,” a paper co-authored by Dan Blumenthal, Rupert Hammond-Chambers, Michael Mazza, Gary Schmitt, and Derek Scissors, noted Taiwan’s many advantages, including its central geographic location, technology manufacturing prowess, skilled labor force, and respect for the rule of law. It urged the U.S. government to find ways to encourage the Taiwan economic reform process for the sake of economic and strategic benefits for both parties.