Taiwan’s Economy: Recovery with Chinese Characteristics

Editor’s Note: In the inaugural installment of CNAPS’s Taiwan-U.S. Quarterly Analysis series, Terry Cooke explores the causes and effects of Taiwan’s pursuit of economic normalization with China. Articles in this series will be written by leading experts on the U.S.-Taiwan relationship and will contain in-depth analysis of bilateral and multilateral policy challenges for Taipei and Washington.

The past year has brought “once in a lifetime” upheaval to the Asian regional economy and to world markets. As a result of systemic failure in global financial markets, the post-World War II pattern of interdependent growth between Asian exporters and Western consumers is under strain and is changing. Taiwan, one of the region’s preeminent beneficiaries of this arrangement over the past sixty years, finds its economy at an important cross-roads. Its globally integrated “sub-economy” (electronics and IT) has been deeply affected by the global credit squeeze at the same time that its domestic economy has been battered by Typhoon Morakot. Its hopes for an economic shot-in-the-arm from possible bilateral Free Trade Agreement (FTA) discussions with the United States or from a breakthrough in the World Trade Organization’s (WTO) multilateral Doha Round hold little promise for success in the near term.

The bright spot for Taiwan’s economy over the past ten months has been rapid progress in “economic normalization” with China built on an ad-hoc framework of high-level cross-strait meetings. The current direction of these talks points to a formal agreement between Taipei and Beijing—the Economic Cooperation Framework Agreement (ECFA)—to be substantively worked out by the end of 2009 and signed in early 2010. As these milestones approach, key questions for Taiwan and the region are whether the ECFA will put Taiwan’s economy on a more sustainable track of stable growth in a new, rebalancing global economy and, if so, whether political benefits—such as China’s recent acquiescence to Taiwan’s observer status at the World Health Assembly—will continue to follow. In the global arena, a key question is whether Taiwan’s contribution to regional economic stabilization through pursuit of the ECFA will lead to shored-up political support from Washington as the Obama administration continues to focus on the Korean peninsula and other competing claims on its attention in East Asia.

The Impact of Global Recession

The 2008/2009 financial crisis originated in U.S. sub-prime markets but quickly spread world-wide. Following the dissolution of Lehman Brothers on September 15, 2008, the heaviest effects of the crisis were soon felt in the world’s oil- and commodity-producing economies and in the export-led economies of Asia. In effect, the global recession represented a reverse gear of globalization. Sudden loss of confidence led to a seizing-up of global credit markets which in turn undercut global demand for manufactured goods from Asia’s export juggernaut (as well as for the oil and resources required to manufacture these goods). A feature of this “globalization-in-reverse” recession was that relatively insulated economies such as that of Bangladesh experienced milder dislocation while newly emerging markets such as Eastern Europe and highly integrated markets such as Singapore underwent wrenching dislocation.

Against this backdrop, it is easy to understand the degree of challenge which the global recession has posed for Taiwan’s economy. With a small internal market of only 23 million, fully 70 percent of Taiwan’s gross domestic product is accounted for by exports. The lion’s share of these exports consists of electronics and information technology products. Already suffering from commoditization pressures, this sector was rocked in the early days of the recession by uncertainty in the final assembly market of China and by wide-scale cancellations and downscaling of purchase contracts in North America, Europe, and Japan.

As a result of its dependence on the IT sector and its high degree of integration with global supply chains, Taiwan took a stronger hit—and is taking a longer time to recover—from the impact of the global recession than its regional competitors. Following an alarming 41.9 percent drop in exports in January, Taiwan’s exports continued to fall off more precipitously than those of the other “Little Dragon” economies in Asia over the next six months of 2009:[1] off 32.8 percent compared to declines in exports of 17.2 percent in Hong Kong, 22 percent in South Korea, and a roughly comparable 31 percent in Singapore.

As a result of the dismal international trade environment in the first half of 2009, the Taiwan government is now facing a revenue shortfall largely attributable to falling corporate profits, government debt approaching legally-mandated limits, and all-time highs in unemployment. The first harbinger of improvement came in the year’s second quarter, with an improving trade surplus with China as Beijing’s stimulus took hold and inventories for Taiwan intermediate goods were restocked.

Entering the fourth quarter, it is evident that Taiwan’s economic contraction for the 2009 full-year will be greater than anticipated. This is despite the government’s fiscal stimulus for business and consumers and a significant reduction of almost 250 basis points in its benchmark lending rate. In late September, the Asian Development Bank adjusted its 2009 forecast for Taiwan downward to predict a full-year contraction of the economy of 4.9 percent in 2009. Looking forward to 2010, the Asian Development Bank predicts a GDP uptick[2] of 2.4 percent. Forward indicators and various measures of business confidence are now trending upwards. This anticipated growth for Taiwan’s economy in 2010 is based largely on growing Asian-led demand and tightened commercial links with China.

So, with traditional markets in North America, Europe, and Japan still sluggish and China’s economy for the moment leading the pace of global recovery, in what direction does Taiwan’s economy need to move?

Immediate Issues

The first and most immediate obstacle for Taiwan’s economic recovery is the still-clouded outlook for the broader recovery of the global tech industry, the most globalized part of Taiwan’s economy. Early indications are for a broad-based but modest recovery from the global tech sector’s second major downturn this decade. While stock markets are signaling investor confidence in a return to robust corporate spending on technology, industry executives themselves are far more cautious. Rather than a classic V-shaped recovery, industry executives are expecting at best a slow rebound with 2010 capital spending budgets comparable to the depressed levels of 2009.

A second issue for Taiwan’s economic leaders is to improve trade relations with the United States. While a weak global economy and a new U.S. administration mean that immediately achievable goals in this area will fall short of a U.S.-Taiwan FTA, there is still much for Taiwan to accomplish in this area. Beyond the current controversy over U.S. beef imports into Taiwan, there is an opportunity for Taiwan to build on recent policy advances in the retail, tax, and transport sectors to jump-start the resumption of the U.S.-Taiwan Trade & Investment Framework Agreement talks (TIFA). The TIFA Framework, initially established in 1994 as a high-level governmental forum for U.S.-Taiwan consultation on a broad range of trade, investment and economic issues, has been stalled repeatedly due to U.S. dissatisfaction, first, with Taiwan’s slow progress in protecting intellectual property rights and, more recently, with resolving an array of sector-specific concerns (including agricultural licensing and import requirements; pharmaceutical testing, labeling and certification; telecommunications market barriers; and financial service constraints).

Despite domestic controversy, Taiwan’s lifting of its partial ban on U.S. beef products and its new U.S.-Taiwan beef protocol represent a positive step toward TIFA resumption. So, too, do three recent technical adjustments in trade policy announced by Taiwan in response to lobbying by the American Chamber of Commerce in Taipei: (1) liberalization of retail imports of China-sourced kitchenware and porcelain; (2) clarification of the scope of “Taiwan-sourced income” for corporate tax purposes; and (3) improved customs clearance procedures for digital invoicing of express consignments. If these steps can translate to meaningful progress under the TIFA Framework, it then becomes possible for the U.S. Trade Representative to consider Taiwan as a potential candidate for future Free Trade Agreement (FTA) talks with Taiwan, provided the Obama administration throws its weight behind that process and pushes for ratification of the FTAs with South Korea and Colombia which have already been negotiated.

The Challenge of Global Rebalancing

Beyond these immediate uncertainties, a broader challenge lies on the road ahead for Taiwan’s economy.

The more fundamental, long-term challenge for Taiwan’s economy relates to its adjustment to an on-going rebalancing of the global financial system. In the United States —Taiwan’s largest traditional trading partner—these changes are already proceeding apace. While the U.S. consumer and financial markets were strong enough to support on a deficit basis the dramatic expansion of world trade from 1972 until 2000, those conditions manifestly no longer exist. At the consumer level in the United States, there are already some signs of consumer attitudes shifting from the high-consumption pattern of recent decades back to more balanced, historically-grounded pattern with a meaningful savings component. At the government level, cornerstones are being put in place to reinforce these attitudinal changes through revamped tax and monetary policy.

The rebalancing of China’s economy is likely to take place more gradually through the elevation of the G2O and other venues. For China, this portends some degree of shift away from “neo-mercantilist,” export-focused growth strategies led by heavy investment in “hard” infrastructure. It signals a gradual transition toward a more sustainable economic model[3] where growth is less dependent on Western consumer pockets, where profits from growth reach more Chinese consumer (and small business) pockets, and where investment flows more readily to the “social infrastructure” of education, health care, and pensions.

These tectonic shifts in global markets, particularly in the United States and China, represent a fundamental challenge for Taiwan’s economy. Any long-term softening of end-user demand for Taiwan’s core products as a result of changed patterns of consumer and corporate spending in Western markets will not be easily recouped in China[4] or elsewhere. Facing these global trends and on-going marginalization in the regional trade arena, Taiwan needs a game-changer, both to offset these weaknesses in its economic posture and to encourage closer cooperation with regional trade partners. To withstand commoditization pressures in the fast-moving IT industry, Taiwan manufacturers will need to stay close to consumers in China and other key markets to maintain their recent pace of innovation in mobile handsets and netbook computers. To tap regional markets more effectively through trade agreements, Taiwan needs to overcome concerns about possible Beijing displeasure among potential trade partners. (While the recent warming of relations between Taiwan and China has largely ended “checkbook diplomacy” and “recognition tug-of-war” in the political sphere, Taiwan has been a wall-flower in the bilateral and regional trade agreement “speed-dating” that has cropped up as the Doha Round has dragged on inconclusively and risks being left out of the blooming regional and global trade relationships.) Formalizing closer trade links with China would in one sweep help boost Taiwan’s economy and its access to other economies around the world.

The ECFA as a Path Forward

Mired in a weakly rebounding tech sector and retrenching Western markets, Taiwan is counting heavily on economic rapprochement with China. The Economic Cooperation Framework Agreement (ECFA) put forward by Taiwan’s President Ma Ying-jeou in February 2009 has now been taken up in earnest by Taipei and Beijing as the main harness for moving bilateral relations forward. In essence, the ECFA amounts to a bilateral preferential or “free” trade agreement between Taiwan and China, adjusted technically to account for sovereignty concerns on both sides. The three preceding high-level rounds of meetings between Taiwan and China, mediated by the Straits Exchange Foundation (SEF) in Taiwan and the Association for Relations Across the Taiwan Strait (ARATS) in Beijing, have already produced a series of significant economic gains for Taiwan: a doubling of direct flights between China and Taiwan to the level of 270 per week; a further boosting of mainland tourism to Taiwan beyond the recently achieved level of 3000 visitors per day; a Financial Framework Agreement to create a supervisory mechanism for financial service companies operating in both markets; a partial opening of Taiwan’s economy to direct investment in select industries by mainland firms; and regulatory agreements governing food safety inspections and cross-strait anti-fraud cooperation.

The objective now in Taiwan is to begin substantive talks on institutionalizing the ECFA by the end of the year and to sign a formal agreement with China in early 2010. Pressure is on in Taiwan to adhere to this timeline, even as its politically-polarized public straggles to absorb its implications. That China’s FTA with ASEAN takes effect on January 1, 2010 is the main impetus for the Ma administration to get its public to rally around the ECFA quickly. In addition to giving Taiwan exporters a more level playing field in China and Southeast Asia, there is also the hope that a Taiwan-China ECFA might lead to enabling Singapore to follow that precedent with a Taiwan-Singapore FTA.

Significantly, private sector analysis of the likely impact shows that the ECFA will have minimal benefit for Taiwan’s IT industry. This is because the IT industry, already highly integrated into the global supply chain, faces low commodity taxes of only 0.58 percent when exporting its components to China for assembly and reshipment to world markets. By contrast, the tariff barriers facing exported products from Taiwan’s more traditional industrial sectors—petrochemicals, heavy machinery, steel, automotive, building materials, and textiles—are significantly higher. Accordingly, these traditional sectors of Taiwan’s economy stand to gain more from the ECFA than Taiwan’s tech sector.

All of this is requiring the Ma administration to undertake strenuous efforts to educate its public of the potential benefits of the ECFA. Despite some clear structural advantages which the proposed ECFA holds for Taiwan given its strengths in knowledge-based industries,[5] there is growing concern and appreciable risk for the ruling party in upcoming regional elections if it fails to persuasively make the case for the ECFA. Currently, the Ministry of Economic Affairs is leading the administration’s efforts in this regard, identifying “early harvest lists” of sectors which stand to benefit directly from the ECFA and initially excluding from the agreement a number of product categories[6] where direct competition with mainland firms is more politically problematic. The administration’s case was underlined in mid-October by a report from the Council of Labor Affairs which showed a positive impact of 0.75 percent GDP growth and a net gain of 125,000 jobs under a favorable ECFA scenario and a dip of almost 0.2 percent in GDP, accompanied by a net loss of 47,000 jobs, in the event of the ECFA not being concluded. Even China has been working to demonstrate the benefits of an ECFA to the Taiwan public (while presumably also demonstrating its role as a responsible regional stakeholder to a global audience). More than a half-dozen procurement missions from China have come to Taiwan in 2009 and purchased close to U.S. $10 billion in consumer electronics, processed foods, and other goods.

In broad view, the key dynamic in all of these developments is their lesser impact for the globally-integrated and globally-mainstream sectors of Taiwan’s economy (i.e. IT/electronics) and their relatively greater impact for more parochial sectors of Taiwan’s traditional economy. By normalizing cross-strait commercial relations in these “stodgier” sectors, the ECFA makes possible an overdue structural adjustment. Along with greater competition, the agreement promises new markets in the mainland and a new level of regional and global economic integration, via the China market springboard.

Perhaps the shock of an economic downturn was required to position Taiwan and China for this next level of mutual engagement and economic integration. While joint entry into the WTO was immeasurably important to both parties as a confidence-building measure, Geneva has not served as an arena for directly advancing bilateral rapprochement. While economic integration has proceeded apace to meld the two countries’ IT sectors into a nearly seamless global supply chain, integration of other, more traditional sectors (such as agriculture, transportation, energy, and petrochemicals) has been impeded by political opposition and, in some cases, by national security concerns.

While the global financial crisis may have pushed Taiwan and China significantly closer in their economic relationship, neither party seems to be ignoring the key “lessons learned” from the crisis. The deliberate ECFA process is structured on a shared recognition that cross-strait integration needs to be pursued in measured and balanced fashion, not as a pell-mell rush. The staging of these talks throughout the year has been designed to allow time for public opinion in Taiwan to recognize the need for, and to help shape the final form of, this outcome. In the final analysis, the ECFA seems to represent a recognition in both Taipei and Beijing that they need to work together to co-manage the impact of global economic crisis by adding previously insulated sectors of their respective economies to the cross-strait grid.

Around the Corner

For sound economic reasons, the government in Taiwan is forging down the ECFA path in an attempt to recapture forward momentum following a year of stalled economic performance. Those at the helm of Taiwan’s economy have made clear[7] that the ECFA is not merely a short-term tactical shift to gain from the world-leading pace of growth across the Strait of Taiwan; rather, it reflects strategic recognition of the fact that traditional sectors of Taiwan’s economy stand to gain from the degree of integration with the world that the technology sector has long enjoyed. In short, the longer-term path to economic recovery for Taiwan is through fuller integration with global markets, not only in the tech sector but across the spectrum of its economy. The ECFA represents a significant stage towards that goal by promising to normalize economic channels ruptured through decades of political antagonism and posturing with China. Whatever variety of economic recovery China ultimately experiences – V, U, or W – and whatever form of rebalancing ultimately takes place between excessive savings in China and overconsumption in the United States, Taiwan cannot realistically afford any of its economic cylinders to be idled. Integrating more fully with the mainland economy through the ECFA roadmap will allow Taiwan to capture drive from China’s rapid growth, to contribute to the prosperity and stability of the regional economy, and to participate with a higher degree of integration in the global economy.

The United States’ stake in these outcomes is significant, as is its role in supporting their realization. As to direct American economic and commercial stake in Taiwan, the Obama administration should recognize the recent steps made by the Ma administration and join in advancing the TIFA process. For its broader stake in cross-strait prosperity and stability, the United States should be appropriately encouraging of Taipei’s and Beijing’s moves to further normalize cross-strait commercial ties through the ECFA process. In essence, the ECFA outcome would represent in the economic sphere the long-standing U.S. policy position toward cross-strait tension in general—namely, U.S. support for China and Taiwan to act together to resolve their differences by peaceful means. Successful conclusion of an ECFA would not only provide “political cover” for regional trade partners to conclude their own trade agreements with Taiwan, it would provide an opportunity for the United States to validate the success of Beijing’s and Taipei’s joint efforts economically and politically.

[1] The following figures represent export performance against prior year results for the seven-month period Jan – Jul 2009.

[2] A more ‘dynamic’ model used by Taiwan’s Chung-hua Institution for Economic Research (CIER) calls for 4.65 percent increase in GDP for 2010.

[3] See commentary by Qin Xiao, Chairman of China Merchants Group, “China Must Keep Its Eyes Fixed on the Exit,” Financial Times, October 21, 2009, p. 9.

[4] The Lenovo case-study illustrates both how difficult it has been for Chinese-owned manufacturers to dislodge Taiwan IT firms from their perch in the global IT value-chain and how important the PRC domestic market is in their current strategy to wrest global market-share away from Taiwan firms.

[5] See “Taiwan’s Improving Relationship with China,” The Economist, May 7, 2009, p. 48.

[6] These include many agricultural products and certain industrial products such as steel, footwear, white goods, printed circuit boards, and others.

[7] “Not only will the ECFA strengthen our economic ties with China, it is also key to Taiwan’s connection with the world market.” (Minister of Economic Affairs Shih Yen-hsiang, Taiwan Today, September 18, 2009)