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Economic restructuring can't wait

`Like Japan, Taiwan has been pursuing macroeconomic bailouts without a commitment to serious reform.'

If Taiwan is banking on a global recovery to lift its economy out of the doldrums, then it had better think again.

Taiwan has missed so many opportunities to restructure its economy. What it needs at this critical juncture is deep structural and institutional reforms that will boost its competitiveness. Otherwise, not even a global economic recovery will cure its many ailments.

Taiwan's main problem is the liquidity trap, where rates fall so low that demand does not react to further rate cuts. Growth in bank loans is expected to decline further even though the central bank has cut rates by 250 basis points this year, bringing the nominal interest rate to a record low of 2.25 percent. Deflation, however, means the real fall in interest rates is only 50 basis points.

Like Japan, Taiwan has been pursuing macroeconomic bailouts without a commitment to serious reform.

Structural flaws have impaired the way the entire banking system functions, eroding public confidence. The result has been a fall in money velocity (the rate at which money changes hands) that has offset the positive impact of monetary expansion in the economy. This produces diminishing returns on capital, a dysfunctional banking system, bad debts and worsening fiscal balances.

Unlike their regional counterparts, Taiwan's banks did not go through a cleansing process during or after the 1997 Asian financial crisis. The government has succeeded in sustaining them via foreign exchange controls and by limiting their foreign debt exposure.

While Taiwan has very little foreign debt, it suffers a massive domestic debt overhang of more than 150 percent of GDP. This debt load has become a serious problem because the nominal GDP growth rate has slipped way below nominal growth rates. This means servicing the existing domestic debt requires recurrent borrowing, a vicious cycle that could cause major economic dislocations.

Moreover, Taiwan's chronic budget deficit is now more than a cyclical concern. The central government's budget deficit has risen to more than 5 percent of GDP, compared to 1 percent in 1995. The total fiscal deficit is now more than 6 percent of GDP. These are higher than the 3 percent deemed prudent by the international financial community.

Increasing fiscal spending to boost growth, and the potential loss of fiscal revenues as businesses migrate to China, will reduce medium-term prospects for balancing the budget.

Non-performing loans represent 7.96 percent of total bank loans, according to official estimates. Private estimates are more than double that. Bank bailouts will therefore add significantly to fiscal spending, and thus the budget deficit.

Nevertheless, the country has high private-sector saving and the public sector can borrow relatively easily, meaning Taiwan's fiscal woes are unlikely to explode into a crisis. Total government debt stood at only 27 percent of GDP last year, way below the 60 percent threshold accepted by the international community.

Although Taiwan still has room to tap private savings for funding, the market is jittery. Standard and Poor's downgraded Taiwan's sovereign rating in July this year to AA from AA+, citing the government's inability to repair the financial system and stem the rising budget deficit.

Taiwan's problems are aggravated by an economic transition that threatens a significant num-ber of its manufacturing indus-tries. China has been a magnet for an estimated US$60 billion worth of Taiwanese investment. Capital outflow is expected to accelerate as local businesses struggle to survive under the WTO by relocating to China. Taiwan will face the daunting challenge of replacing these industries.

Can the island turn itself into a financial hub? Asia does not need another financial hub. Taiwan will have to move up the value-added ladder by focusing on electronics and computers as well as other knowledge-based goods.

The current economic woes should serve as a wake-up call for the government to restructure.

Michael Teo is a freelance writer based in Taipei.
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