EM Thematic/Country – What Ails TWD?

Summary

• Taiwan has a booming economy firing on both domestic and external demand, but the currency remains depressed.
• Lifers are mainly investing via bond ETFs, which are not FX hedged. They are also dropping hedges on existing assets due to a looming change in regulations.
• We estimate that USD/TWD must fall below 31.80 to deplete the FX Volatility Reserve under the new rules and create forced selling by lifers.
• A strong economy and weak currency mean a CBC rate hike in September cannot be ruled out.

Market Implication

• TWD weakness is not warranted by macro fundamentals but reflects changes in lifers’ risk management and asset mix.

Exports Motor On, Economy Booms, FX lags

Taiwan reported stellar export growth of 23.5% YoY, with the 3mma moving to +11% YoY. The breakdown was a familiar pattern with ICT (tech) more than doubling YoY, led by exports to US which were up 74% YoY.

Yet TWD remains unimpressed. USD/TWD is hovering near cycle highs around 32.50. The tight historical relationship between export growth and FX remains broken (Chart 1). The TWD NEER has been trending weaker, even with the CBC leaning against the trend with modest USD sales (Chart 2).

The weak currency is also at odds with the CBC’s tightening bias and an overall strong economy, which is on track for above-trend growth of around 5% this year.

Unlike neighbouring Korea, where booming semiconductor exports contrast depressed domestic sectors, Taiwan’s recovery is truly broad-based, with PCE growing 4.4% in Q1 and the drag from GFCF (mainly fixed machinery investment) diminishing (Chart 3). The various PMIs from NDC and S&P suggest robust growth momentum (Chart 4).

Basic Balance of Payments

In each of the last three quarters, Taiwan ran a current account surplus of around USD30bn, a near record high. Based on monthly trade data, this probably fell a little in Q2 to around USD25bn, but it remains a substantial surplus (Chart 6).

Net FDI is a small outflow of about USD5bn/qtr, though it may increase over time as TSMC is set to expand factories in US, Germany and India.

The main drag on BoP is net portfolio flows, where domestic outflows (80% into global fixed income) easily swamp FII inflows into local stocks. The role of lifers as the key agents is well understood by the market.

However, the pace of outflows on BoP is not increasing. Domestic outflows in the last four quarters are averaging USD16bn per quarter, in line with the five-year average (Chart 7). Total foreign assets reported by lifers are relatively unchanged in dollars (sum of orange and blue bars).

There are three main instruments through which lifers invest in overseas securities: direct purchases, Formosa bonds (foreign currency bonds issued by international firms but listed on Taipei Exchange), and TWD denominated ETFs with foreign bonds as underlying.

The first two require FX hedging, which is costly given US-TW rate differentials, and must be reported as foreign assets on their balance sheets, which is subject to regulatory limits.

In contrast, Bond ETFs are not FX hedged nor reported as part of foreign assets. This provides a loophole to lifers for running outright foreign bond carry trades without breaching foreign investment limits and hedging guidelines.

Since the regulator treats ETFs as an ‘equity’ product, it charges a higher risk-weight – 15% vs only 5% for FX hedged bonds, which puts at least some capital adequacy restraint on this ‘loophole’. But despite the higher capital charge, bond ETFs have become the main channel for outflows in the last two years. We estimate they now account for 10% of total foreign assets (Chart 7). Their popularity reflects the level of carry rather than changes in rate differentials (Chart 8).

Falling Hedge Ratios

The use of the Bond ETF ‘loophole’ is only part of the story. Lifers are also dropping FX hedges on their existing portfolio of foreign assets.

Based on quarterly statements reported for Q1, we estimate that the overall hedge ratio fell from 60% at the end of last year to 54%, the lowest in over a decade (Chart 9). In dollar terms, we estimate this translates to an unhedged (open FX) position of USD230bn, which does not include the USD75bn of bond ETFs.

There are two reasons lifers are reducing FX hedges. First is complacency. FX volatility has been low, which typically reduces their appetite for negative carry hedges. Second, and more important, is the expected change in FSC regulation. This would allow lifers to increase the size of the FX volatility reserve and utilize more of it to smooth operating income during periods of TWD appreciation.

This allows lifers to reduce the total volume of their FX-hedges, thereby reducing the explicit cost of FX-hedging they are currently paying.

The FX volatility reserve at the end of May was TWD188bn (USD5.8bn – Chart 11). The current rules allow lifers to draw down half this amount to offset FX losses. The new rules would allow them to utilize all the reserves during periods of TWD strength and increase the contribution by more during periods of TWD weakness (Chart 12).

While the regulator has not finalized the change yet, lifers are already adjusting their positions. This is evident from the quarterly reports and the recent widening in NDF-onshore forward spreads.

How much cushion do lifers have with the volatility reserve under the new rules? Out of USD685bn of foreign assets, lifers have a net open position of around USD230bn (Chart 10). A 2.2% drop in USD/TWD would wipe out the entire FX volatility reserve. This means USD/TWD must drop to 31.80 before lifers start taking a hit on operating income.

In the past when Lifers were caught under-hedged amid fast TWD appreciation, they rapidly raised FX hedges. This created a self-fulfilling extension of the currency’s rise. The sharp drop in USD/TWD in November and December last year is a case in point.

With hedge ratios falling to record lows, could the stage be set for another sharp rally in TWD? It is possible. But with wider access to the volatility reserve, the bar seems higher than last year. Lifers are fully recycling the current account surplus through unhedged bond ETFs and lower hedge ratios. The status quo suits them, and there is no MTM pressure on them to change risk management.

As such, the catalyst for a stronger TWD would need to be exogenous, such as a sharp drop in the US dollar or a large narrowing of rate differentials.

Not Ruling Out a Rate Hike

Unlike the rest of Asia, the current shape of Taiwan’s interest rate curve is upward sloping, with the market pricing in two more 12.5bp hikes by the CBC in the coming six months. The next quarterly MPC meeting is on 19 September.

We see an outside chance CBC will deliver another hike in September, or at least tighten liquidity via RRR hike and maintain a hawkish stance. However, if the TWD strengthens, there would be less pressure to hike.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)