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Central Bank of the Republic of China


Responding to the Challenges: Financial Development and Structural Change in the ROC Economy

Responding to the Challenges:
Financial Development and Structural Change in the ROC Economy

The ROC economy has again performed well in 1999. Exports grew 7% through the first eight months of this year. The current account registered a surplus of US$3.8 billion, while the overall surplus reached US$10.1billion in the first half of the year. As a result, foreign exchange reserves built up to US$100.1 billion at the end of August and foreign assets held by the private sector approached US$70 billion. Not surprisingly, the level of our external debt is negligible.

Real GDP rose 4.26% at annual rate in the first quarter of 1999 and the pace of growth accelerated to 6.54% in the second quarter. For the year as a whole, the economy is expected to grow 5.74%. The expansion in output has been driven by strong external demand, and an increase in both private consumption and public investment. In the meantime, prices have remained stable. The CPI went up merely 0.23% at annual rate up to the end of August. Inflation should remain subdued and is projected to be around 0.5% for the year.

Unemployment rate is currently the lowest in Asia. The Living Misery Index, as measured by the sum of the unemployment rate and the inflation rate, gives Taiwan a total of 3% as of the end of August, also the lowest in Asia. According to a forecast made by the World Economic Forum, Taiwan's average economic growth rate will be the second highest in the world over the next eight years. In terms of global competitiveness, Taiwan ranks fourth overall in 1999, moving up two places in spite of the Asian financial crisis. Time and again, the Taiwan economy has exhibited exceptional resilience and strong potential in the face of adversity.

If we look at the period from mid-1997 to mid-1999, two features of the ROC economy stand out. First, Taiwan was the economy least affected by the Asian financial crisis and was moreover able to maintain steady growth throughout the crisis. While most other Asian economies experienced sluggish or even negative growth, the ROC managed to register a 4.65% growth rate with 1.68% inflation in 1998. Second, as the crisis has gradually subsided, Taiwan has emerged as one of the few economies to recover strongly. To put it simply, the most remarkable attribute of the Taiwan economy is its flexibility. It has proved itself capable of withstanding the onslaught of a financial crisis while continuing to perform credibly.

Back in 1995, I wrote a paper on the Mexican peso crisis. I concluded by saying: ¡§The Philippines, Indonesia, and Thailand have all been running current account deficits for some time. These economies rely heavily on foreign capital inflows. In the case of Thailand, these inflows are mostly of a short-term nature. This should be a cause for concern.¡¨At this point, let me make it quite clear that I am no crystal ball gazer. My prediction was based on a study of the balance of payments of the various countries in question. Persistent current account deficits, heavy reliance on foreign capital, inflexible exchange rate regimes, and overvalued real exchange rates are a potent mixture that could give rise to currency crises. Short-term capital tends to be highly volatile in nature. Massive and rapid movements of short-term capital can seriously undermine the stability of the financial system and ultimately affect the whole economy. An excessive surge in capital inflows might plant the seeds of a currency crisis by contributing to (1) a real appreciation of the local currency, (2) a build-up of external debts, (3) an explosive growth in domestic credit and a current account deficit, (4) over-investment in risky ventures, and (5) an equity or property market bubble.

International capital movements in the form of long-term foreign direct investment support economic development in recipient countries by providing access to foreign savings. The investing country enjoys a higher rate of return on capital, creating a win-win situation. Short-term capital, on the other hand, is highly volatile in nature. In most cases, the size of a developing or newly industrialized economy is too small to withstand the effects caused by sudden financial reversals. It is for this reason that short-term capital inflows should be modulated so that they do not impair the performance of the domestic economy. The ROC has followed an appropriate sequence to open up its capital account. This orderly and gradual approach has lessened the impact of the recent financial crisis by giving the private sector more time to adjust and improve its ability to compete.

Strong economic fundamentals are also reasons why Taiwan has escaped the Asian crisis relatively unscathed. In 1997, at the height of the financial crisis, the average non-performing loan ratio for the banking sector was 4%, much lower than for other countries in the region. The average capital adequacy ratio stood at 11.4%, well above the 8% requirement set by the BIS. With steady improvement in corporate financial structure, the average debt-to-equity ratio for listed companies has fallen to 78%. Furthermore, companies in Taiwan are less susceptible to foreign exchange fluctuations because they don't rely on foreign borrowing. This in effect creates a firewall that can shield Taiwan from the contagion of a financial crisis.

In order to redress a number of weaknesses that were uncovered during the Asian financial crisis, the government has introduced a series of financial reforms. These measures are designed to improve bank balance sheets and profitability. The government has also actively encouraged consolidation in the banking industry. A new supervisory authority will be set up at the beginning of next year which will assume overall responsibility for supervising financial institutions, including banks, insurance companies, and securities houses. By further strengthening the soundness of the banking system, we are preparing ourselves for the challenges posed by the new global economy.

Financial stability forms the bedrock of sustained economic development. It enables the private sector to make sound judgements with respect to production plans and trade decisions under a consistent macro environment. The central bank in Taiwan adopts a flexible exchange rate regime, allowing market forces to determine the nominal exchange rate, while also ensuring that the real exchange rate reflects economic fundamentals. Other features of our exchange rate policy indicate our resolve to remove distortions from the market, improve bank risk management, and offer market participants accurate and timely information.

With respect to monetary policy, we closely monitor developments both at home and abroad and fine tune our policies accordingly. By maintaining the money stock within the target range, we are not only able to meet the funding requirements of both private and public enterprises, but are also able to create a low-inflation environment. These policies have successfully preserved the stability of the domestic economy during the Asian financial crisis in the short run, and have made important contributions to economic development in the long run.

From our experiences in dealing with the recent financial crisis, I would like to make the following policy recommendations.

Domestic saving should be the major source of capital formation.

Foreign direct investment and long-term foreign borrowing are suitable alternatives if domestic saving is insufficient to meet the needs of domestic investment.

Sustained current account deficits are undesirable and should be corrected by appropriate policies.

The nominal exchange rate should remain flexible, while the real exchange rate should reflect economic fundamentals.

Banks, importers, and exporters should be encouraged to reinforce risk management.

The deregulation of foreign exchange transactions should follow an appropriate sequence. The current account should be liberalized before the capital account, and long-term capital before short-term capital.

The supervision and monitoring of financial institutions should be bolstered.

Corporate governance should be strengthened.

Supply-side adjustments also explain why Taiwan has consistently managed to produce good results. The government and the private sector have worked together to alter the structure of our manufacturing base, with far reaching consequences. Heavy and high-tech industries accounted for 76.5% of total industrial output in 1998, up from 64.6% in 1989. Taiwan is now the world's leading producer in eleven categories of manufacturing products. In terms of output, Taiwan's information technology industry now ranks third in the world, while the semi-conductor industry ranks fifth.

The structural changes that have taken place in Taiwan's manufacturing base have also altered the make-up of our exports. High-tech products accounted for 24.2% of total exports in 1989. By 1998, this figure had risen to 41.1%. Conversely, the share of low-tech products fell from 37.7% to 18.4% over the same period. The shares of heavy industry, electrical and electronic machinery rose from 44.5% and 33% to 64.4% and 52%, respectively. There has evidently been a gradual shift towards technology and capital intensive products. Quality and high value-added have won Made-in-Taiwan products popularity abroad, which in turn has made the export sector less vulnerable to a sudden decline in external prices. Taiwan's competitive edge in high-tech production has been conducive to not only economic growth but also a sustained current account surplus. Over the years we have accumulated sizable foreign exchange reserves that readily served as an important anchor during the financial crisis.

Capital accumulation and total factor productivity have both been instrumental in successfully transforming Taiwan's industrial base. Between 1961 and 1982, capital accumulation and total factor productivity accounted for 53.19% and 23.21% of economic growth, respectively. The corresponding figures for the period 1982-1992 were 36.28% and 49.59%. Technological advancements and the improvement in the quality of education have both contributed to the rise in total factor productivity experienced by Taiwan since 1980. There is much room for further development in these areas in the long run. For now, we are content to say that Taiwan's economic miracle was not built on perspiration alone, but inspiration has also been an important factor.

The government has undoubtedly played a key role in the transformation of the Taiwan economy. Apart from numerous measures designed to stimulate production and investment, the establishment of the Hsinchu Science-based Industrial Park has attracted sizable investments from foreign high-tech firms. In the Six Year National Development Plan, the government selected ten emerging industries, including information technology and semiconductors, as the basis for elevating the domestic economy to a level with higher capital and technology intensity. The Asia-Pacific Regional Operations Center Plan was envisaged as a plan that would integrate resources and technologies across the region and bring about economic development and industrial upgrading. Under the Plan for National Development into the Next Century, Taiwan is to be developed into a green high-tech island that will eventually enable us to join the ranks of the advanced industrialized nations.

Long-term technological advancements and structural changes in Taiwan's industrial base have created a dynamic comparative advantage for the external sector. Though natural resources are scarce, effective utilization of human resources and persistent R&D efforts as well as creative innovations have fostered the development of the high-tech industry, while also creating a cost advantage in the export sector. Between 1988 and 1997, total expenditure on research and development grew on average by 15.8% annually. As early as 1988 more than 34.9% of the R&D workforce held a postgraduate degree. This figure rose by 10 percentage points to 44.7% in 1997.

The diffusion of knowledge and know-how has encouraged development in related industries that will help consolidate our competitive position in the international market place. A number of economists have remarked that, apart from a low level of foreign debt, successful adjustments in Taiwan's industrial structure constitute a major reason why Taiwan has weathered the financial storm better than most. A dynamic comparative advantage combined with the vitality and flexibility of our small and medium-sized firms, which form the backbone of the ROC economy, will prepare Taiwan for the challenges posed by the new international economic order. We also believe that, with its well-educated workforce and a host of technological advantages, Taiwan will be able to make a smooth transition from the production of high-tech products to R&D. Biotechnology and pharmaceuticals are likely to be the star performers in tomorrow's economy. By making good use of available resources, both at home and abroad, and by pooling together knowledge, technical know-how, and innovation, Taiwan can turn these two industries into the engine of economic growth for the next century.

Ladies and gentlemen, the International Monetary Fund and the World Bank have contributed greatly to the stability of the international monetary system, the growth of international trade, and the promotion of economic development over the last fifty years. During the same period, the Republic of China on Taiwan has also made tremendous progress. Economically, Taiwan provides a good example of how a small open economy could be run. Politically, we have attained true democracy. The people of Taiwan are peace loving, and we share with people the world over the same passion for liberty and prosperity. We are now ready and willing to do our part for the international community. Besides, the Asian financial crisis has again highlighted the importance of regional economic and financial cooperation. As the ROC used to be a member country, and most importantly a founding member, of both the IMF and the World Bank, we would very much like to fully participate in these two organizations once again in the future to fulfill our international obligations.