How Taiwan turned a quiet bond market superpower | USAEMALL.com

Brad Setser is a senior fellow at the Council on Foreign Relations, and a former US Treasury official. Josh Younger is a lecturer at Columbia Law School and a former JPMorgan analyst.

A lot of countries have invested a lot of money in the US. And not primarily in Nvidia and the stars of the US stock market. Most foreign investors actually buy one of the many flavours of bonds that the US has on offer.

Take Taiwan. It has invested a ton in US bonds. A ton. Its holdings of foreign exchange reserves — mostly in bonds — and overseas fixed income securities together total $1.7tn.

That’s more than 200 per cent of the country’s GDP, more than five times the size of the entire domestic Taiwanese bond market, and roughly the equivalent of all of Pimco’s fixed income funds. In fact, it’s not much less than the net holdings of Taiwan’s much larger neighbour across the strait. Mainland China has $2.9tn in reserves and foreign bonds, net of foreign investment it its own bond market.

In other words, Taiwan has almost surreptitiously become a major, under-appreciated force in the global fixed income market.

There are a lot of creditor countries in the global economy — countries that have more financial claims on foreigners than foreigners have claims on them. In balance of payments terms, they have more external assets than external liabilities.

However, what might seem like both a reflection and source of financial and economic strength can just as easily be a glaring weakness. For some big-surplus countries the financial stability risks can in practice become inverted — the biggest dangers actually lurk offshore, and above all in the US.

In today’s global economy, Taiwan is one of best examples of this predicament. And unfortunately, such is its reach that any problems are unlikely to stay in Taiwan.

How Taiwan became a bond market king

Around the turn of the millennium, Taiwan’s net foreign asset position was under $200bn. And of that total, almost three quarters was held by the central bank as official foreign exchange reserves.

Taiwan’s central bank is known as the Central Bank of China (Taipei), and like most other emerging markets central banks at the time, it wanted to hold plenty of reserves. Back then, private investors weren’t too keen on investing in the US. That was particularly the case from 2003 to 2010 when, well, the dollar was generally depreciating.

But then things changed, bigly.

Starting in the early 2000s, Taiwan started to run large current account surpluses of 5- 7 per cent of GDP. That’s big. At the time it was only really dwarfed by China. And while China’s surplus fell after the global financial crisis, Taiwan’s surplus actually expanded. It reached double-digits in 2014, and has generally kept climbing ever since.

A current account surplus generally implies that the country is exporting more than it is importing, leading to an accumulation of foreign currency — specifically US dollars, the currency of international trade.

The question was what to do with all that money.

Initially, the dollars piled up at the central bank as foreign exchange reserves. That was not only typical, but prudent (albeit that prudence was taken to extremes. Most countries are fine with reserves of around 20 per cent of GDP, and Taiwan, which doesn’t borrow abroad, arguably needs less).

However, the flood of foreign currency in Taiwan soon grew too large for even the central bank. Taiwan risked attracting undue attention and getting labelled as a currency manipulator by the US Treasury. Moreover, too large a stockpile of reserves can complicate the monetary management of a central bank. Taiwan needed an outlet.

Enter the Taiwanese life insurance industry. 

Life insurance has always been a big business in Taiwan. But it was a manageable 60 per cent of GDP as late as 2006. That’s roughly around where France, Germany, and Japan were at the time, and similar to where the US is today. Moreover, a shortage of domestic bonds made it a bit difficult for Taiwanese insurers to get much bigger — life insurers generally cannot hold that much equity.

However, after changes to the rules governing insurance portfolios, Taiwan’s life insurance companies quickly found they could profitably issue local currency policies and invest the proceeds overseas in dollars. As a result, they exploded in size, and now hold assets equivalent to about 140 per cent of Taiwan’s annual economic output.

What wasn’t disclosed at the time is that Taiwan’s central bank was facilitating this process, as the life insurers were quietly swapping Taiwan dollar with central bank for the central banks foreign exchange reserves.

This proved to be effective pressure release valve. Taiwan’s central bank got to report slowing reserve growth, while Taiwan’s dollar mysteriously didn’t appreciate.

That remained true even as the current account surplus continued to widen, though over time it required an ever-growing set of rule changes that allowed the insurers to put an increasing share of their portfolio in foreign bonds.

At their peak, Taiwanese life insurance companies were buying more than $50bn of US dollar assets a year. Of the $1.7tn of foreign debt now held by Taiwan, about $1tn are in private hands and $700bn are in insurance portfolios specifically.   

Uh oh . . . 

But this financial sleight-of-hand has come at a cost.

Residents of Taiwan generally don’t want life insurance policies that pay out US dollars; they want local currency. That means the funding of life insurance companies remains predominantly in Taiwan dollars even as their investments have increasingly been in US dollars.

And at this point the mismatch in currency exposure is massive — more than 40 per cent of their portfolio, or roughly $460bn. That’s alone more than 60 per cent of Taiwan’s GDP.

As a result, the insurance industry in Taiwan — and given its enormous size, the whole Taiwanese economy — is exposed to three distinct risks. 

The first is obviously the currency mismatch itself. If the US dollar depreciates relative to the Taiwanese dollar, the insurance companies can face massive losses as their assets depreciate relative to their liabilities.

The second is the cost of hedging some of that FX exposure. Although selling US dollars on a forward basis can insulate insurers from movements in the spot exchange rate, those positions can be costly to maintain.

The third is the performance of those foreign assets, in particular their exposure to interest rates. As many now know only too well, rapidly rising interest rates can generate substantial mark-to-market losses on big bond portfolios. That was true for SVB and others, but Taiwan is distinct in the scale of its exposure, not to local interest rates, but to US interest rates.

Patchy hedges

Unsurprisingly, Taiwanese life insurers do hedge, but only partially.

Roughly half of their currency mismatch is hedged with foreign exchange derivatives. But the remaining $200bn or so of foreign bonds — or roughly 2 per cent of Taiwan’s GDP — is exposed to moves in the US-Taiwanese dollar exchange rate. A big move would quickly deplete the capital of the insurers (even if some of the loss could be mitigated by ‘proxy’ hedges which rely non-USD pairs).

The hedges themselves are also not free. The bulk happens through foreign exchange derivatives, with the insurers selling US dollars for Taiwanese dollars on a forward basis — using one to three months in the future. By constantly rolling those positions, insurers seek to insulate themselves from movements in the USD/TWD exchange rate.

But there is a cost. At first approximation, hedging with FX forwards is exposed to short-term interest rate differentials in the two currencies. That’s not a bad deal when all major central banks have their policy rates pinned near the zero lower bound. But when the Federal Reserve raised rates faster than the Taiwanese central bank, the cost proved to be substantial.

At points during the past hiking cycle, it was more than 5 per cent a year.

A decent chunk of those hedges — as much as $140bn four years ago, now more like $100bn — is actually funded out of dollars that are owned by the central bank.

Those swaps long allowed Taiwan to hide the scale of its foreign exchange intervention, but we won’t get into that now. Taiwan starting disclosing its forward position in 2020, and it no longer keeps these swaps in the shadows. But the bottom line for the insurers is that Taiwan’s central bank was and is a pretty reliable source of hedges.

Nonetheless, another $100bn or so of FX hedges are so-called non-deliverable forwards (NDFs) provided by other investors. The price and availability of NDFs is subject to the whims of global markets and can be quite volatile. Those private market hedges are also settled in dollars offshore (that’s the meaning of a NDFs).

This means that Taiwanese insurers cannot use them to actually source local currency in the event it’s needed — for example to convert the proceeds of foreign asset sales into local currency to meet redemptions.

Rate risks

Then we have interest rates. Most of the foreign bonds held by Taiwan’s lifers are in complex instruments with very long duration. That has created some interesting interconnections between the US and Taiwanese financial systems (more on which in another upcoming Alphaville post).

It also means that Taiwanese life insurers will lose money on a mark-to-market basis whenever US rates go up. A lot of money.

Most long-term US dollar-denominated high-grade corporate bonds are now trading at a 10-15 percentage point discount to their face value. Applied to the $700bn foreign bond portfolio, that’s an unrealised loss which is about the same, if not larger, than the Taiwanese insurance industry’ total capital. For comparison, the peak unrealised losses that US banks suffered on their investment securities in 2022 were a tad more than 30 per cent of their tier one capital.

To be sure, these estimates are a bit rough. Taiwan’s insurers probably had some safer low duration bonds. But they also probably had some exposure to riskier Asian corporate bonds (such as dollar bonds issued by Chinese property developers). developers). And actually selling the specific types of bonds they own could be very costly in practice, exacerbating the mark-to-market losses.

The local regulators have certainly helped the Taiwanese insurers out. For example, they were allowed to shuffle a lot of foreign bonds into hold-to- maturity portfolios, where their accounting value didn’t have to reflect their market value at the time. 

However, that has left the Taiwanese insurance companies vulnerable to any new shocks. Bonds stuffed into a hold-to-maturity account basically cannot be sold to help cut losses in the event of further shocks, as that would crystallise the loss and worsen things.

No country is an island unto itself

Variants of this story have played out across Asia. The difference is simply one of scale. Taiwan’s open position is simply much larger and more precarious than that of, say, Japan’s. And for complicated reasons (related to Taiwan’s closed financial account) it cannot really be ameliorated unless the life insurers are allowed to borrow a ton from the central bank.

That means any big increase in the value of Taiwan’s dollar — an increase that is implied by the huge size of Taiwan’s trade surplus and the fact that it is still weaker against the dollar than it was 30 years ago — could obliterate the finances of Taiwan’s huge insurance industry.

To put it plainly, Taiwan’s life insurance industry has bet its solvency (with the support of its regulators) on the assumption that Taiwan’s central bank will be able to avoid a meaningful appreciation of the Taiwan dollar.

That feels like a risky bet. The US Treasury has always treated Taiwan somewhat generously, but there’s no guarantee that this practice will continue. President Donald Trump is already making noise about the size of Taiwan’s trade surplus with the US.

It may seem strange to highlight the financial risks from dollar weakness when all of Asia is dealing with the consequences of extreme dollar strength — which are uncomfortable in their own way.

But for the many parts of the world that have been shovelling money into dollar assets unhedged, and have become big creditors of the US over the last fifteen years, the biggest risk to financial stability is actually dollar weakness. And especially dollar weakness combined with high US rates.

Of course, any such shock would also have reverberations in US markets. After all, the world’s largest external debtor doesn’t live on a self-contained financial island.