Summary

The Taiwan economy, with real GDP growth of -2.4% yoy and -4.2% yoy in Q2 and Q3 respectively, is in recession. As there are still many downside risks to the economy, it is likely that Taiwan will see a few more quarters of growth decline. For the external sector, the large overhang of global technology investment means electronics and IT exports will not pick up until late 2002. Domestic demand will also be sluggish, as rising unemployment and looming deflation will hurt sentiment. The room for further fiscal stimulus is limited because of a rather high level of accumulated deficits. Rate cuts have not been very effective as the intermediate function of the bad loans-ridden banking system is not working. The abolition of the "no haste, be patient" policy towards China-bound investment and the entry to the WTO for both China and Taiwan will prove beneficial in the long term. But the immediate consequence is more likely to be negative, as more and more factories will be relocated into Mainland China, and Taiwan's domestic market has to be further liberalised. We expect the economy to contract 2.5% in 2001 before recovering mildly by 0.5% in 2002.

No signs of sustained export recovery yet

Taiwan's exports dropped 17% yoy for the Jan-Oct period, with electronics exports plunging 24% yoy. Recent statistics suggest that the global technology sector has not reached the bottom. First, global semiconductor sales are still falling and were down 44.6% yoy in September. Even if sales were to increase by 1.2% each month (the historical average monthly growth rate), no positive growth would be seen until July next year. Besides, the book-to-bill ratio for semiconductor equipment manufacturers based in N. America remains below 1. Although the ratio improved to 0.71 in October from the low of 0.44 in April, the level of bookings is still on a downward trend. In October, the amount of bookings was only about one-quarter of the average 2000 level. As the global technology sector is still going through a de-stocking process, it is unlikely that the demand for technology products will pick up before late 2002.

Added to this is the synchronous global slowdown. Taiwan's non-technology exports declined 14% yoy in the first ten months of the year. The situation has become worse after the 11 September atrocity as business and consumer sentiments plunged. It remains to be seen how effective interest rate cuts and/or fiscal stimuli in major economies will be. The market now expects the world economy to turnaround in 2H 2002 in the earliest.

The gloomy outlook for Taiwan's exports for the next 6-9 months is supported by export orders statistics, which nose-dived 20% yoy in Q3. We expect Taiwan's exports, after declining 19% in 2001, will drop 3.4% in 2002.

Industrial production falls as exports collapse

Taiwan being an export-oriented economy, the collapse in exports has resulted in plunging industrial production. Industrial production dropped 7.9% yoy for the Jan-Sep period. Capacity utilisation was reduced to 75.2% in September from the average of 80.3% in 2000. That exports have not yet shown signs of recovery does not bode well for production in the short term. Besides, producers' inventories, growing at a rate of 10% yoy, suggest production will only pick up a few months after export demand recovers. Stockpiling is particularly serious in the electronics sector, with inventories for electrical and electronic machinery having surged over 20% yoy for 6 consecutive months.

Domestic demand remains sluggish

Both consumption and investment have been weakening since Q4 last year. In Q3, private consumption growth slowed to 0.7% yoy, while fixed capital formation declined 27.3% yoy. Consumer sentiment has been hurt by rising unemployment. The unemployment rate hit a record high of 5.2% in October. But this is an underestimation of the situation because discouraged workers (people intending to work but not seeking for jobs) are not included in the labour force. If they are included, the unemployment rate is above 7%. Business sentiment is also weak as a result of declining sales and orders. According to surveys conducted by the Council for Economic Planning and Development, the share of manufacturers with a pessimistic economic outlook has been larger than that with an optimistic one since March. Weak business sentiment will continue to drag down capital expenditure for the next 1-2 quarters.

Prices to go down further

Lacklustre demand continues to put downward pressure on prices. The CPI was up only 0.3% yoy for the Jan-Oct period, compared to the 1.3% increase in 2000. Clearly, the depreciation of the TWD has brought little upward pressure on domestic prices. Import prices, which dropped 5% yoy in October, have been declining. Meanwhile, the WPI for domestic sales excluding imports has seen negative growth for 10 months, which indicates more downward pressure on consumer prices in the months ahead. As economic recovery is still 2-3 quarters away, it is expected that prices will maintain the falling trend until 2H 2002. We expect the CPI to rise 0.1% in 2001 but drop 0.2% in 2002.

Little help from fiscal and monetary policies

Fiscal deficit is a growing concern in Taiwan. The tax base has become narrower over the years, with tax burden as a % of GDP dropping to about 13% now from 18% in the early 90s. Meanwhile, expenditure on financial restructuring is set to grow in the coming years. With a deficit of 4.5% of GDP in 2000 and government debt of about 30% of GDP, there is not much room for further fiscal stimulus measures.

As to monetary policy, the central bank has cut interest rates by 250 bps since last December. But the effectiveness of rate cuts is in doubt, as loan growth remains weak. For one thing, the problem in Taiwan is not a lack of liquidity, but insufficient loan demand. Second, the banking sector is cautious in extending more loans for fear of rising bad debts. The NPL ratio has soared to 7.8% in September from 5.0% in early 2000. The ratio increases to 11.5% if a stricter definition of problem loans is used. As reductions in interest rates do not work, further depreciation of the currency becomes more likely. We expect the TWD to reach 36.5 by end-2002.

Structural and political issues

Efforts are made to reforming the financial sector, which suffers from over-competition. The Legislative Yuan passed in late June six financial reform bills, including a law permitting the establishment of financial holding companies. Taiwan's financial sector is set to see more consolidation and more foreign investor involvement. But the impact of these initiatives has yet to be seen.

The government abolished in early November the "no haste be patient" policy which imposed an upper limit on China-bound investment at US$ 50 million. Taiwan's cumulative investment in Mainland China is estimated to be US$ 75 billion. It is expected that Taiwanese investment in China will grow further after the restriction is removed. This will hasten the hollowing out process of Taiwan's labour-intensive, low value-added industries. But it is believed that the technology sector will be less affected because hi-tech manufacturers in Taiwan still have some advantages over their China counterparts.

Taiwan's WTO accession has not produced much excitement. While joining the WTO means better access to world markets for exporters, Taiwan will have to liberalise its own market restrictions. This could be bad news for industries which are not competitive globally. Second, "three links" with Mainland China will not automatically happen even both economies become WTO members. China has made it clear that Taiwan's adherence to the 1992 "one-China" consensus is a pre-requisite for further discussions on the "three links". The DPP government in Taiwan, nevertheless, still has reservations on this.

On Taiwan's politics, it is expected that no party can win a majority in the December 1 Legislative Yuan elections. The possibilities of a coalition forming a majority in the legislature are still unclear at this stage.