Scary Halloween story: How a weak USD could hand China a major victory

I have written before how a strong USD can be a negative for global financial stability. There are  many EM borrowers who have borrowed in the offshore USD market, and a rising USD puts a strain on their finances.

In addition, FactSet reported that companies with foreign domestic exposure have exhibited worse sales growth than companies with domestic exposure.
 

 

The USD Index staged an upside breakout out of a multi-year cup and saucer pattern with bullish implications, which was bearish for global risk appetite. More recently, it fell below the breakout line, which should be bullish for global assets. Indeed, the bottom panel shows that the relative performance of EM stocks is making a broad based bottom, just as the USD weakened.
 

 

Here is the scary Halloween story to be told around the campfire. A falling USD has the potential to hand China a major geopolitical victory without firing a single shot. In the ancient text, The Art of War, Sun Tzu wrote that a general could win by arraying his forces to exploit his enemy`s weaknesses. That way, he can achieve victory without bloodshed if it becomes evident that the enemy will collapse before any fighting begins.

Here is a little known but glaring weakness that Beijing could exploit.
 

Taiwan`s weakness

Our story begins with how the Taiwanese channel their savings, namely life insurance products. Bloomberg reported that even Taiwan`s insurance regulator called himself out over the Taiwanese insurance obsession:

Taiwan’s chief financial regulator is urging people to stop using life insurance as a way to make money and he points to his own family as part of the problem.

The widespread use of life insurance as a wealth-management product has made Taiwan into the most insured market in the world. But it has also created a level of competition and reckless offers that threaten the stability of an industry with $876 billion in assets, the Financial Supervisory Commission Chairman Wellington Koo said in an interview Monday.

“Insurance isn’t the same as savings. It’s not a wealth management product,” Koo said. “You shouldn’t take out an insurance policy instead of a wealth management product just because your bank only offers 1% on your savings.”

The problem is one Koo is personally aware of. The 60-year-old readily admits he and his wife, Taiwan’s deputy economics minister Wang Mei-hua, have nine high-return fixed term insurance policies between them. He says they were taken out on his behalf by his mother on the advice of staff at her local bank.

Life insurance assets is $876 billion, which is more than Taiwan`s GDP of roughly $600 billion.

Taiwan’s life insurance companies controlled NT$27.5 trillion ($876 billion) in assets as of the end of March, according to the Taiwan Insurance Institute, dwarfing the island’s $567 billion economy. And while they raked in a record NT$3.5 trillion in premiums last year the rate of growth is slowing. After increasing as much as 13% in 2012, premium revenue grew only 1.4% in 1Q this year.

Here is the problem. The liabilities of Taiwanese life insurance is in TWD, but they don`t have enough investment opportunities in Taiwan. The WSJ reported that they have instead invested mostly in US corporate debt.

Asia’s insurance behemoths, particularly in Taiwan, pose a growing risk to the U.S. corporate-bond market after a multiyear binge on greenback debt.

Insurers in Asia’s more developed economies have promised returns far greater than their government-bond markets can provide, and they need to hold far more assets than their domestic bond markets can satisfy.

That has left them fishing for other sources of returns, most notably in the U.S. corporate-bond market. South Korea, Japan and Taiwan’s holdings of U.S. dollar corporate bonds have more than doubled to over $800 billion in the past five years, according to the International Monetary Fund’s global financial stability report, published last week.

Corporate bond markets in the U.S. and the eurozone are 81% and 41% of the size of their life insurers’ total assets, respectively. In Korea, Taiwan and Japan, the respective figures are 10%, 8% and 4%.

This has created the possibility of financial instability as bond yields rise.

The IMF notes the risk posed by U.S. dollar bonds with call options. These allow issuers to redeem long-dated bonds early, reducing their financing costs but causing paper losses for insurers.

This is no longer simply a possibility: The risk has begun to materialize in Taiwan, where such securities are known as Formosa bonds, after the island’s colonial-era name. The plunge in U.S. rates this year has cut yields on American BBB-rated corporate debt from around 4.7% at the beginning of the year to just 3.3% today. Issuers of long-dated debt will be eager to refinance at lower rates.

While all Asian life insurers have foreign exposure, Marketwatch observed that the size of Taiwan`s exposure dwarfs all others.
 

 

Moreover, Taiwanese life insurance companies are thinly capitalized.
 

 

An enormous foreign currency mismatch

In addition to interest rate risk, the much bigger threat to Taiwanese life insurers’ financial stability is foreign currency risk. At $540 billion in foreign assets, that’s nearly Taiwan’s $600 billion in GDP.

What about foreign currency hedging?

Brad Setser at the Council on Foreign Relations and the blogger Concentrated Ambiguity has done extensive work on this topic.

First, some conventions in this analysis. For the purposes of the study of international fund flows, Taiwan is not a country. It is an economy. Taiwan is not part of the IMF or any other global financial institutions, and therefore it does not report its exposure in accordance with IMF standards. The Central Bank of the Republic of China (CBC) is Taiwan’s central bank, and it is distinctly different than the PBoC, which is China’s central bank based in Beijing.

First, let us begin with the reported unhedged foreign exchange (FX) positions. Setser reported that “life insurers’ own open FX position increased to USD 120bn as of mid-2019”. Further, “FX risks taken by households via FX denominated life insurance policies grew from practically zero in 2008 to USD 140bn”. Those are the official and stated unhedged positions.

The rest of the life insurance book is “hedged”. But how? Setser could not find the counterparties to the FX hedge, until he discovered that the CBC was providing a significant amount of the hedge by holding down the TWD exchange rate.

Had the CBC not intervened by at least USD 130bn in FX markets via its swap book, TWD would likely have appreciated and safety-oriented private sector actors in Taiwan would have been much less likely to assume long USD positions. Pondering counterfactuals might not always be helpful, yet in a world in which the CBC had not intervened sizeably, a USD/TWD exchange rate in the mid 20s would not surprise.

Setser concluded:

Given that Taiwan still maintains a large trade surplus, the CBC appears to have itself boxed in and has, at least implicitly, written a put on USD/TWD, keeping TWD weak to shield its private sector from FX losses. For most actors, this put is merely implicit: “TWD has not appreciated in the past so why should it in the future; let’s buy USD”.

For life insurance companies themselves, this put might actually be rather explicit. In a relatively closed system as Taiwan, the major actors on the demand and supply side typically know each other fairly well. This is especially the case for lifers owned by a financial holding company also operating a banking subsidiary. This would apply to three of Taiwan’s four largest insurers: Cathay, Fubon and Shin Kong. While conjecture for now, this is exactly the framework the Bank of Korea used to provide FX hedges under in a similar situation.

If lifers know the CBC is the ultimate counterparty to the majority of their current FX hedges and know that it will likely continue to be so in the future, it is much easier to run larger open FX positions. In case of difficulties, the CBC would, after all, be ready and provide additional FX hedges at reasonable rates. Switching perspectives, if the CBC knows lifers are unlikely to unwind open FX positions at the first sign of trouble, Taiwan’s authorities can be much more lenient in their regulation of FX exposures. Currently, this is most relevant for the regulation of FX exposures lifers acquire via domestically-listed bond ETFs acquiring foreign bonds FX-unhedged.

Any attempt to scale these risks suggests they are big: Lifers in aggregate currently hold ~65% of assets in foreign bonds, of which 22% is FX unhedged. This implies long USD exposures worth USD 123bn, or 14.3% of assets. Against that, lifers hold capital of USD 50bn, or 5.5% of assets. In a static environment without hedge adjustments, a 10% increase in TWD/USD thus inflicts losses of USD 12.3bn, or 22% of stated capital, on lifers. Larger moves are of course possible.

Concentrated Ambiguity added:

The CBC’s (deliberate?) influence in incentivizing private sector institutions in Taiwan to assume FX risks worth almost USD 500bn (~80% of GDP). Previous Balance of Payment turmoil usually followed FX mismatches originating from the liability side of a nation’s balance sheet – is Taiwan the first case the asset side is the driver?

To summarize, the Taiwanese life insurers have boxed the Taiwanese economy in with a “this will not end well” story. Any significant depreciation in the USD could collapse the Taiwanese financial system, not just because of life insurers’ exposure, but the implicit cheap hedge provided by the CBC. What’s more the CBC has actively suppressed the TWD by providing this hedge.
 

China’s opportunity

Now view this from China’s perspective. Even since Mao’s victory in 1949, when Chiang Kai-shek’s Nationalist forces fled to Taiwan, Beijing has coveted Taiwan and the return of Taiwan to Party rule. This outsized exposure of the Taiwanese economy’s foreign currency and interest rate exposure presents Beijing an opportunity.

Imagine the following scenario. A disinformation campaign installs a China friendly candidate in Taiwan’s presidential election in January. Then Beijing starts a two-pronged approach to put a wedge between the US and Taiwan. It plants stories to publicize the fact that Taiwan has been actively undervaluing its currency through central bank manipulation (all true).

Then Beijing goes for the kill. The PBoC begins to sell its USD holdings to buy TWD assets, which drives up the TWDUSD exchange rate. The Taiwanese financial system gets strained. At what point does it collapse? Taiwan’s GDP is roughly $600 billion. The PBoC’s assets are about $3 trillion. What price will Beijing pay to get Taiwan back?

During this financial attack on Taiwan, the US stands aside. Trump has always been highly transactional in his relationships. Besides, Taiwan has been manipulating its currency, and the Chinese military has not threatened Taiwan in an explicit fashion, so any defense treaty is not applicable in this situation.

Once Taiwan’s financial system collapses, a friendly China stated owned financial company graciously steps in to offer a lifeline by buying the life insurers and banks at pennies on the dollar. A Chinese SOE now owns the Taiwanese financial system, and a Beijing compliant candidate is the president.

The takeover is effectively complete. It is only a matter of time that Beijing and Taipei negotiates a reunification pact on Beijing’s terms. And all this was accomplished without mobilizing a PLA invasion force.

Your Halloween campfire story is over. Now go to bed, and sweet (funny) dreams.