The Sino-American trade war is rattling markets, but a lesser-appreciated and potentially significant tail risk is lurking off the coast of China.
Taiwan may be small, but the island has emerged as a financial superpower thanks to the thriftiness of local savers and an eye-watering current account surplus of about 15 per cent of gross domestic product. The country now has the second-largest financial system in the world, relative to gross domestic product. And its life insurance industry is the biggest, with assets-to-GDP of 145 per cent, according to JPMorgan.
The local economy is not big enough to accommodate these enormous sums, so Taiwanese financial institutions have funnelled a whopping $1.2tn abroad. Other countries have large overseas stashes of money, but largely in the form of central bank reserves or sovereign wealth funds. Taiwan is anomalous both in terms of the size relative to its economy, and that this pool of money consists of private, rather than public savings.
The money has been invested conservatively, largely in US government and corporate bonds with high credit ratings. But there is a widening gap between the US dollar liabilities of the insurance sector and the US dollar assets the insurers have accumulated, rising from 34 per cent of total balance sheets in 2013 to just under half today, on JPMorgan estimates. In dollar terms, the mismatch amounts to about $420bn, or 72 per cent of Taiwan’s GDP.
That is worrying. Currency exposures have historically been hedged on a rolling basis but these days they are increasingly unhedged, given the rising cost of buying protection against FX movements. If the Taiwanese dollar were to weaken, it could trigger losses far beyond the measly coupon payments that are collected on the bonds, forcing the country’s insurers to pull back from the US market.
This is arguably a systemic risk. Taiwanese insurers hold about 4 per cent of the entire US investment-grade corporate bond market, and 14 per cent of longer-term corporate bonds, according to JPMorgan. Insurers’ holdings of US mortgage-backed securities have nearly doubled over the past five years, to $260bn. That makes Taiwan the second-biggest foreign owner of such securities.
That is not all. Taiwanese banks have also become big players in the Fed funds market, where US interest rates are set, now accounting for about 12 per cent of all trading volume. It is therefore possible that domestic financial ructions in Taiwan could even affect the implementation of US monetary policy.
Authorities in Taiwan have attempted to grapple with these issues, through regulatory measures that attempt to ameliorate the rising currency risks. But this has become a game of whack-a-mole, with insurers finding innovative ways to skirt restrictions — such as developing a $14bn market for Taiwan dollar-denominated exchange traded funds that simply buy US dollar bonds.
So far the US-Taiwan financial entanglement has been beneficial to both sides. But deterioration is a risk that investors need to be aware of — especially at a time when markets are already frazzled.