The Taiwan Banker

Freedom or fortune? This is how Beijing has consistently framed the choice facing Hong Kong. If the unrest in the second half of this year has prompted any soul-searching on the mainland, it has been in the realm of real estate policy, where it has thrown its weight behind proposals to bolster land supply, support public housing, and encourage mortgage lending. The larger fiscal implications if the ‘hidden tax’ in high real estate prices is to be abolished are less clear.The protesters insist that even if the housing situation is far from ideal, it is not the impetus for their mobilization. Never mind the deep structural roots of the housing crisis, many of which were by Beijing’s design; the larger question is whether the mainland could have ever delivered Hong Kong to its next development stage. The conditions in Hong Kong before the protests broke out would not have justified a full-scale revolt among a previously apolitical population. Rather, it was concerns about its future direction – in particular, skepticism over China’s ability to deliver on its end of the social contract – which arguably contributed to the present sense of urgency.Across the strait, meanwhile, Taiwan appears to have gained the upper hand in competition with China. Its economy has outperformed, in large measure due to the trade war which has erupted between the world’s largest economies. A UN report released in November has now confirmed that Taiwan was the largest beneficiary of the trade war in the first half of 2019. It gained a net US$ 4.2 billion in exports to the US, mainly in “office machinery” and “communication equipment” – key technology industries which had previously been bleeding due to competition from China.The divergence the two respective economies has been reflected in performance in their respective stock markets this year: Taiwan is one of the world’s best performers this year, after recovering from uncertainty in the trade war late last year, while Hong Kong’s Hang Seng index has dropped about 10% since the scale of the discontent became clear in May. In a few areas, this divergence might represent Taiwan taking over the Hong Kong model as a conduit to China, but the larger story is rewards from economic independence.The Hole Has Finally Been PluggedGoogle recently confirmed that it will invest NT$ 26 billion in a second data center in Tainan, reportedly to serve China. This business reflects a direct rivalry with Hong Kong.Not long ago, it might have been credible to assert that data centers could become a new source of growth in Hong Kong, bolstered by “One Country, Two Systems” as finance was. Over the last couple of years, however, China had been enforcing more mainland laws in the Special Autonomous Region (SAR). Upcoming updates to the Cybersecurity Law on the mainland entail that all data stored in China must be made accessible to the government. Regulatory arbitrage could have been profitable, if the opportunity existed. In response to the upheaval, however, the Hong Kong government has started discussing the possibility of internet censorship. The central government has encouraged Hong Kong to enact a security law, which will mark a new stage in its history.IPOs for mainland-based companies. Nevertheless, a previous outflow of IPOs has been reversed, so one could say that this effect is occurring on a net basis. Up until 2018, the loss of listings such as Hon Hai through the “T + A model” (Taiwan headquarters + mainland A shares) had prompted some ruminations about the future of the TAIEX exchange.These outflows have been the result of a deliberate strategy by the mainland to attract capital, talent, and businesses from Taiwan. More recently, as these factors have been returning, it has responded with additional measures to retain them. Still, as business becomes more politicized on multiple fronts, from technology to public relations, the approach of one foot in the Chinese market is clearly becoming less viable.Opposite DirectionsHong Kong’s protests are working in concert with the trade war to undermine its model as a gateway to the mainland. The US won’t revoke its special status for the time being – although the Hong Kong Human Rights and Democracy Act, which will come into force soon, calls for yearly reviews. Nevertheless, numerous other organizations have moved to distance themselves from the Hong Kong government. When HKEX bid for the London Stock Exchange in June, the proposal was swiftly shot down as a Beijing influence operation. In September, Fitch downgraded Hong Kong’s sovereign rating from AA+ to AA; Moody’s downgraded its outlook later that month.Meanwhile, on the other side of the world, Canada is now launching a comprehensive probe on money laundering as China continues to detain two high-profile Canadian citizens (which is itself widely interpreted as retribution for Canada’s role in the Meng Wanzhou case). A previous report found that money laundering contributed 5% to Vancouver housing prices; moreover, it further noted that the wager volume in Hong Kong horse racing in the 88 trading days of the 2016/2017 season amounted to HK$ 115 billion (US$ 15 billion) – a suspiciously high average of about US$ 2,000 per Hong Kong citizen.The quality of Hong Kong’s accounting has in fact ceased to be world-class. In 2013, the European Commission withdrew regulatory equivalence to Hong Kong due to the lack of an independent auditor. The US has discussed delisting mainland stocks because of the lack of verifiable audit information – which is equally true of mainland stocks listed in Hong Kong. Many facts that were previously known to specialists about Hong Kong will become more widely disseminated in the new political environment.Meanwhile, despite its good showing in equities this year, the Taipei market is still far comparable to those of New York, London, or even Tokyo. Taiwan has received outsized ratings for its business environment, ranking 12th in the world in the World Economic Forum’s 2019 Global Competitiveness Report, and 15th in the 2020 Doing Business report by the World Bank Group. Its innovation capacity is high, with affordable labor costs in the technology sector.Its FDI trends also match those for listed companies. Taiwan has lagged in FDI compared to its regional peers, but this year’s numbers have trended up, driven by electronic components (although finance/insurance also received US$1.5 billion as of September). Meanwhile, outward FDI to China is down 57% for the first nine months of the year.Taiwan can consider how to make use of its newfound profile in the US and other Western countries in light of its advantages in technical talent. For instance, it is currently deepening its cooperation with the US on cybersecurity. Some aspects of election security, like automated traffic analysis, can also be applied almost directly to a trust-based industry like finance. Even if Taiwan won’t compete as a general contract execution hub, it is being supported by the strength of its industries.A Fading StarTaiwan’s challenges however pale in comparison to the full suite of economics issues China will face in the medium term. There is some degree of truth to the proposition that its banking system plays by different rules than others, particularly western ones. Government control over the entire financial system has made its monetary policy effectively irrelevant, and also made the business cycle apparently obsolete. These results are however only guaranteed for as long as it is willing and able to increase its debt load without limit. The deleveraging campaign of the last couple of years shows that this premise may no longer hold.A spate of regional banks has experienced solvency problems this year, culminating most recently in runs on Yingkou Coastal Bank and Yichuan Rural Commercial Bank. These smaller lenders make up an important part of China’s financial system, funding more productive private sector companies, which the larger SOE banks have found difficult to incorporate into their business model. China’s current debt level means that it lacks the flexibility it once had to deal with complex issues without imposing costs on any constituency.Even outside of a sudden hard landing scenario, it is very likely that growth will slow substantially in the next decade. China has already essentially reached its limit for personal credit leverage without harming growth, restricting how much higher it can let real estate prices soar. Within a couple of years, it will face a growing pension crisis as more retirees hope to withdraw their money from the financial system. Long before the time of full handover in 2047, China will stop being associated with easy money.Therefore, Hong Kong would face a difficult future even notwithstanding recent events, simply because of its giant neighbor. Fitch’s justification for its ratings downgrade makes clear that it is driven just not by internal factors, but also its connection to the mainland: ‘…the gradual rise in Hong Kong's economic, financial, and socio-political linkages with the mainland implies its continued integration into China's national governance system, which will present greater institutional and regulatory challenges over time. In Fitch's view, these developments are consistent with a narrowing of the sovereign rating differential between Hong Kong and mainland China (A+/Stable).For Taiwan, although China is in its backyard, the relationship is not to the point of sharing credit ratings. This means that it has both the economic and political space to forge its own future.