Taiwan’s Economic Recession and Recovery

I.Introduction

Following two years of economic recovery from the shock of the Asian financial crisis (the economic growth rates in 1999 and 2000 are 5.42% and 6.26% respectively), the downturn in the Taiwan economy has been sharp and notable for the speed with which it occurred. After still expanding in the first three quarters in 2000, the economy slowed down in the fourth quarter. In 2001, except the positive growth rate of 0.91% in the first quarter, the economy has been pushed into recession, with output falling in the second quarter of the year. In fact, economic situation in Taiwan is severe, with a recession manifest in a deflationary pressure in goods and asset markets. This has never been happened in Taiwan since 1952. Policy makers have not been able to prevent private-sector confidence from plunging and spending from being deferred. In addition, the weakness in export markets and a continuing credit crunch have led to production cutbacks and a further downward adjustment in medium-term expectations.

Although recovery sign in the US export market and the appearance of the expansionary monetary policy effects in 2001 may stabilize economic activity by the second half of 2002, there still remains some degree of risks about any rebound of the economy. To restore confidence and bring about a vigorous and sustained recovery, there is still some needs for coherent and credible policy measures that directly address the structural and balance-sheet weakness of the financial and corporate sectors. In addition, how to deal with capital outflow problem is still uncertain. And further reform in the fiscal structure in the public sector is needed.

This paper is organized as follows. Secton one is introduction. Section two describes recent trends of recovery and adjustment in the Taiwan economy. Section three shows that fiscal and financial restrictions in 2000 caused the economic downturn, while section four shows the slow reaction of monetary policy during the downturn. Section five points out that the foreign exchange intervention policy further restrict the growth of monetary supply. In section six, we will show that the recent economic trend of recovery becomes clear. However, whether the Taiwan ecomony has started a full-scale recovery is still with uncertainty, since there remain some structural reforms needed to be implemented. Finally, we will set up an econometric model based on a small open economy like Taiwan to explain the interaction between monetary policy and the macroeconomic behavior. Forecast about the economic growth rate, exchange rate of the NT dollar as well as the short-term interest rate will be analyzed.

II.Recent Trends of Recovery and Adjustment

During the last five years, Taiwan had been experienced two economic down-turns. One started in 1998, and picked up through the second quarter of 1999. The second one in recent times started in the fourth quarter of 2000. The recent recession was not simply a cyclical phenomena, although one determined by a world-wide technology cycle. Rather, it was a combination of cyclical and structural factors with the latter not only serving to keep the underlying economic growth weak but also making the economy vulnerable to shocks. Moreover, these structural factors have also acted to severely constrain the tendency over time for the Taiwan economy to experience periods of above average growth rate of, i.e. 6%.

The shock to the economy had been primarily the sharp turnover of economic policy in 2000. GDP growth fell in the second quarter, slowing to 5.1% from 7.94% in the first quarter. The weakness was precipitated by a pull-back in household spending and a reduction in public investment spending, since net exports and private investment spending stayed robust and anchored growth over the second quarter of 2000. On the one hand, government spending was scaled back after the presidential elections, which partially neutralized robust growth in private investment spending. On the other hand, the weakness in the stock market and lack of policy clarity had damaged consumer confidence.

As shown in Table 1, the real private consumption in 2000 went down all the way from the growth rate of 8.36% in the first quarter to 6.62%, 5.23% and 3.89% in the second , third and fourth quarters respectively. Drop in private consumption was mainly due to shrinkage in household wealth. The decrease in net worth in the second half of 2000 was concentrated in corporate equities, which suffered from large capital loss. The equity price index dropped from about 9000 point in May 2000 to 5000 at the end of 2000.

The depression in the equity market was triggered by the political uncertainty and policy vacuum. A policy vacuum was deepened as a new administration with a shortage of experienced ministers remains hamstrung by an opposition-controlled legislature and an opposition-appointed government bureaucracy. The problem became more serious after the resignation of Premier Tang Fei and Finance Minister Shea Jia-dong in September 2000, since the new cabinet did not improve the stalemate between the executive and the legislative wings of government. As the new Premier Chang Chun-hsiung announced to hold out for no nuclear power station, the policy issue and political conflict between the executive administration and the legislature turn out to be a total deadlock.

Table 1 also showed that the growth rate of real public investment slowed down, since the new government promise to crack down on so called “black gold” politics and to give the people a clean political environment. Although the new government claimed no delay in the reconstruction of disaster areas, including industrial and spiritual recovery, however, the reconstruction work from the government had lagged behind for at least three quarters. As a result, the public investment grew negatively at – 4.28% in 2000.

The slump in external demand that began in the fourth quarter of 2000, combined with concern over domestic problems of low growth rate of real private consumption and public investment resulted in a slowdown in most sectors of the Taiwan economy. Consequently, the growth rate of real GDP fell from 6.25% in the first half of 2000 down to 5.28%.

The external shock to the economy had been primarily the sharp downturn in the production and export of information and communication technology goods (ICT) that underpinned the moderation of the economic slowdown. The growth buffer from this source of ICT export however turned out to be weakened in 2001, since the negatively external shock became permanent. The profitability of a significant number of firms that cater to domestic demand remained poor even during first half of 2000 when the economy was still upturn. The sharp weakening of investment activity in the first half of 2001 had been led by falling exports of ICT products, which had resulted in an unusually rapid decline of industrial production. As shown in Table 1, the private investment growth rates in the first and second quarters were –7.6% and –13.66% respectively. These caused the contraction of the second-quarter real GDP by 2.35% year on year, the first time in 26 years. Moreover, in the third quarter both domestic and external demand had been hit by one-off factors such us the terrorist attacks in the United States and typhoon “Nari” assaulted Taiwan.

Keynesian approach to fiscal policy to expand public investment was expected when the supplementary budget passed in June of 2001. However, due to the lag effect, the real economic growth in the third and fourth quarters were negative. And the Taiwan economy experienced a severe recession in 2001, recording negative growth rates in three successive quarters to the fourth quarter of 2001, with annual real GDP growth rates reaching a level of –1.9% lower than any year during the past 50 years.

Table 2 shows that even in 1998 when the economy was shocked by a combination of the effects of Asian economic turbulence, an enfeebled banking system and the balance-sheet problems of corporates, the real GDP growth rate still remained at 4.57%. This may be due to the favorable effects of various stimulative policy measures from the summer of 1998, leading to a jump in the second quarter of 1999. The slump in the Taiwan economy throughout the second half of 1998 and the spring of 1999 resulted from a combination of negative foreign and financial shocks ended at the second quarter of 1999. The economic recovery has been prompted by policy measures in the monetary and fiscal sphere.

III.Fiscal and Financial Tightening in 2000

Fiscal and financial policy tightened in 2000, when new government announced to eliminate “ black gold” and investigated into illegal practices linked to financial gain such as insider trading and under-collateralized bank lending. The fiscal tightening was not expected and motivated by any thinking that it was necessary to undertake fiscal structural reform. This was a political and government reform to establish a government that is clean.

However, the negative effect on the economy became clear as the crackdown on Taiwan’s “black gold” action was pursed to combat with corruption in the corporate and financial areas. Not only did a cutback in government expenditure weaken effective demand, but also the willingness of bank lending to traditional sectors became weak. The sluggish bank credit growth lied primarily with high non-performance-loans (NPLs) and investigations into illegal lending practices. This also caused lower growth in narrow money (M1B) and sell-off of equity market.

The investigations into business fraud were the only factors responsible for the financial markets’ skittishness in the first three months of the new government regime. Lack public confidence in the new cabinet of Tang Fei added to the uncertainty. In particular, some companies affiliated with or at least friendly to the former ruling Kuomintang (KMT) had lost their special access to financing from state-owned banks and privileged treatment from the Finance Ministry for bailout packages. All this cases were related to list companies and thus hurt investor confidence in finance and real estate.

Table 3 shows that the stock price index in 2000 went down since June, even though the government funds tried to stabilize equity market. It also shows that the growth of bank loan and investment declined sharply since June 2000. In the meantime, the NPLs rate accelerated. The depressed asset market thus brought to the fore the problems of the financial sector. The weakest link in the financial system were the community-based financial institutions, i.e. the credit co-operatives and fishermans, which accounted for about 14% of domestic deposits, had accumulated nearly three times the bad-loan ratios of commercial banks. Equity market sell-off had brought financial-sector fragility to the fore.

The financial market was shocked further since September 2000 by conflicting views of supporting the building of a fourth nuclear power plant, which most business believed to be essential to meet the future energy needs of Taiwan’s fast-growing high-technology industries. Since the nuclear plant was already one-third completed and major contracts had been signed for equipment, the costs of stopping were large. However, because president Chen Shui-bian and his party oppose the plant, arguing that there’s nowhere to store nuclear waste and that safe and more environmentally friendly energy sources are preferable, while Premier Tang Fei and the KMT supported the building, the tension and emotional debate over nuclear power triggered Tang’s resignation on October 3, followed by that of the entire cabinet. The new appointment of Premier Chang Chun-hsiung was not accepted and welcomed by the KMT, since this meant that President Chen had returned to old-fashioned party politics and abandoned his bid to build an “all people’s government,” a populist slogan blurring party affiliations. The political uncertainty had further depressed public confidence in the government’s ability to manage the economy, and therefore the stock prices went down even further.

Although the fiscal and financial tightening in 2000 appeared to be justified by the relatively good growth in industrial production and private investment spending in the second and third quarter in 2000, however, policy makers and most economic forecasting research institutions seemed to have overestimated the underlying strength of the economic situation. In fact, the policy uncertainty with financial sector fragility had pulled down private investment spending and the economic growth in 2001. The private investment contracted in the fourth quarter of 2000 and its growth rate became negative, i.e. –1.28%. In 2001, the growth rate of private investment declined ever further to –22.66%. These and lower private consumption caused serious recession and the negative growth, starting from the second quarter of 2001, lasted for three quarters. The weak household expenditures combined with the negative growth of bank credit in the second half of 2001 had shown sign of deflation.

IV.Inflexible Reaction of Monetary Policy

With the domestic-oriented traditional industries faced with a credit freeze and low inflation pressures in 2000, the Central Bank was expected to shift to an accommodative monetary stance. However, the monetary authority did not respond either quickly or actively to mitigate asset deflationary pressures and did not provide fully support to the economy and the financial system in the face of fiscal and credit tightening as well policy uncertainty in 2000. Instead, the Central Bank raised rediscount rate twice on March 24 and June 27 in 2000 in the face of high interest rate in the international market and high oil price inflation pressure since 1999（see Table 4）. In addition, to prevent individuals and firms to transfer domestic deposit account to foreign currency deposit account in December of 2000, the Central Bank imposed the required reserve on the foreign currency deposit account by 10%（see Table 5）. Although this action aimed at fighting against the exchange rate depreciation and keeping domestic deposits from capital outflows, the NT dollar still depreciated although with temporary stable in the first quarter of 2001.

The main problem of monetary policy as the economy slipped into recession in the second half of 2000 and 2001 was that the monetary authority reduced the target zone of monetary aggregate M2 from (6%, 11%) to (5%, 10%) in 2001, and then even further to (3.5%, 8.5%) in 2002 as shown in Figure 1. The historical pattern showed that the Central Bank reacted to a weakening economy with a lower target for its monetary policy instrument, the monetary aggregate M2 growth rate. This suggests that if a typical recession does unfold in the coming months, the target for money growth rate will much lower. But there is an important difference this time compared with the last recession in 1998-99, which ended in the second quarter of 1999. The difference is that this time the Central Bank was essentially on hold as the recession began and indeed until it was well underway in 2000, whereas in the 1998-99 episode, the Central Bank began to lower the required reserve ratios in August 1998 and the rediscount rate in September 1998 before the onset of recession. Although the Central Bank lowered the rediscount rate for 12 times and started in December 2000 before the Federal Reserve of U.S. lowered the federal funds rate in January 2001, it seemed to be too late to do so comparing with that of the Federal Reserves（see Table 4 and 5）.

The passive and inflexible response of monetary policy caused money growth rates to slide down from 8.2% in the first quarter to 6.7% in the fourth quarter of 2000. In contrast with this time, the money growth rate in 1998 did not contract too seriously as shown in Table 3. In fact, the money growth rate was raised from 8.1% in the first quarter to 9% in the fourth quarter of 1998.

Its is worth mentioning that the time pattern of monetary base or high-powered money shows that monetary policy was more contractive recently than that in 1998-99 period. In face of low velocity and money growth rate as well as bank credit crunch since 2000 as shown in Table 6 and Figures 2-4, according the monetarist view, it is no wonder that the Taiwan economy became weaker and weaker. And the unemployment rate increased from 2.74% in January 2000 to 5.22% in December 2001.

The passive reaction of monetary policy could be found easily from the money supply targeting process. The Central Bank set the target zone according to its estimation of the money demand in the coming year, with the money demand function of government forecast values of economic growth rate and other financial variables (including interest rates and foreign exchange rate). If the forecasting value of economic growth rate is lower, then that money demand and therefore the target money supply will be also reduced. That is, with recession ahead, the Central Bank will react with tight monetary policy. This sounds irrational, however, this is what the monetary policy targeting process has truly been made. That is, the pattern of monetary policy had been following the rule of leaning with the wind instead of leaning against the wind.

As mentioned above after a brief economic recovery from 1999 that peaked in the first quarter of 2000, the Taiwan economy had been shocked by equity price volatility due to the sharp downturn in the public investment (including government and public enterprise investments) as well as the credit squeeze to traditional business. The economy had experienced capital outflow since the second quarter of 2000. The painful experience of asset-price deflation, that had triggered the balance-sheet problems of list companies in the fall of 1998, had reminded the new government to intervene in equity market by using government funds as well as asking state-owned banks to buy stocks. However, due to liquidity problem caused by banks unwilling to lend to traditional sectors and low growth in narrow money (M1A and M1B) starting from July of 2000, the equity market sell-off and banking sector fragility interacted with a vicious circle. The balance-sheet problem of corporations affected the cost of credit and caused credit contraction further.

As Federal Reserve Chairman Greenspan had emphasized the increasing importance of the role of asset prices in monetary policy and suggested that central bankers should have a better understanding of how asset prices were determined and how changes in asset prices affected economic activity. In particular, Greenspan called for further research into the channels by which asset prices affect macroeconomic activity (Greenspan (1999)). However, the Central Bank of China seemed to forget the drag on the Taiwan economy of equity-price deflation in 1998, and therefore did not implement an expansionary monetary policy earlier in the second quarter (at least in the third quarter) of 2000 as it had been done in 1998. The wrong and lagging reaction of monetary policy to the equity price deflation and capital outflows had caused the economy to be in serious downturn situation. In fact, as the NT dollar exchange rate started to depreciate in the third quarter of 2000, the Central Bank feared for inflation and therefore intervened in the foreign exchange market by selling foreign exchange reserve. This exchange rate intervention combined with capital outflows had made monetary base（or Reserve money）and therefore money supply reduced further as shown in Table 6 and Figure 2.

V.Foreign Exchange Intervention Policy

Buying foreign currency through unsterilised intervention is a theoretical option mainly because foreign-exchange market operations treat the various flows of funds as homogenous. In addition, it is always difficult to decide whether the level of a currency is inappropriate. Even the long-term equilibrium value of the NT dollar in US dollar terms has not been estimated sufficiently.

Exchange rate policy, like monetary and fiscal policy, is potentially vulnerable to populist pressures and other political considerations. Sometimes policymakers will refuse to devalue a currency that needs to be devalued out of a stubborn unwillingness to admit publicly that their past policies have failed. Other time they will seek to devalue a currency that should not be in order to gain the short-term advantage of higher output and employment, figuring that the costs in terms of higher inflation will not show up until after the next election. For such reasons, it is preferred to see an independent authority having technical expertise and insulation from politics to have responsibility for intervention in the foreign exchange market（see Dominguez and Frankel（1993））. The Central Bank in Taiwan has primary responsibility for foreign exchange intervention policy as well as for monetary policy.

Over the past two years the exchange rate has depreciated from 30.73 (NT/USD) in May 2000 to 35.06 in March 2002, by about 16%, and then appreciated to 34.46 in May 2002. Driving the depreciation of the exchange rate has been the high level of capital outflow since the second quarter of 2000. Recently, since the March of 2002 when the Japanese Yen started to appreciate, the NT dollar also appreciated against US dollar, despite repeated interventions.

In comparison with the depreciation rate of the Japanese Yen over the period from May 2000 to February 2002 as shown in Table 7, the NT dollar was over-depreciated. The intervention of the Central Bank exerted deflationary pressures and caused money supply growth rates to decline all the way down. The exchange rate intervention policy had made the contractive monetary policy even worse. This partially contributed to the low rates of money supply in the past two years.

VI.Economic Recovery and Structural Reforms

6.1 Economic Recovery in 2002

Recent economic indicators have generally provided encouraging signs about the prospects for recovery. The Taiwan economy returned to growth in the first quarter of 2002, lifted by rebounding exports of computer chips and mobile phones. Increases in semiconductor prices, orders, and shipments over the first quarter of 2002, together with the broader strengthening of activity appearing in the United States and other advanced economies, support export performance and industrial production in Taiwan. The real gross domestic product (GDP) rose 0.89% in the first quarter from a year earlier. As Taiwan’s two main export markets (i.e. China and the US) had been recovering, Taiwan’s exports and industrial output rose in April 2002 faster than expected. Export orders in April and May rose 11.45% and 8.97% from a year earlier respectively, for the continuing increases for two months after the lasting negative growth for 14 months since February 2001.

Indeed, production has already picked up, as has consumer or business confidence. The Taiwan’s unemployment rate dropped to a nine-month low of 4.98% in April from 5.16% in March 2002. The decline in unemployment came as more high-tech jobs opened up and more people became self-employed, particularly in the retail and wholesale sectors. According to criteria released by the Council for Economic Planning and Development (CEPD), the composite indicator of economic business cycle turned to a “green light” level that pointed to steady economic growth. This maked the first green light since October 2000, after which the indicator moved to a “yellow blue” light for economic showdown in November 2000. The economy is expected to perform stronger in the second half of 2002.

However, whether the Taiwan economy has started a full-scale recovery is not without any uncertainty. Among these are the magnitude of the recovery in the US economy, possible terrorist attacks, political and military conflict in the South Asia and other economic and financial structure problems. As the rapid growth of investment and exports associated with the information technology in that period of 1990s appears unlikely to be repeated, domestic sources of growth as well broadening the manufacturing and export base have become more important. These include structural reforms, trade and investment relations with China, as well as both easing of monetary policy and public investment expansion of fiscal policy.

In normal circumstances, the recovery indicators would lead to a relatively optimistic view of the economy by most observers. However, in the case of Taiwan at this moment, the economy still adjusting to massive imbalances, not only from the asset price bubble of the late 1980s but also from the past policy of heavy regulation of deliberately slowed adjustment. It is the interaction between cyclical processes and structural adjustments, with the latter not only serving to keep the underlying recovering growth rate weak but also making the economy particularly vulnerable to shocks. In fact, these structural factors have also acted to severely constrain the tendency over time for a market economy to experience periods of above average growth.

The shock to the Taiwan economy in 2000-2001 had been primarily the sharp downturn in the production and export of information and communication technology goods (ICT), as well as the mismatch of deflationary monetary and restrictive fiscal policy. Although the external demand for ICT goods have underpinned the recent recovery, it is still not so strong. The rest of the economy has remained sluggish. The profitability of a significant number of firms that cater to domestic demand will remain poor, masked by the increase in profits earned by internationally competitive firms. It is in this domestic sector where bad loans are concentrated, with firms being allowed to survive thanks to low interest rates and debt forgiveness on the part of banks. The vulnerable banking sector that is due to the delay in dealing with non-performing loans and other balance sheet problems might again drag the recovery of the economy.

Moreover, as show in Figure 5, due to the downward rigid adjustment of bank loan rates, the interest rate spread has been enlarged. This will discourage private consumption and investment, since the real interest rate is high while CPI inflation rate is low（see Table 8）. The policy implication is that the interest rate structure reform is needed.

6.2Restructuring of the Banking Sector

Reform priorities include the interwined issues of restructuring the banking sector and foreign exchange market, reforming the fiscal structure, and redesigning the pension system. As shown in Table 3, the non-performing loan has been recorded at 8.04% in April 2002. However, this does not include those debt forgiveness and extension followed by the loan agreement, which is about 4% of bank loans. The government has placed great emphasis on the need for the banking sector to finally dispose of bad loans with the purpose of improving the supply of capital to the private sector of the economy. However, the volume of non-performing loans is much greater than NT$ 1,147 billions (about US$ 33.73 billions), and the balance sheet of the banking sector remains weak. Thus, more ambitious measures need to be considered. A clearer timetable for bad loan disposal and balance sheet restructuring should be drawn up.

There is widespread concern that the self-assessment of loan quality by banks is too optimistic and that the residual value of collateral is also significantly over-estimated. As shown above, non-performing loans are officially underestimated. At the same time, reserves for potential loan losses are much lower. The most important reason for the evident under-provisioning for bad and doubtful loans is the low profitability of the banking sector. In addition to non-performing loans, the banking sector is also saddled with large holdings of equity as collateral, which makes their balance sheet vulnerable to changing stock prices.

A key to restoring the banking sector is for the authorities to enforce via regulatory means accurate timely disclosure of non-performing loans and especially those which must be regarded as bad. But there were aspects of moral hazard on the part of banks, management, since banks concern about low profitability and capital. Therefore, the financial inspections should be made annually rather bi-annually, and loans to large clients which have suffered a worsening in their market conditions such as their credit rating and relative share price, should be checked semi-annually.

One reason for the low profitability is the over-capacity in the banking sector. One manifestation of this is the presence of important government financial institutions, including state-owned banks, which are not subject to the same cost structure (for instance, not paying taxes and deposit insurance premiums). The other reason is uncertain about the actual residual value of the collateral and difficulty in enforcing claims.

The government is planning to reinvigorate the real estate market and enhance the capacity of the new asset manage companies to dispose of assets effectively. However, due to the financial technology difficulty and lacking transparency of bank’s balance sheets, the financial innovation proceeded very slowly. To resolve the over-capacity problem in the banking sector, the Financial Holding Company Act was passed in June 2001, while the Acquisition and Mergence Law was enacting in December 2000. However, up to the second quarter of 2002, only one case of full banking mergence came out, which occurred in May 2002, although there were 13 cases of consolidation among financial institution to form joint financial holding companies.

To aid the resolution of bad loans, especially for regional banks including credit co-operatives and farmers and fishermens associations, it is planned to widen the operations of the Resolution and Trust Funds (RTF) which established in August 2001. Although details are still to be decided, it is intended that banks should either sell those bad loans that have not been cleared within the three years time limit to RTF or transfer them for collection against a fee. The RTF has been granted an asset management license which will allow the RTF to repackage assets, shares, and loans it has received as new financial assets for resale, as long as a new law of Loan Securitization Act is passed.

The other structural problem of the banking sector is the large bank equity holdings. The cross-shareholdings had been resulted from the policy of stock market stabilization since 1996. Unless bank acquisition and mergence come out, it is an unstable factor to the banking sector.

In sum, the government’s intention to resolve the balance sheet problems of the banking sector is appropriate and progress is being made. Important legislation has already been submitted to the Legislative Yuan（i.e. the Congress）. The key question is whether it is enough to deal with the true scale pf non-performing loans. Banks need to be kept under pressure and tighter inspections by the finance authorities to deal with non-performing loans and to continue restructuring with the objective to raise profitability. In the absence of further capital injections, proper provisioning for non-performing loans at some banks might be so high as to wipe out their capital base, in which case the authorities should not hesitate to take them into ownership. If such a step were to prove necessary, the government should replace the top management and demand more extensive restructuring. In addition, more rigorous guideline covering private work-outs and loan forgiveness should be implemented since they avoid restructuring commitments. And the role of RTF remains unclear, especially its policy towards pricing loans, the financing and its governance. Whether it will be used as a transparent way of recapitalising banks is not so clear and remains a challenge work.

6.3Liberalization in Foreign Exchange Market and Establishment of an Efficient Real Estate Market

To ensure that financial markets and institutions do not hinder the likelihood of economic recovery, the financial authorities have continued to pursue financial deregulation and restructuring, especially for corporate restructuring and consolidation among financial institutions. However, restrictions on entry into the foreign exchange market and lack of competition in foreign exchange services offered had caused an inactive foreign exchange market.

To enhance the transaction in foreign exchange market and to set up an internationalization of Taiwan financial market, further liberalization of cross-border capital flows and financial services is needed. This will improve the profitability of banks, by removing the ban on over-the-counter sales of foreign investment trusts（mutual funds）by banks. And banks and public retirement funds should be allowed to investment in foreign financial market.

Real estate has an enormous importance in Taiwan and in the past has played a major role in the monetary transmission mechanism, the supply of credit being closely related to the value of real estate as collateral. It has also had a significant impact on resource allocation so that an efficiently functioning real estate market is important. Advances have been made in establishing a market for commercial mortagage-backed securities. In the future, after Real Estate Securitization Act is passed, investment companies should be allowed to hold real estate-backed securities.

6.4Regional Integration between Cross-Strait Economy

Due to geographical proximity, shared cultural and language background, the economies of Taiwan, Hong Kong and China together have formed one of the fastest growing regions in the world since the start of China economic reforms.

The so-called Cross-Strait Economy included the Regional Economic Integration among these economies. As shown in Table 9 and 10, the degree of the interdependence among these three economies rose up over time. This can be found in the trade and FDI data. Robust growth narrowed the gap in the development level among the three economies and accelerated regional integration. This fact is turned out to be crucial to the continuing growth of Taiwan and Hong Kong.

Table 9 illustrates the sources of China’s FDI in selected countries and regions. Foreign capital has flowed into China from more than 180 countries and regions in the world. Hong Kong rank the first, accounting for 52.73% of the total FDI inflows into China over the period 1990-2000, followed by the United States 8.49%, Japan 8.43% and Taiwan 8.23%. Hong Kong and Taiwan, accounted for about 60% of all FDI in China.

Trade between China and Taiwan also rapidly increased (see Table 10). The share of exports to China relative to Taiwan’s total exports rose from 0.02% in 1993 to 2.84% in 2000 and the share of imports from China rose from 0.47% in 1991 to 4.44% in 2000. Similarly, between 1991 and 2000, the share of exports to Taiwan relative to China’s exports also rose from 0.83% to 2.02%, and the share of import from Taiwan relative to China’s imports rose from 5.70% to 11.33%. In 2000, Taiwan was the seventh largest trading partner of China.

Despite that China reduced its trade with Hong Kong after 1993, she was still China’s fourth largest trading partner, comprising 11.4% of China’s total value of exports and imports in 2000. In 1989 this percentage reached 32.1%[1]. Hong Kong was also the second largest buyer of Taiwan’s exports since 1990, although some of Taiwan’s exports to Hong Kong were re-reported to China. Similarly, some of China’s exports to Taiwan were through Hong Kong. That is why Hong Kong plays an important role of intermediary in the trade between Taiwan and China (see Table 11). According to the Hong Kong Customs Statistics, among the US$1207 million that Taiwan exports to Hong Kong in 1979, US$21.5 million was re-exported to China, account for 1.8% of Taiwan exports to Hong Kong. However, the share reached to 60.3% in 2000. Likewise, the share of Taiwan imports from China via Hong Kong relative to Taiwan imports from Hong Kong rose from 16.3% in 1979 to 38.8% in 2000.

In addition, the market share of China export goods in Japan and the United State were markedly increased from 6% and 3.89% in 1991 to 14.53% and 8.22% in 2000 respectively. However, over the same period, the marked share of Taiwan export goods in Japan and the United State were still in within the range 3.33% ~ 4.72% and 3.69% ~ 4.37%, respectively.

The rapid pace of economic interaction between the two sides of the Taiwan Strait has increased the pressure on Taiwan to change the regulatory approach toward cross-strait exchanges. An easing of the restrictions on the flow of goods, people and investment between Taiwan and China should be an importance to facilitate global business plans, which often include market on the mainland China. Direct transportation between Taiwan and China is by far the most important to the business needs.

Proximity to and familiarity with the China market is Taiwan’s comparative advantage. Aside from obvious cultural and linguistic strengths, Taiwanness have extensive experience operating in China. This makes Taiwan companies and professionals attractive partners for foreign business wishing to invest in Taiwan as well as use Taiwan as a platform for China investment. Thus, in order for Taiwan-based business to take full advantage of these opportunities, the government needs to remove the bulk of the unilateral restrictions on cross-strait business.

VII.Forecast Results for a Small Open Economy

In this section, we will extend Walsh’s (1998) optimization model to a small open economy like Taiwan (see Walsh (1998), section 5.4.1). The model consists of four equations. In addition to policy-reaction function, aggregate demand, and aggregate supply functions, we also incorporate an equation for the foreign exchange market.

Assume the Central Bank’s objective is to stablize the internal and external values of the currency（i.e. domestic prices and foreign exchange rate）and promote economic growth. And suppose that the Central Bank attempts to use short-term interest rate r_t as the short-run operational target of monetary policy and sets r_t according to the following rule:

, (1)

where the subscript t refers to time; ris the short-term nominal interest rate; ygdp_t-1 is the output gap at t-1; ygdp is the difference between the real GDP（y）and its capacity or full-employment value y^* ; p is the inflation rate,p^* is the target inflation rate; e is the exchange rate depreciation rate ( a higher e means currency depreciation); and e^* is the target exchange rate depreciation rate. The policy feedback parameters a₁, a₂ and a₃ are expected to be positive, so that the interest rate instrument rises in response to output, inflation and exchange rate that are high relative to their targets.

We specify the open macroeconomics model as follows:

, (2)

, (3)

, (4)

Equation (2) is the aggregate demand equation. Output depends on lagged interest rate, its own lagged value, the current change in the exchange rate, and a demand shock. Equation (3) is the aggregate supply equation. The inflation rate depends on the lagged output gap, its own lagged value, the lagged value of change in the exchange rate, and a supply shock. Finally, equation (4) is exchange rate equation. The change in the exchange rate depends on the current interest rate, output, its own lagged value, and the exchange rate shock.e₁, e₂ and e₃ are demand, supply and exchange rate shocks respectively.

We will use quarterly data from 1983:1 – 2002:1 to estimate the model. We use weighted averages of overnight interest rates in inter-bank call loan market as short-term nominal interest rate proxy. The short-term nominal interest rate is the instrument of monetary policy. The data for the interest rate are from Financial Statistics Monthly. The percentage change in the Consumer Price Index (CPI) is the measure of inflation rate. The data for CPI (1996=100) are from Commodity-Price Statistics Monthly. The percentage change in the New Taiwan dollar exchange rate against the US dollar is the measure of exchange rate depreciation rate. Data for the New Taiwan dollar exchange rate are from Financial Statistics Monthly. We use the growth rate of real GDP as the indicator of output growth rate. The quarterly real GDP data are from the Quarterly National Economic Trend. The output gap is the percentage deviation of output from a quadratic trend.

Since variables may be endogenous, the OLS estimates are inconsistent. To overcome the difficulty, we utilize the generalized method of moments (GMM) to estimate our model, with one to five period lagged dependent and independent variables serving as instrumental variables. All estimates are consistent. Table 12 reports the GMM estimation results. It shows that all the estimated coefficients for the monetary policy-reaction function have the expected sign and statistically significant. In the aggregate demand equation, all the estimated coefficients have the expected sign except the exchange rate depreciation rate. In the aggregate supply equation, all the estimated coefficients have the expected sign and statistically significant except the lagged value of the change in exchange rate. As for the exchange rate equation, all the estimated coefficients have the expected sign and statistically significant except that of the interest rate.

In the following, we will use the estimated model to forecast. The forecasting periods are December 2001, March 2002, and May 2002 respectively. Due to the Central Bank of China has followed the United States by lowering interest rates 12 times consecutively in 2001, the coefficient of inteRCEPt term in the policy-reaction function had been revised downward. The forecast results are shown in table 13. Because the world economy continues to expand, the Taiwan economy improves gradually in 2002. According to our latest forecast results (May 2002), we find that real GDP growth rates will reach 2.21%, 3.32% and 4.26% in the second, third and fourth, respectively, and annual average growth will reach 2.67%. The figure (2.67%) is consistent with the Chung-Hua Institution for Economic Research’s prediction.But the result is different from the prediction of the Taiwan Institute of Economic Research (2.88%).

For the interest rates, although the economy will gradually recover, the Central Bank will continue to maintain an expansionary monetary policy, the overnight loan rate will continue to fall. Our model forecasts of annual average overnight loan rate will reach 2.28%. As for the exchange rate, the exchange rate of the NT dollar will depreciate in the short run. The annual average exchange rate depreciation rate will reach 7.69% in 2002. As for the prices, although the economy will gradually recover, the consumer price index will slowly increase. The annual inflation rate will decline to –0.01% in 2002.

Table 2. Economic Growth Rate of Main Countries

	1996	1997	1998	1999	2000	2001	2002(f)
Would (WEFA estimate)	3.2	3.6	2.3	2.9	4.0	1.3	1.7
US	3.6	4.4	4.3	4.1	4.1	1.2	2.3
Japen	3.5	1.8	-1.1	0.7	2.4	-0.5	-1.0
Germany	0.8	1.4	2.0	1.8	3.0	0.6	0.9
France	1.1	1.9	3.5	2.8	3.8	2.0	1.5
UK	2.6	3.4	3.0	2.1	3.0	2.4	2.1
Taiwan	6.1	6.7	4.6	5.4	5.9	-1.9	2.6
Singapore	7.6	8.5	-0.1	5.9	11.3	-2.0	3.0
Korea	6.8	5.0	-6.7	10.9	9.3	3.0	4.9
Hong Kong	4.5	5.0	-5.3	3.0	10.5	0.1	2.1
China	9.6	8.8	7.8	7.1	8.0	7.3	6.7
Thailand	5.9	-1.4	-10.8	4.2	4.4	1.0	1.8
Malaysia	8.6	7.3	-7.4	6.1	8.3	-0.4	3.1
Philippines	5.8	5.2	-0.6	3.6	4.0	3.4	3.6
Indonesia	8.0	4.9	-13.7	0.8	4.8	3.3	3.2

Source： IMF「IFS」、OECD、US、Japan、Korea、Singapore、Hong Kong Statistics Monthly Report、Internal Economy Dynamic Index. 2002 forecast data from DRI-WEFA.

Table 4. Interest Rates of Central Bank of China
Unit：Percent Per Annum
Effective Date of Change	Discount	Accommodations with Collateral	Accommodations without Collateral
1997/8/1	5.250	5.625	9.625
1998/9/29	5.125	5.500	9.625
1998/11/11	5.000	5.375	9.625
1998/12/8	4.750	5.125	9.625
1999/2/2	4.500	4.875	9.625
2000/3/24	4.625	5.000	9.625
2000/6/27	4.750	5.125	9.625
2000/12/29	4.625	5.000	9.625
2001/2/2	4.375	4.750	9.625
2001/3/6	4.250	4.625	9.625
2001/3/30	4.125	4.500	9.625
2001/4/23	4.000	4.375	9.625
2001/5/18	3.750	4.125	6.000
2001/6/29	3.500	3.875	5.750
2001/8/20	3.250	3.625	5.500
2001/9/19	2.750	3.125	5.000
2001/10/4	2.500	2.875	4.750
2001/11/8	2.250	2.625	4.500
2001/12/28	2.125	2.500	4.375
Source: The Central Bank of China.

Table 5. Bank Deposit Reserve Rates
Unit：Percent Per Annum
			Saving Deposits			Other Liabilities
Effective Date of Change	Check Deposits	Passbook Deposits			Time Deposits
	（%）	（%）	Passbook	Time	(%)	New Foreign deposits(%)	Others(%)
			（%）	(%)
1997/9/25	21.25	19.25	11.75	6.250	8.250	0
1997/10/16	19.75	17.75	10.25	5.750	7.750	0
1998/8/3	19.25	17.25	9.75	5.550	7.550	0
1998/9/29	18.75	16.75	9.25	5.350	7.350	0
1999/2/20	15.00	13.00	5.50	5.000	7.000	0
1999/7/7	15.00	13.000	5.50	5.000	7.000	0
2000/10/1	13.50	13.000	6.50	5.000	6.250	0
2000/12/8	13.50	13.000	6.50	5.000	6.250	5	0
2000/12/29	13.50	13.000	6.50	5.000	6.250	10	0
2001/10/4	10.75	9.775	5.50	4.000	5.000	5	0
2001/11/8	10.75	9.775	5.50	4.000	5.000	2.5	0
Source: The Central Bank of China.

Table 6. Velocity of Money
Unit：100 million NTDs, Percent Per Annum
	Velocity of Money	Reserve Money (daily average)	M2	GDP	M2/GDP
1992	0.683273211	12.51	86823	59324	1.463543
1993	0.633112073	10.75	100274	63485	1.579499
1994	0.5888886	13.53	115467	67997	1.698114
1995	0.572614954	7.03	126377	72365	1.746374
1996	0.554585548	4.17	138448	76781	1.803148
1997	0.547629373	6.85	149568	81908	1.826053
1998	0.525175148	6.92	163091	85651	1.904127
1999	0.517055607	5.88	174637	90297	1.934028
2000	0.512855211	2.33	186382	95587	1.949868
2001	0.480360416	0.83	195191	93762	2.08177
Source: The Central Bank of China.

Table 8. Real Interest Rate and Investment
Unit：Percent Per Annum
	Fixed investment growth rate-Private	Real interest rate	Prime rates offered by major banks	CPI growth rate
1993	16.71	5.100	8.000	2.90
1994	10.27	3.835	7.935	4.10
1995	11.37	3.970	7.670	3.70
1996	3.44	4.280	7.380	3.10
1997	18.56	6.600	7.500	0.90
1998	11.8	6.004	7.704	1.70
1999	-0.68	7.467	7.667	0.20
2000	15.74	6.411	7.711	1.30
2001	-26.73	7.387	7.377	-0.01
Source: Directorate General of Budget Accounting and Statistics Executive Yuan, R.O.C.

Table 9. Source of China’s Foreign Direct Investment in Selected Countries and Regions

Period	Hong Kong	Taiwan	Hong Kong And Taiwan	Japan	United States
1990	54.87	6.38	61.25	14.44	13.08
1991	56.96	10.68	67.64	12.20	7.40
1992	68.20	9.54	77.74	6.45	4.64
1993	62.78	11.41	74.19	4.81	7.50
1994	58.24	10.04	68.28	6.15	7.38
1995	53.46	8.43	61.89	8.28	8.22
1996	49.56	8.33	57.89	8.82	8.25
1997	45.59	7.27	52.86	9.56	7.16
1998	40.71	6.41	47.12	7.48	8.57
1999	40.58	6.45	47.03	7.37	10.46
2000	38.07	5.64	43.71	7.16	10.77
1990-2000 Mean	51.73	8.23	59.96	8.43	8.49

Note: Data of Hong Kong include that of Macao before 1991 and after 1992 only refer to Hong Kong..

Sources: China Foreign Economic Statistical Yearbook, China Statistical Yearbook.

Table 10. The Share of Cross-Straits Trade in Taiwan and China Total Foreign Trade

Unit:%

Period	Taiwan Exports to		Taiwan Imports from		China Exports to		China Imports from
	Hong Kong	China	Hong Kong	China	Hong Kong	Taiwan	Hong Kong	Taiwan
1986	7.33	-	1.57	-	31.62	-	13.08	-
1987	7.68	-	2.16	-	34.94	-	19.52	-
1988	9.21	-	3.87	-	38.44	-	21.66	-
1989	10.62	-	4.22	-	41.71	0.18	21.20	3.14
1990	12.73	-	2.64	-	42.92	0.52	26.72	4.23
1991	16.32	-	3.10	0.47	44.73	0.83	27.38	5.70
1992	18.92	-	2.47	1.04	44.16	0.82	25.48	7.28
1993	21.69	0.02	2.24	1.32	24.03	1.59	10.05	12.44
1994	22.85	0.14	1.80	2.18	26.74	1.85	8.17	12.18
1995	23.38	0.34	1.78	2.99	24.19	2.08	6.50	11.19
1996	23.10	0.54	1.67	2.99	21.79	1.86	5.64	11.65
1997	23.50	0.51	1.74	3.42	23.95	1.86	4.91	11.55
1998	22.44	0.76	1.86	3.93	21.09	2.11	4.75	11.86
1999	21.39	2.09	1.89	4.09	18.91	2.03	4.16	11.78
2000	21.13	2.84	1.56	4.44	17.86	2.02	4.19	11.33

Note: - Nil.

Source: China Foreign Economic Statistical Yearbook, Monthly Statistics of Exports and Imports Taiwan Area.

Table 11. Trade between Taiwan and Hong Kong and Transit Trade to China

Unit: US$ million, %

Period	Taiwan Exports to H.K			Taiwan Imports from H.K.
	Amount	Re-exports to China		Amount	Imports from China
		Amount	As Percentage of Exports to H.K.		Amount	As Percentage of Imports from H.K.
1979	1,207.0	21.5	1.8	346.0	56.3	16.3
1980	1,592.2	235.0	14.8	445.8	76.2	17.1
1981	1,921.8	384.2	20.0	432.1	75.2	17.4
1982	1,671.8	194.5	11.6	436.4	84.0	19.2
1983	1,705.2	157.8	9.3	473.2	89.9	19.0
1984	2,224.0	425.5	19.1	624.1	127.8	20.5
1985	2,679.2	986.9	36.8	554.5	115.9	20.9
1986	3,074.0	811.3	26.4	761.4	144.2	18.9
1987	4,274.0	1,226.5	28.7	1,241.7	288.9	23.3
1988	5,686.8	2,242.2	39.4	1,811.5	478.7	26.4
1989	6,613.7	2,869.5	43.4	2,112.6	586.9	27.8
1990	7,446.7	3,278.3	44.0	2,724.1	765.4	28.1
1991	9,563.0	4,667.2	48.8	3,175.0	1,126.0	35.5
1992	11,301.2	6,287.9	55.6	3,396.9	1,119.0	32.9
1993	12,203.7	7,585.4	62.2	3,658.6	1,103.6	30.2
1994	13,936.3	8,517.2	61.1	3,700.3	1,292.3	34.9
1995	16,572.6	9,882.8	59.6	4,580.6	1,574.2	34.4
1996	15,795.1	9,717.6	61.5	4,274.8	1,582.4	37.0
1997	15,967.6	9,715.1	60.8	4,693.7	1,743.8	37.2
1998	13,342.9	8,364.1	62.7	4,342.7	1,654.9	38.1
1999	12,875.2	8,174.9	63.5	4,225.6	1,628.1	38.5
2000	15,919.5	9,593.1	60.3	5,102.6	1,980.5	38.8

Source: Cross-Strait Economic Statistics Monthly, August 2001.

Table 13. Macroeconomic Forecasts

		Short-term Interest Rate (overnight loan rate)				Real GDP Growth Rate				Inflation Rate				Exchange Rate Depreciation Rate
			2001.12	2002.3	2002.5		2001.12	2002.3	2002.5		2001.12	2002.3	2002.5		2001.12	2002.3	2002.5
Quarterly		Actual	Forecast			Actual	Forecast			Actual	Forecast			Actual	Forecast
2001	Q1	4.51				0.91				0.58				5.82
	Q2	4.06				-2.35				0.02				9.13
	Q3	3.46				-4.21				0.01				11.55
	Q4	2.54	2.70			-1.87	-2.11			-0.63	-0.20			6.59	11.86
	Annually	3.64	3.68			-1.88	-1.94			0.00	0.10			8.27	9.59
2002	Q1	2.28	2.64	2.16		0.89	-0.23	0.22		-0.09	-0.24	-0.71		7.70	10.72	5.38
	Q2		2.58	2.09	2.26		1.38	2.04	2.21		-0.22	-0.75	-0.12		8.78	3.33	8.07
	Q3		2.52	2.01	2.27		2.78	3.60	3.32		-0.16	-0.71	0.003		6.43	0.90	7.82
	Q4		2.45	1.94	2.32		3.99	4.94	4.26		-0.08	-0.63	0.15		3.91	-1.64	7.17
	Annually		2.55	2.05	2.28		1.98	2.70	2.67		-0.18	-0.70	-0.01		7.46	1.99	7.69

Reference

Dominguez, Kathryn M. and Jeffrey A. Frankel, (1993), Does Foreign Exchange Intervention Work, Institute for International Economics.

Greenspan, Alan, (1999), “Opening Remarks.” New Challenges for Monetary Policy, 1-9, eds. By Gordon H. Sellon, Jr. and Charmaine R. Buskas, Federal Reserve Bank of Kansas City, pp.1-12.

Walsh, Carl E. (1998), Monetary Theory and Policy, Cambridge: The MIT Press.

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[1] Hong Kong was China’s largest trading partner between 1989 and 1992.