The legacy of the past recommends caution and the exercise of considerable wisdom, while the current pace of economic growth and acquisition of foreign exchange dictates immediate action. At present, the process of defining new financial policies is still in progress.
In the following article, Dr. Norman Yin, chairman of the Department of Banking at National Chengchi University in Taipei, places the current pressures for change of the financial system into historical perspective, showing how in this instance internationalization has come before liberalization.
About four decades ago, the Republic of China suffered severe inflation. Prices rose 500 percent annually from 1946 to 1948, and then accelerated to 30-fold in the first half of 1949. In order to bring the price level under control, the government after moving to Taiwan announced a currency reform by converting the Taiwan dollar into the New Taiwan dollar (NT) at the rate of 40,000 to one, and by backing the new currency with 100 percent hard reserves.
In the meantime, the government adopted a high interest rate policy to encourage savings; monthly interest rates were once raised to 7 percent, which successfully absorbed extra liquidity. Inflation was finally brought under control after 1951. The high savings, due to the "preferential interest rate savings deposit" that remained in people's savings accounts after the interest rate fell, helped increase the potential capital formation for the economic growth of the 1950s.
Because of its unhappy experience with severe inflation in 1949, the government understandably took extremely cautious steps in regulating financial institutions in Taiwan. All new banks had to be approved by the authorities, and up to 1960 there were only 12 banking institutions on the island, nearly all of them state-owned banks. Although in June 1988 there were 24 domestic and 35 foreign banks registered, more than 90 percent of the total bank assets were still owned by the state banks. The state bank, acting like an extension of the monetary authority in the financial market, thus played a very important role in the earlier stages of Taiwan's economic growth.
Prior to 1980, the interest rate was strictly controlled by the Central Bank of China. In order to stimulate an economy characterized by a labor surplus and a capital shortage, the authorities deliberately set the banking interest rate at a lower level, which encouraged investment by lowering the cost of capital and speeded up the accumulation of capital formation.
But when the rate was set below the market equilibrium price, the funds available in the market were insufficient to meet market needs. The government was forced to channel a good portion of its funds into specifically needed directions by special low interest rate loan programs, such as imported machinery loans, export finance programs, and special loans for investment in strategic industries. The low-cost financing guided resources to designated key industries. The expansion of these strategic key industries not only improved industrial efficiency but also brought technological progress. Early on, special loan functions were assigned to specific banks, such as the Export-Import Bank, Bank of Communications, Farmers Bank of China, Land Bank of Taiwan, and Central Trust of China.
The fund rationing created a "financial dualism" on the island: an organized financial system consisting on one hand of all institutions crowded with excess demand, and on the other an unorganized financial system, into which funds were channeled to a fragmented curb market (a system that according to the Banking Law is operated illegally). Sometimes this latter system is known as the underground financial market; it satisfies those people who cannot meet the credit requirements set by the banks, or who cannot acquire bank loans because of fund rationing.
The premium to cover the default risk plus the market interest keeps the price in the underground market much higher than in the legal market. While it is estimated that the average underground market interest rate is 2 to 2.5 times higher than the average banking interest rate, the curb market fills the vacuum left by the organized financial system.
In November 1980, the Central Bank deregulated the discount rate on CDs and bank debentures, letting the Bankers' Association set the range of the maximum and minimum lending rates. In addition, the individual banks can decide the rate charged to their customers according to credit rating and the maturity date of the loans.
Interest rate liberalization started in September 1984 when the Central Bank informed individual banks through the Bankers' Association that they could set the prime rate based on their cost of funds. In January 1986, the Central Bank further simplified deposit ceilings, moving from 12 rates to 4, and enlarged the range of maximum and minimum interest rates. But since the Bankers' Association is a cartel of banks, and has to act for the best interest of all its members, the partial loosening up of the restrictions on the interest rate has obviously not worked very well. The liberalization of the interest rate still needs to be further strengthened.
Back in the 1950s, due to the huge balance-of-payment deficit and severe shortage of foreign exchange, the authorities adopted an over-valued multi-exchange rate system in order to preserve foreign exchange for the best use of the economy. The tight control of foreign exchange kept the local financial market separated from the influence of the international market. But the complicated exchange rate structure was simplified and unified by 1961. The New Taiwan dollar was pegged at NT$40 to one US dollar, and the fixed exchange rate, plus the export-oriented governmental policy, led to a massive expansion of exports.
From 1951 to 1965, a total of US$1,482 million in aid was received from the United States. This aid not only helped control inflation, it also filled in the trade gap by augmenting foreign exchange reserves, sustaining employment, and increasing capital formation.
While the tightly controlled monetary policy and strictly regulated financial sector fueled economic growth, provided price stability, and sustained a high level of employment throughout the 1960s, the balance of trade condition also steadily improved. At the end of 1971, Taiwan experienced its first trade surplus; since then it has continued to strengthen. In 1987, the trade surplus reached US$19 billion, more than 88-fold that of 1971.
As a result of restricted foreign exchange controls and continuous intervention by the monetary authorities, the foreign exchange reserves increased rapidly as well. In December 1987, they hit a record high of US$76.7 billion, the second largest in the world.
The substantial build-up of foreign exchange reserves forced the New Taiwan dollar to appreciate sharply. In December 1983, the exchange rate was NT$40.32 to one U.S. dollar; four years later, it rose to NT$28.50 to one U.S. dollar—the New Taiwan dollar thus increased more than 41.4 percent in value against the U.S. dollar. This accumulation of massive foreign exchange reserves has caused a rapid growth in the money supply, creating a substantial fear of inflation.
The Central Bank has incurred heavy losses by holding a huge amount of depreciated U.S. dollars. Total accumulated deficit reached an estimated US$10 billion in 1987. Obviously, the cost of maintaining the foreign exchange rate control was too high for the Central Bank. On July 15, 1987, foreign exchange controls were therefore liberalized. When the foreign exchange market opened up, the fence that separated the local and international financial markets was torn down. The step had a heavy impact on the local financial system, which was still constricted in the straitjacket of the domestic Banking Law.
Whether legal or not, foreign financial agents and international financial speculators sneaked in and began playing a role in the underground financial curb market. Even though the conservative and stable domestic financial institutions suddenly faced substantial international competition, they still hesitated to respond. The result: internationalization has come before liberalization, and the financial institutions in the legal financial market are now endangered.
The Chinese virtue of maintaining a high savings ratio, one of the major factors of the economic growth of Taiwan, has turned out to be a negative factor for the financial sector because 35 to 40 per cent of national income went into savings. As the money supply increased, banks were flooded with money, and too much idle cash in reserve forced most local banks to turn down large deposits. Market interest rates soon hit their lowest point. In the first half of 1987, the passbook interest rate was set at 2 percent per annum.
As a result, all the "hot money" began seeking higher returns. Prices in the real estate market were driven sky high, and the Taiwan Stock Exchange Composite Index went wild, soaring from 1,063 points in 1987 to 8,789 points in September 1988. Although the stock market has already experienced two crashes—one on October 3, 1987, and the other on September 29, 1988 — the excess demand driven by the hot money still keeps stimulating the market. Because the capital market lacks both breadth and depth, it seems that nothing can stop it from rising even further.
Wang Tso-jung, a well-known economics professor and columnist once called this a special case of nouveau riche: here not only a poor person or family suddenly becomes rich, a substantial portion of the overall population suddenly becomes wealthy in comparison with the immediate past. Thus, they must now learn how to live a life characterized by high income. This will include, for example, more sophisticated understanding of how a stock market actually operates and how to take better advantage of other investment opportunities.
While Taiwan's whole economy continues moving ahead, the financial sector still lags behind; it is badly in need of an overhaul. Although the government has recently revised its Banking Law to help catch up with the fast-changing environment, more measures are needed to speed up financial liberalization in order to strengthen the island's financial structure. Among the priority requirements are the following: (1) to encourage the establishment of more private financial establishments, including banks, insurance companies, investment and trust companies; (2) to abolish restrictions on new, creative financial tools; (3) to allow the formation of a financial futures and option market; and (4) to force underground financial curb markets into the sun, so the authorities can supervise them.
The only way out of the current financial chaos is genuine liberalization and internationalization—and only by these two approaches can new life be injected into financial institutions. In this way yet another economic miracle may be created for Taiwan in the future.