Last week the US Federal Reserve announced that it would take the unprecedented step of purchasing individual corporate bonds as part of its open-ended asset purchase programs launched earlier this year to further stabilize the COVID-19 wracked US economy. The Fed’s aggressive moves continue to push down yields, making it easier for US corporations to continue their frantic tempo of debt issuance in 2020.
The short-term stabilization of US bond markets may be a necessary step in a fragile pandemic recovery, but it also introduces further risk into the market. The Fed’s moves should be be a signal for investors in US corporate bonds to reassess their holdings. Specifically, Taiwan should take this opportunity to rebalance its portfolio away from the United States.
Relative to its economy’s size, Taiwan has an outsized external portfolio, holding roughly $2.3 trillion in external assets against GDP of $586 billion. Much of this money is held privately by Taiwan’s life insurance companies. Their investment footprint is significant: the Financial Times reported that as much as 14% of longer-term US corporate debt is held by Taiwanese insurers.
Regulation and government encouragement helped insurers build up this massive portfolio, and pre-pandemic, it worked as intended. Taiwanese insurers were able to generate higher yields by investing in US corporate bonds than they could have locally, where rates have been stuck at historic lows.
However, the current situation is highly unfavorable for Taiwan. Taiwan is exposed to risks underlying this portfolio that may have serious implications for the island’s economy.
The most immediate impact comes from falling yields. US companies can call back existing debt held by Taiwanese insurers to take advantage of low yields and reissue at lower rates. For bonds with longer maturities, reinvestment risk has been significantly heightened given the open-ended nature of the Fed’s asset purchase program.
Falling yields make a second risk more acute — unhedged currency exposure in Taiwanese bond holdings. Taiwan’s life insurers are paid in US dollars from their bond investments, but need to pay their customers in Taiwanese dollars (NTD). US dollar depreciation reduces the payouts they receive, but their customer payouts do not change. Typically, this would be hedged through currency swap purchases, but with the explosive growth in Taiwan’s bond portfolio and the cost of hedging instruments, the Financial Times estimates that $420 billion is unhedged against FX risk, roughly 3/4ths of Taiwan’s GDP.
How sensitive is this portfolio to the USD / NTD exchange rate? The Wall Street Journal estimates that a 10% rise in the NTD against the dollar would result in losses of $12.3 billion for insurers alone, or more than a fifth of their available capital.
As the United States continues to set record deficits, Taiwan’s insurers ought to be leery of the continued strength of the dollar. Economist Stephen Roach noted that in addition to the US’s borrowing binge, political pressure towards decoupling and other macro trends would put major downward pressure on the dollar’s value.
When the dollar begins to decline, Taiwan would face a very difficult choice — the government would need to depreciate the value of its own currency significantly to keep insurers afloat, or it would need to provide a massive bailout. Neither of these options are palatable.
Similar to Iceland in its 2008–2011 financial crisis, the massive size of Taiwan’s external portfolio relative to local GDP would make it extremely difficult for the government to manage the fallout. And given the Tsai administration’s poor record with pensioners, the government may not act decisively to protect Taiwanese pensions and savings.
There’s still time, however. As the saying goes, an ounce of prevention is worth a pound of cure, and there is a window of opportunity for Taiwan to rebalance its massive portfolio away from US financial assets and diversify. Notably, yuan-denominated bonds have seen massive growth and would be one of many interesting options for Taiwanese life insurers.
Beyond a basic reallocation away from dollar-denominated assets, the administration must also act to restrict further bond purchases, which had been growing by $50 billion a year during the Tsai administration and shows no sign of slowing down. As recently as April 2020, life insurer juggernaut Cathay Life Insurance was contemplating further purchases of US corporate debt.
Finally, the administration could also force life insurers to fully hedge their portfolios against currency risk, although this would require the Taiwanese central bank to serve as a counterparty to these hedges, which simply shifts the risk burden onto the government.
Taiwan would be wise to act now and avoid an entirely foreseeable financial crisis in the near future. With the United States’ COVID-19 outbreak worsening as states start to reopen, there is simply too much downside risk and not enough upside for Taiwan to continue on its current trajectory.
