Brad Setser on the Big Surge in the Taiwanese Dollar

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1:23Hello and welcome to another episode of the Odd Lots podcast. I'm Jill Weisenthal. And I'm Tracy Alloway. Tracy, sometimes our old random episodes on just random things end up being kind of relevant. What do you mean sometimes? What do you mean random? All of our episodes, each of them are like our children. They're each special and relevant in their own way. That's what I say. You're right. They're all special. I would say they're all special in their own way. Some of them probably have more relevance to others. You know, this used to not even be our full-time job. We just found interesting things, sometimes connected to the news, sometimes not.

2:01But I remember in 2019, the first time I noticed people talking about Odlods before the pandemic was an episode we did on Taiwanese life insurance companies. That's right. And I guess the reason this episode kind of went viral or became a thing was because of the framing. We sort of framed it as a financial market murder mystery almost, or sort of whodunit in global financial flows. And I guess you don't get many of those. You still don't get many of those. We should do more of them. But people definitely got into this one and definitely still remember it. Definitely still remember it, definitely get into it.

2:37So the basic gist was that it was sort of well-known, obviously, that Taiwanese life insurance, which is this huge investing savings product in Taiwan, that they were a major purchaser of U.S. treasuries, which of course leaves the companies potentially at risk for currency slippage, but that the central bank in Taiwan was revealed in the whodunit as the entity sort of providing a hedge of sorts such that this was an economic safe trade for the life insurance companies. And of course, there's only one person we could have ever been talking to who would have been able to explain this whole phenomenon.

3:15That's right. And of course, we're going to be speaking to them again because it's a new month. And in fact, one of the things we've seen happening, the big story so far this month, is the move in the Taiwanese dollar. So we've seen this massive appreciating move in the Taiwanese dollar against the U.S. dollar. I think just this morning alone, we're recording on Monday, May 5th. It was up something like 5 % just in a day against the U.S. dollar. It's up 2.5%. I think it's up like 5 % total in two days. 5 % total in two days, sorry. But still, for a currency that tends to be fairly stable and boring, this is a huge deal.

3:57So there's three certainties in financial life, right? There's death taxes and the idea that the Taiwanese life insurers are going to be buying dollar-denominated assets because they can. Because things have remained so stable and so boring for decades now that they can just keep on doing this trade. And then suddenly, out of nowhere, just in the past two days, we've seen this really violent shift in the way things have always been happening in Taiwan. And so we got to talk about it. We definitely got to talk about it with Brad. We got to talk about it. Actually, I'm looking at this, a three-day chart, USDTWD down 6.6 % since April 30th.

4:37Crazy move. You're right. We got to talk to Brad Setzer. He's the one who's been on this story longer than anyone else. Brad Sensor, Senior Fellow at the Council on Foreign Relations. Thank you so much for, I don't know, you're like coming back for like your like 15th odd lots appearance. Not quite 15, but it's a lot. Okay. Maybe I'm just exaggerating, but not by much, I don't think at this point. You know, it's interesting in the post-April 2nd environment, you know, a lot of markets like treasuries or just the, you know, treasuries and the stock market have stabilized quite a bit. But the currency does seem to be where the action is.

5:12Stepping back up, before we get to the move that we've seen over the last few days, just for the sake of our listeners, give us the sort of top-level description of the flows that we see out of Taiwan and the role of the central bank there in making that trade economical for the lifers. Well, Taiwan runs one of the biggest current account surpluses in the world. It's fluctuated between 10 % of Taiwan's GDP and 15 % of Taiwan's GDP. is now on the high side. It's close to 15 % of Taiwan's GDP, over$100 billion a year. That is a big sum. And obviously, a current account surplus means that someone in the economy has to, on net, be accumulating foreign assets.

5:58And over time, that entity has shifted from, you know, in the 15 or the 10 years after the Asian financial crisis, it was essentially the the Central Bank of China, Taiwan's Central Bank, accumulating foreign exchange reserves, mostly going into treasuries. At some point, the Central Bank of China said more or less, hey, we've got enough reserves. And maybe they were coming under a little bit of pressure from the U.S. to manage their currency a little bit less. So the Central Bank and the insurance regulator, in a sense, worked together to make it possible for the life insurance industry, which in Taiwan is big, to add to the share of its assets, which were in foreign currencies, and to increase the sales of insurance policies so that the insurance industry was growing relative to Taiwan's economy.

6:53Combine those two things, and the insurers, basically from 2010 to 2020, build up an enormous portfolio of foreign bonds. They put about two-thirds of their total assets in foreign bonds, an enormous share. And as in our famous episode, there was a secret hedge book that offset, let's say, a quarter of that exposure with a hedge with the central bank, which wasn't disclosed until 2020. So our famous episode actually triggered a change in the central bank's policy. The central bank started disclosing that forward book in 2020. Johnny, after the pandemic, this flow has been more modest. It hasn't gone away, but the lifers aren't buying up the entire current account surplus.

7:42You're seeing a little bit more purchases from the banking system, which is now able to offer foreign currency policies. And then another favorite topic of odd lots, the Taiwanese semiconductor manufacturer, TSMC, when it started building chip factories, fabs, in Japan and in the US, that outward FDI became a big counterpart to the current account surplus. But the net effect is that, you know, Taiwan is just stuffed to the gills with unhedged holdings of dollars and dollar bonds. Never let it be said that OddLots is not an agent for change. So we actually affected the world through that episode, mostly Brad, but we gave you a platform, I guess.

8:25You did. Very powerful one. All right. So I would definitely encourage anyone who's really interested in this topic to go back and listen to the whole thing because there's a lot of nuance in there. And, you know, Joe mentioned in the intro that Taiwanese life insurers buy a lot of U.S. treasuries, but it's not just U.S. treasuries. It's also things like U.S. corporate bonds. And we're not going to rehash the whole thing here. But why don't we just dive into what's been happening today? So things had been changing recently, and I guess Taiwanese life insurers hadn't been buying as many U.S. bonds as they once did.

8:57But they still have this huge, enormous stack of dollar assets. And they're still pretty under hedged relatively. And I think I saw some people talking that it seems like the life insurers weren't even very well hedged comparatively in recent months. They'd taken off some of the hedges since April 2nd. Do we have any indication why that was or why they wouldn't have been particularly hedged in this particular moment in time? Well, with Josh Younger, who formerly was the interest rate strategist at JP Morgan, and one of the other people who had a little bit of an obsession with understanding the Taiwanese flow.

9:35We put out an estimate in January that the unhedged book of the life insurers was about$200 billion, which is 15 % to 20 % of their assets, a very big sum. Why have they stayed unhedged, maybe gotten a little bit more unhedged? Yeah, simple reason. Hedging was expensive. Hedging is essentially a function of the differential between Taiwanese short-term rates and U.S. dollar short-term rates. So as the U.S. hiked rates in 2022 and 2023, they've come down a little, but they're still absolutely high, the cost of hedging went up. And I think what you see across Asia, not just in Taiwan, is that as the cost of hedging went up and as Asian currencies were basically trading on the weak side, so there was no financial penalty to being under-hedged.

10:24Institutions took advantage of those incentives and reduced their hedge ratio. On top of that, the Taiwanese insurance regulator, under pressure from the life insurers, essentially allowed the lifers to substitute a foreign exchange volatility reserve for some hedging and let them go a little more unhedged going into this year. Classic kind of mistake. So it's not just a Taiwanese dollar story. Since April 2nd, we've obviously seen this broad weakness in the U.S. dollar. It's one of the few charts that you can find that really has not bounced at all or very little since that first week. The Bloomberg dollar index down broadly against everyone.

11:04But the Asian currencies, the East Asian ones, have really flown. And you know, what's funny is that a lot of people expect that they're like, oh, well, when tariffs come in place, then the dollar is going to strengthen, and that's going to offset some of the tariffs. We've seen the exact opposite. Before we get to Taiwan specifically, what's the general story, in your view, for why the dollar has weakened as much as it has post-April 2nd? I think there's two general factors. The first factor is the dollar was just exceptionally strong against most Asian currencies. So the starting points do matter.

11:38And a yen at 145, no, it's not $1.55, but$1.45 is an incredibly weak yen. Until very recently, the Taiwan dollar was on the weak side of its long-term range. The Korean won was at$1 ,450. $1 ,450 is the level it reached during the Korean financial crisis and during the global financial crisis. And it's actually weaker than that in a real sense because of the inflation differentials. So I think the fundamental reason is that Asian currencies were very weak. The dollar was very strong. And then China made a policy choice not to respond to the draconian tariffs, the 145 % tariff, 20 % from the legacy fentanyl case, and 125 % on the reciprocal tariff case.

12:25You know, like China's the only country that got really clobbered with the reciprocal tariff. In the end, China chose not to respond by depreciating the yuan. And I think the fact that China didn't respond, that the yuan didn't depreciate. And that, you know, in a sense, there was news flow that is suggestive that there's at least some chance there'll be an agreement or even in the absence of an agreement, a decision to pull back some of the U.S. tariffs on China. All that laid the backdrop for this recent move.

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13:51Giving teams across your organization an easy way to order from a huge variety of restaurants, all on one platform. All while consolidating your corporate food spend so you can control costs, streamline billing and payment, and simplify reporting. Easy Cater, your business tool for food. To learn more, visit easycater.com slash podcast. Okay, so getting back to Taiwan specifically, I'm not going to ask you if Taiwan's central bank, when they would have to intervene, because I think that's kind of a boring question. But instead, I'm going to ask you, what are the limitations on Taiwan's central bank in terms of intervention?

14:30Well, that's a good question. The usual intervention limits on a central bank's intervention is in a sense that they run out of foreign exchange and they can't borrow more. But that's what the limits you face when you're trying to prevent your currency from falling, from depreciating. When you're trying to prevent your currency from appreciating, arising, there's really no intrinsic limit to how much foreign exchange a central bank can accumulate. So in that sense, the Central Bank of China could at any point step in and buy up a lot of dollars. The Central Bank of China has close to$600 billion already, a little more when you count its off-balance sheet.

15:11It's already holding close to 100 % of Taiwan's GDP and foreign exchange reserves. But there's no intrinsic limit on how high that could go. I think the limits are, in a sense, twofold. One is, and we don't really know what motivated the Central Bank of China to stay relatively restrained. I mean, I think they were in the market to smooth some of the moves. They had more or less admitted that both Friday and Monday and today. But they weren't trying to stop the move. They were trying to smooth the move. And one reason why is that maybe they thought the life insurance industry had gotten a little bit too aggressive.

15:46It was not paying enough attention to risk. And they were afraid that if the Central Bank of China came in too quickly, stopped the move too rapidly, in a sense, the lifers wouldn't learn a useful lesson in risk management. So you can call that thesis one. The second thesis is that the central bank is feeling a little bit of heat from the United States, partially because the U.S. Treasury is preparing its next foreign exchange report. That report may be out any day, partially because Peter Navarro has long thought that the Taiwanese dollar was undervalued, partially because currency has been a topic in the negotiations over these supposed deals with most Asian countries.

16:31And so the Central Bank of China may have been a little bit reluctant. Central Bank of China's Taiwan Central Bank may have been a little bit reluctant to just put an absolute block on this move and in the process draw attention to the fact that Taiwan's currency is heavily managed, that Taiwan keeps its currency from appreciating when necessary, at least historically, through actions of the Central Bank, which some people would call manipulation. So there's a few different ways this could go. And as you mentioned, perhaps one possibility is that Taiwan, along with Korea, maybe along with other East Asian countries, as part of a possible trade deal, if there is going to be one, maybe they're going to let their currencies strengthen and let that do some work in terms of balancing out trade.

17:21Another possibility, and I'm curious, you know, just sort of where this games out, could you see a scenario in which these countries reinvest more of their dollar inflows into like something that resembles consumer demand or domestic demand and produce the sort of global demand for goods, perhaps some from the United States or services from the United States that leads to, you know, some sort of the type of desirable balance that the new administration would like to see? Well, I mean, I think those, in a sense, are part of the discussion. They aren't mutually exclusive. You can let your currency appreciate and then try to take steps using your domestic fiscal capacity or the government as opposed to the central bank's balance sheet to support domestic demand.

18:09That would be a very sensible thing, frankly, for Taiwan to do. Running a 15 % of GDP current account surplus in perpetuity effectively has meant that Taiwan has been overpaying for U.S. dollar bonds for the past 15 years, and it's accumulating an ever bigger forward-looking financial loss from the inevitable currency move because the Taiwan dollar is by any measure incredibly weak. Some part of the Taiwanese economy just has to overpay for U.S. financial assets and build up a loss. You may say that doesn't make sense. We should be investing more in our own people. We should be building out our social welfare system, The same issues that China faces actually are relevant in Taiwan.

18:51The government doesn't run much of a fiscal deficit. The government actually doesn't spend very much on defense either. So for Taiwan's case, there's a pretty clear and compelling case that they should have a more aggressive fiscal policy, more investment in their own defense, and a bigger and more generous social safety net. All that, though, takes time. And you're starting from a 15 % of GDP current account surplus. That surplus isn't going to go away. TSMC still has a very dominant position in logic chips, so their export position won't be enormously impacted by moves in the Taiwan dollar, at least not in my judgment.

19:31So I think there is a separate set of questions about how you manage the risk that has already been built up in the insurance sector. And what I would like to see the central bank do is set up a hedging program so that the lifers can hedge pretty much directly with the central bank, and thereby reduce the financial stability risk if the Taiwan dollar continues to appreciate, take away some of the pressure on the central bank to avoid appreciation. I think that would facilitate a broader move in Taiwan's currency. And no doubt you're right. Taiwan, Korea, Japan all prefer to appreciate when all their currencies are going up together.

20:09And I think that, plus some of the negotiations around China, is at least potentially an opportunity to make some progress on the rebalancing front in a healthy way. Okay, so I'm going to ask, I guess, just the really blunt question to this point. But is this basically a win for Trump? You know, if I think back, U.S. officials, perhaps even you, have basically been complaining of, if you're going to be diplomatic about it, under the radar currency intervention by Taiwan's central bank and other people not being diplomatic would call it outright currency manipulation in Taiwan for years now. Suddenly, the Taiwanese dollar has appreciated by 6.6 % in the space of a few days.

20:51Is that a win? Not yet. We're still at around 30. We've gone from whatever, around 33 to around 30. In the past, the Taiwan dollar has gotten up to around 28. I think in order for it to be a real win, we have to see evidence that Taiwan is allowing its currency to strengthen through the levels which the central bank has historically defended, defended in the sense of defended against pressure from appreciation, not the usual sense of the word. So, I mean, there is a broader, I guess, irony, which is I don't think the administration was hoping for a dollar sell-off. A lot of the talk around a Mar-a-Lago accord was trying to mitigate the risk that tariffs would lead the dollar to appreciate and thereby undermine some of the expected benefits from the Trump administration's point of view of the tariffs.

21:40But it is certainly the case that the most effective way to bring the U.S. trade deficit down is just to let the dollar weaken. And so if one effect of Trump's policies is to reduce the appeal of the U.S. as a destination for foreign investors, including some foreign investors who were maybe overly eager to buy U.S. financial assets, that would prompt some adjustment. I think that adjustment process was going to happen to some degree independent of Trump. But, you know, let's see. I mean, if Scott Besson can engineer a coordinated appreciation of all Asian currencies and that the net result of all these trade deal negotiations, which seem to be a little broader than just trade negotiations is a meaningful change in the level of all of the Asian foreign exchange complex against the dollar, that would be a win, in my view.

22:35And then again, just on this point, you've set out very brilliantly already the impact that Taiwanese life insurers and some of the other big Taiwanese investors have on, I guess I would say, three buckets of assets slash financial markets. So U.S. treasuries, corporate credit, and then the interest rate space where we see them as big players in rate volatility in various ways. How would you expect those three buckets to be impacted by what we've just seen over the past few days? Well, I think there's already been some important shifts. Josh Unger and I highlighted that the Taiwanese lifers have not been big buyers of so-called callable bonds, bonds which can be called by the issuer if rates fall.

23:22They bought a lot of those before the COVID as part of a yield pickup strategy, but that particular bid has sort of disappeared. And that in turn had knock-on effects on the agency market. So there's already been some adjustments as a result of the slowdown in Taiwanese lifers purchases over the past few years and the fact they've gotten a little bit more conservative. Right now, where the lifers are particularly important is for long-dated U.S. corporate bonds, 20-year-plus, that kind of stay-investment-grade corporates, and then a lot of dollar bonds issued by relatively high-grade emerging markets and Asian issuers.

24:03The lifers themselves tend not to be super heavy investors in treasuries. I mean, they have some, but they're not the dominant buyer of treasuries out of Taiwan. The dominant buyer of treasuries out of Taiwan tends to be the central bank or the banking system. So what I think will happen if the lifers are no longer willing or trying to reduce their dollar book is you're going to see less demand for corporate bonds, including in some particular corners of the market where they're very important. And then you're going to see if the Central Bank of China comes in and intervenes pretty either to smooth the move or to at some point cap the move, then you'll see a rotation in demand back towards treasuries.

24:45One of the ironies that I don't think a lot of people kind of have internalized is that central bank demand for treasuries tends to be very correlated with dollar weakness. Countries that don't want their currency to appreciate or don't want their currency to appreciate too quickly, intervene in the market. They buy dollars. And central banks tend to be the player that is least inclined to buy corporate debt to take credit risk and most inclined just to plow that money into the treasury market and typically into the shorter end of the curve. So that's kind of the rotation that I would expect going forward.

25:21I don't think you're going to see big changes in the treasury book because I think you're going to see this central bank bid. There's a small, subtle question that comes up if the Central Bank of China does what I suggested, which is opens up a hedging facility with its banking system and ultimately with its insurers. That would take dollars. But I think one thing that the U.S. has done over the past five years is that it's created a repo facility for foreign central banks. And that really is the kind of facility that would allow a central bank like Taiwan Central Bank that has a ton of dollar bonds to get dollar cash without selling its bonds.

26:01So I think you could have some sort of coordination there that could effectively help the lifers close some of their hedging need. So that's one of the things I'd like to see happen. And I think that would facilitate an orderly appreciation of the Taiwan dollar, one that doesn't break the back of its insurance industry. Thank you so much, Brad Setzer at the Council on Foreign Relations. Thank you so much for coming back on Odd Lots, the only one who could have explained it as clearly as you do. Really appreciate it. Well, thanks for letting me talk about one of my great passions.

26:46Love talking to Brad. Love the return of the relevance of this sort of what seemed like a niche thing. Look, Joe, I'm just going to say you need to live your life every day like Taiwanese life insurers are the biggest story in the world. That's how to do it. You know what? Unironically that, you're right, that we should never do episodes, period, that you and I don't consider the most important story of the day. Like, that's just a good editorial dictum to live by, isn't it? Excellent. Yes. I mean, this is definitely the case at the moment. This is the story. It is the story. And like, you know, what's interesting is, OK, here you have this huge line on a screen and this big jump and it intersects with the financial markets.

27:27And, you know, looking at the stocks today, you know, it's not like we've seen some major spillover. In fact, S &P 500 is barely down right now. But still, it's hard not to get anxious when you see like big 90 degree angles in a chart, you know, USD, TWD. So I have two things to say about this. So number one, I don't think a lot of investors are very good at thinking about basically international financial flows. And I would say that of financial media organizations as well. I have long said that every financial media organization that takes itself seriously should have a global flows correspondent.