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Skyrocketing Interest Rates – The New Risk


As the recession continues, Taiwan's banking system is actually overloaded with money, and looking like a pressure cooker ready to blow. Some experts already warn of accelerating inflation and soaring interest rates.



Skyrocketing Interest Rates – The New Risk

By Yi-Shan Chen, Monique Hou
From CommonWealth Magazine (vol. 420 )

After issue No. 417 of CommonWealth Magazine came out on March 11 with the cover story "Taiwan's Insurance Industry Left Stranded," describing the plight of policyholders left in limbo after their life insurance companies pulled out of the market, the Financial Supervisory Commission immediately sprang into action.

In a letter sent out to all life insurers, the finance industry watchdog demanded the names of all insurance products with an expected interest rate of more than 2.5 percent. The life insurance industry interpreted the move as a prelude to the FSC Insurance Bureau's halting the sales of high-yield insurance policies.

As soon as this piece of news came out, consumer interest in high interest insurance policies soared. "Bank deposits carry only a little more than 1 percent in interest. The interest rate on insurance policies is more than twice as much," Li Chiung-fang, of Jhongli in Taoyuan County, said excitedly as she considered the sales pitch of an insurance agent.

The reaction of Li is not surprising. People in Taiwan are not certain when these economically hard times will end. The economy is in recession, and interest rates are at a historic low, so that people are unsure where to put their hard-earned money to generate returns, or at least to prevent it from losing its current value.

People have a lot of cash on their hands. Taiwan faces a crisis due to rising cash positions so that even the central bank, which monitors Taiwan's cash flow, has become alarmed.

On March 26 the central bank announced after a board meeting that key interest rates would remain unchanged. When journalists asked central bank governor Perng Fai-nan why the bank stopped lowering interest rates after seven consecutive rounds of interest rate cuts, he responded somewhat mysteriously that the bank had "at least not raised interest rates."

The global economy is presently going through its worst recession since World War II. Governments and central banks around the world are spending big. This has led numerous experts to warn that too much money is already in circulation and that we might face inflationary pressure. What about Taiwan?

Huang Yin-ji, chief economist at SinoPac Holdings, sees a monetary bubble coming. "Compared to the late 1980s when hot money was flowing into Taiwan and we were drowning in cash, I think that the current situation is somewhat closer in nature to the burst of the Internet bubble, when the central bank quickly lowered interest rates," Huang explains.

More Money than Ever

Huang provides hard figures to back his assertion. Growth of broad money supply (M2) stood at 6.68 percent year-on-year in January and February, a rarely seen instance of the money supply exceeding the central bank's monetary policy target zone, yet there is not as much excess idle capital as in the late 1980s. Back then the stock market and real estate market skyrocketed, so that M2 increased at an annual rate of more than 30 percent.

M2 is a broad measure of the money supply. Generally speaking, a higher volume of M2 indicates a faster circulation of money, and looser monetary controls.

But central bank statistics show that in February Taiwanese banks held as much as NT$130.4 billion in excess reserves, above the central bank's reserve requirements. This is about twice as much as during the cash-rich late 1980s when NT$71.1 billion in excess reserves had been bunkered and more than three times as much as during the dotcom burst of the late 1990s.

Perng, who has all along adamantly insisted that Taiwan will not see zero interest rates, defends the bank's decision not to carry out further interest cuts on the grounds that "Japan has zero interest rates, but our housing loan interest rate is even lower than Japan's." But Perng's statement also indicates that Taiwan might have entered an era of even more excessive capital than Japan's.

Was Perng's remark that interest rates have at least not been raised meant to indicate that from now on interest rates are more likely to be hiked than lowered? This possibility deserves some consideration. Given repeated warnings from monetary experts and scholars around the globe that we need to beware of the risk of inflation, interest rate hikes seem more likely than rate cuts not only in Taiwan, but also in the rest of the world.

The Specter of Soaring Interest Rates

It would not be the first time that interest rates bounced back with a vengeance after a period of extremely loose money policy.

In its history Taiwan has repeatedly seen massive interest rate hikes within a short period due to inflationary pressure. In just twelve months between September 1973 and August 1974, for instance, the central bank raised the rediscount rate by a total of 4.5 percentage points.

Between April 1979 and September 1981, the central bank pushed up the rediscount rate by a total of 5 percentage points from 8.25 percent to 13.25 percent to dry up excess capital. During another period of surplus cash between March 1989 and June 1991, the rediscount rate was also markedly raised by 3.25 percentage points.

"If interest rates are going to bounce back, they will do so rapidly and fiercely. In Taiwan interest rate hikes will start with a 0.5 percentage point rise, but I'm afraid that countries like Australia will go up by a whole percentage point," predicts SinoPac's Huang.

It's Raining Money, but Banking Business is Bad

With its loose monetary policy, the central bank has injected the banking system with a lot of liquidity, while the man in the street puts his money into safe bank deposits for fear that investments might fail. But due to the economic downturn, banks do less business in the areas of corporate finance and personal loans. As a result, as much as NT$130 billion is sitting idle in the banking system with nowhere to go, and bankers keep complaining about bad business prospects.

In mid-March the newspaper headline "Bank of Taiwan posts first-ever losses" shocked Taiwan's finance industry. When U.S. financial services firm Lehman Brothers declared bankruptcy last year, many people feared for the future of private banks. Consequently, they withdrew their savings and deposited them with public or state-run banks instead, which are perceived as safer. Few would have imagined that the Bank of Taiwan, the largest state-run bank and seen as the last bastion of Taiwan's banking industry, would also end up operating in the red.

"If we don't count in subsidies from state coffers for preferential loans, the spread between loan and deposit interest rates at the Bank of Taiwan is a meager 0.31 percentage points," says Tsai Fu-thi, spokesman for the Bank of Taiwan, in a frank admission.

In other words, the Bank of Taiwan makes only NT$0.3 per every NT$100 worth of deposits it lends out again. "Such a narrow spread is not enough to even pay our utility bills or fax costs," laments the vice president of one financial holding company.

Taiwan's banks originally seemed to be better off than the insurance industry, having narrowly evaded the brunt of the financial crisis, but now that Taiwan's central bank has joined the world's other central banks in printing new money and rapidly lowering interest rates, it also faces a structural crisis.

But the idle capital that is locked up in bank vaults has already created a number of new problems. Since the money cannot find creditworthy borrowers, it is looking for bargains in the call loan and government bond markets. As a result, Taiwan's bond market has become completely anemic.

The New Age of Capital Protection

On April 10 this year, the central bank, on behalf of the Ministry of Finance, auctioned off treasury notes carrying a one-year interest rate of just 0.195 percent, an all-time low. On April 8 transaction volume for 10-year government bonds, which are the main product in the bond market, shrank to just NT$1.2 billion, about one tenth of the volume on an average trading day. Traders feel that the bond market "is about to breathe its last gasp."

While no improvement is in sight with regard to unemployment and payment difficulties among ordinary people, there is too much money in the market, because the government has been generously handing out money and the central bank has lowered interest rates. Against this backdrop the central bank might eventually be forced to quickly hike interest rates to hold down inflation. Should this happen, the money in our hands is at risk of losing value.

Therefore, we need to pay extremely close attention amid the current money glut to the potential risks arising from the coming wave of price hikes and a rebound in interest rates.

Translated from the Chinese by Susanne Ganz