Brad Setser is a senior fellow at the Council on Foreign Relations, and a former US Treasury official. Josh Younger is a lecturer at Columbia Law School and a former JPMorgan analyst.
A lot of countries have invested a lot of money in the US. And not primarily in Nvidia and the stars of the US stock market. Most foreign investors actually buy one of the many flavours of bonds that the US has on offer.
Take Taiwan. It has invested a ton in US bonds. A ton. Its holdings of foreign exchange reserves — mostly in bonds — and overseas fixed income securities together total $1.7tn.
That’s more than 200 per cent of the country’s GDP, more than five times the size of the entire domestic Taiwanese bond market, and roughly the equivalent of all of Pimco’s fixed income funds. In fact, it’s not much less than the net holdings of Taiwan’s much larger neighbour across the strait. Mainland China has $2.9tn in reserves and foreign bonds, net of foreign investment it its own bond market.
In other words, Taiwan has almost surreptitiously become a major, under-appreciated force in the global fixed income market.
There are a lot of creditor countries in the global economy — countries that have more financial claims on foreigners than foreigners have claims on them. In balance of payments terms, they have more external assets than external liabilities.
However, what might seem like both a reflection and source of financial and economic strength can just as easily be a glaring weakness. For some big-surplus countries the financial stability risks can in practice become inverted — the biggest dangers actually lurk offshore, and above all in the US.
In today’s global economy, Taiwan is one of best examples of this predicament. And unfortunately, such is its reach that any problems are unlikely to stay in Taiwan.
How Taiwan became a bond market king
Around the turn of the millennium, Taiwan’s net foreign asset position was under $200bn. And of that total, almost three quarters was held by the central bank as official foreign exchange reserves.
Taiwan’s central bank is known as the Central Bank of China (Taipei), and like most other emerging markets central banks at the time, it wanted to hold plenty of reserves. Back then, private investors weren’t too keen on investing in the US. That was particularly the case from 2003 to 2010 when, well, the dollar was generally depreciating.
But then things changed, bigly.
Starting in the early 2000s, Taiwan started to run large current account surpluses of 5- 7 per cent of GDP. That’s big. At the time it was only really dwarfed by China. And while China’s surplus fell after the global financial crisis, Taiwan’s surplus actually expanded. It reached double-digits in 2014, and has generally kept climbing ever since.
A current account surplus generally implies that the country is exporting more than it is importing, leading to an accumulation of foreign currency — specifically US dollars, the currency of international trade.
The question was what to do with all that money.
Initially, the dollars piled up at the central bank as foreign exchange reserves. That was not only typical, but prudent (albeit that prudence was taken to extremes. Most countries are fine with reserves of around 20 per cent of GDP, and Taiwan, which doesn’t borrow abroad, arguably needs less).
However, the flood of foreign currency in Taiwan soon grew too large for even the central bank. Taiwan risked attracting undue attention and getting labelled as a currency manipulator by the US Treasury. Moreover, too large a stockpile of reserves can complicate the monetary management of a central bank. Taiwan needed an outlet.
Enter the Taiwanese life insurance industry.
Life insurance has always been a big business in Taiwan. But it was a manageable 60 per cent of GDP as late as 2006. That’s roughly around where France, Germany, and Japan were at the time, and similar to where the US is today. Moreover, a shortage of domestic bonds made it a bit difficult for Taiwanese insurers to get much bigger — life insurers generally cannot hold that much equity.
However, after changes to the rules governing insurance portfolios, Taiwan’s life insurance companies quickly found they could profitably issue local currency policies and invest the proceeds overseas in dollars. As a result, they exploded in size, and now hold assets equivalent to about 140 per cent of Taiwan’s annual economic output.
What wasn’t disclosed at the time is that Taiwan’s central bank was facilitating this process, as the life insurers were quietly swapping Taiwan dollar with central bank for the central banks foreign exchange reserves.
This proved to be effective pressure release valve. Taiwan’s central bank got to report slowing…