Speaker 1: Hello, and welcome to another episode of the Odd Lots Podcast.
Speaker 1: I'm Joe Wasn't and I'm Tracy Halloway. Tracy, I've been
Speaker 1: really happy with some of these strings of episodes that
Speaker 1: we've had lately, particularly sort of talking about the relationship
Speaker 1: between a country's own domestic balance sheets, savings, profits, etcetera,
Speaker 1: and then how those funds interact with the rest of
Speaker 1: the world. That's good, Joe. I'm happy that you're happy.
Speaker 1: I'm thank you, Tracy. I really, uh, I really appreciate that.
Speaker 1: Did I just ruin your intro? You just ruined it?
Speaker 1: It felt it's so condescending, So I'm sorry. I'm sorry. Yes,
Speaker 1: I agree with you. I feel like I've been learning
Speaker 1: a lot from our recent string of guests. Yeah, say,
Speaker 1: I mean, I feel personally like we are tackling some
Speaker 1: of the really big picture question and issues in financial markets.
Speaker 1: We're talking about these huge flows of money that actually
Speaker 1: dictate how the markets were exactly right. So today we're
Speaker 1: going to talk about what is something that I feel
Speaker 1: like probably or more of our listeners have never thought of.
Speaker 1: I'm only saying that because I had never even really
Speaker 1: heard of this issue up until a few weeks ago
Speaker 1: when I heard about it from a friend of mine,
Speaker 1: a friend on the playground with my daughter. But apparently
Speaker 1: there's like this sort of interesting phenomenon in the world
Speaker 1: of finance and it relates to uh Taiwanese life insure. So,
Speaker 1: first of all, I love the idea that you're on
Speaker 1: a playground in New York talking about Taiwanese life insurers.
Speaker 1: But but secondly, I think you're right in framing this
Speaker 1: is something that not a lot of people think about,
Speaker 1: and that's kind of a shame because we do hear
Speaker 1: people talking about the Asia savings glut all the time,
Speaker 1: this idea that there's just this huge amount of money
Speaker 1: coming from Asia and it has to go somewhere, and
Speaker 1: most people think about China, or most people think about Japan,
Speaker 1: but rarely do people think about Taiwan and that place
Speaker 1: actually has this huge, huge financial industry, not just banks,
Speaker 1: but life insurance. Right. So obviously we talked to Michael
Speaker 1: Pettis a few weeks ago, and you talked about the
Speaker 1: high savings rate in China and the result of you know,
Speaker 1: that being the result of a few different factors such
Speaker 1: as the poor social safety net and so on, and
Speaker 1: there's also for similar reasons, I think a massive, incredibly
Speaker 1: high savings rate in Taiwan and that is also showing
Speaker 1: up in very strange and usual ways, and it's a
Speaker 1: kind of through the life insurance sector that it's apparent
Speaker 1: and that is going to be what we examined today.
Speaker 1: I'm glad you said strange and unusual because I have
Speaker 1: to say the piece of work that this podcast is
Speaker 1: based on, or this particular episode is based on. Once
Speaker 1: you're done listening to this episode, don't turn it off
Speaker 1: just yet, but once you're done listening, go and read
Speaker 1: the actual work that this is based on. Because it's
Speaker 1: framed like a giant financial Who done it? It's like
Speaker 1: a mystery novel about Taiwanese life insurers and it's great.
Speaker 1: I completely agree. And Uh, without further ado, I want
Speaker 1: to bring in the author, who is I think now
Speaker 1: the record holder for the most frequent times appearing on
Speaker 1: our on the odd Lots podcast. He's a brad said
Speaker 1: Sir of the Council on Foreign Relations and Exante Data.
Speaker 1: He was also a recent guest at the recent odd
Speaker 1: LODs Live podcast talk about all things trade, and today
Speaker 1: he's going to talk about his work on the Taiwan
Speaker 1: His Life insurance sector, of which he has written co
Speaker 1: written a six part series and up Brad, thank you
Speaker 1: for joining us. As I mentioned, I was, I'm not
Speaker 1: making this up. I was at the playground. My daughter's
Speaker 1: friends dad was there and he's in the insurance industry.
Speaker 1: Did she ask you about Taiwanese life insurance? My three?
Speaker 1: And have your old daughter asked me about Taiwan His
Speaker 1: Life insures? No, it's a friend. Uh, he's in the
Speaker 1: insurance industry, and somehow I always asked him about insurance questions.
Speaker 1: Somehow Taiwan came up. But it just so happened that
Speaker 1: you wrote this huge series on it. So I guess
Speaker 1: what I wanted to start with is this question, why
Speaker 1: are we talking about this? Why are we having a
Speaker 1: podcast on this? Why did you write a co author
Speaker 1: a six part series on Taiwan His Life insurers? What
Speaker 1: what's going on here? Why is this interesting? Well? It
Speaker 1: was interesting to me for a bunch of different reasons.
Speaker 1: The first one is the one you started with. There
Speaker 1: is this Asian savings squad. Taiwan actually has a bigger
Speaker 1: current account surplus or a bigger savings surplus relative to
Speaker 1: the size of its economy than either China or Japan.
Speaker 1: Current account surplus has been over ten percent of GDP
Speaker 1: for a really long period of time. That raises the
Speaker 1: question of where this money is going? Uh, and when
Speaker 1: you started, When I started looking at this more closely,
Speaker 1: it soon became clear that after the global financial crisis,
Speaker 1: the way this money was reaching global financial markets changed.
Speaker 1: It used to be that the Central Bank of China Taiwan,
Speaker 1: the central bank bought foreign exchange reserves and invested those
Speaker 1: foreign exchange reserves and let's say treasuries and agencies the
Speaker 1: standard reserve assets. After the global financial crisis, the Central
Speaker 1: Bank of China appear or to step back, and instead
Speaker 1: the outflow was all coming from the life insurance sector,
Speaker 1: and the life insurance sector was taking on new kinds
Speaker 1: of risk, risk that a central bank typically wouldn't take. Okay,
Speaker 1: I don't want you to give the whole thing away.
Speaker 1: Before we get to that, talk to us about how
Speaker 1: Taiwan actually ended up with this huge life insurance industry,
Speaker 1: because I think again, to a lot of people, it's
Speaker 1: not necessarily an intuitive development. You're talking about a relatively
Speaker 1: small country, not a lot of natural resources, in a
Speaker 1: really unique political situation, and for a long time it
Speaker 1: was known as a sort of manufacturing hub, and then
Speaker 1: at some point it just develops this giant insurance industry.
Speaker 1: What happened, I'm not sure I understand entirely what happened.
Speaker 1: I can see the end result. The end result is
Speaker 1: that Taiwan's life insurers now have about nine billion dollars
Speaker 1: in total assets. That's ballpark fifty percent of Taiwan's GDP.
Speaker 1: I think what happened in the broadest possible sense is
Speaker 1: that Taiwan was faced with a challenge as over the
Speaker 1: past twenty years is China emerged as the region's dominant
Speaker 1: manufacturing power, and one consequence of that was that a
Speaker 1: manufacturing investment and investment in general in Taiwan fell, and
Speaker 1: Taiwanese savings because of the low, relatively modest social safety
Speaker 1: net and other structural factors, rapid aging Haiwan savings rate
Speaker 1: state high. So this massive savings surplus developed, and the
Speaker 1: Taiwanese government wasn't out borrowing large sums either, so the
Speaker 1: savings had to go into some kind of financial instrument,
Speaker 1: and the lifers started offering long run investment products that
Speaker 1: offered a higher return than Taiwanese dollar bank deposits, and
Speaker 1: that whole the savings surplus in a sense into the
Speaker 1: life insurance industry. This is an important point, and maybe
Speaker 1: it's one of those things that's really obvious to some people,
Speaker 1: but it didn't, you know, when I first started paying
Speaker 1: attention to finance. It took me a lot of grasp it.
Speaker 1: But this sort of shades of gray between what we
Speaker 1: consider an investment product and an insurance product, or in
Speaker 1: a savings product, and I sort of like mentally put
Speaker 1: insurance in one bucket of something that pays off in
Speaker 1: a contingency. Investment is something that a little different, or
Speaker 1: savings is different, but they're not that different. And fundamentally,
Speaker 1: historically you can think of, say investing in a mutual fund,
Speaker 1: or investing in a bank account, or investing in a
Speaker 1: retirement fund. It's not that different from buying life insurance.
Speaker 1: And effect a lot of life insurance here offers annuities,
Speaker 1: so they're very they're very related. Good, right, and an
Speaker 1: annuity is a life insurance classic life insurance policy combined
Speaker 1: with an investment portfolio. Okay, So these Taiwanese life insurers
Speaker 1: basically end up with a huge amount of money flowing
Speaker 1: into them via insurance policies, annuities, whatever, and they need
Speaker 1: to do something with that money. So what is it
Speaker 1: that you've observed them doing well. The difficulty the insurer's
Speaker 1: face was that the kind of classic products which an
Speaker 1: insurance industry would invest in were rather small in Taiwan's case.
Speaker 1: So you know, typically if you're pulling in a lot
Speaker 1: of life insurance policies, you would invest in government bonds
Speaker 1: or local corporate bonds. There just aren't that many though
Speaker 1: Taiwanese dollar denominated government bonds or Taiwanese dollar denominated corporate bonds.
Speaker 1: The corporate sector didn't need to borrow that much, and
Speaker 1: it could borrow, you know, the economy was flush with
Speaker 1: savings that could borrow from the banking sector. So over time,
Speaker 1: the insurers started buying more and more foreign bonds. The
Speaker 1: share that they put into foreign bonds was initially capped
Speaker 1: at of their total assets, which is a high number.
Speaker 1: Actually that's much higher than is typical across other Asian
Speaker 1: life insurance sectors. But when they hit that number, rather
Speaker 1: than stopping, a new instrument in a sense developed the
Speaker 1: Taiwanese allowed the insurers to invest in what are called
Speaker 1: for MOSTA bonds, which are dollar denominated bonds issued in
Speaker 1: Taiwan US do US dollar, not Taiwanese dollar issued in
Speaker 1: Taiwan listed on the Taiwanese a Stock Exchange, and those
Speaker 1: were not counted against their cap on foreign assets. It
Speaker 1: was a blatant loople and a lot of financial institutions
Speaker 1: started issuing in this market, particularly calla ble bonds, so
Speaker 1: bonds which have the option where the issuer can call
Speaker 1: them if a test rates fall. The lifers like them
Speaker 1: because they offered a little bit higher yield today. The
Speaker 1: issuers like them because if interest rates fell, they had
Speaker 1: the option of reducing their borrowing costs. And this became
Speaker 1: a really big market, goes from like zero to fifty
Speaker 1: billion in a couple of years. And then the insurers
Speaker 1: and the regulators started asking, like, okay, this is getting
Speaker 1: a little big. They put a cap on the insurers
Speaker 1: holdings not just of foreign assets, but foreign assets plus
Speaker 1: for most of bonds. That roughly s their total assets. Again,
Speaker 1: that is a huge number. No other insurance sector in
Speaker 1: the world, at least to my knowledge. Maybe some in
Speaker 1: a tiny country has put two thirds of their assets
Speaker 1: in a foreign currency, particularly when most of their policies
Speaker 1: are still in Taiwee stall. We'll get back to that,
Speaker 1: But then they've kind of blown through that SI cap
Speaker 1: as well with a new product. So now the hot
Speaker 1: new product is the UH Local Exchange traded funds, which
Speaker 1: in Taiwan are invested entirely in foreign bonds sold entirely
Speaker 1: to the life insurers, and are considered a Taiwanese dollar asset,
Speaker 1: so obvious regulatory arbitrage. The net effect is that close
Speaker 1: to it depends a little bit on which statistical source
Speaker 1: you use, but close to se close to six billion
Speaker 1: dollars of life ensure money has invested been invested in
Speaker 1: foreign assets. That is to the first approximation of Taiwan's GDP,
Speaker 1: So Taiwan's basically future retirement savings has been invested abroad
Speaker 1: through the life insurers, and the flow has been so
Speaker 1: big that it impacts particular parts of the global market.
Speaker 1: Now before we go on, I mean, a that's fascinating
Speaker 1: the degree of regulatory arbitrage and loopholes that they continue
Speaker 1: to develop to blow through the caps. So I'm trying
Speaker 1: to think of like some of the things that need
Speaker 1: to be unpacked. Here. One of the reasons in your
Speaker 1: research why this is this needed to be picked apart,
Speaker 1: and maybe you can explain it. You mentioned statistical questions.
Speaker 1: They don't report their statistical data on these things the
Speaker 1: same way as everyone else does. UM. One of the
Speaker 1: first things I learned when I started working at the U. S.
Speaker 1: Treasury it was never too right that Taiwan is a country.
Speaker 1: H Alright, Taiwan is always an economy. Taiwan is not
Speaker 1: a member of the i m F. It has a complicated,
Speaker 1: to put it mildly, UH position in the international community,
Speaker 1: in the sense that for now the convention is that
Speaker 1: both UH Taiwan, the Republic of China and the People's
Speaker 1: Republic of China formally believe they are the right full
Speaker 1: government to all of China. But for almost all global
Speaker 1: institutional purposes, the People's Republic of China is the representative
Speaker 1: of all of China. So the Republic of China Taiwan
Speaker 1: doesn't participate in most global bodies, and so taiwan statistical
Speaker 1: practices don't necessarily follow every global norm. How much does
Speaker 1: Taiwan's again unique political situation also feed into its need
Speaker 1: to find someplace to put its money abroad, and the
Speaker 1: fact that it's generally put that money into US corporate
Speaker 1: bonds because a lot of people know this is a
Speaker 1: stupid question. I know what the answer is. Never mind,
Speaker 1: I changed my mind. I might I might not know
Speaker 1: the answer tracing well. No, I was going to say, like,
Speaker 1: you know, there's a huge like market right next to
Speaker 1: it that actually needs a lot of capital, and that
Speaker 1: would be China. But what I was wondering, I'm I'm
Speaker 1: glad you're going to ask this because I'm curious. Why
Speaker 1: doesn't Taiwan invest in China. That's kind of an obvious one,
Speaker 1: isn't it. No, Actually, I don't know is that? I mean,
Speaker 1: it's a good question. I mean, the Chinese manufacturing sector
Speaker 1: has invested enormously in China. Han Hai makes all of
Speaker 1: Apple's smartphones in China. Hiwanese owned, I mean the Taiwanese
Speaker 1: contract Taiwanese own contract manufacturers are an enormous source of
Speaker 1: investment inside China. I think there's a couple of things here. One,
Speaker 1: China's UH capital account has historically been closed, so it
Speaker 1: hasn't been it's now getting more open. But Historically, it
Speaker 1: hasn't been possible even if the Taiwanese wanted to to
Speaker 1: put a large sum of money into the to the
Speaker 1: Chinese market. And then second, I think there probably is
Speaker 1: some concern about the political risk that would come with
Speaker 1: putting a large amount of Taiwanese savings in Chinese financial instruments,
Speaker 1: particularly in a context where you have to be a
Speaker 1: little bit blunt and provocative. A lot of Chinese financial
Speaker 1: instruments that offer yield a moral hazard plays on the
Speaker 1: willingness of the Chinese government to bail out a given institution,
Speaker 1: and of bailing out to give an institution and bailing
Speaker 1: out to Taiwanese investor, you could see why that might
Speaker 1: lead to some concerns. On the other hand, the Taiwanese
Speaker 1: have been big buyers of Asian dollar bonds. The it's
Speaker 1: not that a significant part of Taiwan's dollar portfolio is
Speaker 1: not in bonds issued by American companies or American banks.
Speaker 1: Taiwan actually disproportionately buys the dollar denominated bonds issued by
Speaker 1: foreign companies and foreign banks. Just one of the many
Speaker 1: peculiarities of Taiwan. So I would say, you know, like
Speaker 1: European banks issuing dollar bond dollar callables to raise funds
Speaker 1: Asian companies that issued dollar bonds all we're finding big
Speaker 1: buyers amongst the Taiwanese life insurance community. So before we
Speaker 1: go on, we need to establish that essentially, as you
Speaker 1: describe it, the Taiwanese life insurers have a current a
Speaker 1: potential currency mismatch situation. Their liabilities to Taiwanese savers or
Speaker 1: two policy holders are denominated in Taiwanese dollars, but their
Speaker 1: assets that they go out and buy are in US dollars,
Speaker 1: which I guess it works fine as long as the
Speaker 1: US dollar keeps strengthening and doesn't know, that doesn't pose
Speaker 1: a problem. But how big is this sort of like
Speaker 1: the crux of the issue that they face, that this
Speaker 1: potential flip. If suddenly the Taiwanese dollar were to strengthen
Speaker 1: and those UH priced and newest dollars or priced in
Speaker 1: Taiwanese dollars, their assets fell by a lot. Unambiguously, the
Speaker 1: biggest risk facing the Taiwanese life insurance sector comes from
Speaker 1: their open foreign exchange position. The fact that they have
Speaker 1: sold a lot of life insurance policies that promise a
Speaker 1: Taiwan dollar return, and then they have invested those the
Speaker 1: proceeds from those policies in US dollar denominated assets. There's
Speaker 1: an intrinsic currency mismatch, and that's the number one risk
Speaker 1: facing the lifers. They've also taken some more exotic credit risk,
Speaker 1: and so they do face some potential risk just from
Speaker 1: the the investment side of their portfolio from the particular
Speaker 1: bonds that they have bought. So they have a currency
Speaker 1: mismatch unless they actually go out and hedge their effects
Speaker 1: exposure with another entity. And this is in large part
Speaker 1: what your series is about uncovering. What did you find
Speaker 1: out about the actual hedging processes of the Taiwanese life insurers. Well,
Speaker 1: let's let's start with the fact that Taiwanese lifers have
Speaker 1: about six hundred billion dollars or a hundred percent of
Speaker 1: Taiwan's GDP and foreign assets. That it creates an enormous
Speaker 1: hedging need. It's a much bigger relative to the size
Speaker 1: of Taiwan's economy than the hedge need of the Japanese
Speaker 1: life insurers is relative to the size of Japan's economy,
Speaker 1: or the hedge need of Korea's life insurers is relative
Speaker 1: to the size of Korea's economy. So the question is, okay,
Speaker 1: can you trace back and find who is providing the
Speaker 1: the counterparty, who's providing the hedge. The obvious answer is
Speaker 1: that the Taiwanese life insurers have started selling dollar denominated
Speaker 1: policies inside Taiwan, so that gets rid of the mismatch
Speaker 1: because rather than selling Taiwan dollar policies, you sell US
Speaker 1: dollar policies. You're naturally matched against US dollar assets, but
Speaker 1: that only can cover roughly of the six billion in
Speaker 1: foreign assets. That still leaves Ballpark fifty billion, So some
Speaker 1: of that has been emerging. Some of that has been emerging.
Speaker 1: The trend has been to push the risk into Taiwanese
Speaker 1: savers to Taiwanese households. You could think that's a consumer
Speaker 1: protection financial protection issue because Taiwanese savers are presumably expecting
Speaker 1: a taiwan dollar return, but technically they've bought US dollar
Speaker 1: denominated policies, and if the Taiwanese dollar were to appreciate,
Speaker 1: which arguably it should, you shouldn't run of GDP trade
Speaker 1: surpluses forever. Then they would face significant losses on their
Speaker 1: relatively safe retirement accounts. But clearly that's been one of
Speaker 1: the ways the life insurance sector has laid off some
Speaker 1: of this risk. Another portion of the risk is just
Speaker 1: taken on directly by the life insurers. Somewhere between twenty
Speaker 1: and depending on the time, is just run as an
Speaker 1: open foreign currency position, so there is no hedge, just
Speaker 1: straight up long do They're just straight up long dollars.
Speaker 1: If Taiwan dollar were to appreciate, they would take a
Speaker 1: head out of their capital. No. I mean, this is
Speaker 1: a pretty big open position relative to the size of
Speaker 1: their capital, certainly relative to the size of Taiwan's economy.
Speaker 1: But then all right, you still got about three hundred
Speaker 1: billion of Taiwan's GDP which is hedged. So you kind
Speaker 1: of start having to get into the mechanics of cross
Speaker 1: currency hedging, and this gets super technical. This is the
Speaker 1: this is the this is where I like sort of
Speaker 1: check out. It's just Brad and Tracy tire for the
Speaker 1: rest of the episodes. I'm just gonna listen from here on.
Speaker 1: If you are doing a standard cross currency hedge, uh,
Speaker 1: someone who has dollars offshore will typically swap those dollars
Speaker 1: or the Taiwan dollar. UH. The offshore investor will get
Speaker 1: taiwan dollars and that money will then be invested in
Speaker 1: either a Taiwanese bank account or a Taiwanese government bond.
Speaker 1: I mean, that's in principle how cross currency hedging works.
Speaker 1: That is what you see in Japan. There's this enormous
Speaker 1: flow from the cross currency hedging into Japanese government bonds,
Speaker 1: which is simply foreign investors with dollars, swapping those dollars
Speaker 1: for yend, collecting a premium, and then parking the money
Speaker 1: in Japanese government bonds. So there are certain things you
Speaker 1: would see if foreign investors were supplying the the hedge.
Speaker 1: You would see a large inflow from offshore investors into
Speaker 1: Taiwanese dollar instruments, and you just don't see that. There's
Speaker 1: actually a financial control, financial account control, so foreign investors
Speaker 1: are not allowed to buy Taiwanese dollar denominated government bonds.
Speaker 1: Taiwan hasn't wanted that inflow, and the bank flow is
Speaker 1: all in dollars, so that's not explaining the hedge. The
Speaker 1: hedge seems to be coming from local entities. Now what
Speaker 1: local entities could be providing the hedge. You could have
Speaker 1: Taiwanese companies going out and borrowing in dollars and then
Speaker 1: swapping dollars back into Taiwan dollar. That would allow them
Speaker 1: to finance their domestic investment perhaps more cheaply, but you
Speaker 1: can kind of look at that and see and it's
Speaker 1: not that big. So then you can look at the
Speaker 1: commercial banking sector, which would be a classic source of hedges.
Speaker 1: And when a banking sector is providing a lot of hedges,
Speaker 1: they need to take in more dollars deposits offshore borrowing
Speaker 1: than they have lent out. Then there's a spare surplus
Speaker 1: of dollars. They swapped those dollars for the lifers Taiwan
Speaker 1: dollars and then they basically get Taiwan dollar funding and
Speaker 1: the lifers get US dollar funding. So it's in a
Speaker 1: complicated way, it becomes a it becomes cheaper in a
Speaker 1: sense for a Taiwanese bank to take in a dollar deposit,
Speaker 1: swap it with the life insurers who have Taiwan dollar,
Speaker 1: and then use the Taiwan dollars that they got from
Speaker 1: the life insurers to finance their Taiwan dollar winding. So
Speaker 1: conceptually that could be a funding source, and it is.
Speaker 1: There's fifty issue billion of funding from the commercial banking system.
Speaker 1: But you add this all up and there's still a gap.
Speaker 1: You can't find a set of counter parties equal to
Speaker 1: the four and fifty billion dollar hedging need, which becomes
Speaker 1: a three billion dollar hedging need once you account for
Speaker 1: the open position. But you just can't find counterparties that
Speaker 1: add up to three billion dollars except if you look
Speaker 1: to the Central Bank of China, the missing force in
Speaker 1: the market, not the PBOC. Just to be clear, are
Speaker 1: not the People's Bank of China. Absolutely the I mean,
Speaker 1: it would be easier if you could call uhai You know,
Speaker 1: you can call it Taiwan Central Bank. You just call
Speaker 1: it the Central Bank of Taiwan because it gets back
Speaker 1: to the Taiwan is not a country question. So it
Speaker 1: is technically the Central Bank of the Republic of China
Speaker 1: in Taipei. If it just it just to add one
Speaker 1: last complicat, and it's just you know, it just is
Speaker 1: what it is, and so CBC if you want to
Speaker 1: use the standard acronym central Bank of the Republic of China,
Speaker 1: central Bank of China. The People's Bank is the People's
Speaker 1: Bank of China. People legacy of communism da okay, But
Speaker 1: you talked earlier about how in many ways, Taiwan Central Bank,
Speaker 1: the CBC, has a sort of different or unusual reporting
Speaker 1: regime when it comes to a lot of things. So
Speaker 1: how did you go about actually unpicking whether or not
Speaker 1: the central bank had anything to do with the ffex
Speaker 1: hedging of the Taiwanese insured. So if Taiwan Central Bank
Speaker 1: acted like a standard central bank and followed the global
Speaker 1: reporting conventions, you could look at a footnote, line item
Speaker 1: and the standard International Reserve reporting template and you can
Speaker 1: essentially see how much foreign exchange a central bank has
Speaker 1: swapped for local currency. It shows up as a forward
Speaker 1: position as the just so because of the way the
Speaker 1: accounting for works for a central bank. So there are
Speaker 1: central banks elsewhere in Asia, the Monetary Authority of Singapore,
Speaker 1: the Central Bank of Korea, the Central Bank of Thailand
Speaker 1: that have significant forward positions because of the swaps that
Speaker 1: they engage in with local counterparties, but those are reported.
Speaker 1: Taiwan has said we're not reporting this. They've refused to
Speaker 1: voluntarily follow the standard Global reserve reporting template, so you
Speaker 1: can't directly measure Taiwan's hedging or the amount of head
Speaker 1: dollar hedges the Central bank provides the life insurance sector.
Speaker 1: It's just it's the unknown, it's the mystery variable. And
Speaker 1: you know, people have been asking the Taiwanese to report
Speaker 1: this number for a long time. This Treasury has US
Speaker 1: Treasury has been asking Taiwan to report this because this
Speaker 1: is a It turns out that buying a dollar in
Speaker 1: the spot market and then swapping it makes it disappear
Speaker 1: from your balance sheet. So when you buy a dollar
Speaker 1: and swap it out, you have this forward UH commitment
Speaker 1: to buy a dollar back in the future, but you're
Speaker 1: not holding a dollar and you're not reporting the dollar.
Speaker 1: And since people count on the reported level of reserves
Speaker 1: to measure how much UH, any government is intervening in
Speaker 1: the foreign exchange market. Without knowing the forward book, which
Speaker 1: is the leg part consequence of the swaps book, you
Speaker 1: don't actually know how much the central bank is intervening
Speaker 1: in the spot market. So there's been pressure on Taiwan
Speaker 1: too reveal more to report using standard international conventions, and
Speaker 1: that the Central Bank of China Taipei has just refused.
Speaker 1: So you had to go look. And you know, I
Speaker 1: did this work with co author a blogger Concentrated Ambiguity
Speaker 1: who's an expert on many things Asian institutional investors but
Speaker 1: also central bank pseudonymous concentrating and I love, I love
Speaker 1: the modern era. It's like a work between former Treasury
Speaker 1: employe BRD center and pseudonymous blogger concentrated ambiguity. But he
Speaker 1: is a market participant. UM, I think you can judge
Speaker 1: his work from no doubt it. I mean, he really
Speaker 1: is genuinely an expert both in central banks and a
Speaker 1: cross currency edging undoubted. I wanted to ask about this so,
Speaker 1: I mean one thing, one thing that any reader of
Speaker 1: this particular series will get is the amount of work
Speaker 1: that went into it. Absolutely. Did you ever consider just
Speaker 1: calling up, you know, someone at a time when he's
Speaker 1: life insurance company or maybe a market participant who's on
Speaker 1: an ex hedging desk at a large counterparty bank and
Speaker 1: just going like, hey, what have you heard about this issue?
Speaker 1: Like what it's sort of gossip or color is there
Speaker 1: in the market about this particular dynamic. So the lifers
Speaker 1: are not gonna like give away their secrets. Um. So
Speaker 1: I've never tried that. UM. I've actually been slapped a
Speaker 1: few times by the Taiwanese for writing things that the
Speaker 1: central Bank of China did not approve of I am
Speaker 1: not the favorite former Treasury officials think tank fellow for
Speaker 1: getting information from the Taiwanese. I did write a blog
Speaker 1: a couple of years ago about how Taiwan was sort
Speaker 1: of like the opposite of Argentina. Argentina too much foreign
Speaker 1: currency debt that when the paso deppreciates, they blow up,
Speaker 1: And I asked, well, is Taiwan in the opposite position,
Speaker 1: too many foreign currency assets? If the Taiwan dollar appreciates,
Speaker 1: will they blow up? And that blog actually got a
Speaker 1: lot of h I got a lot of feedback on
Speaker 1: that blog, which I wasn't really expecting. I thought this
Speaker 1: was a really kind of super or esoteric interest of mine.
Speaker 1: It was going to be one of those things that
Speaker 1: I write that no one pays attention to. And you know,
Speaker 1: in general, if I write about China, people pay a
Speaker 1: lot of attention to it, and if I write about
Speaker 1: something like Puerto Rico or even Turkey, a lot of
Speaker 1: Turkey less, so I get a lot less attention. And
Speaker 1: I figured Taiwan is gonna get no attention. But I
Speaker 1: actually got a lot of emails from trading desk in
Speaker 1: New York who we're dealing with various parts of the
Speaker 1: Taiwanese flow. So if you're selling thirty year US corporate bonds,
Speaker 1: you pay a lot of attention to what the Taiwanese
Speaker 1: life insures are doing. And if you're on an interest
Speaker 1: rates derivative desk, and this gets you know, even more complicated,
Speaker 1: you're on an interest rates derivative desk, You're the fuel
Speaker 1: for your desk in New York are the collible bonds
Speaker 1: that you're selling to the Taiwanese insurance sector. So these
Speaker 1: parts of the market in New York were actually had
Speaker 1: developed pretty sophisticated models for estimating the flow coming out
Speaker 1: of Taiwan, what fraction was going to be hedge, when
Speaker 1: would you hit a foreign currency issue in a limit,
Speaker 1: when might this flow stop? And there were various investment
Speaker 1: bank reports generally done from the point of view of
Speaker 1: when will this flow stop and what will that mean
Speaker 1: for our corner of the corporate credit market that had
Speaker 1: done some a lot of the same financial forensics that
Speaker 1: we did, and the Josh Younger of JP Morgan obviously
Speaker 1: has been a leader in doing this kind of analysis.
Speaker 1: Just to be clear, not only are Taiwanese insurers a
Speaker 1: large source of demand for US dollar denominated assets, but
Speaker 1: they're also a big buyer and seller of basically interest
Speaker 1: rate volatility in the market as well, So a number
Speaker 1: of different functions for different and very important assets. I mean,
Speaker 1: I think what's interesting is that, you know, the Taiwanese
Speaker 1: are a small part of the overall US corporate credit market,
Speaker 1: small but not insignificant. They become a very big part
Speaker 1: of certain corners of the market, so Asian dollar bonds,
Speaker 1: US callibles, thirty year fixed rate corporate issue ince things
Speaker 1: where there isn't so much demand from the traditional investors
Speaker 1: in US corporate credit. I guess I wanna go back
Speaker 1: and when you that missing piece? So how did you
Speaker 1: the final step? Because as you say, they no one
Speaker 1: in Taiwan is going to answer your phone calls, and
Speaker 1: they don't publish that information despite treasure pressure from the
Speaker 1: Treasury to talk about the degree to which the central
Speaker 1: bank is intervening in the foreign exchange market, Where specifically
Speaker 1: did you find this missing piece? So you have to
Speaker 1: be a sort of connoisseur of of bank balance sheets,
Speaker 1: in central bank balance sheets to appreciate this. But the
Speaker 1: Central Bank of China has historically, so before the Global
Speaker 1: financial crisis, published its net worth on a monthly basis.
Speaker 1: It's the gap between its assets and its liabilities. And
Speaker 1: since the Central Bank of China the Central Bank of Taiwan,
Speaker 1: it's all of its assets for a very long time
Speaker 1: because they've been a heavy intervener, are in foreign currency.
Speaker 1: All the liabilities are in Taiwan dollar. So the main
Speaker 1: driver of the net worth has been foreign exchangements. And
Speaker 1: you could find an almost perfect correlation between foreign exchange
Speaker 1: moves and changes in the net worth of Taiwan Central
Speaker 1: Bank before the Global financial crisis. After the Global financial crisis,
Speaker 1: the reported net worth change, it stopped being as volatile,
Speaker 1: it stopped moving with the Taiwan dollar US dollar right,
Speaker 1: And we noticed or perhaps discovered that other assets and
Speaker 1: other liabilities had a very strong correlation with moves in
Speaker 1: the exchange rate. And if you do the math right,
Speaker 1: you can some together the net position and other and others.
Speaker 1: You know, just like this throw away let's not go
Speaker 1: into the details, let's hide things kind of account. That's
Speaker 1: always what other is right. And what we concluded was
Speaker 1: that there was a revaluation account embedded in other liabilities
Speaker 1: and other in the net other liabilities, and so when
Speaker 1: you add the reported net worth with net other you
Speaker 1: get a series which more or less tracks the exchange
Speaker 1: rate as it should, because there's nothing that changed the
Speaker 1: fact that taiwan On central banks reported net worth should
Speaker 1: be a function of the exchange rate because all their
Speaker 1: assets are in foreign currency, all their liabilities there are
Speaker 1: still domestic currency. So you can find this and established
Speaker 1: this correlation, and then you ask, are the moves in
Speaker 1: this constructed series consistent with the reported foreign exchange reserves
Speaker 1: of the central bank, And it turns out there's a
Speaker 1: little bit more movement and is explained by their reported
Speaker 1: for an exchange reserves with the most obvious explanation for
Speaker 1: the greater movement. You know, it's movement when it should move,
Speaker 1: being that they have more foreign assets than they are
Speaker 1: disclosing e g. The inferred Swapswook? Can I just say?
Speaker 1: I actually like, wasn't breathing in I was so no.
Speaker 1: I was like, you know, Tracy, like you said up,
Speaker 1: was like this, who done it? And I think that
Speaker 1: was good? But then by the end listening to that,
Speaker 1: I actually noticed myself, I was like, well, that's gonna
Speaker 1: be the answer here, and I think exciting. I think
Speaker 1: we need Laura, our producer, to add like the dunt
Speaker 1: dunt dump music onto this just yea, yeah, no, seriously,
Speaker 1: I like that's like I started noticing that. I was like,
Speaker 1: oh my god, I really am It was pretty fun
Speaker 1: to do and it literally am at the edge of
Speaker 1: my seat waiting for that answer. And there was a
Speaker 1: moment and then and then, and just to be clear,
Speaker 1: that gap you just described is the size of the
Speaker 1: missing hedge for the life vers more or less. It's
Speaker 1: more or less, so we estimate, and the math is complicated,
Speaker 1: about a hundred and thirty billion of greater foreign assets
Speaker 1: than Taiwan discloses in its foreign exchange reserves, so they
Speaker 1: have it would push their total foreign exchange reserves up
Speaker 1: from a little under five billion now would push it
Speaker 1: up to about six And that's roughly what we think
Speaker 1: the missing hedge is on the life and sure side.
Speaker 1: So we tried to get at it from both sides
Speaker 1: of the equation. Is their demand for this kind of swap?
Speaker 1: And then is there evidence that the central bank is supply?
Speaker 1: So the inference here is that not only is uh
Speaker 1: the central bank basically on on the other side of
Speaker 1: a lot of this hedging activity, but also that it's
Speaker 1: effectively well I guess it's suppressing hedging costs, but it's
Speaker 1: also suppressing the Taiwanese dollar. It's it's currency intervention, right,
Speaker 1: I mean, this is evidence that Taiwan has been intervening
Speaker 1: more heavily than it reports, And in a sense, it's
Speaker 1: an evidence that the shift where we started, you know,
Speaker 1: the shift from a world where the Asian savings glut
Speaker 1: flowed through central bank reserves into the U S Treasury market.
Speaker 1: You know that change supposedly to a world where Asian
Speaker 1: savings glut throw flowed through private intermediaries into the US
Speaker 1: corporate credit market. Well, it turns out the change wasn't clean.
Speaker 1: That some fraction of the flow into corporate credit market
Speaker 1: from the lifers was using money that the Central Bank
Speaker 1: of China had bought, in effect, swapped or lent to
Speaker 1: the lifers. So the the the intervention has been a
Speaker 1: bigger contributor to the outflow from Asia, then you would
Speaker 1: guess from the reported data. So is this you know,
Speaker 1: you throw around these numbers about the size of the
Speaker 1: life insurance sector relative to GDP, and a huge part
Speaker 1: of the ability for that to go on is obviously
Speaker 1: um you know, as you revealed the central bank engaging
Speaker 1: in FX hedging, is it sustainable or is there a
Speaker 1: plausible scenario in which the central bank could run out
Speaker 1: of its ability to provide that service to the lifers
Speaker 1: and create serious financial instability in Taiwan or perhaps elsewhere,
Speaker 1: or perhaps part of the credit markets that are so
Speaker 1: depend on purchasing buying from Taiwan. Well, theoretically, as many
Speaker 1: people have noted, I think, going back to two Keynes, Uh,
Speaker 1: there is no upper limit on the foreign assets that
Speaker 1: a central bank can accumulate. There is a lower limit
Speaker 1: you have you cannot go below zero. So in that sense,
Speaker 1: there is no necessary reason why the Central Bank of
Speaker 1: of China and the Central Bank of Taiwan couldn't take
Speaker 1: a foreign asset position of acent of Taiwan's GDP and
Speaker 1: raise that two of Taiwan's GDP. There probably is a
Speaker 1: limit to the lifer's ability to continue to invest in
Speaker 1: foreign bonds at their current pace. You know, if you
Speaker 1: put if you raise your foreign allocation from forty to seventy,
Speaker 1: you probably can't go from seventy to a hundred. You
Speaker 1: do need a few assets in your own currency, So
Speaker 1: at some point the growth in the Taiwanese lifers foreign
Speaker 1: currency portfolio will need to be proportionate to the growth
Speaker 1: in their assets. But there is no limit on the
Speaker 1: central banks ability to intervene and buy foreign currency other
Speaker 1: than perhaps the limits imposed by its trading partners. Even
Speaker 1: if there's no technical mathematical limit, and the size of
Speaker 1: the balance sheet can and can grow arbitrually large, could
Speaker 1: it be a situation in which this ceases to be
Speaker 1: appropriate monetary policy for the other non insurance needs of
Speaker 1: the domestic Taiwanese economy. And as such, even if theoretically
Speaker 1: they could continue to subsidize or prop up the lifers,
Speaker 1: this starts to create other imbalances or domestic problems. Yes,
Speaker 1: so supposed Taiwan's economy were to start to boom. Yeah,
Speaker 1: and suppose is the central bank wanted to raise interest rates.
Speaker 1: And suppose the US economy and the European economy we're
Speaker 1: in the doldrums, and so US interest rates were low.
Speaker 1: The balance sheet of the Taiwanese Central Bank is a
Speaker 1: mix of dollar and Euro assets on one hand, which
Speaker 1: have a certain yield and Taiwanese dollars currency which pay nothing,
Speaker 1: and Taiwanese dollar sterilization instruments. I think of it as
Speaker 1: central bank bills which pay a Taiwanese dollar interest rate.
Speaker 1: Once you have a really big balance sheet, the interest
Speaker 1: cost on your central bank bills become potential constraint. So
Speaker 1: part of the reason why Taiwan has been able to
Speaker 1: accumulate such a big balance sheet central bank has been
Speaker 1: able to accumulate such a big balance sheet is because
Speaker 1: Taiwanese dollar rates have been low. If Taiwanese dollar rates
Speaker 1: were to go up, it's not that you can't have
Speaker 1: this big balance sheet. Is that this big balance she
Speaker 1: starts to become much more costly. Yeah. The more you
Speaker 1: continue this, the more foreign currency you accumulate, the bigger
Speaker 1: your capital loss. And there's this big question about what
Speaker 1: doesn't mean if a central bank has negative equity but
Speaker 1: bigger The conceptually your capital loss is when the currency
Speaker 1: ultimately appreciates. So you can try to hold it down forever,
Speaker 1: but unless you can really do it forever, Eventually, when
Speaker 1: the currency does appreciate, you'll take a bigger Just on
Speaker 1: the global financial stability question, that that Joe Kind of
Speaker 1: alluded to. When people think about risks to the financial
Speaker 1: system right now, one of the things that you often hear,
Speaker 1: you know, whether it's from the i m F for
Speaker 1: the Bank for International Settlements, is the idea of excesses
Speaker 1: in corporate credit, that we might get a bunch of
Speaker 1: defaults or you might get a bunch of downgrades that
Speaker 1: cause about a forced selling. Could it be that instead
Speaker 1: of looking at credit risk, we should be considering effects
Speaker 1: risk based on the fact that one of our very
Speaker 1: very big buyers in this space might actually be quite
Speaker 1: effects sensitive. I think that's a very important point. The
Speaker 1: stress that leads to a fall off and demand from
Speaker 1: Taiwan or from any of the other Asian countries fall
Speaker 1: off and demand for the corporate for US corporate credit
Speaker 1: couldn't just be a sharp appreciation of their currencies, because
Speaker 1: that e roads the capital that has been used to
Speaker 1: take and support the open foreign currency positions behind the
Speaker 1: unhedged portion of this. The Taiwanese book, but also you know,
Speaker 1: the Japanese have an unhedged book. Korea maybe a little
Speaker 1: less so. But there's a range of investors who've been
Speaker 1: taking partially hedge bat on currency hedge batches on US
Speaker 1: corporate credit and therefore are potentially their capital could be
Speaker 1: eroded not by a a large losses on a US
Speaker 1: company that goes into default, but rather by foreign exchangements.
Speaker 1: Brad setser, that was just phenomenal. I was not big
Speaker 1: facetious earlier when I said I I had noticed myself
Speaker 1: stopped breathing. I was very excited to have this conversation,
Speaker 1: and it was like five times more exciting than I
Speaker 1: even appreciate it. If if this gets people interested in
Speaker 1: people are gonna be balance of payments, financial forensics, I'll
Speaker 1: be thrown fantastic work, really impressive you and your co
Speaker 1: author concentrated ambiguity. Thank you so much for coming on
Speaker 1: and really doing a phenomenal job of putting into UH.
Speaker 1: I'd say pretty relatively plain English. What is an extraordinary
Speaker 1: complicated subject. So great to have you back on the show. Thanks,
Speaker 1: Thank you, Brad well deserved fourth appearance on All thoughts, Joe.
Speaker 1: I really enjoyed that conversation, not least because it hit
Speaker 1: on a number of my favorite topics, you know, a
Speaker 1: cross currency, basis, swaps, and corporate credit. I love discussing,
Speaker 1: but also because I get to roll out random facts
Speaker 1: of knowledge such as, this is the reason why the
Speaker 1: world's fastest growing E t F market is actually in Taiwan,
Speaker 1: and no one would have expected that, but that's where
Speaker 1: it is for all the reasons we just discussed. Yeah,
Speaker 1: I I was not aware of that, So I learned
Speaker 1: something new from you just now. No. I love that
Speaker 1: episode two. I mean, you know, kind of like we
Speaker 1: were talking about it, or as I was mentioning in
Speaker 1: the beginning, this was like sort of a continuation of
Speaker 1: some themes we've been talking about lately on recent episodes,
Speaker 1: like with Michael Pettis and so forth. But I love
Speaker 1: the sort of taking from the macro to the qual
Speaker 1: something in between macro and micro because we can talk
Speaker 1: all the time about, oh, there's a lot of savers
Speaker 1: in various East Asian countries and that flows through to
Speaker 1: other economies and interesting ways. But I think actually really
Speaker 1: drilling down to a sort of hyper specific level about
Speaker 1: how the dollar or how a Taiwan East dollar that's
Speaker 1: earned by a family in Taiwan gets put into a
Speaker 1: life insurance company which has all these different things is
Speaker 1: just super interesting to work out. And the fact that
Speaker 1: there was a puzzle at the end of it made
Speaker 1: it even more interesting, right, And I think that's exactly
Speaker 1: that's exactly right. So that dollar kind of ends up
Speaker 1: flowing into a US asset, but then you have to
Speaker 1: talk about the feedback loop when it starts to go
Speaker 1: the other way. And the reason I was thinking about
Speaker 1: that is do you remember repo madness back in September
Speaker 1: and that actually started feeding into cross currency swaps um
Speaker 1: and so that you know, even something like that that
Speaker 1: seems completely unconnected to Taiwanese life insurers, if you listen
Speaker 1: to the discussion we just had, it actually could have
Speaker 1: an impact. No, absolutely, because I remember like we had
Speaker 1: that we had a Sultan Posar on this and we
Speaker 1: were talking to him prior to even the repo market
Speaker 1: going crazy, but he was well ahead of the curve.
Speaker 1: But I think it was on this exact subject because
Speaker 1: he was talking about the challenge of these Asian buyers
Speaker 1: of US denominated debt in the world in which US
Speaker 1: denominated debt doesn't yield very much, and of course that
Speaker 1: increases demand for direct holdings at the Central Bank, which
Speaker 1: is part of why there was a reserve shortage. So
Speaker 1: it's all connected. I think we're gonna have re Sultan
Speaker 1: back on the show at some point soon. So well,
Speaker 1: now we have to know I thought about that during
Speaker 1: this about how it was connected to that, and I'm
Speaker 1: glad you remembered to make that point here because I
Speaker 1: do think that's really interesting aspect here. All right, Well,
Speaker 1: a fantastic conversation. If you haven't read Brad Setzer's full series,
Speaker 1: you should definitely go on his blog and and look
Speaker 1: it up. And like we said at the beginning, it
Speaker 1: does read like a sort of financial markets who done it?
Speaker 1: It's very entertaining, absolutely must read. I think after having
Speaker 1: listened to this conversation, it'll make the reading you perhaps
Speaker 1: even more compelling because then you can sort you're gonna
Speaker 1: go back and read it. I'm going to read it again,
Speaker 1: cannot You can print it out, take it to the
Speaker 1: playground with you for for next time. That is my plan.
Speaker 1: This has been another episode of the Odd Lots Podcast.
Speaker 1: I'm Joe Wisn'tal. You can follow me on Twitter at
Speaker 1: the Stalwart and I'm Tracy Alloway. You can follow me
Speaker 1: on Twitter at Tracy Alloway. And you should definitely follow
Speaker 1: our guest on Twitter, Brad Setser at Brad Setser, and
Speaker 1: again go read his work. It's fantast a stick And
Speaker 1: be sure to follow our producer on Twitter, Laura Carlson.
Speaker 1: She's at Laura M. Carlson. We've just given her a
Speaker 1: very long episode to turn around in a short time,
Speaker 1: so she definitely deserves a follow, And follow all the
Speaker 1: Bloomberg podcasts on Twitter with our new handle at podcast.
Speaker 1: Thanks for listening.