A Report on the Financial Services Sector

• Taiwanese Banks Gearing Up to Tap Chinese Market  - By Philip Liu
• Shifting the Rules on Offshore Sales - By Don Shapiro

• Investment-link Policies: Are they Insurance? - BY Don Shapiro

• “Offshore” versus “Overseas” Funds - By Don Shapiro

• Getting to Developed Market Status - By Don Shapiro

   

Taiwanese Banks Gearing Up to Tap Chinese Market

The proposed exchange of MOUs between Taipei and Beijing should open up new opportunities in the financial sector.

BY PHILIP LIU

With the two sides of the Taiwan Straits ready to open up financial markets on a mutual basis, Taiwanese banks are gearing up to tap the huge Chinese market and thereby break out of the confines of the limited business opportunities domestically.

During shareholders’ meetings this year, almost all the major domestic financial institutions unveiled Chinese market plans. Perhaps the most aggressive of these belongs to Chinatrust Financial Holding, the leading private-sector financial group. Charles L.F. Lo, its vice chairman, has explained that the company will embrace a triple-pronged strategy in tapping the Chinese market: establishing a subsidiary on the Mainland, upgrading its existing representative office in Beijing into a branch, and buying into Chinese banks. The subsidiary, mostly likely located in Shanghai or Beijing, will be the priority task, and will require at least 1 billion yuan in capital, according to Chinese regulations.

Chinatrust Financial envisions establishing a network of one subsidiary, six branches, and 42 offices in China within 10 years. The company initially will focus on corporate banking, later expanding into renminbi-denominated business and finally wealth management. A ranking Chinatrust official discloses that over the past three years, members of the company’s China team have visited at least 50 listed or municipal Chinese banks to explore opportunities to buy into their operations. The prime targets are banks that have not yet developed a credit-card business, a strong business sector for Chinatrust.

The company also plans to develop strategic partnerships with Chinese counterparts so as to facilitate its effort to penetrate the Chinese market. For that purpose, its shareholders’ meeting this year passed a resolution raising its registered capital to NT$150 billion (US$4.5 billion), up from the original NT$100 billion (US$3 billion). It also approved a plan to issue 250 million new shares via private placement, provisionally priced at NT$16.44 per share, to enable it to raise some NT$40 billion (US$1.2 billion) in fresh funds.

Lo laments the government restrictions that prevented Chinatrust from accepting offers to buy into some Chinese banks a decade ago. “Foreign banks which bought into Chinese banks or subscribed to their initial public offering have reaped huge profits, to the tune of tens or even hundreds of billions of NT dollars,” says Lo.

Fubon Financial Holding, for its part, aims to accelerate the pace of its penetration of the Chinese market, capitalizing on the head start already achieved. The company plans to convert its stake in Xiamen Commercial Bank to direct ownership, rather than holding it indirectly through Fubon Bank (Hong Kong), to facilitate funding of the expansion of its Chinese operation. Fubon Financial has over NT$2 trillion (US$60.6 billion) in assets, compared with the NT$278.3 billion (US$8.4 billion) of Fubon Bank (Hong Kong), in which it has a 75% stake. Although Fubon owns only 20% of the shares in Xiamen Commercial Bank, it is heavily involved in the institution’s management, including the right to appoint its president, reflecting Fubon’s excellent rapport with the local government.

Moreover, Fubon Financial president Victor Kung reports that Taipei Fubon Bank, the company’s banking subsidiary, plans to set up a subsidiary in Shanghai, extending its reach into the Yangtze River Triangle, thereby completing its deployment in the Chinese market.

Another major player, Cathay United Bank, will benefit from the progress of its affiliated Cathay Life Insurance in establishing an extensive business network in China. Consisting of a headquarters and six branches, that network has been formed through a joint venture with China Eastern Airlines. As a first step, the bank plans to upgrade its representative office in Shanghai into a branch.

State-owned Mega Financial Holding also harbors an aggressive plan for the Chinese market. Chairman Wang Rong-jou notes that Mega Bank, its flagship operation, plans to set up offices in four regions – the Zhu River Triangle, Yangtze River Triangle, the West Coast of the Taiwan Strait, and the Bohai coastal area (Tianjin) – all areas in which numerous Taiwanese-invested firms are clustered. The bank has just obtained approval from the Chinese regulator to set up a rep office in Suzhou in Jiangsu Province as a prelude to creating a comprehensive network in China. Mega Financial president Shiu Kuang-si says that network will eventually include branches, a subsidiary, and stakes in Chinese banks. 

The scramble among Taiwanese financial institutions to position themselves in the Chinese market has been triggered by the thaw in cross-Strait relations since the inauguration of President Ma Ying-jeou in May 2008. Ma has liberalized economic policies towards China in the hope of helping domestic enterprises open up new business opportunities.

Taiwanese banks view development of the Chinese market as an answer to the problem caused by the exodus of many of their business clients to the Mainland. As domestic demand for loans has shriveled, domestic banks have seen their interest spread narrow to 1.1 percentage points, only half the level in China. By setting up offices in China, Taiwanese banks would be able to serve their customer base among the many Taiwanese-invested enterprises there.

To facilitate the mutual opening up of the financial markets, Taiwan’s Financial Supervisory Commission (FSC) is now engaged in talks with its Chinese counterparts – namely the China Banking Regulatory Commission, China Insurance Regulatory Commission, and China Securities Regulatory Commission – for the signing of memorandums of understanding (MOUs) for cross-Strait cooperation in financial supervision. After protracted negotiation, both sides have already ironed out their differences over the substantive details, leaving only some semantic problems to be worked out, Minister Lai Shin-yuan of the Mainland Affairs Council told the Central News Agency on September 17. The MOUs, three separate documents covering banking, insurance, and securities/futures respectively, are expected to be signed by the end of the year. They will provide a mechanism for information exchange, the assurance of information confidentiality, the examination of financial institutions, and sustained cooperation.

With the inking of the MOUs, seven Taiwanese banks – Cathay United, Chang Hwa, Chinatrust, First Commercial, Hua Nan, Land Bank of Taiwan, and Taiwan Cooperative Bank – will immediately be able to upgrade their existing rep offices in China to branches. The move is also expected to help the Bank of Taiwan and E. Sun Bank obtain Chinese regulatory approval on their longstanding applications to establish representative offices.

In addition, the MOUs will enable domestic securities firms to enter the Chinese market, mostly likely in cooperation with Chinese counterparts. Since the Chinese companies in this field are still quite young, they hope to benefit from the expertise and experience of the Taiwanese firms. Another aspect of the MOU will be to pave the way for the stock exchanges on the two sides to establish cooperative links, for example enabling the mutual listing of ETFs (exchange traded funds).

Existing insurance operations

For Taiwan’s insurance industry, the MOU is considered less important, as they are already allowed to enter the Chinese market, though only through joint ventures with Chinese partners. To date, three Taiwanese insurance firms – Cathay Life, Shin Kong Life, and Taiwan Life – have set up such operations.

With regard to investment in the other direction, the banking MOU will allow Chinese banks to set up branches in Taiwan or buy into Taiwanese banks. Moreover, it will flash the green light for China’s 10 QDIIs (qualified domestic institutional investors) to each invest up to 10% of book value in the Taiwanese market, a move expected to bring some US$900 million into the domestic bourse.

Additionally, the MOU may facilitate other forms of cross-Strait financial cooperation, such as establishment of a cross-Strait currency clearance mechanism. In a meeting with visiting Taiwanese legislators in September, Liu Minkang, chairman of the China Banking Regulatory Commission, noted that after the MOU is signed, foreign banks’ share of the cross-Strait remittance market may drop to 10%, down from the current 32% now, yielding the 22% share to Taiwanese and Chinese banks. Another type of post-MOU banking cooperation could be the provision of guarantees by Taiwanese banks on loans extended to Taiwanese-invested enterprises in China by Chinese banks.

Even before the MOU signing, financial executives from both sides have been shuttling across the Strait to look for investment and cooperation opportunities. Taiwanese banking executives have been searching for prospective Chinese partners, including major state banks, listed banking companies limited by shares, and municipal banks. For their part, Chinese banking executives, notably those from state banks and listed banking companies, have been carrying out frequent studies of the Taiwan market with an eye to eventually setting up branches or forming partnerships with local counterparts. Most Chinese banks have been especially interested in corporate banking in Taiwan, particularly to serve Taiwanese clients in China (Tai-shang), and in financing associated with cross-Strait trade; they regard the consumer banking field as too saturated in Taiwan. 

The state-owned Bank of China (BOC) is perhaps the Chinese bank with the most aggressive plan for the Taiwanese market. In an interview with the Chinese-language Economic Daily News during his visit to Taiwan in September, BOC president Li Lihui said the bank intends to set up a Taiwanese branch as soon as possible, mainly to establish linkages with the parent companies of their Taiwanese clients in China. Li noted that such linkages will greatly facilitate its business with the Tai-shang, 80% of which are already its clients. Li urged Taiwanese banks to redouble their effort in tapping the huge Chinese banking market. Chinese banks took in total profits of 580 billion yuan (US$84.8 billion) in 2008, he said, and if Taiwanese banks can garner just a 1% market share they can earn profits of 5.8 billion yuan (US$879 million).

Following the MOU, however, Taiwanese financial institutions will still face formidable barriers in their effort to pry open the Chinese market. A major reason is the existence of tight restrictions on the operations of foreign financial institutions in the Chinese market. Those restrictions have remained in place because China entered the World Trade Organization (WTO) as a developing economy, unlike Taiwan’s developed-economy status in the WTO.

As a result, Taiwanese banks, for instance, will have to set up rep offices first and then wait two years before being allowed to upgrade them into branches. In addition, Taiwanese banking branches initially will only be able to engage in foreign currency-denominated business, undertaking renminbi-denominated business only after operating for three years and registering profits for two consecutive years. Chinese banks, on the other hand, will be able to set up branches and undertake NT dollar-denominated business in Taiwan immediately.

Taiwanese insurance firms will also have to set up rep offices first and wait two years before upgrading them to branches, plus they will also have to meet the additional conditions of having over US$5 billion of capital and 30 years of business history. Otherwise, they can only set up joint ventures with Chinese partners, for which their stakes are capped at 50%. These restrictions will limit Taiwanese firms’ ability to take advantage of the huge potential for growth in the Chinese market brought about by the current low levels of density and penetration for insurance services, as well as the fast-rising income of the people. Although total premium income in China has been growing at an annual clip of 30% in recent years, it still amounted to only 2.85% o GDP last year, compared with Taiwan’s 15.7%.

Taiwanese securities firms, like other foreign firms, will also be subject to various operational restrictions, such as the ban on engaging in such business lines as brokerage for A shares, dealing in A and B shares, and wealth management.

In a meeting in July with a Taiwanese delegation organized by National Taiwan University’s Center for the Study of Banking and Finance, Xu Mang, director of the economic bureau of the State Council’s Taiwan Affairs Office, said that China’s basic stance is to provide preferential treatment to Taiwanese financial firms. But in doing so, he added, China must be watchful not to contravene its WTO obligations. 

Xu said that such preferential treatment might be best arranged under the auspices of special financial zones, such as Tianjin’s new coastal economic zone, the Shanghai financial center, or the West-Taiwan Strait coastal economic zone (Fujian).

This preferential treatment for Taiwanese financial firms is expected to be a highlight of the Economic Cooperation Framework Agreement (ECFA), similar to a free trade agreement, which the two sides are scheduled to begin negotiations on next year.

Whatever special treatment they may get, for their long-term development Taiwanese banks and other financial institutions will need to look beyond simply serving the Taishang and compete in the domestic Chinese market, capitalizing on their more advanced technology and services compared with their Chinese counterparts. “Imagine what would happen if more than 10 banks offer same product and embrace the same strategy for the same clients (Taiwanese businesses) at the same place (such as Shanghai),” says McKinney Y.T. Tsai, president and CEO of SinoPac Holdings, in an interview in June with the Economic Daily News, adding that “it will turn an oasis into a desert in no time.”

Shifting the Rules on Offshore Sales

Investment providers are hoping for clarification of what role, if any, offshore

personnel can play in serving Taiwan clients.

BY DON SHAPIRO

When the Securities and Futures Bureau (SFB) of Taiwan’s Financial Supervisory Commission early this year slapped sanctions on employees of the Hong Kong head office of the Goldman Sachs branch in Taiwan, ordering them to be fired for selling investment products in Taiwan two years ago without a license, the immediate impact was negligible. The two staff members, who happened to be Taiwanese nationals, had already left the company’s employ, rendering the penalty moot.

But now, months afterward, the SFB move is still causing ripples in the investment banking and investor communities. Longstanding assumptions about permissible behavior in dealing with Taiwanese customers have been called into question, as have previous understandings of the boundaries of the Taiwan regulators’ jurisdiction.

The specific case in question involves the 2007 sale to Chunghwa Telecom (CHT) of a series of offshore hedging products known as NDFs (Non-Deliverable Forwards). When the NT dollar then abruptly appreciated, CHT found itself with a massive paper loss on the investment. Although the formerly state-owned company had already been privatized, the government is still the largest investor, and the deal-gone-bad aroused the ire of legislators, spurred internal investigations within the corporation, and even caused prosecutors to look into the matter.   

Later movement in the forex market in the other direction shrank the losses to less alarming levels, but still the SFB chose to crack down on the employees of the offshore vendor of the NDFs on the grounds that they had entered Taiwan to conclude the sale, without a license, of an unauthorized product. Some observers have speculated that the SFB’s reaction was influenced by other events going on at about the same time that raised suspicions about foreign investment bankers: the collapse of Lehman Brothers, the whole structured note meltdown, and the role of some offshore private bankers in ex-President Chen Shui-bian’s alleged money laundering.

But the issue has not died down. On September 1 the regulator took further action by issuing a public statement warning offshore providers not to engage in unauthorized marketing activity – prompting possibly hyperbolic media headlines such as “Taiwan threatens jail terms for unlicensed offshore funds.” The SFB also warned local investors not to invest with unlicensed providers, and the web sites of the various industry associations posted lists of approved offshore products and providers. 

The controversy has raised concerns on a variety of levels. To begin with, industry observers see the handling of the sanctions of the Goldman Sachs employees as a disturbing example of changing the rules in mid-game – what in American sports parlance is referred to as “moving the goalposts.” In the past, the law had been viewed as giving the regulator authority only over domestic securities houses or the Taiwan branches of foreign securities houses. Violations of the law by other parties were seen as falling only under the purview of the prosecutors and the courts. But in sanctioning the Goldman Sachs employees, the SFB appeared to be broadening its jurisdiction to cover the head offices and offshore sister branches of the Taiwan operations of foreign companies.

That reinterpretation is troubling, says Thomas McGowan, a Taipei-based legal consultant who specializes in financial law. “While the criminal justice system has very clear standards about process, evidence, and transparency, in the regulatory world there is no defined due process and no real burden of proof. The regulatory authority is judge, jury, and executioner. It can decide something is not legal but doesn’t have to articulate the specific facts and reasons why.”

Another example that has been cited of shifting goalposts was the SFB’s intimation that unlicensed offshore personnel are barred not just from selling products in Taiwan – as was previously regarded as being the case – but even from various acts that may facilitate such sales. That suggestion has raised many unanswered questions as to just where the line is being drawn in terms of allowable behavior. “If I’m an offshore relationship manager sitting in Hong Kong, is it okay for me to pick up the phone and talk to my customer in Taipei?” asks McGowan. “Is it okay to send an email? May I fly to Taiwan, meet my client and chat with him about the market? May I hand him a brochure? A proposal? The industry is uneasy because right now they don’t know when they will be crossing the line.”

In hopes of receiving some clarification from the regulator on such points, Taiwan Business TOPICS has submitted several questions to the SFB. Although the Bureau has indicated its willingness to reply, it could not provide its response before this issue of the magazine went to press. As a result, a follow-up report will appear in the October TOPICS.

In the meantime, the current uncertainty presents a problem for Taiwanese investors as well as for the offshore providers. High net-worth private individuals and large corporations such as insurance companies are investing heavily overseas, and they want the benefit of market information and advice from the experts found in such places as Hong Kong and Singapore.

“Perhaps the answer is to train up local people to that level of expertise,” suggests a foreign banker in Taipei, who asked not to be identified by name because of corporate restrictions. That could well be a popular idea among banks that already have a presence in Taiwan. But besides the length of time it would take, the notion is criticized as creating an oligopoly of favored institutions, freezing the remaining providers out of the market.

Currently the Joint Banking Committee of AmCham and the European Chamber (ECCT) is considering how best to raise its concerns to the authorities, and what to recommend as a potential solution. One possibility is to ask the regulator to give greater latitude to the offshore investment providers in dealing with sophisticated investors such as financial institutions, large corporations, and wealthy individuals, while strictly prohibiting any contact with the general public. The regulatory regime for mutual funds already contains such a mechanism, known as a “private placement safe harbor.”

Both investment providers and professional investors doubt the logic of implementing different sets of rules for investment offshore in mutual funds and in structured products.

Investment-link Policies: Are they Insurance?

A recommendation that these products be subject to taxation has brought rejoinders from the life insurance industry.

BY DON SHAPIRO

In the wake of the recent recommendation by the government’s advisory Tax Reform Committee (TRC) that investment-link life insurance products should be made subject to taxation, the AmCham Insurance Committee and other insurance industry organizations are preparing to make a case to two different audiences.

To the Executive Yuan, industry representatives will emphasize that investment-link products – insurance policies that combine the functions of investment and protection – are a legitimate form of life insurance that should continue to receive the tax-exempt status long accorded to life insurance under Taiwan law. At the same time, the industry wishes to communicate to the public that regardless of tax status, investment-link insurance policies represent a highly attractive option for many insurance buyers.  

The 20-member TRC, consisting of both government officials and academic experts, was established in June last year shortly after the Ma Ying-jeou government took office. Its purpose was to recommend revisions in tax laws and regulations in the interest of creating greater fairness in the tax system.

To the TRC, investment-link products look too much like other forms of investment rather than insurance, and therefore should be taxed like other investment vehicles. When policyholders buy investment-link insurance, they are able to choose from among a broad portfolio of mutual funds offered through their insurer, with the earnings from those funds used to build up cash value to fund death-benefit cost and for eventual retirement. Their holdings are maintained in their own individual accounts, causing some critics to observe that maintaining such separate accounts is contrary to the basic insurance principle of pooling risk (the industry view on that is cited below). 

The TRC position on taxing these policies has had the support of the Ministry of Finance, but not of the Financial Supervisory Commission (FSC) and its Insurance Bureau, which presumably should be the proper authority to define what constitutes insurance and what does not. The Bureau has indicated that if investment-link products have been overly weighted toward investment, the problem can be solved by the regulator by further adjusting what are called the “corridor” rules. Those regulations ensure a sufficient amount of insurance coverage in the policy by stipulating the minimum proportion of the fund, varying according to age group, that must be earmarked for death benefits.   

Given the differing opinions even within government, the issue will come to the Executive Yuan for decision when it takes up the TRC’s complete set of recommendations. It is also possible that the Legislative Yuan will eventually play a role, since existing law grants tax-free status to insurance policies as a matter of public policy – encouraging citizens to prepare for their old age so they don’t become a burden on society. Lawmakers could be expected to insist that any deviation from that position be by legislative action instead of merely an administrative interpretation. 

Although investment-link products have been a more important part of the business model for the foreign insurers in Taiwan than for their domestic competitors, the AmCham Insurance Committee stance has been shared not only by the European Chamber’s Insurance Committee but also by the Life Insurance Association of the Republic of China.

In responding to arguments that investment-link products should not be treated as insurance, industry representatives point to what they regard as several misconception on the part of the TRC. “Once consumers decide that they need insurance to protect their family and plan for retirement, the next question is how to pay for it,” notes Lee Wood, co-chair of the AmCham Insurance Committee. “Investment-link policies are just another way to finance your insurance.”

In addition, the fact that the investment funds are held in separate accounts actually contributes to reducing the policyholder’s risk. “When you take out a traditional life insurance policy, you’re trusting that the insurance company will still be there in 40 or 50 years to honor its obligation,” says Wood. In the event that the company fails, the separate investment account protects the policyholder’s money against the claims of the insurance companies’ creditors. The recent government takeover of troubled Kuo Hua Life was a reminder that such a situation is not beyond the realm of possibility. Six other Taiwanese insurers had risk-based capital below the required 200% minimum at the end of 2008.

Finally, Wood notes that some critics of investment-link policies regard them merely as the equivalent of term insurance plus mutual funds. But that is an over-simplification that does not bear out in reality, he says. To obtain the benefits of the investment-link products, consumers who buy insurance and mutual funds separately would have to calculate of the value of their funds monthly and then adjust the amount of insurance they carry accordingly. “That’s even assuming you don’t fall ill and find you can’t buy additional insurance,” says Wood. “It’s not a real-world scenario.”

What does risk-sharing mean?

As to the question of whether the separate accounts contravene the spirit of insurance of sharing the risk, the insurers reply that risk-sharing should be looked at in terms of the mortality risk, not the investment risk made to finance the policy. “In fact, most prudent investment advisers recommend that you diversify your risk to the extent of holding policies with multiple companies,” says Wood. “By the same token, you wouldn’t put all your investments in one stock.”

The industry is also stressing to the public that even if the TRC recommendation is adopted and taxes are imposed, investment-link products still offer numerous advantages. Besides the already mentioned protection against insurer insolvency, a key advantage is the opportunity to earn a far better return than the 1.5% annual gain currently available on traditional policies from the insurance companies, which are typically investing in 10-year bonds.

“For the more aggressive policyholder, you have the hope of earning more from your investment – perhaps 4%,” says C.Y. Huang, a lawyer with Tsar & Tsai who serves as a consultant to the AmCham Insurance Committee. Policyholders also have the flexibility of moving their money around, without incurring extra fees, among the various funds in the insurer’s portfolio. 

For the foreign insurance companies, a decline in their investment-link business – if large numbers of customers are deterred by a change, or even the possibility of change, in the tax rules – could be a significant blow. And that would come on top of another massive challenge being posed by what is called the “negative spread” – investment returns that because of the extremely low interest rate environment are too low to support the guarantees previously given to customers (see the TOPICS report in the April 2009 issue).

The problem has already led to the departure from the Taiwan market of three foreign life insurers within the past year – ING Life, Prudential U.K., and Aegon. In each case, their Taiwan operations were sold to domestic companies, passing the challenge on to local enterprises who either may be prepared to exercise patience until interest rates start rising again or else expect that the Taiwan government will offer the industry some relief.

Not coincidentally, the three companies to exit the market were all European in origin. In their consolidated balance sheets with their parent companies, they are required to use the International Financial Reporting Standards (IFRS) in place in Europe, stipulating that assets and liabilities be marked to current market conditions and reflect the full cost of future policy guarantees. The cost of policy guarantees increases significantly when interest rates fall. Taiwan’s accounting rules do not recognize this fact and permit companies to continue keeping their books based on the original investing assumptions made when interest rates were high; the result is to camouflage the gap between the value of assets and of liabilities adequate enough to pay future policy guarantees. As IFRS standards are gradually being adopted by in more and more of the world, eventually to include Taiwan, the problem can be expected to intensify.

Besides ING, the other comparatively large foreign investor in the insurance market, the American International Group (AIG), is also looking to sell its local unit, Nan Shan Life – but in this case the main reason is the battering that AIG took in last year’s financial crisis. According to local media reports, two domestic groups – Chinatrust Financial and a consortium led by Primus Financial – remain in contention in the bidding for Nan Shan, but the process has been complicated by disputes between AIG and Nan Shan employees over pension rights.         

“Offshore” versus “Overseas” Funds

The prospect of differentiated tax treatment between two similar kinds of mutual funds threatens to distort the market.

BY DON SHAPIRO

The insurance industry (see the story above) is not the only segment of Taiwan’s financial services business that is currently facing a serious challenge due to prospective changes in tax policy. AmCham’s Asset Management Committee is greatly concerned about the potential impact on the Offshore Funds business if capital income and redemption earnings from investments in those funds are regarded as “overseas income” for purposes of calculating Alternative Minimum Tax (AMT). From January 1 next year, overseas income is scheduled to be counted in AMT assessments for the first time.

Executives at Offshore Fund companies say they were taken by surprise when the Ministry of Finance disclosed this summer that investors’ capital income and redemption earnings from those funds would be considered as overseas income – while equivalent earnings from another category of mutual funds known as Overseas SITE Funds would not. Until that time, government policy had consistently been to treat the two types of funds equally from a tax standpoint.

As shown in the accompanying chart, the characteristics of the two types of business are virtually identical. They share the same regulator (Financial Supervisory Commission), transaction location (ROC), sales model (public offerings), investment vehicle, beneficial owner, treatment of dividends and interest, and the investment objective of investing in overseas securities. Even the terminology used in naming the two categories – one “Overseas” and the other “Offshore” – is so close as to confuse anyone other than an industry professional.

The only major difference between the two types of mutual funds is the kind of company serving as the issuer: domestic Securities Investment Trust Enterprises (SITEs) in one case and Offshore Fund institutions in the other. But the Offshore Fund companies bristle at the suggestion that they are merely “foreign” operations when they operate through local subsidiaries that are subject to Taiwan regulation and when investors purchase the Offshore Funds through local distributors rather than transact with the Offshore Fund Institution directly.

The major players among the Offshore Fund issuers are such prominent U.S.-based companies as AllianceBernstein, BlackRock, FIL (Fidelity), and Franklin Templeton. The combined market share for those four is put at well over half of the industry’s estimated US$46 billion in assets under management in this market.

When the Legislative Yuan amended the Income Basic Tax Law to create the AMT system, the intention was described as social fairness – preventing the super-rich from parking the bulk of their assets overseas, out of the reach of the Taiwan tax collector. But in practice, considering that Taiwan lacks tax treaties with most other countries, the local authorities have little ability to track down the location of offshore assets. Because they are doing business in Taiwan and their operations are transparent, the Offshore Fund Institutions suspect that their funds have become a convenient target, enabling the tax authorities to point to at least some yield from the new system.   

The Offshore Fund companies also note that the preponderance of their customers are middle-class individuals looking for ways to diversify their personal investment opportunities, not the “fat cats” that lawmakers had in mind in enacting the AMT legislation.

In response, government officials argue that the thresholds for imposing the tax are sufficiently high that the vast majority of investors would not in fact experience any increase in their income tax bill. According to the new law, taxpayers will be required to include overseas income on their return only if the total amount of such income in a given tax year exceeds NT$1 million (about US$28,000). And only if total income surpasses NT$6 million would they be subject to the AMT tax rate of 20%.

But asset management industry executives note that Taiwan individual investors are not always making their decisions based on complete and accurate information. The mere suggestion that Offshore Funds investments will be taxable is already causing many investors to prepare to sell off their holdings in these funds before the end of the year.

To the industry, the situation is uncomfortably reminiscent of what occurred two years ago in Korea, when the tax authority began to differentiate between mutual funds domiciled in Korea and those domiciled offshore. After a 15-20% capital gains tax was imposed only on the offshore funds, those funds lost close to 90% of their assets within two years. “This created quite a disaster for the Korean offshore fund business,” says a Taiwan-based executive familiar with the situation there. “Now the regulator has recognized that this policy was a mistake, and they plan to change back to treating the two types of funds on an equal footing. I hope Taiwan can still avoid repeating the same mistake.”

The negative impact in Taiwan could actually be greater than in Korea, the executive said. Whereas in Korea most of the money removed from the offshore-domiciled funds stayed in Korea, but were simply transferred to domestically domiciled, in Taiwan a large share of the total is likely to be shifted to Hong Kong, just an hour away by air.

At a time when the government is taking action aimed at attracting back substantial amounts of Taiwanese capital kept overseas – as seen in the recent slashing of the estate and gift tax rates from 50% to 10% – the proposed new approach to taxing mutual funds would have just the opposite effect, setting back Taiwan’s efforts to establish itself as a regional asset management center.

“It would drive the business to Hong Kong and Singapore,” said the fund executive. “The biggest beneficiary would be offshore private banks.” In fact, there is already talk in the industry that if the proposed changes go through as planned, foreign financial institutions will be reducing their employee headcount in Taiwan while building it up in Hong Kong and Singapore to serve the Taiwanese market.     

Getting to Developed Market Status

What does Taiwan need to do to qualify for FTSE and MSCI upgrading, and why is it worth the effort?

By Don Shapiro

For several years Taiwan has been seeking an upgrading of its country classification from emerging to developed market by the major international indexes, FTSE and MSCI. Such an upgrade was viewed as a matter of prestige as well as recognition of the steps already taken by regulators and the stock exchange to improve conditions for investors.

But in their most recent classification reviews (in mid-September for FTSE and in June for MSCI), the two indexes once again deferred the decision to change Taiwan’s status. While acknowledging that some positive reform measures had recently been adopted, they also noted continued areas of deficiency.

At the same time, some financial commentators in Taiwan have raised questions about the desirability of in fact moving up to developed market status, asking whether it isn’t preferable to be a big fish in a small pond rather than the other way around. In the developed market category, Taiwan would need to compete for attention against the world’s strongest and most important economies. Its share of the index would be a fraction of the proportion it enjoys as an emerging market.

To help put the situation in perspective, AmCham’s Capital Markets Committee this month invited Jimin Kao, general manager of Merrill Lynch in Taiwan, to give a presentation on Taiwan’s pursuit of developed market status. His conclusion: Taiwan is already on a “road of no return” and basically has no choice but to step up efforts to burnish its qualifications for receiving country-classification upgrading.

There is no turning back, said Kao, because Taiwan no longer has the attribute of rapid annual growth that investors expect from an emerging market – the kind of high single-digit growth that markets such as China and India are providing. “Taiwan will need to reinvent itself” to contend in a different arena, he noted, even if that means competing with 700-pound gorillas.

Beyond the lower GDP growth, he added, Taiwan’s economy already resembles that of a developed market in other ways. In terms of market size, for example, Taiwan takes 26th place in the International Monetary Fund’s ranking of economies by nominal GDP. The market cap of the Taiwan Stock Exchange is the 21st largest in the world, and it offers high liquidity, with turnover rates consistently exceeding those of Singapore and Hong Kong (both rated as developed markets by FTSE and MSCI).

Kao also pointed out the advantages brought by the much larger scale of the developed market indexes. Funds tracking the MSCI developed market index, for example, are worth some US$3 trillion, three times the level for the MSCI emerging market index. So even given the lower weighting Taiwan could expect as a developed market, the bigger pie would likely bring a larger flow of investment.

There is also the more intangible benefit of the higher visibility that comes with entrance into the developed market. But like playing in the major leagues in baseball, more is expected of you at that level. Competing there means relying on “innovation, efficiency, transparency, and corporate governance” to attract investment.

Substantial improvement

In fact, Taiwan has come a long way in improving its securities investment environment for institutional investors over the past few years. Among the changes Kao cited were the introduction of securities borrowing and lending (SBL) and short-selling, the lowering of the gift and estate taxes to attract more funds back to Taiwan, and the liberalization of regulations on China holdings. Another significant development, specifically cited by MSCI in its Taiwan review, was the adoption of a T+2 delivery versus payment (DVP) settlement cycle to reduce settlement risk.

But a number of further steps are still seen as needed to meet FTSE and MSCI criteria, including:

• Further relaxing of foreign exchange controls. Kao gave the example of the mandatory conversion of cumulative realized gains whenever the amount reaches NT$300 million (about US$9 million). Taiwan’s Central Bank has been extremely cautious about any loosening of foreign exchange regulations.
• Permitting off-exchange trading, which would make it easier for fund managers to meet their targets in a market still dominated by small investors.
• Removing the pre-funding requirement for warning stocks.
• Further liberalizing short-selling.
• Extending the T+2 settlement deadline from 10 a.m. to 3 p.m.

Kao also offered some broader suggestions for enhancing the development of Taiwan’s capital markets. In particular, he urged a change in mindset by the regulators away from piecemeal approaches and micromanaging. The regulators’ usual approach, he said, is to make incremental revisions in regulations – taking a “baby step” and then returning to review the results after six months before considering another step. That is “not the way to compete in a fast-paced capital market” where it is necessary to be quick and nimble, he emphasized. While deregulation entails risks, the “burden should rest upon the governance, not the government.”  

Another suggestion for regulators was to follow international practices rather than placing uncommon compliance burdens on the industry. He offered a rule of thumb: “if the proposed rules/regulations can make them among the strictest in the world, then it is better to think twice.” AmCham’s annual Taiwan White Paper, Kao said, is an excellent reference to international best practices.

In addition, he urged regulators to stress investor education rather than resort to excessive investor protection, as has been the tendency since the financial crisis. And he expressed the hope that Taiwan would take full advantage of the stabilized cross-Strait relationship to further cultivate industrial and capital-market ties with China.

Since FTSE and MSCI rely heavily in their evaluations on feedback from institutional investors, effective communication of Taiwan’s story is important, Kao noted. He said that road shows and joint conferences with foreign brokers by the exchanges and regulators have proved to be quite useful, and he suggested that Central Bank representatives join those programs in future to help answer the inevitable questions about foreign exchange regulations.