Brad Setser is a senior fellow at the Council on Foreign Relations, and a former US Treasury official.
Sometime on May 2, a Taiwanese company probably came to the conclusion that it was time to sell a slug of its export proceeds. Like the proverbial butterfly, it caused a financial storm that we’re still not through.
Maybe the exporter, sitting on dollars from freshly sold semiconductor chips, worried that the US would put pressure on Taiwan to strengthen its currency as part of the coming negotiation over how Taiwan can avoid the 32 per cent “Liberation Day” tariff rate. Perhaps it saw reports that the US was prepared to unilaterally reduce tariffs on China, and figured that the risk of a depreciation of the Chinese yuan — which would pull down Taiwan’s currency — was reduced. Or maybe the dollar’s slide against the euro and the yen simply prompted a sense that the Taiwan’s dollar would join the rally. We just don’t know for sure.
But there is no doubt what happened next — or rather what didn’t happen next. Taiwan’s central bank didn’t immediately step into the market to buy dollars. That was a surprise. As JPMorgan has noted, the Taiwan dollar is “highly managed”, and “pronounced volatility is extremely rare”.
Once the Taiwan dollar started to appreciate, other private sector actors — additional exporters or Taiwanese financial institutions that had been holding dollars to collect a bit of extra interest income — joined in. The central bank did eventually enter the market: Jefferies told its clients that “the central bank was reportedly the only buyer of USD.” But a rumoured $3bn in purchases didn’t couldn’t quell the rise.
And it didn’t immediately enter the market with an unlimited bid for dollars the following Monday — though it eventually did put a ceiling on the Taiwan dollar’s appreciation towards the end of the trading day. The Taiwanese currency stabilised, but only after the largest one-day move in the Taiwan dollar ever, and an appreciation of around 9 per cent in the span of a few weeks.
Taiwan’s troubles
The scale of the move was a reminder that the apparent stability of the Taiwan dollar has long rested on a fragile equilibrium. After all, Taiwan’s dollar is structurally weak, and there all sorts of reasons why it should be stronger. A lot stronger.
The purchasing power parity value of the Taiwan dollar is way above its market value; and that is usually a pretty reliable sign of undervaluation. The Taiwan dollar is lower against the US dollar than it was 30 years ago, a surprising outcome given that Taiwan’s economy has moved to the upper rung of the world’s technological powers. And then there is a massive, sustained trade and current account surplus, now 14 per cent of GDP (or $120bn) — among the largest in the world, particularly if you exclude oil and other commodities-producing countries.
The equilibrium that supported a weak Taiwan dollar therefore required a sustained willingness from Taiwan’s companies — both exporters and financial companies — to buy dollars and euros and hold their funds abroad. Domestic interest rates are low, and there aren’t many local government bonds. Taiwanese exporters have at times been willing to pick up a bit of extra interest income by keeping their cash reserves in dollars. Taiwanese households also have been willing to hold dollar deposits and buy dollar-denominated insurance policies.
And most importantly, Taiwanese financial institutions — particularly the massive life insurance sector — have sought out foreign bonds to fund domestic, local-currency obligations. All these outflows hinged on an expectation of currency stability, which makes the extra income on dollars worth the FX risk.
It’s worth stepping back and thinking how unusual this situation is. Historically, for most emerging markets, the main danger to financial stability has come from a sudden fall in their own currency. Governments, banks and firms in emerging economies often borrowed in dollars or euros to avoid paying sky high local interest rates, so called “original sin”. A currency depreciation therefore created a balance sheet problem — the burden of paying dollar liabilities increased — and ultimately risked default and financial crisis.
Taiwan — and for that matter many other economies across Asia — now face the opposite risk. Local interest rates have been very low. Their financial institutions have been tempted to invest local savings in foreign assets to get higher returns. Thus a rise in the local currency and a fall in the dollar reduces the value of their assets relative to their liabilities and threatens their solvency.
This is, in other words, not the traditional emerging market problem of too much foreign debt and not enough income to support it. It is, in fact, the opposite: too many foreign assets and not enough willingness to hedge them.
Taiwan’s life insurers are of course a central part of this story. They didn’t cause the initial move in the Taiwan dollar. But they are enormously exposed to any large move in the Taiwan dollar. Over the last 15 years, with the complicity of their regulator, the insurers put a rising share of a growing portfolio into foreign bonds. The life insurance industry now has just over $1.1tn in total assets (and liabilities) and an insane two-thirds of those ($750bn) are invested in foreign bonds.
They have something like $300bn in foreign currency liabilities (domestic foreign currency policies) that reduces their hedging need, and they do hedge a bit in the onshore and offshore markets. But the insurer still run a massive open position. Earlier this year, Josh Younger and I estimated it to be around $200bn; others have put it at $250bn. That mismatch is 25 per cent of Taiwan’s GDP, and between 15 and 20 per cent of total assets.
The financial maths in the face of this kind of mismatch is brutal — a 5 per cent move in the Taiwan dollar costs the insurers $10bn or so, a 10 per cent move would constitute a $20bn hit, and so on.
Standard and Poor’s has estimated that the insurers foreign exchange risk ratio was 12-13 per cent in 2024, well above their pre-Covid exposure. (The risk ratio is insurer’s unhedged foreign exchange exposure to its total assets after taking into account the insurers foreign currency volatility reserve).
What’s more, the currency moves this year have likely already exhausted the roughly $9bn of reserves kept as a buffer against FX fluctuations. Further foreign exchange moves would cut into the insurers $80bn in reported capital. They are therefore now extremely exposed if the Taiwan dollar starts appreciating sharply again.
To make matters worse, the insurers weren’t in good shape even before the recent move in the dollar. The bulk of their bond holdings are long-term bonds (including callable bonds that now are unlikely to be called) bought before 2020 and that now are “underwater” — their market value is less than their face value. Indeed, a typical US bond held by a foreign investor saw its value fall by around 15 per cent between the end of 2021 and the end of 2023, as the Federal Reserve jacked up interest rates.
This should have triggered a bit of a crisis among the insurers, but they have long benefited from a generous regulator, which allowed most of those underwater bonds to be held in parts of the balance sheet that don’t have to be marked to market.
However, the combination of valuation and currency losses means that some insurers probably don’t really have any economic capital left (even if they still have regulatory capital).
And with large holdings of relatively low-yielding legacy bonds and high hedging costs (the cost of a hedge is the difference between short-term US dollar interest rates and Taiwanese dollar interest rates) they will have trouble earning their way out of their bond market losses if they ever had to hedge. If anything, a fully hedged foreign bond portfolio could result in negative income at this point.
It’s all a bit of a mess, really.
What cannot go on . . .
There’s a strong case that the Taiwan dollar still has the potential to move up in a big way. That’s what often happens if a currency has been held down for a really long time, and the gap between the Taiwan’s dollar’s current value and its strong fundamentals has become huge.
Given Taiwan’s massive current account surplus (and the fact that Taiwan will benefit from lower oil prices), the equilibrium condition for a stable Taiwan dollar is a willingness across local actors to add $120bn a year to their foreign portfolios. And they would be adding to a stock that is already huge — $1tn in “privately” held bonds (private is in quotes because around $100bn of that is already hedged with the central bank), $400bn in foreign equities, almost $600bn in foreign exchange reserves. All told, over 200 per cent of GDP has already been invested abroad.
The details of the massive flows that have kept the Taiwan dollar weak over time are interesting to review, as they help highlight why the flow equilibrium is now so fragile.
From 2010 to 2019, the bulk of the outflow came directly from the life insurers (“other financial corporations” in balance of payments speak), with a secret assist from the Taiwanese central bank.
But that has changed a bit in the last five years. In 2020 and 2021, with US interest rates stuck at zero during the pandemic and with a tighter regulatory regime, the life insurance outflow slowed for a while.
The Taiwan dollar did appreciate a bit as a result, but the central bank then started buying in scale to keep the Taiwan dollar from strengthening much beyond 28 Taiwanese dollar to the US dollar, and in the process added about 6 per cent of Taiwan’s GDP to its reserves.
That got the attention of the US Treasury. Taiwan was in 2021 subject to “enhanced engagement”. (a euphemism for “we’ve got our eyes on you sonny”).
In 2022, though, things changed.
The Federal Reserve started raising interest rates to counter a surge in US inflation, pulling the dollar up across the board. And more importantly, Russia’s invasion of Ukraine and rising cross-straights tensions led foreign investors in Taiwan’s stock market to sell a lot of Taiwanese stocks. Those outflows, ironically, made the central bank’s job easier.
In the past few years, higher dollar rates and regulatory loosening led to rising onshore deposits in foreign currency. That fuelled outflows through the banking system, as the banks’ purchases of foreign bonds rose to match those of the lifer insurers. And the central bank was further helped by FDI outflows linked to TSMC’s decision to start to build “fabs” outside of Taiwan (even though it is apparently more profitable for TSMC to keep building in Taiwan).
As a result, the Taiwanese dollar became unanchored from its fundamentals, and weakened to a nine-year low in March despite one of the world’s strongest trade balances.
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So what next?
Taiwan is therefore in a bit of a bind, and probably in more of a bind than most of its policymakers realise.
Despite the recent dash for FX hedges, the life insurance industry still has a massive open position. That position is arguably both too big to be hedged in the private market and too costly for the lifers to hedge in full without destroying their profitability.
Taiwan’s FX stability depends on the willingness of the central bank to keep buying dollars, and potentially on the durability of an accord between the insurers and their regulators not to even try to hedge their legacy position.
But without private outflows, the scale of the purchases needed from the central bank are enormous — there’s a $100bn or so gap, even if TSMC continues to invest $20bn a year abroad. And that is the gap even if Taiwanese investors bring back any of the funds they have invested overseas to try to get ahead of an appreciation of the Taiwan dollar.
The scale of the intervention that is now likely to be needed to preserve financial stability generates another problem. There’s no limit on the foreign reserves a central bank in an economy with high savings and low inflation can accumulate (viz, Singapore). But there is a limit to how much Taiwan can intervene without incurring the ire of the US generally, and the Trump administration specifically.
In the past, criticism of Taiwan’s economic policies were tempered by concern about its geopolitical vulnerability. But the core argument of the Trump administration is that America’s allies have taken advantage of the United States. They aren’t likely to ignore a return to large scale “manipulation”, as Trump’s trade adviser Peter Navarro has repeatedly called it. President Trump has himself argued that Taiwan “stole” the US chip industry with unfair trade practices.
Hence the dilemma. To save its insurance industry, Taiwan probably needs to intervene massively to keep its currency weak. To save its export industry from the threat of “reciprocal” tariffs, Taiwan likely need to step back from the foreign exchange market and let its currency appreciate.
Is there are a way out?
At the depths of the global financial crisis, former Treasury secretary Tim Geithner often liked to say that “plan beats no plan.” Taiwan is facing a crisis, and needs a plan. And the US needs to be a part of the solution as well.
The first part of such a plan is conceptually simple, though hard to execute. Taiwan’s central bank should open a facility to allow the life insurance industry to hedge with banks who know that they themselves can hedge with the central bank, and Taiwan’s previously feckless insurance regulator needs to force the insurers to hedge even if it eats into their profits. The insurers will then need suspend dividends and raise new capital at punitive rates. So what. The insurers are functionally bust already. The government may even need to proactively help recapitalise some of the weaker insurers.
Taiwan’s central bank wouldn’t necessarily need to sell its own portfolio to fund such a facility. The life insurers simply need a hedge that supplies them with Taiwan dollars in the event the Taiwan dollar appreciates, not actual dollars. The central bank could therefore offer swaps that settle in Taiwan dollar (a local currency version of an non-deliverable forward, if that makes sense) and protect against the financial loss on the life insurers’ dollar portfolio.
The Taiwanese central bank could supply the hedges at cost, or even at a subsidised rate. With nearly $600bn in foreign exchange reserves, the Central Bank of China (China’s central bank is called the People’s Bank of China) alone has the balance sheet needed to be the counterparty to the lifers hedging need.
And if there’s an actual need for dollar liquidity, the CBC would not necessarily need to sell its Treasury portfolio. The Fed now has a repurchase programme for foreign central banks that can post good collateral — the Foreign and International Monetary Authorities Repo Facility — that would allow Taiwan’s central bank to borrow dollar against its existing bond portfolio.
A hedging facility would allow the life insurers to survive a sustained appreciation of the Taiwan dollar that corrects the underlying structural undervaluation.
However, the US should also show a little flexibility and not insist that Taiwan stop all intervention in the foreign exchange market. Specifically, the US should show a bit of nuance around how it evaluates “currency manipulation” both in the formal foreign exchange report and more broadly.
The Treasury Department’s current criteria for designation as a manipulator are more or less mechanical. Any intervention in excess of 2 per cent of GDP in the presence of a large ongoing trade surplus is manipulation. No consideration is given for the path or trajectory of the exchange rate, at least not formally. That’s a problem, as countries typically have to intervene more not less when their currencies are appreciating. Specifically, appreciation through levels that the central bank has historically defended (for example, 28 for Taiwan) could trigger a wave of dollar selling/Taiwan dollar buying.
In other words, after years of a structural undervaluation, the Taiwan dollar could “melt up” if the central bank ever really stepped out of the market.
That kind of sudden disruptive move isn’t really in the broad interest of the US either. Yes, a stronger Taiwan dollar would make investment in the US chip industry more attractive, even in the absence of subsidies and tariffs. But the lags between a currency move, an investment decision and the actual production of chips are long; in the short-run the US would still need to import Taiwanese-made chips. A disorderly adjustment also could lead to the sale of US bonds by distressed Taiwanese life insurers and banks (likely in response to massive hedging costs) without any offsetting purchases by Taiwan’s central bank.
For all the talk about a “Mar-a-Lago” accord, the actual content of any Trump currency agreement has remained undefined. That could change if the US struck a deal with Taiwan that combined a commitment by Taiwan to force the lifers to hedge and not defend a specific level of the Taiwan dollar, an understanding that Taiwan could “smooth” the appreciation of the Taiwan dollar through intervention, and an understanding that the Federal Reserve is willing to provide dollar liquidity to the central bank against high quality collateral (via the FIMA facility)
That kind of deal would take a bit of finesse, and a bit of old fashioned currency diplomacy. It is plausible in part because the current Treasury secretary, Scott Bessent is a currency trader familiar with distressed market dynamics.
This story hasn’t ended. In my view, it is only beginning.