Tightening cycle begins

Taiwan’s central bank raised the benchmark discount rate by 25bps to 1.375% at yesterday’s meeting. This is the first hike since the economy recovered from the Covid-19 disruptions. And it has reversed the one-off 25bps cut delivered in March 2020 after the Covid outbreak. The timing of this move came slightly earlier than expected but was not surprising.

As said by the central bank in the policy statement, the rate hike decision was aimed to curb public inflation expectations and maintain consumer prices stability. Due to the surge in global energy prices, inflation pressure is stronger than expected in Taiwan. Headline CPI has risen above 2% YoY and stayed there for seven consecutive months as of February. Core CPI remains tame at the mid-1% level for the time being. But the passthrough effect from higher oil prices is likely to become more pronounced in the coming months, in the context of tighter labor market conditions and rising demand for wage increases.

Meanwhile, economic recovery has become more robust, which provides confidence for the central bank to tighten. Unemployment rate has fallen back to the pre-pandemic level of 3.7% sa in January. Private consumption also looks set to return to the pre-pandemic level in 1H. Some of the Covid-hit services sectors (e.g., transportation, tourism, food catering) have not fully normalised. But the prospect of a broader, across-industry recovery is likely to continue to improve, as the authorities further ease the social distancing rules and border control measures on the back of a higher domestic vaccination rate.

Furthermore, the US Fed has kickstarted its tightening cycle this week, which also paves the way for more EM central banks to follow. Our global team now forecasts the Fed to hike a total of 175bps in 2022 and 100bps in 2023, taking the Fed Funds Rate to 3%.

As Taiwan’s central bank has formally started to tighten, the key questions are now shifting to the pace and duration of future rate hikes, as well as the level of neutral rate.

Pace of hikes: We expect the central bank to hike rates at a modest pace of 12.5bps per quarter after the one-off 25bps move yesterday. Taiwan’s central bank adopted a careful and calibrated approach in the past normalisation cycles, hiking rates by 12.5bps per quarter in both the 2004-2008 and 2010-2011 tightening periods. A bolder move of 25bps happened only two times – in September 2004 when the economy entered a strong V-shaped recovery after the end of SARS, and in June 2007 when capital outflow pressure intensified due to the persistent widening of a negative rate gap with the US.

Duration of hikes: We think the current rate hike cycle will last for at least one year into 1H 2023. Each of Taiwan’s past tightening cycles was comprised of consecutive moves at each quarterly meeting. Before the 2008 global financial crisis, the central bank tightened four years from September 2004 to June 2008. After the GFC, growth was relatively weak due to a fragile global economic environment amid higher public/private debt and greater geopolitical conflicts. Still, the rate hike period lasted one year, from June 2010 to June 2011.

Level of neutral rate: We now expect the discount rate to peak at 2.25% by the end of 2023. Before the GFC, the discount rate peaked at 3.625% in the summer of 2008. During the more recent tightening cycle, discount rate peaked at 1.875% in 2011. The level of neutral rate, in accordance with today’s growth and inflation conditions, is inferred to be 2% at least. Under a bull case scenario of a sustained, multi-year economic expansion, we think the discount rate will reach 3% by mid-2025.

Ukraine crisis has bigger impact on inflation than growth

The ongoing Russia-Ukraine conflicts are expected to have bigger impact on Taiwan’s inflation than growth outlook. This also justifies the case of higher rates in the short term.

On the exports side, international export control sanctions on Russia will directly affect the sales of products to the country. Bank runs and currency depreciation as a result of financial sanctions will also drag the Russian economy into recession and weaken its international purchasing power. Meanwhile, Ukraine’s economy will also contract sharply this year due to the war-related damages. Thankfully, neither Russia nor Ukraine is Taiwan’s major export destination. Russia accounts for merely 0.3% of Taiwan’s total exports, while Ukraine accounts for 0.04%. While TSMC has announced to follow international sanctions to restrict exports to Russia, the company also revealed that it has few products sold to the Russian market.

On the import side, imports from Russia will also be negatively affected by sanctions. Russia is an important global supplier of oil, gas, industrial metals, and certain agricultural products. The US has officially banned Russian oil imports. And refiners in other countries have adopted self-imposed embargoes of Russian oil. Concerns about oil supply decline have pushed up Brent oil prices above USD100/bbl since the beginning of March. The rise in global oil prices will directly boost Taiwan’s inflation via the import channel, given the island’s position as a large net oil importer (see the next section). 

Imports from Ukraine will also face disruptions. Ukraine stands out in terms of global supply of semiconductor-grade neon – a gas critical for lithography machines that are used to produce chips. Disruptions on neon supply from Ukraine could aggravate the existing problem of chip shortage in the global market. Nonetheless, considering Taiwan’s dominant role in global chip foundry and strong negotiation power with the upstream suppliers, short-term impact on its semiconductor supply chain would be relatively limited. Taiwan’s Powerchip, for instance, is reportedly to have secured the supply of needed neon for 6-9 months. TSMC and UMC have also said that they have built safety reserves and diversified the sources of neon supply.

 

Stagflation risk remains low

As far as oil price increase is concerned, we think it will push up Taiwan’s inflation notably this year and cut growth by a small margin. Stagflation is unlikely to be a big risk that deters the central bank from raising rates.

It is true that Taiwan heavily relies on fossil fuel imports for its energy supply. Coal, oil/petroleum products, and natural gas/liquefied natural gas accounted for 92% of Taiwan’s total energy supply in 2021. And almost 100% of them came from import sources. In terms of domestic fuel pricing, the state-owned Chinese Petroleum Corporation calculates wholesale fuel prices based on the weighted average of Brent and Dubai crude prices (in TWD terms). And it adjusts retail fuel prices by 80% of the changes in the wholesale benchmark, on a weekly basis. From the perspective of the terms-of-trade loss, we estimate that every USD10 rise in crude oil prices will erode Taiwan’s national incomes by 0.4% of GDP (to be absorbed by both the private and public sectors). CPI inflation will be boosted directly by 0.2ppt, for every 10% rise in crude oil prices.

The actual impact on growth and inflation (especially growth) would be more moderate than the above estimates. Taiwan’s fiscal position is strong. The central government’s fiscal balance stayed in a surplus of 0.7% of GDP in 2020 and outstanding debt was only 28% of GDP. The government could cap the increase in retail fuel prices through providing implicit subsidies via the CPC, based on the past experience. Meanwhile, household balance sheet is also strong. Household savings as a percentage of disposable incomes stood at a 20-year high of 25% in 2020. Savings buffer could help to lessen the impact of higher oil prices on consumers’ discretionary expenditures. Economic impact would also be more moderate than that during the 2008 and 2011 oil price runup. Taiwan’s energy intensity is on a steady declining trend. Energy consumption per unit of GDP has fallen notably by 26% between 2008 and 2021. A lower energy intensity indicates that the economy can handle oil at USD100/bbl better than in the past.

In our base case scenario, our oil analyst expects Brent oil prices to average USD95-100/bbl in 2022. In a bear case scenario of broader sanctions on Russian crude and lengthy conflicts, Brent oil prices for 2022 will be USD110-115/bbl. For Taiwan, we estimate that CPI inflation for 2022 will be pushed up to 2-2.5% in the base case scenario and to 2.5-3% in the bear case. We hence revise up the 2022 CPI forecast to 2.3%, from 1.3% previously. Neither of these two scenarios will tip the Taiwanese economy into a recession. We maintain our 2022 GDP forecast at 2.8% for the time being and will review the forecast in the next few weeks when more data for 1Q become available.

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