No bank in Taiwan has made a more strident play to take advantage of thawing cross-Straits relations with China than Fubon. The truth is that progress for Taiwanese financial services groups in China has been glacially slow, and it will be years before it has any meaningful impact on the bottom line of any Taiwanese bank. But when the money does start to flow, banks across the country will owe Fubon a vote of thanks for getting the pioneering deal through.

When Fubon Financial Holdings bought a 19.9% stake in China’s Xiamen Bank in 2008, it represented the culmination of years of effort and negotiation. The deal was permitted because Fubon bought the stake through its Hong Kong subsidiary, and hence was not a direct purchase by a Taiwan-based bank of a Chinese one; consequently it involved close discussion between not just the People’s Bank of China and Taiwan’s Financial Supervisory Commission, but the Hong Kong Monetary Authority as well.

A minority stake in a smallish Chinese bank is not going to make a big change to anybody’s P&L, and certainly not Fubon’s, but the more important point was that it got all three key regulators around the same table and caused them to hammer out some important issues. Doing so made it easier for what followed: relaxed FSC and PBOC regulations allowing Taiwanese banks to set up business operations in the mainland, a potentially transformative step for the entire Taiwan financial services industry. Fubon launched its first rep office on the mainland, in Suzhou, on December 5.

Like its peers, Fubon must have a rep office in operation for a year before being allowed to upgrade to a branch, and then a further two years before it becomes a subsidiary (and even then only if it was profitable for a year as a branch); it’s only then that they will be able to offer deposits and financing in RMB, which is a crucial part of the product set whether representing Taiwanese businesses or Chinese ones. Development in investment banking and brokerage will evolve from there, a modest securities presence within Xiamen Bank notwithstanding. But the point is, a foothold has been achieved.

Back home, Fubon is one of the largest financial groups in the country, a leading consumer brand with particular strength in Greater Taipei. The investment banking arm, Fubon Securities, includes an impressive presence in brokerage and local underwriting, although the group’s mainstays are more generally seen as corporate lending, wealth management and insurance. As of June 2011 it ranked third by trading value among the island state’s securities firms, and was third for spot trading brokerage, fifth in margin loans, and second in underwriting local IPOs.

But it’s really in Greater China that it will make its name, initially in broader corporate work but in time perhaps also in securities and brokerage. Already the only Taiwanese financial holding company to own a Hong Kong bank, it has set its mainland ambitions firmly on the West Strait Economic Zone centred around Xiamen in Fujian Province – geographically, the closest to Taiwan. Fubon has been a first mover in China, but it’s also been focused and smart.

For many years, technology and electronics have dominated the Taiwanese economy. The country’s acknowledged global champions – names like Acer, Hon Hai or Taiwan Semiconductor – all hail from the technology field; electronics-related stocks make up about 65% of the market capitalisation of the Taiwan Stock Exchange. But this may be set to change, and the spur for that change – as with so much in Taiwan today – is China.

Partly, it’s a matter of necessity, because prospects for Taiwan’s electronics industry – or manufacturing generally – are not good in a troubled world economy. “Taiwan has historically been an exporting country,” says Paul Yang, senior executive vice president and chief investment officer at China Development Financial Holding Corporation. “Most of our wealth comes from outbound businesses. These businesses, while still going well, face murky prospects as a result of the uncertainties in the global marketplace.” The US is, after all, still Taiwan’s top export destination, and its slump has heavily hit demand.

Others are more blunt. “The tech sector is losing steam,” says CY Huang, president of FCC Partners and Chairman of the Taiwan Mergers & Acquisitions and Private Equity Council. “The D-Ram industry is losing money, haemorrhaging, while global consolidation is taking place. The TFT-LCD panel industry is losing money because of global overcapacity issues. Symbols of Taiwan like Hon Hai are suffering from a margin squeeze, Acer has lost ground in worldwide notebook sales, and even in the best companies there are problems,” such as smartphone manufactuer HTC being sued for copyright infringement by Apple. “Nobody in the tech sector, from the worst to the best, seems to be immune from this.”

It’s causing some deep reflection. “Taiwan is in a stage of transition, and everyone – government, owners of enterprise – is asking what’s next?” asks Huang. “Where’s our next growth engine?”

The answer may be previously unexceptional industries given a new lease of life by increasingly close ties with mainland China. “What’s promising is that there is a lot of inbound business in Taiwan,” says Yang. “And it’s mainly benefiting from the normalization of relations with China. We’re seeing more of that peace dividend.”

People have been talking about this peace dividend for years – with increasing frustration at the slow pace of its fruition, particularly in financial services – but there do seem to be areas where it is coming through in genuine growth. Tourism is the most obvious example, as mainlanders seek to visit Taiwan; natural knock-on effects from that are hotels and airlines, for example. But there’s actually a broader trend at work.

“What we’ve been suffering from for the last decade is a lack of domestic demand,” says Yang. “A lot of our population, many of them in their prime, are working in mainland China now. And there is soft demand in just about everything, from consumer related products to housing: Taiwan already has one of the highest rates of home ownership in Asia, at 85%. So local services and consumer related industries were soft until this normalization began.”

The arrival of tourists has changed patterns around consumption; so, too, has the return of Taiwanese expatriates who have done well in the mainland and are now keen to come home to invest in their homeland. “It’s a shot in the arm in the local economy,” says Yang. One sees it in a number of ways: Taipei hadn’t had a new five-star hotel for a decade, for example, but has now welcomed two in a year. Better still, any economy driven by domestic consumption tends to feel the effects quickly. “When you have a booming export economy, it takes longer for wealth to trickle down,” Yang says. “With a strong domestic economy, the benefits are really felt.”

The government has highlighted six sectors to try to rejuvenate growth in Taiwan, in varying degrees of success: tourism, and the cultural industry, are clearly seeing progress although little major impact on FDI; agriculture, venture capital and green energy are slow, but there are very positive signs in biotech, which is becoming a clear and sophisticated niche sector in Taiwan, both in terms of the industry itself and listed constituents on the stock market. But Huang – who sees progress in these areas as “pretty pathetic and insignificant,” biotech and tourism apart – agrees with Yang that the future has to lie in a much broader mindset. “One way for more and more Taiwanese companies to transform themselves is to treat China as a domestic consumption market rather than a factory,” he says. “Hong Kong Chinese treat China as a home market. Taiwan, with few exceptions, does not. But people are changing, and those people who are deploying resources cleverly are reaping the fruit.”

Related to this, some see the future of Taiwanese business growth in the services sectors. “I believe the engine for Taiwan’s economic growth is shifting,” says Victor Kung, President of Fubon Financial. “Taiwan’s economic growth has been led by manufacturing growth for 40 or 50 years, since we began to industrialise in the 1960s. But the warming of the cross-straits relationship is a great opportunity for Taiwan to shift into a more services-led growth model, like other mature developed economies.” The premise is that Taiwan will become a major service centre to China. Some of the manufacturing that previously took place on Taiwan will inevitably move to the mainland – it’s already happening, in fact – “but what retains in Taiwan will be the more high value-add services components of the value chain,” Kung says. That will drive the economy and make Taiwan a nicer, less polluted place at the same time, he says.

Kung sees this coming through in some interesting areas: alongside tourism and healthcare, he points to creative industries, noting that at least half of the Chinese pop singers he is aware of are actually Taiwanese. This is an argument that a free culture, without inhibitions on expression, manifests itself in greater creative talent. And Kung is also clear that services, in his definition, doesn’t just mean the service industries like banking (although, with Fubon’s new mainland asset management venture with Founder Securities finally approved on June 30, he is one of the few executives with any positive progress to report on cross-straits banking). Instead, to him services includes the service components within manufacturing – research and development, design and corporate finance.

International analysts have become wise to the same themes. Jenny Lai, head of Taiwan research at HSBC, crunched the numbers in a July 27 report and found that publicly listed Taiwanese companies’ aggregate investment in China since 2005 has reached 12% of their combined net profit, a figure she expects to grow. While that’s not so surprising, she dug further and found that while tech companies have historically accounted for up to 65% of Taiwanese investment in China, investment by non-tech companies grew 75% in 2010 alone. “The gap between tech and non-tech is closing,” she says, noting that the China revenue contribution for Taiwanese non-tech companies on her radar ranged from 23% to the whole lot. It’s coming through in stock market behaviour too. “Investors appear eager to reward Taiwan parent companies for their success in China,” she says.

Two days after Lai’s report, Deutsche’s strategist Joelian Tseng put out a Taiwan report entitled ‘one market, two worlds’, concluding that investors should expect outperformance in non-tech sectors while tech remains under pressure. “Non-tech has delivered a better return on equity and margin recovery than tech,” said Tseng, whose model portfolio is skewed to financials, consumer and property.

If fund managers are rebalancing in line with these ideas, then at the grass roots level of venture capital the same thing is happening. CDFH, a large part of which has been built on early investment in unlisted businesses, already has 26 investments in China, many of which have already gone public, and expects to expand considerably. But China will also change the nature of its portfolio elsewhere too. “The opening of the China market really expands the universe of companies that will be interesting to us,” Yang says. “When China wasn’t opening up, Taiwan was best known for exporting electronics, communication and light industrial goods. Things like services, consumer and pharma businesses were not so interesting to us because our markets are too small. But China opening up changes things dramatically: now some of the best opportunities are service and consumer related, and many of the most successful brands in China are Taiwanese-run.” While the venture capital portfolio at CDFH is around 60% electronics today, Yang expects it to be less than half of the portfolio within five years, with the shortfall made up by services, tourism, hotels, media, consumer staples, pharma and entertainment related businesses.

The balance between a floundering tech sector and growing domestic consumption economy is coming through in reasonable, but not exceptional, macro numbers. The Taiwanese economy fell from 6.6% year on year growth in the first quarter to 4.9% in the second, but that was much better than most economists expected, largely because of this domestic demand spur. The government’s full year forecast is 5.01%. In sum, it’s a picture with some cause for optimism and some for concern, balancing out as a steady but unexceptional growth market.

BOX

Taiwan and the offshore RMB

One of the most extraordinary financial stories of the last two years has been the growth of the offshore RMB market in Hong Kong. The dim sum market – RMB bonds traded outside China – grew from a nascent pilot program to one drawing international issuers from top-ranked names to high yield within a matter of months. Offshore trade settlement volumes continue to grow, and the pace of RMB deposits in Hong Kong ensures the market is underpinned by further demand.

Singapore is striving to become a second offshore RMB centre. But why not Taiwan too? Bankers here hope that’s on its way. “I think the Taiwan government has certainly paid attention to the development of the RMB as an international currency,” says Kung at Fubon. “The Chinese government has relaxed some restrictions on Taiwanese banks getting involved in RMB business, and from the banking industry’s perspective we’d like to see the possibility of Taiwan becoming another offshore RMB centre.” Certainly, it’s in China’s interest to have more than one centre in Asia, since it allows for more efficient pricing and capital flows. Taiwanese argue that they also have the language skills and cultural affinity with China to make Taipei a natural second home for the currency.

In banking generally, progress remains somewhat slow in cross-straits development, with some areas becoming more open for Taiwanese banking groups (opening branches, investing into Chinese banks, general and life insurance, and fund management) but others still restricted (chiefly brokerage).

Here are some titles of recent analyst reports on Taiwan. “Taking another step down.” “Fundamentals weakening.” “Increasing risk in H2.” One continues: “Late August has brought a gloomy feel to Taiwan.”

It’s an odd backdrop to what is meant to be a transformational, symbolic phase in Taiwan’s history. On Sunday September 12, the Economic Cooperation Framework Agreement between Taiwan and mainland China came into effect, 11 weeks after its June 29 signing. From now on, Taiwan is supposed to start reaping the benefits of the rapprochement with China that has characterised President Ma Jing-Yeou’s two-and-a-half-year administration. Among other things, tariffs on 539 Taiwanese products entering the Chinese market will be reduced or removed, representing about 16% of Taiwanese exports to the country; it’s a better deal than the Chinese have got in the other direction, where tariff reductions cover only 267 items representing 10.5% of that trade.

So why the long faces in Taipei? Partly it’s because, regardless of cross-Straits issues, Taiwan faces a lot of headwinds from other external issues. When Credit Suisse reduced its target for the TAIEX index from 8,500 to 7,300 (it was 8,157 at the time of writing) it was chiefly on the back of a weakening outlook for technology on the back of slowing demand. Credit Suisse has slashed its forecast too, from 7600 to 7200, for similar reasons.

But also, there’s a great sense of anticlimax in Taiwan, and it is most keenly felt in the financial services sector. “The signing of ECFA is of course a boost, but to other people it is a let-down,” says CY Huang, who is CEO of financial advisory group FCC Partners, chairman of the Taiwan M&A and Private Equity Council, and chief advisor to the investment bank Polaris Securities. Allen Wu, senior vice president and head of institutional investor relations at Yuanta Financial Holdings, adds: “The process seems too slow. [Taiwan/China] is open now in a sense. But has there been a practical effect yet? Not really.”

Hopes had been high. The financial sector is one of the areas that had suffered most when relations with China were coldest, because they have had to watch in isolation as others have benefited from exposure to China’s economic boom. They have been unable to serve corporate clients in their business in China, private banking clients who want to invest in China, or to offer individual mutual fund investors products within any Chinese exposure. All this was, and is, meant to change. “The financial sector had hoped the agreement would be equal to or better than CEPA,” says Daniel Wu, president of Chinatrust Financial Holding Company, referring to the Closer Economic Partnership Agreement signed between Hong Kong and China in 2003. That agreement, after several rounds, has involved more than 200 liberalization measures across 38 service sectors. “Unfortunately, the outcome from the first round of negotiation was a bit of a disappointment.”

So what has changed so far? A memorandum of understanding has been struck between Taiwan’s Financial Supervisory Commission and the China Banking Regulatory Commission to allow greater involvement of each country’s banks in the other’s territory, and this has been enshrined in this first round of ECFA. From the Taiwanese standpoint, banks will be permitted to upgrade their representative offices to branches one year after being set up (as opposed to two for most foreign rep offices). Perhaps more significantly, these branches will be permitted to offer RMB-denominated banking services after two years of operations, provided the second year was profitable; they can do so after one profitable year, but only to serve China-based Taiwanese businesses. This is a big difference to the norm: foreign banks generally must wait at least five years for this privilege, so on RMB lending Taiwan has leapfrogged from being banned to preferential treatment. These concessions are part of what is known as the “early harvest” list within ECFA.

Seven banks have received approval to upgrade their rep offices in China to branches, and are awaiting approval from the CBRC to do so, which it is hoped will happen later this year. Five are state-owned: Hua Nan Commercial Bank, First Commercial Bank, Taiwan Cooperative Bank, Chang Hwa Commercial Bank and Land Bank of Taiwan. Two private sector banks, first Cathay United Bank and then on September 16 Chinatrust, have FSC approval too.

Surely that’s good? Well, for Chinatrust, it is, but it’s less than expected. Chinatrust had hoped to set up a subsidiary, not a branch: it had planned to invest RMB3.2 billion into the subsidiary and to launch both retail and wholesale business there. Having a branch – if CBRC approves it – will certainly help, since it will allow more comprehensive corporate banking services. “In the first phase we will target our China-focused Taiwanese manufacturing clients,” Daniel Wu says. “It’s been a long time that we cannot serve them properly. We’ve been waiting eight to 10 years: now we can start serving them right away.” Wu plans to inject RMB800 million RMB into the branch, four times the minimum, in order to chase the business as aggressively as possible. “Based on our database there are 20,000 Taiwanese enterprises in China, but if you add up the upstream and downstream, the total could be 140,000, and that number will keep growing,” he says.

But a branch can’t take RMB deposits under RMB1 million, and that means no retail – which, for Chinatrust, is a key franchise. It also effectively means no wealth management offering, which again for Chinatrust is a mainstay in Taiwan. “We’ll have to bear with a branch for a while,” says Daniel Wu. “We believe in the second round of negotiations, which will start at the end of this year, we may be able to do that.”

But if Chinatrust is disappointed, that’s nothing on securities companies. This part of the market has been completely ignored by ECFA so far and for them, nothing at all has changed with this new agreement. “The banking sector feels excited but the securities sector feels it completely missed the boat,” Huang says.

Why not securities companies? Allen Wu says Taiwan’s security association approached the regulator from the start to ask for an opening into China, but notes that Taiwan’s regulator has “just opened a very tiny door for mainland Chinese financial institutions” in Taiwan and that the block on Taiwanese securities houses going into China is probably a quid pro quo. “It is too early for us to come in, and so far we are not even included.” Consequently cross-straits relations have been something of a damp squib for Yuanta, the only financial holding company in Taiwan to have concentrated its business on securities; “the opening of securities with a full licence or full ownership in China is most important to us,” he says.

Financial institutions beyond those with branch approval are approaching China in different ways. For years, the most closely watched was Fubon, which in 2008 bought a 19.9% stake in Xiamen City Commercial Bank in what was widely seen as a test case for Taiwanese engagement with the mainland. This bank, based in Fujian province, has applied for a branch licence in Chongqing and plans new outlets in Zhangzhou and Wenzhou, bolstered by Fubon’s money; in August the bank said it would inject RMB500 million this year and the same amount in 2011, through Fubon Bank (Hong Kong), which legally holds the Xiamen Bank stake.

More recently, SinoPac holdings and some of its subsidiaries have signed memoranda of understanding with China Huarong Asset Management Corporation on September 3, including personnel training, exchange of management experience and information, research, and product development. Taishin Financial Holding said on September 9 it plans to sign a cooperation agreement with Nanjing Zijin Investment (Taishin Bank also plans an office in Nanjing). Far Eastern International Bank is believed to be close to an agreement with Bank of Chongqing.

But, while there’s progress, there’s also a concern that political momentum behind cross-straits openness may be waning. On November 27 there will be municipal elections in five major cities: Taipei, Xinbei, Taichung, Tainan and Kaohsiung. They will tell us just how much Ma Ying-jeou’s support has dropped, which will have an impact on the pace of further engagement with China. Analysts are watching this closely. “An additional setback in sentiment for the KMT could limit their ability to push through new policies that open up to China in the run up to the elections and affect the balance of power post election,” says Randy Abrams at Credit Suisse. “If the DPP looks like it has a chance of recovering power, the assumptions made about cross-Strait relations may need to be adjusted.” There is still tension here: although ECFA was passed by Taiwan’s parliament without a single dissenting vote, that’s only because the opposition refused to take part in the vote. The DPP still wants formal independence from China and there’s nothing to say it won’t return to power sooner or later and unwind many of the measures that have taken the last two years to adopt.

The DPP is tapping into a fear about the converse of the ECFA arrangement: that, with improving access for Taiwanese institutions in China, there must come increasing opportunity for mainland groups in Taiwan. Many find this alarming, picturing ICBC coming in and either buying the nation’s finest institutions or beating them with their extraordinary scale and resources. It’s true that Chinese banks are getting involved – Bank of China and Bank of Communications applied on September 7 to set up representative offices in Taiwan, which under ECFA can subsequently apply for upgrade to branch status – but those on the ground say the fears are ill founded.

“There is a general fear that Chinese institutions are too big – that if ICBC or Bank of China takes a strategic stake in a financial institution they may swallow it or pose a significant threat to other institutions,” Huang says. “That is generally not true. It shows insecurity and a lack of confidence in Taiwanese institutions. It is not size that makes the difference: the fear is totally unnecessary.” For the moment Chinese institutions are heavily limited in the stakes they can take: 10% can be Chinese held, but each strategic investor is kept to a maximum of 5%. This limitation on Chinese access is hardly helping when the Taiwanese regulator seeks greater access on the mainland for Taiwanese institutions.

Huang believes that Taiwan’s rejection of the proposed sale of Nan Shan Life by AIG to Primus Financial Holdings in August reflects these same fears and objections. “That’s also a reflection of two things,” he says. “Firstly, that Taiwan has taken a very hostile attitude to private equity in general, and also the fact that because Primus is a Hong Kong-listed company, people assume Chinese money is behind it. That casts doubt in PRC institutions’ minds about whether they can participate in the Taiwan financial sector at all.”

All these things have led to a gradual dissipation of the excitement about Taiwan. Back in May 2009, Taiwan was trading at a 53% premium to the region, higher than any other Asian nation. By late August 2010, though, that premium had fallen to just 10%, and it’s still falling now. Net foreign selling in the four months to that time represented a cumulative 0.4% of national market cap, which, while not a damagingly large number, was second in the region only to politically uncertain Thailand.

Still, maybe it’s all about patience; for a visible sign that things are changing one only has to go to the airport and take one of the 370 direct flights per week between China and Taiwan after sixty years of no such connections. They serve a constituency of about one million Taiwanese who base themselves in the mainland, many near Shanghai; that weight of numbers is an unstoppable force in affecting change eventually. The first round of ECFA is not the finished article but a framework within which other things can be done; Allen Wu is still hopeful that the FSC will ask the China Securities Regulatory Commission to include securities in the next batch of ECFA talks, and Daniel Wu has the same hopes for subsidiary banks.

“ECFA is in line with everybody’s expectations,” says Allen Wu. “Maybe it just takes time. A lot of things need to be done. But it’s a good start.”

The Council for Economic Planning and Development said in September that Taiwan’s economy should grow at 5% a year through 2017 thanks to the China trade deal. It may prove that the events of the last year have underwritten Taiwan’s continuing economic success; it’s just that the financial services sector is getting increasingly impatient to enjoy a share of it.

BOX: TDRs

A lot is demanded of Taiwan Depositary Receipts. They are expected to coax Taiwanese capital that has left the country to come back home, and then to attract the Chinese growth story into Taiwanese investment markets. A big ask.

TDRs are listed vehicles much like an American Depositary Receipt, in that they represent a block of underlying shares on some other exchange. They have existed for more than a decade, but interest in them has been galvanized in the last two years as a method of helping the local capital markets benefit from warmer relations with China.

The first aim was to bring Taiwanese companies back home. Many companies have opted for listings in places like Hong Kong and Singapore, in large part because those markets bring with them no restrictions on investing the proceeds in mainland China. TDRs, it is argued, are a perfect way for those companies to seek a second listing now that those restrictions are largely gone: they can attract a loyal and hungry investor base, and support their country of origin too.

This began to happen in 2009, with TDRs from companies like Want Want China, a manufacturer of rice cakes and flavoured milks in China owned by the Taiwanese Want Want Holdings; and Yorkey Optical, a Taiwan-backed manufacturer of optical equipment which, because of its plant in Guangdong, had opted for Hong Kong rather than Taiwanese listing.

The greater hope, though, has always been that the TDR could start to attract Chinese companies in their own right – or at least the red chip companies that, while legally Hong Kong corporations, derive all their business from the mainland. There’s plenty to recommend it: Taiwanese investors are wealthy and have been starved of Chinese investment opportunities. They are a natural source of liquidity for a Chinese company (indeed, most TDRs trade at a considerable premium to their underlying shares – often over 20% – because of this scarcity value relative to demand. One, Solargiga, has traded as high as three times its Hong Kong price.)

A significant deal took place in August when Yangzijiang Shipbuilding Holdings raised NT$4.5 billion in a TDR issue. Yangzijiang is registered and listed in Singapore, but its main assets are in China. This has been billed the first mainland company to list its equity in Taiwan. “The first stage was Taiwanese companies listed in Hong Kong and Singapore,” says CY Huang at FCC Partners whose former employer and current client, Polaris, has been a leader in TDR issuance. “The second was foreign companies, such as Singaporeans, such as Oceanus [an abalone company from Singapore which launched a TDR in December]. Now we’ve moving to the third stage, which is PRC-background issuers.”

Huang expects to see many more. “It has tremendous potential,” he says. “The liquidity is very good, the price earning multiple is higher than they would get at home, and in certain sectors like high-tech Taiwan has an advantage in terms of investor understanding. Also it is perfect for small and medium sized issuers who would get lost in Hong Kong.”

Allen Wu at Yuanta says TDRs represent “another way to move capital freely in the cross-straits region. They create another option.” He doubts, though, whether market conditions will be favourable enough for as many TDRs to go through in 2010 as did in 2009.

September 12 was a big day for Taiwan: the formal start of the Economic Cooperation Framework Agreement, which brings in a host of tariff cuts in the spirit of warmer relations between Taiwan and Mainland China.

The government of Ma Ying-jeou has painted this as a landmark, and in many ways it is: it’s really the first concrete outcome of a thawing between the two states, who have otherwise been hostile to one another since 1949. It will help Taiwan’s economy for decades to come and it illustrates a considerable ratcheting down of tension in one of the world’s most enduring potential flashpoints.

But there is just no disguising a sense of disappointment, frustration and anticlimax in Taipei, particularly in the financial services arena. This was the area that was supposed to flourish the most in this brave new world: banks have for decades been unable to service their clients in their business on the mainland and have watched that lucrative work go elsewhere. Likewise private banking clients have deserted them because Taiwanese banks haven’t been able to offer investment services that include China; the mutual fund industry has suffered from being unable to hold Chinese securities; and the stock exchange has watched the country’s companies go overseas to raise capital in order to avoid onerous restrictions on the use of the proceeds.

There’s been two years of positive noises out of the Taiwanese banking system, but now even the most vocal of cheerleaders is sounding dejected. What’s really changed? There’s potential, for sure: six Taiwanese banks will probably be allowed to upgrade their representative offices to branches, although so far they’re only halfway there, with approval from the Taiwanese but not the Chinese side. And it’s true that, once in place, they will be allowed to offer renminbi business a lot quicker than most foreign banks. But as of today, nothing’s happened.

At least the banks can look forward to new opportunity sooner or later. The securities industry, on the other hand, has looked on in disbelief as their entire sector has been comprehensively ignored. Not only has nothing changed for them by the time of ECFA’s introduction, there’s nothing to suggest it’s going to any time soon either. They still can’t set up licensed branches in China or have full ownership of a venture there. They just have to hope they get remembered in the next round.

There’s nothing in this to suggest that the capital flows expected to flow from ECFA are going to do so. Mutual funds can now invest up to 10% of their capital in China-related investments (which chiefly means H-shares); that’s still not giving their portfolio managers free rein to build what they think is an optimum regional portfolio. Besides, pension funds don’t seem to be covered by the same rules.

What about Taiwan Depositary Receipts, which were supposed to create an avenue for Taiwanese companies that had fled overseas to come home, and for red chips and H-share companies to tap a market full of buoyant investor interest at a mighty premium? There’s been progress, sure, and last week’s deal for Yangzijiang Shipbuilding was the first mainly Chinese company to use the vehicle. But that’s legally a Singaporean company – we still haven’t seen a real red chip give it a try.

Any fair appraisal has to respect that this is a slow process and important to get right. But the problem is, when you look ahead, you see obstacles, not a clear path. Mayoral elections in November are expected to illustrate flagging support for Ma and the KMT party; that, in turn, is likely to impede urgency on closer relations with China, for fear that the DPP party – which continues to demand formal independence – could make greater gains. The government is fond of pointing out that ECFA was passed by the legislature without a single dissenting vote, but rather less keen to mention that this was because the opposition boycotted the entire vote.

The world investment community has spotted this too. In May 2009 Taiwan was trading at a 53% premium to the region. Today, it’s 10%, and heading south. The buzz, the euphoria of enhanced cross-straits relations – it’s gone. Coupled with a weakening outlook for tech stocks, UBS and Credit Suisse have recently cut their forecast for the Taiwan stock market, and foreign capital has been leaving the market.

Can the potential be realised? Sure, and with time, there’s no reason to imagine it won’t be. The next edition of Asiamoney will look in detail at these issues with comment from leading Taiwanese bankers. But in the securities industry in particular, Taiwanese had expected swifter progress than this.

Ever since Ma Ying-jeou became President of Taiwan in May 2008 on a platform of warmer relations with mainland China, the island state’s businesses have been enthusing about the benefits that should flow to them from this new cooperative spirit.

The logic is straightforward. Closer ties mean greater ease of access, which is good for tourism and transportation, and should lead to more business in general. In particular, the lifting of long-standing restrictions on investment in mainland China is not only good for Taiwanese investors and entrepreneurs, but ought to galvanise the financial services sector too as banks follows their clients in to new opportunities.

But two years on, much the same language – of promise, of opportunity, of the future – is being used as it was when Ma came to power. “We are on the verge of a major transformation,” says Victor Kung, President of Fubon Financial, but it feels like Taiwan has been on that verge for some time.

In fairness, the picture varies from sector to sector. In aviation, for example, the whole environment has changed beyond recognition. It is less than two years since the first highly symbolic weekend flights from Taipei to Shanghai took place – the first direct commercial services in half a century – yet already there are 270 direct services between Taipei and mainland China each week, with plans to double that capacity to more than 540. This is a vast difference. “It used to be that when I wanted to go to China I would have to fly in to Hong Kong, wait awhile, and transfer to another plane in the direction I just came from. I’d lose a whole day,” says one businessman. “Today if I get a morning flight I can be having lunch in Xiamen or Shanghai the same day.” In terms of business productivity, this marks a significant shift.

Tourism has also had a major lift from Chinese visitors, with a corresponding effect on hotels and real estate generally. These industries are the front line of what is hoped will be substantive changes, and many international fund managers are positioning their funds to take advantage. “Our biggest country position is in Taiwan,” says Peter Sartori, founder of Treasury Asia Asset Management, which runs chiefly Australian institutional money from its offices in Singapore. “We’re a believer in the relationship with mainland China. We think it has improved dramatically in the last couple of years, and we think that’s set to continue. The market hasn’t priced that in yet.”

But in the financial services industry progress feels rather slower. Since 2008, banks have been excited about the prospect of being able to open branches (or turn existing representative offices into branches) on the mainland. This should allow them to serve their clients who have long been going in to China without them; to help new local clients invest on the mainland; and eventually to take renminbi deposits and build a new sustainable business. Banks have for years watched 40% of Taiwanese exports, worth about US$100 billion a year, flow to China but have been unable to serve their customers in their needs on the mainland, instead watching that business go the way of Chinese or international banks. The hope is that this will all now change. But still not one Taiwanese bank has been granted a branch license.

“Everything is more difficult at the beginning,” smiles Kung. “But we do remain very hopeful that once we have a beginning, everything shall move quickly.”

Institutional Investor’s last Taiwan report, in September 2009, featured an interview with Financial Supervisory Commission (FSC)’s Sean Chen – the country’s chief financial regulator – in which he explained the challenges involved in his negotiations with China to build memorandums of understanding to govern banking, insurance and securities. “The most difficult question to answer is when,” he said then. But he did eventually succeed: the MOU was signed in January, and hailed as a landmark.

After that, Taiwan announced new local domestic regulations regarding Taiwanese financial institutions going in to China. But the implementation of these regulations was then held up in the Legislative Yuan, Taiwan’s parliament, for several months, and consequently the FSC has only just started accepting formal applications from local banks to open Chinese branches. The regulator has not set a timeframe for processing these applications, but Kung does not expect to see branches open any earlier than the third or fourth quarter of 2010.

Even then, though, the impact of that breakthrough will depend on still another piece of negotiation, the Economic Cooperation Framework Agreement, or ECFA, which is being hammered out between the governments of Taiwan and China. This is a monumental discussion for Taiwan. “This agreement will set the framework, economically and politically, between Taiwan and China,” says CY Huang, co-founder and president of Polaris Capital. “It’s a very big thing. It will send a strong message to the world to imply a more normal relationship.”

There are numerous complex issues related to this agreement: the opposition Democratic Progressive Party in Taiwan believes it will lead to unification with China, which they fear; some feel it will reduce jobs and salaries and lead to outflows of capital and human resources; there are issues about migration of Chinese workers into Taiwan; and there are complex issues around tax, tariffs, investor protection and intellectual property to be resolved. ECFA is expected to be signed in June, but the whole agreement may yet have to pass through a public referendum before being implemented. It will be closely watched.

From the financial services point of view, banks are keen to see whether ECFA allows new branches to conduct business in renminbi. Under China’s agreements with the World Trade Organization, branches can only apply to do RMB business after three years of operations, of which two must have been profitable; Taiwanese banks are hoping they will be permitted to do RMB business from the outset.

Apart from commercial banks, other financial services players are watching ECFA closely. Eddy Chang, senior vice president of corporate strategy and planning at China Development Financial Holdings, a holding company that includes China Development Industrial Bank and Grand Cathay Securities, says the ECFA will help it to set up venture capital and private equity businesses in mainland China. “We would be able to set up our own office, and we could possibly raise RMB funds, whereas before we could only invest in US dollars.” Naturally, its potential investment targets will change too, to include mainland Chinese companies. Chang is hopeful that many Chinese local governments will invite CDFH to set up venture capital funds in China’s provinces, attracted by the group’s expertise in technology. “By doing so, they can attract Taiwanese high tech companies.”

While waiting for ECFA to be signed, several banks are already looking at joint ventures with Chinese securities companies or asset management businesses. But in the meantime, the most ambitious attempt by a Taiwanese bank to penetrate Chinese banking remains Fubon’s purchase of 19.9% of Xiamen Commercial Bank through Fubon’s Hong Kong subsidiary in 2008. “Last year was the first year of our investment, sending our team over to take over the management – it was a year of a lot of infrastructure building,” says Kung. “We made some organisational changes, tried to implement a new business model, and this year we will be able to start to build up our business more aggressively, especially for Taiwanese institutions in Xiamen and Fujian Province. This will be the year we are able to show some progress in numbers.”

Bankers describe the situation domestically as intensely competitive in Taiwan, but there are signs of enthusiasm from foreign players, again based on the promise of China. Peter Flavel, global head of private banking at Standard Chartered, is particularly enthused about Taiwan following a tax amnesty last year, “giving people an incentive to bring money that was offshore, onshore. There was quite a flow of money back into Taiwan.” Generally, he says, the Taiwan-China story is a story about trade. “Our wholesale bank will be involved in the explosion of trade flows – not just with China but in Northeast Asia – and trade creates wealth that needs to be invested.”

Certainly foreign brokers appear to believe risks are to the upside. Deutsche, for example, has a buy recommendation on each of Fubon Financial, Cathay Financial, First Financial and Yuanta Financial, saying “we expect further ECFA negotiations to support sentiment.” And Sartori says: “The economic benefits for Taiwan are too great for them to put roadblocks up. The Taiwanese economy and stock markets have lagged the region for about two decades because they’ve been hollowed out by Mainland China. We believe that’s changing.”

While banking is a key focus of China-Taiwan negotiations, there is more to the country than financial services. One of Taiwan’s economic mainstays has been technology and electronics, and here too there is a range of opinion: some think that the country’s semiconductor heavyweights like TSMC could be damaged by free trade with China; others are more optimistic. “There’s a concept called Chaiwan,” says Chang. “It’s Taiwan’s technology combined with mainland China’s market.” Certainly, there are some great believers in Taiwan’s tech story overseas. Robert Parker, special advisor at Credit Suisse Asset Management – which manages Sf1.3 trillion worldwide – says Taiwan is one of his key overweights in Asian equities, “because of the technology play.”

For many, access to China for Taiwanese businesses is only half the opportunity; the broader ambition is that Taiwan becomes a servicing hub to help people from all over the world move into China. “Taiwan is the perfect focal point between China and the world,” says Huang. “Taiwan knows China ethnically, culturally, linguistically.” And it’s a two-way street. “Chinese companies growing globally don’t have the right management capability; they could take minority stakes in Taiwanese companies and gain management talent. It goes both ways.”

For 60 years Taiwanese relations with the mainland have been fractious; yet now it appears Taiwan’s whole economic outlook is dependent on making the peace.

BOX: TDRs AND FOREIGN ISSUERS

Taiwan experienced a landmark on its stock markets on May 18 when Integrated Memory Logic, a Silicon Valley electronic chip manufacturer, listed on the Taiwan Stock Exchange – the first foreign initial public offering on the country’s exchange.

While the NT$1.4 billion offering, equivalent to just US$44 million, looks a fairly insignificant sum, this was a triumph for the TSE and its chairman Chi Shive, who has been pushing for foreign listings. IML chose Taiwan over Nasdaq and others because it had low listing costs, high liquidity and accommodative regulation, as well as being more suitable for a small listing than the Hong Kong or Tokyo stock exchanges.

As well as foreign IPOs, Shive has sought to boost so-called Taiwan Depositary Receipts, or TDRs. These generally involve Taiwanese companies overseas opting to raise capital at home, and once again they represent a play on renewed relationships with China. There were four of these listings from 1998 to 2008, then 10 last year and a further four so far in 2010; Shive hopes to see 20 this year.

The revival of interest has to do with a change in policy in which Taiwanese listed companies had a 40% ceiling on the amount of their capital they could invest in China. In that environment, many local companies – and all foreign companies – had little incentive to list in Taiwan since doing so would mean accepting a restriction on their investments in China, which over the last two decades has been an intolerable handicap. That cap has now gone. “The policy was originally designed to attract overseas listed Taiwanese companies to come back,” explains CY Huang at Polaris.

But the IML listing demonstrates that it’s done more than that, and illustrated the appeal of Taiwan’s capital markets for foreign issuers too. They are attracted by strong liquidity, making it a useful place for a second listing in order to diversify the investor base; and by high valuations, with many TDRs trading at a premium to the underlying share in the issuer’s home country.

Listings in Taiwan appear to work best for smaller companies – like IML – that would be swamped or ignored in bigger markets like Hong Kong or Tokyo. “Taiwan is the best market for small and medium cap companies,” says Huang. “In Taiwan the average IPO size is US$10 million to $30 million. You recently saw a cosmetics company raised $790 million in Hong Kong.” Taiwanese investors, he says, “are the richest, most open-minded and receptive. They love concept plays: there is huge liquidity for these offerings.”

Next could be Chinese companies. “Taiwan recently announced a new policy to allow PRC companies to list in Taiwan, so you have the potential for red chips as well,” adds CY Huang at Polaris. [In Hong Kong the term red chips refers to businesses that are legally domiciled outside of China, but in practice do nearly all of their business within it.] “All of these are a demonstration that the Taiwan market is internationalising and opening up, and the more it opens, the more competitive it will be. Taiwan is a new funding hub,” he says.

Yuanta was the lead manager on the IML deal, but this ability to attract foreign issuers – or to persuade Taiwanese who have listed elsewhere to return – is a source of delight to securities houses across Taiwan. “We hope Taiwanese companies that have listed in Singapore, Hong Kong and other places will dual list in Taiwan,” says Eddy Chang at CDFH, which includes within its holding company Grand Cathay Securities, another investment banking group that has benefited. “The government is encouraging these companies to come back and it has rejuvenated the capital market in Taiwan.”

Kung at Fubon – who says the pipeline for TDRs is “very strong” – thinks the rise of TDRs ties in to the drive towards Taiwan become a service centre for China. “Taiwan has certain advantages – for example it is one of the leading stock markets for electronics and technology-related companies – and I think it can expand on that by attracting technology companies not just from Taiwan and China but all over Asia to seek listing in Taiwan,” he says. “It offers the best valuations, the best coverage by analysts, and liquidity.”

Taiwanese banks are proving a useful source of liquidity for overseas borrowers. They have plenty of funds, but not much of an opportunity to get a return on them domestically since interest rates and spreads are low on New Taiwan dollar lending. Going overseas gets a better return on funds, without necessarily increasing the risk profile too far.

The best way of getting a handle on overseas lending by Taiwanese institutions is to take a look at the Central Bank of the Republic of China’s overview of offshore banking units, published periodically and most recently on September 8 (for July 31 data). This records data on 63 offshore banking units – 36 for domestic banks and 27 for foreign – who between them had US$28.911 billion of outstanding loans as of July 2009, 97% of it to overseas clients. US$19.136 billion of it is considered long-term, US$8.766 billion short term.

This liquidity has been noticed by a variety of borrowers, but has recently been particularly visible in Australia. Taiwanese lenders don’t tend to show up at the mandated lead arranger level here, but they are more and more frequently found in the syndicate. Westfield’s US$1.36 billion three year loan, agreed in early September, featured Bank Sinopac and Chinatrust Commercial Bank in the deal – not with heavyweight contributions, but present nevertheless. Similarly, when waste treatment firm Transpacific Industries Group signed a A$2.128 billion one and three-year loan with three Australian bookrunners in June, they then went out to a co-arranger group including Mega International Commercial Bank of China (a Taiwanese institution) and Chinatrust. Mega and Chinatrust also turned up on the US$500 million-equivalent multi-tranche facility for Foster’s in July, as did a glut of other Taiwanese lenders: Chang Hwa Commercial Bank, Taiwan Business Bank, Taipei Fubon Commercial Bank, Yuanta Commercial Bank, Bank of Taiwan, Hua Nan Commercial Bank, Land Bank of Taiwan and Taishin International Bank.

Asian borrowers have been aware of this source of funding for some time, and here Taiwanese lenders sometimes take higher roles in the syndicate. Chinatrust is probably the clearest example. It joined a S$150 million two-year bullet deal for Toll (Asia) in Singapore in September on an equally underwritten basis with local leads DBS, OCBC and UOB. Chinatrust is also one of six banks in a US$270 million five-year club loan for UEM Group, the Malaysian water and wastewater business, signed on August 28. With Taishin International Bank, it took part in a US$70 million loan for Kopholi, a Mauritius-based arm of Tata Power. And it is also among the banks believed to be sounding out a US$500 million loan to Indonesian coalminer Adaro, and elsewhere in Indonesia participated in a US$400 million facility for state-owned oil refiner Pertamina.

While Chinatrust is the most active name, Mega turns up with similar frequency. MTP HPPI Manufacturing, a joint venture between Dow Chemical and Siam Cement, struck a US$400 million 12-month bridge in August, with Mega one of nine banks in the facility. It was also one of the bigger contributors to a HK$1.2 billion loan for PrimeCredit, alongside Industrial Bank of Taiwan and Yuanta, with SinoPac, Bank of Taiwan, Chang Hwa, Far Eastern International Bank, Fubon and Taiwan Business Bank also appearing with smaller contributions. Mega also joined in a US$125 million deal for Indonesian trade promotion agency Bank Ekspor Indonesia earlier this year.

Then of course there are borrowers with Taiwanese connections who raise funds overseas. Formosa Industries is active in textiles in Vietnam, and raised a US$80 million five-year loan in August through an almost entirely Taiwanese MLA group, including Chinatrust, First Commercial Bank, Hua Nan Commercial Bank, Mega International Commercial Bank and Taipei Fubon Commercial Bank alongside HSBC. Further flung deals this year with entirely Taiwanese lead arranger groups have included the Finnish telecommunications and electronics component supplier Perlos Oyj and a Panamanian borrower called Colon Container Terminal.

Deals like this pay well, but come with a certain risk too: they take Taiwanese banks further and further away from their areas of expertise. There’s little to worry about in some of the Australian deals Taiwanese borrowers have taken part in, but investors may question just how good the credit comprehension is of Indonesian entities, for example, to say nothing of Panamanian or Finnish ones.

Still, Taiwanese banks do need to make money from somewhere: there are proposals working their way through parliament to cap credit card fees, for example, which wealth management revenues – a previous big earner – have been badly hit and there is lingering concern about exposure to the semiconductor industry. Overseas lending has its risks but it seems a natural route for Taiwanese banks to take in the absence of other opportunities.

Institutional Investor, September 2009

Sean Chen took on the chairman role at Taiwan’s Financial Supervisory Commission in December, becoming the agency’s sixth head since its creation in 2005. It has been a difficult period to preside over for the former chairman of Sino-Pac Financial Holding, but he can at least take comfort in the fact that Taiwan, and particularly its banking sector, has weathered the global storm well so far.

“In Chinese we say you can find fortune in misfortune,” says Chen, speaking to Institutional Investor in Taipei. “Our major export market, the US, is the country which suffered most from the financial turmoil, But we are also blessed because for the past 10 years we have been shifting our export markets to mainland China – now the largest export market for Taiwanese manufacturers.”

Since Taiwanese banks have been major providers of credit and services to the manufacturers who are exposed to China’s continuing boom, Taiwan’s banking sector continues to look very healthy. Non-performing loans are just 1.6% – much lower than the US, where the level is around 2.5% – and provisions stand at 69.8%. The capital adequacy ratio for Taiwan’s banking sector as a whole is between 11 and 12%, well above the statutory minimum of 8% and again higher than the norm in the US. “Our banking industry, even after the financial turmoil, remains relatively healthy compared to other areas,” Chen says.

But will it stay that way? Apart from that fact that NPL levels look bafflingly low, there are clear headwinds to come (see main story for NPLs and the D-RAM sector). “Personally I’m not so optimistic: I would not say the worst time is behind our back, because this world is too small for us to prosper or suffer alone,” says Chen.

Bankers are also alarmed by the prospects of a law capping interest rates on credit cards. Chen is quick to point out that the US has a similar law that has already passed the House of Representatives, and argues that the mooted Taiwanese law – which would have a floating cap moving with changes in the central bank base rate – is more flexible than the US approach which proposes an outright cap. (“That’s incredible. The US is a free economy!”) He also points out that although the Taiwanese law has passed a first reading of its legislature, in Taiwan any such amendment must go through three readings, and that major discussion will take place first, including the banking industry and consumer protection associations. Nevertheless, he says: “After the financial turmoil in Taiwan as other countries, the administrative and legislative branches are paying more attention to the interests of the consumer,” and he puts the credit card amendments within that context.

Chen is part of the team negotiating the eagerly awaited memorandum of understanding with China (see main story). “There is a French word, rapprochement, building a bridge; it’s a very good word to describe the present situation,” he says. “We have to mend the relationship between Taiwan and China. Any financial institutions which intend to conduct cross-border activities need a blessing from the home and host regulators. But how can they do that? Those regulators have to sit down and talk to each other.” Taiwan has previously signed MOUs with 35 counterparties in other countries; mainland China has more than 50, so there’s no lack of experience in negotiation. “The problem is, for the last eight years, not only the regulators but the governments on both sides of the strait don’t want to sit down and talk.”

Now that they are, things have improved. “We all agree it will be very healthy for the financial institutions on both sides of the strait to set up a financial presence in each other’s territory,” he says. The MOU provides for an agreement for the two regulators to jointly supervise institutions which intend to conduct cross-border activities, and three are under negotiation: for banking, insurance, and securities businesses. “There will be obstacles, but those obstacles will be removed and the MOU can be signed,” he says. “The most difficult question to answer is when.”

Pressed for detail, he says: “Well, frankly speaking, there’s nothing new in the MOU. A very basic MOU should include, first, the intention of cooperation; second, the intention to exchange necessary information; third, how to protect those information exchanges between the regulators; and fourth, the intention for further cooperation. It’s very simple.”

Interestingly, Chen says one reason progress is slow is that for both sides, despite the common language, this is the first time to structure an MOU in Chinese. “There’s a problem,” he says. “After separation, from 1949, the Chinese language changed a bit on both sides of the Chinese strait. So sometimes it takes a lot of time to find a terminology which is acceptable by both sides.”

When the MOU is signed, “it doesn’t mean Taiwanese institutions will be granted a license in China automatically, because they have to prove their institutions have been managed under prudential principles,” he says. But it paves the way.

It is strongly noticeable how Chen’s attitude towards banking consolidation differs markedly from that of his predecessors, who sought actively to encourage consolidation, even to precipitate it. “You should come back to basics and let market forces operate,” he says. “If a financial institution can operate by its own, it can be a niche player and we should allow it to operate in that way.

“We should not give it any guidance that it should be acquired by another institution. That’s not fair.”  That said, “I would expect to see further consolidation – but not in the instant future.”

Taiwan’s fortunes are shaped by those of two other nations: the USA and China. The trend of recent years has been a shift away from one and towards the other. Where the US has traditionally dominated Taiwanese exports, and remains important today, it is no longer the most important influence on Taiwan’s economy. That, instead, is unquestionably China.

When exports account for 60% of your GDP, as they do in Taiwan – making it the most export-oriented major economy in Asia – then the health of your trading partners matters enormously. And, while the USA has obviously slipped into protracted recession, China is swiftly reviving and is likely to enjoy 8% growth in 2009 in the midst of a global economic crunch. All of which makes the shift in direction of Taiwan’s exports all the more fortuitous today. In 2003, total exports from Taiwan to the USA were US$26.53 billion, 16% higher than the US$22.89 billion to mainland China that year, according to Taiwan’s National Statistics Bureau. By 2008, the US figure was US$30.79 billion – an increase, but less than half of China’s US$66.88 billion, a figure that has trebled in five years.

And it’s not just about exports. On top of that, last year’s change of government to Ma Ying-jeou, who took power in May 2008, brought with it a new attitude to mainland China which is expected to have a major impact on Taiwan’s economy. The administration of Chen Shui-bian, his predecessor, had been characterized by antagonism towards China, a stance that had some ideological support in Taiwan but did not help its economy. Ma’s platform has been for greater warmth between the two states, and it has been reciprocated: When Hu Jintao, China’s president, sent Ma a telegram in late July applauding his election as party chief, it was the first direction communication between China and Taiwan’s leaders since Mao took power in China in 1949.

Already, there have been some visible consequences of this: direct flights have resumed between the two places for the first time in many years, making trade and business easier. Tourism has begun to take off, in both directions, with mainland tourists helping Taiwan’s economy. Direct shipping has also had an effect. But one of the most closely watched areas is in financial services.

This has been one of the sectors that was most obviously impeded by cross-straits tension. China needs Taiwanese exports of things like chips and flat screen components to support its own electrical goods industry which then plays such a large role in China’s export numbers, so it has never objected to Taiwanese factories or the broader involvement of Taiwanese manufacturing with the mainland. But Taiwanese banks have never really been permitted to follow them: seven have opened representative offices but have been unable to upgrade them to branches; there have been restrictions on overall investment in China; and the mutual fund industry has not been permitted to own Chinese stocks, which has driven many local investors to seek funds offshore instead. Taiwanese banks, largely because of this, have had to watch their private clients go offshore to international banks who are able to engage with China.

Central to any change in this situation is a memorandum of understanding (MOU) between Taiwan’s Financial Supervisory Commission and its counterpart in China. This sets a basic framework within which the two groups agree to joint supervision of financial institutions from one location that want to operate in the other; that, in turn, paves the way for the issuance of licenses.

To hear the latest on where that’s up to, see the boxed interview with FSC chairman Sean Chen. But, when concluded, just how much will it really change? Taiwanese banks are making an effort to be pragmatic. “The MOU is merely symbolic, but it’s still a necessary first step in the process,” says Allen Wu, senior vice president at Yuanta Securities, who believes things are “moving in the right direction” for the Taiwanese financial sector but expects further opening to take time. “Even as that happens, not everyone in the financial sector will be able to benefit,” either because they lack a competitive advantage for China or can’t go anyway.

“In our view it’s very important strategically,” says Victor Kung, president of Fubon Financial. “But if people think that just because of the opening then we will see a bottom line effect in the short run, they may be disappointed. Some of these expectations are really somewhat hyped.” There is, too, an important counterpoint to remember: if Taiwanese can open in China, then it follows that Chinese banks will be allowed to open in Taiwan, and there are few more daunting prospects than ICBC or Bank of China – two of the world’s largest banks by market capitalization – turning up on your doorstep. “The concern is they are giants who are going to crush the ants of Taiwan,” says CY Huang, co-founder and chairman of Polaris Capital.

Nevertheless, it’s clearly good news if Taiwanese institutions can expand their business into the world’s most vibrant market.

In parallel with the MOU negotiations is a broader program: the Economic Cooperation Framework Agreement, which would address lowering tariffs, investment protection, intellectual property rights, economic cooperation and trade dispute settlement mechanisms. While these discussions are between China and Taiwan, there is a broader context because it would allow Taiwan to participate in regional free trade agreements such as ASEAN Plus One, which is intended to come into effect among Asian nations next year. As William Dong at UBS puts it: “This would enable Taiwan to remain as an integral part of the Asia economic zone.”

Dong notes that “simply signing the ECFA does not mean that Taiwan’s economic growth will suddenly leap forward. We believe it will really just put Taiwan on a more equal footing with its regional trading partners.”

Indeed, in a way the bigger issue is the risk of not completing it. “If Taiwan is not part of that [ASEAN plus one], it will have to pay additional tariffs and that means it cannot compete at all,” notes Huang. “Investor confidence is very much related to the signing progress of these agreements.” It’s tense, too, though, as there is a concern that agreements like these will turn Taiwan into something of a Hong Kong – a specially administered territory of China rather than the more independent nation most Taiwanese consider themselves to live in.

While banks have yet to see the clear benefits of China cooperation, they’ve also done OK in a difficult environment. “So far it [the banking sector] has held up relatively well,” says Kung at Fubon. “It has long rooted problems – the industry is too fragmented, highly competitive and is therefore eroding its profitability. But as far as this financial tsunami is concerned, we have our share of the losses but they are not big enough to hurt the capitalization of most of the banks.”

Indeed, it looks so good it is actually a little puzzling. As of May 2009, the non-performing loan data for the industry was just 1.6%, only about 10 basis points higher than its historical low. “I don’t know how much credibility investors can give those numbers,” says Matthew Smith, analyst at Macquarie Research in Taipei. “There’s a lot of loan restructuring and rollovers which could in future mean having to take extra provisions. It’s hard to believe that Taiwan of all places could withstand this shock to the global system and not experience any rise in NPLs.”

In particular, there is concern about the health of the semiconductor sector, specifically the D-RAM manufacturers ProMos Technologies and Powerchip Semiconductor. “It’s difficult to see what the endgame is for those two names, unless the government comes up with a plan to put them back on track,” says Smith. “Banks and other creditors already have extended debt repayments for the D-RAM makers and this is going to be a recurring theme, probably next year, when debt comes due and has to be restructured again.”

Kung is concerned. “Certainly D-Ram is the weakest link in Taiwan’s industry,” he says. “We all, and our bank also, have some exposure but the government has come out strongly to try to instill some confidence into the industry.” But he takes comfort from the fact that last year the LCD component industry also appeared a major worry, and has since recovered. “Even during the gloomiest days we have been saying that asset quality is not going to be a major issue this year.”

In sum: so far, so good, but there are causes for both concern and optimism in Taipei today.

BOX: The Fubon approach

For years, the Fubon group tried to find a way around the tricky relations between China and Taiwan, and eventually they managed it. Last year Fubon’s Hong Kong subsidiary purchased a 19.99% stake in Xiamen Bank for RMB230 million, becoming the first major investment by a Taiwanese bank in a mainland one. Despite the low stake, Fubon was entitled to appoint three directors onto Xiamen’s 11-strong board.

The deal was perhaps more symbolically than financially significant. “Xiamen Bank is very small: it only has about $2 billion of total assets [at the time of the announcement they were disclosed as RMB17.7 billion] so obviously if we look at the bottom line the contribution will be very small, almost negligible,” says Victor Kung. “But from a strategic development point of view, it is certainly a very important strategic step for us, because it makes us the first Taiwanese institution to operate a retail branch network in China.”

Getting the acquisition approved required help from the Hong Kong Monetary Authority, which acted as something of a go-between for the Taiwanese and Chinese regulators. But, now the two sides are talking directly, is the Fubon model quickly going to become obsolete? Financial Supervisory Commission Sean Chen notes: “once the MOU is signed by regulators on both sides of the Taiwan strait, I don’t think any reasonable operation would take that road, it’s not necessary.” And Kung himself points out that “once we can go directly, definitely we will go directly as well – it’s not that we have to go through Hong Kong.” That said, the first groups expected to benefit from the MOU are those seven Taiwanese institutions who already have mainland representative offices, because the norm in Chinese MOUs is that representative offices must exist in China for two years before being permitted to become a branch. Fubon is not one of the seven, so it’s possible the Xiamen venture may have to be its flagship mainland presence for a while yet.

BOX: CHEN IN THE HOTSEAT

Sean Chen took on the chairman role at Taiwan’s Financial Supervisory Commission in December, becoming the agency’s sixth head since its creation in 2005. It has been a difficult period to preside over for the former chairman of Sino-Pac Financial Holding, but he can at least take comfort in the fact that Taiwan, and particularly its banking sector, has weathered the global storm well so far.

“In Chinese we say you can find fortune in misfortune,” says Chen, speaking to Institutional Investor in Taipei. “Our major export market, the US, is the country which suffered most from the financial turmoil, But we are also blessed because for the past 10 years we have been shifting our export markets to mainland China – now the largest export market for Taiwanese manufacturers.”

Since Taiwanese banks have been major providers of credit and services to the manufacturers who are exposed to China’s continuing boom, Taiwan’s banking sector continues to look very healthy. Non-performing loans are just 1.6% – much lower than the US, where the level is around 2.5% – and provisions stand at 69.8%. The capital adequacy ratio for Taiwan’s banking sector as a whole is between 11 and 12%, well above the statutory minimum of 8% and again higher than the norm in the US. “Our banking industry, even after the financial turmoil, remains relatively healthy compared to other areas,” Chen says.

But will it stay that way? Apart from that fact that NPL levels look bafflingly low, there are clear headwinds to come (see main story for NPLs and the D-RAM sector). “Personally I’m not so optimistic: I would not say the worst time is behind our back, because this world is too small for us to prosper or suffer alone,” says Chen.

Bankers are also alarmed by the prospects of a law capping interest rates on credit cards. Chen is quick to point out that the US has a similar law that has already passed the House of Representatives, and argues that the mooted Taiwanese law – which would have a floating cap moving with changes in the central bank base rate – is more flexible than the US approach which proposes an outright cap. (“That’s incredible. The US is a free economy!”) He also points out that although the Taiwanese law has passed a first reading of its legislature, in Taiwan any such amendment must go through three readings, and that major discussion will take place first, including the banking industry and consumer protection associations. Nevertheless, he says: “After the financial turmoil in Taiwan as other countries, the administrative and legislative branches are paying more attention to the interests of the consumer,” and he puts the credit card amendments within that context.

Chen is part of the team negotiating the eagerly awaited memorandum of understanding with China (see main story). “There is a French word, rapprochement, building a bridge; it’s a very good word to describe the present situation,” he says. “We have to mend the relationship between Taiwan and China. Any financial institutions which intend to conduct cross-border activities need a blessing from the home and host regulators. But how can they do that? Those regulators have to sit down and talk to each other.” Taiwan has previously signed MOUs with 35 counterparties in other countries; mainland China has more than 50, so there’s no lack of experience in negotiation. “The problem is, for the last eight years, not only the regulators but the governments on both sides of the strait don’t want to sit down and talk.”

Now that they are, things have improved. “We all agree it will be very healthy for the financial institutions on both sides of the strait to set up a financial presence in each other’s territory,” he says. The MOU provides for an agreement for the two regulators to jointly supervise institutions which intend to conduct cross-border activities, and three are under negotiation: for banking, insurance, and securities businesses. “There will be obstacles, but those obstacles will be removed and the MOU can be signed,” he says. “The most difficult question to answer is when.”

Pressed for detail, he says: “Well, frankly speaking, there’s nothing new in the MOU. A very basic MOU should include, first, the intention of cooperation; second, the intention to exchange necessary information; third, how to protect those information exchanges between the regulators; and fourth, the intention for further cooperation. It’s very simple.”

Interestingly, Chen says one reason progress is slow is that for both sides, despite the common language, this is the first time to structure an MOU in Chinese. “There’s a problem,” he says. “After separation, from 1949, the Chinese language changed a bit on both sides of the Chinese strait. So sometimes it takes a lot of time to find a terminology which is acceptable by both sides.”

When the MOU is signed, “it doesn’t mean Taiwanese institutions will be granted a license in China automatically, because they have to prove their institutions have been managed under prudential principles,” he says. But it paves the way.

It is strongly noticeable how Chen’s attitude towards banking consolidation differs markedly from that of his predecessors, who sought actively to encourage consolidation, even to precipitate it. “You should come back to basics and let market forces operate,” he says. “If a financial institution can operate by its own, it can be a niche player and we should allow it to operate in that way.

“We should not give it any guidance that it should be acquired by another institution. That’s not fair.”  That said, “I would expect to see further consolidation – but not in the instant future.”

Taiwanese banks, flush with cash, have become a useful source of funding to borrowers around the world. It’s a happy coincidence of interests: a source of revenue and loan growth for the banking sector, and a well of capital for overseas banks and companies starved of many of their usual funding outlets.

According to the Central Bank of the Republic of China, total loans outstanding among the overseas business units and branches of Taiwanese banks was NT$1.8 trillion in 2008: about 11% of total loans, and more significantly a 25% increase in value year on year. In the first quarter of 2009 year on year growth was 21%. This is a continuation of a trend that started around 2005 and shows no sign of ebbing.

“Talking to the banks, most indicate this is one area they want to grow,” says Matthew Smith, a banking analyst at Macquarie Research in Taipei. “It’s the only real lending stream they have now that pays – there’s so much liquidity here in Taiwan, and the interest rates and spreads are so low that it is almost not economically profitable to lend in NT$,” he says. “Certainly it’s difficult to generate high return on equity without ramping up the risk curve and getting yourself into trouble. One way around that is to expand overseas lending, and especially US$ lending, which has better spreads and is more profitable.”

So, for example, when Bank of Queensland raised $295 million in a syndicated loan last August, its mandated lead arrangers included Chinatrust, First Commercial Bank and Taiwan Cooperative Bank. When the Finnish telecommunications and electronics component supplier Perlos Oyj went to the markets for $145.8 million a month later, its lead arrangers were almost entirely Taiwanese: Chang Hwa, Chinatrust, Land Bank of Taiwan, Mega Bank, Taishin International, Taiwan Cooperative, and First Commercial.

More recently, Colon Container Terminal, a Panamanian borrower, raised $96 million in June, with an entirely Taiwanese arranger group: Cathay United Bank, First Commercial, Mega, Taiwan Business Bank and Taiwan Cooperative. Other examples of companies that have raised funds in loans that are at least jointly lead arranged by Taiwanese banks include Dynamic Apex Macao Commercial Offshore, CRCI of Thailand, PT Astra Sedaya Finance of Indonesia, Hannstar Board Holdings from Hong Kong, the Thai arm of Maxis International, Vietnam’s Phuc Son Cement (in a $73 million leveraged deal in April, sole led by Mega International Commercial Bank), Hong Kong’s Masstop Asia Pacific, and the USA’s Meade Instruments.

The Phuc Son deal, for example, is believed to have paid Mega 300 basis points over costs, far more than the bank could expect on domestic deals. And the deals above only highlight the leads: the Bank of Queensland deal, for example, involved a total of 13 Taiwanese institutions at some level in the structure. More and more Australian borrowers are considering Taiwanese lenders as a specific target when they arrange funding; the same has recently been true of India too. Reliance Industries’ US$1.2 billion five-year bullet loan, signed last August, included Chinatrust as an arranger, with Bank of Taiwan, First Commercial Bank, E.Sun Commercial Bank and Hua Nan Commercial Bank all in general syndication. The facility paid a top level all-in fee of 151 basis points over Libor.

The push overseas seems to be taking place across the board. Private sector names like Mega, Cathay and Chinatrust are all growing strongly, but so are government banks: Taiwan Cooperative, for example, which is 100% state-owned. Many Taiwanese banks are expanding their branch network overseas: Mega, for example, has branches in four US cities, two in Panama, and others in Paris, Amsterdam, London, three Australian and two Japanese cities, Ho Chi Minh City, Singapore, Labuan, Hong Kong and (representative offices) Bahrain and Mumbai. That said, in many cases the actual loan participation takes place in an overseas business unit that is run from the bank’s own Taipei head office.

While these deals generate useful revenue, there is a question too. How much do Taiwanese banks really know about the credit of a Finnish telco supplier or a Panamanian container group? “In Taiwan there’s a question to what extent they are mispricing risk,” says Smith. “So far we haven’t seen it: the NPLs for offshore businesses have not picked up, with the exception of US subsidiaries.” Many of the loans that appear in CBC data would actually be to the overseas arms of Taiwanese corporations: an example is the $220 million loan to Nan Ya Plastics (HK). Clearly that sort of loan is not a cause for concern. But necessarily, loans further afield stretch the degree to which banks can know their clients. “Risk management is the key question,” Smith says.

Asian stock markets are suffering – even more than the US markets whose banks precipitated the credit crunch. While the S&P 500 index was down 12.2% in the year to August 18, Hong Kong’s Hang Seng index is down 24.7%, Singapore’s STI 19.9%, India’s Sensex 27.8% and China’s CBN600 an eye-watering 55.5%.

While the experience has been painful for investors, many feel that the decline represents a rare buying opportunity in Asia. There might be worse to come, but almost universally analysts and fund managers feel that investors with a long term view will be rewarded. The question is: where to pick?

The consuming issue of the moment is just what is happening to China. China’s economy is slowing, but all things are relative: it has slowed from 11.9% year on year GDP growth in 2007 to 10.1% in the second quarter of 2008, which by the standards of any other market is still breakneck speed. Even bears like Kenneth Rogoff, a Harvard economics professor and former International Monetary Fund economist, speak only of a “significant growth recession in China” to “at least one year of sub-6 per cent growth,” still dramatically higher than is routine in the developed world. The threat, though, is chiefly inflation, which hit 8.5% in April; on top of that, a US and European recession would clearly hit exports.

In the short term, some are still bearish about China. Stephane Mauppin-Higashino heads a product specialist team at Credit Agricole Asset Management, which offers a global emerging markets fund. His fund is overweighting Russia and Brazil at the expense of China and India. But looking further ahead, he has little doubt about the country’s prospects. “We believe the growth is here to stay,” he says. “Whether it’s nine or 10 or 11 or six, China will grow. It will average seven to eight per cent annualised growth through the cycle and we don’t have much of an issue with it falling below the trend, even to five per cent, if it were to happen.

“The issue we have had with China is the price: valuation, and inflation. It’s been a fantastic story but too expensive.” 

Some investors are also troubled by transparency in Chinese listed companies. Hugh Young is the managing director of Aberdeen Asset Management Asia in Singapore; he actively avoids most Chinese stocks. “At the company level, we really don’t have a clear view of earnings because of the lack of transparency,” he says. “Aside from that, so much depends on policy action: the level of stamp duty, the pipeline of IPOs, the release of non-tradable shares, and so on.”

That said, most foreign investors in China don’t go anywhere near the so-called A-share markets, which are domestic Chinese stocks listed in Shanghai and Shenzhen. Generally, they can’t, except through tightly controlled occasional institutional allocations from the Chinese state. Instead, they are more likely to invest in H-shares (Chinese companies listed in Hong Kong), red chips (Hong Kong listed and incorporated companies with substantially mainland operations and management), or Greater China plays – and in this regard Taiwan is looking increasingly interesting.

Taiwan has been a perennial underperformer over the years. “Over the last eight years the market has consistently disappointed, primarily due to policies that have encouraged capital flight,” says Adrian Mowat, chief Asian and emerging equity strategist at JP Morgan in Hong Kong. But when a new government was voted in on March 22, there was great hope of a change in fortune. President Ma Ying-jeou was elected on a platform that included a much more friendly relationship with mainland China than his predecessor, Chen Shui-bian. Ma will not push for independent statehood for Taiwan as Chen did, but will instead look for a better economic future for Taiwan predicated on greater freedom of trade, investment and general cooperation with the world’s most populous and vibrant nation.

An initial euphoria that prompted a 20% climb in the stock market in the run-up to and through the election has since unwound, partly because of the behaviour of world stock markets, partly because of the outlook for electronics stocks that dominate Taiwan’s economy, but also with a sense of reality about just what can be achieved in pro-China relations. Still, as CY Huang, the president for Greater China investment banking at the Taipei financial institution Polaris, points out: “Nobody can make magic in two months.”

And change is taking place. The iconic moment came with the announcement of direct flights between Taiwan and mainland China, albeit only on weekends. But there are more substantial shifts happening in investment and financial services. A long-standing limit on Taiwanese companies obliging them to invest only 40% of their net worth in China is being raised to 60%, and is likely to rise further. In June, limits were relaxed on the amount Taiwanese funds can invest in Chinese stocks. Additionally, an equally long-standing ban on Chinese investment in Taiwan’s stock and futures exchanges has been lifted: qualified domestic institutional investors, or QDIIs, which are Chinese institutions with approval from Beijing to invest overseas, will be permitted to buy in. Foreign mutual funds backed by Chinese capital can also now come in to Taiwan. “The government wants to attract PRC money to come into Taiwan,” says Huang. “Previously, you needed a declaration: if HSBC wanted to bring money in it would have to declare none of it came from China.”

Measures like this have two effects: they mean that Taiwanese companies are more likely to use Taiwanese banks and other service providers to handle their business, rather than moving the whole lot offshore to avoid restrictions; and they mean there is a greater chance of capital flooding into Taiwan instead of constantly leaving it. It’s this sort of momentum that has attracted Mowat at JP Morgan to make Taiwan one of his four major overweights in emerging markets today (the others being China, Mexico and Turkey). “Our argument is that during the DPP administration [under Chen] you saw capital flight and the government appeared to have no economic policy. The KMT government has come to power, liberalised investment restrictions for Taiwanese going into China, and has improved relations with the mainland.” Taiwan has three prongs for accelerating growth in the next year, Mowat says: tax cuts, infrastructure development and deregulation.

Elsewhere, prospects vary from market to market. (India is a whole other subject, beyond the scope of this article.) In southeast Asia, markets are struggling, whether through basic economics (Singapore, which being fundamentally a country of service industries suffers more than most when the US and other major trading partners run into trouble) or unusual specifics (the increasingly fractious political environment in Malaysia).

But the turmoil has created some unlikely opportunities. Global fund managers searching for a combination of low stock market valuations and high earnings potential might want to take a second look at Thai equities. The Stock Exchange of Thailand (SET) not only trades on a 2008 PE of 9 compared with 12.6 in Malaysia and 11.6 in the Philippines, but it offers a dividend yield of 4.9%. Better still, after years of dismal returns, analysts are forecasting that corporate earnings will increase by 21.3% this year and by 6.6% next year.

In its latest strategy report on the Asia-Pacific, Merrill Lynch rates Thailand as one of the cheapest markets in the region and suggests that investors overweight it. Merrill is not the only one with a buy on the market. Andrew Stotz, head of research at CLSA also believes that Thai stocks look attractive. “With the Thai market down almost 20% this year and with valuations looking the lowest in Asia, we believe that investors should be aggressively buying the market,” he says.

As is so often the case in Thailand, however, there is one major problem. And that’s the political situation. Few analysts believe that the coalition government led by Prime Minister Samak Sundaravej will survive the next 12 months let alone its full term in office. Furthermore, despite the recent decision by deposed former Premier Thaksin Shinawatra to seek political asylum overseas, the threat of mass street protests and a possible violent confrontation has not gone away.

Concerns over the fragile political situation together with fears of rising inflation, which reached 9.2% in July, have already dampened expectations for the second half of the year. The Securities Analysts Association recently downgraded its forecast for the SET Index to a range of 628 to 828. That compares with a current level of 702.

Still with the SET index having fallen by 20% since the beginning of the year and by more than 60% since its all time high in January 1994, canny fund managers will certainly find bargains. Asia Plus Securities suggests that investors look at property company Land & Houses, coal miner Banpu and energy giant PTT. These companies are expected to show impressive second quarter earnings as well as solid long term growth potential. Meanwhile Kim Eng Securities recommends select blue chips like Bangkok Bank, PTT Exploration and Production (PTTEP) as well as Total Access Communication.

So after the recent sharp correction in equity prices, has the stock market finally bottomed out?  Poramet Tongbua, head of research at Tisco Securities in Bangkok, certainly thinks that it has. “We believe that the market already reflects more than 80% of the worse-case scenario for political developments, rising inflation and higher NPLs. Consequently we are convinced that Thai stocks now offer an attractive risk to reward ratio for longer term investment,” he says.

Perhaps the best news for investors is the fact that for the first time since 2005, managers of listed companies in Thailand have become significant buyers of their own stock, suggesting that they believe that their businesses are undervalued. According to Phatra Securities, so far this year management of 47 of the SET100 companies have been net buyers of their own shares on a cumulative basis. That compares to only 28 companies where management have been net sellers.

To date, foreign investors have shown considerably less confidence in the market. Since January, they have sold off Bt86 billion (US$2.6 billion) of stock, representing most of what they had accumulated since the beginning of 2006. As a result, large capitalized companies like Advanced Info Services, PTTEP and K-Bank are at their lowest level of foreign ownership for at least three years. If and when foreign investors decide to return, Ian Gisbourne, strategist at Phatra Securities believes that these stocks could be amongst the star performers.

But whilst Thailand does offer some compelling reasons to buy, fund managers would do well to remember that this has been one of the worst performing markets in the region over the past decade. And whilst by most measures Thai stocks look cheap, investors will want to know that this time round, the market really will go up. Stotz for his part remains upbeat. “In Thailand, analysts are at the tail end of four long years of earnings downgrades. To us, earnings look much more vulnerable in China, Singapore, India and Hong Kong.”

In terms of sectors, three have been particularly badly hit in Asia. One is financial services, although banks in Asia generally had very limited subprime exposure. The others are real estate and gaming.

Here, too, there is ammunition for the bold contrarian. “People are going to make an awful lot of money out of real estate in the next couple of years,” says Mowat. “But at the moment it’s incredibly out of favour, particularly Chinese real estate. We think it’s oversold.”

Nobody has escaped. Take Capitaland, the Singaporean blue chip often considered the best run company in the country, the unquestioned leader in Asia’s fledgling real estate investment trust sector, and a true real estate blue chip. By August 19 it had almost halved in value in the space of a year. Ascott REIT, one of its trusts based around serviced apartments, looks even worse: well over $2 a share a year ago, 99 cents in August.

The fall in stocks like these reflects a number of dynamics. A slowing economic outlook reduces demand for high-end residential property and commercial property. Stocks that have used a lot of gearing – this applies to many REITs – have been particularly badly hit. But generally property related share prices have fallen by much more than the prices of the underlying assets, which causes some fund managers to see a buying opportunity – if it can only be timed right.

The pain has hit the region’s other developed markets too, notably Australia, which has the most entrenched REIT market in the region. “It’s been incredible, really,” says Andrew Saunders, CEO of Real Estate Capital Partners, a Sydney-based real estate fund manager. “The A-REIT sector was worth about A$145 billion in June 2007. Now it stands at A$70 to A$75 billion.” Saunders says some REITs are trading at as much as a 45% discount to net tangible assets, despite being underpinned in some cases by world class assets – such as Australian bank Westpac’s head office on Sydney’s Kent Street.

Arguably the chief attraction of this sector is the extraordinary yield. Australia is a high-dividend market at the best of times – CommSec chief equities economist Craig James says the Australian stock market today is paying its highest yield for 17 years, with blue chips paying as much as 6 or 7%, particularly in the banking sector – but the REIT sector is more generous still.

Fund manager Stephen Hiscock of SG Hiscock & Co in Melbourne says the sector has a forecast yield of over 9% for 2009, and 11% if one big and distorting stock, Westfield, is excluded. One fund manager calls it “potentially the buying opportunity of a decade. But the problem is, you know it could still all halve again tomorrow.”

The other big listed property market in the Asia Pacific region is Japan, which at the start of this year had a higher market cap in its REIT sector than the rest of ex-Australia Asia put together, at US$46.035 billion, though it has fallen since. There are 42 REITs listed in Japan.

Japan’s property sector generally has been hit by a credit crunch despite the fact that Japan had little exposure to subprime. 43 real estate developers filed for bankruptcy in July alone, mainly because they could not access funds. This, rather than the underlying properties themselves, has been the problem: at a time when Jones Lang LaSalle puts Tokyo CBD office vacancies at only 3%, relatively big names such as Urban Corporation and Ardepro have been badly hit by concerns about their ability to access credit.

Once again, there’s a question of whether falls create opportunities for investors. A recent report by Merrill Lynch said around half of all J-REITs are now trading below book value. They also pay what is, by Japanese standards, an exceptionally high yield of over 5%. And among listed real estate developers generally, those with the strength of balance sheet to ride out the credit crunch are likely to be well positioned and modestly valued by the end of it, and even in a position to acquire from troubled peers.

Already, several landmark transactions have taken place this year: CBRE Research highlights the acquisition of the Resona Bank headquarters in Otemachi, with Mitsubishi Estate acquiring a 73% sectional ownership of the building for Y162 billion. Others include GIC Real Estate, the property investment arm of the Government of Singapore Investment Corporation, purchasing the Westin Tokyo from a Morgan Stanley real estate fund for Y77 billion; Morgan Stanley Real Estate Investment acquiring the Citigroup Centre in Shinagawa-ku from Citibank for Y48 billion; and another Morgan Stanley acquisition, of the Shinsei Bank Building in Chiyoda-ku, for Y118 billion. REITs, too, have been acquisitive this year, with examples including Industrial and Infrastructure Fund acquiaring IIF Haneda Airport Maintenance Center for Y42.2 billion, and Japan Retail Fund acquiring Aeon Sapporo Hassam Shopping Center in Sapporo for Y18.4 billion.

Yuto Ohigashi, an analyst at Jones Lang LaSalle, sees opportunity. “While the type of real estate buyers has changed from high-leveraged investors to low-leveraged ones, the Japanese market remains attractive due to the sheer size of its investment grade property market compared with that of other Asian markets,” he wrote in a recent report. “Among Japanese real estate, Y490 trillion is held by corporations, about Y68 trillion of which is considered as revenue-generating properties. Part of the remaining real estate, which is valued at about Y420 trillion or more than six times revenue-generating real estate, is likely to be simply dormant, suggesting the enormous size of the potential market.”

The other sector to have been horribly hit is the gaming industry. Two years ago there was great fanfare and optimism in Macau. The state had opened up the gaming industry once dominated by Stanley Ho and awarded three concessions and a further three sub-concessions, bringing competition and money into a previously seedy sector. Groups like Las Vegas Sands, Wynn Resorts, Melco and Galaxy Entertainment had all committed considerable sums to casino development in the years ahead, and in terms of gaming revenue (as opposed to retail and entertainment in the same area), Macau has now overtaken Las Vegas as the world’s gaming centre. Many of the new ventures are very much in the Vegas style, combining world class entertainment and retail facilities with the traditional casinos, plus top-of-the-line hotels.

But if the share price performance in real estate looks bad, that’s nothing compared to gaming stocks. Consider Dore Holdings, which specialises in the VIP junket game, providing high-roller players to casinos. It has gone from HK$3.60 per share to HK$0.21 in a year – that’s a 94% fall. While not all stocks have suffered quite so dramatically, the situation has not been kind to anyone: when Sociedade de Jogos, the casino business owned by the ultimate gaming tycoon Stanley Ho, sought a Hong Kong listing, it took three years, more than 30 court cases, an application for judicial review on the eve of the float which caused half of the retail investors to back out of the offering, and a halving of the targeted amount to get away. And when it did, it promptly started sinking.

Part of the reason for the problems in Macau’s gaming industry are related to an apparent rethink on China’s part about just what it wants Macau to be. Over the course of this year it has introduced a number of measures designed to cool the growth of Macau’s gaming industry, to reduce the maximum length of time Chinese nationals can spend there, and to cut the frequency of their visits. Since the development of Macau is to a large extent based on the promise of China’s population, this has hit the industry hard. Increased competition is another concern.

But some consultants feel the future is much brighter than these headwinds would suggest, which again raises the possibility of buying opportunities. The Las Vegas based consultancy Globalysis estimates that Macau will experience 28.8% growth in gross gaming revenue (GGR) in 2008 year on year, to reach a total of US$13.5 billion. “It now looks like Macau will bypass not only the Las Vegas strip once again in terms of gaming revenue in 2008, but for the first time, also that of the entire metropolitan area of Las Vegas,” said Jonathan Galaviz, partner at Globalysis, in May when he launched his most recent report on Macau. “Macau’s continued growth in GGR is a reflection of the generally strong macro-economic environment that Macau finds itself within Asia.” If he’s right, then the sector is clearly oversold and presents opportunities.

A big question for the Asia Pacific region is what happens to commodity prices, which will have differing impacts in different locations. Of major markets, Australia is probably the one that has benefited most from the commodities boom: it is home (or a joint home) to world mining leaders like BHP Billiton and Rio Tinto, and its role as a quarry and breadbasket for ardent importers like China has led it to a stunningly protracted period of economic strength. Consequently Australia has not had a year of less than 2.5% GDP growth since the early 1990s, remarkable in a developed economy.

Australia’s market has been hit as hard as any this year though, and was down 21.4% year to date by August 18, partly as a result of market contagion spreading to the commodity sector. Those who believe the commodities boom has further to run tend to be more bullish on Australia than on other markets, although the short term is likely to be less favourable. “Given the relative important of resources in the Australian share market, Australian shares may underperform global share markets for a while yet as the commodity correction runs its course,” says Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors in Sydney. “Asian shares are likely to be key beneficiaries of the correction in commodity prices given Asia’s high reliance on commodity imports.”

Asia, then, as ever presents a wide range of differing stories. Putting money into such volatile markets requires some tough nerves and a willingness to ride out some likely losses along the way. But, as one fund manager says: “Contrarianism is where the real money is made.”