Risks of rate cut underestimated in Taiwan

This week's central bank meeting will be interesting to watch. While the market consensus expects Taiwan's central bank (CBC) to hold rates steady at 1.875%, the risk of a surprise rate cut to 1.75% shouldn't be underestimated. The CBC has kept rates unchanged over the past four years ever since 2011. The global context during this period was that Asian central banks have jointly eased monetary policy amid slowing economic growth and diminishing inflation pressures.

The US Fed also refrained from hiking rates last week, citing concerns about China's slowdown and emerging market volatility. Downside risks in the external environment should be sufficient to justify policy easing in Taiwan, a small and open economy that is highly exposed to external trade especially trade with China. 

Indeed, as a result of falling demand from China, GDP growth in Taiwan has contracted sharply by 6.6% (QoQ saar) in 2Q15. The government has downgraded the full-year GDP estimate to 1.56% during the latest review in Aug15. This is the slowest growth over six years and far lower than the long-term trend of 4%, which suggests a sharp deterioration in the output gap and a decline in the neutral interest rates implied by current economic conditions. 

Adding to the concerns is that the downswing in economic cycle has persisted for two quarters. Exports, manufacturing PMI and industrial production have continued to weaken in Jul-Aug15, showing little signs of an imminent turnaround. Despite the hope for rising demand from the US in 4Q15 after the release of new Apple products, the outlook for Chinese demand remains lackluster. A prolonged period of exports weakness could increase the likelihood of a slowdown in job/wage growth and domestic demand going forward. 

The government has announced a package of economic support measures in recent months. But the impact won't be immediate as the focus of the proposed measures is on structural reforms. Implementation of these long-term policies will also be a question, given that the nation is heading towards elections and the election outcomes are uncertain. At the current juncture, the burden of supporting growth mainly falls on the central bank. 

In fact, the CBC has already conducted de facto monetary easing over the past one month, such as guiding down the interbank rates via open market operations, and relaxing the LTV rules imposed on banks' lending to property buyers. An outright cut in the benchmark discount rate will help to directly push down the short-term money market rates and the lending rates, in line with the policy intention of reviving credit growth.