Taiwan faced slower growth and higher price pressures during 1H, in the context of the Ukraine crisis, Fed tightening, China lockdown, and domestic Omicron outbreak. GDP growth decelerated to 3.1% YoY in 1Q, down from 4.9% in the final quarter of last year, and the slowest pace seen since 3Q20. CPI inflation rose to 3.6% in June, the highest level in nearly 14 years. Balancing the risks of growth and inflation, the central bank opted for a gradual pace of monetary policy tightening in 1H.

1) China lockdown

The supply and demand-side disruptions from China’s Covid restrictions were more serious than expected. Shanghai/Yangtze River Delta is a key area where many Taiwanese electronics contract manufacturers are located. Following the lockdown in Shanghai, Taiwan’s export orders fell immediately by -5.5% YoY in April. Despite the 6.0% rebound in May, export orders growth remained weak compared to the 16.2% seen in 1Q. Actual exports stayed in the expansionary territory, but the growth rate also slowed to 15.4% in 2Q from 23.5% in 1Q. Meanwhile, manufacturing PMI trended downwards through the second quarter and hit 49.8 in June, below the neutral 50 level for the first time in two years. Surveyed firms continued to report disruptions from Covid, notably restrictions and staff absence on the mainland, along with the weakening of customer demand.

China’s Covid controls will likely continue to weigh on Taiwanese manufacturers through the supply and demand channels in 2H.  Scattered supply chain disruptions in China’s key economic hubs will remain a risk in the near term, unless the zero-Covid policy shifts substantially. The knock-on impact on Chinese demand, due to losses in corporate profits, jobs and incomes, is likely to linger. Taiwanese manufacturers have been actively reshoring and building alternative production bases (e.g., Vietnam, India) since the outbreak of the China-US trade war in 2018. Nonetheless, mainland China remains Taiwan’s largest offshore production center and largest export market today. It accounted for 32% of Taiwan’s total outward FDI and 28% of total exports in 2021.

2) Domestic Omicron outbreak

Coincidentally, Taiwan also experienced a domestic Omicron outbreak in 2Q. While the outbreak happened earlier than expected, its overall impact did not deviate much from our expectations. The daily number of infections started to surge in mid-April, approaching a record 100k at end-May. The government refrained from tightening restriction measures. Supply chains of critical industries were largely unscathed. Residents voluntarily reduced outdoor activities – retail and recreation declined by nearly 20% between mid-April and end-May. Still, this magnitude of decline was relatively moderate compared to the -40% seen during the first major Covid wave in May 2021.

Currently, a large portion of Taiwan’s population should have Covid antibody positivity – through natural infections and vaccinations. The cumulative number of infections stands at 4.2mn, equivalent to 18% of the total population. This number might be underestimated; Taiwan counted confirmation cases primarily based on the PCR test results until end-May. In terms of Covid vaccination, 74% of the population have received the booster shots as of early-July, on par with the levels in Singapore and South Korea.

Consumer demand is expected to bottom out in 3Q and recover further in 4Q. The ongoing Omicron wave has started to subside in Taiwan. The public is now better prepared to coexist with the virus. The government is also mulling plans to further reopen borders in 2H, including raising the arrival quota, loosening quarantine requirements, and allowing the entry of tourists.

3) Ukraine crisis and inflation

CPI inflation rose slightly faster than expected in 1H, due to the Ukraine crisis that pushed up global commodities prices. We had estimated that every 10% rise in global crude oil prices would boost Taiwan’s CPI inflation by 0.2ppt. But global food prices also surged in 1H due to the supply side disruptions caused by the Ukraine crisis, and fertilizer prices went up due to the passthrough effects of higher oil costs. Prices of various food items in Taiwan increased accordingly, including cereals, meat, eggs, dairy products and edible oil. Food prices contributed 1.5ppt to the 3.1% rise in headline CPI in 1H.

Our forecast model currently suggests that CPI has peaked in June and will ease slightly below 3% by year-end. The embedded assumptions include 1) international oil and food prices will not rise further in 2H, 2) domestic weather conditions will not deteriorate, 3) inflation expectations will be anchored at the current levels, and 4) money supply M2 growth will slow to the trend rate, as a result of the central bank’s monetary policy tightening..

4) Fed tightening

The impact of Fed tightening is multifaceted. Capital outflows from Taiwan increased in 1H, but a broad correction in asset prices was averted. Foreign net remittance into Taiwan’s stock market declined by USD6.2bn in 1H. The TAIEX fell about 20% YTD, among the worst performers in the Asia region. Nonetheless, real estate prices stayed resilient as domestic liquidity conditions remained ample. Residential property prices in Taipei continued to gain 6.0% YoY in May (Sinyi index), a mild slowdown compared to the 8.0% in January.

The central bank (CBC) maintained the independence of its monetary policy, raising rates at its own pace in 1H. Following the 25bps rate hike in March, the CBC raised the benchmark discount rate by a small 12.5bps in June and lifted banks’ reserve requirement ratio (RRR) by 25bps to tighten liquidity. This was in line with our non-consensus forecast.

The impact of Fed tightening on the external demand outlook warrants a review, however. The Fed Funds Target Rate is now expected to rise above the neutral level to reach 3.50% by year-end. Restrictive monetary policy will likely increase the risk of a sharp US economic slowdown in 2023. The US is Taiwan’s largest source of final export demand, accounting for 30% of its total export orders in 2021. It is also the world’s third largest smartphone market and the key hub for technology innovation.

In the tech sector, there are mounting concerns about a cyclical downturn. Gartner forecasts global PC, tablet and mobile phone shipments to contract 7.6% in 2022. WSTS expects global semiconductor sales to maintain a strong 16.3% growth this year, but slow to 5.1% in 2023. Taiwan’s tech giant TSMC remained confident about its demand outlook at the 2Q earnings briefing, while acknowledging the risk of inventory adjustments in the semiconductor sector through 1H23. The company also said that it would postpone part of its 2022 capex plans, due to the longer time of equipment delivery.

Forecast revisions

We are revising the 2022 GDP growth forecast down to 3.4% from 3.8%. The growth forecast for 2023 is also trimmed to 2.8% from 3.0%. Our 2022 forecast is now more conservative than the government’s projection of 3.91% and the central bank’s 3.75%. We still expect a moderate growth rebound to 3.7% YoY in 2H, up from 3.1% in 1H. Third quarter data will likely show a notable improvement, due to fading impacts from the China lockdowns and domestic Omicron outbreak. Downside risks will likely re-emerge in 4Q, as US demand starts to soften. By expenditure, private consumption is expected to lead the recovery in 2H as the Covid impact dissipates and inflation pressure abates. Exports growth will likely decelerate, amid a more uncertain global demand outlook.

Our CPI inflation forecasts are kept unchanged at 3.0% for 2022 and 1.8% for 2023. The 2022 estimate is higher than the government’s 2.67% and the central bank’s 2.83%. The quarterly inflation figures are expected to ease slightly in 2H, to 3.2% in 3Q and 2.7% in 4Q.

We maintain the forecast for the central bank to hike rates by 12.5bps per quarter, taking the policy discount rate to 1.75% at end-2022 and 2.25% at end-2023. We don’t expect outsized rate hikes from the CBC, as inflation pressure in Taiwan is not as serious as in the US or other advanced Asian economies like South Korea and Singapore. Also, note that the CBC has a record of using the non-policy rate instruments such as RRR and CD/NCD rate to tighten liquidity or boost the costs of borrowing. We see a good chance for the CBC to further raise the RRR in 2H, in the range of 25-100bps.

To read the full report, click here to Download the PDF.