On trade, look east instead of west

By Hwan C.Lin, reprint from Taipei Times, June 30, 2005

More than a month ago, Chinese Nationalist Party (KMT) Chairman Lien Chan (連戰) launched his so-called "ice-breaking tour" of China. Lien met with Chinese President Hu Jintao (胡錦濤) on April 29 and then issued a joint communique, stressing their desire to establish a "cross-strait common market" and push for across-the-board economic cooperation between the two sides of the Taiwan Strait. In the communique, the two parties did not forget to reiterate their common opposition to Taiwanese independence.

The idea of a cross-strait common market is not new at all. It has already been trumpeted by proponents including KMT Vice Chairman Vincent Siew (蕭萬長). These proponents are either those who crave to see an eventual political integration between Taiwan and China or those who naively mistake the emerging China market for an easy path to an ever-flourishing Taiwanese economy.

In contrast to that widely circulating common-market idea, the proposed US-Taiwan free trade agreement (FTA) has not sparked as much attention.

Taiwan's government proposed to enter into such an FTA with the US in 2002, the same year as its successful accession to the WTO, which came after an unnecessarily prolonged 12-year negotiation process thanks to China's political objections.

For an industrialized economy like Taiwan, economic development helps people enhance their standard of living and quality of life through the creation of domestic high-wage job opportunities, rather than pursuit of foreign low-wage workers. But high-wage jobs will never be created without domestic investment in education, research and development (R&D), and social infrastructure.

Overseas investment by itself, be it in the form of either foreign direct investment (FDI) or short-term portfolio investment, cannot create -- and can even destroy -- high-wage jobs for domestic residents, in spite of potential efficiency gains in the short run. That points to a need for a balance between internal and external investment -- a balance that must be struck through government policy.

The cross-strait common market Lien recently proposed would further integrate Taiwan into a developing Chinese economy abundant in cheap labor.

This would further encourage the already massive outflow of Taiwan's FDI to China and its low-wage workers, while making no contribution to the creation of high-wage jobs at home. Taiwan would also run the risk of seeing its historical links to the US, Japan and other developed economies weaken.

Taiwan's officially-approved China-bound FDI last year totaled US$7 billion, or 2.3 percent of Taiwan's GDP. This massive amount of China-bound investment is about the same amount as Taiwan's aggregate R&D investment, of which 60 percent comes from private sources and 40 percent comes from the government. It also dwarfed Taiwan's FDI to developed countries as a whole.

This is "China fever." It's alarming that Taiwan's domestic resources have been rushing to meet China's development needs rather than nurturing long-term economic growth potential at home.

Taiwan is playing catch-up in the global technology race. It cannot overlook the fact that just a few rich countries account for most of the world's creation of new technology. The G7 countries (the US, Japan, Germany, France, the UK, Canada and Italy) together account of more than 80 percent of the world's R&D spending.

From empirical studies, international technology diffusion is very much localized. Only those economies that have invested enough domestically in R&D are competent to exploit external benefits from the developed world's innovations, and thereby help themselves climb up the technology ladder.

It is time to refocus Taiwanese investment away from a China-centric economic approach and back toward the developed world and Taiwan itself. A US-Taiwan FTA should be looked at within this strategic context.

It is true that trade barriers between Taiwan and the US are modest, and that the direct benefits of further trade liberalization via an FTA must therefore also be modest. However, its strategic implications go beyond the economic dimension.

First, the US is a member of the North American Free Trade Agreement and is working with six Central American countries toward a free trade agreement called CAFTA (Central American Free Trade Agreement). An FTA between Taiwan and the US could serve as a gateway to extending Taiwan's economic outreach into Central America.

Second, a US-Taiwan FTA could serve as a platform for further development of a variety of mechanisms that channel Taiwan's venture capital and human capital into international R&D cooperation with the US and other advanced countries.

Third, a US-Taiwan FTA could provide a shield against Beijing's political clout and spur so-called "competitive liberalization" in East Asia by encouraging countries including Japan and ASEAN members to enter into FTAs with Taiwan. Taiwan could therefore mitigate the risk of being marginalized by China's plan to push an "ASEAN plus three" free trade area (the three being China, Japan and South Korea) -- a bloc that would deliberately exclude Taiwan and the US.

Last but not the least, a US-Taiwan FTA could help Taiwan prosper economically. This would enable Taiwan to better contribute to regional stability and prosperity.

A US-Taiwan FTA is thus a win-win strategy from both an economic and political perspective. US-Singapore and US-Australia FTAs have already been concluded. Why does Washington hesitate to deal with Taipei to strike a US-Taiwan FTA?

Economic integration has its risks

By Hwan C. Lin, reprint from Taipei Times, April 06, 2005

The early 1990s ushered in a sea change in the Taiwan Strait. The Taiwan-China relationship finally broke a four-decade-long bilateral embargo and marched into a new era of cross-strait integration. Capital, goods and people move in massive amounts from the nation to the world's largest developing economy.

This is a 15-year long experiment of economic integration between two long-term military rivals. Integration has generated economic gains skewed toward China, while causing a potential drag on Taiwan's long-term economic viability, an austere "aggregate risk" that is looming on the horizon.

President Chen Shui-bian (陳水扁) has not sensed the looming risk. Instead, in the recent Joint Statement issued on Feb. 24, Chen and People First Party Chairman James Soong (宋楚瑜) voiced their common stance of reinforcing cross-strait integration between Taiwan and China. Moreover, article 6 of the statement reads, "On the basis of goodwill from both sides of the Taiwan Strait, we would not exclude any possibility to establish future relations between the two sides, in any form whatsoever."

Evidently, neither the ruling nor opposition parties seem to resist some form of political integration, in the wake of 15 years of cross-strait economic integration. Neither party showed the intent to seek measures to cool down the Taiwan-China economic relationship in the Joint Statement.

More recently, China's National People's Congress rubber-stamped a bellicose "Anti-Secession" Law on March 14. This is clearly a scheme of China to utilize a domestic law to legitimize its future annexation of Taiwan. It is about time that Taiwan's government should re-examine the nation's overall relationship with China.

Since Japan renounced its sovereignty over Taiwan under the Peace Treaty of San Francisco that came into force in 1952, Taiwan has been a territorial entity under the governing authority of the Republic of China, but not subject to any existing sovereignty (see Frank Chiang, State, Sovereignty, and Taiwan (2000), and One-China Policy and Taiwan (2004), Fordham International Law Journal).

Taiwan's postwar external relationships had been closely linked to the US, Japan and Western Europe. These advanced economies served not only as markets but also as sources of technology diffusion, helping the nation advance to a newly industrialized economy that is now empowered to export technologies and capital to developing economies, like China.

History was often made, with far-reaching repercussions. The Tiananmen Square incident of 1989 strained the Sino-West relationship for years, while ironically paving a way for Taiwan to integrate economically with China at an astonishing pace. The West has been imposing an embargo on arms sales to China for fifteen years, although the EU now seems ready to lift this ban despite US opposition. The strains between China and the West, however, unintentionally rendered a preface for integration between Taiwan and China.

In tandem with the Sino-West strains, the global economic environment also acted as a catalyst. During the second half of the 1980s, the world's advanced economies were plagued by extraordinary disequilibriums in their current-account balances, which measure international trade in goods and services. The US suffered huge current-account deficits against both industrial economies such as Japan and Germany and Asia's newly industrializing economies like Taiwan, South Korea, Singapore and Hong Kong.

Against that background, surplus economies' currencies (including the New Taiwan dollar, Japanese yen and German mark) drastically appreciated against the US dollar, both as a result of the world's current-account disequilibrium and as a necessary remedy to the disequilibrium adjustment problem. Currency appreciation impaired export competitiveness. The nation's economy was therefore forced to engineer large-scale reallocation of resources, triggering a production exodus of its low-value-added labor-intensive products. China, an extremely labor-abundant economy, was an ideal low-wage production location for Taiwan's labor-intensive products.

The Democratic Progressive Party (DPP) took power in 2000 for the first time. The DPP government failed to slow down cross-strait economic integration. Rather, it hastened integration by replacing the "No Haste, Be Patient" policy, which was initiated by former president Lee Teng-hui's (李登輝) KMT government, with a policy titled "Actively West-bound, Effective Management." However, the new policy precipitated the outflow of capital and technologies to China in the relentless "China fever," without effective government management.

Today more than 80 percent of Taiwan's foreign direct investment (FDI) and over one-third of its merchandise exports are China-bound. Last year, China replaced the US as the nation's largest export market for the first time. Now China, not the US, is the largest source of Taiwan's external trade surplus.

Evidently, trade created in the Taiwan Strait has diverted Taiwan's external trade away from the US. From a static economic analysis, Taiwan may have acquired economic gains, ceteris paribus, if trade creation dominates trade diversion in the fifteen-year experiment. Some pundits even squarely said that Taiwan had gained from its economic integration with China because the nation has enjoyed a sizable trade surplus across the Taiwan Strait.

But economists agree that such static analysis is over-simplistic because it overlooks long-term dynamic elements. In the long-term, Taiwan's economic might and well-being must depend on technology-driven productivity growth.
Trade created across the Taiwan Strait mostly resulted from Taiwan's China-bound investments, which was driven by Taiwanese businesses' strategy to search for more cost-effective vertical integration, in addition to an early foothold in the emerging China market.

The politically isolated nation therefore climbed in the world's supply chain, becoming an up-stream base that supplies equipment and parts for Taiwanese businesses that have established a down-stream base that manufactures labor-intensive goods in host country China.

Such vertical integration is efficient in production because Taiwanese businesses can reap lower-wage benefits in China.

But production efficiency arising from Taiwan's China-bound investments can never be the entire matrix that measures the nation's economic well-being.

In fact, Taiwan's excessive China-bound FDI, though efficient in production, could be inefficient in allocation of the nation's economic resources. In a nutshell, an individual's overseas investments could be privately efficient but socially inefficient. After all, Taiwan's long-term economic viability rests on its forward-looking investment in nurturing innovative capabilities rather than on its China-bound investment to utilize low-wage opportunities. Investment in China can achieve gains in production efficiency by freeing up Taiwan's domestic resources, mainly land and workers, that would otherwise be used to domestically produce older goods with higher production costs.

But investment in China can also incur losses in allocation efficiency by absorbing Taiwan's domestic resources, mainly capital and non-production workers (mostly engineers and managers), that would otherwise be allocated to sustain its domestic investment in innovative new products or processes.

Investment in China therefore gives rise to both efficiency in production and inefficiency in allocation of resource from the nation's economic perspective.

As such, a laissez faire policy for Taiwan's China-bound FDI would never serve the nation's best interests because of the loss of allocation efficiency, nor would a totally prohibitive policy do this because of its adverse effects on production efficiency. Taiwanese policymakers must hold a forward-looking perspective to circumspectly weigh the marginal gain of production efficiency against the marginal loss of allocation efficiency so that the nation's China-bound investments may slow down to a level of socially optimal equilibrium.

A dynamic analysis of both market competition and the externalities of global-technology diffusion also points to a need to better manage or curb Taiwan's China-bound FDI, which has exceeded 80 percent of the nation's overall overseas investments, as noted earlier, and which is far more than the nation's annual private investment in research and development (R&D), given that for many years more than 60 percent of Taiwan's overall R&D investment had come from the government sector.

Production efficiency gains from investments in China tend to be static and short-lived when market competition increasingly intensifies. Conversely, the loss of allocation efficiency arising from resources diverted away from innovative activities is inherently dynamic and long lasting. It is certainly doubtful that Taiwanese businesses can prevent their FDI profit margins from sizable erosion under free-market competition.

Moving to China socially unjust

By Hwan C. Lin, reprint from Taipei Times, Dec 04, 2002

Over the past decade, Taiwan has undergone a drastic change in its industrial structure, with a fall in its labor-intensive production along side a rise of knowledge- intensive, high-tech industry in the country. Two major forces engendered this change.

First, China's low-wage labor along with its open-door policy for international capital and trade has radically changed patterns in the region, giving it a comparative advantage leading to a re-allocation of resources in East Asia. Taiwan and other newly industrialized Asian economies (NIEs) have been losing their labor-intensive industry to China's labor-abundant, emerging economy.

Second, the information technology revolution which began in the mid-1990s was a golden opportunity for Asian NIEs. Taiwan capitalized on this boom and built a highly competitive original equipment manufacturing (OEM) position in the world's high-tech supply chain. These structural changes have posed great challenges to Taiwan.

First, the economic integration of Taiwan and China has increased in speed and scope. The shifting of production from Taiwan to China has even begun to spread to the high-tech industry. Taiwan Semiconductor Manufacturing Co for instance, plans to build an eight-inch wafer foundry in China. Such a production shift has caused painful displacement of workers in Taiwan.

Second, Taiwan's command of comparative advantage has increasingly been confined to the high-tech sector. This is an inevitable outcome of increased integration of regional economies. But specializing will also expose Taiwan's economy to the volatility of business cycles. This has aggravated the aforementioned adjustment problems since the global economy started a severe technology-led downturn in the first half of the last fiscal year.

True, it accords with the principles of optimizing profit to liquify capital and move it to a place that has the lowest-cost production site, but in some cases it is socially unjust. This contradiction has heightened and become a problem in Taiwan's economy, since its high-tech industry has failed to absorb jobless
workers. These workers lack marketable skills for the high-tech industry.

The high-tech industry requires both sophisticated knowledge and ample capital. Expansion creates very few job opportunities for displaced workers who were formerly employed in Taiwan's traditional, labor-intensive industries. Most of these workers are incapable of being transferred between traditional and high-tech industries.

This problem has been reflected in the nation's stubborn unemployment rate, which stood at 5.31 percent in October. If hidden unemployment is factored in, the October unemployment rate rose to a record high of 7.45 percent. At the same time, income distribution has continued to deteriorate along with its sagging labor market.

The co-existence of high unem-ployment rates and a widened income gap is unprecedented in the nation's economic development. It appears to have weakened the public's confidence in the DPP and dimmed President Chen Shui-bian's (陳水扁) prospects for a second term.

Confronting difficult political and economic situations, Chen must have a sense that time is of the essence. At a Nov. 18 National Security Council meeting of high-ranking economic and financial officials, Chen asked the Executive Yuan to reduce the jobless rate from 5.32 percent to less than 4.5 percent before the end of next year.

Unfortunately, the sheer political divide over whether Taiwan is a sovereign state or as a part of China underlies most public-policy issues. As far as the nation's economic situation is concerned, partisan bickering always results in an over-simplified conclusion.

In contrast to the TSU, for instance, the KMT-PFP bloc always hastily concludes that implementing direct links is a quick fix for Taiwan's sagging economy.

Ironically, Taiwan is second only to Hong Kong in economic integration with China. But such integration has saved neither Hong Kong nor Taiwan from the dip in the international economic cycle. South Korea is much less economically integrated with China, but has recorded a relatively better macroeconomic performance in recent years.

Taiwan is in desperate need of an omnibus economic policy package to cope with the decade-long stagnancy of its per capita income; a rapid erosion of its tax base coupled with its undisciplined government spending; the boom in investment in China against the bust of its investment in itself and an alarmingly high non-performing-loan ratio.

But, the DPP government has tended to subordinate economic policy to political concerns, swaying back and forth between the pro-independence and pro-unification forces. As a result, the government's economic policy has become a reaction to political ideology rather than to economic reality.

The "go West" (to China) versus the "go South" (to ASEAN nations) policies can never be the core of an omnibus economic policy which serves the best interests of the nation and its people.

The government needs to stand firm against political ideology and act effectively to put forth a policy package that features a Taiwan-based global vision. Investing in Taiwan and its global networks should be the core of such a policy package.

Without sufficient investment in infrastructure, education (at all levels), research and development and the global networks that help foster multilateral cooperation and integration in marketing, production and technological innovation and spillovers, Taiwan would risk being hollowed out by its massive investment in China and would also risk suffering another decade of high unemployment and stagnancy in its per capita income.

Chen must hurry to put Taiwan on the right track with a determined Taiwan-based global vision. Failure to do so could cost him the 2004 presidential election and countless jobs.

Taiwan has overinvested in China

By Hwan C. Lin, reprint from Taipei Times, Oct 31, 2002

The director of the American Institute in Taiwan, Douglas Paal, made an imprudent comment on Sept. 18 to the American Chamber of Commerce. "If Taiwan continues to view the mainland through the prism of economic threat, it is in danger of isolating itself and getting cut out of tomorrow's deals," he said.

Not long afterwards, an article appeared in the Taipei Times by Tu Jenn-hwa (杜震華) ("Taking a close look at investment in China," Oct. 9, page 8) which, surprisingly, supported Paal's view, saying, "Taiwan's investment in China is no higher than that of its major competitors, suggesting that the nation's so-called `China fever' is relatively rational."

Tu concludes from Taiwan's trade surplus that, "We can easily see the benefits of our investment in China." His logic runs as follows: From 1991 to last year, Taiwan's investment in China totaled US$29.6 billion. And during the same 11-year period Taiwan accumulated a US$162.8 billion trade surplus with China, according to the Mainland Affairs Council. On that basis, each dollar invested in China "has generated more than US$5 of revenue and profits continue to grow."

His computation -- US$162.8 divided by US$29.6, which equals 5.5 -- is simple, but his logic is flawed.

International trade balances as measured by exports of goods and services minus imports of goods and services, whether in surplus or deficit, are not evidence, nor even implications, of economic gains or losses.

Bilateral trade balances, such as those between Taiwan and China, basically reflect the two trading partners' patterns of supply and demand, subject to government regulations on trade, investment, and so on. On a global basis, a country's multilateral trade balance simply mirrors the extent of the imbalance between its national savings and its domestic investment.

The US, for instance, has run a trade deficit for more than 20 years. This indicates that US national savings are insufficient to fund its domestic investment, and so it must borrow from overseas. Japan's global trade, in contrast, has long been in surplus, meaning that its national savings exceed its domestic investment, so it lends to the rest of the world. To the US, the 1990s was a golden decade for productivity growth. To Japan, the 1990s was a lost decade.

The balance of trade, either bilateral or multilateral, largely measures a nation's capital inflow or outflow according to balance of payment accounting. Taiwan has increasingly run a trade surplus annually with China since the early 1990s. This simply tells us that Taiwan's saved funds are increasingly flowing to China.

From 1991 to last year, as noted earlier, Taiwan's cumulative trade surplus with China was US$162.8 billion. This surplus in effect reflects Taiwan's cumulative capital outflows to China during the period, ignoring minor adjustment factors such as official settlement balances and statistical discrepancies. It is by and large consistent with unofficial estimates that Taiwan's China-bound capital flows have accumulated to more than US$100 billion.

The accumulated total of US$29.6 billion that Tu reported in his article is obviously far removed from reality. Official statistics on Taiwan's investment in China have been notoriously imprecise.

Taiwan has indeed over-invested in China. Taiwan's annual China-bound capital flow has risen to at least 3 percent, indeed it has probably exceeded 4 percent, of its GDP. These estimates largely match Taiwan academics' figures cited in a recent Taipei Times editorial ("Taiwan must protect its eco-nomy," Sept. 29, page 8).

Japan and the US invested in China a mere 0.4 percent and 0.5 percent respectively of their GDP, based on last year's official statistics on foreign direct investment (FDI). Taiwan is playing catch-up in the world's technological races and is supposed to devote more resources to research and development. Yet Taiwan's domestic R&D still barely exceeds 2 percent of its GDP, in stark contrast to the world's technologically advanced countries. For instance, both Japan and the US invest little in China in relation to the size of their economies, but each invests up to 3 percent of its GDP in R&D.

It is ironic that Paal said that Taiwan is in danger of isolating itself from China. In fact, no nation appears to be doing more than Taiwan to exploit business opportunities in China. Taiwan ships more than 25 percent of its exports to China. China has replaced the US as Taiwan's largest export market.

The 1990s witnessed a rapid process of economic integration between Taiwan and China. This trend has even accelerated in recent years, despite the two countries' lingering political and military tensions. Worrisome to many pro-Taiwan politicians is the Taiwanese economy's excessive reliance on the China market, which has transformed into a trump card that Beijing can use to influence Taipei's China policy.

Even purely on the economic front, the extent to which Taiwan is being increasingly integrated into China is also worrisome. China's nominal GDP is about US$1 trillion, more than three times as much as Taiwan's US$300 billion or so. An expanding Chinese market certainly presents an opportunity for Taiwan to reap gains from cross-strait trade and investment, directed by the law of comparative advantage. But integration has gone too far too fast. The benefits of integration have not translated into sustained growth in per capita GDP. In reality, the entire 1990s was a stagnant decade, because Taiwan's per capita GDP did not grow at all.

"China fever" has borne no economic fruit for Taiwan over the past decade. Rather, it represents a false signal that directed a massive amount of resources into the development of vertical integration with a developing Chinese economy. This diverted resources away from the development of vertical integration with the innovative developed world, investment in basic and applied research and the building of a modern infrastructure conducive to sustained growth in living standards.

True, it is not easy to determine the optimal level of Taiwan's economic integration with China. But evidently, from the perspective of the national interest, the status quo dictates that the marginal benefit of further integration, assuming there is such a thing, is too small to warrant its marginal cost.

Rethinking investment in China

By Hwan C. Lin, reprint from Taipei Times, March 08, 2002

The Ministry of Economic Affairs is planning to allow Taiwan's chipmakers to build eight-inch wafer fabs in China. The plan's supporters say it would give Taiwan better market footing and global deployment and that it would free up resources for the development of more advanced 12-inch wafer fabs.

In fact, those familiar with original-equipment-manufacture (OEM) chipmakers know that production close to the market is not necessary. Transporting chips is a straightforward exercise and shipping costs account for a negligible proportion of the total cost. The great distance between Tai-wan and the US has not stopped Taiwan's semiconductor producers, such as TSMC (台積電) and USMC (聯電), from rising to become internationally competitive OEM partners of the US. Taiwan is so much closer to China than to the US that the "market footing" argument holds little water.

Further, both Taiwan and China have joined the WTO. With the two nations operating under a multilateral framework to promote freer trade, Taiwan's chipmakers do not need to dodge tariff and non-tariff barriers to get access to China's market.

There is therefore no real argument for allowing eight-inch wafer fabs to move to China for market footing. The global deploy-ment argument, however, does have merit. Global deployment results from the strategic need to hedge against local risks. The 921 earthquake in Taiwan and the recent economic and social chaos in Argentina highlight the importance to companies of dispersing their production sites. Overseas investment by chipmakers should be seen as, among other things, a way of managing risk.

Where China-bound investment is concerned, however, there is an urgent and crucial need for the government to accelerate and broaden its thinking to achieve a holistic view of national security, the economy and industry. Both official and unofficial statistics indicate that a disproportionately large amount of Taiwan's outbound investment has been going to China. Rushing to lift bans on building eight-inch wafer fabs in China will exacerbate the excessive concentration of Taiwan's outbound investment in one country, thereby defeating the object of reducing risk but also putting Taiwan's national security and economy at risk. The reasons for this are numerous.

First, China is universally recognized as a high-risk country to invest in. Any Taiwanese busi-nessperson who doesn't believe that should try to buy insurance from an internationally-known insurance company to see if he or she can afford the costly premiums to cover the risks associated with investments in China.

Second, China is Taiwan's enemy and has hundreds of missiles aimed at Taiwan. How can Taiwan throw caution to the wind and step up its reliance on China under such circumstances?

Third, given its minuteness in relation to China, Taiwan has no hope of peacefully transforming China through economic activity. This is difficult for the US, let alone Taiwan.

Fourth, as has been reported, Taiwanese chipmakers' advanced 12-inch-wafer fabs have been unable to reduce defect rates to satisfactory levels and eight-inch fabs still dominate the nation's semiconductor industry.

Those in favor of allowing the building of eight-inch wafer fabs in China assert that such a liberal policy would help free up and redirect resources toward the development of 12-inch-wafer fabs in Taiwan. A look at several possible outcomes exposes the weak-nesses of this argument.

In the first scenario, Taiwanese set up eight-inch-wafer fabs in China but do not shut down their equivalent fabs in Taiwan. As a result, no resources are freed up but some resources are removed from Taiwan, adversely affecting the development of 12-inch-wafer-fab technology.

In the second scenario, Tai-wanese set up eight-inch-wafer fabs, but also shut down equivalent fabs in Taiwan. As a result, resources such as industrial land and low-skilled labor are freed up, but a portion of the resources required for the development of 12-inch-wafer fabs, such as high-skilled labor, management and capital, are deployed in China, as in the first scenario.

In the third scenario, eight-inch-wafer fabs in China give rise to "agglomerative effects," whereby the entire vertically integrated system of support firms are lured out of Taiwan's semiconductor industry. As a result, massive amounts of industrial land and low-skilled labor are freed up, but massive amounts of high-skilled labor, management and capital are redirected to China.

There is no guarantee that businesses will devote more resources to research and development to hasten Taiwan's upgrade to 12-inch-wafer fabs. Indeed, the upgrade could even be slowed as investment in China extends the life of eight-inch-wafer fabs. The third scenario would rapidly narrow the gap between China's and Taiwan's semiconductor industries and thus threaten Taiwan's economy and national strength.

The best way to induce chipmakers to accelerate efforts to upgrade is to directly expose them to the pressure of global competition, with the government blocking efforts to lengthen the life of these firm's lower-end technologies. To survive, Taiwan's chipmakers would thus be compelled to direct more resources into R&D to maintain competitiveness by upgrading technology, instead of seeking easy solutions by choosing low-cost venues, such as China, to temporarily extend their product life.

Once R&D becomes a widely practiced activity in Taiwan and the nation develops an unquestioned record of technological innovation, outbound investment and technology transfer will no longer be a sensitive policy issue. Instead, such developments will be viewed as normal phenomena in the cycle of global technology innovation and transfer.

Unfortunately, Taiwan is no longer in a virtuous cycle with respect to technology development and transfer. If it were, the imbalances caused by the paradox of sagging domestic investment on the one hand, and booming China-bound investment on the other, would not continue to plague Taiwan's economy. Yet, in precisely these circumstances, the economics ministry is planning to lift the ban on chipmakers building eight-inch-wafer fabs in China. Where is the holistic thinking in that?

Economic reality and political ideologies

By Hwan C. Lin, reprint from Taipei Times, Dec 30, 2001

Taiwan is suffering its worst ever economic recession in 26 years. Its economy shrank 4.21 percent in the third quarter of this year compared with last year. Unemployment swelled to 5.36 percent in October. While the November unemployment rate experienced its first drop in 13 months, easing down to 5.28 percent, it is only a seasonal change and short-lived.

Because of partisan bickering, economic reality got mired in political ideology, especially during the Dec. 1 election campaign. Pro-China opposition parties often blame Taiwan's economic malaise on the ruling DPP's lack of administrative experience and its failure to further Taiwan-China integration. Together with pro-China businesses and media, they successfully pressed the government to ease the "No Haste, Be Patient" (戒急用忍) policy.

Before the Dec. 1 elections, Mainland Affairs Council Chairwoman Tsai Ing-wen (蔡英文) announced that Taiwan would lift the ceiling that capped China-bound investment at US$50 million. Meanwhile, Minister of Economic Affairs Lin Hsin-yi (林信義) said that the new policy would come into effect on Tuesday.

Can Taiwan's economic slump be turned around by the new cross-strait investment policy? The answer is no. Taiwan has become a highly open economy after launching a series of tariff reductions and trade liberalization measures beginning in the late 1980s. Taiwan is integrated into the global economy, forcing it to specialize in an ever-narrowing range of the world's industries. Today, the world's largest wafer foundry -- belonging to Taiwan Semiconductor Manufacturing (台積電) -- can even serve as a barometer of the global semiconductor industry. Industry specialization enhances economic efficiency, while exposing an open economy to global business cycles.

Taiwan will become a WTO member on Tuesday. This will hasten globalization and further deepen Taiwan's industrial specialization, not only making pronounced economic fluctuations unavoidable, but also increasingly limiting the government's short-term ability to fine-tune the nation's economy through traditional monetary and fiscal polices.

Taiwan's economic fluctuations are synchronized with world economies and, in particular, the US economy. After five years of technology-led expansion, US economic activity peaked in March of last year and has since slipped into recession. Simultaneously, its main trading partners were dragged into a severe economic downturn.

There is no panacea for a small open economy to fight worldwide recession. Macroeconomic fine-tuning policies, such as lower interest rates, currency devaluation and fiscal expansion, are needed to help mitigate economic recession, but they only have limited effects on a small, open and highly specialized economy, like Taiwan's.

In fact, the government should focus more attention on microeconomic policies designed to, among other things, solidify the economy's tax base, improve financial market efficiency, spur product and process innovation, strengthen intellectual property rights protection and make the education system more responsive to changing labor market demands.

What matters is whether Taiwan's economy is resilient enough to synchronize with the forthcoming global recovery in the short run and also viable enough to prosper in the long run. Easing China-bound investment to further integrate Taiwan into the hostile, developing Chinese economy is not only unnecessary but dangerous.

One Taiwan but two economies

By Hwan C. Lin, reprint from Taipei Times, Aug 17, 2000

The new government recently unveiled a NT$330 billion policy package aimed at stimulating Taiwan's sagging real estate market. The hope is that a reviving construction industry can serve as a locomotive to pull traditional and basic industries out of their long-term doldrums,thereby gearing up the bearish stock market.

The policy package is larger in dollar amount than a similar, unsuccessful one launched by the KMT government. Some analysts have criticized the package as a recycled idea, saying it will only have short-lived effects. In fact, an in-depth look into the recent evolution of the world economy would highlight a far more fundamental problem facing Taiwan.

The problem lies in the emergence of "dual economies," in which a flourishing new economy co-exists with an ever-weakening old economy. The new economy builds on knowledge-based high-tech industries, whereas the old one is based on traditional and basic industries. This problem -- "one Taiwan, two economies" -- is more complicated and far-reaching than a stimulus package can cope with.

Macroeconomic strength is still impressive in Taiwan, thanks to explosive growth in its new economy, which consists mainly of semiconductors and other information-related products. Taiwan therefore has kept an annual economic growth rate of 6 percent or above in the wake of the Asian currency crisis of 1997.

In recent years, a fundamentally structural change has been at work in the world, hastening Taiwan's evolution into a dual-economy nation. Beginning in the mid-1990s, the US pioneered a revolution in information technology, spawning a series of innovations in internet-related software and hardware.

This revolution not only created new business opportunities, but also made communication, production and consumption much more efficient. All these have re-engineered the US economy, producing remarkable productivity gains, fast income growth and low inflation.

A knowledge-based new economy has emerged in the US. This new economic paradigm is rapidly spreading to other countries, by varying degrees.

The US is a global center of high-tech innovation. Its venture capital market is by far the largest in the world. More than 75 percent of its venture capital was distributed to information/communication technology and health/biotechnology in 1997. Meanwhile, Taiwan has emerged as a high-tech manufacturing center and has been vertically integrated into the US economy.

The information revolution is still in its early stages. It continues to create strong OEM (Original Equipment Manufacturing) demands for Taiwan's semiconductors and other information-related products.

The information revolution hastens globalization and further deepens Taiwan's industry specialization in its high-tech niche. It is splitting Taiwan into a dual economy. In the new economy, the high-tech industry is flourishing and commanding much higher P/E (price/earning) ratios in the stock market. In the old economy, the traditional and basic industries are largely faltering and receiving much lower P/E ratios. Most old-economy companies have found it increasingly difficult to compete with new-economy companies for financial capital and other resources.

Tense Taiwan-China relations have been a drag on Taiwan's stock market performance. Nevertheless, the emergence of a dual economy will play a more complicated role in aggravating the overall market weakness.

According to official data, the high-tech industry made up 39.1 percent of Taiwan's total output of manufactured goods (as of 1998), compared to the basic industry's 36.6 percent and the traditional industry's 24.3 percent. The size of the new economy relative to the old one is about 2:3 in terms of manufactured goods. The old economy remains dominant, in terms of size.

These figures seem to imply ample room for the smaller, but dynamic, new economy to expand further. But it depends on whether resources can be smoothly redirected away from the old economy. Such resource reallocation conforms to free-market forces and Taiwan's long-term economic interest. It will continue year by year as guided by Taiwan's emerging high-tech comparative advantage. Its transitional process, however, will be prolonged and painful, since there are hurdles defying Taiwan's move toward a full-fledged knowledge-based economy.

As analyzed in my earlier article ("Development needs action, not talk," Feb. 17, Page 8), Taiwan has long been short of R&D investment and, in particular, research talent. This is a well-known hurdle to industrial upgrades and innovation.

The government must see that knowledge-based industries have been outpacing GDP growth for many years in virtually all Organization of Economic Cooperation and Development (OECD) countries. These economies spend more resources on the production of knowledge. Investment in knowledge (referred to as R&D, software and public spending on education) now represents 8 percent of OECD-wide GDP, a figure similar to investment in physical equipment.

By OECD standards, Taiwan has under-invested in knowledge. This inference is based on these figures: R&D outlay made up about 1.9 percent of GDP and its public spending in education was no more than 3 percent of GDP, though software investment was unknown. An accurate measure of investment in knowledge should be adjusted downwards, because the R&D components of higher education and software investment should be subtracted from the R&D expenditures. Taiwan's actual investment in knowledge should be only somewhere between 5 percent and 6 percent.

From a political-economic stance, business firms and labor in the old economy would also resist the transition to the flourishing new economy. In fact, this is what has been happening. Both the traditional and basic industries have successfully pushed the government for financial aid. The housing-stimulus package is just one example. As the next legislative elections draw near, political pressure from the old economy will loom larger and larger, as long as business and labor cannot adapt to the new economy paradigm.

The dual-economy problems are brand-new experiences and present an unprecedented challenge to the new government. For Taiwan, a transition to a knowledge-based economy is the inevitable direction. The nation is in need of policies that can facilitate such transition. In the Internet era, the new government really has no time to stay on probation and get mired in partisan politics.

Development needs action, not talks

By Hwan C. Lin, reprint from Taipei Times, Feb 17, 2000

KMT presidential candidate Lien Chan announced his science and technology platform on Feb.10, outlining a policy package aimed at raising Taiwan's national research and development (R&D) outlay to 2.5 percent of the gross domestic product (GDP) by 2002 and to 3 percent by 2010. He also expressed the hope that TAiwan could catch up with the US, Japan and others.

There is a basic consensus among economists that Taiwan's sustained development and economic viability is critically dependent upon whether it can steadily transform itself into a knowledge-based, R&D-intensive economy.

Hence, Lien's science and technology policy direction has hardly drawn any criticisms, even from opposing parties.

However, there is substantial contention over the KMT government's overall creditability problems.

In its Six-Year Plan for National Construction (1991-96), for instance, the government said it planned to raise the national R&D outlay to 2.2 percent of GDP in 1996, but it ended up with 1.85 percent.

The government then expected, naively, to push R&D to 2.5 percent of GDP by 2000, as specified in National Science Council Review (1997, page 1).

That goal must be unreachable by the end of this year, otherwise Lien would not be empha-sizing his goal of increasing national R&D outlay to 2.5 percent of GDP by 2002.

It is ironic that after years of airing the slogan of "Sci-Tech Island", Taiwan today remains an economy of low R&D intensity.

In Taiwan only 1.85 percent of the GDP was invested in R&D in 1996, compared to the average of 2.2 percent among the OECD (Organization of Economic Co-operation and Development) countries in 1995.

Of these industrial countries, Sweden led with a 3 percent R&D intensity, followed by Japan's 2.8 percent, South Korea's 2.8 percent, the US' 2.5 percent, Germany's 2.3 percent and France's 2.3 percent.

The R&D intensity of most OECD countries surpassed the 2 percent threshold about 20 years ago.

Taiwan has only recently begun to approach this threshold.

Low R&D intensity weakens Taiwan's capabilities for innovation and invention, thereby harming the nation's long-term growth momentum.

This deep-seated problem is also reflected in Taiwan's lack of research talent. In 1996, Taiwan had only 25.1 researchers per 10,000 workers, far below the OECD average of 55 researchers.

In his science policy package, Lien set a goal of 35 researchers per 10,000 workers by the year 2010.

This goal is not ambitious at all and is overwhelmingly dwarfed by the research talent of the main industrial countries.

According to currently available OECD data, for every 10,000 workers, Japan had 83 researchers (in 1995), the US 74 (in 1993), Sweden 68 (in 1993), France 60 (in 1995), Germany 58 researchers (in 1993) and Britain 52 (in 1995).

South Korea already had 48 researchers per 10,000 workers in 1995, a level that Taiwan apparently won't even reach 10 years from now. Taiwan must take this harsh reality seriously.

True, Taiwan has gradually seen its industrial might grow in its burgeoning semiconductor and other technology-intensive sectors in recent years. But, much more must be done correctly to make Taiwan a true "Sci-Tech Island." In terms of R&D intensity and research talents, Taiwan is not yet prepared.

In the new millennium, Taiwan has entered a critical stage where sustainable growth must rely on technological advances.

The government must be committed to cultivating the so-called Shumpeterian dynamism of constructive destruction, for which R&D leads to technological innovations and gives rise to new firms and new business opportunities by destroying declining traditional firms.

With resource constraints, innovative firms must sooner or later crowd out those low value-added, old firms through free-market competition.

It is therefore both economically impossible and socially undesirable for Taiwan to support both traditional and high-tech industries with government policies.

However, it is also politically troublesome in a democratic society to selectively subsidize high-tech industry and punish traditional industry with discriminatory tax policies.

Indeed, innovative R&D warrants direct subsidies from the government due to its remarkable external economies and high social rate of returns. But the R&D subsidy policy alone is not enough to nurture Taiwan's high-tech development.

The government should take more steps to strengthen social pro-innovation fundamentals so that all firms can be guaranteed to work in a society with a solid pool of research talent, an efficient innovation system and well-functioning financial markets.

Otherwise, Taiwan may risk becoming a permanent imitative economy, as the industrial world sets off toward a revolution of both information and biotechnology.

Media should be fairer with the WTO

By Hwan C. Lin, reprint from Taipei Times, Dec 17, 1999

The recent trade talks in Seattle invited violent rallies against the World Trade Organization (WTO) and, unsurprisingly, ended in complete failure on Dec. 3. Unfortunately, the media has not provided a fairer view of the WTO (formerly called GATT), which had largely been successful in dismantling tariff barriers to international trade in manufactured goods.

Today, the most favored nation (MFN) tariff rates for manufactured goods averages only 5 percent or below in the US, the 15-nation European Union, and Japan. Though developing countries are allowed to keep higher MFN tariff rates, these rates will be moving down year by year, as bound by WTO/GATT rules.

World trade has grown much faster than world output since WWII, as the GATT launched several rounds of multilateral trade negotiations after its debut in 1947.

Today world trade is overwhelmingly concentrated among WTO member countries, which made up 90 percent of total world exports under MFN tariff rates in 1997, compared to 87 percent in 1982.

Evidence shows that as post-war world trade kept expanding, many outward-oriented economies -- such as those of Taiwan, South Korea, Singapore, Hong Kong -- performed much better than those formerly inward-oriented economies -- such as India, Brazil, and China -- in terms of economic growth and improvements in living standards. Outward-oriented economies gain from trade through improved market access, technology diffusion, and the constructive market competition that rationalizes resource allocations based on each country's comparative advantage. Though the static gains of trade liberalization are often very small, the dynamic gains are enormous in the long run, according to economists' computable general equilibrium (CGE) analyses.

True, over the past two or three decades, trade liberalization was also accompanied by widened wage gaps in favor of skilled labor, particularly in the United States. This development seemingly accords with the prediction of the famous "Stolper-Samuelson theorem," which was published more than three decades ago in the international trade literature.

But empirical studies indicate that the main culprit of wider wage gaps is the rapid development of skill-biased technology, which increasingly devalues unskilled labor in job markets. Trade liberalization has at most played a negligible role, if any, in this regard.

The WTO's past success, however, may have paved the way for future failure in years to come, as its multilateral efforts begin to extend into thorny non-economic issues, such as human rights, ecology and environment, worker's rights and child labor.

These non-economic areas intertwine with the already-controversial economic issues, such as US antidumping laws, agricultural subsidies and protection, trade and investment in services, and the enforcement of intellectual property rights. The collapse of the Seattle trade talks was not surprising and might be an omen of more forthcoming failures into the next century.

In Seattle, acrimonious conflicts of interest arose within developed countries as well as between developing and developed countries. For example, the world's major agricultural exporters, led by the US, Canada and Australia, sought to liberalize trade in farm commodities in the Seattle talks, but they encountered formidable opposition from the EU.

For their part the EU, Japan and other WTO members called for a revoking of US antidumping laws, but the US government, under strong domestic pressure, opposed this. Many developed countries sought to link trade to worker's rights with the goal of enforcing a global labor standard, while developing countries, led by India and Egypt, refused this idea outright.

From the perspective of political economy, the WTO exists to overcome a classical dilemma for policy reform, which dictates that the costs of trade liberalization fall upon a few import-competing interests but the benefits are distributed thinly across mass consumers.

Consumers therefore have little incentive to stand up together against the opponents. In the past, the WTO successfully facilitated trade reform by changing the political equation to generate support for multilateral trade agreements. These agreements created a set of concentrated "winners" in member countries.

They are the exporting firms and multinationals. They stand to benefit from lower tariffs in potential export markets and therefore have an incentive to oppose import-competing firms.

Unfortunately, in the Seattle trade talks, the political balance was tilted against the exporting firms and multinationals, as the aforementioned economic and non-economic agenda was put on the table.

China is to complete its WTO accession next year. As the largest emerging market in the world, China has a notorious record of disobeying international norms. It is believed that China would complicate international powers' political wrestling due to its deep-rooted problems with human rights, labor standards, environmental protection, lax enforcement of intellectual property rights, and reforms of state-owned enterprises.

For sure, the undercurrent of global trade reform will be turbulent, as the world sails into the next century.

Don't be misled by the size of a country

By Hwan C. Lin, reprint from Taipei Times, Nov 18, 1999

China's sheer size in territory and population has often misled many in coping with the cross-strait ties.

Many Taiwanese businessmen are intoxicated with the seemingly "huge" Chinese market; so are politicians from the ruling and opposition parties. One dangerous illusion they harbor in common is that Taiwan's economic prosperity cannot persist without the Chinese market. Thus, many have called for revoking the "no haste, be patient" policy from time to time, hoping that Taiwan government will loosen the bans on three links: direct communication, direct shipping and direct flights.

We need to awaken those who still deeply harbor the market-size illusion. Country size is not tantamount to market size. According to 1998 data from the WTO, China's total imports just account for only 2.5 percent of world merchandise trade, much less than the US's 17 percent, Germany's 8.4 percent, Britain's 5.7 percent, France's 5.2 percent and Japan's 5 percent.

By this measure, the market sizes of some small countries, such as Netherlands (3.3 percent) and Belgium-Luxemburg (2.9 percent), are even a bit larger than China's.

The world's seven largest industrial economies combined absorb almost 50 percent of world merchandise imports, and the world, excluding China, takes up 97.5 percent.

But many people continue to mistake country size for market size.

True, the Chinese market has expanded with the rapid economic growth in recent years. Yet, it is impossible that the Chinese economy can maintain the trend of growth of 8 percent to 10 percent per year.

One-third of China's GDP is currently produced by its highly inefficiently state-owned enterprises (SOEs). These SOEs are just like time bombs.

It is fair to say that China is an inherently unstable economy. Without creditable reforms in many areas, including SOEs, this low-income, developing economy will be full of political and economic risks.

As for Taiwan, its economy has entered a critical stage in which sustainable growth must be fueled by technological advances. In other words, Taiwan's engine of growth in the 21st century will mainly reside in the Shumpeterian innovation process.

China is not a huge market that Taiwan cannot afford to lose. Moreover, China is far from a global center of innovation and ideas.

To adapt foreign leading-edge technologies, Taiwan should rely on the US, Europe and Japan, via corporations' strategic alliances or cross-licensing of patents.

To acquire venture capital for risky research projects, Taiwan needs to access to the US-centered global capital market. The technologically laggard Chinese economy is neither Silicon Valley nor Wall Street.

Many have overexaggerated the role of cross-strait trade and investment relationships in Taiwan's long-term economic prosperity.

Evidence indicates that Taiwan already has close ties with China with respect to cross-strait trade and investment.

It makes no sense to further integrate Taiwan with a nation that is aiming its missiles here. What Taiwan needs today is not to abandon the "no haste, be patient" policy, but to refine it in a legalized, transparent framework.

A limited and prudent economic integration with China remains consistent with Taiwan's long-term interests.

From the perspective of national security and economic prosperity, any unilateral moves by Taiwan for the "three links" would be bold but counterproductive, unless Beijing agrees to sign a cross-strait peace agreement with Taipei, under the auspices of the US or the UN.