Odd Lots - Why Taiwanese Life Insurers Are The Great 'Whodunit' Of The Financial World

Episode Date: October 28, 2019

You probably haven't thought much about the Taiwanese life insurance industry. Why would you have? But they're among the most fascinating entities in the financial world. And for a long time they've been a source of incredible mystery. They've built up a gigantic position in foreign, US-dollar denominated assets in order to fund domestic liabilities denominated in Taiwanese Dollars. But how do they hedge this currency mismatch? Nobody has figured it out until now. On this week's podcast, we speak with Brad Setser of CFR and Exante Data about how he and a pseudonymous partner finally cracked the code.See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa, play the Odd Lots podcast on Amazon Music. Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthall. And I'm Tracy Allaway. Tracy, I've been really happy with some of the strings of episodes that we've had lately, particularly sort of talking about the relationship between a country's own. domestic balance sheets, savings, profits, et cetera, and then how those funds interact with the rest of the world. That's good, Joe. I'm happy that you're happy. Thank you, Tracey. I really appreciate that. You're welcome. Did I just ruin your intro? You just ruined it. It felt so condescending. I'm sorry. I'm sorry. Yes, I agree with you.

I feel like I've been learning a lot from our recent string of guests, is all I'm trying to say. I mean, I feel personally like we are tackling some of the really big picture question and issues in financial markets. We're talking about these huge flows of money that actually dictate how the markets work. Exactly right. So today we're going to talk about what is something that I feel like probably 99% or more of our listeners have never thought of. I'm only saying that because I had never even really heard of this issue up until a few weeks ago when I heard about it from a friend of mine, a friend on the playground with my daughter. But apparently there's like this sort of interesting phenomenon in the world of finance and it relates to Taiwanese life insurance. So first of all, I love the idea that you're on a playground in New York talking about Taiwanese life insurance. But secondly, I think you're right in framing this is something that not a lot of people think about.

And that's kind of a shame because we do hear people talking about the Asia savings glut all the time. This idea that there's just this huge amount of money coming from Asia and it has to go somewhere. And most people think about China or most people think about Japan, but rarely do people think about Taiwan. and that place actually has this huge, huge financial industry, not just banks, but life insurance. Right. So obviously we talked to Michael Pettis a few weeks ago and you talked about the high savings rate in China and the result of, you know, that being the result of a few different factors such as the poor social safety net and so on. And there's also, for similar reasons, I think, a massive, incredibly high savings rate in Taiwan. And that is also showing up in very strange and unusual ways. And it's kind of through the life insurance sector that it's apparent.

And that is going to be what we examined today. I'm glad you said strange and unusual. Because I have to say the piece of work that this podcast is based on or this particular episode is based on. Once you're done listening to this episode, don't turn it off just yet, but once you're done listening, go and read the actual work that this is based on because it's framed like a giant financial whodunit. It's like a mystery novel about Taiwanese life insurers and it's great. I completely agree. And without further ado, I want to bring in the author who is, I think now the record holder for the most frequent times appearing on our

the Oddlots podcast. He's a Brad Setser of the Council on Foreign Relations and Exante Data. He was also a recent guest at the recent Odd Lots Live podcast, talk about all things trade. And today he is going to talk about his work on the Taiwanese life insurance sector, of which he has written, co-written a six-part series. And Brad, thank you for joining us. As I mentioned, I'm not making this up. I was at the playground. My daughter's friend's dad was there and he's in the insurance industry. Did she ask you about Taiwanese life insurance?

Yeah, my three and a half year old daughter asked me about Taiwanese life insurance. No, it's a friend. He's in the insurance industry and somehow I always ask him about insurance questions. Somehow Taiwan came up. But it just so happened that you wrote this huge series on it. So I guess what I want to start with is this. question, why are we talking about this? Why are we having a podcast on this? Why did you write a co-author a six-part series on Taiwanese life insurers? What's going on here? Why is this interesting?

Well, it was interesting to me for a bunch of different reasons. The first one is the one you started with. There is this Asian savings club. Taiwan actually has a bigger current account surplus or a bigger saving surplus relative to the size of its economy than either China or Japan. Current account surplus has been over 10% of GDP for a really long period of time. That raises the question of where this money is going. And when I started looking at this more closely, it soon became clear that after the global financial crisis, the way this money was reaching global financial. financial markets change. It used to be that the Central Bank of China, Taiwan, the Central Bank,

bought foreign exchange reserves and invested those foreign exchange reserves in, let's say, treasuries and agencies, the standard reserve assets. After the global financial crisis, the Central Bank of China appeared to step back, and instead the outflow was all coming from the life insurance sector, and the life insurance sector was taking on new kinds of risk. risk that a central bank typically wouldn't take. Okay, I don't want you to give the whole thing away. Before we get to that, talk to us about how Taiwan actually ended up with this huge life insurance industry.

Because I think, again, to a lot of people, it's not necessarily an intuitive development. You're talking about a relatively small country, not a lot of natural resources in a really unique political situation. And for a long time, it was known as a sort of manufacturing hub. And then at some point, it just develops this giant insurance industry. What happened? I'm not sure I understand entirely what happened. I can see the end result.

The end result is that Taiwan's life insurers now have about $900 billion in total assets. That's ballpark 150% of Taiwan's GDP. I think what happened in the broadest possible sense is that Taiwan was faced with a challenge as over the past 20 years, as China emerged as the region's dominant manufacturing power. And one consequence of that was that a manufacturing investment, an investment in general in Taiwan fell. And Taiwanese savings,

because of the low, relatively modest social safety net and other structural factors, rapid aging, Taiwan's savings rate stayed high. So this massive savings surplus developed. and the Taiwanese government wasn't out borrowing large sums either. So the savings had to go into some kind of financial instrument. And the lifers started offering long-run investment products that offered a higher return than Taiwanese dollar bank deposits.

And that pulled the savings surplus, in a sense, into the life insurance industry. This is an important point. And maybe it's one of those things that's really obvious to some people. but it didn't, you know, when I first started paying attention to finance, it took me a while to grasp it. But this sort of shades of gray between what we consider an investment product and an insurance product or in a savings product. And I sort of like mentally put insurance in one bucket of something that pays off in a contingency. Investment is something that a little different or savings is different, but they're not that different. And fundamentally, historically, you can think of, say, investing in.

in a mutual fund or investing in a bank account or investing in a retirement fund is not that different from buying life insurance. And in fact, a lot of life insurance here offers annuities. So they're very related good. Right. And an annuity is a life insurance, classic life insurance policy combined with an investment portfolio. Okay. So these Taiwanese life insurers basically end up with a huge amount of money flowing into them via insurance policies, annuities, whatever, and they need to do something with that money. So what is it that you've observed them doing?

Well, the difficulty the insurers face was it the kind of classic products which an insurance industry would invest in were rather small in Taiwan's case. So, you know, typically if you're pulling in a lot of life insurance policies, you would invest in government bonds or local corporate bonds. There just aren't that many, though, Taiwanese dollar-denominated government bonds or Taiwanese dollar-denominated corporate bonds. The corporate sector didn't need to borrow that much, and it could borrow, you know, the economy was flush with savings. It could borrow from the banking sector. So over time, the insurers started buying more and more foreign bonds.

the share that they put into foreign bonds was initially capped at 45% of their total assets, which is a high number, actually. That's much higher than is typical across other Asian life insurance sectors. But when they hit that number, rather than stopping, a new instrument, in a sense, developed that Taiwanese allowed the insurers to invest in what are called Formosa bonds, which are dollar-denominated bonds issued in Taiwan. U.S. dollar denominated? U.S. dollar, not Taiwanese dollar.

Okay. Issued in Taiwan, listed on the Taiwanese stock exchange. And those were not counted against their cap on foreign assets. It was a blatant loophole. And a lot of financial institutions started issuing in this market, particularly callable bonds. So bonds which have the option where the issuer can call them if interest rates fall. The lifers like them because they offered a little bit higher yield today. The issuers like them because if interest rates fell, they had the option of reducing their borrowing costs.

And this became a really big market. It goes from like zero to $150 billion in a couple of years. And then the insurers and the regulators start asking like, okay, this is getting a little big. They put a cap on the insurers' holdings not just of foreign assets, but foreign assets plus for most of bonds at roughly 65% of their total assets. Again, that is a huge number. No other insurance sector in the world, at least to my knowledge, maybe some in a tiny country, has put two-thirds of their assets in a foreign currency, particularly when most

of their policies are still in Taiwan. We'll get back to that. But then they've kind of blown through that 65% cap as well with a new product. So now the hot new product is the local exchange traded funds, which in Taiwan are invested entirely in foreign bonds, sold entirely to the life insurers, and are considered a Taiwanese dollar asset. It's an obvious regulatory arbitrage.

The net effect is that close to 70%, it depends a little bit on which statistical, source you use, but close to 70%, or close to $600 billion, of life insurer money has been invested in foreign assets. That is to the first approximation 100% of Taiwan's GDP. So Taiwan's basically future retirement savings has been invested abroad through the life insurers, and the flow has been so big that it impacts particular parts of the global market. Now, before we go on, I mean, A, that's fascinating, the degree of regulatory arbitrage and loopholes that they continue to develop, to blow through the caps. So I'm trying to think of some of the things that need to be unpacked here.

One of the reasons in your research why this is, this needed to be picked apart, and maybe you can explain it, you mentioned statistical questions. they don't report their statistical data on these things the same way as everyone else does? One of the first things I learned when I started working at the U.S. Treasury was never to write that Taiwan is a country. Ah. All right. Taiwan is always an economy. Taiwan is not a member of the IMF. It has a complicated, to put it mildly, position in the international community, in the sense that.

that for now the convention is that both Taiwan, the Republic of China and the People's Republic of China formally believe they are the rightful government to all of China. But for almost all global institutional purposes, the People's Republic of China is the representative of all of China. Right. So the Republic of China, i.e., Taiwan, doesn't participate in most global bodies. And so Taiwan's statistical practices don't necessarily follow every global norm. How much does Taiwan's, again, unique political situation also feed into its need to find some place to put its money abroad? And the fact that it's generally put that money into U.S. corporate bonds. Because a lot of people, no, this is a stupid question.

I know what the answer is. Never mind. I changed my mind. I might not know the answer, Tracy. Well, no, I was going to say, like, you know, there's a huge, like, market right next to it that actually needs a lot of capital, and that would be China. But everyone knows. This is what I was wondering. No, I'm glad you're going to ask this because I'm curious. Why doesn't Taiwan invest in China?

That's kind of an obvious one, isn't it? No, actually, I don't know the answer. I mean, it's a good question. I mean, the Chinese manufacturing sector has invested enormously in China. Hanhai makes all of Apple's smartphones in China. Hanai is Taiwanese-owned. I mean, the Taiwanese contract, Taiwanese-owned contract manufacturers

are an enormous source of investment inside China. I think there's a couple of things here. One, China's capital account has historically been close. So it hasn't been, it's now getting more open, but historically it hasn't been possible, even if the Taiwanese wanted to, to put a large sum of money into the Chinese market. And then second, I think there probably is some concern

about the political risk that would come with putting a large amount of Taiwanese savings in Chinese financial instruments, particularly in a context where, you know, to be a little bit blunt and provocative, a lot of Chinese financial instruments that offer yield and moral hazard plays on the willingness of the Chinese government

to bail out a given institution, and if bailing out a given institution meant bailing out to Taiwanese investor, you could see why that might lead to some concerns. On the other hand, the Taiwanese have been big buyers of Asian dollar bonds. It's not that a significant part of Taiwan's dollar portfolio is not in bonds issued by American companies or American banks. Taiwan actually disproportionately buys the dollar denominated bonds issued by foreign companies and foreign banks. Just one of the many peculiarities of Taiwan.

So I would say, you know, like European banks issuing dollar bond, dollar callables to raise funds, Asian companies that issued dollar bonds, all were finding big buyers amongst the Taiwanese life insurance community. So before we go on, we need to establish that essentially, as you describe it, the Taiwanese life insurers have a potential currency mismatch situation. Their liabilities to Taiwanese savers or to policyholders are denominated in Taiwanese dollars, but their assets that they go out and buy are in U.S. dollars, which I guess works fine as long as the U.S. dollar keeps strengthening and that doesn't pose a problem. But how big is this sort of like the crux of the issue that they face, that this potential flip if suddenly the Taiwanese dollar were to strengthen

and those priced in US dollars or priced in Taiwanese dollars, their assets fell by a lot. Unambiguously, the biggest risk facing the Taiwanese life insurance sector comes from their open foreign exchange position, the fact that they have sold a lot of life insurance policies that promise a Taiwan dollar return. And then they have invested those, the, proceeds from those policies in U.S. dollar denominated assets. There's an intrinsic currency mismatch, and that's the number one risk facing the lifers. They've also taken some more exotic credit risk, and so they do face some potential risk just from the investment side of their portfolio, from the particular bonds that they have bought. So they have a currency mismatch,

unless they actually go out and hedge their FX exposure with another entity. And this is in large part what your series is about uncovering. What did you find out about the actual hedging processes of the Taiwanese life insurers? Well, let's start with the fact that Taiwanese lifers have about $600 billion or 100% of Taiwan's GDP and foreign assets. that it creates an enormous hedging need. It's much bigger relative to the size of Taiwan's economy than the hedging need of the Japanese life insurers

is relative to the size of Japan's economy or the hedging need of Korea's life insurers is relative to the size of Korea's economy. So the question is, okay, can you trace back and find who is providing the counterparty, party who's providing the hedge. The obvious answer is that the Taiwanese life insurers have started selling dollar-denominated policies inside Taiwan.

So that gets rid of the mismatch because rather than selling Taiwan dollar policies, you sell US dollar policies, you're naturally matched against US dollar assets. But that only can cover roughly 25% of the 600 billion in foreign assets. That still leaves ballpark 450 billion. So some of that has been emerging. Some of that has been emerging. The trend has been to push the risk into Taiwanese savers to Taiwanese households. You could think that's a consumer protection, financial protection issue,

because Taiwanese savers are presumably expecting a Taiwan dollar return, but technically they've bought U.S. dollar-denominated policies. And if the Taiwanese dollar were to appreciate, which arguably it should, you shouldn't run 10 to 15 percent of GDP trade surpluses forever. then they would face significant losses on their relatively safe retirement account. But clearly, that's been one of the ways the life insurer's sector has laid off some of this risk. Another portion of the risk is just taken on directly by the life insurers. So somewhere between 20 and 25%, depending on the time, is just run as an open foreign currency position.

So there is no hedge. They're just straight up long dollars. They're just straight up long dollars. If Taiwan's dollar were to appreciate, they would take a head out of their capital. No, I mean, this is a pretty big open position relative to the size of their capital, certainly relative to the size of Taiwan's economy. But then, all right, you still got about $300 billion, 50% of Taiwan's GDP, which is hedged. So you kind of start having to get into the mechanics of cross-currency hedging. And this gets super technical.

This is where I like sort of check out. It's just Brad and Tracy talking for the rest of the episode. I'm just going to listen from here on now. If you are doing a standard cross-currency hedge, someone who has dollars offshore will typically swap those dollars or the Taiwan dollar. The offshore investor will get Taiwan dollars. and that money will then be invested in either a Taiwanese bank account or a Taiwanese government bond. I mean, that's in principle how cross-currency hedging works. That is what you see in Japan.

There's this enormous flow from the cross-currency hedging into Japanese government bonds, which is simply foreign investors with dollars, swapping those dollars for yen, collecting a premium, and then parking the money in Japanese government bonds. So there's certain things you would see if foreign investors were supplying the hedge. You would see a large inflow from offshore investors into Taiwanese dollar instruments. And you just don't see that. There's actually a financial control, financial account control, so foreign investors are not allowed to buy Taiwanese dollar denominated government bonds. Taiwan hasn't wanted that inflow.

And the bank flow is all in dollars. So that's not explaining the hedge. The hedge seems to be coming from local entities. Now, what local entities could be providing the hedge? You could have Taiwanese companies going out and borrowing in dollars and then swapping dollars back into Taiwan dollar. That would allow them to finance their domestic investment, perhaps more cheaply. But you can kind of look at that.

and it's not that big. So then you can look at the commercial banking sector, which would be a classic source of hedges. And when a banking sector is providing a lot of hedges, they need to take in more dollars, deposits, offshore borrowing, than they have lent out. Then there's a spare surplus of dollars. They swap those dollars for the lifers, Taiwan dollars,

and then they basically, get Taiwan dollar funding and the lifers get US dollar funding. So it's in a complicated way, it becomes a, it becomes cheaper in a sense for a Taiwanese bank to take in a dollar deposit, swap it with the life insurers who have Taiwan dollar, and then use the Taiwan dollars that they got from the life insurers to finance their Taiwan dollar lending. So conceptually, that could be a funding source. And it is. It was 50-ish billion of funding. from the commercial banking system. But you add this all up and there's still a gap.

You can't find a set of counterparties equal to the $450 billion hedging need, which becomes a $300 billion hedge you need once you account for the open position, but you just can't find counterparties that add up to $300 billion. if you look to the Central Bank of China, the missing force in the market. Not the PBOC, just to be clear, not the People's Bank of China. Absolutely. The, I mean, it would be easier if you could call, you know, you can call it Taiwan Central Bank. You just call it the Central Bank of Taiwan.

Yeah. Because it gets back to that Taiwan is not a country question. So it is technically. the Central Bank of the Republic of China in Taipei. Just to add one last complication. It just, you know, it just is what it is. So, CBC, if you want to use a standard acronym, Central Bank of the Republic of China, Central Bank of China, Central Bank of China, the People's Bank is the People's Bank of Communism. Right.

Da-da-da-da-da. Okay, but you talked earlier about how, in many ways, Taiwan's central bank, this is, The CBC has a sort of different or unusual reporting regime when it comes to a lot of things. So how did you go about actually unpicking whether or not the central bank had anything to do with the FX hedging of the Taiwanese insurer? So if Taiwan's central bank acted like a standard central bank and followed the global reporting convention, You could look at a footnote line item in the standard International Reserve Reporting template, and you can essentially see how much foreign exchange a central bank has swapped for local currency. It shows up as a forward position just because of the way the accounting works for a central bank.

So there are central banks elsewhere in Asia, the Monetary Authority of Singapore, the Central Bank of Korea, the Central Bank of Thailand, that have significant forward positions because of the swaps that they engage in with local counterparties. But those are reported. Taiwan has said, we're not reporting this. They've refused to voluntarily follow the standard global reserve reporting template. So you can't directly measure Taiwan's hedging or the amount of head dollar hedges the central bank provides the life insurance sector.

It's just it's the unknown. It's the mystery variable. And you know, people have been asking the Taiwanese to report this number for a long time. This treasury has, U.S. Treasury has been asking Taiwan to report this because this is a, it turns out that buying a dollar in the spot market and then swapping it makes it disappear from your balance sheet. So when you buy a dollar and swap it out, you have this forward commitment to buy a dollar back in the future, but you're not holding a dollar and you're not reporting the dollar. And since people count on the reported level of reserves to measure how much

any government is intervening in the foreign exchange market, without knowing the the forward book, which is the leg part consequence of the swaps book, you don't actually know how much the central bank is intervening in the spot market. So there's been pressure on Taiwan to reveal more, to report using standard international conventions, and that the central bank of China of Taipei has just refused. So you had to go look, and I did this work with a co-author, a blogger concentrated ambiguity, who's an expert on many things, Asian institutional investors, but also central bank. He's pseudonymous, concentrated.

He is a non-old. I love 2019. I love the modern era. It's like a work between former treasury employee Bradstor and pseudonymous blogger concentrated ambiguity. He is a market participant. Okay. I think you can judge the caliber of his work from what he puts out on his website. No one would doubt it.

I mean, he really is genuinely an expert both in. central banks and cross-currency hedging. Undoubtedly. I wanted to ask about this. So, I mean, one thing, one thing that any reader of this particular series will get is the amount of work that went into it. Absolutely. Did you ever consider just calling up, you know, someone at a Taiwanese life insurance company

or maybe a market participant who's on an FX hedging desk at a large counterparty bank and just going like, hey, what have you heard about this issue? Like, what sort of gossip or color is there in the market about this particular dynamic? So the lifers are not going to, like, give away their secrets. So I've never tried that. I've actually been slapped a few times by the Taiwanese for writing things that the Central Bank of China did not approve of. I am not the favorite former Treasury officials, think tank fellow, for getting information. from the Taiwanese. I did write a blog a couple years ago about how Taiwan was sort of like the

opposite of Argentina, too much foreign currency debt. Yeah. When the peso depreciates, they blow up. And I asked, well, is Taiwan in the opposite position? Too many foreign currency assets. If the Taiwan dollar appreciates, will they blow up? And that blog actually got a lot of, I got a lot of feedback on that blog, which I wasn't really expecting. I thought this was a really kind of super esoteric interest of mine. It was going to be one of those things that I write that no one pays attention to. And, you know, in general, if I write about China, people pay a lot of attention to it. And if I write about something like Puerto Rico or even Turkey, a little turkey less so, I get a lot less attention. And I figured Taiwan is going to get no attention. But I actually

got a lot of emails from trading desks. in New York who were dealing with various parts of the Taiwanese flow. So if you're selling 30-year U.S. corporate bonds, you pay a lot of attention to what the Taiwanese life insurers are doing. And if you're on an interest rates derivative desk, and this gets, you know, even more complicated, if you're on an interest rate's derivative desk, the fuel for your desk in New York are the callable bonds

that you're selling to the Taiwanese insurance. So these parts of the market in New York were actually had developed pretty sophisticated models for estimating the flow coming out of Taiwan, what fraction was going to be hedged, when would you hit a foreign currency issue in limit, when might this flow stop? And there were various investment bank reports generally done from the point of view of when will this flow stop, this flow stop and what will that mean for our corner of the corporate credit market that had done a lot of the same financial forensics that we did. Josh Younger of J.P. Morgan obviously has been a leader in doing this kind of analysis. Just to be clear, not only are Taiwanese insurers a large source

of demand for U.S. dollar denominated assets, but they're also a big buyer and seller of basically interest rate volatility in the market as well. So a number of different functions for different and very important assets. I mean, I think what's interesting is that, you know, the Taiwanese are a small part of the overall U.S. corporate credit market, small but not insignificant. They become a very big part of certain corners of the market. So Asian dollar bonds, U.S. callables, 30-year fixed-rate corporate issuance, things where there isn't. so much demand from the traditional investors in U.S. corporate credit. I guess I want to go back and that missing piece. So how did you, the final step? Because as you say, no one in Taiwan is

going to answer your phone calls and they don't publish that information despite pressure from the Treasury to talk about the degree to which the central bank is intervening in the foreign exchange market. Where specifically did you find this missing piece? So you have to be a sort of connoisseur of bank balance sheets and central bank balance sheets to appreciate this. But the central bank of China has historically, so before the global financial crisis, published its net worth on a monthly basis. It's the gap between its assets and its liabilities. And since the Central Bank of China, the Central Bank of Taiwan, all of its assets for a very long time because they've been a heavy intervener are in foreign currency. All the

liabilities are in Taiwan dollar. So the main driver of the net worth has been foreign exchange moves. And you could find an almost perfect correlation between foreign exchange moves and changes in the net worth of Taiwan Central Bank before the global financial crisis. After the global financial crisis, the reported net worth change. It stopped being as volatile. It stopped moving with the Taiwan dollar, US dollar rate. And we noticed, or perhaps discovered, that other assets and other liabilities had a very strong correlation with moves in the exchange rate. And if you do the math right, you can sum

together the net position in other. And others, you know, just like this throw away, let's not go into the details, let's hide things kind of account. That's always what other is, right? And what we concluded was that there was a revaluation account embedded in other liabilities and other. In net other liabilities. And so when you add the reported net worth with net other, you get a series which more or less tracks the exchange rate, as it should, because there's nothing that changed the fact that Taiwan's central bank's reported net worth should be a function of the exchange rate because all their assets are in foreign currency, all their liabilities are still domestic currency. So you can find this and establish this correlation.

And then you ask, are the moves in this constructed series consistent with the reported foreign exchange reserves of the central bank? And it turns out there's a little bit more movement than is explained by their reported foreign exchange reserves. With the most obvious explanation for the greater movement, you know, it's movement when it should move, being that they have more foreign assets than they are disclosing, e.g. the inferred swapsbook. Can I just say I actually like wasn't breathing in the last? I was so, no, I would like, you know, Tracy like you set up as like this, who done it and I think that was good. But then by the end, listening to that, I actually noticed myself, I was like, what's going to be the answer here? I think we need I think we need Laura, our producer, to add like the dun dun dun

music onto this. Just to end up. Yeah, no, seriously. I like, that's like, I started noticing that. I was like, oh my God, I really am. I mean, it was pretty fun to do. I'd be honest. I literally am at the edge of my seat waiting for that answer.

There was a moment. And that, and just to be clear, that Gabby just described, is the size of the missing hedge for the lifers, more or less. Yes, more or less. So we estimate, and the math is complicated. complicated, about 130 billion of greater foreign assets than Taiwan discloses in its foreign exchange reserves.

They have, it would push their total foreign exchange reserves up from a little under 500 billion now and push it up to about 600 billion. And that's roughly what we think the missing hedge is on the life insurance side. So we tried to get at it from both sides of the equation. their demand for this kind of swap? And then is there evidence that the central bank is supply? So the inference here is that not only is the central bank basically on the other side of a lot of this hedging activity, but also that it's effectively, well, I guess it's suppressing hedging costs, but it's also suppressing the Taiwanese dollar. It's currency intervention.

Right. I mean, this is evidence that Taiwan has been intervening more heavily than it reports. And in a sense, it's evidence that the shift where we started, you know, the shift from a world where the Asian savings glut flowed through central bank reserves into the U.S. Treasury market, you know, that changed supposedly to a world where Asian savings glut flowed through private intermediaries into the U.S. corporate credit market. Well, it turns out the change wasn't clean, that some fraction of the flow into corporate credit market from the lifers was using money that the Central Bank of China had bought, in effect, swapped or lent to the lifers. So the intervention has been a bigger contributor to the outflow from Asia than you would guess from the reported data. So is this, you know, you throw around these numbers about the size of the size of the the life insurance sector relative to GDP and a huge part of the ability for that to go on is

obviously, you know, as you revealed, the central bank engaging in FX hedging. Is it sustainable or is there a plausible scenario in which the central bank could run out of its ability to provide that service to the lifers and create serious financial instability in Taiwan or perhaps elsewhere or perhaps part of the credit markets that are so dependent on purchasing, buying from Taiwan? Well, theoretically, as many people have noted, I think going back to Keynes, there is no upper limit on the foreign assets that a central bank can accumulate. Right. There is a lower limit.

You cannot go below zero. So in that sense, there is no necessary reason why the central bank of, of China and the central bank of Taiwan couldn't take a foreign asset position of 100% of Taiwan's GDP and raise that to 150, 200% of Taiwan's GDP. There probably is a limit to the lifers ability to continue to invest in foreign bonds at their current pace. If you raise your foreign allocation from 40 to 70, you probably can't go from 70 to 100. You do need a few assets in your own currency. So at some point, the growth in the Taiwanese lifers foreign currency portfolio will need to be

proportionate to the growth in their assets. But there is no limit on the central bank's ability to intervene and buy foreign currency other than perhaps the limits imposed by its trading partners. Even if there's no technical mathematical limit and the size of the balance sheet can grow arbitrarily large, could it be a situation in which this ceases to be appropriate monetary policy for the other non-insurance needs of the domestic Taiwanese economy? and as such even if theoretically they could continue to subsidize or prop up the lifers, this starts to create other imbalances or domestic problems. Yes. So suppose Taiwan's economy were to start to boom. Yeah. And suppose the central bank wanted to raise interest rates. And suppose the U.S. economy and the European economy were in the doldrums. And so U.S. interest rates were low.

the balance sheet of the Taiwanese central bank is a mix of dollar and euro assets on one hand, which have a certain yield, and Taiwanese dollar's currency, which pay nothing, and Taiwanese dollar sterilization instruments. Think of it as central bank bills, which pay a Taiwanese dollar interest rate. Once you have a really big balance sheet, the interest cost on your central bank bills become a potential constraint. So part of the reason why Taiwan has been able to accumulate such a big balance sheet, Central Bank has been able to accumulate such a big balance sheet,

is because Taiwanese dollar rates have been low. If Taiwanese dollar rates were to go up, it's not that you can't have this big balance sheet, it's that this big balance sheet starts to become much more costly. Yeah. The more you continue this, the more foreign currency you accumulate, the bigger your capital loss, and there's this big question about what does it mean if a central bank has negative equity, but bigger the conceptually your capital loss is when the currency

ultimately appreciates. So you can try to hold it down forever. Right. But unless you can really do it forever, eventually when the currency does appreciate, you'll take a bigger hit. Just on the global financial stability question that Joe kind of alluded to, you know, When people think about risks to the financial system right now, one of the things that you often hear, you know, whether it's from the IMF or the Bank for International Settlements, is the idea of excesses in corporate credit that we might get a bunch of defaults

or we might get a bunch of downgrades that cause about a forced selling. Could it be that instead of looking at credit risk, we should be considering FX risk based on the fact that one of our very, very big buyers in this space might actually be quite effect-sensitive. I think that's a very important point. The stress that leads to a fall-off and demand from Taiwan or from any of the other Asian countries. A fall-off in demand for the corporate, for U.S. corporate credit, could just be a sharp appreciation of their currencies, because that erodes the capital that has been used to take and support the open foreign currency

positions behind the unhedged portion of the Taiwanese book, but also, you know, the Japanese have an unhedge book. Korea may be a little less so. But there's a range of investors who've been taking partially hedge bets on currency hedge batches on U.S. corporate credit and therefore are potentially their capital could be eroded not by a large losses on a U.S. company that goes into default, but rather by foreign exchangements. Brad Sensor, that was just phenomenal. I was not being facetious earlier when I said I had noticed myself stop breathing. I was very excited to have this conversation, and it was like five times more exciting than I even appreciated.

I mean, this is really... If this gets people interested in balance of payments, financial forensics, I'll be thrilled. Fantastic work. Really impressive. You and your co-author concentrated ambiguity. Thank you so much for coming on and really doing a phenomenal job of putting into, I'd say, pretty relatively plain English, what is an extraordinary complicated subject. So great to have you back on the show. Thanks a lot. Thank you, Brad. Well-deserved fourth appearance on all thoughts. Joe, I really enjoyed that conversation, not least because it hit on a number of my favorite topics, you know, cross-currency basis swaps and corporate credit. I love discussing, but also because

I get to roll out random facts of knowledge, such as this is the reason why the world's fastest growing ETF market is actually in Taiwan. And no one would have expected that, but that's where it is for all the reasons we just discussed. Yeah, I was not aware of that. So I learned something new from you just now. No, I loved that episode too. I mean, you know, kind of like we were talking about it or as I was mentioning in the beginning, this was like sort of a continuation of some themes we've been talking about lately on recent episodes like with Michael Pettus and so forth. But I love the sort of taking from the macro to the quote something in between macro and micro because we can talk all the time about, oh, there's a lot of savers in various East Asian

countries and that flows through to other economies in interesting ways. But I think actually really drilling down to a sort of hyper-specific level about how the dollar or how a Taiwanese dollar that's earned by a family in Taiwan gets put into a life insurance company, which has all these different things, is just super interesting to work out. And the fact that there was a puzzle at the end of it made it even more interesting. Right. And I think that's exactly that's exactly right. So that dollar kind of ends up flowing into a U.S. asset.

But then you have to talk about the feedback loop when it starts to go the other way. And the reason I was thinking about that is, do you remember repo madness back in September? And that actually started feeding into cross-currency swaps. And so that, you know, even something like that that seems completely unconnected to Taiwanese life insurers. If you listen to the discussion we just had, it actually could have an impact. No, absolutely. Because I remember, like, we had a Zoltan Pozar on this. And we were talking to him prior to even the repo market going crazy, but he was well ahead of the curve.

But I think it was on this exact subject because he was talking about the challenge of these Asian buyers of U.S. denominated debt in a world in which U.S. denominated debt doesn't yield very much. And, of course, that increases demand for direct holdings at the central bank, which is part of why there was a reserve shortage. So it's all connected. I think we're going to have Zoltan back on the show at some point soon. Well, now we have to. No, I thought about that during this about how it was connected to that. And I'm glad you remembered to make that point here because I do think that's really interesting aspect there. All right. Well, a fantastic conversation. If you haven't read Brad Setser's full series, you should definitely go on his blog and look it up. And like we said at the beginning, it does read like a sort of financial markets, who done it. It's very entertaining. Absolutely. Must read. I think, after having listened to this conversation, it'll make the reading perhaps even more compelling because then you can sort of... You're going to go back and read it. I'm going to read it again now.

You can print it out, take it to the playground with you for next time. That is my plan. This has been another episode of the Odd Lots podcast. I'm Joe Wisenthal. You can follow me on Twitter at the stalwart. And I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway. And you should definitely follow.

our guest on Twitter, Brad Setser, at Brad Setser. And again, go read his work. It's fantastic. And be sure to follow our producer on Twitter, Laura Carlson. She's at Laura M. Carlson. We've just given her a very long episode to turn around in a short time. So she definitely deserves a follow. And follow all the Bloomberg podcast on Twitter with our new handle at podcasts. Thanks for listening.