- 19 -

for the first time issued its own Class B, 9l-day, treasury bills to commercial
banks and the general public. Apparently encouraged by the results in 1972,
the central bank in 1977 and 1978 again sold its own time certificates of
deposit to banks in order to reduce their excess reserves.

In a move to enlarge the scope of the money market and to make its
open market operations more flexible, the central bank in November 1983 began
to issue treasury bills on a noncompetitive basis for small investors. Since
then, purchasers of small amounts have been awarded treasury bills under a
noncompetitive system on the basis of the weighted-average price of the accepted
competitive bids.

In view of the trend to date, it can be concluded that open market
operations have not been the central bank's primary instrument of monetary
control. While these operations have been helpful at times, changes in the
level of the discount rate and central bank accommodation have been more
important, However, it is possible that at some time in the future open market
operations may become more important and possibly even surpass all other
monetary instruments in importance.

Moral suasion and selective credit controls -- The central bank has

made some use of moral suasion from time to time; however, this instrument--at
best--has been merely a supplement to the bank's more powerful direct controls.
Moral suasion was used in 1968, for example, when banks were cautioned against
supplying an excessive amount of credit that might be channeled into specula-
tive investment. This warning, plus an active use of discount and interest

rate policy, was successful in moderating bank credit expansion _/ Much

later, in January 1977, the central bank again used moral suasion to induce the
government-owned Chinese Petroleum Corporation to repay its foreign loans, thereby

1/ Annual Report: 1968, Central Bank, p. 36.


-13-

and (3) refinancing of secured loans not exceeding 360 days. In actual prac~

tice, a very high proportion (over 90 percent) of the monetary authority's
accommodation is for rediscounts, rather than for the other two types. Accom-
modation is also provided in foreign currencies, including for import financing,
and for export financing (in local currency). Of the central bank's six
discount rates, the lowest rate has generally been the rate for export
financing /

Since its reactivation in 1961, the central bank has also used a
penalty rate system. Until January 27, 1974, this applied to a bank's
borrowing from the central bank that was in excess of 10 percent of the bank's
average daily balance of deposits for the previous week or ten days. The
penalty rate was set at the same level as the maximum permissable commercial
bank lending rate. In recent years, the penalty rate has been related to a
bank's reserves. Thus, since August 1980, for central bank accommodation in
excess of 35 percent of a bank's required reserves, a penalty rate 20 percent
above the normal accommodation rate has been imposed.

The basic philosophy followed by the central bank since its 1961
reactivation has been to reduce gradually the interest rate structure in order
to bring it closer to the interest rate levels in industrial countries and also
to narrow the spread between loan and deposit rates. The expectation of the
authorities in the early 1960s was that this would help accelerate agricultural
and industrial development, improve the competitiveness of exports, and also
make government bonds more attractive since the yields on these bonds had
traditionally been low.

T/ Effective May 9, 1984, for example, the rediscount rate (i.e., the basic

discount rate) was lowered to 7.0 percent, while the rate for export financing
was lowered to 6.75 percent.


-23-

in the price index from about 60 (1976 = 100) in June 1973 to 93 by March 1974--
an increase in nine months of 55 percent. The increase in prices was finally
arrested by April 1974 and the central bank began to lower the rediscount rate
in September 1974. The bank continued to reduce the rate piecemeal over
roughly a three-year period until June 1977 when it reached a low of 8-1/4
percent.

In retrospect, the 1973-74 monetary policy must be considered some-
thing of a failure since the inflation rate rose to 47-1/2 percent in 1974 from
only & percent in the previous year. (See Table 2 and change in yearly average
consumer price index.) However, Taiwan, China, was one of the few less
developed areas both to restore stable prices fairly quickly and to keep them
relatively stable for as long as five years. In this, it was aided by the
large trade deficit in 1974 which acted as a contractionary factor on the money
supply, and by its willingness to accept a single, large, increase in prices
rather than have the inflation spread out over a period of several years. It
would be interesting to know if a substantial part of the inflation could have
been avoided by a large, once-and-for-all, increase in interest rates in July
1973 to the levels they eventually reached in January 1974.

Inflation in 1979-81 -- The third inflationary threat occurred in
March 1979 when prices began to accelerate as large trade surpluses and the
second oil shock (1979-80) caused the rate of inflation to jump to 19 percent
(annual average) in 1980 and to 16 percent in 1981, or roughly double the rate
in 1978 and 1979. Again, the central bank acted to raise interest rates,
increasing the rediscount rate in four steps from 8-1/4 to 13-1/4 percent
between May 1979 and June 1981. (See Chart 1.) Bank deposit rates were also
increased. By October 1981 consumer prices stopped rising and since then they
have increased only slightly. Between October 1981 and May 1984, the central
bank lowered the rediscount rate nine times from 13-1/4 percent to 7.0 percent.

(See Chart 1.)


-4-

Various data also indicate that there has been considerable financial
deepening since the early 1960s. Between 1962 and 1983, narrow money supply
(M1), measured as a percentage of GNP, increased from 11 percent to 31 percent,
while broad money (M2) rose from 25 percent to 89 percent. On the other hand,
the ratio of public and private bonds to GNP only increased from 2 percent to
about 5 percent.

The first step toward establishing a money market occurred in 1976
when the Chung Hsing Bills Finance Corporation began to operate. Since then
four types of money market instruments have come into general acceptance, viz.,
commercial paper, bankers' acceptances, negotiable certificates of deposit and
treasury bills. One of the objectives in establishing the money market has
been to channel financial savings from the unorganized private money market
(i.e., private moneylenders) to businesses. In this regard, the money market
appears to be off to a good start as it has generally grown much faster than
the rate of growth of bank loans with the exception of the Treasury bill
component .2/ It is also hoped that the establishment of the money market
will pave the way for more flexible interest rate movements. In April 1980,
the central bank helped the Bankers' Association of Taipei add a further
component to the money market by assisting in the establishment of an interbank
call loan market. It is expected that this new market will help the commercial
banks in the management of their reserve positions.

With regard to the financial system and the government's mode of
operation, the government since early in the postwar period has been an impor-
tant shareholder in the province's commercial banks. Of nine regular commer-
cial banks in July 1984, the government held over 50 percent of the shares in

T/ Shirley W.Y. Kuo, The Taiwan Economy in Transition, Westview Press, Inc.,
Boulder, Colorado, 1983, p. 321.



- 20 -

drawing down deposits with local commercial banks. This was successful in
reinforcing the tight money policy as it tended to squeeze the reserve position
of the commercial banks.

The use of selective credit controls by the central bank has been
rather limited and diverse in nature. For example, in 1972 the central bank
sold about $80 million in foreign exchange to certain designated banks in order
to slow the rate of expansion of the money supply, and in 1975 a similar action
was taken. In November 1975, in a move to stimulate exports and the economy,
the central bank increased the maximum amount of financing allowed as a propor-
tion of the total value of an export transaction from 70 percent to 85 percent.
Then in 1977, when economic conditions were also sluggish, the central bank
took steps to extend further the maturities of loans that had been provided
under various government programs to certain industries. None of the selective
credit controls utilized by the central bank since its reactivation appear to
have been important in terms of their quantitative impact.

Conclusion: An Assessment of Policy Instruments and Responses

The main objective of this paper has been to see what lessons might
be learned from the central bank's use of monetary policy since 1961. It is
Probably easier to judge the effectiveness of monetary policy when the objec-
tive is financial restraint to reduce inflationary pressures, rather than when
the objective is economic recovery. An easy money policy may, or may not, lead
to economic recovery. Hence, the following assessment of the degree to which
monetary policy has been a success, neutral, or a failure in Taiwan, China,
centers on the three main periods of deliberate monetary restraint since the
central bank's reactivation in 1961. These three periods occurred in 1968,

1973-74 and 1979-80.


- 26 -
REFERENCES

Central Bank, Annual Report, 1961 through 1983, Taipei.

» Financial Institutions in Taiwan, Taipei, 1982.

Chang, Kowie, Economic Development in Taiwan, mimeograph (Taipei: Cheng Chung
Book Co., 1968).

Chiu, Paul C.H., “Performance of Financial Institutions,” mimeograph (Taipei:
Taiwan University, 1981).

Emery, Robert F. and Irvine, R.J., “Interest Rates as an Anti~Inflationary
Instrument in Taiwan," National Banking Review (Washington, D.C.:
Comptroller of the Currency, Sept. 1966).

Kuo, Shirley W.Y., The Taiwan Economy in Transition (Boulder, Colo.: Westview
Press, 1983).

Liang, Chin-ing Hou, "The Operations and Development of Financial Institutions
in Taiwan (manuscript, 1979).

Lundberg, Erik, "Fiscal and Monetary Policies,” from Economic Growth and
Structural Change in Taiwan, edited by Walter Galenson (Ithica: Cornell
University Press, 1979).

Perng, Paul F.N., "Monetary Policy 1973-77 and Recent Monetary Developments,”
mimeograph (Taipei: Central Bank, 1977).

Tsiang, S.C., “Fashions and Misconceptions in Monetary Theory and Their
Influences on Financial and Banking Policies” (Tubingen: Zeitschrift fur
die gesamte Staatswissenschaft, 1979).

» “Monetary Policy of Taiwan", from Conference on Experience and
Lessons of Economic Development in Taiwan (Taipei: Institute of
Economics, Academia Sinica, 1981).



-22-

on time and savings deposits were also raised in September These actions, plus
some use of moral suasion, were successful in bringing the rate of inflation
under control in November-December 1968. During 1969-72 the rate of inflation
remained relatively low, ranging between about 2~1/2 and 5 percent per year.
(See Table 2.)

In short, although the inflationary threat in 1968 was not as strong
as in 1973, the situation still did not get out of hand, and the response of
monetary policy must be judged in this case as having been successful.

Inflation in 1973-74 -- The next major threat to price stability
occurred in 1973 when two large trade surpluses in 1972 and 1973 led to a sharp
acceleration in the rate of growth of the money supply (see Table 2), and the
central bank was not able to neutralize the large increase in net foreign
assets 1/ Price stability was also threatened at this time by a sharp
rise in international commodity prices, a widespread floating of exchange
rates, and the 1973-74 oil shock.

Consumer prices began to rise in July 1973 and increased very rapidly
through March 1974. (See Chart 1.) From a level of 8-1/2 percent, the central
bank in 1973 raised its rediscount rate to 9-1/2 percent on July 26, to 10-3/4
percent on October 24 and to a whopping 14 percent on January 27, 1974. (See
Chart 1.) In addition, rates on time and savings deposits were also raised in
July and October 1973, and in January 1974. Unfortunately, the central bank
did not increase rates quickly enough, allowing six months to pass before the
rates reached their peak in January 1974. The result was a tremendous rise
T7 The type of economic analysis used in this paper is based largely on the
IMF/Polak model which, in a balance-sheet framework, views money as being
affected positively by increases in net foreign assets and net domestic credit,
and negatively by increases in quasi-money and other miscellaneous liabilities
such as banks' capital accounts. See IMF Institute: Financial Policy

Workshops: The Case of Kenya, Chapter 7: The Polak Model, International
Monetary Fund, Washington, D.C. 1981.



-17-

reserve requirement system was simplified by unifying the required reserve
ratios for all financial institutions and by combining into one type of reserve
the guarantee and payment reserves. In addition, the minimum and maximum range
for the legal requirements was increased (e.g., from 10-15 percent to 15-40
percent) so as to give the central bank more flexibility in employing this
monetary instrument. As a result of this reform, reserve requirements were
differentiated only according to the maturity of the deposits and the type of
deposit (e.g., demand vs. savings). To avoid a disruptive change the total
average reserve ratios in July 1975 were reportedly kept as close as possible
to their previous levels.

The key element in this reform was the widening of the permissible
range of legal ratios. Until this change, the ranges had been too narrow for
the reserve requirement weapon to be used effectively at all times.

The central bank does have the power to impose a marginal reserve
requirement on the increase in checking and demand deposits that occurs after a
specific date. However, the bank has so far not utilized this power.

About two years after the unification of the guarantee and payment
reserve requirement into one reserve requirement, the central bank introduced
on August 1, 1977, a new additional liquid asset ratio requirement. This
second reserve requirement of liquid assets to deposits was set at a minimum of
5 percent. The central bank stated that the purpose of this action--which was
authorized in 1975 under the revised general banking law--was to ensure that
the banks maintained the proper amount of Liquidity 2/ Imposing a
liquidity reserve requirement in addition to a general reserve requirement is a

fairly common practice among some of the countries in Southeast Asia.

1/ Acceptable liquid assets include excess reserves, net amounts due from
Danks, Treasury bills, negotiable certificates of deposit, bankers acceptances,
commercial paper guaranteed by banks or dealers, government bonds, and other
securities approved by the central bank.


-9-

example, large trade surpluses expanded the money supply sharply, one important
result being a horrendous jump in the rate of inflation to as high as 47
percent in 1974 as measured by the consumer price index. (See Table 2 and
Chart 1.) In 1978, the main factors expanding bank credit (and hence the money
supply) were the large trade surplus and the inflow of capital ./

In line with a general increase in interest rates, and also in an
attempt to reduce the amount of funds converted from foreign exchange to
domestic currency, thereby decreasing the rate of domestic monetary expansion,
the central bank in January 1974 raised the interest rates paid on time
deposits denominated in foreign currencies. (Interest ‘rates paid on foreign
currency deposits are under the control of the central bank.) At this time the
central bank also encouraged imports (a contractionary factor) by once more
allowing the use of import acceptance credits for up to 180 days. These and
other actions were successful in slowing sharply the rate of inflation by March
1974.

During the first half of 1978, the Taiwan, China, authorities became
dissatisfied with their exchange rate system which pegged the New Taiwan dollar
to the U.S. dollar. Both the United States and Japanese exchange rates experi-
enced sharp fluctuations in 1978, which caused problems for Taiwan, China, in
carrying out its domestic policy objectives, such as maintaining price
stability. The authorities felt that with their pegged system, exchange rate
movements did not reflect the balance of payments of Taiwan, China, but rather
that of the United States.

Therefore, on July 11, 1978, the government unpegged the new Taiwan
dollar from the U.S. dollar; however, a managed float was not introduced at the
time. Instead the currency was administratively revalued by 5.6 percent

against the U.S. dollar. (This moved the rate from approximately NT $38 to NT

1/ Annual Report: 1978, Central Bank, p. 29.


-6-

Another development was the central bank's response to the artifi-
ciality of prices in the government bond market that prevailed up to the middle
of 1971. Dissatisfied because the bond prices did not reflect accurately the
forces of supply and demand, the central bank on July 2, 1971, established an
open market for government bonds by authorizing 10 financial institutions both
to function as government bond brokers and to let bond prices fluctuate in line
with changes in bid and asked prices. Since June 1966 the Bank of Taiwan had
been the sole agent handling the purchase and sale of government bonds at par
value.

In 1972, as the large current account surplus swelled money supply
and banks' excess reserves (see Table 2), the central bank responded with an
innovative monetary instrument. Beginning in August 1972 the central bank
began to sell to commercial banks its own certificates of deposit in one-,
three- and six-month maturities. This action was highly successful in reducing
commercial banks' excess reserves to levels that the central bank could deal
with much more easily.

To deal with strong inflationary pressures in 1973--mostly generated
from abroad--the government revalued the exchange rate in February from NT $40
to NT $38 to the U.S. dollar, issued NT $1 billion in savings bonds to the
general public in June, and in October began to issue treasury bills every two
weeks. In addition, the central bank raised interest rates and reserve
requirements in July, and in October raised interest rates again. As further
anti-inflationary actions were taken in 1974, the inflation was eventually
brought under control by April 1974.

One other special action occurred in 1977 when certain textile
companies experienced financial difficulties. Five of the companies producing

artificial fiber merged and the central bank used money that it had set aside


-5-

five of the banks. This may have helped to reinforce the public's confidence
in the banking system. The postal savings system has also been operated in
such a way that roughly 90 percent of the funds received are redeposited in the
central bank. These deposits are then placed with four specialized banks to
supplement the loanable funds of those banks, in order to achieve a better
allocation of resources in the economy 2/ The central bank has also taken
special measures to aid export industries. One of these included the estab-
lishment in December 1974 of a NT $5 billion (about $132 million) special
financing facility to provide credit to commercial banks for working capital
loans to export industries.

Special Economic Developments and the Central Bank's Response

During the 1970s various developments prompted the central bank to
change the financial system. However, none of these adjustments could really
be characterized as a major financial reform. For example, in February 1970
the government liberalized substantially the gold cover ratio adding “securi-
ties and commercial paper” to the legal reserves--such as gold and silver--that
could be held as backing behind the currency issue. Central bank authorities
stated that this change was made because currency issue fluctuates seasonally
and the change would facilitate the central bank's adjustment measures .2/
Probably the more important influences leading to this liberalization of the
gold cover requirement were the unsettled international monetary conditions at
the time, as well as the elimination during the postwar period of the gold
cover requirements by many countries, including the United States in 1968.

T7 Since March 1982, the Bank of Communications has been allocated 40 percent
of the redeposit of postal savings in the central bank, the Farmers Bank of
China and the Land Bank of Taiwan 25 percent each, and the Business Bank of

Taiwan, 10 percent.
2/ Annual Report: 1970, Central Bank, Taipei, 1971, p. 25.


- 18 -

Even after the new reserve requirement system was introduced in July
1975, the central bank still did not make much use of this monetary instrument.
Between 1975 and May 1984, for example, the reserve requirement changed only
three times (in 1978, 1979 and 1982) for checking and passbook deposits, and
even less for time and savings deposits. During 1981, when the discount rate
was changed four times, there was no change at all in reserve requirements.
(See Table 3.) Also, the range of adjustment during 1975-84 (viz., 7 percen-
tage points for checking deposits) was only moderately larger than the 5 per-
centage point range that was utilized prior to 1975. Thus, not much use has
been made of the higher, permissible, maximum reserve requirements.

All of this points to the conclusion that the reserve requirement
weapon, while useful at times, has not been in the forefront in the central
bank's efforts to restrain inflation. Rather, discount policy has been used
much more frequently and flexibly than reserve requirements.

Open market operations ~- Although the central bank began to make
some use of open market operations in 1979, i.se., about 2-1/2 years after the
formal establishment of a money market in Taiwan, China, this monetary
instrument appears to be much less important than discount rate policy--
including central bank loans to commercial banks. During the period from 1979
through 1983, the amount of yearly central bank credit accommodation far
overshadowed the amount of commercial paper, treasury bills and bankers’
acceptances purchased by the central bank. For example, in 1983 the amounts
were NT $122 billion and NT $18 billion, respectively _/

Prior to the commencement of open market operations in January 1979,
the central bank did engage in some limited open market operations--but solely
on the selling side. Thus, in August 1972 when the central bank wanted to
reduce the banks' large reserve position, it sold central bank time certifi-
cates of deposit to commercial banks. Later, in April 1973, the central bank

1/ Annual Report: 1983, Central Bank, p. 38.


-8-

in a long-term fund, to subscribe to the preferred stock of the newly-merged
company. This allowed the company to repay overdue debt to commercial banks.

International Linkages and Their Impact on the Financial Markets of Taiwan,
China

During the postwar period, particularly after the move to realistic
exchange rates in April 1958, the economy of Taiwan, China, evolved into a very
open economy. Domestic financial markets are now strongly influenced by the
trade balance, capital flows and the relationship of the exchange rate for the
New Taiwan dollar to the currencies of the province's major trading partners.

One external influence disappeared about 20 years ago. This
consisted of the bank deposits resulting from the United States foreign aid
program in Taiwan, China. Under the foreign aid program, these U.S. dollar
deposits were used to import goods, but the local importer had to provide the
equivalent in local currency to pay for the imports. This local currency
became counterpart funds, jointly administered by Taiwan, China, and the United
States. The considerable time lag between the generation of local currency
from aid imports, and its use in financing development projects, served to
“sterlize" purchasing power and reduce inflationary pressures. During the
1950s and the first half of the 1960s, these deposits were an important factor
tending to contract the money supply -/ With the phase-out of U.S. aid
around 1965, however, this altered the situation drastically and forced the
central bank to find some means of replacing the loss of this contractionary
factor. One alternative utilized was offering attractive rates on deposits
(i.e., interest rates that were positive in real terms) to increase the amount
of quasi-money.

Probably the most important external influence over the years on
domestic financial markets--and particularly the money supply--has been the

trade surplus and capital inflows. In 1972-73 and again in 1977-78, for

T/ Annual Report: 1965, Central Bank, Taipei, 1966, p. 48.


- 24 -

Again, monetary policy fell short of being successful during this
period of restraint. Although the rate of price increases was not as steep as
in 1973-74, nevertheless the consumer price index rose 50 percent between March
1979 and October 1981. As before, it would appear that a faster rate of
increase in interest rates by the central bank to the top level would have been
a more effective policy for restraining inflation. There was one long period
from August 1979 to January 1981 when no change was made in the rediscount rate--
yet consumer prices continued to rise rapidly. The central bank might also

have made effective use of a penalty discount rate during 1979-81.

kk RK

Why is it that monetary policy was not more effective during 1973-74
and 1979-81? One of the main reasons is that it took too long to get interest
rates up to a truly restrictive level--even though the first increase in rates
began about the time that the rate of inflation began to accelerate. In
retrospect, it would have been better to have moved fairly quickly to the 13 to
14 percent truly restrictive level than to have delayed the process--in one
case, for as long as 17 months up to January 1981. The apparent lesson here is
that the authorities should not be afraid to return to the historically high
interest rate levels that prevailed in earlier cycles whenever the
circumstances merit such action.

Another aspect that should be noted is that the state of the
international trade balance is an important factor influencing how strong a
restrictive monetary policy the authorities should pursue. In 1974 the large
trade deficit helped significantly in exerting a contractionary impact, but in
1979-81 the problems of monetary restraint were exacerbated by a trade surplus

in all three years.


International Finance Discussion Papers

Number 252

December 1984

POSTWAR FINANCIAL POLICIES IN TAIWAN, CHINA

by

Robert F. Emery

NOTE: International Finance Discussion Papers are preliminary materials
circulated to stimulate discussion and critical comment. References in
publications to International Finance Discussion Papers (other than an
acknowledgment by a writer that he has had access to unpublished materials)
should be cleared with the author or authors.


-ll-

$36 to the U.S. dollar.) Then, about seven months later on February 1, 1979,
new foreign exchange regulations were issued and a managed floating rate system
was introduced. Earners of foreign exchange were no longer required to sur-
render their earnings to the central bank. These actions gave the authorities
more flexibility in managing the exchange rate, and since a change from roughly
NT $36 to NT $38 to the U.S. dollar in August 1981, and a further depreciation
to about NT $40 per dollar in the summer of 1982, the rate has roughly stabi-
lized at the NT $40 per U.S. dollar level.

Financial Policies and Instruments

In attempting to achieve the three basic objectives listed earlier,
the central bank carries out the following important functions: (1) issues the
currency; (2) regulates interest rates; (3) determines reserve ratios; (4) acts
as a lender of last resort; (5) supervises and examines financial institutions;
(6) acts as fiscal agent for the government; (7) holds and manages official
foreign exchange; (8) collects financial data; and (9) conducts economic
research.

With regard to its activities in the field of monetary policy, the
central bank is able to utilize both general and selective credit controls.
The main general controls include changing the central bank's rediscount rate
and the amount of credit accommodation for banks, setting maximum rates on
banks' deposits and the range per banks' loan rates, raising or lowering bank
reserve requirements, buying and selling foreign exchange, and conducting open
market operations. The last of these instruments has not been particularly
important because of the underdeveloped money market, but open market opera-
tions could play a larger role in the years ahead if the money market continues
to develop rapidly. Aside from moral suasion (which can be used in either a

general or selective manner), the central bank's main selective controls have


-10-

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-7-

Table 2. Taiwan, China: Selected Economic Indicators

Reserve Position

Percentage Changes Income Excess Reserves Central Bank Credit
Year-end Consumer Price Index Velocity in Mill. NT $ in Mill. NT $

Year Money Supply Yearly Avg. Dec. Avg. GNP/M Dec. Avg. Dec. Avg.
1961 20.0 7.9 2.9 9.7 77 14
1962 5.0 2.4 2.9 9.5 -104 986
1963 28.1 2.2 0.7 8.4 - 63 129
1964 35.0 -0.2 0.5 7.3 245 379
1965 15.9 -0.1 0.7 6.9 -437 739
1966 12.2 2.0 1.6 6.9 -338 752
1967 30.1 3.4 4.4 6.1 559 1,028
1968 11.5 7.9 6.1 6.4 -793 1,892
1969 15.6 5.1 5.7 6.4 954 1,664
1970 15.0 3.6 3.8 6.4 -1,046 1,594
1971 30.6 2.8 2.7 5.7 255 1,037
1972 34.1 3.0 2.6 5.1 2,724 441
1973 50.4 8.2 24.0 4.4 510 1,115
1974 10.5 47.5 33.1 5.3 7 230 25
1975 28.8 5.2 0.2 4.4 3,404 -
1976 25.1 2.5 3.6 4.2 8,970 -
1977 33.6 7.0 6.8 3.7 6 ,698 -
1978 37.0 5.8 7.7 3.2 5,708 1,267
1979 747 9.8 12.5 3.6 3,728 -
1980 22.7 19.0 22.2 3.6 2,296 2,463
1981 13.8 16.3 9.9 3.8 11,421 -
1982 15.6 4.0 3.0 3.5 7,560 1,803
1983 18.1 1.4 0.1 3.2 3,131 2,282

Sources: A Supplement to Financial Statistics Monthly, Central Bank, October 1983; Taiwan
Statistical Data Book, Council for Economic Planning and Development, June 1983; and
Taiwan Statistics Monthly, Central Bank.



-21-

It should be recognized that it is often not possible to see clearly
the relationship between accelerating monetary expansion and accelerating
inflation. There are too many other factors capable of obscuring the relation-
ship, In the case of Taiwan, China, these have included (as contractionary
forces) the rapid rate of increase in the monetization of the economy in the

1960s ,2/

the sharp gains in agricultural productivity in the 1950s and 1960s,
and the secular decline in the velocity of money in the past 25 years as shown
in Table 2. All three of these factors have tended at various times to offset
partly the relatively high rate of monetary expansion in Taiwan, China, in the
postwar period. A major factor operating on the expansionary side--at times--
has been the large trade surplus, the impact of which could have been lessened
by a more flexible exchange rate system than what actually prevailed. Budget
operations--at least since the early 1950s--have not been an important factor in
influencing price stability and have been roughly neutral in their impact.

1968 developments. -- The central bank's basic policy since 1961 of
lowering the structure of interest rates was interrupted in 1968 when incipient
inflationary forces reappeared. Monetary expansion accelerated in 1968 due to
a sharp rise in loans to the private sector and a slower rate of growth in time
and savings deposits. Beginning in April, consumer prices began to rise more
rapidly and by August were up 11 percent over the March 1968 level. During
1967 the consumer price index (annual average) increased only 3-1/2 percent.
The central bank acted by raising its discount rate in August 1968 from 10.8
percent to 11.9 percent and holding it at that level through May 1969. Rates

1/ Brik Lundberg has shown that Taiwan, China, had a tremendous expansion in
‘oth money supply and the banking system between 1955 and 1975, with broad money
(M2) rising from 9 percent to 56 percent of the value of total output--a level
of monetization roughly comparable to Japan's. See Erik Lundberg, "Fiscal and
Monetary Policies", from Economic Growth and Structural Change in Taiwan, ed. by
W. Galenson, Cornell University Press, 1979, p. 2/1.



-3-

Table 1. Taiwan, China: Assets of Financial Institutions

(In billions of New Taiwan Dollars; as of April 30, 1984)

Central bank

Domestic banks

Postal savings system

Credit cooperative associations

Credit departments of farmers' associations
Medium business banks

Investment and trust companies

Local branches of foreign banks

Life insurance companies

Fire and marine insurance companies
The Fuh-Wha Securities Finance Company
Bill finance companies

Total

As a
% of No. of
Assets Total Units
740 20.2 1
1,662 45.4 16
363 9.9 1,092
238 6.5 75
207 5.7 282
152 4.1 8
115 3.1 8
112 3.1 30
54 1.5 9
12 0.3 14
4 0.1 1
3 O.1 3
3,662 100.0

Note: The above data are not presented on a consolidated basis.
convert to U.S. dollars, the exchange rate at the end of April 1984 was

approximately NT $40 per U.S. dollar.

Source: Financial Statistics Monthly, Central Bank, Taipei, May 1984.



-14-

However, there have been three times since 1961 when the central bank
has had to reverse direction and move rates up in order to restrain inflation.
This occurred--in a mild way--in 1968, and more vigorously in 1973 and 1979, as
shown by the trend in the central bank's rediscount rate in Chart 1. The
details regarding the central bank's use of interest rate and discount policy
are discussed at some length in a later section assessing the effectiveness of
policy instruments.

It should be noted that in connection with its discount policy, the
central bank also varied substantially the amount of bank accommodation
provided during various phases of the economic cycle. For example, during the
last seven months of 1974, when the authorities were anxious to revive the
economy, there was a substantial increase in central bank credit to the banks,
the result being a 74 percent increase in accommodation during all of 1974 over
the previous year. Similarly, credit accommodation has been curtailed during
tight money periods, thereby reinforcing the central bank's interest policy
during restrictive periods.

Use of reserve requirements. -- The reserve requirement weapon has

generally been used less than the discount weapon. Over a 14-year period to
1974, for example, commercial bank reserve requirements were changed only four
times for demand deposits and five times for time deposits. (See Table 3.)
Since the mid~1970s, the central bank has been reluctant to raise the reserve
requirement to the maximum permitted by law as this might act as a partial drag
on economic growth. An indirect indication of this was a mid-1960s statement
that the reserve requirement was lowered "...in order to sustain economic

1/

growth. "—

————____
1/ Annual Report: 1966, Central Bank, p. 55.


- 16 -

During the period from 1961 to the present, Taiwan, China, has had
two different systems of reserve requirements. During the first period from
1961 to July 3, 1975, the reserve requirement varied according to: (1) which
of five categories a bank belonged; (viz., commercial, industrial, savings,
trust, or Chinese native); (2) the type of deposit (e.g., demand, time or
passbook); and (3) whether the minimum ratio was for a guarantee reserve

requirement or a payment reserve requirement .2/ The central bank was

allowed to set the guarantee reserve requirement within a rather narrow range

of about 3 to 5 percentage points (e.g., for demand deposits, between 10 and 15

percent), but the payment reserve requirement was fixed at a flat rate (e.g.,

15 percent for commercial bank demand deposits). As to the difference between
these two, the guarantee reserve had to be deposited with the central bank,
while the payment reserve could be held (within certain limits) in the form of
vault cash, as current deposits with other banks, or as a cash deposit with the
central bank.

During the late 1960s the banks were lax in observing the minimum
reserve requirements. To deal with this problem, the central bank in 1970
amended the reserve requirement regulations, specifying that if a bank had a
reserve deficiency, the central bank would impose, as a penalty, an interest
charge for 10 days on the amount of the deficiency at a level 50 percent above
the prevailing call loan rate. This action was successful in causing the banks
to be more attentive to their reserve positions.

In 1972, when the banks had excess reserves and the reserve
requirements were already at their maximum (except for savings banks), the
central bank resorted to selling both foreign exchange and short-term non-
transferable certificates of deposit to those banks with excess reserves.

In 1975 there was a substantial reform of the reserve requirement

system following a revision of the general banking law. Effective July 4, the

I7 Prior to 1968 the “payment reserve” was called a “cash reserve.”


-2-

On July 1, 1961, the central bank was reactivated and once more
assumed most of the traditional functions of a central pank.2/ Its three
basic objectives since 1961 have been to stabilize the internal and external
value of the currency, to promote financial stability, and to provide sound
guidance to all banking institutions-~all three of these objectives being aimed
at fostering economic growth. One function that the central bank did not
resume in 1961, however, was that of carrying out commercial bank activities.
It had acted, in part, as a commercial bank while operating on the mainland
prior to 1950, but the bank has been prohibited from engaging in such activi-
ties since it was reactivated in 1961.

; The information provided in Table 1 gives some idea of the 12 types
of financial institutions that operate in Taiwan, China and their relative
importance. Although the central bank last April accounted for 20 percent of
the assets of the financial institutions in Taiwan, China, the commercial banks
(including foreign banks) had roughly half of the assets listed. The rest of
the assets were scattered among the remaining 10 types of financial institu-
tions, with no single institution having more than 10 percent of the total.

The financial system of Taiwan, China, can usefully be characterized
as a specialized system. Although the commercial banks extend a variety of
credits, there are many other institutions providing finance in a variety of
forms and to a diverse group of borrowers. Farmers, for example, are served by
282 credit associations, and small- and medium-sized businesses are able to
obtain credit from eight medium and small business banks which evolved from
former mutual savings and loan companies.

T7 With regard to the fiscal agency function, however, the central bank serves

only the Taipei area, while the Bank of Taiwan's branches serve all of the
remaining areas in Taiwan, China.


- 25 -

Another reason why monetary policy was not more effective in 1979-81
was the rather weak use made of the reserve requirement weapon and open market
operations, despite the reserve requirement reform of 1975. There appears to
be a reluctance on the part of the central bank to make use of some of the
higher ranges of the reserve requirement (e.g., up to 40 percent). As a
result, the excess reserves of banks increased to a high level in 1981 (see
Table 2)--a year in which no use was made of the reserve requirement weapon./

It should also be noted that the central bank may be pursuing an
inappropriate policy in attempting to set Taiwan, China, interest rates at the
same level as in the major industrial countries. (This policy was described
earlier.) A more appropriate policy would be to let interest rates find their
own level under relatively free market conditions, rather than be set at some-
what artificial levels through administrative action. In less developed coun-
tries and regions, capital tends to be relatively scarce, with a high oppor-
tunity cost, and it is only logical to expect this to be reflected in interest
rates that will often be higher than the rates in the major industrial countries.

In short, more use should be made of all available monetary instru-
ments, including the newly developed open market operations. Also, the most
important instrument--interest rate policy--should be used more quickly and
flexibly, along with central bank credit accommodation policies, both to dampen
loan demand in inflationary periods and to stimulate a rise, which would be
anti~-inflationary, in time and savings deposits. Provided policies like these
are pursued, the authorities should be more successful in bringing future
inflationary pressures fairly quickly under control.

T7 Erik Lundberg, in discussing the postwar period in Taiwan, China, also
concludes that “there is no evidence that...reserve [requirement] policy was

really effective in controlling the money supply and credit availability." See
Erik Lundberg, op. cit., pp. 285-6.


Postwar Financial Policies in Taiwan, China
by
Robert F. Emery

The objective of this paper is to examine the monetary policies of
Taiwan, China, since the reactivation of its central bank in 1961 to see what
lessons can be learned from its credit control operations, rather than the
subject of financial reform per se. Although there have been certain innova-
tions as the authorities have improved their control of money and credit, there
has been no dramatic financial reform in Taiwan, China, since the 1961 reacti-
vation. The financial structure in Taiwan, China, has remained relatively
stable, partly because of the authorities' willingness to allow relatively high
interest rates whenever this was required as a result of inflationary pressures.
To the extent that there has been a major financial reform in the postwar
period, this occurred in 1950 when high nominal interest rates (125 percent,
compound rate) were paid on certificates of deposit to successfully eliminate
the 85 percent rate of inflation at the time 2/

Taiwan's Financial System in Brief

Following the founding of the People's Republic of China in 1949, the
central banking functions for Taiwan, China, were transferred to the Bank of
Taiwan, a provincial bank. However, the central bank continued to collect
statistics and to supervise banks. The Bank of Taiwan--which was established on
May 20, 1946, and received its capital from a treasury appropriation-—handled
such central bank functions during the 1950s as issuing bank notes, serving as
fiscal agent for the provincial government, and, in conjunction with other

government authorities, adjusting interest rates and bank reserve requirements.

The views represented in this paper are the author's and they do not necessarily
represent the views of the Federal Reserve Board or any other members of its
staff.

17 For the details of that reform, see “Interest Rates as an Anti-Inflationary
Instrument in Taiwan,” by Reed J. Irvine and Robert F, Emery, National Banking
Review, September 1966, pp. 29-39, and “Monetary Policy in Taiwan" by S.C.
Tsiang, Conference on Experience and Lessons of Economic Development in Taiwan,
Institute of Economics, Academia Sinica, Dec. 1981, pp. 249-274.



-12-

included regulating downpayments and maturities for consumer and construction
credits, limiting credit extended to securities dealers and securities finance
companies, and imposing maximum loan ratios in relation to the appraised value of
commodities or real estate used as loan collateral.

Interest rate regulation and the discount window.--Since the central

bank's reactivation in 1961, the most important monetary instrument used has been
interest rate regulation. The central bank fixes not only the various discount
rates that it charges borrowing banks, but also prescribes the upper limit for
bank deposit rates and approves the range of interest rates on bank loans as
proposed by the Bankers’ Association. Bank regulations also specify that the
minimum lending rate must exceed the maximum deposit rate 2/" A quick glance d
at Chart 1 indicates that the central bank made fairly frequent use of its
discount rate weapon in the 1970s and 1980s.

Although there was a revision of the general banking law in July 1975,
it fell far short of constituting a reform of the interest rate system. The two
major interest rate actions were to specify that the central bank can set a
ceiling (i.e., maximum) rate for interest paid on deposits, and that commercial
banks' maximum and minimum lending rates should not exceed a range of 0.25
percentage points.

The central bank has the authority to provide three types of accomoda-
tions to banks: (1) rediscounts of eligible bills, with maturities not exceeding
90 days for commercial and industrial bills and 180 days for agricultural bills;
(2) temporary advances not exceeding 10 days to cover a deficiency in reserves;
T/7 In November 1980, the central bank issued new interest rate guidelines.
These specified that the Bankers' Association could propose changes in the
ceiling deposit rates in response to market conditions and specified that
negotiable certificates of deposit (a relatively new liability for the banks)

and bank debentures could carry interest rates in excess of the deposit rate
ceilings set by the central bank.


Table 3. Taiwan, China:

-15-

Rediscount Rate and Reserve Requirement

Commercial Bank

Reserve
Central Bank Requirement

Effective Date Rediscount Effective Date Demand
of Change Rate of Change Deposits

(%) (@)
July 1, 1961 14.40 July 1, 1948 15
Jan. 1, 1962 12.96 May 1, 1953 13
July 1, 1963 11.52 Aug. 1, 1958 10
May 6, 1967 10.80 Jan. 1, 1959 13
Aug. 12, 1968 11.88 Feb. 1, 1959 15
May 10, 1969 10.80 Jan. 1, 1966 12
Dec. 22, 1970 9.80 May 6, 1967 15
May 29, 1970 9.25 May 10, 1969 12
July 1, 1972 8.50 July 21, 1971 15
July 26, 1972 9.50
Oct. 24, 1972 10.75 Checking
Jan. 27, 1974 14.00 Account
Sept. 19, 1974 12.50
Dec. 13, 1974 12.00 July 21, 1975 25
Feb. 22, 1975 11.50 Nov. 21, 1978 30
Apr. 21, 1975 10.75 May 16, 1979 25
Oct. 22, 1975 10.00 June 29, 1982 23
Dec. 15, 1975 9.50
Apr. 1, 1977 8.75
June 10, 1977 8.25
May 16, 1979 9.50
Aug. 22, 1979 11.00
Jan. 5, 1981 12.00
June 15, 1981 13.25
Oct. 21, 1981 12.25
Dec. 17, 1982 11.75
Feb. 26, 1982 11.25
Apr. 17, 1982 10.25
July 12, 1982 9.25
Sept. 18, 1982 8.50
Dec. 30, 1982 7.75
Mar. 16, 1983 7.25
May 9, 1984 7.00
Sources: Taiwan Statistics Monthly, Central Bank.