*Special* The Rot Spreads in Taiwan

Taiwan is only now beginning to experience the deleveraging process of debt deflation.
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HONG KONG -- Taiwan's downward lurch Monday prompts Greed & Fear to issue a flash alert to detail our regional asset-allocation model. We remain significantly underweight Taiwan (8% vs. a 16.1% weighting in Taiwan accorded by the

Morgan Stanley Capital Int'l Far East Free Ex-Japan

index), a stance initiated early last year.

Taiwan is at the wrong end of the deflationary cycle in Asia in that the deleveraging process of debt deflation is only now really starting to work. In brief, the Taiwanese stock market's key vulnerabilities are an extremely highly leveraged domestic economy (with domestic credit totaling 174% of GDP), an opaque at best banking system, retail investors still margined to the hilt, a corporate sector with a Japanese penchant for

zaitech

and a government still trying to get out of these problems via flawed administrative guidance.

The drop through the key 6,200 level raises the question of how much lower the market can go. There is near-term resistance at 5,850 in the

TAIEX

, which should allow for a pause for breath after, undoubtedly, more boosting measures from the government. But the ultimate bear-market low for this index looks to be more around the 3,500 level, as the familiar process of debt deflation causes the credit multiplier process to go into reverse. Currency risk will also grow since the more the stock market declines, the easier the central bank will become in a belated response to limit the damage.

Foreign experts on Taiwan will continue to underestimate the scale of the bear market now hitting the country because they tend to be electronics experts. It is true that there are lots of impressive electronics companies in Taiwan. Still, exports have been falling as manufacturing capacity has increased. Moreover, these companies -- and the multiple ratings they command -- cannot stay immune from the fallout as excess liquidity exits the market.

Private lending as a percentage of GDP has been rising ever since the late 1980s and has never corrected in 1990 despite the stock market's precipitous collapse that year. That deleveraging process is now about to happen. More fuel to the bear story on Taiwan will be added by renewed disappointment on the China growth story as realization dawns that most of Taiwan's companies are not making any money in the mainland -- like most other people.

In this respect, Greed & Fear is most bearish in Asia on the Greater China markets, as well as Japan, of course.

Christopher Wood, the author of Greed & Fear, is the global emerging market strategist for Santander Investment. He is the author of The End of Japan Inc. (Simon & Schuster, 1994). Under no circumstances is this to be used or considered as an offer to sell, or a solicitation or recommendation of any offer to buy.