T he scenario is frighteningly familiar: A building boom fuelled by aggressive bank lending goes bust. Bad-loan levels soar. The stockmarket sags amid a rash of corporate defaults. Confidence evaporates.

 All this has happened in Taiwan in the past few months, prompting some local economists to use ominous words like "disaster" and "recession." For the first time in 13 years, GDP growth is expected to drop below 5% in 1999, they lament. The doomsayers among them talk darkly of economic growth plummeting as low as 3%-4% this year.

 If that's a crisis, it's one that almost any other East Asian country would envy. Taiwan does have problems--and they're likely to get worse before getting better--but the island stands out as a beacon of economic resilience in a region struggling to claw its way out of recession. Only China, whose statistics are questionable, is predicting a faster rate of growth than Taiwan.

 What makes Taiwan different? Unlike Thailand, Taiwan has the means to sort out its banking woes, thanks to a deep financial conservatism rooted in insecurity over its political confrontation with China. Unlike South Korea, which is still trying to break up its unwieldy chaebols, Taiwan's economy is powered by smaller, more agile enterprises that make whatever the world wants to buy. And unlike Indonesia, where political uncertainty is paralyzing economic recovery, Taiwan has transformed itself into one of Asia's most vibrant democracies, endowing the government with the legitimacy to lead through tough times and the people the means to protest if it doesn't. 

These strengths kept Taiwan afloat amid the regional economic crisis--and should keep it above water now that the crisis has reached its shores. (Unless the U.S. and European markets go bust, in which case all bets are off.) "I've seen this country in tight spots before," says Theo Stiftl, head of the European Council for Commerce and Trade and a 25-year resident of Taiwan. "But overall, they've gotten themselves out in a relatively short time and back on the track of growth." Stiftl is confident the same will happen this time.

 How long Taiwan takes to come out the other side, however, may depend largely on how the political leadership uses these strengths. If the government lets market forces purge the economy of its weaknesses, Taiwan could quickly emerge leaner and meaner, economists say. But if the government insists on supporting sickly enterprises and denying the severity of the problems--its reaction so far--Taiwan's economic troubles could drag on.

 If so, investors are likely to stay on the sidelines, leery of the financial problems they suspect remain concealed by lax disclosure rules. Consumer gloom will also persist. "I've never seen business so bad," says Lin Jieh-ming, whose company packages tea for the domestic market. He grumbles about an early January speech by President Lee Teng-hui affirming once again that Taiwan's economic fundamentals were sound and that it had outperformed much of Asia. "Our president shouldn't boast so much."

 Lin, like many across Taiwan, has been rattled by a barrage of bad news. In the fourth quarter of 1998, a series of defaults on stock settlements or debts by mid-sized firms, including An Feng Steel, Kuoyang Construction Co., PanVest Group and New Magnitude Group, rocked business confidence. At the same time, exports were shrinking, down more than 9% for 1998, due mainly to the Asian slowdown and China's latest anti-smuggling campaign. It was the sharpest drop in half a century. 

Financial trouble at the Taichung Medium Business Bank, which was temporarily taken over by the government in November, also set off alarm bells. Then the main stock index plunged, falling below 6,000 points in late January for the first time in almost three years, down 40% from its August 1997 peak of 10,116. 

Those blows are by no means fatal, but they do signal some structural problems in the economy. For all its vaunted discipline, Taiwan grew flabby during two decades of prosperity, adopting some of the worst practices found elsewhere in the region. Nowhere is that more evident than in the proliferation of new banks, not to mention bills-finance companies, which underwrite and sell corporate debt.

 The government licensed 16 new commercial banks in 1991-92, and nine more have since been converted from credit and trust institutions. Once financial liberalization made it possible, every big-time business group seemed to want its own bank. "It's the downside of Taiwanese entrepreneurship," quips a senior executive from one of the new banks. The explosion of banks triggered five years of aggressive lending. As in Thailand, a lot of the loans went into property, the one sector that could easily absorb that much liquidity. Bending the rules, some banks have also lent liberally to affiliates of their major shareholders, and failed to secure adequate collateral. Meanwhile, numerous industrial firms borrowed capital to play the stockmarket, instead of investing in productive assets.

 Now the party's over. After weathering the first year of the regional crisis, the decline in export orders started squeezing manufacturing groups, some of which were already exposed to a depressed stockmarket and a bloated property market. Construction companies had built their way into a glut, with more than 900,000 unsold houses across the island at the end of 1998, despite a home-ownership rate of 85%.

 Short of cash, manufacturing and construction companies began bouncing checks and defaulting on loans. Nonperforming loans among commercial banks rose to a record NT$565 billion ($17 billion), or 4.47% of total outstanding loans, by December. Bankers say nonperforming loans for new banks could average 7%-8% of total loans outstanding, while some of the island's small, loosely run credit cooperatives have reported levels above 20%. The extent of the problem has been masked, bankers say, because the government has urged them to roll over problem loans for six months.

 That means some ugly numbers may show up on banks' books in the second quarter, after the six-month period expires. "The first half of this year could be dangerous," says Thomas Lee, a banking professor at National Chengchi University. "The situation in Taiwan is worse than it looks from the outside." 

All this makes Taiwan sound a lot like Thailand on the eve of its crash. Don't be fooled, however. While Taiwan has some of the problems of its crisis-hit neighbours, they don't run nearly as deep. It's almost certainly strong enough, financially and industrially, to take the beating.

 First look at finances. Taiwan has a deep tradition of financial conservatism, even if some new players have ridden roughshod over it. The roots go back to the 1940s, when hyperinflation helped undermine the Kuomintang government in mainland China. After fleeing to Taiwan following the communist victory in 1949, the KMT vowed not to repeat its economic mistakes. Much more was at stake than currency stability: Financial strength was seen as a bulwark against a hostile China.

 Taiwan's diplomatic isolation reinforced the need for frugality. "Since Taiwan is not a member of the IMF, we must look after ourselves and keep a high level of reserves," says Simon Lin, president of Acer, Taiwan's leading personal-computer maker. Taiwan's central bank had $90 billion in reserves at the end of 1998, among the largest in the world. The conservatism has seeped into Taiwan's corporate culture: Many companies prefer to finance their expansion with minimal outside borrowing, giving Taiwan one of the lowest corporate-debt levels in the region, according to Moody's Investors Service.

 Lending grew rapidly in the 1990s--but not enough to seriously endanger a system built on decades of prudence, analysts and bankers say. It helped that the central bank promptly cut off excess credit to deflate a growing stock and property bubble in the late 1980s, meaning that Taiwan did not have as far to fall when the crisis first hit.

 Even more significant is the modest level of offshore corporate borrowing. Combined foreign debt from the public and private sector was estimated at around 15% of GDP at the end of 1998. Contrast that with Thailand, South Korea and Indonesia, where banks and companies borrowed heavily in U.S. dollars for local ventures. Banks reaped huge profits by re-lending in local currencies at higher interest rates, but when those currencies crashed, domestic borrowers were unable to pay their debts.

 In those three countries, the currency crash crippled industry; even healthy companies couldn't get trade financing. But with a solvent financial system, Taiwan can inject enough liquidity into the system to keep the wheels of industry turning--though it's no easy task to ensure that the money flows to the right places. And that's crucial.

 The core strength of Taiwan's economy is cost-effective manufacturing. The Taiwan difference is stark when its industry is set next to South Korea's. Both were Japanese colonies until the end of World War II and benefited from early industrialization. But while a score of mammoth chaebols dominate South Korea, hundreds of small and medium-sized businesses drive Taiwan--thanks in part to the island's individualistic, immigrant culture. Taiwanese consider owning their own business far superior to working for someone else's firm, no matter how big. "It's better to be the head of a donkey than the tail of an elephant," goes a local aphorism.

 History and government policy also shaped the two economies. Rebuilding from the devastation of the 1950-53 Korean War, South Korea's government channelled credit to a few chaebols to build "strategic" industries such as steel making and shipbuilding. Hyundai, Samsung and Daewoo were among them.

 By the 1990s, however, strategic had turned into myopic and the system was distorted by corruption: The chaebols contributed hundreds of millions of dollars to the ruling party, which in turn instructed banks to give them credit. Without discipline from their bankers, many chaebols diversified into prestige areas where they had no competitive advantage, racking up huge debts.

 In Taiwan, by contrast, the state confined itself to key sectors such as finance and energy, leaving most industrial opportunities to private entrepreneurs. When the government did try to jump-start costly projects, there were built-in checks and balances. In the early 1990s, for example, the financial authorities scuttled attempts by the cabinet to push aerospace joint ventures. In one instance, the state-owned Bank of Communications refused a soft loan for a project with British Aerospace, and the venture was dropped, to the embarrassment of the president and premier.

 Contrast that with Indonesia, where B.J. Habibie, who was technology minister until last year, won millions of dollars in state funding to build a regional aircraft. Habibie is now president, and the aircraft project continues to lose money.

 Since the 1970s, Taipei's industrial policy has been to build the infrastructure and promote the technology for future growth. It has nudged domestic private investment into hi-tech, and with a few exceptions, let the entrepreneurs take it from there. It established the Hsinchu Science Park in 1980, for instance, primarily to attract hi-tech companies from abroad. But the park soon became home to spin-offs of government-research institutes for the micro-electronics industry. These companies--such as United Microelectronics Corp. and Taiwan Semiconductor Manufacturing Corp.--have since become pillars of the economy. 

For years, the Taiwan and South Korean systems turned in roughly similar annual growth rates of 8%-13%. But while many chaebols grew fat on easy credit, Taiwan's smaller enterprises had to keep trimming costs to compete worldwide. The result is a large and diverse export market, which has so far given Taiwan the resilience to survive (see chart). 

Witness the headquarters of Asustek Computer, on the outskirts of Taipei. It's a holiday weekend, but employees are working overtime to fill an order. They beaver away at a state-of-the-art assembly line that's stamping out one of the world's most sought-after electronic components--the Asustek motherboard, the heart of a personal computer.

 Has the Asian economic crisis affected Asustek's business? "Not at all," smiles Alexander Lee, its chief financial officer. Asustek's customers are building PCs for booming markets in the West. No wonder, then, that Asustek's sales swelled 65% to $1.1 billion in 1998.

 Several years of such growth have left locally listed Asustek sitting atop $800 million in cash. The company plans to use the money to ramp up notebook production and push into CD-ROM drives, but it won't touch the stockmarket. "We've got to keep focused on our main business," Lee says. If we can't find a new project which makes us comfortable, we'd prefer to keep our money in the bank."

 New challenges lie ahead for Taiwan's manufacturers, as they keep trying to climb up the value-added ladder (see next story). But as globalization continues to ratchet up competition, the proven agility of Taiwan's closely held manufacturers augurs well for the island's future.

 Over the past decade, democracy has added another layer of strength to Taiwan. Elections have become routine, and, despite hard-fought campaigns, candidates and parties win office and lose it smoothly. That gives reason to hope that while governments may change, the system can provide the stability that business demands. 

Electoral victory also gives the KMT a popular legitimacy that it lacked when it ruled through martial law up to 1987. Taiwan's free and highly competitive press acts as a watchdog over government and business, enhancing the transparency and accountability that modern economies increasingly demand.

 Thanks to these underlying strengths, Taiwan doesn't need to take fright in the face of the current slowdown. Instead, it can seize the opportunity to enhance efficiency, while pressing ahead with economic and political reforms. 

So far, however, the government seems to be more concerned about averting panic. It has been downplaying the economic problems, while trying to prop up the stockmarket and bailing out property developers, banks and certain industrial groups. Rather than restoring confidence, the scatter-shot measures have drawn wide-ranging criticism (see story on page 12).

 The suspicion that greeted the government's rescue measures highlights another point: Political reform needs to continue for the government to keep the confidence of the people. The KMT still has massive business interests, which bankroll an awesome electoral machine, tilting the playing field. Some government institutions, such as the Control Yuan, its anti-corruption body, are not as effective as they could be.

 If Taiwan allows its democratic development to stall, the system could get mired in money politics, and popular enthusiasm for democracy could turn into cynicism. Vice-President Lien Chan seems to recognize this: In early January, he issued a vigorous call for further political reforms, giving impetus to proposals that had lost momentum in his party. 

Taiwan, for all its strengths, is still a work-in-progress. In its short history, it has developed an economic and political system that may be one of the best-suited in Asia for the challenges of the 21st century. But the economic slowdown may offer the temptation to retreat. The choices Taiwan makes now will determine whether it widens its difference with Asia's stricken countries, or slips back into the pack.