Things were different a decade ago, when both Taiwan’s economy and equities managed to avoid the turmoil of the Asian financial crisis. What’s changed?

For one thing, Taiwan has run into the law of diminishing returns. It’s per capita GDP is now close to $20,000. Economic growth slows at the higher stages of development; the same process has occurred in South Korea and Japan. Most low-end manufacturing has migrated to China and Vietnam. And it faces a demographic problem, with a slowing birthrate and little immigration.

Some of these factors are endemic to advanced economies. So should Taiwan accept relatively low growth as its fate? While the country won’t be able to replicate the “miracle economy” pace of 8 per cent growth it had in the 1970s and 1980s; policymakers can still aspire for higher than 4 per cent by pushing the economy into higher value added sectors.

Still, many foreign portfolio investors find it hard to comprehend the reasons for Taiwan’s slowdown and have thus poured more money into its stock market than into any other emerging market since the current global bull run began in March 2003. Investors are chasing the island’s stocks in the hope that its economy will accelerate once more. Others think the market’s slowly deflating equity valuations are inexpensive compared with their historical values. After all, Taiwan’s market traded at a price-to-earnings ratio of 100 in 1989, when the country was one of the world’s fastest-growing economies and strict capital controls kept money trapped at home. It now trades at a P/E ratio of 15, which is slightly above average for emerging markets. Foreign investors are confusing the more normal valuation levels with outright cheapness.

Now that some capital restrictions have been lifted, and growth has slowed, domestic investors have taken an opposite approach; they are moving their money to more attractively valued emerging markets from Brazil to India. Total outflows from local investors have averaged a staggering $3 billion a month over the past couple of years. The accelerating pace of outflows has so worried Taiwan’s central bank that it has increased interest rates this year to prevent the currency from depreciating. It must be the only emerging-market central bank currently worried about a weak exchange rate.

The unbalanced external accounts are a sign to Taiwan’s problems: the lack of local confidence in the country’s long-term prospects is rooted in the realisation that while a 4 per cent economic-growth rate may be respectable for an advanced economy in ordinary times, it’s not when global growth is greater than at any time in history. Domestic consumption remains moribund — a sign of anxiety about the future.

Politics is further dampening hopes, with elected officials trading blows in Parliament rather than fixing the economy. The two main national parties, the DPP and the KMT, have been at loggerheads over how to manage relations with China.

Taiwan’s policy of having the region’s highest tax rates and an inefficient goods distribution system has inflated the country’s cost structure and accelerated the outward flow of investments, resulting in low job growth and virtually stagnant wages. As Hong Kong and Singapore have shown, the key to keeping employment at higher stages of development is to fill the vacuum created in the manufacturing sector by boosting the services sector. But in Taiwan, financial services remain hamstrung, thanks to the government’s penchant for interfering with banks.

As was the case in the run-up to the 2004 election, hopes have risen in recent weeks that after the next polls in early 2008, whoever wins will focus on reviving Taiwan’s competitiveness. Top priorities should be liberalising the financial sector and strengthening ties with China.

Given its wealth, Taiwan may never match the growth rate of poorer, larger neighbours like China or India. It will be similarly difficult for the Taiwanese stock market to outperform its emerging-market peers, as its valuations are not yet deeply discounted. Policy paralysis and slow progress on the reform front raises the risk of Taiwan’s becoming a permanent regional also-ran. That would once again dash foreign investors’ hopes of another boom.

The writer is head of emerging markets at Morgan Stanley Investment Management Newsweek