I knew that Taiwan and Hong Kong’s stock markets were correlated when I began penning this — they have to be, as China is a powerful force in both regional economies — but all the same I was surprised to see how much they have converged in the past couple of years.

For most of the rally (up until May of this year) holding the iShares Taiwan ETF (NYSE: EWT) was nearly identical to holding the iShares Hong Kong ETF (NYSE: EWH).

Since China affects both economies disproportionately, new 52-week highs in the Taiwan and Hong Kong ETFs are still more pieces of the crash puzzle that we have been solving throughout this year.

At first glance, the regional economies are not that similar. Hong Kong is about real estate, finance and commerce, while Taiwan is a technology manufacturing powerhouse.

I looked a little closer at these two ETFs, and the correlation reasons were clearly not due to either similar stocks or similar sectors in the ETFs (as the different focus of the economies would suggest).

In fact, these two ETFs have almost nothing in common, other than, of course, mainland China exposure.

The top sectors say all you need to know in both economies. The Taiwan ETF is 57.6% weighted in information technology, while the Hong Kong ETF is 59.1% weighted in financials. Unlike Hong Kong that has a hard currency peg to the U.S. dollar, Taiwan has a dirty float — the Taiwanese dollar moves against the U.S. dollar, but the central bank heavily intervenes in the foreign exchange market. From the lows in the exchange rate in March 2009, the Taiwan dollar has appreciated from 35 to about 31 to the U.S. dollar.

Unlike Hong Kong, which is officially part of China — but has an autonomous economy — Taiwan is considered a renegade territory by the mainland that broke off after 1949 Civil War. The reunification issue is one that will play over time, but increasing economic cooperation is clearly leading down that road.

In my personal opinion — which may or may not be shared by many Taiwanese — a Hong Kong type of solution to this regional issue seems likely. There is a lot more at stake that just controlling the island. Whoever controls Taiwan controls the Strait of Taiwan, which carries huge maritime traffic bound for Japan.

In typical Asian fashion, electronics and machinery exports generate about 70% of Taiwan’s GDP growth. Heavy dependence on exports increases the volatility of economic performance. Given that the island has an extremely low birth rate — 1.2 children per family — the rapidly-aging population is creating a Japan-style issue with stagnant domestic demand. The island may have labor shortages and falling tax revenues if the situation with China is not resolved soon (any form of reunification would address this labor issue).

Due to the Japanese style mercantilist export-driven economy, Taiwan has amassed foreign reserves of $380 billion that are the world’s fourth largest — behind China, Japan, and Russia. But considering that Taiwan has a population of only 23 million, on a per capita basis they are actually number-one in the world.

The diplomatic issue with China and fact that the country is not recognized by many major foreign governments has not stopped Taiwan from becoming one of the most vibrant economies in the world. Still, the diplomatic isolation prevents it from participating in free-trade agreements.

A lot has been done in the past five years to improve relations with China and capital has been flowing in both directions in a major way. It seems that the performance of the EWH and EWT ETFs says a lot about the health of the Chinese economy — much more so than the action of the Shanghai Composite.

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