The financial world will feel better now Korea has got most of its foreign debts rolled over. The bankers who lent Korea the money in the first place declare they have solved the Korean crisis a mere momentary liquidity squeeze and the Asian crisis along with it. The world may believe them for a short while (though it’s ironic it should grant credibility to bankers it was their stupidity that let the crisis happen).
But I don’t believe the crisis is over. That’s because the emerging-market crisis is global and will hit earnings of big multinational blue chips. Trade figures showing how little of rich countries’ GDP depends on exports to the emerging markets disguise the ugly truth. Most international business done in emerging markets is produced there and then sold to the new middle classes in these countries at prices way above those prevailing in the US. That business will suffer from currency collapse, demand deflation and from a wipe-out of much of the moderate stock of wealth built up by these middle classes.
In the US, Japan and Europe, domestic producers will also lose pricing power because of deflationary pricing of emerging-market imports. With the US market selling on a PE ratio of 22 and Europe on 20, equity markets are supported by growth, not dividend yield. I reckon that up to a third of the consensus 1998 real GDP growth forecast for the US of 2.6%, and for Europe of 2.8%, could get wiped out in this way.
The loss of corporate pricing power in Europe, the US and Japan will throw the risk-premium mechanism for pricing global equities into reverse. Bond yields will continue to fall because inflation does. And inflation will fall because corporations lose control of prices and make smaller profits. So when bond yields fall, so will equity prices.
Economic pain in Asia is just beginning. It is necessary and it will go on for a long time, entailing huge bankruptcies and massive lay-offs. The financial-market misery may wane for a while, only to be replaced by political panic as the regional economic crisis deepens.
East Asian countries are still toddlers when it comes to creating mature political institutions. Most countries’ reigning political elites earned legitimacy from economic success. Now the lack of it will bring them low. The lightning conductor from financial markets to economic deflation, and then to political turmoil, may be the food chain in Indonesia or the cracking of the social contract in Korea. But it will come. Today’s Asian financial crisis hides tomorrow’s political one.
Take Indonesia. There is no “Korean option” for Indonesia’s government to borrow abroad in order to bail out the corporate sector. The government has already too much foreign debt for that. So then comes default and political upheaval. That will cause massive deflation in one of Asia’s poorest countries and one that has the worst income and wealth distribution. The Chinese community makes up 10% of the population and controls over 80% of the wealth. Already our intelligence reports speak of blackmail of the Chinese by the army and rising levels of ethnic violence and intimidation.
Indonesia is a political tinderbox. Suharto won’t make it to the end of the year. His regime will be carried out with him. So will his children. That should move no-one to tears. It may have been okay to pocket 2% of the country’s wealth when the economy was growing by 9% a year. Now it’s a different story.
The problem with Indonesia is that it is only halfway to becoming a civic society. A state ruled by a dictator for 30 years as his private property has no legal or political system to ensure smooth transition. And there are no obvious personalities that could succeed who are not tainted by Suharto’s backing either. And Indonesia is a state of over a dozen minorities, 250 languages and five religions. So the transition will be chaotic and quite possibly bloody.
Does anyone care? Indonesia may be the world’s fourth-most populous country, but it is minute in terms of its share of global trade and GDP. But Indonesia does matter, because when it defaults it will hit, yet again, the Japanese and Korean banking systems, which have lent large amounts to the regime. That will set off further capital withdrawals from Asia, more currency weakness and more deflationary impact on the west.
Then there’s Korea. Even after the massive won devaluation, the added cost of debt will offset the export gains for Korean corporations. I estimate that the cost of debt service will rise by almost 21% of 1998 GDP, swamping the devaluation gain from selling into overseas markets (worth around 13% of GDP). That leaves the chaebols way short of the sort of returns they need to pay their debts and maintain their existing stock of capital and employed workers.
The Korean authorities could go for a Mexican-style solution, under which the state artificially reduces the impact of the rise in corporate debt service. This would require a massive swap of corporate for sovereign debt, equivalent to at least 9% of 1998 GDP. The Korean government then has the option of funding the additional debt service through fiscal receipts, or printing money or issuing bonds. But the scale is phenomenal. That 9% of GDP is equivalent to 40% of central government tax revenue, or almost 240% of Korea’s narrow money supply.
Ultimately, the debt roll-over is a face-saving mechanism for OECD bankers. It may let the world skid past a 1929-style meltdown sparked by outright default in Korea. But it does not obviate the need for Korea to shrink industrial capacity by 30% to 40%, or stop Korean companies exporting deflation at knock-down prices. Japan still sits firmly in Korean sights, with its corporate sector likely to suffer the biggest loss of pricing power from Korea’s struggle to fill its excess capacity at any price. Japan Inc will then do a credible job of exporting a cocktail of Korean- plus Japanese-enhanced deflation to western markets.
And most significant of all, there is China. China will be forced to devalue the renminbi by between 30% and 40% within 18 months. When it does, the Hong Kong dollar/US dollar peg is doomed. Hong Kong interest rates will go up, not down, permanently, and serious damage will be done to one of the pillars of the global financial system. A big Hong Kong dollar depreciation (we reckon a minimum of 25% against the US dollar) will be the ultimate comeuppance for Japanese banks, which account for 53% of all bank lending in the Special Administrative Region.
The big question mark is when the US dollar peaks. If the emerging-market crisis is not over, the US and Japan will have to go on acting as lenders of last resort to the emerging world. Sooner or later, that will lead to a reversal of US monetary policy, as the Federal Reserve cuts rates to save the world, but at the price of a falling dollar. The alternative is a situation in which Asia freezes in its cold recession while the US fries in its overheated, rising-labour-cost economy. Then the Fed would be caught between the need to hold or even raise rates to cool the domestic economy and the need to boost global liquidity by easing rates. That really would be a nightmare for financial markets worldwide.
David Roche is president of Independent Strategy, a London based research firm.
