What will go wrong next?


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Just about anything. China could launch economic warfare against the west, the US could start raising trade barriers against imports, South Korean banks could dump their Russian bonds, the IMF could run out of money, European monetary union could start amidst economic turmoil. Brian Caplen explores the financial shocks waiting to happen.

When the world started to melt

Asian banks: Now comes the real crisis
Asian research: Worth the paper it's printed on?
Peregrine's still flying
Hedge funds: You can run but you can't hide
Country Risk December 1997: It could be worse
Global Economic Projections: Overall Rankings

Time to buy

China goes for broke

The worst outcome in the current economic crisis would be a Chinese devaluation. The last devaluation of the renminbi yuan in 1994 allowed China to undercut rival Asian exporters and paved the way for the current problems. A further weakening would almost certainly take the Hong Kong dollar with it and renew the downward pressure on other Asian currencies. The feared rerun of 1930s-style competitive devaluations around the world would be unavoidable.

But a weaker renminbi is a tempting option for China's leaders facing internal financial and economic difficulties. Quite simply, China's banks are insolvent and 50% of state-owned enterprises (SOEs) are losing money.

The government is committed to reforming the banks and the SOEs but it needs a healthy, growth economy to absorb the pain. That it doesn't have. China's economy is slowing down and projected 8% to 9% growth rates are unachievable. Consumer prices declined by 0.4% in October ­ a remarkable event in a large developing economy like China's ­ prompting deflation fears. Direct foreign investment ­ an impressive $140 billion over the past four years, 20% of GDP ­ is also declining. Out of an 850 million workforce, 150 million are unemployed and reform of the SOEs could add another 50 million to the total. This is a political time bomb in China where unemployed workers roaming the country in search of work are causing social problems.

"China has tried to solve its problems in the traditional Asian way by exporting more," says Michael Howell, managing director of investment advisory firm CrossBorder Capital. "China is failing to create jobs and must have sustainable growth. One way to get this is by reducing the value of the currency."

The impact would be felt worldwide. With its low-cost labour, China can produce most standard goods cheaper than rivals and in vastly greater quantities. Devaluation magnifies this advantage. China's trade surplus, currently $30 billion, would go on rising and the resulting US-China trade imbalance would bring the two countries head to head.

Global overproduction, the root cause of the current malaise, would get much worse.

China's economy is partly insulated from the world economy, which is why the government may feel dumping exports is the easiest solution to its difficulties.

Unless the IMF or the G7 persuades China to rethink, a fatal blow could be delivered to dwindling prospects of containing the crisis in Asia. Instead, China needs to boost domestic demand. The policy dilemma is that this can best be done through the SOEs, which analysts have been advising China to slim down.

Global deflation without a cure

Even if China doesn't devalue, the waves of Asian deflation will spread across the world bringing down stock markets and currencies. Excess capacity has built up over the past two decades and cannot be cut back quickly.

The knee-jerk reaction of governments is to erect trade barriers against the incoming tide of cheap goods and to devalue the currency to make exports cheaper. This brings temporary relief to one country but worsens the global situation. The solution is demand management, but international bodies like the IMF have not yet addressed this. It's an unfashionable concept and grasping the nettle is made more difficult because current policy-makers have never had to deal with a situation like it.

"Asia is the epicentre of global deflation," says Ed Yardeni, chief economist with Deutsche Morgan Grenfell. "There are just too many goods chasing too few consumers on a global basis. In the worst case competitive devaluations could push everybody deeper and deeper into the hole."

And that includes the US and Europe. Yardeni has lowered his forecast for US GDP growth in 1998 from 3% to 2% and says it could flatten out if things got even worse. Similar forecasts have been made by other economists for Europe and Japan. In prospect is a global recession fitting for a global economy. But the transmission mechanism will not be trade but poor performance from multinationals (see next section) hitting stock-market valuations. Either way the impact of the Asian crisis on the US is unlikely to be "modest but not negligible", as suggested by Federal Reserve chairman Alan Greenspan. It's going to be major.

Overproduction is unprecedented - the world car industry has capacity to turn out 35% more vehicles than required; huge inventories of computer chips pushed down prices last year by 80%; Japan alone has built manufacturing capacity across Asia three times larger than French industrial output; China makes 30 million TV sets a year, about a third of world production; China and Korea produce more steel than the US and the UK added together.

The economic catch-22 is that the low wage costs making Asia the workshop of the world are not conducive to developing a domestic consumer market. Car ownership, for example, starts at a per capita income of $6,000 a head. Chinese incomes are one-tenth of that and Indonesia's one-sixth. On current growth trends it will take 30 to 50 years before Asia is wealthy enough to consume its own output.

There is a consumer crisis in the developed world, too. Unemployment may be at contemporary lows in the US and UK (though not in Germany and France) but income distribution has become more uneven and there is a huge underclass in both countries. While low-income consumers don't have the ability to increase their spending, higher-income ones - a bigger proportion of total demand than two decades ago - have the option to spend or save. If the outlook is bleak they will decide to save or pay down debts.

A curious price phenomenon could arise in big service economies such as the US and UK. Tight labour markets, rising wages and low productivity gains could result in inflation in services while manufacturing is hit by deflation. Monetary authorities might raise interest rates to squeeze out service-sector inflation and thereby exacerbate worldwide deflation.

The greatest danger is that governments raise interest rates rather than lowering them.

They have been conditioned to do this by past inflationary excesses. Asian governments have illustrated this trend over the past few weeks. If it continues, the world economy will fall into a downward deflation spiral.

Initial signs of other likely policy responses are also not encouraging. As well as denying US president Bill Clinton fast-track trade-negotiating authority, the US Congress has prevented him from paying overdue payments to the UN and adding $3.5 billion to the IMF. It's obvious that mean-spirited nationalism is taking hold. It only needs the US to raise trade barriers and devalue the dollar and the world will be back in the 1930s.

America's yuppies lose their shirts

When US retail investors bought into stockmarket falls on October 27 - so-called Grey Monday - observers hailed this as symbolic of a new era. Mutual-fund investors were becoming more sophisticated and committed to owning equity in the long term, it was said.

A more likely explanation is that this was a speculative frenzy typical of a mature bull market - the buying madness of the small guy seen before every great crash.

There is little doubt the US small investor will sell if the market dips low enough. When he does, it promises to be an ugly scene. The US public is more widely involved in the stock market, in new and dangerous ways, than ever before. It is no exaggeration to predict bankruptcies, suicides and murders when the Dow finally comes down.

"Retail investors don't sell until they do," says Michael Metz, chief investment strategist for CIBC Oppenheimer. "We will have the real test during the next sweep down. One problem is that the US householder has the biggest exposure to the equity market in a generation."

Many have been gambling with money they don't own, taking out loans on their homes to buy stock and investing on margin. Much of their new-found sophistication has been channelled into riskier ways to invest.

The turmoil in the Asian markets may not have brought on a crash so far, but it will come when US multinationals exposed to Asia report sharply lower earnings. European stock markets will also be upset but European small investors, more conservative than their US counterparts, will be less badly hit.

"It hasn't sunk in yet in the western world how much this will impact on multinationals from Coca-Cola to Nestlé to Unilever to
Procter & Gamble. A lot of their earnings come from Asia," says Marc Faber, a Hong Kong-based investment adviser.

Morgan Stanley Dean Witter has come up with a list of US and European companies and banks with high exposure to south-east Asia and Latin America. The figures illustrate the true effects of global capitalism on earnings. Among well-known US companies with high proportions of total operating profits coming from south-east Asia are Seagate Technology (126.8%), AIG (27.1%) and Mobil (22.9%). Adding in Latin America brings up Citicorp to 41.5%, Bankers Trust (33.3%) and Colgate Palmolive (46.6%). BankBoston derives 21.5% of operating profits from Latin America but none from south-east Asia.

In the UK, HSBC and Standard Chartered, predictably, are among the worst exposed to south-east Asia (54.7% and 66.0% respectively) while Cable & Wireless gets 78.2% from the regions combined, Rio Tinto (31.0%) and Rolls-Royce (29.9%). The reliance on south-east Asia by Australia's Commonwealth Bank, Westpac, ANZ, Amcor and National Australia Bank is above 75% for each of them. The UK/Netherlands' Royal Dutch Shell earns 45.1% in south-east Asia and Latin America combined and Switzerland's Holderbank 43.4%.

Two key US sectors can expect a real drubbing from the Asia crisis - aircraft and auto manufacturers. Asia is Boeing's biggest growth market and probably accounts for a third of the commercial order backlog. But finding the $150 million to buy a large aircraft is increasingly difficult for Asian airlines, since a proportion of their earnings is in depreciated local currencies. Indonesia's Garuda Airlines has 12 Boeing 737s on order but hasn't taken delivery because of financing difficulties - the US Export-Import Bank wants a guarantee from the Indonesian government. Three of the planes are sitting finished on Boeing's runways. Other airlines say they may not take up options on ordered aircraft.

US car makers fear Japan and Korea will devalue and try to export their way out of trouble. Japanese auto companies control 25% of a North American car market experiencing its fifth boom year. A market slowdown and undercutting by the Japanese together would be very serious for General Motors, Ford and Chrysler. The Koreans, whose rapid auto expansion has been described as "irrational", will hurt Europe in the same way.

Economists who rubbish the idea of over-production must await its impact on US equities via the earnings route and think again.

Banks under pressure

Could a major international bank go under in the current turmoil? On the current outlook for US and European banks the answer must be "no". But there could be some severe earnings dents and loan write-offs. The demise of Japan's Yamaichi Securities, Sanyo Securities and Hokkaido Takushoku, Japan's 10th largest commercial bank, has sounded a warning bell. As further Japanese and Korean banks tumble how much bad debt will western banks have to write off?

Chief focus of attention are HSBC Holdings and Standard Chartered because of their high exposure to south-east Asia and other emerging markets. HSBC is highly capitalized with a tier-one ratio of 9.9% as of the last year-end. Standard Chartered's is 8.58%. Both banks are known as prudent lenders. An October Salomon Brothers report says: "We expect a meaningful impact from the Asean [Association of South-east Asian Nations] difficulties on HSBC and Standard Chartered, but the amount needs to be kept in perspective."

The real worry for HSBC and Standard Chartered is a meltdown in Hong Kong. The special administrative region of China contributes 40% of HSBC's operating income and 35% of Standard Chartered's. The break-up of the peg between the Hong Kong dollar and the US dollar, together with a real-estate crash, would be very serious for both banks.

Analysts estimate that 14% of HSBC group's total loans are to Hong Kong property, a high exposure to a single sector. But as bank executives point out, loans advanced are considerably below current values and even during the property crash of the early 1980s the delinquency rate among home mortgages was less than 0.5%. If the peg goes, the value of HSBC's tier-one capital coming from Hongkong Bank, put at 37% of the total, would be hit.

European banks as a group have the highest debt exposure to Korea - $32.2 billion at the end of 1996, according to the BIS. Japanese banks held $24.3 billion. As the lengthy business of resuscitating Korea begins it is anyone's guess how much of that will come back.

US banks' vulnerability to the financial crisis has been shown by Chase Manhattan's disclosure of a $160 million pre-tax loss arising from trading activities in October, mainly on Brady bonds and sovereign global Eurobonds.

US investment bank Brown Brothers Harriman in a September report noted that "as at March 31 1997, the exposure [to emerging markets] of six money center banks (BankAmerica, Bankers Trust, Chase, Citicorp, First Chicago and JP Morgan) equalled 97% of their combined tangible equity and 3.7 times their estimated 1997 pre-tax income. A 35% write-down of emerging-market exposure, reminiscent of what happened in the 1980s, would wipe out all of the six banks' estimated 1997 earnings and $6 billion (pretax) besides".

These gloomy warnings are based only on trouble in the emerging markets. If the financial crisis spreads to the banks' domestic markets their difficulties will escalate rapidly.

Asian property crash

An Asia-wide downturn in property values is a certainty. The interesting questions are: which markets will crash? Which will have soft landings? Which banks will go under?

By the laws of economics Thailand's property market should have crashed already - prices are down at least 50%. It hasn't, because no-one's transacting. The Asian tendency to fudge rather than face huge losses applies here. Owners don't want to admit asset prices have crumbled; nor do lenders. As long as no-one sells everyone can pretend things are normal.

"There could be protracted foot-dragging making things worse," says Michael Green, director and property analyst with Salomon Brothers, Hong Kong. "It's a fait accompli that Thai property is in a mess. The best solution is to let foreigners buy some of the assets. But if the authorities leave it too long the foreigners may not want to. By then Bangkok will be littered with derelict buildings."

It may also be littered with derelict banks. Officially banks' exposure to real estate is some 10% of total loans plus another 5% to the construction sector. But this is a fraction of the true amount, which is disguised in the way Thai banks record their loans. Many mortgage loans are classified as consumer loans, for example, and loans for hotel construction are recorded under services. On top of this Thai real estate provides the collateral for many other loans and a lot of money borrowed for purposes such as working capital ends up in property. Even a conservative estimate of Thai banks' true exposure to property puts it at 25% of total loans. It may be much higher.

Thailand is looking to foreign money to help recapitalize its banks. But the plan could be scuppered if a purchaser discovered that his newly acquired Thai bank's true property exposure was much higher than shown in the books. Thai banks' hopes of a quick way out of their difficulties would be dashed.

Banks in Indonesia, the Philippines and Malaysia have the same level of exposure to property and could experience similar problems. But the hardest property sector to call is South Korea's where the market is controlled by big companies. The banks there have less direct exposure to property. Instead they lend to construction companies and the chaebols. The chaebols are both highly exposed to property and highly leveraged, with debt-to-equity ratios of three to one. Many bank loans are secured against property or shares. As the IMF moves in to try to sort out Korea's woes, property is a house of cards waiting to collapse.

Korea versus the IMF

There are two outlooks for South Korea and both are terrible. One is that the IMF is tough enough to impose full-scale restructuring on the economy, leading to corporate closures and massive lay-offs. The country's traditionally militant unions would take to the streets and there would be pitched battles between riot police and workers. So strong are feelings against the IMF (the decision to call it in has been described in the local press as "a national shame") that its staff could be in physical danger. Next month's presidential elections will be won by Kim Dae Jung, who does not enjoy the support of foreign investors. North Korea, beset by its own economic problems, could even take this as an opportunity to launch a military offensive on the south.

The alternative outlook is that the IMF does not persuade Korea to undertake reforms. There is a general belt-tightening programme that aggravates the debt deflation rather than curing it. No real attempt is made to sort out banks. The bad ones are not shut down, the salvageable ones are not recapitalized. Further opening up of stock and bond markets to foreigners is not done seriously or quickly enough, monetary conditions are not eased sufficiently and fiscal stimulus is applied too sparingly. In other words Korea reruns Japan's response to its own post-bubble recession.

Given Korea's penchant for repeating Japanese mistakes this is a likely option. "The senior managers of Korean conglomerates learnt absolutely nothing from the serious miscalculations of their Japanese mentors during the late 1980s or their own recent past," says Stephen Marvin, head of research at SsangYong Investment & Securities in a recent report. "Gorging on debt, the conglomerates spent vast sums on production capacity and diversification without ever rationally assessing the likely return on investment."

Marvin continues: "[Korean] managements will be forced to freeze or cut budgets for payroll and investment. Japanese companies began restructuring for similar reasons under similar circumstances in 1992; many of them are still not finished and the economy has yet to fully recover. The process in Korea will not end this winter or next summer or even one year from now; it could very well carry over into the next century."

But Korea doesn't have the luxury of time Japan had; it doesn't have the financial strength. Its foreign-currency debt is $110 billion, two-thirds of it short-term. Its foreign reserves have fallen to $20 billion after failed attempts to support the won. Bad bank loans are put at $40 billion. To avoid a sovereign default will require much more than the $20 billion requested from the IMF. Japan will have to step in, but its long-term influence will be negative if this pushes Korea towards a Japanese-style approach to the problem.

The effects of the Korean banking crisis will be felt worldwide. Korean banks have been big lenders in south-east Asia using dollar funds much of them borrowed from Japanese banks. They have also invested anywhere between $5 billion and $15 billion in emerging-market debt paper, especially Russian GKOs and Brazilian Bradys. Their aim was to boost pitiful domestic returns resulting from the policy loans they were forced to make to chaebols. As those loans turn bad, the Korean banks will have to sell overseas assets.

Brazil and Russia drain IMF funds

If desperate governments continue going to the IMF at the current rate, sooner or later one will be shown the door. Brewing troubles in two of the world's major economies, Russia and Brazil, bring this prospect closer.

Forget the threat of Japan selling US treasuries. The real threat will come when Koreans and other foreigners dump Russian government bonds (GKOs). Foreigners hold more than 30% of outstanding GKOs and early indications suggest up to half those holdings may be sold in early December (investors have to give a month's notice of sale). Interest rates have been jacked up to 28% but that will not be enough if it's felt the rouble is heading for free fall. The Euromarkets would be closed to Russia and it would have to ask for more IMF funds, even though a $700 million tranche of a $10 billion support loan was suspended in October because of a poor tax-collection record. Russia's long-held ambition of positive growth in 1998 would be blown apart.

Meanwhile, as the giant of eastern Europe staggers, Latin America's whale - Brazil's president Fernando Henrique Cardoso dismissed talk of contagion by declaring: "We're not a [Asian] tiger. We're a whale" - could find itself beached. Interest rates which went up to 46%; tax increases and spending cutbacks that will take $18.6 billion out of the economy, roughly 3% of output; and $50 billion of reserves as a fighting fund may not be enough to defend the real, which was overvalued even before the Asian crisis hit. Currency stability has become a Holy Grail in Brazil and the government will do anything to prevent devaluation - and that includes calling in the IMF.

Latest estimates are that the IMF has only about $50 billion freely available (even though total subscriptions are $200 billion) following the Thai and Indonesian packages but not taking account of South Korea. Depending on what that bill comes to and how much is put up by other countries, the IMF might have scope for one more major rescue. Asked about its financial position, a senior executive replied none too convincingly that "as far as the present situation is concerned the liquidity position of the IMF is comfortable. We don't expect any problems as a result of current operations." The important word is current.

The executive pointed to the 45% increase in members' quotas agreed at the last annual meeting in Hong Kong. But these funds won't be available for another year. If the crisis continues members may have difficulty putting up the cash and it may be too late.

"The IMF has only gotten hold of the tip of the iceberg [of the financial crisis]," says Michael Metz, chief investment strategist for CIBC Oppenheimer. "It's going to cost hundreds of billions of dollars. I don't think the IMF has the money ...This has the ingredients of real catastrophe. The financial markets haven't fully woken up to it yet."

The IMF's limited resources point to a single conclusion to the crisis - a sovereign default.

MIT economist Rudi Dornbusch believes this would be a better outcome anyway than IMF programmes which are not really forcing restructuring in stricken countries: "If Korea [or another country] says we don't have the money to pay off its loans, let's face reality - we are back in 1982. The notion is that there is always a bail-out with the IMF paying so that the private sector can take its money out."

"It's probably better to have a moratorium," Dornbusch continues, "since it's mostly [poorly managed] Japanese banks [affected in Korea's case] it's probably an even better idea. The IMF is doing everything they can but they don't go far enough in getting a proper restructuring." He says borrowers from the IMF should be given an ultimatum: either carry out IMF-sanctioned reforms or default and go under for 15 years.

Maybe Brazil or Russia will do just that.

The Yamaichi domino

The fall of Yamaichi Securities, Japan's fourth-largest broker, is sure to be followed by other bank and brokerage collapses. But the impact on the financial system should be positive rather than negative. If Japan can belatedly sort out its banks by getting rid of deadwood and recapitalizing healthy banks, corporate lending can resume. This would reflate the economy, giving the best chance of a full-scale Asian recovery.

Before that happens there must be several Yamaichi-style deaths. The lesson of Yamaichi is that two practices are no longer tolerable - payments to sokaiya corporate racketeers and the hiding of losses in tobashi accounts. The sokaiya scandal that engulfed Nomura Securities earlier this year meant that no public money could be put in to save Yamaichi. And rumours that Yamaichi had concealed losses through tobashi deals (moving losses from one account to another to disguise them) prevented foreigners coming in as partners. (Eventually, Yamaichi revealed some ¥260 billion of off-balance sheet losses concealed through tobashi deals, some conducted through Cayman Islands companies.)

The whiff of scandal, together with the downgrading of its debt to junk-bond status and the resulting liquidity crisis, were what killed Yamaichi, rather than trading losses or lack of capital.

Yamaichi's main shareholder, Fuji Bank, refused to help - another sign that a new era in Japanese corporate life is beginning.

Before it arrives, other banks have to fail. Rumours are circulating. The big Japan fear is that financial sector distress will start a sell-off of the country's foreign assets, mainly stocks and bonds, worth $1.3 trillion. Widespread market disruption, particularly in US bond markets, would push up interest rates and usher in a worldwide recession. The only beneficiary would be Japan. Its domestic money supply would expand, putting the economy on the road to recovery.

Carl Weinberg, head of High Frequency Economics, has proposed a novel scheme for getting this latter benefit without the related problems. "One way out would be for the Bank of Japan to create a domestic repo facility that would allow it to lend to individuals and companies, as well as banks, in yen using foreign bonds as collateral," he wrote recently. "The bank could assure G7 governments - and thus financial markets - that bonds taken into this facility would never be sold."

The stance of the Japanese government is critical. If it starts to get cold feet about letting other banks go under, the financial system will continue to seize up. If Yamaichi's demise is a sign that it is really getting tough with Japanese banks, the outlook is promising. The health of Japan's financial system is the most critical element in the current global crisis.

Commodities take a tumble

In a global deflation, commodities are bound to be hurt. Many are priced in dollars, so hard-pressed governments will step up production to boost revenues and cover financing shortfalls. But flooding markets, at a time of decreasing demand and growth slowdown will cause prices to tumble. Governments will finish up worse off than before they started.

A first crack has appeared in natural rubber. Beleaguered Thailand is operating a price-support scheme and building up stocks of 122,000 tonnes. As prices are low and world stocks high any sales will depress the market. But analysts think the IMF will not allow Thailand to carry on with such flagrant and costly state intervention. The rubber market will be hit as Thailand winds down its scheme.

The much more important oil market is also under pressure. Holding Opec producers to their quotas has been an uphill struggle for years. Countries such as Venezuela and Nigeria regularly exceed their limits and Opec is thought to be producing 2.5 million barrels a day above the 25 million barrels a day ceiling.

This makes the timing of Saudi Arabia's push for increased production ominous. Right now world demand is sufficient to prevent a price collapse but worldwide recession could change that in a few months. Yet Saudi Arabia's financial position is sufficiently tight that such warnings are likely to go unheeded.

Reports early last month suggested the state-owned airline Saudia was struggling to pay for a $7.5 billion aircraft order from Boeing. Then news emerged that a syndicated loan with government guarantee had been put together by JP Morgan. Saudi Arabia has always played a stabilizing role in Opec, holding back its own production to allow others to expand. It may have decided to forsake this role at a critical time.

Finally, there is gold, which lost its lustre long before the current crisis with prices falling 16% since January and touching 13-year lows. Worries that central banks will sell off reserves plague the market. The Asian crisis might be the trigger that puts them into play.

EMU adds to the turmoil

What a time to embark on the historic project of introducing a single currency in Europe. Many analysts have predicted dire consequences for the euro even if economic conditions are favourable. To introduce it in 1999 when the world economy is likely to be in general crisis is asking for trouble. US computer consultants are so concerned they have asked president Clinton to request a postponement.

But Emu is a political enterprise upon which German and French leaders have staked their reputations. Long-time sceptics of Emu such as Bernard Connolly, executive director and senior economist with AIG International, believe the Asian meltdown could exacerbate tensions already present in Emu.

The main one is the different economic cycles of the major economies, France and Germany, which are in sluggish recovery, and those of peripheral countries, such as Ireland, Finland, Spain and Italy, which are facing a boom. The new European central bank, however, will conduct a loose monetary policy to favour France and Germany, says Connolly, leading to inflation and overheating in the other countries.

"If the wealth-destruction affect of Asia leads to an implosion in global demand, the likely impact on G7 interest rates will be to keep them down," he says. "This is a serious problem for the peripheral Emu countries facing an uncontrollable boom as their short-term rates will be even lower."

From the US perspective the timing of Emu is all wrong. A report by computer software company Capers Jones warns against attempting Emu at the same time as the millennium problem has to be solved. Since neither countries nor companies can afford two upgrades, it suggests moving Emu to 2005.

But the project carries too much political weight for this to happen. The likely outcome is that Euro turmoil will compound Asian turmoil.