Time will also tell whether, as suggested in the very first Issue, the world economy has entered the winding down phase of a global credit expansion/contraction cycle similar to that in the late 1920s and 1930s. Events in the last year have however made that prediction much more, not less, likely.

Last, but not least, I got through the entire year without using either of the words "impact" or "impacted"!

Both the cause and the consequences of the big global trends are to be found in the interplay between the two mightiest economies on earth and their currencies: the USA and Japan. Given the combined dominance and power of these two nations it is not surprising that it is they that drive events whilst the rest of the world merely follows in their wake. Some day Euroland and the Euro will establish themselves as another such giant global economic driving force, but not just yet, and I am discounting the significance of the Euro for now. Even further out the Sleeping Giant, China, is going to emerge and may become the dominant world power sometime during the 21st Century. But not yet, though we certainly have to keep our eyes open for signs that the Yuan may be devalued again. For now though, it is still mainly the USA and its dollar and Japan and its yen that we should look to in our task of interpreting what is going on and using that interpretation to divine as best we can what may be coming next . . .

"One more such victory and we are undone" (King Pyrrhus of Epirus 297 B.C.)

A long period of prosperity has, as it always does, resulted in the creation of more and more credit and global industrial overcapacity. There are complex economic reasons - relating to the level of interest rates, inflationary expectations, etc. - but suffice it to say here that obviously in good economic times banks become willing, even eager, to lend and entrepreneurs and businesses to invest in new projects and productive capacity to meet the ever growing demand. This process continues until eventually irrational optimism results in too much investment. Particularly insidious is the over valuation of real assets due to the unrealistic expectations that now dominate thinking. Malinvestment continues. This is invisible at first, but eventually something happens, some trigger that makes it apparent that much of the credit that has been extended has paid for fundamentally worthless projects and capacity. The whole thing unwinds. A business slump follows.

It looks today as though this is what is happening on a global scale. First to go were the fast growing Asian economies because they were the most vulnerable. Blaming "crony capitalism" for it is disingenuous. Crony capitalism stinks and I wouldn't be unhappy to see many of those involved strung up from lampposts, but it is just one of the things that caused over investment and malinvestment in Asia. No, the nations involved were the most vulnerable because of massive over investment, particularly in manufacturing for export, because this depended on continuing huge inflows of overseas capital to maintain it, and because of their dollar-linked currencies. (July 1997 Issue)Next in line, mainly because of its large investments in the region, was Japan. Had this nation by last year cleaned up the huge bad debts that had been carried ever since its own asset bubble burst, then it probably could have absorbed the effects of the addition of all the new bad debt created in the falling Asian Tigers, but it had not and the consequence is that it has been driven into a recession and the start of a deflationary slump.

The flow of flight capital from Asia and Japan into the dollar has continued, exacerbating the US asset bubble and worsening the crisis in Asia.

During the first phase of the Asian crisis last year, there was some weakening of currencies and stock markets in Latin America and Eastern Europe due mainly to the fear that they would be affected too. This fear receded to some extent as people began to think that the worst was over as Asian currencies temporarily stabilised and investors began bargain hunting for what they thought were cheap stocks. But real economic effects flowing from the events in Asia have increasingly started to appear. Worldwide demand is slowing and commodity prices are falling (the Commodity Research Bureau Index is at a five year low) so the economies of the next most vulnerable countries are now also being affected, resulting once again in weakening stock markets and capital flight (much of it into the dollar) from nations in Latin America, Eastern Europe and Australasia.

The reality of these capital flows and the forces driving them are not in doubt. Taken to their logical conclusion there can also be little doubt about what the outcome will be. There will be further economic collapses in more nations, and at some point a collapse of North American stock markets taking with them a crippling percentage of global wealth. When this happens there will be nowhere left to drive the global economy: we will then be in a worldwide depression.

As I write this, there is nothing going on to indicate that this is not what is going to happen. There is simply no slowing or reversal of the fundamental trends, most disturbing is the absolutely crucial dollar:yen exchange rate which is rapidly deteriorating ($1 = ¥144). Remaining confidence in the yen is evaporating everywhere. Every attempt to arrest or confine the spreading crisis has so far been an abject failure. Can anything now be done to prevent a global economic contraction?

The question now is whether there can be successful intervention to arrest this slide downhill. (By asking that question I am not joining the supporters of statist intervention. Anything that is done will inevitably cause worse problems somewhere down the line. But it is essential to assess what is likely to happen, not what I hope will happen.)

South East Asia and Korea.

Japan

Is there a final line of defence?

"Rubin said the crucial job now was to stabilize conditions in other countries that have seen their markets swoon as investors have grown concerned about Asian-style meltdowns happening elsewhere. He said problems in Russia and South Africa and market turbulence in other parts of the world in recent weeks was attributable in part to fears the crisis could be spreading."

Does this mean that the authorities have given up on holding the line at Japan? More massive IMF bailouts on the way perhaps, this time for Latin America and Eastern Europe?

But Japan still looks to me to be the key. There is still incredible pressure being put on her - most recently from the People's Republic of China - to "do something". Particularly to arrest the slide of the yen.

Pointer 1: Keep a close watch on the dollar:yen . This looks like the major and perhaps the final, defence line. The rest of South East Asia has more or less been written off for now. All efforts must be towards preventing the recession in Japan from becoming a crisis. Some kind of coordinated international action aimed at stabilizing the yen still looks like the option that will be considered.

Pointer 2: Looking at the other side of the equation, the US dollar, I expect no action on interest rates or anything else for that matter in the short term. The Americans are in a bind, stymied. Domestically, all they can do is desperately hope for stabilisation in Asia so that they will be able to start actively managing their own fiscal and monetary policy again without risking triggering domestic and global meltdowns.

Pointer 3: If the yen is abandoned to its fate, expect massive action aimed at stabilising the 'Second Wave' of crisis countries.

My best guess as to what will happen is that (a) any action, whether aimed at Japan or elsewhere, will ultimately fail, and (b) global financial stability will not come back in time for the Americans to be able to successfully take action to head off the economic problems building up under the surface there.

What comes next? The following scenarios must be read in the context of what I have written above i.e. they start from the premise that the existing global trends will not be stopped or reversed. Remember they are merely my opinions.

SE ASIA AND KOREA. There will be no more financial help other than those IMF and other programs already in place, and more debt rescheduling. Their economies will continue to wind down for now: international attention will shift to concern about political instability. As a proxy for the region, have a look at a 12 month chart of the Hang Seng Index. It was unaffected July-early August (the conventional thinking then was that the Thai crisis was irrelevant), then began to slide steadily during August and September as some Hong Kong corporations began to be affected (rational revaluing of some stocks based on new information). October saw crash and panic, bottoming in January (psychological collapse - no rational basis for valuing stocks was available). Recovery until the end of March (returning confidence meets reality of declining equity values as the real effects of the Asian crisis show up in corporate results). A trend line from the early August peak to the present approximate level of 8000 reflects the reality. Simply projecting this trend gives a reasonable forecast for the Hang Seng, and I expect something similar for the other countries.

JAPAN has been discussed at length already. There may be some kind of coordinated international effort to defend the yen. I will certainly be watching very closely for something to change, but if it does not I will not be surprised if we see the Nikkei 225 below 10,000 eventually.

EASTERN EUROPE. Part of the Second Wave. Russia is the key here. Despite a $10bn IMF loan which is already in place, the ruble has been under massive attack and the stock market is near collapse. Moody's has downgraded Russian sovereign debt to B1. During a recent bout of speculative attack on the ruble, the Central Bank had to take draconian measures to defend the currency, raising interest rates to 150% and massively reducing the availability of rubles (so that they would not be available for the short-sellers to borrow). These measures worked this time, but during the crisis it became obvious that other countries including Poland, Hungary, Ukraine and the Czech Republic were being directly affected. If the ruble is devalued, this is going to be another whole region plunged into financial chaos. Ominously too, the problems with the ruble weakened the German mark.

KEY STOCK MARKET INDICES.

Market..........52-wk high.......June 12 close...Percent decline.

Russia..........843.1 ...........384.3............54.4%
Czech Republic..517.3............438.5............15.2%

LATIN AMERICA. Also part of the Second Wave. One of the major factors here is the dependence of these economies on the export of raw materials. Prices are falling as economies elsewhere weaken. Oil prices, which have fallen severely, create real problems for Mexico and Venezuela, but most commodity prices are falling as demand declines globally. I expect these trends to continue: currency crises and stock market crashes are possible in this region.

KEY STOCK MARKET INDICES.

Market..........52-wk high.......June 12 close...Percent decline.

Brazil..........14005............9585............31.6%
Chile............5880............4215............28.3%
Mexico...........5396............4216............21.9%
Venezuela.......10852............5445............49.8%

AUSTRALIA. Australia is very vulnerable to the Asian crisis because of (a) the scale of its direct trade and other economic links with the region (for example Japanese Life Insurance companies are some of the world's biggest holders of A$ denominated assets and they have now virtually ceased making new investments), (b) its raw materials exports (which are affected by decreasing prices as the economic slowdown bites), and (c) a soft socialist anti-business political, legal and tax environment. The A$ is already at record lows, and without big interest rate increases, likely to push the economy into recession, it is expected to weaken further. Economic recession in Australia is now probable (GDP growth is still officially forecast as positive, but is being revised down): I think of Australia as another of the Second Wave countries.

CANADA. Not as directly vulnerable to the Asian crisis as Australia, but it also suffers from the effects of falling commodity prices and is economically weak due to its socialistic policies. The C$ is already at an all time low against the USD, and I expect it to deteriorate further. The stock market has been somewhat weak recently. The Canadian economy will probably slide into recession more slowly than, say, Australia - in fact it may not experience anything very severe unless and until the United States' stock markets crash (the Canadian markets will follow them down).

WESTERN EUROPE. Experiencing its own stock market bubble. Some European banks are very exposed to Asian lending: there must be some very large bad loans on the books of many.

UNITED STATES. It is difficult to construct any credible scenario for the USA. Extrapolate the current trends - and these are still very strong and very much in place - and all the capital in the world eventually ends up in dollars! Something has to give, but how will this happen? If I as an investor start getting nervous about an apparently overvalued USD, where do I put my money instead? For now therefore, I anticipate continued dollar strength. Unless something big happens in the meantime, I plan to have a look at this issue and review the US financial markets in the next Issue.

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