THE SKEPTICAL INVESTORTM

Issue No. 4 September 1997

Posted 23.IX.97

CONTENTS

The two great global economic trends that I have been exploring in here - the gathering storm in the Asia Pacific Rim (which I consider could possibly be the harbinger of a worldwide depression) and the, not entirely unrelated, growing magnitude of the US dollar assets "black hole"- are certainly not the only ones playing out in the world today. But I have restricted my commentary to these two because I am convinced that they are the most significant and most likely to drive events in the near term. (See Appendix for others.)

Asia Pacific Rim (ex-Japan)

Despite international bail-out funds, jawboning officials and politicians,and soothing commentaries to the effect that it is bottoming out, the crisis is actually still spreading and deepening. The financial losses that have been incurred by the nations of the region in their foreign reserve accounts, by corporations and conglomerates, by banks and by individuals, will all prove to be much larger than has been admitted. I can safely say that because it is always the case.

The region is now steadily sliding into recession. Economic growth rates in most countries remain positive, but are being revised down, and Thailand already has a negative GDP. Expect the growth rates of other countries to decline further and likely turn negative. Malaysia and South Korea look especially vulnerable. Further there is an especially dangerous signal in the spread of the malaise to Hong Kong. The SAR (which now has the sole surviving US dollar-linked currency in the region) was able to successfully fend off speculative attacks on its currency that began in earnest in early August by using its $83 billion of foreign exchange reserves, but interest rates are rising (HK$ 1-month deposit rates were at 8.75% last time I checked) and its stock markets began to crumple at the end of the month. The Hang Seng Index fell 4.98% on 28 August, and the slide continues. As of 22 September close, it stood at 14,108, off about 2,000 points from its recent peak. Watch Hong Kong: it is a long way from facing recession, but it is a bellwether for the region. The recent decoupling of its equity market from the US markets is, in view of the fact that they have moved up in such a tight day-by-day lock step with each other for so long, a rather significant indicator of failing investor confidence there and throughout the entire region.

What is happening in SE Asia has several hallmarks of the start of the shake-out phase of a classic deflationary spiral resulting from excessive credit creation. The ready availability of credit offered at attractive rates results in huge investments in what turn out to be unsound projects, though this is not apparent for a long time. Then something happens that makes the problem apparent. This time it was the flight of capital into US dollar assets. This had been accelerating throughout 1997 culminating in the collapse of the baht on 2 July.

As an illustration, look at South Korea. The bad debts resulting from the unwinding of the credit cycle are snowballing. So far in 1997, five of the giant "chaebol" (conglomerates) have failed or are under bankruptcy protection, and five more are rumoured to be facing problems as their cash flows weaken. Already, banks are owed an estimated $13 billion by failed or bankrupt chaebol: 60% of their combined capital reserves. Ten of twenty-five South Korean commercial banks posted losses in the first half of 1997before the currency crisis even began. The worst hit, Korea First Bank, took losses of $396 million.

There are only two ways that these sort of bad debts - present to a greater or lesser extent throughout the region - can be purged. They can either simply not be paid or they can be inflated away. Government bailouts and other artificial devices merely shift them around: they still exist.If the problem is severe enough, either will lead to a recession or depression - in the first case (i.e. debts not paid) deflationary in the second inflationary.Governments of course attempt to engineer a "soft landing", but their ability to do this is less than they hope or believe. Whether this one will "get away from them" remains to be seen. George Soros has recently opined that the crisis can be contained if Thailand adheres to the conditions attached by the International Monetary Fund to the rescue fund.But it won't. I would also add: and provided that there isn't a market crash in the US in the meantime.

It should also be kept in mind that the series of currency devaluations that have taken place since early July are - because they reduce the price of exported goods - a global deflationary force.

At this point, other than continuing to monitor events, (and in due course look for a point to reenter the region as bottom-fishing investors), we can turn our attention to the next stage of the unfolding drama - the effects on a Japanese economy already weakened by the collapse of its bubble economy in 1990. Japan's economy ( = 18% of global GDP ) is in size second only to the USA, and it is in the interplay between these 5 economies that we might divine the future course of events.

Japan.

Only ten years ago, in 1987, Japan looked set to challenge and eventually replace the United States as the world's supreme power. Not yet a resurgent military power burdened by the cost of maintaining a standing army, economically "Japan, Inc." appeared unstoppable as it flooded American markets with superb quality and competitively priced Toyota cars,Sanyo radios and all the rest. The American economy, burdened by high taxes, dismal industrial productivity, powerful trades unions, increasing government hand-outs, and poor quality consumer goods and levels of customer service was in relative decline. America had a huge trade imbalance with Japan, the dollar was sliding against the Yen and the real wages of workers were falling. American corporations were simply being outsmarted and out competed.

But, in 1997, the USA is enjoying almost absolute global economic hegemony. Japan looks to be out of the running for for now (but we must not forget that it remains the worlds largest creditor nation, whilst the USA in the biggest debtor).

[Although the USA is certainly a nation in an irreversible long-term decline, crippled by moral relativism, confiscatory taxation, excessive debt, pork barrel politics, outrageous socialistic entitlement programmes, misandrist undermining of the family and a legal system that beggars belief; it may be The People's Republic of China, not Japan, that emerges as the next superpower sometime during the twenty-first century.]

The USA has not achieved this reversal merely through successful business competition. Rather it embarked upon an undeclared political economic war against Japan. In fact, by 1987, the attempted fix was already in, though we did not know it then.

In September 1985 - in what were then secret provisions of the Plaza Accord - the G5 nations agreed to manipulate an appreciation of the Yen against the USD (and, by implication - this became important later - against other world currencies). The aim was give American manufacturers an artificial competitive edge against the Japanese by increasing the price of Japanese exports. But it failed utterly, and set in motion awesome global imbalances that have been impossible to correct. It was not that the intended artificial overvaluation of the Yen was not achieved. It was.But Japanese manufacturers simply moved their factories offshore and continued to make and sell their superb quality goods - from outside the Yen!

Japanese direct foreign investment during this period was to a large extent responsible for the rapid industrialisation of the Asian Tiger economies. And the currency provisions of the Plaza Accord were responsible for the long commitment of these Countries to USD-linked currencies (the falling dollar was helping their exports). Both effects ultimately led to the disastrous consequences of recent months.

The effects in Japan itself however were also disastrous; and happened much more quickly. The high Yen led to low domestic inflation hence low domestic interest rates: the classic trigger for a financial asset bubble.Combined with a continuing massive trade surplus, that is exactly what happened. It took only five years for the Japanese bubble economy to grow, and burst.

For the next five years Japan struggled to contain the effects of the collapse of the bubble. Property and land prices spiralled down: the average rate of decline of land prices in metropolitan areas of Tokyo, Osaka and Nagoya has been more than 10% p.a. A huge debt problem developed, mainly in the construction sector and in banks. No big bank collapsed but Japanese banks admit to Y25 trillion in outstanding bad loans, and there are estimated to be at least another Y15 trillion worth.In fact the potential losses may be equal to 10% of Japan's annual GDP.By the mid-1990s, the economy was tottering on the edge of a financial meltdown: a massive deflationary collapse.

The USA and other western nations had thus been hoist by their own petard by their economic war against Japan. Not only did this country account for 18% of global GDP and a full 70% of East Asian GDP, it had become the world's principle creditor supplying more than half (60%in 1995) of total net international capital export flows. A winddown of Japanese overseas investment (which would certainly happen in the event of a major domestic deflationary depression) would collapse the global economy.

This was no longer just a powerful USA bullying Japan. This was a real financial crisis that might engulf the world. The US did the only thing it could: Treasury Secretary Robert Rubin and Japanese central bankers now agreed to a 180-degree reversal of policy: now they would weakenthe yen sharply to help Japan to increase its exports in the hope of avoiding disaster. In return, the Japanese government agreed to help 6 deal with its own financial problems by pumping in money through massive purchases of US Treasury bills (US$120 billion in the last two years). As in the case of the Plaza Accord, this deal has worked in so far as the desired currency revaluations have been achieved. A 50% drop from the yen's peak against the US dollar and 35% against the deutschmark have been brought about. But why should this "Reverse Plaza Accord" not have at least as disastrous consequences as the first?

Well, it looks as though it will. But before I go on to attempt to describe what I believe is happening now, I should point out to anyone reading this who believes that the economic picture out there is all rosy that this insane see-sawing between the USA and Japan has been going on for twelve years always in secret until well after the fact. The enormous economic problems that underlay it have not been resolved. Their resolution has only been postponed: and it is not unlikely that the attempted cure will kill the patient.

The consequences so far are:-

  1. The rise in the value of the USD triggered the financial chaos in non-Japan SE Asia;

  2. It has also fed a new financial asset bubble, this time in the USA;

  3. Instead of helping Japan it has harmed it. The low Yen is helping exports, and the trade surplus with America is soaring. But domestically,the economy is weakening further. Interest rates are still trending down.Yield on the key 10-year Japanese Government Bond has fallen below 2% (it is at 1.91%). At the same time yields on many corporate bonds (especially those of construction firms) have been sharply rising (some construction firm's bonds are yielding 10%) due to the risk premium. Wide spreads of bonds are a classic symptom of deflation. The government had predicted 1.9% growth n GDP in FY97 but admit that will not now be achieved. 1Q97 =+1.4%. 2Q97 = -2.9% (11.2% pa): the worst since 1Q74 (-3.4%). Admittedly,thiswas partly due to special circumstances (an increase in Sales Tax on 1st April 1997) but these figures are from before the regional crisis. As much of the debt problem left over from the late 1980s still exists, and now huge new bad debts have been created by the size of direct investment in Thailand and other countries , a recession now looks very likely. It is not impossible to think that Japan may soon be once again on the brink of a financial collapse.

The crisis in SE Asia and recession in Japan are both forces of deflation, threatening but not in themselves disastrous for the rest of the world. Both will however tend to feed the USD asset bubble and perhaps drive it much higher, increasing the probability of an eventual catastrophic market collapse in the United States. Either this event, or a financial collapse in Japan, will unleash global economic contractionary forces that will be difficult to contain, and it is herein that the dangers lie ahead.

The Crash Busters (continued)

In 1987, the crisis was contained and did not spread to the wider economy. The stock markets recovered after a few months, and the only price paid was a subsequent surge in inflation - a direct result of the reflationary actions taken by the Federal Reserve in managing the crash. Today, a decline of 20% or even 30% can likely be weathered,but the American equity markets have become so huge that should they fall further than that, the potential economic consequences are severe. More about this in the next Issue. (Skeptical Investor Issue 3. August 1997).

What is likely to happen if there is a crash and the markets fall by say 50%?

In the crash itself, billions of dollars will simply disappear. There is a widespread loss of wealth, i.e. purchasing power, throughout the economy.Obviously a lot of spending dries up. Many businesses begin to experience declining cash flow and many will fail. The creditors of those businesses lose money. These creditors include bondholders, banks, and other businesses that have supplied goods and services on credit. A further evaporation of wealth that drives the process further.

And the crash will also have created acute problems for those who have purchased equities on borrowed money and on margin. Many individuals,businesses and other organisations will suffer huge immediate losses and many will go bankrupt or into liquidation.

In such conditions creditors become gun shy: the availability of loans and working capital for business, and loans for consumer spending, rapidly declines.

Spending throughout the economy decreases. With no-one to buy, the prices of goods and services fall. And you have a deflationary contraction.

The government will of course try to interrupt this vicious cycle, but it is very difficult to do anything once the process has become established.There is no doubt therefore that the US Crash Protection Team will pull out all the stops toprevent things getting this out of hand: that is, I believe,anything more than a 20%-30% overall fall in the stock markets. But let's make here an assumption that things have gone beyond that.

The tools at their disposal now become very limited, and history suggests that they are not likely to be effective. They can massively reflate:increasing money supply sufficiently that, in theory, the consequent inflation will bail out debtors (who, because of the inflation, are paying back what they owe in dollars of lower value.) Many of their creditors who would have got nothing back will now get something, albeit in devalued money, but remember that also those holding sound credit that would have been repaid in full now also lose through being paid back in the same devalued money. The bond market is wrecked, interest rates soar, and business activity suffers further. If this attempted cure is pursued too far, there will be hyperinflation.

Another approach is to attempt to free up the availability of credit by reducing interest rates, but lenders are often too fearful to lend no matter how low the cost to them of the funds they are using. The risks are simply too high. (This is the current situation in Japan where short-term interest rates are below 0.5%. Sometime after the 1929 Crash, US T-Bills were at 0.25%, but this failed to stimulate the economy).

And, of course there is the old Keynesian standby. Increase "aggregate demand" by taxing and spending. But in 1929 governments were in good financial condition, and they could do that. Today the US Government has very little wriggle room to even attempt that. And anyway, it didn't work in the 1930s (not I suppose that that will influence the politician's thinking).

The best thing for a government to do is "very little". Unfortunately,this process is a consequence of past mistakes. The economy needs to go through a cleansing to be rid of its excesses and start off with a clean balance sheet. But doing very little is precisely what the government will not do.

Where to invest in a deflation

Point 1: Have no debts. In a time of deflation you are repaying the debt with increasingly costly money.

Point 2: Even holding cash is profitable. As the purchasing power of the cash increases, you are in practice earning interest even on dollar bills under the mattress.

Point 3: Good quality bonds, debentures, and also T-bills, will be highly profitable generating the face rate of interest, the capital gain as overall interest rates decline, and the nominal interest rate resulting from the increasing purchasing power of the dollar.

Point 4: Low quality bonds, especially junk bonds, will be big losers. The interest rates will rise due to the increasing risk premium, generating large capital losses. (And some companies will go into liquidation).

A (very!) few analysts believe that the financial state of the USA is so bad (due mainly to debt and to the stock market bubble) that it will unwind in a total collapse of the economy and of the currency. The author and Newsletter writer/publisher Steve Peutz is a proponent of this view. I think it is too pessimistic, but if Steve is correct then even cash will become valueless: he suggests gold and silver bullion coins, wafers and bars.

APPENDIX
European Monetary Union.
Due for launch on 1st January 1999, but may be delayed. The EURO currency unit was intended to be a hard currency, but this is now in doubt. Creation of a potential reserve currency that will compete with the USD will certainly have global consequences, but these will not really be tremendously important until the whole thing starts to crystallise, and upon the state of the world economy and capital flows at that time. At present the biggest effects are confined to the European currencies and bond markets.
China.
Unless something unexpected happens, it will be China, not Japan, that becomes the real economic rival of the United States. Unlike Eastern Europe, the People's Republic is adroitly managing the dismantling of communism by systematically introducing market mechanisms whilst at the same time maintaining absolute political control to prevent social breakdown (difficult times lie ahead as unemployment increases). The Chinese government sensibly resisted pressure from the UK and the USA to introduce democracy to Hong Kong: a blatant attempt to sabotage the economic success of Hong Kong which has never been a democracy and is doing very well thank you without it. Hong Kong is one of the very very few bona fide free market economies. Imagine the whole of China run the same way? But that is still a long way off,though China and Hong Kong will likely again be very rewarding places to invest money in the not too distant future.
Eastern Europe.
The so-called "peace dividend" has had a big and largely helpful effect on the US economy, but I think it is now built in and is no longer a developing theme. Eastern Europe and Russia are having too many internal problems for now to be dominant players.
Expansion of NAFTA.
This bears watching. It may become significant.
The unexpected.
Really of course this one should be included with the big trends! Right up there top of the list. But all one can do is try to react quickly to the unpredictable.
Copyright© 1997 Max Moseley and The Skeptical Investor, All Rights Reserved

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