The danger signs in the micro-economy
By John Thornhill
Published: December 29 2002 21:22 | Last Updated: December 29 2002 21:22
In one sense, financial crises are too easy to foresee. As an official from the International Monetary Fund once noted: "The IMF has predicted 15 of the last six crises."
In another sense, financial crises are becoming more difficult to predict. Few economists saw the Asian financial crisis until it was upon us and wildly underestimated its contagious effects. Even the Nobel prize-winning boffins at Long-Term Capital Management, the high profile hedge fund that produced spectacular returns in the 1990s, failed to understand the causes and consequences of the Russian debt market default in 1998.
But the authors of a new book* titled Dangerous Markets have created an intriguing methodology to spot pre-crisis warning signs and have devised some practical solutions as to how companies and countries can best deal with financial crashes once they have occurred.
Their contention is that crises are likely to becoming increasingly common as more emerging markets plug into the global financial system. The costs of rectifying these crashes are also likely to soar. In the 1980s, the World Bank counted 45 systemic banking crises. In the 1990s, this rose to 63.
One of the main reasons that economists have had such a bad record in spotting financial crises, the authors contend, is because they have been looking in the wrong place. They have been fixated on macro-economic indicators, such as exchange rate movements and fiscal and monetary aggregates, and have paid insufficient attention to what is going on in the real economy.
The authors, all members of the McKinsey management consultancy tribe, argue that micro-economic conditions are far more important in indicating where and when a crisis will strike. In most of the past crisis economies they studied, the real sector had been misallocating capital and destroying value for years before storm broke.
In particular, companies had been failing to generate sufficient return on invested capital to cover their weighted average cost of capital. In South Korea, for instance, the corporate sector had been able to cover the pre-tax cost of debt in only four of the 15 years prior to the 1998 crisis. The inability of companies to make enough money to cover the cost of the money they borrowed is the most obvious red flag that a crisis is going to happen.
The easiest way for investors to understand the dangers is to study the interest coverage ratio of the top listed companies in any country. If the ratio between the cash flow and the interest payments of the corporate sector falls below two, it might be time to panic.
But the authors list eight other warning signs that should send tingles down investors' spines. Many of them are in the banking sector: a systematically low return on assets of less than 1 per cent; over-rapid growth in banks' lending portfolios; shrinking deposits or rapidly rising deposit rates; the swelling of non-performing loans; and an increase in inter-bank money market borrowing rates.
Other alarm signals can often be seen in a country's capital markets and cross-border financial relationships. Asset price bubbles, a build-up of short-term borrowings in foreign currencies and a rapid growth - or collapse - of international capital flows can also indicate that something is awry.
Which region is currently most vulnerable to crisis? The authors point to Asia, the fastest-growing, where there has been a worrying rise in non-performing loans. According to Ernst & Young, the value of NPLs in the region stood at $2,000bn last year, a rise of about one-third in the previous two years.
Japan's financial problems have been well trailed. But the authors also highlight growing concerns in China and India. In spite of impressive rates of growth in the overall economy, 41 per cent of state-owned enterprises in China generate losses as well as 20 per cent to 30 per cent of private companies. The NPL ratio may be as high as 44 per cent of gross domestic product.
In India, the real economy has been steadily destroying value for the past eight years. The authors suggest that 80 per cent of available capital has been directed towards non-profitable sectors.
But financial crises are not certain in these countries; they can still be forestalled. As the authors argue, the advantage of flagging concerns early is that it buys policy makers time to act.
* Dangerous Markets. Managing in Financial Markets. Dominic Barton, Robert Newell, and Gregory Wilson. John Wiley & Sons
john.thornhill@ft.com
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