Billy, see the bolded section below on China.....
A Not-So-Wonderful Life in '98?
Asia's turmoil will dominate the script for world markets next year
-- and don't bet on a happy ending.
By Jim Jubak
I hope you saw Frank Capra's "It's a Wonderful Life" at least
once this holiday season. This movie is the key to
understanding 1998.
Forget about the hokum with the angel and the cast of
small-town eccentrics straight out of central casting. Fast
forward to the run on Jimmy Stewart's savings and loan. Capra
got financial panics right. They aren't caused by how much
money sits in the vault -- banks never have enough cash on
hand to pay off all depositors at once. Financial systems
collapse when people lose faith in them -- and it takes nothing
more or less than a restoration of faith to put them back on their
feet again.
In 1998 we face a crisis of confidence throughout Asia that could
lead to the collapse of the financial systems in much of the
region. That possibility overshadows all other financial worries for
next year. Let me try to handicap the odds that the financial
world as we know it will blow up.
I'll use Capra's movie to explain where I think we are as 1997
ends. In the film, hapless Uncle Billy precipitates the crisis that
drives Jimmy Stewart to the brink of suicide when he misplaces
a bundle of money -- a few thousand dollars representing the
entire working capital of the savings and loan. Well, capital has
been disappearing throughout Asia in the past few months faster
than poor Uncle Billy could even count. Japan's banks had
almost 400 trillion yen in loans outstanding last March. (The
country works on a March fiscal year.) The banks themselves
estimate that about 20 trillion yen of those loans should be
written off as bad debts. Lehman Brothers recently pegged the
figure at 50 trillion yen, and the actual amount could be closer to
80 trillion.
At least 1/8 and perhaps as much as 1/5 of the loans at Japan's
banks are worthless.
But that's not the full extent of the problem. Japan's banks are
the country's biggest stockholders. Every point drop in Tokyo's
Nikkei 225 index reduces the banks' capital. Recently, the
Nikkei fell below 15,000. According to the global
investment-banking firm HSBC James Capel, the stock
portfolios of nearly half of Japan's big banks are now worth less
than the banks paid for them. At these prices, selling stock puts
losses on a bank's books and reduces capital even further. (Until
a sale, banks can value the securities on their books at the
historical purchase price.)
The situation is similar throughout Asia. Problem loans and a
falling stock market in Korea and Indonesia virtually duplicate
the Japanese situation. Hong Kong's banks are in good shape
only as long as investors are willing to pay an extremely high
premium over prices on the mainland for a Hong Kong address.
In the movie, Jimmy Stewart actually saves his family's savings
and loan during the Depression by convincing every depositor,
during a sudden and somewhat unexpected run on the bank of
the kind common in those days, to take just the few dollars
necessary to get through the day. Well, the real economy
doesn't work quite so cooperatively. Companies with access to
the international capital markets -- New York Stock
Exchange-listed firms such as Sony (SNE), for example -- don't
need the banks' money. They've got essentially the same
access to the international equity and debt markets as General
Motors (GM) and IBM (IBM). Small and midsize companies
throughout the region, however, depend on bank loans for
working capital. Right now, the banks aren't making loans to
these companies. The amount of yen lent by banks, which as
recently as 1992 was growing by 4% a year in Japan, has been
shrinking since late 1996. In other words, each time a bank
actually succeeds in getting a loan repaid, it lends out less than
100% of the capital it just collected.
When we hear
that South Korea
will go from 8%
growth in 1997 to
3% or less in 1998,
that doesn't sound
too bad to us.
-- Courtney Smith
I really can't say I blame banks in the
region. I wouldn't be a willing lender in
Korea right now, either -- even if the
optimists are right and the economy
does manage to grow at 3% in 1998.
Why not? "Most U.S. investors still
don't get it," Courtney Smith, the chief
investment officer of Orbitex, an
international money-management firm,
told me recently. When we hear that
South Korea will go from 8% growth in
1997 to 3% or less in 1998, that doesn't
sound too bad to us. After all, the U.S.
Federal Reserve has been thinking
about raising interest rates to slow the
U.S. economy because the recent 3%
growth here is too fast.
"But the Koreans have built their companies so that they require
8% growth," says Smith. Unless these companies are
expanding constantly, they can't generate the cash flow to pay
their debt. Remember that this is a country of corporations
willing to borrow at 10% for projects that earn 2%. That only
works if rapid growth generates cash flow that can be used to
pay interest on loans. Banks, seeing a steady stream of interest
payments and rapid growth, are only too willing to extend more
loans. No wonder that some Korean companies show
debt-to-equity ratios of 4-to-1. Just for reference, the
debt-to-equity ratio at a U.S. company such as Procter &
Gamble (PG) is 0.4.
In "It's a Wonderful Life," Jimmy Stewart
is the bank of last resort. He sacrifices
the cash that was going to finance his
romantic personal dream of seeing the
world (and enjoying a swanky
honeymoon with his new bride) to keep
the bank afloat. In 1998, every American
consumer will get a chance to play
Jimmy Stewart -- we're the bank of last
resort. Our purchase of Japanese
VCRs, Korean TVs, Thai plastics and
Malaysian shirts will provide a flood of
dollars to a thirsty region. A Korean
company will use the dollars it earns
from your next trip to the mall to buy oil
in dollars.
In "It's a Wonderful Life," Jimmy Stewart
ends the immediate crisis by dipping
into his pocket. But I don't think we're
anywhere close to wrapping up our story so quickly. And I think
we could be part of a much darker movie without the warmth of
Capra's final scene. I certainly don't know how the story is going
to end, but here are the clues that I'll be watching along the way.
1.I can't imagine that the U.S. Federal Reserve will
seriously consider raising rates next year. Slowing U.S.
growth when U.S. consumers are the lenders of last
resort to dollar-starved Asian economies would court
disaster. This Fed does not want to go down in history
alongside the bankers of 1929, who helped bring on the
stock market crash and the Great Depression. Look
instead for steady rates in 1998 -- or even a rate cut. I'd
now say the likelihood of a rate cut is better than 50/50.
2.I'm worried that U.S. consumers can't spend enough to
save the world. The U.S. trade deficit ran at an
annualized rate of about $200 billion in the third quarter of
1997. So we pull out those credit cards and tack $50
billion onto that. That feels like a drop in the bucket,
when the International Monetary Fund is pouring $70
billion into Korea alone. But I think it's bad news if the
trade deficit doesn't soar by at least that much.
3.Of course, that will set the motor-mouths in Congress
railing about the need to protect American jobs. (How
many American jobs get "protected" if the Japanese and
Koreans can't buy U.S. computers or software?) I hope
efforts to stop Asian "dumping" of goods below cost turn
out to be long on the hot air and short on action. In fact,
I'm counting on the free traders in the Clinton
Administration to limit the damage. I think the odds are
that Congress won't be able to pass anything that slows
the flow of imports.
4.We will see more bankruptcies in Asia than anyone now
expects. Small and mid-size firms will go belly-up by the
hundreds. Firms too big to fail will fail -- the big business
combines of Korea and Japan will cut off divisions and
affiliated companies without mercy. How much is
enough? Too little and the crisis becomes permanent, as
it has in Japan -- at the current pace, it will take Japan's
banking system another five years to work out its
problems. Too much and we could wind up with political
upheaval in countries like Korea and Japan -- these are
not societies accustomed to U.S. levels of
unemployment. At a minimum, I would expect a rise in
political violence next year, a deepening of the divisions
within Japan's ruling consensus, and far more
anti-Western rhetoric. (Which will feed into the U.S.
political debate.) At worst -- a military coup in Thailand or
Korea.
5.Indonesia worries me. President Suharto is 76, his health
isn't good, and he has failed to arrange for a successor. If
he dies, the country will plunge into chaos. If he lives and
continues his present course of watering down the
reforms promised to the IMF, he would undercut the
credibility of his own country and of regimes that have
made similar promises throughout the region. The IMF
will either have to crack down and withdraw aid or give
ground. The second would be a disaster, since neither
the Koreans nor the Thais are deeply committed to the
IMF reforms. There's a very good chance -- 70/30, I'd say
-- that the Indonesians and the Thais would raise
sufficient doubts among international lenders and
investors to prevent an economic or financial recovery in
those countries by the end of 1998.
6.What will the Chinese do? They started this mess by
devaluing their currency in 1994. Growth is slowing.
Unemployment is rising. I think that the Chinese are
willing to spend another year demonstrating that they are
committed to financial reforms -- more efforts to create a
strong central bank, for example -- and that they are a
good global citizen. But I don't think the Chinese
leadership can afford to be endlessly patient. If the
economy isn't improving by the end of 1998, competitive
devaluation of the yuan will again be a possibility. In
1998, though, I think we will dodge the bullet of regional
depression as long as the Chinese don't devalue.
7.Everyone assumes that the Japanese will do nothing
significant. Certainly the financial markets are treating the
recent tax cuts like the bad joke that they are. (The
combined corporate tax rate is set to drop from 46% to
43%.) I expect more gestures, half-measures, and
equivocation. Under the circumstances, Japan's great
international giants will continue to export capital and
jobs. Japan's consumers will buy even less. A strong
Japanese economic revival would jump-start the rest of
Asia -- but I'm not expecting one.
8.The price of oil should continue to fall. Slower global
growth plus more pumping by the cash-hungry OPEC
nations makes that a lock.
9.I think we could see two sets of surprises from U.S.
corporate profits in 1998. In the first half of the year, I
expect profit growth to slow and the announcements from
corporate CFOs to be full of downward revisions. Slower
growth in Asia, price competition from imports, and the
slowing of U.S. economic growth should do the trick. In
the second half of the year, however, I expect to see at
least a smattering of positive surprises. Smart and
efficient companies will find ways to take advantage of
the cost savings that come with buying and producing in
Asia. As the Japanese export giants demonstrated in the
expensive-yen era, well-run companies find ways to make
money at any exchange rate -- if they have some time to
adjust. By the second half of 1998, the best U.S.
companies will have adjusted. Companies that aren't
managed well, or that can't turn the Asian fire sale to
their advantage, will take further hits to profits, however.
10.And then there's all that other stuff that might happen in
the world -- upheaval in Russia (almost certain), a
shooting war in Iraq (even odds), natural disaster that
drives up the price of some foodstuff (in an El Ni¤o year
that's a bet I'd take), and the arrival of a common
currency in Europe (the only suspense is who will join).
This last group will make the headlines -- in many cases, in far
bigger type than anything in the first nine points. But if you're
investing in 1998, your fortune will rise or fall with the nine -- no
matter how big the type devoted to them. |
