contd. from previous post
IN CHINA: SPEND, SPEND, SPEND (int'l edition)
Its plan to keep growth humming is fraught with risk
Last spring, when the Asian financial crisis started taking its toll, Chinese Premier Zhu Rongji announced a bold plan to keep the economy on track. He vowed to make the collapsing state sector profitable in three years and to pump $750 billion into infrastructure by the end of the century. A confident Zhu predicted Asia's big domino wouldn't fall; he could keep China growing at 8% a year.
But Zhu didn't foresee just how bad the global economy would get. As the U.S. and European stock markets shudder, the rich export markets that have been China's one economic hot spot could cool. Beijing leaders have all but given up hope that a paralyzed Japan will help matters. At the same time, Russia's sudden collapse is a chilling reminder of the frailty of China's own state sector. And Hong Kong's losing battle to fight off speculators is heightening fears that Hong Kong and China may be next in line to devalue their currencies.
BOND BONANZA. To keep the financial devastation at bay, Zhu is rushing to open China's financial spigots and slow down the kinds of reforms that have hurt its Asian neighbors. The government announced that it will issue an additional $12 billion worth of bonds to fund power, telecommunications, transport, housing, and irrigation projects before yearend, a steep increase over last year's sum. Economists say government infrastructure spending may now reach $398 billion this year. Beijing also announced in late August that it would raise this year's total bank lending quota from $108 billion to $120 billion.
While most analysts agree this move will get Zhu closer to his growth target, there are dangers. Bureaucrats are under intense pressure to approve massive projects without giving them the proper scrutiny. Officials at the State Development Bank need to know little more than a project's name and its size to sign off on it, says one source. And Zhu is clearly out of his element: A master at fighting inflation by curbing wayward bankers, he is now trying to fight deflation and falling consumer spending by urging commercial bankers to pick up the speed of lending.
Some officials fear this headlong rush to spend will waste scarce resources while real reforms are put on the back burner. They point to government plans to construct more toll roads around Beijing, despite the fact that only one existing tollway to the airport is profitable. ''I don't think this kind of artificial stimulation can improve China's economic fundamentals,'' says Mao Yushi, chairman of the Unirule Institute of Economics in Beijing, a private think tank and consulting group.
WHAT REFORMS? But Zhu and his cohorts realize that tampering with the fundamentals could burn them badly as the crisis intensifies. So Zhu is opting to delay some reforms to avoid further swelling of the ranks of the unemployed, which are already growing due to the ongoing privatization of state-owned enterprises. And in an effort to maintain its firewall, which has shielded it to date against currency speculators, China will not make good on its promise to make the yuan fully convertible by 2000. ''Why should [China] throw more gasoline on the fire?'' says Carl E. Walter, a director at Credit Suisse First Boston in Beijing.
But delaying key reforms isn't without hazards. As Zhu keeps liquidity flowing into the economy, poorly performing enterprises will be thrown a lifeline just when the economy can scarcely afford to prop them up. And Zhu risks increasing nonperforming bank loans and new strains on China's wobbly banking system. Even Zhu's plans to sharply reduce the size of the state bureaucracy are running into obstacles. One reason: Leaders want to avoid scathing attacks from those losing their jobs.
Zhu is not abandoning reforms altogether, of course. He is pushing through some financial fixes, such as a Western-style credit-rating system and tougher asset requirements at China's banks. He is also trying to school the top government officials in accounting techniques so that they can better manage state enterprises.
Chinese economists believe that as long as the West keeps growing, they can buffer the country from the worst effects of the global market. ''We have confidence that the U.S. economy is healthy,'' says Qian Ping, an accounting lecturer at Tsinghua University. But after the market shocks of recent months, China's insulation may finally be starting to wear thin.
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IN TAIWAN, TIME TO INTERVENE (int'l edition)
Recession is inevitable. Will aggressive stimulus help?
Having sailed through the first year of Asia's crisis virtually unscathed, Taiwan's luck has finally run out. Exports are down 8% this year. Unemployment, while low, is on the rise. Blue-chip companies such as President Enterprises, China Airlines, and Formosa Plastics have reported steep drops in first-half earnings. Consumer confidence is falling sharply. Even the government concedes that Taiwan can no longer avoid Asia's recession. ''We are under the influence of a typhoon,'' says Chi Schive, vice-chairman of the cabinet-level Council for Economic Planning & Development. ''To avoid the impact is simply impossible.''
But Taipei vows to minimize the damage. Having watched neighboring countries as the International Monetary Fund crippled demand with stringent restraints on spending, Taiwan wants to pump billions of dollars into infrastructure projects. It is also resorting to intervention in the stock market, bailouts, attacks on short-selling, and limits on currency trading. While Japan has tried to spend its way out of recession, with little to show for it, Taiwan insists it's different.
That's because Taipei has not spent much on infrastructure over the last few years as it tried to erase a chronic budget deficit. But now fiscal prudence is out the window. ''To maintain a stable growth rate is far more important than sticking to budget deficit reduction,'' says Schive. So officials are topping off the annual $15 billion public works budget with an additional $2 billion. In a $35 billion budget, that's considerable.
Meanwhile, Premier Vincent C. Siew's cabinet is studying proposals--including from President Lee Teng-hui--to intervene to support Taiwan's stock market, similar to moves the government took during the 1996 standoff with China. Analysts believe that government-employee pension funds will be ordered to buy stocks if the market drops further. Says government spokesman C.J. Chen: ''If there is a very abnormal situation developing in the stock or exchange markets, then the government has to do something.''
FRIENDLY BAILOUTS. The government also wants to guard the Taiwan dollar. It has restricted short-selling and vows to enforce rules that keep out George Soros-like hedge funds. Bureaucrats are implementing informal controls. Volume in the currency market has dwindled, from an average of $500 million at the start of the year to $150 million. ''If you do a large trade, they give you a call and invite you for coffee and then ask you very politely to cut off your customer's credit line,'' says Peter Tsao, branch manager at ING Barings Securities (HK) in Taipei. ''The government has rendered the Taiwan dollar completely nontradeable.''
In these scary times, the government isn't beyond bailing out the politically connected. The ruling Kuomintang last month helped get emergency loans of $50 million to ailing steelmaker An Feng Group, which is controlled by a powerful southern clan. President Lee doesn't want to lose support in the runup to local elections in December. Should the KMT lose seats to the independence-minded Democratic Progressive Party, Beijing would be furious--and that could further rattle the economy.
Not all is gloom and doom. Corporations have little debt. Capital controls have limited foreigners in the stock market to 3% of market cap, providing protection from hot-money flows. Yet 60% of the loans made by Taiwan's banks have gone into the property sector, which could sour fast in a recession. So a smaller version of Asia's bank crisis could play out in Taiwan. The safe haven is a lot less safe.
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IS HONG KONG A FREE MARKET? (int'l edition)
Cartels and cozy government deals finally wreak havoc
The Hong Kong government has stopped buying stocks to prop up the local market. Implausibly, it has even declared victory, despite the damage to Hong Kong's reputation, saying its intervention foiled speculators. But the central problem remains: The economy is perilously dependent on overpriced real estate. The government can step back and let the real estate market find its own bottom--even though that process will badly damage major property companies and wipe out the equity of hundreds of thousands of homeowners. Or it can keep intervening to protect the banks and developers--and probably just postpone the inevitable.
It's a hard choice. The economy is contracting at a 4% rate. In the process, Hong Kong property values have declined nearly $250 billion since their peak last September, estimates SG Securities (Hong Kong) Ltd. analyst Alan Dalgleish. Share prices have lost $300 billion in value. And there's more pain to come. Property values could tumble as much as 50% from current levels, while stock prices probably have 20% more downside. ''We haven't reached the bottom,'' says property consultancy First Pacific Davies Ltd. Research Director Simon Smith.
That leaves banks, which have 44% of their loans in real estate, still perilously exposed. High interest rates, which rose to 12.33% for short-term loans at the end of August, from 7.36% a year earlier, are squeezing both banks and borrowers. And borrowing costs will be pushed higher yet by Standard & Poor's downgrade of Hong Kong's sovereign credit rating on Aug. 31, along with those of some blue-chip institutions.
The real estate crash is a humbling experience. In early 1997, New World Development Co. set a record with its $92 million purchase of a home atop Hong Kong Island for redevelopment. That house would be lucky to fetch half as much today, property analysts say.
CARTELS RULE. These woes reveal the deceptive nature of the Hong Kong economy. Although it has many features of a free market, its power center is a group of cartels. Bankers set key interest rates among themselves. A small band of property developers divided most of the spoils during the price runup from 1986 until 1997. Pegging the currency to the U.S. dollar fueled the boom by keeping financing costs low. And companies from bus lines to electricity producers, through cozy deals with the government, have kept prices high.
But now, with the economy slowing and rates spiking, the game is over. Instead of lashing out at speculators, the government would do better to make Hong Kong more competitive and productive. One way to do that would be to set up a Western-style antimonopoly commission. In a freer economy, with the cartels curbed, the bloated real estate sector will shrink to its proper size.
By Mark L. Clifford in Hong Kong
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FOR EMERGING MARKETS, 'PURE CARNAGE'
And for market makers, a major shakeup seems almost certain
If you want to check the pulse of the emerging-markets securities business, Merrill Lynch & Co.'s trading desk in London is a good place to start. There, Robert A. Butler, an angular, 34-year-old Scot, presides over the trading in ''emerging Europe'' stocks. Ever since Moscow defaulted on its debt on Aug. 17, Butler and his colleagues on the desk have been run ragged helping clients dump once fashionable Russian stocks such as energy giant Lukoil and Mosenergo, the big utility. At the same time, the Polish and Hungarian stocks that Butler's desk trades have been beaten to a pulp. ''We have seen two weeks of pure carnage,'' he says.
By Sept. 1, the frantic trading has subsided, giving Butler time to survey the wreckage. It is not a pretty sight. The Russian index is down more than 50% in the past month to a record low, while Poland and Hungary are not much better off. Trading in Moscow is almost dead. On one recent day, a single trade worth $37,000 went through the Russian trading system during the usually frenetic opening hour.
Merrill and other offshore market makers are still open for business. On Sept. 1, Merrill did $15 million to $20 million in Russian stock trading--a decent day's work. But the business has changed. Before the recent battering, Butler had been taking orders from big clients such as mutual funds and pension managers, which wanted stakes in what seemed one of the great emerging markets. But recently, such former enthusiasts, as well as hedge funds scrambling to meet margin calls, have been selling at just about any price.
Butler and other emerging-markets pros have few illusions about the future of their industry. Since just about every emerging economy from Thailand to Venezuela has taken a drubbing, a major shakeup of the business seems to be in the cards. ING Barings Ltd., once one of the biggest emerging markets players, announced some 250 layoffs in emerging-markets earlier this year and just vowed to reduce costs by a further 25%. ''Every financial institution is going to take a close look at how they want to conduct their business,'' says Marcus A.L. Everard, head of the emerging-markets client business at Credit Suisse First Boston Corp. A pioneer in Russian investment banking, CSFB admits to a $254 million cut in profits thanks to Russian turmoil, and Eve-rard acknowledges this could widen if markets sag further.
Of course, investors have also taken big hits. Long-Term Capital Management, the $2.3 billion hedge fund managed by former Salomon Brothers Inc. Vice-Chairman John Meriwether, lost 44% of assets in August. At least four hedge funds heavily invested in Russia have filed for Chapter 11 bankruptcy protection, according to Nicola Meaden, president of TASS Management Ltd., which tracks the industry in London. Three of those, with $180 million to $200 million in capital, were managed by McGinnis Advisors in San Antonio. ''We were not aware that we had this kind of [default] risk because it is unprecedented,'' says Dana F. McGinnis, the company's president.
NO RETURN? With many emerging-markets funds down 50% or more in the past 12 months, investors are certainly on notice about the dangers now. One of the most respected hands in the business, Peter R. Geraghty, former head of emerging markets at ING Barings, wonders if burned investors will come back as quickly as they did after Mexico's financial collapse in 1994-95 rocked the world's smaller markets. ''There's a fundamental disappointment with performance,'' he says.
For one thing, in recent years, just about every small market from Egypt to Zimbabwe has been hawked to investors, so firms won't be able to use novelty to hype securities. Even if investors do return, they may commit less money and stick to the bigger markets, such as Brazil and Hong Kong, Geraghty reckons. He also bets that with so many companies in financial trouble, private equity and bonds may turn out to be the way the emerging-markets game is played, eclipsing investing in stocks. He is about to go to work building a bond portfolio for Washington-based Darby Overseas Investments Ltd., the emerging-markets firm headed by former U.S. Treasury Secretary Nicholas F. Brady.
Having endured the chaos of the past few weeks, it is tough for traders to believe investors will come trooping back. Why should people buy Lukoil when IBM is so much cheaper than a few weeks ago? asks Butler. It is a question that any company or country scrambling for capital is going to have to answer.
By Stanley Reed in London
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BONDS MAY NOT BE AS SAFE AS YOU THINK
Buying them now might mean you're buying at the market's top
With continued stock market instability, many investors are following a path that's heavily trod in times of trouble: They're selling stocks and buying bonds. They could also be making a big mistake.
How? After all, bonds historically do well when stocks are falling and are a safe harbor for your cash during stormy times. Bonds, the assumption therefore goes, are less risky than stocks. In general that's true, but in the markets, all things are relative. And now, relatively speaking, bonds are just about as expensive as they've ever been. Stocks, on the other hand, are getting cheaper by the day. And as deflationary pressures build and the dollar rises, cash itself is becoming more and more of an attractive asset.
Beyond that, bonds, despite their reputation as a haven, can sometimes swing just as wildly as stocks. Those swings tend to be in narrower bands than they are with stocks (it isn't often that a bond will lose 15% of its value in one panicky day, as Yahoo (YHOO) did on Aug. 31). But it's a misconception that bonds somehow have a limited downside. Just ask the hedge funds that loaded up on Russian government bonds rather than play the Moscow stock market -- and are now holding worthless paper. "The man who says bonds are not volatile has clearly never held one in his portfolio," says Hugh Johnson, chief strategist for First Albany.
UPSIDE SWING. Right now, the U.S. bond market, which is admittedly light years safer than Russia's, is experiencing one of its wildest swings ever -- but to the upside. The benchmark 30-year Treasury bond, which is the most closely watched bond in the market, has a yield of 5.31%. That's lower than it has been for the last 30 years. At the beginning of the year it was at 5.8%. In other words, we're in the midst of a phenomenal bull market in bonds. And as bonds have grown in price and declined in yield, they become riskier to own. "It's clear that as yields go down, the risk level goes up," says Pat Retzer, head of fixed income at Heartland Mutual Funds in Milwaukee.
It isn't just the long bond that is currently expensive. The 10-year bond, which is often used as a gauge for where mortgage rates are going, has seen its yield fall below 5%, another 30-year low. Meanwhile, the short end of the yield curve, which some think is being kept artificially high by the Fed's unwillingness to cut interest rates, is actually higher than the long end, with the overnight lending rate at approximately 5.5%.
That, dear friends, is known as an inverted yield curve, and it doesn't occur very often. It also doesn't tend to last very long. That's because it goes against the basic laws of bond physics. The whole bond world is based on the concept that the farther out in time that lent money is to be returned, the greater the risk that the lender won't get it back or that the returned money won't be worth as much as it is today. An inverted yield curve usually means that something is very wrong with the state of bond. And it's often, though not always, a precursor to a recession.
So why do we have an inverted yield curve right now? There are two main reasons. The first is that deflationary pressures have convinced the bond market that inflation really is dead. Without inflation eating away at the value of money over time, then it makes sense that it would cost more to borrow for the short term than it would for the long term.
The second cause of the inverted yield curve is the "Flight to Quality," otherwise known as the "Dance of the Lemmings." As global markets collapse, and foreign currencies teeter, foreigners are desperately buying up the most secure investment they can, which happens to be bonds issued by the U.S. government. Thanks to the universal laws of supply and demand, this has caused the price of bonds to skyrocket and the yield, which always moves in the exact opposite measure as the price, to plummet.
RISKY BET. If you had forecast that all this would happen around this time last year, when the long bond was yielding 6.61%, then you would be wealthy today. But the problem with moving into bonds now is that you can't invest for the previous time period, you have to invest for the future. Buying bonds now would mean that you expect them to perform even better -- and their yields to fall even further -- than they have in the recent past. And that is a very risky bet.
You don't have to look back very far for a sobering reminder of how quickly the bond market can turn on investors. In October, 1993, the long bond yielded 5.97%, and the bulls were galloping at full speed. One year later, the yield had risen to 8.15%, and many bond mutual-fund investors had lost as much as 30% of their portfolios. While the economic situation is very different today than it was in 1994, it's still true that the direction of bond yields is very difficult to predict.
So where is a safe place to put your money now? Each time the stock market falls, it becomes safer. But few expect the volatility that has characterized the past few weeks to go away any time soon. If you insist on trying to sell out of the stock market just when it's becoming cheaper, try cash, not bonds, says First Albany's Johnson. "Every investor should understand that the best way to shore up the defenses of their portfolio is in cash right now," he adds. Whether that means redeeming stock for greenbacks or simply reinvesting the money in bank CD or short-term money market funds doesn't matter. If you believe in the concept of buying low and selling high, this doesn't look like the right time to put your money into bonds.
By Sam Jaffe in New York
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