TIME Asia | Egad! The Asian Virus is Mutating!

	ASIA	JANUARY 19, 1998 VOL. 151 NO. 2
Egad! The Asian Virus is Mutating! The crisis is likely to batter Japan, China and, finally, Wall Street BY DAVID ROCHE The emerging-market crisis is far from over, changing shape and locus like a mutating virus. It veers from Thailand to South Korea and, with a vengeance, back to Indonesia. There are actually two carriers of the virus to worry about now. The first is Japan, where deflation and deteriorating asset-quality will ultimately undermine Tokyo's government bonds. The second is China, where there will be a banking crisis, and export growth will evaporate under the impact of Asia-wide competitive devaluations. The Chinese nightmare may not surface for another six months or a year. But when it does, the world will shudder. Many analysts see a replay of the Mexican meltdown of 1995. If that's the case, then at about this point in the crisis, the Mexican stock market started to recover, while the currency and fundamentals went on deteriorating. But is Asia really another Mexico? In some ways, the region is in better shape than Mexico was (lower foreign debt, more economic openness, a famously higher savings rate). In other ways, Asia is worse off. The stock of unneeded factories in North Asia and abandoned buildings in Southeast Asia are much larger than they were in Mexico. That country's problem was foreign financing of a domestic consumer boom. Asia's crisis will have broader ramifications. First, running down that stock of useless assets will hobble regional growth, throwing Asia into recession throughout 1998 and beyond, and causing global growth to slow. Second, cleaning up the bad loans on these assets will squeeze global credit and liquidity. Third, multinational corporations will find their profits far more damaged than they now imagine by the travails of all emerging markets, as the Asian crisis spreads elsewhere. Fourth, the problems in Korea and Japan will create considerable price deflation for goods in global markets. Fifth, while Mexico was a one-country crisis resolved with massive U.S. support, Asia has received much less outside aid per dollar of its bad debts. And in Mexico, living standards plummeted nearly 30%, to the benefit of export competitiveness and profits. If that were tried in Asia, you could expect nothing short of a revolution. All this suggests that Asia's economies and stock markets are going to take much longer to recover than Mexico's did. If Asia's deflation does sweep the world, it will start in Japan. The black scenario goes this way: South Korea beats down the price and volume of Japanese exports. The Nikkei index plummets. That puts Japanese banks back into intensive care, if not the funeral parlor. And banking failures would call into question the asset backing of Japan's public institutions--all the supposedly nice, safe investments of the Trust Fund Bureau, public pensions and Post Office savings. Why do we imagine that loans made by these scandal-tainted bodies would be of better quality than those run by Japan's brokers and bankers? Before long, the crisis will spread to China. Policy there is currently too deflationary. Retail prices are falling, and interest-rate reductions are stingy. Some time in 1998, a combination of state-sector reform, a banking crisis and social unrest will force a change. For the moment, however, the authorities in Beijing think they can pursue tight money, fiscal restraint and industrial reform at the same time. They will learn they can't when the major motor of Chinese growth--exports--starts to sputter. And exports will fall, as sure as little green apples grow on little green trees. The rest of Asia's now-devalued little green apples will clobber China's overvalued apples, and deflation in Asia will kill demand for the 60% of Chinese exports that go to the region. Also killed will be the profits that Hong Kong companies repatriate from their factories on the mainland. That will squeeze the Hong Kong banking system and pinch the territory's money supply. U.S. financial markets are behaving as if these grim prospects are nothing to worry about. The American consensus is that capital will flee the emerging world and flow to the U.S. as the ultimate safe haven. So a widening trade deficit, as U.S. exports fall and Asian exports rocket, won't matter. Indeed, exported deflation from the emerging world will benefit American consumers. The long-running U.S. boom will be curbed by the Asian crisis, but not enough to damage profit growth. At least that's the U.S. consensus. But for it all to come true, U.S. Federal Reserve Chairman Alan Greenspan will need more luck than a Las Vegas gambler with a six-lemon row on a one-armed bandit. It's more likely that the U.S. economy will go on churning out wealth, which Americans will spend in vast gobbets. But soon there will be almost nobody left without a job, and wage costs will rise. Either inflation will go up or profit margins will fall, just as the squeeze on multinational earnings from the Asian crisis hits Wall Street. Then the Asian virus will have a real economic impact, and falling profits will undo current optimism. And the day that Wall Street turns--when the bad news stops being good news and the good news turns bad--rosier prospects elsewhere on the globe won't be worth a plugged rupiah in shoring up the world's financial markets. David Roche heads Independent Strategy, a London investment firm
time-webmaster@pathfinder.com

The crisis is likely to batter Japan, China and, finally, Wall Street

BY DAVID ROCHE

The emerging-market crisis is far from over, changing shape and locus like a mutating virus. It veers from Thailand to South Korea and, with a vengeance, back to Indonesia. There are actually two carriers of the virus to worry about now. The first is Japan, where deflation and deteriorating asset-quality will ultimately undermine Tokyo's government bonds. The second is China, where there will be a banking crisis, and export growth will evaporate under the impact of Asia-wide competitive devaluations. The Chinese nightmare may not surface for another six months or a year. But when it does, the world will shudder.

Many analysts see a replay of the Mexican meltdown of 1995. If that's the case, then at about this point in the crisis, the Mexican stock market started to recover, while the currency and fundamentals went on deteriorating. But is Asia really another Mexico? In some ways, the region is in better shape than Mexico was (lower foreign debt, more economic openness, a famously higher savings rate). In other ways, Asia is worse off. The stock of unneeded factories in North Asia and abandoned buildings in Southeast Asia are much larger than they were in Mexico.

That country's problem was foreign financing of a domestic consumer boom. Asia's crisis will have broader ramifications. First, running down that stock of useless assets will hobble regional growth, throwing Asia into recession throughout 1998 and beyond, and causing global growth to slow. Second, cleaning up the bad loans on these assets will squeeze global credit and liquidity. Third, multinational corporations will find their profits far more damaged than they now imagine by the travails of all emerging markets, as the Asian crisis spreads elsewhere. Fourth, the problems in Korea and Japan will create considerable price deflation for goods in global markets. Fifth, while Mexico was a one-country crisis resolved with massive U.S. support, Asia has received much less outside aid per dollar of its bad debts. And in Mexico, living standards plummeted nearly 30%, to the benefit of export competitiveness and profits. If that were tried in Asia, you could expect nothing short of a revolution. All this suggests that Asia's economies and stock markets are going to take much longer to recover than Mexico's did.

If Asia's deflation does sweep the world, it will start in Japan. The black scenario goes this way: South Korea beats down the price and volume of Japanese exports. The Nikkei index plummets. That puts Japanese banks back into intensive care, if not the funeral parlor. And banking failures would call into question the asset backing of Japan's public institutions--all the supposedly nice, safe investments of the Trust Fund Bureau, public pensions and Post Office savings. Why do we imagine that loans made by these scandal-tainted bodies would be of better quality than those run by Japan's brokers and bankers?

Before long, the crisis will spread to China. Policy there is currently too deflationary. Retail prices are falling, and interest-rate reductions are stingy. Some time in 1998, a combination of state-sector reform, a banking crisis and social unrest will force a change. For the moment, however, the authorities in Beijing think they can pursue tight money, fiscal restraint and industrial reform at the same time. They will learn they can't when the major motor of Chinese growth--exports--starts to sputter. And exports will fall, as sure as little green apples grow on little green trees. The rest of Asia's now-devalued little green apples will clobber China's overvalued apples, and deflation in Asia will kill demand for the 60% of Chinese exports that go to the region. Also killed will be the profits that Hong Kong companies repatriate from their factories on the mainland. That will squeeze the Hong Kong banking system and pinch the territory's money supply.

U.S. financial markets are behaving as if these grim prospects are nothing to worry about. The American consensus is that capital will flee the emerging world and flow to the U.S. as the ultimate safe haven. So a widening trade deficit, as U.S. exports fall and Asian exports rocket, won't matter. Indeed, exported deflation from the emerging world will benefit American consumers. The long-running U.S. boom will be curbed by the Asian crisis, but not enough to damage profit growth. At least that's the U.S. consensus.

But for it all to come true, U.S. Federal Reserve Chairman Alan Greenspan will need more luck than a Las Vegas gambler with a six-lemon row on a one-armed bandit. It's more likely that the U.S. economy will go on churning out wealth, which Americans will spend in vast gobbets. But soon there will be almost nobody left without a job, and wage costs will rise. Either inflation will go up or profit margins will fall, just as the squeeze on multinational earnings from the Asian crisis hits Wall Street.

Then the Asian virus will have a real economic impact, and falling profits will undo current optimism. And the day that Wall Street turns--when the bad news stops being good news and the good news turns bad--rosier prospects elsewhere on the globe won't be worth a plugged rupiah in shoring up the world's financial markets.

David Roche heads Independent Strategy, a London investment firm