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VIEWPOINT:
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BUSINESS | February 23, 1998 VOL. 151 NO. 7 |
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Shakespeare Couldn't Beat This Indonesia's the entree. China's devaluation will bring the house down By David Roche
For the moment, the investment audience has cleared out to the lobby bar for ice cream and champagne. Soon everyone will return to the theater, where bloodied bodies, heaving and groaning, still litter the stage. The killing spree in Act V, Scene V is yet to come, however. But come it will, when U.S. and European equities join the emerging-markets rout, their profits massacred by the advancing tide of a global deflationary crisis that will move from Asia to places like Brazil, Mexico, Russia and South Africa. Here's the plot line. First, Indonesia will blow up. As much as 90% of the corporate sector is already bankrupt at today's exchange rate. And the corporate sector is responsible for more than 60% of Indonesia's $140 billion foreign debt-not including an additional $60 billion or so in undeclared offshore borrowing. Forget about any "Korean option," in which Indonesia's government would bail out the corporate sector by borrowing abroad. There is too much foreign debt for that. We already have a de facto freeze on repayments. Indonesia is a political tinderbox. With the economy worsening, President Suharto won't make it to the end of the year. Unfortunately Indonesia is only halfway toward becoming a civil society. Suharto has ruled the country with an iron fist for more than 30 years, and there is no legal or political system to ensure a smooth transition. So things are likely to be chaotic and quite possibly bloody. When Indonesia defaults, it will clobber the Japanese and Korean banking systems, which have lent a combined $27 billion or so to the country. That will mean further capital withdrawals from Asia, more currency weakness and a greater deflationary impact on the West. The setting for the final, tragic act will be China. Despite official promises to the contrary, Beijing will be forced to devalue the renminbi by 30% to 40% within 18 months. When it does, Hong Kong's currency peg is doomed. Interest rates in Hong Kong will soar, damaging one of the pillars of the global financial system. It may seem unnecessary to cheapen the currency when China has a huge trade-account surplus, currently 4.5% of gdp. But China's inability to produce enough new jobs will eat at the legitimacy of the Communist Party and force a move to make exports more competitive. China's economic motor is its ability to sell goods abroad, and these make up 18.5% of gdp and contributed about 3.8 percentage points of 1997's official 8.8% real gdp growth. But this year exports will collapse: the renminbi has risen 25% in real terms against the currencies of China's Asian trading rivals since July, which means Chinese exporters are at a disadvantage. Moreover, their markets are likely to shrink. Non-Japan Asia currently takes 21% of what China sells abroad. As demand falls, those exports will sag. That would take a huge toll on China's vast state sector, which accounts for about 60% of exports. As China's export markets collapse, state enterprise cash flow will turn a deep red, while the bad debts of the country's four major state banks will mushroom. Bad debts are already estimated at 30% of all loans, or about 23% of gdp. The shakeout would be enormous. As exports shrink, many state enterprises would simply shut down. China would fall well short of the 11%-a-year real gdp growth it needs for the next few years to attain its goals of keeping down unemployment and maintaining social stability while pushing state-enterprise reform. If China grows just 4.6% over the next two years, 78 million people would be unemployed. Social stability would be the first casualty, the Party's grip on power the second. Beijing won't allow this play to be shown. To stop it, China has only two choices short of devaluation. One is to abandon state-enterprise reform. But that would mean continuing the subsidies that the budget can't maintain for long. The other is to build new mega-projects, financed by printing money, to stimulate the economy. Indeed, the government has just announced $750 billion worth of them, but most are unlikely to be built. What money is spent would soon find its way out of the economy, as imports flood in to supply the projects and wipe out the country's trade surplus. That leaves devaluation. When Beijing is forced to choose between social stability and a stable renminbi, the currency will lose. And once China does devalue, the last economic argument for sustaining the Hong Kong dollar peg will be gone and all support for it from Beijing will become a political liability. The timing may not be certain, but the script is written. Act V is going to bring the house down. David Roche heads Independent Strategy, a London investment firm
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on't be fooled. the recent rise in asian stock prices represents only an intermission. There are still two big acts to come in the emerging-markets version of Shakespeare's Macbeth. After this happy hiatus, the crisis will spread further and swamp additional financial assets around the world. There are two main catalysts. Indonesia will suffer a social explosion. And China will deflate and then devalue, wiping out the Hong Kong currency's peg to the dollar in the process.