The Pulse of Capitalism

Issue 98-1, April 1998

The Latest Crisis

While Washington busied itself peeking through keyholes and threatening the government of Iraq, a far more important development was unfolding: the end of the great post-war economic boom in East Asia. The countries affected to date Thailand, Malaysia, Indonesia, the Philippines, and South Korea. They now join Japan, which has been mired in low to no growth since 1991; it ended 1997 with GDP growth of about one percent, despite a huge trade surplus. The business press has followed this story in a rather piecemeal fashion, but it makes fascinating reading.

For several decades, these nations led the world in GDP growth. From 1985-94, Thailand experienced an annual growth rate of 9.8 percent, Malaysia 8.2, Indonesia 7.6, the Philippines 3.9, and South Korea 8.8. These high rates were commonly ascribed to certain common characteristics: cheap land; a hard-working, well educated and trained labor force; a strong propensity to save; a vigorous entrepreneurial class eager to invest in efficient plants and equipment; and societies with strong family and social relationships. Despite these common characteristics, these five economies differ just as much among themselves as the developed western economies do. Yet all have been hit with similar problems, which suggests that something fundamental has been at work.

We shall begin our examination of the Asian problem with a look at its most striking manifestations: the collapse of currency and stock market valuations:

As the table snows, theses valuation losses have been quite severe. particularly in currencies. The Indonesian rupiah is now worth only one fourth as much in U.S. dollars as it was at the beginning of 1997. The Korean won is worth about half as much, and the other three have incurred comparable losses. The stock markets have lost about one third of their earlier values with the exception of S. Korea, where the market rallied strongly in January and February. The declines would be equivalent to a fall of about 3,000 in the American Dow Jones average.

Press reports have devoted much attention to the immediate cause of these declines, focusing principally on the foreign debt incurred by the Asian countries in the course of their expansion. Business Week (11/17 p118) expresses it this way:

"For years, Asia's corporate and political chiefs have borrowed far more money from foreigners than could prudently be invested. Asian countries have gone into hock to the rest of the world to the tune of at least $700 billion since 1992. - - - Japanese banks alone have lent Asians $263 billion, while Europeans have lent $155 billion, and Americans $55 billion."

B.W. (12/1 p 56): "The global capital markets sent hundreds of billion of dollars into Asia from 1986 to 1996, providing local banks with even more funds -, to lend out on incredibly easy terms."

The Economist (11/15 p 20): "On one estimate, the bad loans of East Asian banks now account for between 10% and 20% of their total loans, compared with a mere 1% in America, and that estimate may rise. The danger now, in South Korea and elsewhere in the region, is that a vicious circle of slowing growth, failing banks and contracting credit will cause not merely a brief and shallow recession but a deep and prolonged slump. The key to avoiding such a slump is prompt attention to the state of the region's banks. That may be a lot easier said than done."

This foreign borrowing reinforced the region's other advantages and provided the groundwork for East Asia's remarkable increase in wealth. Beginning at the low end of manufacturing - textiles, shoes, toys - the nations in this area quickly moved into steel, ship building, appliances. automobiles, and electronics. As a result, Asia now accounts for one-third of global trade.

B.W. (11/24 p 58): "The Korean people, with a combination of gritty industriousness and fierce pride, achieved an economic miracle. They managed 6.2 percent growth over the decades and raised annual income from $80 in 1960 to over $10,000 today. A poor farming country transformed itself into an industrial powerhouse in a generation."

B.W. (1/19 p 44): "For years, no industry seemed too crowded and no market too far-flung to escape the tendrils of South Korea's expansion-minded capital. Conglomerates such as the $47.6 billion Hyundai Group boasted of making everything from 'chips to ships, from Europe to Latin America.'

Econ. (11/15 p 77): "Where there has indeed been an investment boom over the past decade is in developing Asia. The region's investment increased from 23% of GDP in 1960 to 36% last year."

But, hold on. Isn't more investment the holy grail of capitalism? Don't our economists tell us we need to save more for investment, even while unprecedented amounts of money flow into stock speculation? What gives?

Econ. (12/20 p15): "That brings on the wider questions. How could this [financial] crisis have happened, in a region where growth was preceding swimmingly, where the "fundamentals" of high savings, top notch education and technology, and social peace seem still to apply? Has the "Asian model" gone wrong?"

Econ. (12/13 p 65): "In East Asia, none of these situations applies. The countries themselves have more resources (than Latin America and Eastern Europe), and the governments by and large have kept spending in check and inflation down; the problematic foreign debts are those of banks and industrial companies, not of governments."

And how serious is the debt problem?

Econ.(11/15 p 20): "According to the Bank for International Settlements, at the end of 1996 foreign-currency debt with a maturity of less than two years ... was equal to about 120% of foreign exchange in Thailand and nearly 200% of reserves in both Indonesia and Korea. The figures have almost certainly risen since then."

B.W. (2/2 p 49): "Many of the region's indebted banks simply can't lend because they remain far short of the 8% capital adequacy ratio required by the International Monetary Fund as part of bailout packages. 'If we don't meet the requirements, we get shuttered,' explains a Korean bank exec."

B.W. (1/19 p 45). "Analysts figure investment needs to be cut 30%, as Samsung and Hyundai (Korea) have announced, to free up cash to pay down debt loads that now on average approach 4.5 times equity at the top 30 Conglomerates."

B.W. (2/16 p 54): "Sure, Seoul Stocks have surged on news that government has restructured $24 billion in short-term debt owed to European, U.S., and Japanese banks. But that workout benefits the big Korean banks and their large corporate clients, the chaebol. Meanwhile, the vast majority of Korean manufacturers still owe some $150 billion of won-denominated debt to local banks and other Korean firms, just when rates are hitting record highs."

Worries by investors about these high debt loads are assumed to be responsible for the collapse of the region's currencies and stock markets. But these debt loads were not new and were not significantly higher than a year or so ago, so what rigged the collapse in 1997? On this point there are many revealing comments.

Econ. (11/15 p77): "Around the world, too many factories are making too many cars, too many computer chips, and too many chemicals."

B.W. (12/1 p 56): "Chinese family conglomerates, Korean chaebol, and Malay business people with good political connections built an enormous over capacity that now haunts them."

E.W. (11/24 p 59): "Because of global deflation, prices for Korean products are dropping. As a result, exports are growing 20% annually by volume but export revenues are growing 8%. The chaebol cannot survive with this kind of growth."

B.W. (2/2 p 48): "World markets for cars, chemicals, and many electronics components already are glutted. China, with its vast base of suppliers and efficient infrastructure, remains a fierce competitor in many industries."

Econ. (11/15 p 20): 'The (East Asian) bankers' second error was to lend recklessly on property. Convinced that demand for offices, hotels, and luxury homes would continue to soar, they threw money at grandiose construction projects. But over capacity has caused rents and prices to fall sharply in many Asian cities. That in turn has squeezed some of tie biggest banks, which now typically have between 10% and 35% of their loans committed to bricks and mortar.'"

All of this is very reminiscent of the S & L banking crisis in the U.S. in the early '90s and of the collapse of the high tech boom in New England; the same processes caused all of them. Capital growth is the greatest of all contributors to demand. When capital is multiplying rapidly, income, jobs, and tax revenues all grow with it. Job creation exceeds job destruction - the obverse of increased productivity. But endless high growth is impossible since both demand and resources are limited.

What Asia has experienced is a classic case of capitalist development, much like the West in the last century. Starting from a low base, growth and expectations seem boundless. Industrial capacity and real estate construction proceed at a faster pace than the demand for their product. When realization of this fact spreads, all the credit expansion that fueled the boom begins to reverse itself, and this in turn brings on the collapse in currency , stock market, and real estate valuations that afflicted Asia during 1997.

The international rescue package mounted by the IMF, which now totals more than $100 billion, may well bring some stability back to Asia. But the basics will be altered. Instead of importing capital to expand their economies, the Asian nations will be cutting back in order to repay the funds they have borrowed. Imports will be more expensive, unemployment will grow, and social dissatisfaction will spread. East Asia is likely to join Japan in a low growth environment. With Europe mired in ten percent unemployment, this presages more serious problems for the world economy in the years to come.

GDP growth was relatively strong in four of the five economies in 1997. In Japan it declined, and most observers do not forecast a recovery in 1998. Canada experienced the greatest increase. Industrial production advanced at a faster pace than in 1996, with Canada and the U.S. leading the way.

Interest rates were unchanged to a bit higher in four of the economies. In Canada , although lower for the year, they ended December at 4.68 percent.

Despite the assurances of low inflation, the Economist's index shows little change in any of the five economies, with the U.S. ending the year with a 3.6 percent increase. Stock markets again reached record highs except in Japan, where the average fell. Apparently, all of the world's liquidity is being channeled into its bourses. The U.S. Dow average has continued to surge in 1998, with the dividend-price ratio at a historic low of 1.5.

Unemployment trends are mixed. Canada, Britain and the U.S. achieved reductions but Germany and Japan experienced increases, despite higher industrial production. Canada's rate in January was 8.9 percent.

The U.S. current account deficit again worsened in 1997 with no prospect of a turnaround in 1998, while the Japanese surplus rose. The Japanese currency, however, along with the German, weakened considerably against the U.S. dollar, while the British pound rose. The Canadian dollar, by January, was down to $1.44.The U.S. has benefited from strong capital inflows.

Real GDP grew 3.8 percent in 1997 compared with 3.1 percent in 1996. Industrial production rose 5.0 percent, the largest increase since 1994, and primarily in business equipment. Capacity utilization was close to recent years, while manufacturers' new orders trended upward through the year.

Construction also had a good year, rising $32.0 billion; residential housing improvements were strong. The vacancy rate for residential housing was 7.7 percent, while the construction contracts rate was up to 138.

Real gross investment continued to rise at the same steep pace that has prevailed since 1991. Producers' durable equipment - information processing and related, industrial, and transportation related - led the way.

Business sales rose about the same in 1997 as in 1996 while retail sales rose a little less. The inventory-sales ratios for both categories were lower than for most recent years. Real per capita expenditures increased $428 in 1997 as disposable income grew 2.0 percent. This income growth was accompanied by increases in total employment and in total hours worked.

National income advanced at a faster pace than in the preceding two years, with strength in all sectors. Real per capita income and average weekly earnings rose in tandem. Average overtime hours of 4.2 was the highest in over a decade.

Gross saving increased $23 billion more in 1997 than in 1996; the increase was in the business and government sectors as personal saving fell. Commodity prices ended the year on a weak note, only 4.2 percent above the 1990 base. Industrials such as copper and oil were weak while foods were relatively strong, thanks to the beverages such as cocoa and coffee. The Economist comments "Prices of industrial materials are falling fast as the Asian economic crisis deepens; weaker import demand in the area is likely to affect all commodities in 1998." (1/17 p 96)

The producer price index was little changed in 1997 after a long rise. It may be significant that the consumer durables index fell while the capital equipment was unchanged after years of increases. Those who cheer these developments as "containing inflation" may be missing the message.

Corporate profits rose $69.7 billion in 1997, continuing their long upturn. However, the fourth quarter came in with a drop of $6.9 billion; the next few quarters may be crucial in determining the direction of the stock markets and the economy. The ten year Treasury rate drifted down to 5.63 percent by Feb. 28, while the three month rate was 5.14, an unusually narrow spread. The M3 money supply rose 8.9 percent in 1997, the sharpest increase since 1984. Is this the reason the Fed anticipates a rise in inflation?

After huge revisions for the months of June through October, Fed open market operations totaled $20.0 billion for 11 months; the full year is likely to set a new record. Total bank credit increased $341.6 billion, also one of the largest ever. Securities purchases and real estate loans were particularly strong. Consumer debt growth slowed further in 1997, led by revolving credit and "other" such as mobile homes, vacations, etc. Total credit market debt grew at about the same rate as in the preceding two years. But the composition shifted from federal government and households toward business and state/local government.

The merchandise trade deficit hit a new record in 1997 of $199.0 billion. Exports rose $66.1 billion while imports rose $73.9 billion.

The capital accounts reflect only nine months data, yet the (negative) net change is already higher than in 1995 and only $20.9 billion below the 1996 total. Thus, the widening trend that began in 1992 continued. Net foreign purchases of U.S. securities have been quite strong for several years now, helping to propel their prices upward. The extent of foreign purchases of Treasure securities may be appreciated from the following:

In just four years, foreigners acquired $640.5 billion of Treasury obligations. During the past three years, they acquired far more than the net amount issued by the Treasury. Financing the Federal deficit cost the American public nothing.

What are the implications? One third of the national debt in now owed to foreigners, and one third of the interest on that debt now flows to foreigners. Are we now dependent on these flows?

Are these flows one of the major causes of the stock market boom? From 1993 to 1997, foreign funds flowing into Treasuries (and they also went into other securities) equaled 70.4 percent of the net issues of mutual fund shares. Will this inflow continue, and what might cause it to stop? What happens to stock prices if it does stop? These are good questions for our policy-makers to consider. If they do nothing now, they may find themselves facing far more serious problems than tobacco smoking and school voucher plans.