International Money

1997 Revisited?

For we who have been through several business cycles in high tech markets, it is a matter of when the market will turn around. One of the leading indicators for the turnaround is the stock market. In the last issue of the newsletter, I talked about how the stock market leads in upturn by six months or so. This was before the attack on the WTC. The market fell from around 1700 to the low 1400s.

Judging from the P/E ratios, it would be a big mistake to take any bull market at this level to signal an upturn. For instance, concentrating only on the semiconductor industry, the average trailing P/E ratio is currently (10/4/01) 26.1. This compares with the 30.4 P/E ratio for the whole technology sector. I also took a basket of prominent high-tech companies and found their trailing P/E ratio to be 16. Their current P/E was 28. There are so many solid companies selling at a price at or below this level that we can discount any market upturn as a return to former levels.

What is more important to monitor is the global situation, and in particular, Japan. This country has been languishing for a decade now and the endpoint in not in sight. In the October 15 issue of Forbes, Benjamin Fulford writes in his article, It's Worse Than You Think in Japan, "The world's economy hinges in part on a financial system that, by Western standards, is a shambles." Fulford describes the excessive debt that exists in Japanese banks, and in particular, the large percentage of non-performing loans. This situation compares rather well with the situation that existed in Korea and most of Asia during 1997 and 1998.

Drawing from the course that I teach in Global Business Strategies at the University of Phoenix, I will offer a little history lesson regarding the causes of the Asian monetary debacle and the slide of Japan's currency. My source is International Business by C.W.L. Hill of the University of Washington.

The Asian Debt Burden

The Asian economies had been growing at unprecedented growth for a decade prior to 1997. Exports were growing at 14% to 18% annually. This created an investment boom in the local economies. There was heavy investment in residential, commercial, and industrial real estate. Korea invested heavily in the global automobile and semiconductor industries. This expansion was funded by large bank debt.

The quality of investment declined as a natural consequence of two many dollars following a marketplace that was becoming overinvested. In semiconductors, capacity utilization teetered on a precarious edge, and when the excess capacity overcame demand, the bottom fell out of the market. DRAM prices fell by 90% and South Korean manufacturers could not service the debt they had taken on to finance the expansion. In Thailand, over investment in residential and commercial property had created enough space to meet their demands for the next five years.

Exchange Rate Depreciation

Much of the borrowing was in US dollars. US interest rates were lower and their currencies were mostly pegged to the dollar. However, at the slightest movement in exchange rates, the Asian countries had to keep buying their currencies by using their US dollars in order to keep their currencies from depreciating. When they were unable to prop up their currencies, the size of their debt burden increased as measured in local exchange rate. The current accounts of Asian countries were all operating in the red because of the huge amount of imports that they needed as they built up their internal industries, real estate, etc. Their currencies plummeted.

In mid-1997, several key Thai financial institutions were on the verge of bankruptcy. Foreign investors tried to void themselves of the Thai baht - the currency further plunged and the stock market tanked. Depleted of US dollars, Thailand could no longer defend the baht and the exchange rate fell from 1$=Bt25 to 1$=Bt55 by January 1998. The International Monetary Fund (IMF) intervened.

The IMF agreed to provide $17.2 billion provided that the Thai government increase taxes, raise interest rates, reduce public spending, and privatize state-owned businesses in order to cool down their economy. In addition, they were to let insolvent financial institutions fail. By the end of 1997, 56 financial institutions were closed down, deepening the country's recession.

The turmoil in Thailand spread like wildfire to the other Asian ecomomies who were having the same currency problems. Virtually all of the Asian currencies were floating against the dollar, depreciating them severely. In October 1997, the IMF intervened in Indonesia, providing $37 billion in partnership with the World Bank and the Asian Development Bank. Indonesia's difficulties in adhering to the IMF's loan conditions finally resulted in President Suharto being removed from power in May 1998. The currency pressures eventually forced South Korea to float its currency. The IMF loaned the country $55 billion based on the same draconian measured that were imposed on the other governments.

The Japanese Yen

During the decade prior to the Asian crisis, Japanese financial institutions were having their own problems. The exchange rate had changed from 1$=¥250 in 1985 to $1=¥85 in 1995. Although the inflation rates were different in the two countries (US rates were at least twice Japanese rate), the movement in exchange rates (purchasing power parity) were 30% more than could be explained by inflation.

Japanese Financial Institutions

Because of the large trade balance surplus with the US, Japanese companies had excess dollars. They traded their banks for yen and the banks promptly invested in the US economy. In this way, the exchange rates did not move appreciably, except as could be explained by inflation. However, when the Japanese economy entered into its worst recession since 1945 in the early 1990s, the financial institutions saw their balance sheets deteriorate. They reduced their US investments and put their money into Japanese bonds. This shift in the current ratio caused the value of the yen to appreciate against the dollar to the the 1995 rate.

This process reversed itself in 1996. The US was experiencing a sustained boom. Its inflation rates were low and interest rates were kept relatively high by the Federal Reserve Bank. In addition, there was the incipient currency debacle in Asia. Japanese interest rates, by comparison, had been kept very low in order stimulate their flagging economy. The financial institutions began investing in US stocks and bonds taking advantage of the interest differential and the appreciating value. By 1998, the exchange rate was $1=¥140.

Conclusion

Today the rate stands at $1=¥120. Japanese institutions have had to continue to plow money back into the Japanese economy. The high exchange rate has caused foreign competiton and the acceleration of imports into Japan, further exacerbating the business environment. Fulford illustrates that Oji Shinkin Bank has "$8.1 billion in loans and officially $790 million in nonperforming debt." A national association of "bank victims" exists in Japan, formed to pursue claims that Oji had fraudulently used their assets as collateral for bad loans to others. Fulford presents a case that "'If Japan's government tried to clear up all the bad debt honestly it would go bankrupt.' (Naoko Nemoto, chief banking sector analyst at Standard & Poor's in Japan)"

I, for one, have the feeling that we are like a pencil balanced on its point. OK - so it's not that bad. However, we are in a global economy. In 1963, the US share of the world output was 40.3%; in 1997 it was 12.6%. [Hill, p.13]. Our current economic problems are not simply a domestic problem.

Robert McGeary

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