Martin Wolf: Threats of depression

Financial Times 98-08-26

What is happening in the "emerging market" economies is a disaster. That is beyond doubt. The question now is whether it will become a worldwide catastrophe. The chances may be small. They are not, alas, zero.

With the downfall of the rouble and the Russian government, the crisis that began in Thailand in July 1997 has jumped continents. Russia is Indonesia with missiles: the path towards an enfeebled presidency, a collapsing currency and deeper political turmoil lies open before it. The justification for July's $23bn support programme, orchestrated by the International Monetary Fund, was the chance that it might prevent this calamity. It has failed.

Unfortunately, it is no isolated failure. Even where the IMF's medicine has been taken, the economic downturn is proving far deeper than expected. with each forecast for gross domestic product this year lower than the previous one.

In Indonesia, South Korea and Thailand, domestic demand is already contracting massively. That contraction will be partially offset by improvements in external balances: ING Barings forecast current account surpluses of over 10 per cent of GDP in 1998. Nevertheless, they will still suffer depressions. In its latest Asia Economics Analyst, Goldman Sachs forecasts that this year real GDP will contract by 15 per cent in Indonesia, 8 per cent in Thailand and 7 per cent in Korea.

Neither is recovery likely next year. An important reason for pessimism is the debt overhang. Angus Armstrong and Michael Spencer of Deutsche Bank (Global Emerging Markets, August 1998), estimate non- performing loans from domestic banks at more than 40 per cent of GDP in Korea and Thailand and more than 30 per cent in Indonesia and Malaysia. To this must be added an overhang of unpayable external debt, estimated at $30bn for Korea, $22bn for Indonesia and $13bn for Thailand.

Clearly, the Asian crisis is no local difficulty. It has spread globally, changing trade patterns, depressing commodity prices and undermining financial markets.

The direct effects on imports and exports have been greatest within Asia. China's net exports are forecast to deteriorate by up to 1 per cent of GDP this year. Similarly, Japan was far more reliant on exports to the rest of Asia than other high-income countries. In 1996, 42 per cent of Japan's exports went to emerging Asia, compared with only 18 per cent from the US and 15 per cent from the European Union. This year, Japanese exports to some Asian countries have halved.

But the knock-on effect goes further than that, notably through the impact of depressed commodity prices. Since May 1997, The Economist all-items index of commodity prices has tumbled 30 per cent. The price of Brent crude has collapsed from nearly $22 last September to below $13 today. Russia is the most prominent victim. But countries vulnerable to collapsing commodity prices include Australia, New Zealand and Canada; Argentina, Chile and Brazil; and the oil exporters, some of whom including Indonesia, Nigeria, and Venezuela are already in trouble.

This is raising "uncertainty premia" in emerging markets. Since the start of the year, J.P. Morgan's emerging market bond index shows a rise in spreads over corresponding US Treasuries from 500 to 1,300 basis points, with much of the increase occurring in recent weeks. Over the same period, equity markets, in dollar terms, have fallen 29 per cent in Argentina, 36 per cent in Hong Kong, 37 per cent in Singapore, 40 per cent in Mexico, 58 per cent in Indonesia and 74 per cent in Russia (see chart).

Already, therefore, this crisis has global significance. It has brought low some of the most successful developing countries. It is imposing heavy pressure on the political and social stability of many countries directly affected. It has raised questions about global capital markets. And it is spreading almost everywhere via adjustments in trade, declining commodity prices and the shrinking appetite for risk.

Yet, bad though it is, this is not the worse that could happen. Japan, the US and the European Union account for two-thirds of global output (at market prices). Provided they are reasonably stable, the crisis will remain limited to "only" one-third of the world economy. Unfortunately, that cannot be taken for granted. Things could become far worse.

The weakest link in the chain is Japan. Some recent estimates suggest non-performing loans in the banking system have reached the stupefying total of $1,000bn. With each year the authorities fail to deal with the overhang of bad debt, the worse it becomes. The difficulty, however, is that if the Japanese government were - miracles of miracles - to confront the problem, it would force households to recognise how far their wealth had been impaired. This would be because of the hole in bank balance sheets and the effect of the liquidation of collateral on house prices.

Together, argue David Folkerts-Landau and Peter Garber of Deutsche Bank, this could mean people waking up to a decline in household wealth of some 140 per cent of disposable income. The obvious conclusion is that households would want to rebuild their wealth. Increased savings would then more than offset any spending boost from planned tax cuts.

A weakening yen and a consequent improvement in Japanese exports, seem almost inevitable. The same conclusion comes from the argument, by Paul Krugman of the Massachusetts Institute of Technology, that Japan needs negative real interest rates.* Others argue that inflation is the only way to eliminate Japan's debt overhang.

The only plausible counter to these recommendations is the argument, advanced by Adam Posen of the Institute for International Economics, that Japan should combine monetary expansion and bank reconstruction with a more aggressively expansionary fiscal policy. This might work. But whether it would is, in a sense, irrelevant, since it is unlikely to be tried. The combination of a more expansionary monetary policy with a still weaker yen seems much the more likely outcome.

One result would be further pressure on exchange rates in the region. China could take a yen depreciation as an excuse for a large devaluation of its own. This would then have knock-on effects on other currencies. The still more important conclusion is that Japan is set to remain what it has been: a big part of the problem, rather than a part of the solution.

The consensus view is that even this should leave the US and EU largely unaffected: the deterioration in external balances is insufficient to slow growth decisively; declining commodity prices are a helpful disinflationary shock; and, combined with the global flight to quality, low inflation is helping drive bond yields to deliciously low levels: 5.6 per cent for 10-year bonds in the UK; 5.4 per cent in the US; 4.8 per cent in Italy and around 4½ per cent in Germany and France.

The complacent conclusion is then that the agonies of emerging markets bring almost nothing but gain to the US and the EU. There is one big risk, however: stock markets.

A recent paper from those well-known British bears, Phillips & Drew (Spending and Stocks in the USA: research group occasional paper, number 1), notes that US household cashflow has been strongly negative in recent years. This is associated with a decline in the personal savings rate to its lowest level in the past 35 years. Those who say US baby boomers are saving for their retirement are talking nonsense. They are letting rising paper values do it for them: the value of equities has risen from 0.7 times household annualised income to 2.1 times since 1988 because of rising stock prices.

The biggest risk confronting the world economy is that this miraculous wealth machine will go into reverse. Since equities are at historically high valuations, while swathes of the world economy are in dire straits, this is no remote concern.

In one intriguing analysis, Goldman Sachs The Global Equity Correction - How Big and How Damaging? August 5th 1998) suggests that a 20 per cent decline in global equities would itself shrink global GDP by 0.75-1 per cent by the second year, with the US losing most and the EU least. This would represent a shock as large as the Asian crisis. At worst, this could even start a cumulative decline in the US economy and Wall Street.

To indicate what this might mean, consider the impact of a 50 per cent decline in the US stock market (which would merely put US price/earnings ratios at about their historic average). According to Phillips & Drew, the effect on US GDP in the second year would be to put it almost 7 per cent below what it would otherwise be. If monetary policy were eased substantially, with short-term interest rates down 4 percentage points, the shrinkage would still be 5 per cent of GDP.

Already, because of a series of mishaps and mistakes, many emerging economies are caught in a horrifyingly deep and rapidly spreading downturn. So far, this has done little to damage prospects for the US and the EU. In some ways, that has been helpful. But it is rash to assume this must last.

Much now depends on the indefinite maintenance of historically extraordinary stock market valuations in the midst of an increasingly global deflation. The world economy is being held up by its stock-market boot-straps. It is no longer a question of asking whether this can last, but of praying for it to do so.

Paul Krugman, "Japan's Trap", and "Further Notes on Japan's Liquidity Trap",

Adam S. Posen, How Much is Enough for Japan? Institute for International Economics, Washington D.C.

Martin Wolf

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