Wind From The East. 11/12/1997

Barely three years ago another financial crisis roiled the stock market. The Mexican crisis struck with lightening speed and raged like a tornado through the hemisphere, collapsing currencies and stock markets like so many cups and saucers falling from a shelf. The U.S. market was very unsettled during this period and many economic observers issued dire forecasts of the outcome. With the help of a $50 billion loan from the U.S., Mexico recovered and actually repaid its loan early. With the necessary restructuring of its banking system, Mexico’s economy is now flourishing and its financial position and currency are sound. The crisis that so threatened the entire American continent has passed into the history books with little lasting impact on the markets.

Today another financial crisis is sending shivers through the U.S. stock market. Thailand incited the crisis by its July 2 devaluation of the baht. The result was unexpected, immediate, and shocking. In a chain reaction the currencies of Indonesia, Malaysia, and the Philippines, in addition to Thailand, collapsed. The stock markets in these countries started precipitous declines resulting in losses of more than 50 % of their pre-crisis levels. The International Monetary Fund accepted the various requests for assistance, demanding in return financial reforms which will bring economic growth to a crawl. The turmoil also has sent tremors elsewhere. Economists have expressed concern that South Korea, the world’s eleventh largest economy, could be the next country in need of financial assistance. Hong Kong, no longer a self-governing colony, has had to defend its currency aggressively. Halfway around the globe, Brazil has instituted draconian measures to protect the integrity of its currency. In the process Brazil is sacrificing economic development for financial stability. In the economically linked region, Brazil’s actions will force its neighbors to follow its lead and reduce development spending.

What are the causes of this tragedy, and what is the prognosis for the United States? The issues are complex and the crisis is still evolving. One approaches the topic therefore, with some humility. At the risk of oversimplifying, however, the common thread running through all the feeble currencies is the excessive amount of foreign capital which flowed into the countries, compounded by the rudimentary regulation and lax oversight of their banking systems. In a world of sluggish or negative growth, continued development especially in East Asia, has been expected to provide a large portion of the world’s expansion in the future. Confidence in continued rapid expansion was so high that some private economists were fond of referring to the Asian countries as miracle economies. The huge infusion of capital was far in excess of the amount needed to finance rapidly expanding international trade or the number of viable industrial projects that could be safely developed. Increasingly, the massive flows were being channeled into inflated real estate ventures, ill conceived industrial expansion, stock market speculation, and even corrupt dealings. As long as the baht and other currencies were stable or appreciating, the flow of foreign capital gushed forth. Suddenly currency speculators, sensing an overvaluation, started selling Thai baht. The Thai monetary authorities purchased the unwanted currency, paying in dollars. Others, however, also sensed a turn in the prospects for the baht. In essence, banks, finance companies and others piled on, essentially disgorging their huge holdings of baht for dollars. Lacking sufficient reserves of dollars, the government devalued its currency. This devaluation by Thailand exposed the same problems of excessive real estate speculation and unsound industrialization projects in the other countries of East Asia. So exposed, there was no hiding. To borrow a phrase, the emperor had no clothes. The currencies of all these countries are convertible to the dollar and they were unable to meet the overwhelming demand for conversion of their currencies into dollars.

These unfolding events caused a severe correction in the U.S. stock market in September, and some truly attention grabbing price swings during October. Tension in the worlds financial markets continues to be high. With some benefit from hindsight, however, it does not appear that the problems in Asia alone will have a pronounced impact on the course of the United States economy. American banks are simply not heavily exposed in the region. Any earnings decrements by U.S. banks will hardly be noticeable. Japanese banks are the predominant lenders to the region. Lacking opportunities at home, flush with domestic savings, and with the lowest interest rates in many decades, Japanese banks were aggressive lenders and developers in the region. It should not come as a surprise therefore that the government of Japan is taking the lead in rescuing Southeast Asian countries from default.

Overlooked in the flurry of news is the fact that our exports to Asia are simply not large enough to drive our economy into a recession. Overall, American exports amount to about 12% of our gross domestic product. They are dominated by exports to Mexico and Canada which amount to 32% of exports, more than to all the Asian countries combined. Exports to Thailand, Malaysia, Philippines and Indonesia are estimated at 4% of our total exports, or less than 1% of our gross domestic product. Then too, it is not likely that all exports to East Asia will be eliminated nor will all development evaporate. The region simply has too many dynamic growth attributes. However, higher risk premiums and banking reform will undoubtedly be demanded. An extended period of much slower growth is the likely outcome.

Perhaps most relevant to our stock market prospects, the U.S. economy is truly in excellent shape. We have created over 14 million new jobs this decade with no inflation consequences of note. Our budget deficit, the Achilles heel of the U.S. economy for decades, seems to be declining rapidly. Slower growth in Asia and elsewhere should calm lingering fears of too rapid economic expansion and a resurgence of inflation. Monetary policy is unlikely to become more restrictive anytime soon. As the aftershocks of this summer’s turmoil roll through the weaker currencies of the world, attention will again be drawn to the United States as an oasis of stability, safety, and non-inflationary growth. These are appealing qualities indeed and in our view, support a very constructive attitude to the U.S. stock market despite the current high tension.

THE INVESTMENT POLICY COMMITTEE
Alfred A. Lagan, CFA, Chief Investment Officer
November 21, 1997