First, an explanation. Future Shock was an IDEA conference
held in Hong Kong in October 1996, where some of Asia's top
policymakers gave their views on the appropriate response to
currency crises. The financial market turmoil which swept the
region eight months later has been extreme enough to keep authorities
across Asia in largely reactive mode.
IDEA early on recognised the potential for the strain that
began in Thailand in July 1997 to encompass the whole region.
Although at the time the market was relaxed about China-risk,
we identified that China would be badly affected by Asia's slide
into recession, and our Clouds Over China research note
in December 1997 projected risks for a yuan depreciation. This
we suggested would have fatal ramifications for the HK$ peg
and risk another round of competitive depreciations on the other
Asian regional currencies.
In addition we have been identifying the risks to the global
economic agenda were the Asian crisis to enter this new and
dangerous phase. Policymakers outside Asia have been too
slow to react to the potential risks to their previously robust
growth paths and booming asset markets. In this research
note we assess the policy reaction function of these policymakers
- in particular to the now key variable of USD/JPY. In
addition we assess the flexibility of G7 fiscal and monetary
policy to cushion the impact of this next Future Shock.
G7 policymakers are acutely aware that the final quarters of
1998 could be more turbulent than even the dramatic events of
1997. Four key risks are evident in discussions
1) USD/JPY: Critical as a bellwether of confidence in
Japan, but also as a potential catalyst to ignite remaining
global imbalances. G2 policymakers understand the
imperative of avoiding a further slide in the JPY, but now feel
that 'determined' FX intervention on USD/JPY rather than singular
intervention alone can only achieve this. The sense
is that this is required to also inject some stability in Asia
and in turn buy some time while other fires are put out.
2) China and HK$: High level monetary officials reveal
that the consensus among policymakers is that the HK$ and yuan
are highly overvalued on a real exchange rate basis and risk
a major market-driven test. If economic fundamentals
ultimately drive market prices, then these adjustments will
occur. The only question is when; to what degree and with what
ramifications. IDEA believes that the HK$ peg will be abandoned
and floated. Given the relatively superior fundamentals
of HK to other Asian economies we would expect a fall in the
HK$ comparable to that of the Sin$ that since Q2 1997 has seen
a 30-40% decline producing a rate of approximately 10 to the
$ versus 7.75 now. In the meantime, international support
for the JPY could buy time to delay the adjustments until a
less unstable global period.
3) Equities/Other asset-market bubbles: Fears are growing
amongst policymakers that the remaining global imbalances together
with the deleveraging of private liquidity that has swept global
capital markets over the last 18 months, could not only trigger
a hefty correction but also a more prolonged bear market.
Coming at a time when equities are providing a major boost to
US growth, it risks a hard landing. Our understanding
of the Fed policy equation suggests that a further 10% decline
in the US equity market would trigger Fed easing.
4) Emerging-market dominoes: Russia is merely a symptom
of the left hand swing in financial markets towards risk aversion.
The remaining risk is that the gap in private funding could
force a crisis in LATAM countries, which would require an official
US response. An event that US policymakers would want
Rarely have policymakers been challenged by or reacted to
so many major problems simultaneously. Just
as the three-ball juggler faces the difficulty of suddenly keeping
four balls in the air, the danger is that global policymakers
will fumble when attempting to meet one of the above-mentioned
challenges. Such a worst case outcome has significant
market consequences, especially as US policy credibility is
currently riding so high. A lame duck Clinton; a
restrained IMF; and a growing realisation of the imbalances
in the US economy could leave the US Treasury and policymakers
unable to cope with the above problems. In this paper we look
at these risks in greater detail and identify the best and worst
1. DLR/YEN: This rate could climb fast towards
155-60, in a 'benign neglect' environment, or slowly, perhaps
after a bout of sustained intervention, towards 155 - driven
by continued attraction of international returns for Japanese
savers, and the resulting cheap financing the yen provides for
global borrowers. .
2. US-European equities: Vulnerable - in any scenario.
Failure by policymakers to smooth risks could see bubble bursting
and Dow Jones at 7000.
3. Emerging markets: All at risk, policy arrangements
in core markets like Russia, Brazil and Argentina could be swept
away in the event of a China/HK crisis. Policymakers can only
provide cushions of support.
4. DLR/DM: We expect this rate to trend towards 1.60
this year, as US markets are more vulnerable and as it become
apparent to the financial markets that the ECB starts to build
monetary credibility for the EURO with a tightening in January
BEHIND THE CURVE?
Global financial markets have had several reminders over
the past months that Asia does matter. Starting in October
of last year, the contagion from the Asian crisis has prompted
asset market mark-downs in the early part of January this year,
again in early-to- mid June, and once more in August. But
despite the increasing frequency of these global bear phases,
the impression remains that the world's most influential policymakers
remain a little behind the curve in reacting to the true scale
and duration of the Asian crisis, and quite how far and how
fast the influence of this crisis can spread.
THE WORLD'S REPONSE TO ASIA SO FAR
Of course it would not be fair to say that the world's major
powers have merely left Asia dangling in the wind. G7 can
point to an unprecedented spate of huge IMF rescue packages,
(Korea and Indonesia most notably). International creditors
are also now conceding the reality that many of their exposures
into a now recession-bound Asia must be forgiven and/or rescheduled.
But so far, these efforts have not put a floor under the Asian
economies. Indeed it could be alleged that the rigid policy
environment enforced by the IMF has helped to exacerbate the
very latest phase of the region's problems. On this, it is clear
that following on from the extreme financial market crises of
H2 97, we have moved into a fundamental macroeconomic shakeout
across Asia which has further undercut asset prices. This has
lengthened the whole business of full recovery into a multiyear
process. Given the structural shakeouts that are required across
Asia's corporate and banking sectors, an upturn in Asia was
perhaps never going to be as simple as devaluations followed
by export-led recoveries. All this said however, it is clearly
not helping the region that:
1) The key engine of Japanese growth is spluttering
alarmingly amidst a stagnation of political and economic reform
2) There is a seeming willingness to accept or propagate
a weak yen, even when this threatens to cause the Asian crisis
to enter a new and dangerous phase involving a depreciation
of the Chinese yuan and de-pegging of the HK$.
PATH TO GLOBAL DEFLATION?
On these points, global financial market leadership seems
to be lacking and the negative consequences of this could be
immense. Increasingly, it is easy to trace a path starting
with a multimonth depreciation trend on the yen and ending in
a large chunk being taken out of global GDP and maybe the beginnings
of a hugely damaging deflationary trend.
Put very simply, a persistently weak yen trajectory has the
Eroding China's no depreciation/no devaluation pledge on
A renewed round of competitive devaluations in Asia.
(Remember that the large de facto Chinese yuan devaluation at
the start of 1994 has been blamed by many as sowing the seeds
of the Asian currency contagion, which spread from Thailand
in July of last year). Another spate of Asian currency weakness
but this time sparked by China, would likely be more 'inclusive'
dragging down the likes of the HK$ and previous outperformers
like the Indian rupee and Taiwan dollar.
More feedthrough into other Emerging Market regions and
perhaps fatal attacks on key policy anchors like the Russian
rouble, Brazilian real, and Argentine peso (all currency
board arrangements under threat following any HK$ depegging.).
A further diminution of global growth prospects, and in
the US, another round of debilitating earnings revisions on
Wall St. The latter would threaten to turn the ongoing correction
here into a deeper rout, and in combination with extreme volatility
on the Hang Seng would threaten to trip up recently outperforming
large cap European bourses.
Very clear effects on global growth. In the US it already
appears that we are heading towards a slowdown in the underlying
growth impetus in the 2nd half as the impact of an already expensive
dollar, robust domestic wage trends and slowing major export
markets eat into corporate performance. The dip in activity
threatens to be exacerbated of course were all this to be accompanied
by a major deleveraging on Wall St, which is after all is still
showing around 60% gains in a little over 2 years. With
the household sector exposed to US financial markets like
never before, a Dow Jones setback to say the 7000 level would
have very marked effects on US economic performance. Given
the present raft of disinflationary pressures, the addition
of a sharp asset market correction could easily set in train
some very definite deflationary trends. The US consumer
in particular could quickly shut off the spending tap, as it
switches from funding consumption out of perceived wealth to
managing the recent built up in borrowing and exceeds model-based
estimates that a 20% stock market falls knocks 1% off PCE growth.
In a similar vein, corporate earnings growth could turn negative,
undermining the return on investment and prompting a setback
to the investment cycle (the high level of investment/GDP after
many years of strong investment growth is also an imbalance
in the economy that economists have been ignoring). As these
effects spread back into Asia (cheap exports with nowhere to
go), and start to undercut the momentum of European growth,
we could easily be facing the grim reality of 1% or more off
global growth starting in the next 6 months.
SO HOW CLOSE ARE WE TO THE DOOMSDAY SCENARIO?
CHINA PLAYING BALL FOR NOW....
As suggested above, the loose thread that could start to
unravel global economic prosperity is the Japanese yen. Two
weeks ago, we seemed to be on the brink of this unfortunate
chain reaction as China started to send out signals that they
are hugely dissatisfied about the falling yen. This saw:
i) PBoC governor Dai quoted as suggesting that a small
adjustment on the yuan is possible under certain circumstances
ii) The Chinese central bank withdrawing from the local
forex market, seeing CNY trade intraday to 8.2850 and fixed
through the 8.28 level for the first time since November 1997.
Increasingly, the market is coming round to the view that
some sort of deal was cooked up by US-China-Japan two weekends
ago (Notably, Japanese Foreign Minister Komura visited Beijing).
Under this, the Chinese may have agreed not to shift their currency
policy in response to a weaker yen - at least not for now. Certainly
there has been a marked change in PBoC since this time, with
the PBoC deputy governor apparently contradicting his boss and
ruling out even minor yuan adjustments. On top of this,
we hear that China is considering lowering its GDP growth target
a touch, which would seem to indicate a willingness to keep
CNY stable for a little while longer. Still however this
is a high risk strategy, even in the absence of n-t yuan devaluation
risks. The symbolic damage of relatively small scale yen losses
retain the power to cause 'disproportionate' financial market
reactions in Asia and elsewhere. In addition, it is quite clear
now that China's no devaluation pledge has some very specific
......BUT NOT FOR LONG
China may be willing to play the responsible role for now,
but the pledge to keep the yuan stable won't last for too much
longer especially if Beijing perceives that there is a deficit
in global leadership when it comes to reasserting control over
CHINA IS SLOWING
A DEFICIT IN GLOBAL LEADERSHIP?
It has been IDEA's view since late 1997 that China's macroeonomy
was heading towards a sharp enough growth slowdown to have Beijing
rethink their pledge on the yuan. It needs to be understood
quite how politically sensitive it is for China to meet their
GDP growth targets. It is thought for example that given underlying
demographic patterns, China needs 6% growth merely to stand
still. H1 trends suggest however that even this number - let
alone the official 8% target -- will be undershot. Jan-Jun saw
a 7% y/y GDP expansion, a slowdown trend likely to be exacerbated
in H2 by: impact of historically bad flooding; steady deterioration
of export dynamism as the Yuan gets ever more expensive and
more key export markets slow; deepening deflationary pressures
within domestic demand as huge stockpiles and continued labour
shedding from within the state owned enterprise sector take
their toll. The Chinese are ever more reliant on (mostly government-driven)
gross fixed capital formation - now targeted to grow 20% this
year to meet that 8% GDP growth number. Locally there is a growing
realisation that a change in yuan policy is coming - in the
last weeks the black market $/yuan rate has been quoted as strong
as 9.2. In addition, Chinese corporates are reportedly budgeting
for a weaker currency in their financial projections out to
end Q199. Finally, the trend on PBoC fx reserves holdings has
been flat so far this year as exporters have kept hold of their
A useful focus for US/Japan policy would actually be measures
which help shore up Chinese performance and forestall damaging
yuan weakness. This will certainly need to include the maintenance
of a liberal trade stance, but even more importantly, a real
push to get Japan growing again and to stop the yen from falling.
Unfortunately though, there are plenty of reasons why this may
i) Political drift in Japan. Economic reality
is little guide to a shift in political action in Japan on the
economic policy front, as politicians are slowed by the headwinds
of consensus politics; restrained by the inexperience of current
officials in the wake of numerous scandals; cushioned by Japan's
large net creditor position and restrained by the long-term
desire to avoid a government debt spiral in light of the rapidly
ageing Japanese population. In terms of any future
net fiscal policy changes, it restricts the magnitude and timing
of announcement/ implementation of stimulative measures (we
prefer public works measures given the better relationship with
GDP in the short-term, which is more important than the long-term
GDP merits of expenditure increases versus tax cuts).
It will be late autumn before the next fiscal policy package
is unveiled and then potentially only in the wake of a domestic
banking crisis along the lines of last November.
Additionally, the close relationship between the LDP and business
still restricts the implementation of a more rapid and painful
cleanup of the banking system. With only limited
movement on interest rates but a neutral to easier bias, it
still provides one reason why some Japanese policymakers will
not fight too hard too support the JPY.
ii) Political vacuum in the US. With President
Clinton having made his historic testimony to the Grand Jury,
suggestions are that the independent prosecutor will have enough
incriminating evidence in this sex and perjury case to allow
Congress to start impeachment proceedings. The word from Republican
strategists is that they will not pursue this ultimate sanction,
and will be satisfied that even without impeachment, the Clinton
White House will lie in tatters. (The GOP fear a scenario where
an impeached Clinton is replaced by a resurgent Al Gore who
then goes on to score an easy election victory in 2000). What
we could be left with then is a lame duck Presidency likely
to concede ground to the Republicans on Capitol Hill. The end
result could be a more inward looking policy. (It may for example
have a significant effect on the presently gridlocked bill that
is targeted to increase US contributions to currently depleted
IMF funds via the New Agreements to Borrow). The risk that the
US takes a step back from its global economic responsibilities
would be even greater if - according to street talk we have
heard - Treasury secretary Robert Rubin has been contemplating
leaving office in the near term.
These are the precise conditions which could spark a gross
miscalculation on the Japan-China axis. Risk under these conditions
would be to see $/yen escaping sharply up through 160, prompting
China to throw in the towel and setting off the above-mentioned
sequence across global markets.
DELAYING THE INEVITABLE HAS CLEAR ADVANTAGES
Were US and Japan able to shackle dlr/yen, we feel that a China
policy adjustment and a depegging of the HK$ can be delayed
until early 1999. That these policy moves in North Asia will
still be made, suggests that we must retain concerns about renewed
volatility in Asia, and knock-on effects into other core Emerging
Markets. Thus we continue to warn about global growth slowdown.
However, it is certainly better that these adjustments are delayed
until next year rather than being frontloaded into the second
half of 1998. By this time, the very worst of the macro deterioration
should be over in Asia while another chunk of reforms will have
been kick-started. Additionally we can hope that by this juncture
that the impact of tax cuts/bank reforms will have started to
tell on the Japanese economy, and that more of the froth will
have been knocked off Wall St. Unfortunately, it seems
that the political environment in the US and Japan restricts
effective joint intervention activity and sufficient fiscal
policy stimulation to prompt a recovery to modest growth for
Japan and a stabilisation/ rebound in the JPY. Thus
the risk grows for a Domesday scenario. What can policymakers
do to avoid a vicious spiral ?
SAVING THE WORLD:G7 RATE CUTS AND FISCAL POLICY
While a 25% correction in the Dow and a 1% plus cut in global
growth is a dramatic shock, we could actually build a more bearish
picture. Asia has experienced at first hand
how major financial market reversals can fuel any adverse impact
on the economy, especially when it has been preceded by a phase
of asset price inflation. The US and European equity
markets could risk a large correction turning into a full scale
bear market, as valuations are undermined by the realisation
that the business cycle was not dead after all and that corporate
earnings could not be forecast with a greater degree of certainty
in the current era. The difference with Asia is
that US and European policymakers are likely to rely on an easing
in monetary policy and fiscal policy stimulation.
Central bankers in the US and Europe are aware of the
feedthrough of global contagion on their economies, which is
why interest rates have been but on hold despite growing wage
pressures in the US; the stimulative effect of low long-term
interest rates in both regions; wealth effects from higher asset
prices and cyclically low interest rates in core Europe.
Indeed, in the case of core European central banks this has
prompted a cancellation of the planned tightening.
Thus G7 central banks are effectively easing relative to
previous planned policy paths, it would not be a gigantic step
to actually cut interest rates in the aftermath of the simultaneous
occurrence of a deeper emerging market crisis/hefty equity market
correction in the US/Europe.
While much has been made of not repeating the policy
mistakes in the wake of the 1987 equity market crash, the same
scale of overheating/inflationary pressures are not evident
in the European/US economies. Moreover, Asian economies
were rebounding after the mid 1980's pause, in contrast to the
poor cyclical outlook over the next 6-12 months.
Add in the greater influence of equity markets on economies
due to the higher proportion of household wealth and you see
some of the reasons why central banks have already changed the
planned monetary policy trajectory in the wake of last year's
events. The scale of any future monetary policy easing
will depend not only on the scale of the knock-on effect from
emerging markets equities, but also the ramification on bond
yields/fiscal policy stance.
Fiscal policy in the US and Europe has received even
less attention than monetary policy easing in the worst case
situation. Nevertheless, the reality is that US
policymakers have a budget surplus to play with, but a political
reluctance to currently use the funds. However,
a substantive slowdown in late 98/early 99 would provide the
Democrats with the incentive to shift stance to sustain growth
towards the 2000 presidential race. While tactically the
GOP has the incentive not to break the budget deadlock, a lame
duck Clinton is still politically astute to include tax cuts
as part of any fiscal stimulus package to support the US economy
in the wake of an emerging market/equity crisis. Meanwhile,
September should confirm a socialist government in all major
European economies except Spain, which suggest an underlying
fiscal policy stimulation in such a crisis despite the post
EMU stability pact. It is more important for European
politicians to convince sceptical voters that EMU is working,
than to avoid the possibility of fines for excessive deficits
(the stability pact process allows governments to delay and
fudge moderate budget deficit overshoots of the 3% target).
Even so, outside of a major bear market in equities, the structural
change in fiscal policy may amount to no more than 0.5% of GDP,
which might slow the decline in bond yields or easing of interest
rates but not stop such action.
For bond yields, the question is how much has been discounted
already with respect to the worst case. Low nominal
bond yields could provide a misleading impression of what is
already discounted. A secular trend that has been
evident in the 1990's has been a reduction in real yields, as
disinflationary forces from the era after the fall of the Berlin
Wall had prompted a gradual assessment of what are appropriate
real yield levels, the risk of poor economic growth across the
globe could only reinforce this impression (parallels could
easily be drawn with the no inflation era at the end of the
last century rather than the low inflation era of the 1950's
as the historical model for bond market thinking). Add
in moderate disinflationary effects and nominal bond yields
do not appear to be fully discounting the worst. We can
see a further 30-50bps off 10yr bond yields in the worst case
situation and with fiscal policy stimulation.
FINANCIAL MARKET RAMIFICATIONS
Current rhetoric suggests concern among European central
bankers over the medium-term fiscal consolidation, never mind
an easing in fiscal policy that could threaten the stability
pact. Nevertheless, the important impact on monetary policy
formulations of a worse case situation suggests that these considerations
could be outweighed by the need to avoid a hard landing and
the disinflationary outlook, though a deterioration in the European
fiscal policy outlook could leave the ECB reluctant to make
an aggressive interest rate response. Acknowledgement
that the constructive tailwinds of 1998, and lack of cyclical
imbalances should also cushion the adverse impact on European
growth, should also restrain the ECB. However, the ECB's
need to set high credibility for the monetary policy supporting
the Euro necessarily means a current bias towards tightening
at the first opportunity in January 1999 - and very reluctant
acknowledgement of anything other than monetary indicators as
a basis for interest rates even in the worst case situation.
This stance could leave European markets move vulnerable in
a bearish asset price environment. The Fed's greatest priority
will be growth, but without the ECB fiscal credibility dilemma.
While easing maybe modest at first, the risk that any hefty
equity market correction could produce a larger than expected
swing in the consumption and investment cycles suggests that
Fed easing could be more substantive over the medium-term.
1. DLR/YEN: Intervention doesn't work to reverse a trend
while the macro underpinnings are absent, which is suggestive
of a continuation of the multimonth yen depreciation trend.
On a fundamental basis, this could easily reach 155-160 levels
by the autumn, before the worsening US c/acc position and the
fruits of this year's Y16trn Japanese fiscal stimulation start
to justify a reversal.
2. US Equities: We would be selling into any relief
rally on Wall St that could be provoked by a more static dlr/yen
trend over the next weeks. Earnings support for this market
is ebbing as the economy slows and maybe also as the political
environment worsens. The worst case situation of multiple risks
souring simultaneously hasten the index's reversal to the 7000
level. European equity markets leverage suggests
similar adjustments, despite a slightly better corporate earnings
outlook. Fed policy and 30-50bps off long-term rates
should avoid the hefty correction becoming a full scale bear
3. Emerging-market risk: IDEA believes that it is not
possible to start talking about the end to the Asian crisis
until we have seen a full shakeout across the region. We feel
that this will spread to include China and HK either in Q4 this
year or Q1 next, dependent on yen trajectory. This risk makes
us nervous going forward about emerging market exposures per
se with the recognition that policy arrangements in core markets
like Russia, Brazil and Argentina could be swept away in the
event of a China/HK crisis.
4. FED/ECB: Sinking equity markets pose more of
a risk to the US than Europe, given the greater exposure of
the consumer and investment cycles to the equity market and
this could lead to a more noticeable response in US than European
growth. Add in the enhanced net export drag and risks are for
mild growth at best, impact on commodity prices/labour demand
suggest rate cuts from the Fed.
5. DLR/DM: More aggressive Fed action, plus the risks
to the US economy, suggest an adverse reaction from the USD.
Though Russia has a large impact on Europe, this should be more
than outweighted in the medium-term by the impact on the US
of Asia/Latam. We can see Dollar-Mark trading toward 1.60 by
For information please contact John Davitte and Mike Gallagher
on 0171 430 2888, or Chris Turner on 212-571-4332 or Lindsay
Coburn on 65-332-0700.
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