Research paper No: 14, August 21, 1998

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.

Summary

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 with policymakers:

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 to avoid.

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 case outcomes.

Market ramifications

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 1999.
 

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 in Tokyo.

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 effect of...........

Eroding China's no depreciation/no devaluation pledge on the yuan

Leading to.............

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.

Leading to.............

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.).

Leading to............

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.

Leading to...........

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 time limits.

......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 dlr/yen.

CHINA IS SLOWING
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 dlr earnings.
 

A DEFICIT IN GLOBAL LEADERSHIP?

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 not happen.

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.
 
  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.
 

FINANCIAL MARKET RAMIFICATIONS

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 market.

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 year end.

 
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.

I.D.E.A. obtains information for its analysis from sources it considers reliable but does not guarantee its accuracy or completeness. All conditions warranties and representations expressed or implied by statute common law or otherwise are excluded and in no event shall I.D.E.A. be liable for any loss or damage (whether direct or consequential, foreseen or unforeseen).  I.D.E.A.'s products are supplied on I.D.E.A.'s standard terms and conditions, a copy of which can be supplied on request.

© I.D.E.A.   1998