prudent investor newsletters: Ignoring the Risks of an Asian Crisis and the Bang Moment

The consensus has spoken, there will be no Asian crisis.

The common denominator of their defense: huge international currency reserves.

While I agree that rich foreign currency reserves may reduce the risks of a crisis, as previously pointed out, these reserves must not be treated as a “get out of jail” or free passes for more bubble policies.

Second, a common mistake by the consensus is to anchor on the past. Their general focus has been on the risks of a currency crisis. They have ignored the risks of other forms of crisis such as banking crisis or sovereign debt default.

The Foreign Exchange Reserve Myth

The above chart reveals of Japan’s foreign exchange reserves today and in 1990. During the pre-bubble era, Japan’s reserves jumped to $100 billion. Japan’s asset boom was even given a boom day buzzword called “Japan Inc”, where many ‘revisionist experts’ argued that Japan’s state capitalism would lead her to overtake the US[1]. Unfortunately these experts failed to see that artificial booms eventually unravel. The banking crisis of 1990s, an offshoot to the bursting bubble, put a kibosh on the phony Japan Inc. boom.

During the halcyon days, Japan’s external position as earlier noted seemed strong embellished by current account surpluses, enormous net international investment position[2], huge savings and low external debt. So who would have seen a bubble unless the theory of bubbles has been adequately comprehended?

By the time of the crisis, Japan’s forex reserves reached $80 billion (about current Philippine levels in nominal terms).

Fast forward today, as of August of 2013 Japan’s reserves have skyrocketed to US$1.254 trillion[3].

Here is Wikipedia description on Japan’s asset price bubbles of the 1980s[4], “The bubble episode has been characterized by rapid acceleration of asset prices, overheated economic activity as well as uncontrolled money supply and credit expansion”

Has huge forex reserves been a factor in preventing crisis? Again from Wikipedia

By August 1990, stock price has plummeted to half the peak by the time of fifth monetary tightening by Bank of Japan (also known as BOJ) The asset price began to fall by late 1991 and the asset price officially collapsed in the early 1992. Consequently, the bubble's subsequent collapse lasted for more than a decade with asset price plummeted resulting a huge accumulation of non-performing assets loan (NPL) and consequently difficulties to many financial institutions. Such Japanese asset price bubble contributed to what some refer to as the Lost Decade.

This is what the lost decade looks like. Japan’s asset bubbles crumbled when domestic credit shrank[5] (lower bottom). The lost decade also saw Japan’s statistical economy popping in and out of recessions.

Ironically today’s Japan’s aggressive monetary experiment called “Abenomics” where the monetary base has been targeted to double in two years represents one of the many similar attempts to resolve on the carryover or the lingering malaise from the 1990 bubble bust.

Nevertheless Japan’s massive decline in private sector credit has been replaced by a massive quadrillion yen[6] worth of government debt. This comes amidst a colossal stockpile of forex reserves. Will Japan’s giant reserves prevent a government debt default? We shall soon see.

So Japan’s experience shows that having massive forex reserves hardly serves as a guarantee against a crisis.

The Bang Moment

There’s more. The impression peddled by the mainstream is that a country with supposedly strong fundamentals would translate to immunization from a crisis.

It’s sad to see how people use backward looking data to forecasts on forward looking markets. Such type of mistaking forest for trees analysis can lead to big frustrations.

Now even the IMF seems to understand this (bold mine)[7]:

Policy makers should allow exchange rates to respond to changing fundamentals but may need to guard against risks of disorderly adjustment, including through intervention to smooth excessive volatility

I am not saying that I agree with the policy recommendation I am saying that IMF recognizes that current market prices have reflecting on changing fundamentals something which the mainstream refuses to acknowledge.

A more important factor is that crises tend to flow from periphery to the core.

Writing at the New York Times, MIT Professor and former IMF chief economist Simon Johnson[8] (bold mine)

In 1982, higher interest rates in the United States raised borrowing costs for Mexico and other emerging markets, contributing to the onset of what became known as the Latin American debt crisis and, for many of the affected, a “lost decade.” And in early 1997 the United States was also tightening monetary policy. Sometimes small changes in global funding can have big consequences on emerging markets.

Mr Johnson further describes on the contagion effects which is usually regional of nature.

Most financial crises begin with one weak country and then spread as investors re-evaluate prospects more broadly. The 1982 “developing country debt” crisis was brought on initially in Mexico, and the financial unraveling of Asia in 1997 started with Thailand. Greece was supposed to be an isolated case in early 2010, but then pressure followed on Ireland, Portugal, Spain and Italy.

While Mr. Johnson sees no imminent emerging crisis he warns the public not to dismiss or ignore them.

The difference between then and today is that the bond market seems as saying that current dynamics hasn’t been sourced from the US only as the bond vigilantes has gone global.

Crises have always been an ex-post reckoning: we never know they exist until the bang moment.

Harvard’s dynamic duo of Professors Carmen Reinhart and Kenneth Rogoff describes the bang moment[9], (bold mine)

Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence – especially in cases in which large short-term debts need to be rolled over continuously – is the key factor that gives rise to the this-time-is-different syndrome.

Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang – confidence collapses, lenders disappear, and a crisis hits.

Economic theory tells us that it is precisely the fickle nature of confidence, including its dependence on the public's expectation of future events, which makes it so difficult to predict the timing of debt crises. High debt levels lead, in many mathematical economics models, to "multiple equilibria" in which the debt level might be sustained – or might not be.

Economists do not have a terribly good idea of what kinds of events shift confidence and of how to concretely assess confidence vulnerability. What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fueled asset price explosions seem too good to be true, they probably are. But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite."

The bang moment has always been a product of an accretion of a series of events.

It is easy to dismiss the risks of a crisis, but when one sees crashing markets on multiple fronts and on a regional scale, we understand that such signs as reversal of confidences that have real economic consequences.

In other words, for me, recent market actions seem to have already set in motion real world dynamics that risks evolving into a full blown crisis

Take for instance signs of the real world impact from the recent market crash on Asia

From Wall Street Journal[10]: (bold mine)

Companies in exposed parts of Asia are facing a debt-repayment crunch as plunging local currencies make it more costly to repay foreign loans, a situation that is exacerbating stresses on the region's economies.

Asian companies took out sizable foreign loans in recent years as the U.S. Federal Reserve kept interest rates low and printed money. For companies in nations like India and Indonesia, rates on U.S.-denominated debt were more attractive than local borrowing costs…

The situation in India is notable. Indian companies have a combined $100 billion of unhedged foreign debt, according to data from Indian ratings firm Crisil, an affiliate of Standard & Poor's. A nearly 18.5% fall in the rupee since May has increased the cost of repaying those debts in local currency terms.

The article further notes that the huge ASEAN reserves seen in the context of current account and short term external debt or foreign exchange cover may not warrant the region’s perceived impregnability from a crisis. Bubbles in the ASEAN region has led to a sharp deterioration of reserve cover.

Another example: Indian banks have reportedly been taking a big hit, from the Financial Times[11]

Fears are rising for the health of India’s banking system as slowing economic growth and rapid currency depreciation threaten to worsen asset quality and reduce demand for bank credit from large industrial companies.

Non-performing and restructured loan levels in Asia’s third-largest economy have risen steadily over the past year to stand at about 9 per cent of assets and could reach 15.5 per cent over the next two years, according to Morgan Stanley.

A combination of weaker growth, waning business confidence and RBI measures to support the rupee will further dent asset quality, analysts say, in particular as some of the larger industrial companies struggle to repay loans.

So if market pressures in India will be sustained and if the banking system gets hit, then a no-crisis can easily morph into a crisis.

Bear Market Slows Philippine Loan Activities

The recent market crash have begun to impact on loan activities of the Philippine banking system

Loans on production activity has been on a decline since May, based on the year on year change per month—data from the BSP[12].

The biggest impact has been in the financial intermediation where growth seemed to have hit the wall. The slowdown in loan growth will impact the pace of statistical economic growth of the service sector.

Lending to the Hotel and restaurant sector fell dramatically.

Loans to the real estate renting and other businesses dropped below the 20% level. This will partly impact construction related activities in the statistical economy.

Loans to the trading sector and construction activity (perhaps public construction) has partly offset these declines.

If the July trend will be sustained then we will likely see a modest slowdown by the 3^rd quarter. There are two months to go for the statistical data to be completed.

And if the July trend worsens, then statiscal growth likely post a bigger than expected slowdown.

The BSP reformatted their statistical treatment of domestic liquidity[13], nonetheless they report that the strong M3 growth is a manifestation of expanding credit to the domestic sector

Finally while government statistics tend to dismiss the risk of domestic price inflation I suspect that the current brouhaha over rice price inflation[14] could be signs of a rotation from domestic asset bubble to price inflation or increased risks of a price inflation given the recent decline of the Peso.

Bottom line: Be Vigilant and Cautious

It will be hasty and reckless to dismiss the risks of a crisis merely out of forex reserves grounds.

Market selloff represents fundamental changes. They are not based on mere sentiment or irrationality.

We must take vigil of the continuity and the intensity of volatility in the domestic markets, the damages or ramifications from the recent market crash, and importantly, the policy responses that may exacerbate or reduce the odds of a crisis.

Since the common trait of many crises has been one of regional contagion, then observing the ASEAN markets based on the above parameters may provide clues if a crisis, or if a recovery, is coming.

Conditions are so fluid and fragile for one to take on substantial risks.

[1] Brink Lindsey and Aaron Lukas Revisiting the “Revisionists”: The Rise and Fall of the Japanese Economic Model, Cato.org July 31, 1998

[2] See Phisix: Will Domestic Fundamentals Outweigh External Factors? August 12, 2013

[3] Tradingeconomics.com JAPAN FOREIGN EXCHANGE RESERVES

[4] Wikipedia.org Japanese asset price bubble

[5] Tradingeconomics.com DOMESTIC CREDIT TO PRIVATE SECTOR (% OF GDP) IN JAPAN

[6] See Japan’s Ponzi Finance: Public Debt Tops Quadrillion Yen Mark! August 10, 2013

[7] Reuters.com Exclusive: IMF sees emerging economies vulnerable to U.S. tapering September 4, 2013

[8] Simon Johnson The Next Emerging Market Crisis New York Times Blog September 4, 2013

[9] Carmen Reinhart and Kenneth Rogoff This Time is Different MAULDIN: The 'Bang!' Moment Is Here Businessinsider.com

[10] Wall Street Journal Plunging Currencies Crimp Asian Companies (bold mine)

[11] Financial Times, India crisis threatens big hit on banks September 4, 2013