With or without devaluation in China, with or without meaningful government stimulus and economic revival in Japan, one thing is clear. The economic and financial health of the many developing countries in Asia, Eastern Europe, and Latin America that have been infested by the Asian flu has deteriorated significantly. As a result, they will cease borrowing abroad for big national projects and instead scrounge for money to service their immense foreign debts, with or without IMF help. They will also slash imports from hard currency areas, due to the much higher costs in their devalued currency terms. They will cut imports from weak currency countries as well, as their economies stumble.

At the same time, these lands will emphasize exports, exports, and more exports as the only way to keep their citizens employed and earning precious hard currencies. The export advantages of 30%, 50%, and even 80% devaluations against the dollar will still be large after some offsets from higher domestic inflation. And most important, the sudden economic changes in Asia will have immense effects on the rest of the world. East Asia accounts for 27% of global output and 25% of exports, and cannot suffer these ongoing setbacks in isolation.

Like Mexico Initially

What lies ahead may be very like the immediate aftermath of the 1994 Mexican devaluation. That devaluation, too, went much further than officials thought possible, over 60% so far, and as in Asia, the first crack revealed many hidden problems. The Mexican economic collapse that followed also occurred despite the rapid and huge international bailout, $20 billion, largely financed by the US. Mexican imports collapsed overnight. Exports leaped but more gradually, not surprising since it takes time to crank up export production. Also, until the initial shock of the peso crisis subsided, many exporters, especially smaller ones, lacked the dollars needed to first import essential raw materials.

Similarly in Asia, imports have dropped like rocks, and some exporters cannot get financing for raw material and component imports. They cannot cut and sew the garments if they cannot pay for and import the cloth. But those are short-term problems. Developed country governments are working hard to insure that their goods keep flowing to Asia. The US and Australia are extending trade finance guarantees to their exporters in South Korea; Japan is doing the same with Indonesia, and other similar arrangements by Western countries are underway.

Already, South Korea's current account balance has swung to a $1.3 billion surplus in January 1998 from a $3.5 billion year-earlier deficit. And the swing was much greater in won, of course, which nose-dived against the dollar in that time period. Exports are also leaping in Malaysia and Thailand as imports plummet.

Global Glut

The net result is to add to already excessive global supplies of almost everything. US computer capacity has leaped in recent years and is now rising at a 40% annual rate, and China's big production of electronic products, scheduled to come on line next year, will add much more to the worldwide total. This will be further augmented by other Asian lands that already are heavy exporters of electronic products and want to export even more to offset weak domestic demand. Asian countries want to accelerate their shares of global exports, which have jumped in past decades. Unless other countries cut their production substantially, which is highly unlikely, excess capacity will leap.

Too Many Cars

In America, Japan, and Western Europe car sales are basically static as new cars are purchased mainly to replace junked vehicles. The world's automakers have been looking to the emerging markets of Asia and Latin America for their growth, and have made huge investments in production facilities in those areas. The US producers have invested heavily in Asia and Latin America, Japanese automakers in Asia, Western European automakers in Asia, and the North Korean automakers in Latin America and Eastern Europe. Asian production facilities are scheduled to add 6 million cars to capacity in the next five years. While worldwide supply is scheduled to increase to 80 million autos over the next five years, it's estimated that demand will only rise to 75% of that total, and that estimate was made before the Asian meltdown.

Before the crisis, South Korean auto production capacity was scheduled to reach 5.2 million in 2002. This would have been 1.9 million above domestic demand, so 1.9 million would have been destined for export. Now financial straits have forced Samsung Group and other South Korean auto makers to scale back capacity additions, but domestic demand has dropped even faster. It looks like capacity will exceed domestic sales by 2 million even earlier, in 1999. Japan produced 10.4 million vehicles last year, 3.3 million below capacity. India also has more capacity than is needed domestically. Toyota recently cut auto production in Thailand when local demand fell, but has since resumed operations with more locally made parts to avoid costly imports, and re-aimed output at exports. Other Japanese auto companies are doing the same elsewhere in Asia.

Excess capacity is, of course, a powerful deflationary force, and even more so when so much of it is in countries with devalued currencies. Where will all the goods and services that these developing countries desperately want to export end up? Obviously, not in their fellow sufferers. In 1996, the nine developing East Asian countries sold 40% of their exports among themselves. As that source of export demand drops, the pressure increases further to sell to the only remaining buyers -- Western developed countries, especially the US.

Furthermore, Japan remains part of the Asia problem, not the solution. Her domestic demand is lousy. Her instinct is to grow by exports, but her Asian markets are collapsing. Where do you think her export guns are trained?

Happy Dumping Ground

Without question, America is the happy dumping ground for the world's excess goods and services, the buyer of first and last resort. The US is running a merchandise excess of imports over exports of over $200 billion, while other countries, on balance, have an equal net surplus. China is at $45 billion and leaping, and Japan has the biggest, $116 billion. As the largest market in the world and one of the most open, the US is where the rest of the world comes to sell its surplus. Not surprisingly, Japan's trade surplus with the US is rising in lock-step with her declining surplus elsewhere.

But the US also exports, about 11% of all goods and services. Our goods exports to developing Asian countries account for 1.5% of total output, while Latin America takes an additional 1.3%. Even though the Asia crisis started only in mid 1997, the negative results are already apparent. Medical equipment exports to Asia were expected to grow 20% annually in the foreseeable future as countries there planned big hospital construction projects. Now, sales are lean and Asian buyers want price concessions that American producers cannot afford. Athletic footwear maker Nike has seen its Asian orders nosedive. US casino operators fret over the demise of big rolling Asian visitors. The fiscal tightening in Brazil is beginning to hurt US exporters as well and is spreading to Argentina and other Latin American countries where American exports were growing twice as fast as those to any other area.

US farmers are now free to plant as much as they like and have been counting on big exports to a booming class of middle income Asian consumers. Those hopes are gone as millers there switch to domestic tapioca from imported corn in some cases, and shrinking incomes curtail consumption of beef fed with imported corn.

Asian troubles affect Western American states most since over half their exports are bound for Asia -- compared to about 25% in the West North-Central and West South-Central states, and about 20% east of the Mississippi. On average, 2.4% of US gross state produce is exported to Asia, but for Washington state and Alaska, it is over 10%. Louisiana, Oregon, California, and Arizona are all in the 4.4% to 7.4% range.

Tourism-dominated Hawaii is already on the ropes. The weakening yen has kept many Hawaii-loving Japanese at home, and the length of stays of those who do come has fallen to 5.5 days from 6.5 in 1995. The effects have sped throughout the Hawaiian economy. In Oahu, existing home sales have dropped 55% since 1990, when the Japanese bubble economy burst, and prices are down 11%. And yet, the effects of the Asian collapse outside Japan are yet to be felt in the Aloha state.

Europe And Canada Are in the Same Boat

If you think that the Asian crisis is a much bigger problem for the US than other developed countries, think again. True, Asian lands send more of their exports to the US and Japan, but those are the globe's two biggest economies. Other developed countries get similar shares in relation to their GDP. Continental European countries tend to be more closed to Asian imports than the US, but they will end up with more goods coming in as prices drop.

And perhaps surprising to you, weakened exports to Asia will hurt European and Canadian economies about as much as America=s. Even more so in the case of Continental European countries, when you consider that in recent years they have depended on exports for about 100% of their total growth. The US exports 2.4% of GDP to Asia, but Western countries have similar involvement with 2.2% for German, 2.1% for the UK, Canada with 2.7%, Italy at 1.9%, and France with 1.4%. Conservative estimates have the Asian crisis cutting German GDP output 0.3% this year compared to 0.5% in the US as a result of more imports and fewer exports. These estimates may prove far too low.

Europe is already feeling the Asian crisis. Because of Asian weakness, German foreign orders have been falling since September 1997. European air traffic to Asia is on the wane as are sales of luxury European cars and Scotch whisky. South Korean conglomerates are postponing new factories in France and Scotland. Whether Europe, especially Continental countries, can absorb the impact of the Asian crisis and still continue their expansions is debatable, and those who expect European growth to offset Asian weakness may be sadly disappointed.

The Commodity Price Effect

Industrial commodities are traded on a global basis and are very price sensitive to demand. So, the weaknesses in Asian demand so far and that which is anticipated is pushing the prices of crude oil and many other commodities through the floor. Paper and pulp prices are sliding. US producers are shifting output previously sent to Asia to Europe, pushing down prices there. In sugar, big world production is meeting shrinking Asian demand head-on, and prices have gone off the top of the roller coaster.

As chemical demand in Asia falls, global prices are under heavy pressure. Furthermore, Asia has huge chemical capacity; much of it developed by European, Japanese, and US companies. Asian companies, desperate for cash, are dumping inventories and killing prices. Dupont was selling 90% of the output of a South Korean plant on the local market, but now with weak South Korean demand, it is exporting 40%. One-third of US chemical exports goes to Asia.

Even the global diamond market is affected by Asian troubles. In the second half of 1997, the DeBeers cartel suffered a 16% drop in sales due to weak demand in Japan and elsewhere in the region. And in Antwerp, the world=s leading diamond center, sales fell last year for the first time in two decades due to weak Asian demand for luxury goods.

Canada has been clobbered due to its Pacific exposure and high dependence on commodity exports. Our neighbor to the north is the world=s biggest exporter of construction-bound softwood lumber, with British Columbia accounting for 30% of global exports. Residential construction weakness, especially in Japan, knocked down prices about 30% last year and more of the same is likely. Mining accounts for 16% of Canadian exports, much more than most other developed countries, and the price declines of gold, lead, zinc, copper, etc., are devastating. It's no wonder that the Canadian dollar has hit its lowest level since it replaced pounds, shillings, and pence in 1858. I knew they were in trouble when they abandoned the "Shilling."

And, of course, Australia and New Zealand, due to their geographic locations, are hard hit by the Asian crisis. Asia takes two-thirds of Australian exports -- 60% of her coal and iron output is accounted for by exports, which are tumbling along with steel production in Japan and South Korea. Live cattle exports are also falling. Adding insult to injury, not only is the volumes but also the prices of diamonds, nickel, coal, and iron ore exports declining.

Falling commodity prices aren't confined to industrial raw materials. Global grain prices are down 20% to 30% since the Asian crisis started, to the detriment of big developing country exporters like Argentina, but also hurtful to the likes of Canada, Australia, and the US.

The Banks, Too

Europe exports not only goods but also money to Asia. German banks more than tripled their exposure from the end of 1993 to the middle of 1997 and, along with the French, have more exposure there than US banks. Deutsche Bank has set aside $773 million to cover Asian losses, Societe Generale earmarked $162 million, Dresdner Bank $55 million, and Commerzbank $492 million. Standard & Poors Ratings Group expect Asia's problems to cut the pretax earnings of 20 European banks by 75% this year. And, with loan defaults in Asia growing, the credit rating of Asian-debt laden European banks are being slashed.

And don't forget the losses, present and potential, for developed country firms that have made direct investments in Asian production facilities. Those investments don't get the press attention of sour bank loans, but they can suffer even bigger losses as both the demand for their output and the prices at which it can be sold drop. Then there are the Western investors who own Asian stocks and bonds at much higher prices. There losses in local currencies are bad enough, but excruciating when the devaluations in those currencies are also considered.

Asia may account for only a minority of the globes demand for raw materials, loans from Western banks, and sales by G-7 countries, but a big majority of expected worldwide growth in all of these areas. Earlier, few comprehended this completely. Only now is the reality becoming manifest through collapsing commodity prices, sour bank loans, and nosedives in the stock prices of companies suffering Asian setbacks, as it becomes clear that Asia has zipped from boom to bust.

Asian Recovery -- When?

To some degree recovery in Asia depends on the region's two heavyweights -- China and Japan. But even if China doesn't devalue and Japan promotes a speedy recovery, revival in the rest of Asia will take time. Perhaps a lot of time.

Many disagree. They note that rapidly developing countries periodically over expand, then suffer setbacks, but revive quickly. That happened in the US in the 19th century, in Japan in earlier postwar days, in Mexico and Brazil repeatedly, and in the original four Asian tigers -- Taiwan, South Korea, Hong Kong, and Singapore. Why not in Asia this time? Certainly, the legendary Asian work ethic and high saving habits will survive the current crisis. And if the IMF continues to bail out those countries and, indirectly, international banks and other foreign lenders and investors, why won't they go right back to supplying Asia with ample credit and play one more round of Heads I win, tails Western governments (read, taxpayers) make me whole? That happened in Mexico in 1982, 1986, and 1994.

Further, those who look for a quick recovery in Asia point to the fast rebound in Mexico after the 1994 peso collapse, which allowed that country to float bonds promptly and use the proceeds to repay US bailout money. Why not a repeat in Asia?

Mexico Is No Model

Indeed, some ventured back into Asia in early 1998, figuring the worst was over. Legendary global investor Sir John Templeton put money into South Korean stocks. Some mutual funds did the same in South Korea and Hong Kong. A trickle of foreign money returned to Asian bond markets, figuring on a quick revival that would rival Mexico's in the mid 1990s. So far, those investments have proved disastrous, and for good reason.

To begin, don't confuse Mexico with Asia's developing countries. Mexico's ultimate and not so secret weapon is her 2,000 mile border with the US. Whenever she gets into financial difficulty, all she needs to do to get American aid, and promptly, is to point out that an economic collapse south of the border will result in another million illegals heading north of the border each year.

No such border exists in Asia between developing countries and Japan, the only close-by advanced nation, which is, of course, a group of islands. Besides, the US, despite recent concerns over illegal immigrants, is populated by outsiders and has always had a soft spot for immigrants. In contrast, the Japanese have been traditionally suspicious of outsiders and quick to repel them. The first Europeans to reach Japan, usually shipwrecked sailors, were often killed on the beaches. Even today there is no such thing as an immigration visa in Japan, although foreign work permits do exist. About 99% of the population are of pure Japanese ancestry, and professional baseball teams there are each only permitted to have three foreign players.

Also, Mexico's recent recovery came in the midst of a robust expansion in the US, the major buyer of Mexican exports, as well as the trade liberalizations of NAFTA. When America grows, Mexico booms. Asian developing countries have no similar trade liberalization spur, and Japan, their biggest market, is reentering recession. Furthermore, the deflationary atmosphere we foresee will be a big change from the previous postwar era. Almost every country will have excess capacity, and growth through exports will be tough.

In addition, the 1994-95 tequila crisis was essentially isolated. Except for Argentina, no other country suffered any lasting effects. But Asia accounts for about a quarter of global output and the economics there are very interrelated, unlike Latin American countries until quite recently. And we've all seen how these interrelationships lead to domino-like behavior. South Korea may appear stabilized at present, but what if China devalues following the recent Russian devaluation and default on government debt? Singapore has been dragged down by Malaysia and Indonesia. Bear in mind that after the Latin American debt crisis of the 1980s, the whole region went into eclipse for a decadeCand that was during a period of strong growth elsewhere in the world.

Also, unlike Mexico, it seems unlikely that the IMF bailout of Asia will let foreign investors off Scot free, as was recently suggested when the IMF refused to throw more money into Russia to prevent devaluation. Congress is balking over further money for the IMF, and Administration leaders agree that lenders must pay for their risk taking. In Latin America foreign borrowing tends to be by governments, but in Asia it's by private enterprises that garner less international sympathy when financial rescues are needed.

Is Reform Welcome?

Finally, a major reason for rapid recovery in Mexico was rapid reform. Banks, telecommunications, and other key industries (but not petroleum) were privatized. Foreign competition was allowed in, and foreign ownership became possible. It's far from clear that Asian countries, including Japan, really have similar plans.

Most of these countries are semi-dictatorships, and if they really wanted financial reforms, they'd have instituted them long ago. But why should they? For years, their growth prospects were so mouth watering that foreigners showered them with money, while accepting opaque accounting, capricious or nonexisting financial regulation, severe limits on foreign ownership, nepotism, graft, corruption, and government guidance on investments and financing.

No wonder that these leaders regard the reforms required by IMF bailouts as offensive. And, of course, like all humans, they tend to blame their problems on others, embracing free global markets when they work in their favor, but pining for other systems, even regional self-sufficiency, when times are rough.

Prime Minister Mahathir of Malaysia blasted international investors last summer by saying, "We are not going to allow these people to manipulate our economy as if they have a right to have a free ride with us. My view is that this level of manipulation must be made illegal." Interesting words from a man whose country's growth has been largely fueled by foreign investment. I guess money coming in is fine, but money going out is evil. Maybe he hasn't a clue about free markets. Or, maybe he enjoyed letting off steam, but each outburst was lethal to Malaysian stocks and the ringgit. Furthermore, recent political, as opposed to market driven, mergers of troubled Malaysian companies suggest that "crony capitalism" remains alive and well.

Former Indonesia President Suharto said, "We have 30 years' experience in building a strong foundation. Then in six months it collapses, not because of an internal crisis but because there is manipulation of (our) currency." His comments cost the rupiah 25% of its value. And, despite promises to the IMF, Indonesia is dismantling cartels controlled by Suharto's family and friends in name only, and the promised removal of food subsidies has been delayed. A Senior Thai Official said, "The US has been a major proponent of liberalization and globalization for the past decade, and now the perception is that it is reaping greater benefit from it." The West, especially the US, has been branded as the bad guy.

South Korea, a financial basket case that is now completely at the mercy of the IMF, is antagonistic. Students there have protested against the US and the " "humiliating" IMF agreement. An array of matronly women, South Korea's anti-consumption league, has assailed imports and oversees travel. This is not surprising given their traditional hostility to outsiders, but don't we still have troops there protecting them from North Korea?

The new Hindu, nationalist-led government of India promises to continue free market reforms but also plans to limit foreign investment and be less accommodating on foreign trade agreements. It looks like the recent trend toward lower import tariffs will be stopped, if not reversed, and the nation will go back to ad hoc approval of foreign investments as opposed to clearly delineated guidelines.

In the final analysis, Asian countries can, to a considerable degree, blackmail the West. They have no Rio Grande to send millions of illegals across, but they can and do point out that without bailouts, their economies and financial systems will probably collapse completely and could very well take the West with them. This is a threat to be taken seriously. It's a mistake to assume that economic growth is at the top of those countries' leaders' agendas, as it is in America. Staying in power and alive probably ranks first, and amassing huge fortunes for their families and friends comes next.

But Some Reforms

Still, reforms are being made. Malaysia, under international pressure, has postponed some of her pet projects, including Linear City, which was to be the world's longest building, and a new international airport. Thailand is allowing foreigners to take bigger stakes in local banks and has lifted most currency restrictions on foreigners.

The door to foreign ownership in Asia is opening, slowly, as it's becoming clear that foreign capital is no longer available with no preconditions. Similarly, accounting standards are improving and financial statements are becoming more transparent in order to re-attract, they hope, foreign investors. Asian reforms are being made, but slowly and not by choice.

South Korea has agreed that foreign banks can buy South Korean banks, that the government will no longer direct bank loans into favored industries, and that South Korean firms will be permitted to borrow abroad. They have also agreed that insolvent merchant and commercial banks will be closed or merged, tariff-lowering commitments will be honored, and stock and bond markets will be opened to foreign investors. State-run companies will be privatized, trade subsidies will be eliminated, foreign ownership of South Korean firms will be allowed, and accounting standards on banks and conglomerates will be introduced.

Gee, I had no idea a country could have so many restrictions and still have the growth that South Korea has enjoyed. I guess that if a developing country is loaded with dedicated, hard-working people and a stable currency, it can grow rapidly because foreign investors will throw money at it under regulatory conditions that would be totally unacceptable elsewhere. Let=s see if South Korea honors these new agreements.

Newly elected President Kim has endorsed the IMF deal. He's also publicly stated that the cozy relationships between the South Korean government and the chaebols (family conglomerates) was partly responsible for the severity of the nation=s crisis and must be dismantled. Also, despite labor union opposition, he's backing measures to ease restrictions on layoffs, which are now almost impossible. As a result, monthly wages have risen four fold in the last decade and placed a heavy burden on South Korean firms. Still, Kim doesn't expect recovery from the financial crisis to start until the end of 1999. This may be an optimistic estimate for South Korea, much more so for other Asian lands that have yet to assess their problems realistically, much less take steps to solve them.

The world has been on the verge of deflation, and the Asian crisis probably pushed it over the edge. The Asian drama, including Japan and China as key players, is still on stage. Even if the play has reached its low point, it is unlikely to revive fast enough to prevent severe consequences elsewhere. And if a region that accounts for a quarter of the worlds output and trade and a majority of its expected growth is in trouble, the world is in trouble.

* * * * * * * *

1 September 1998

Excerpt from:

"Deflation: Why it's coming, whether it's good or bad, and how it will affect your investments, business, and personal affairs."

By Dr. A. Gary Shilling

Deflation is available through Lakeview Publishing Company,
1-888-346-7444 or through A. Gary Shilling & Company,
e-mail: shil@ix.netcom.com