Currency Chaos and Financial Collapse
To understand the world financial situation is to understand the difference between reality and illusions of reality. It is to understand that the basis of all financial failures is the inability to pay debt. Debt is repaid from income or profits. When income or profits are insufficient to repay debts, default occurs. Occasionally, new debts are provided to repay old debts, but this will only increase total debts and future losses.
Since 1990, the world has witnessed a large economic expansion in the U.S., and explosive growth in South East Asia and China. Within Japan, short term interest rates were decreased to 0.5% and the government initiated the largest fiscal stimulus program the world has ever seen. Has anyone questioned why the second largest economy in the world, with all of its major trading partners having sustained growth, with the lowest interest rates the world has ever seen, with the largest fiscal stimulus package the world has ever seen, has not grown and now the economy is contracting at an annual rate exceeding 11%?
To begin to answer this question, one must return to pre-bubble Japan, when the Nikkei was near 40,000 when land values at Ohtemachi and Toranomon in central Tokyo would have bought all of Canada or all of California, and when Tokyo was worth more than the United States. On the basis of these valuations, trillions of dollars were lent by the Japanese Banks, making them some of the largest corporations in the world. These loans were not supported by the income of the borrowers, but by the assets they pledged for security. Today, the Nikkei is below 16,500 and dropping, and commercial land prices are down 70% and dropping. The loans are still outstanding, but with borrowers unable to repay loans from income and realizable asset values far below loan values, these loans remain on the books as the losses, and most likely far exceed the banks capital. The size of total losses is unknown. However, during November/95, Japan's finance ministry announced that non recoverable loans at the Osaka based Kizu credit co-operative were 960 billion yen representing more than 70% of total loans. A further 230 billion yen were thought to be doubtful leaving less than 10% of Kizu's loans as performing assets. Does this tell us anything about how the balance sheets of the large banks really look? The loss of net worth represented by the collapse of the Japanese stock and real estate markets represents many trillions of U.S. dollars. At the height of the bubble, Japanese land values were estimated to be between 16 to 20 trillion U.S. dollars. A 70% decline represents a $11 to $14 trillion dollar loss in the real estate market alone. When the banks start selling real estate to repay bank loans, look for the market to drop even further. Add this to the losses totaling trillions of U.S. dollars on the stock market and the potential loss exposure of the Japanese banks is staggering. When the bubble in Japan burst and banks were facing massive loan losses and negative growth prospects, a new source of revenue had to be found. This led to a large increase in lending to South East Asia which helped fuel a bubble in these economies. In addition, exposure to derivatives increased to trillions of dollars.
When the Japanese bubble burst, the Japanese government began a series of fiscal and monetary stimulation to get the economy restarted. Total government debt rose to between 87% to 89% of GNP at the end of 1996 and could be as high as 97% of GNP by the end of 1997. The government budget deficit has been running over 7% of GNP. Significantly, despite record low interest rates, interest payments now absorb over 60% of total tax revenue. In addition, their is Japan's Fiscal Investment and Loan Program, a system that draws money from public pension and postal-savings systems and lends to 57 government agencies. Total borrowings are about 374 trillion yen, and when combined with official borrowings could see Japan's debt inflate to 150% of GNP.
Japan's life-insurance industry reportably holds 25% of the U.S. 12 trillion dollars in household savings. As highlighted by the failure of Nissan Mutual Life Insurance Co., his industry is also in need of a life line. When Nissan Mutual collapsed, liabilities exceeded assets to such a degree that the industry's entire 200 billion yen emergency reserve covered only 2/3 of the loss. These company's have promised returns as much as 5.5% while earning only 2.9% on investments in 1996. For 1997, with bond interest rates decreasing and the stock market declining, returns on investment will likely fall below 1996 levels. According to Standard & Poor's, the level at which hidden profits on stock holdings disappear are as follows:
|Company - Nikkei||Company - Nikkei|
Toho Life - 19327
Kyoei Life - 19006
Nippon Dantai - 18835
Chiyoda Life - 17876
Sumitomo Life - 17485
Mitsui Life - 17167
Dai-Ichi Life - 14948
Meiji Life - 13181
Nippon Life - 12894
Taiyo Life - 9757
Despite near invisible interest rates and huge fiscal stimulus programs, the Japanese economy continues to implode, contracting at a rate exceeding 11% in the last reported quarter. Problems will only increase with the financial turmoil in South East Asia where 44% of Japanese exports go. The question that no one dares ask is what does the Japanese government do? The economy is imploding, government direct and indirect debt is 150% of GDP, the government budget deficit is large and unsustainable, and the banks and life insurance companies appear to be insolvent and will need substantial capital infusions to remain viable. The answer is that the Japanese government cannot repay present loans and that borrowing additional funds to bail out the banks and insurance company's will only speed the road to bankruptcy. The banks are large holders of government debt, and while it could be argued that the government could borrow even more money from the banks and then turn around and give this money back to the banks to improve their equity positions, this simply amounts to transferring debt and does not address the central issue that neither the banks or the government are financially solvent. In fact we have the situation where an insolvent government is borrowing from insolvent banks who in turn rely on the backing on the insolvent government. Loans now far exceed the capacity of debt repayment, and compounding interest and an imploding economy will seal their fate. Basically, it is simple mathematics. How long will this continue? Like any bankrupt person, until the credit cards are cut off. It is important to realize that this will take much longer than in a normal commercial situation. Japanese banks must be willing purchasers of Japanese government bonds at all times, regardless of fundamentals. Should a government default on its debt, the value of its currency which reflects the credit of the government must approach zero. Currency is simply another unsecured promise to pay, and currency issued by a bankrupt government will have no value. Generally speaking, the bank's assets are financial (currency based) and will also fall to zero if the currency collapses. The banking and financial industries are dependent on a functioning government bond market. It is for this reason that governments which are insolvent can continue to borrow. For clarity, let me repeat the initial question.
Since 1990, the world has witnessed a large economic expansion in the U.S., and explosive growth in South East Asia and China. Within Japan, short term interest rates were decreased to .5% and the government initiated the largest fiscal stimulus program the world has ever seen. Has anyone questioned why the second largest economy in the world, with all of its major trading partners having sustained growth, with the lowest interest rates the world has ever seen, with the largest fiscal stimulus package the world has ever seen, has not grown and now the economy is contracting at an annual rate exceeding 11%? These are all conditions which over an extended period of time should produce explosive growth, especially in a country like Japan with a hard working, well educated population with a high level of national savings. The fact that they have not can only mean that debt levels are so high that they are consuming more than the country can produce. If unreported bad debts at Japanese banks were only say $500 billion U.S., over the last 7 years, the effect of world wide growth, 0.5% interest rates, and trillions of U.S. dollars spent on government stimulus programs would have easily solved the problem. The fact that none of these measures has solved the problem can only mean that bad debts are much larger than anyone realizes. Bad debts must total trillions of U.S. dollars.
Over the last several years South East Asia and China have expanded manufacturing capacity at a furious rate, much of this financed by debt. Over capacity is driving down prices, with Asia's export prices falling 4% over the last year. With recent currency depreciations, this trend will likely accelerate. Falling prices mean falling profit margins which further reduce debt payment capacity. Over capacity and high debt have now infected Japan's neighbors. In Korea, company after company has gone bankrupt, threatening the stability of the banks and possibly the entire country. In 1996, net profit at the 30 largest chaebols fell 90%. Due to the size of its economy, should the Korean won continue to fall, it will add to deflationary pressures within China and Japan.
Over capacity financed by debt leads to falling prices which leads to the bankruptcy of first the borrower and then the lender. Problems accelerate when banks make loans on overpriced real estate or for stock market speculation, as income from these assets is often only a fraction of debt service requirements. When the market revalues these assets based on their ability to generate cash flow, losses are huge. When these events occur in countries where governments have borrowed far beyond their capacity to repay, then bond markets and the value of the currency are destroyed.
In China, consumer price inflation is virtually zero, down from 24% three years ago. Japan, Indonesia and Vietnam are similar. Asset values, from real estate to stock markets are in a major deflation.
In the United States, during the last 3 to 4 years, foreigners have purchased over 2 trillion U.S. dollars in debt and shares. These funds have driven up the value of the U.S. dollar in spite of a large current account deficit. They have kept down the level of interest rates, driven the level of the stock exchange to new highs, and propelled the economy to strong growth. Price deflation in Asia and a strong U.S. dollar have kept inflation at a very low level. It has been the best of times for America. Some even call it a paradigm shift.
"In equity markets, continual upward revisions of longer term corporate earnings expectations have driven price-earnings ratios to levels not often observed at this stage of economic expansion"
"It is difficult to believe that our much higher than expected income tax receipts are unrelated to the huge increase in capital gains which, since 1995 have totaled the equivalent of one-third of national income"
"Today's Central Bankers have the capacity of creating or destroying unlimited supplies of money and credit."
"Clearly, how well we take our responsibilities in this modern world has profound implications for participants in financial markets."
These are all quotes from Mr. Greenspan, head of the U.S. Federal. Greenspan cannot tell us that Asia is insolvent and will collapse. He is giving us a warning that we must heed. Price deflation and a collapsing economy in Asia will decrease U.S. corporate profits. Lower profits and a lower price to earnings multiple will significantly reduce the level of the U.S. stock markets. The U.S. budget deficit has decreased because of capital gains taxes. When people report capital losses, the budget deficit will balloon.
The U.S. is the largest debtor in the world, much of it owned by foreigners. They have the largest current account deficit in the world. These factors have caused major financial problems for every country where they have existed. When the Japanese are forced to sell U.S. Treasury debt, it will cause a panic in the treasuries which will sharply increase U.S. interest rates. In addition to other factors already mentioned, higher interest rates will accelerate falling U.S. corporate profits, will accelerate the drop in the U.S. stock market and will accelerate a move to a much higher U.S. government budget deficit. When foreigners sell treasury's, Americans must buy them, which will take money out of other economic activities. Future government budget deficits will have to be financed by Americans, and Americans may find that they may not be able to run large current account deficits. When Americas banker goes broke, we may see another paradigm shift.
The problems of large debt levels in a deflating economy are very real. Deflation reduces both income and asset values, which leads to the bankruptcy of both borrowers and lenders. Japan has been deflating for the last 7 years. With the rest of Asia also deflating, deflation in Japan can only continue.
Japanese households have about U.S. $12 trillion in savings. The banks have gambled these funds on real estate and stock market speculation, and over-built manufacturing capacity. The government has spent it attempting to kick start the economy. Some day, everyone will realize that the real value of the assets backing these savings is only a small fraction of this U.S. $12 trillion dollars. Already, some of this money has moved to safer destinations like the United States. While the U.S. financial position is much better than Japan's, fundamentals are still very poor and will deteriorate rapidly when Japanese banks and insurance companies are forced to sell U.S. assets.
In 1997, the world wide demand for gold will be the highest in human history, and will far exceed mine production. Yet the price of gold has fallen to 12 year lows. As the world watches the first tremors to the world wide financial default, speculators are adding to huge short positions. Experts in the financial markets will tell you that gold has lost its monetary value and their is the continual threat of Central Bank selling. Central bankers in Australia and Switzerland claim that gold is no longer a suitable investment. Australia's actions appear totally unreasonable. Gold is a major employer and export earner for Australia. Even if it were true, why would you tell the world that it has little value? The funds obtained from the gold sale have now been lent to Thailand and Indonesia? Are loans to bail out bankrupt countries a more suitable investment than gold? Even the Swiss announcement appears to be more geared to lowering the price of gold than maximizing the price of an asset you may wish to sell. Gold has nothing to do with the trillions of dollars in bank loans outstanding that are not supported by either the income or assets of the borrower. It has nothing to do with the trillions of dollars in government bonds that are supported by no assets and which interest costs now take up large amounts of government tax receipts. The only thing holding world wide financial markets together is confidence. Confidence that governments and bankers will not let things get out of hand. Confidence that requires the price of gold to remain low.
Yet all of the confidence one can have does not change the fact that the direct and indirect liabilities of the Japanese government total about 150% of GNP, it does not change the fact that liabilities at Japanese banks and insurance company's likely exceed realizable assets by trillions of U.S. dollars ,it does not change the fact that the Japanese economy is contracting, and does not change the fact that Japan and Asia are deflating at an accelerating rate. Some may say these problems are manageable. I would only ask, "How"? In the end, finance comes down to simple mathematics, nothing more nothing less.
17 November 1997