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Economic Collapse vs Economic Destruction

January 29, 1998

As economies continue to implode, world leadership continues to show a total misunderstanding of financial dynamics. Policy is to treat current events in Asia as a crisis of currencies and banks to be solved by an increase in debt and liquidity.


It fails to realize that the real problem is
too much debt and too little profit by corporations, governments, and individuals. It is this problem (too much debt and too little profit) that causes first a banking and then a currency crisis.

In a market plagued by over capacity and falling demand, profits can only be restored by the elimination of capacity. Instead, we see governments and banks propping up insolvent companies, who continue to undercut prices, *thus seriously weakening stronger companies.

Governments, with their high taxes and large deficits continue to take large sums out of the economy, making the financial condition of companies and individuals more difficult. It is totally ironic that what much of the world calls wealth is the accumulation of these government losses (budget deficits).

The key to understanding the internal dynamics in Japan is to understand what is happening to Japanese banks. By some accounts, Japanese banks have written off about U.S.$300 billion in bad loans over the last few years. In addition, the Japanese government has advised that remaining problem loans are Y79 trillion, up about 3 1/2 times estimates of only a few months ago. Actual problem loans likely far exceed this total with government only releasing information it deems necessary to meet its objectives. In this case, to justify a major injection into the banking system, it had to raise bad debt estimates.

Japanese banks are now finding that their ability to lend is very restrictive. Firstly, actual write-offs have reduced their capital base by $300 billion over the last few years, with additional write-offs likely to far exceed this in the future. With total loans restricted to a percentage of equity, this contracts the total level of loans banks can lend. If banks restrict their lending to 8% of equity, a $300 billion decrease in equity would represent a $3,750 billion decrease in lending ability. As bank assets fall, this will hurt earnings. In addition, due to the concern about their financial health, Japanese banks pay a premium for off-shore borrowings, further hurting profits.

Japanese banks are now exiting U.S. lending, where they were once big players. Japanese banks exposure to Britain is down to 8.3% of British banking assets vs a peak of 26.6% in 1986. Nippon Life Insurance Co. has just advised that it has received requests for loans totaling 1 trillion yen in the January-March quarter due to banks unable to lend. In addition, Japanese companies are turning to the bond market to raise funds, another indication of the banks inability to lend.

The financial viability of Japanese banks must be questioned due to falling assets, rising funding costs, massive undisclosed losses due to past lending in the bubble era, new losses due to loan exposure in South-East Asia, and new losses accumulating to corporate Japan, where bankruptcies reached record levels in 1997, and where profitability will contract even further in 1998. I note that there have been no projections regarding possible loan losses in Japan's large Postal Savings System.

In 1997, corporate bankruptcies in Japan increased 75% to their highest level in 50 years, with a total of Y14 trillion ($164 billion) in liabilities. Recent information would indicate a much greater deterioration in 1998. Toshiba Corp. has just announced that while sales were expected to decline by 2%, pre-tax profits would be 92% lower than what was anticipated only a few months ago. Mitsubishi Electronic Corp. announced that they expected a loss of 40-50 billion yen, down sharply from previous positive earnings' estimates. Fujitsu Ltd., Hitachi Ltd. and NEC Corp. also acknowledge that they will have to adjust earnings' forecasts. With large Japanese companies having earnings slashed or losses increased, what does this tell us about smaller Japanese companies, many of whom have been losing money prior to the down turn in Asia? A combination of business losses and a contraction in bank lending will make 1998 a very difficult year for corporate Japan.

Unless Japanese companies can increase bank loans to fund operating losses, working capital will soon be depleted to the point that many will not be able to operate. Evidence continues on a daily basis that Japanese banks are contracting their lending. The result can only mean substantial bankruptcies in corporate Japan.

To fund their budget deficits and inject funds into the banking system, the Japanese government must borrow U.S.$660 billion. Recently, the Japanese government stated that they must do more to stimulate the economy which will increase this figure. In addition, should corporate profits fall - as is becoming apparent - this will decrease tax revenues, further increasing borrowing requirements. It is not readily apparent where these monies to fund government borrowing will come from. This may be another factor that restricts lending to corporate Japan, with banks opting for the apparent safety of government bonds as opposed to lending to finance the losses of the corporate sector.

With a backdrop of falling profits, decreased demand, and restrictive bank loans, it is likely that capital spending will fall dramatically in 1998. This is another factor causing an economic contraction.

Despite the adverse ramifications of the above factors, the Nikkei has seen a substantial rise over the last two weeks. The view is that the government will announce programs to turn the economy around. Nonetheless, it is imperative to emphasize that this government is massively in debt (direct and indirect liabilities exceed 150% of GDP), and will need to borrow over $660 billion over the next year. Furthermore, Japan over the last eight years has shown itself to be totally incompetent in dealing with its financial crisis. With financial events in Asia and Japan now deteriorating on a daily basis, any market perception that the Japanese government can solve these financial problems, indeed borders on pure delusion.

In Hong Kong, many companies are struggling for survival. The pool of bank credit is being drained, as highlighted by the collapse of the leading investment bank, Peregrine Investment Holdings. With a major economic slowdown reducing economic activity, higher interest rates are squeezing many corporate borrowers. Shares in Ideal Pacific Holdings Ltd., Leading Spirit Conrowa Electric Co., and Mansion Holdings Ltd. have been suspended from trading as they negotiate with creditors.

In Indonesia 266 of the 288 publicly traded companies are technically bankrupt. Most large Indonesian banks are unable to settle transactions as they become due. The financial and economic system in Indonesia will soon collapse without massive foreign aide. Throughout Asia, exporters cannot raise the credit to import the raw materials needed for their exports. It's growing nightmare without the merciful ability of waking up.

At an exchange rate of 1700 won to the dollar, it is estimated that domestic corporate debt in South Korea is U.S.$310 billion. This is in addition to foreign debts which are estimated to exceed $150 billion. With domestic interest rates doubling in the last four months, it is estimated that non-performing loans are 20% of the total, equivalent to more than of $60 billion. Even if South Korea could solve its external debt problems, internal problem loans are sufficient to destroy their banking system.

Financial problems in Asia are very real and cannot be papered over with more loans. Consumer spending is declining, capital spending is declining, banking systems are insolvent and corporations are incurring substantial losses.

The Asian Governments' response has been to take what savings remain, and use these funds to prop up the sick system for a short time yet. This maintains overcapacity in the economy, causing financial losses for relatively healthy companies. Moreover, it also destroys what savings remain. On the other hand if the governments would let bankrupt companies and banks fail, there would be a major financial collapse.

Ironically, Asian Governments' frantic short-term solutions may bring temporary respite from the crisis of recent months, but will ensure that the embattled economies will eventually be destroyed.

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