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Financial Collapse: The Death Spiral

December 29, 1997

When commenting at the recent APEC Leaders Summit in Vancouver, Canada, on the financial situation in Asia, President Clinton's view was that it was "Just a glitch in the road"

Hiroshi Mitsuzuka, Japan's minister of finance recently called in Sanwa Bank Ltd. president Naotaka Saeki to encourage him and his industry to lend more in order to avoid a credit crunch.

In an effort to increase lending, China's central bank announced that interbank deposit rates were to drop to 1.7% from 7.9%. A few days later, possibly fearing that this could lead to a run on bank deposits, they reversed this decision.

We are currently witnessing one of the greatest events in world history, a total and complete economic collapse. Leadership of the three largest economic powers appears not to know what is going on, or does not have the foggiest on how to deal with it.

South Korean president-elect, Kim Daerjung, at least appeared to now have some idea of the financial situation, announcing that without emergency aid the country would be bankrupt within a day or two.

I will start my analysis by a quick review of the situation in South Korea, keeping in mind that many of the same elements are prevalent now in many other countries.

South Korea's economic miracle was financed by massive amounts of debt. Consequently, debt to equity ratios of many Korean companies are at very high levels. These companies require large profits in order to meet debt repayment, and maintain working capital. Even a brake-even situation will lead to bankruptcy, as this will force companies to use working capital to meet loan repayments. Eventually working capital will be depleted to the point that the company will be unable to operate.

For much of 1997, many of South Korea's largest companies have been losing money. This means that working capital has depleted to the sum of the financial losses plus loan repayments. Without adequate working capital, many of these companies have filed for bankruptcy. Bankruptcy means that these companies will not be able to repay their obligations to the banks or their suppliers. Now, companies that rely on receiving payments due from these bankrupt companies find that they are unable to collect their accounts receivables. This results in financial losses and decreased working capital for these companies, which may result in their bankruptcy.

The inability of Korean companies to meet debt repayment has caused confidence in the Korean won to plummet, leading to a collapse of the won to below 1900 per U.S. dollar, and sky-rocketing short term interest rates which now exceed 33%. Many companies have borrowed in U.S. dollars, which resulted in real debt levels more than doubling for these loans. High interest rates in an over-indebted country can only increase bankruptcies.

Many companies sought bankruptcy protection prior to the collapse of the won and sky-rocketing interest rates. Now these events will seal the fate of these and many other companies. As a side note illustrating the interdependency of companies, Hyundai Motor has announced that they will shut down production due to parts shortage, caused by the insolvency of Mando Machinery Corp. With much of corporate Korea now facing bankruptcy, Korean banks will never collect much of this debt.

In addition, Korean Banks have borrowed billions of U.S. dollars. The collapse of the won has resulted in major foreign exchange losses for the banks. Bankrupt borrowers and large foreign exchange losses will lead to the failure of most banks in Korea. It has been estimated that Korea owes foreigners about $170-200 Billion U.S. Repayment of these loans must now be questioned. This could lead to the bankruptcies of the companies and banks holding this debt. Many company's have exported their goods to Korea. Often these exports are financed through bank letters of credit. With Korean banks unable to honor these letters of credit, exporters to Korea or their banks will incur additional losses.

The IMF cannot alter the financial collapse of South Korea. Every dollar lent by the IMF will be used to bail out a foreign lender. That is all. It replaces private debt with public debt. It does not alter the financial strength of Koreans' Bankrupt Companies.

Japan has major financial strength, compared to Korea or most counties in the world. Whereas Korea owes the world money, the world owes Japan. Korea is running a current account deficit, while Japan has a large current account surplus. However, Japan like Korea must contend with many potential bankrupt banks and bankrupt companies. Moreover, the Japanese government has squandered the savings of the nation. Its direct and indirect liabilities exceed 150% of GNP, and will grow substantially over the next year. These are debts, not assets and can only be repaid by the taxing [taking away] from its citizens. Japans latest budget consisted of three main points. Taxes would be cut by five Trillion yen, resulting in the budget deficit rising to a staggering 9.7% of GDP. Initially 10 trillion yen, but now 20 trillion yen will be borrowed to inject into the banking system. An additional 12 trillion would be borrowed to lend to small business, who no longer qualify for the loans they have outstanding with commercial banks. This third point must be viewed as an additional bailout of the banking system.

The Japanese government will loan companies - that are technically bankrupt - money so that they can repay their bank debt. It represents the transfer of loan losses from banks to the public sector. Japan's Finance Ministry recently announced that problem loans held by all Japanese deposit-taking financial institutions were 28.1 trillion yen. If this were the case, then the recently announced 32 trillion yen bail out of the banks should be sufficient to recapitalize the banks. Do not count on this. Actual loan losses in Japan are multiples of this figure.

In addition, the Finance ministry has announced that banks no longer have to value securities at the lower of cost or market value. For bank capital purposes, they can record securities [stocks] at cost. Let this be clear, the above actions reflect only creative bookkeeping.

To date, no one has questioned who will lend the Japanese government almost 10% of GDP to finance its budget deficit, plus an additional 42 trillion yen to bail out the banks. This debt is not going to be financed by foreigners. For many years, money has been going out of Japan, not in. I know of no major country with a surplus of capital.

Besides, what foreigner would lend to Japan given its very low interest rates, huge debt load, and budget deficit, insolvent banks and insurance companies, collapsing economy, and creative bookkeeping?

The Japanese do not earn enough to finance the type of borrowing required by the Japanese government, not even close. Much of what is earned is now heading to safer destinations. What will happen is that Japanese banks will end up purchasing most of these bonds. In effect, the banks will lend the government to bail out the banks. Should the banks fall short of resources to purchase the bonds, then the Bank of Japan will be called in to monetise the debt.

All of this creative bookkeeping does not change what is happening in corporate Japan. For years, the Japanese banks have been financing the losses of corporate Japan. Loans that cannot be repaid are refinanced with new larger loans that pay all past due interest, plus additional funds for working capital. Now, Japanese banks are facing a major credit squeeze. Due to fear about the financial health of the banks, the Japanese are moving money out of the banks, and out of the country. Japanese bank borrowings in international markets are priced at a substantial premium (hurting profit margins) and it is likely that Japanese banks are finding it more difficult to obtain international loans. Loan repayment from loans to Indonesia, South Korea, and Thailand is now very questionable. Soon, the banks must find the capital to purchase the government bonds, so the government has the money to bail them out. Japanese banks must now squeeze corporate Japan for loan repayment.

For the first quarter of 1997, the Japanese economy contracted at an annual rate exceeding 11%. The second quarter was only a slight improvement over the first. In the third quarter, the Asian crises started to accelerate. Vehicle sales within Japan fell 20% in November. Exports to South-East Asia are falling and will decrease substantially as South Korea, Indonesia, and Malaysia collapse. Even China now appears to be standing still.

I expect the fourth quarter to be really ugly. With a mountain of bad loans, corporate Japan was in terrible financial shape BEFORE the Asian Crisis. Now demand within Japan, and its Asian trading partners is falling drastically. In addition, the collapse of the Korean won means that unit prices also face large reductions. This will translate into large losses for Japanese companies. These losses, together with the credit squeeze facing Japanese banks will cause a major loss of working capital for corporate Japan. This will force many companies into bankruptcy. As companies go bankrupt, they will be unable to pay their suppliers, forcing more firms into bankruptcy. This will also add to the loan losses at Japanese banks. *We have now entered into a financial death spiral from which their is no way out.* The response to this debt crises by Japan's Ministry of Finance is more debt and creative bookkeeping.

Financial problems in China echo many similarities to South Korea and Japan. Non-performing loans are estimated at US$200 billion. This does not include loans on empty buildings or bad loans that are simply rolled over from year to year. Many companies are losing money which is resulting in bankruptcies and layoffs. Factories are closing on a daily basis. In some provinces, unemployment is estimated at 1/3 of the workforce. Authorities have no idea what to do, as evidenced by last week's decision to drastically decrease, and then not decrease interbank deposit rates. Compounding the problem of not really knowing what they are doing, a devaluation of the Chinese Yuan appears to be a high probability, especially in view of the collapse of the Korean won.

Indonesia and Malaysia are also heading for financial collapse. There are reports that Indonesia's foreign debts now total US$200 billion. With the Indonesian currency decreasing up to 10% per day, these funds will never be repaid. Malaysia's banking sector debt is estimated at 165% of GDP, with interest service absorbing 18% of GDP.

To date, the United States appears relatively immune to the Asian Crises. In fact, over the last 2 years, it has been a major beneficiary as money has flowed into the safe haven. Of present concern, personal installment debt has increased 50% over the last four years. At the top of its economic cycle, personal bankruptcies are at record levels, substantially exceeding one million personal bankruptcy's for 1997. There is now concern that growth will decrease due to decreased exports to Asia, and profit margins may fall to compete with cheaper Asian imports.

The real problem for the United States starts when Asia collapses, and the last dollar has exited Asia. At that time, the vast flow of money stops entering the United States, and now starts to exit. Consequently, the current account deficit will likely exceed $250 billion, which must be financed. In addition, between $1 to $2 trillion dollars will move back to Asia. These funds will be needed to finance losses and rebuild.

In addition, Americans may also be moving funds out of the United States to take advantage of all the bankruptcy bargains in Asia. Faced with a massive sale of U.S. Treasuries, America has three options. They can withdraw funds from stock markets, they can raise taxes to finance the redemption of Treasuries, or they can monetize the debt. None of these options appears attractive, expecially since the economy will be contracting due to the Asian collapse.

One may question why modern economics was unable to forecast this economic collapse. My opinion is that traditional economics does not understand debt and its effect on the economy. Traditional Keynesian economics teaches that increased government spending through deficit financing increases demand, and hence growth in an economy. It neglects to mention that the borrowed funds are removed from the economy which reduces demand and growth. Also, as repayment of government bonds comes from increasing taxes, they only represent a redistribution of wealth, but in themselves do not represent wealth. They have no tangible value.

Whether my $5000 purchase of a widget is paid from earnings, or by a loan, traditional economics treats both transactions as the same. They add the same amount to GDP. However, they are not the same. If I purchase the widget with loan proceeds, my future spending will decrease, and my financial solvency may be threatened if debt payments are not considered in relation to my income. Moreover, my financial strength is less if I have to borrow. Traditional economics pays little attention to financial strength. To a modern economist, increased debt means increased growth. Increased growth is good, so the more debt the better. Again, modern economics does not consider the ability of this debt to be repaid. Financial problems are considered to be due to a change in investor opinions. This is clearly reflected by the policy response of the IMF and various governments to the present financial crises. Their basic response is more debt, and massive amounts of it.

It may be possible that my thoughts, my reasoning and logic are wrong. Maybe debt does not matter, and the world can be saved from financial collapse by a further massive increase in debt levels. However, if I am correct, governments around the world are demonstrating a total lack of logic and reasoning which will further compound the financial hardships that millions of people will soon face. I do not expect that it will be very long before we know who is right and who is wrong.

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