Prepared by Merrill Lynch & Co.

International Fixed Income Research

Investors can be excused for feeling a bit shell-shocked following the turbulent activity in the world currency, bond and equity markets in the past few weeks. While some calm appears to be returning, we may simply be in the eye of the storm. It is therefore difficult to come up with reliable estimates of the economic damage that this crisis will have on the global economy. Under such circumstances, it is best to be cautious when formulating currency and global fixed- income investment strategies.

The currency crisis spreading across Asia, and threatening to reach other parts of the world, is a classic case of how speculative attacks against one currency can spread to other currencies. The transmission mechanism for contagious currency crises works in the following manner: The collapse of one currency adversely affects the competitiveness of other economies whose currencies remain unchanged. The stronger the trade links between the depreciating currency's country and the adversely affected countries, the greater the pressure will be for a competitive depreciation of the latter countries' currencies, in order to re-establish a more even playing field.

Theory has very little to say about how quickly contagious effects spread from one country to another. In the fall of 1992, the collapse of many of the ERM currencies spread rapidly at first, but a number of currencies managed to survive the speculative assault for a while. The turbulence in the European currency markets subsided in the winter and following spring, but by the summer of 1993 the crisis had erupted again, this time taking out the majority of the European currencies that had survived the fall 1992 crisis.

The current Asian currency crisis is not very different from its ERM counterpart. Its causes can be traced to the 35% devaluation of the Chinese Renminbi in early 1994. The devaluation gave China a major competitive edge in world markets. China's exports surged by nearly 32% in 1994, and rose another 23% in 1995. As a result, China's trade surplus, which amounted to a mere $5.0 billion in 1994, has risen sharply in the last few years, and should amount to nearly $30.0 billion this year. China's gains have come at the expense of a slowdown in export growth in Southeast and Northeast Asia.

The dramatic depreciation of the yen since the spring of 1995 also played a key role in drawing market share away from Southeast and Northeast Asia. With the yen's fall of nearly 50% versus the dollar, and with most Asian currencies effectively pegged to the dollar, Asian countries suffered a serious loss in international competitiveness versus Japan.

At the same time, many of the Asian economies had become extremely vulnerable to a possible negative external shock. They had perhaps grown too rapidly in recent years, as many questionable investment and construction projects were financed by a rapid expansion in bank lending. Many of those loans were dollar-denominated, leaving Asian businesses and banks at risk if the dollar suddenly rose in value.

This placed many of the Southeast Asian nations in what economists refer to as a “multiple-equilibria” position. This means that at a particular point in time, a currency may have more than one equilibrium value–one if not attacked, and another if attacked. In a “no-attack” equilibrium, Southeast Asian currencies could maintain their peg to the dollar, allowing businesses and banks to continue borrowing dollars and hopefully grow out of their economic and financial problems. However, in the event of an attack, a sharp rise in the dollar could throw otherwise viable firms into bankruptcy, and drive an otherwise vibrant economy into a tailspin.

To a large extent, Southeast Asian countries have fallen from a “no attack” into an “attack” equilibrium. Once in an “attack” equilibrium, it is sometimes difficult for an emerging market economy to lift itself up without the assistance from others. Mexico needed a U.S.-led IMF support package to help lift its economy in 1995 and so have Thailand and Indonesia needed similar packages this time around.

While economists and market participants are aware of the power that contagious speculative currency attacks can have, it is striking how many underestimated the spillover effects that the current crisis has engendered. For example, when the Thai Baht originally came under pressure in early July, most initially felt that the problem would be isolated to Thailand and would not spread to the rest of Southeast Asia. Once the crisis spread to Southeast Asia, most felt that North Asia would be spared. Once the crisis spread north, most felt that it would not spill over onto Latin America, but it clearly has.

There is good reason why the current crisis may continue to spread. If the crisis stopped dead in its tracks today, we would find that most countries in Asia had gained a major competitive advantage over countries in the West as a result of their competitive devaluations. Over time, we would find that Asian firms were gaining significant market share at the expense of firms in the West. Since this would harm the growth prospects of aspiring emerging-market economies, the foreign-exchange markets may come to expect that currencies in Eastern Europe and Latin America should decline in value to offset, at least in part, the potential adverse consequences of the competitive devaluations in Asia. Hence, the contagion effects from the Asian currency crisis are unlikely to fade away. One should not confuse temporary calm with an ending of the crisis. The ERM currency crisis took a year to unfold, and the Asian currency crisis has been 2-3 years in the making.

Where and when the next shock may hit is hard to discern at this stage. Investors may look to potential problems in Korea, the 11th largest industrial economy in the world, which has seen a buildup of debt problems as overleveraged conglomerate firms have been unable to service their debts to Korean banks. This has brought about a wave of bankruptcies, and will probably lead to considerably slower growth in the year ahead.

Brazil will also be on most investors' watchlists, given the significant real appreciation of the Brazilian real since mid-1994 and the growing deterioration in Brazil's trade balance. China may not be very far behind in terms of vulnerability, since nonperforming loans of China's state-run banks are mounting. Somewhat further down the list would be the Eastern European countries, most of which have experienced sizable current-account deficits, significant real currency appreciation, and major lending booms. In the past, such trends have served as reliable leading indicators of speculative attacks on emerging- market currencies.

Speculative pressures on emerging-market currencies can lead to slower growth in the developing economies. First, a major decline in a currency can have a contractionary effect on output in the short run. When a currency weakens, inflation is likely to work its way higher. To counter this, monetary policy needs to be tightened, which then slows the growth of the domestic economy. This happened in Mexico in 1995. In addition, since devaluations raise the prices of imported goods, real incomes tend to decline, which is also contractionary. If domestic residents incur large foreign-currency liabilities and the domestic currency depreciates, the domestic-currency value of those liabilities will soar. This, in turn, could lead to a rise in bankruptcies and therefore contribute to a slowdown in domestic growth.

Second, policies to defend against a speculative attack could also lead to slower growth if higher domestic interest rates are needed to stem the potential outflow of short-term capital. Higher interest rates could negatively affect the domestic property and equity markets, and possibly aggravate an already weak domestic banking system. Thus, even if a speculative attack is successfully resisted, it could have a significant negative impact on real growth.

Finally, in periods of major turbulence in the financial markets, business confidence tends to be eroded. Investment projects may be put on hold until the dust settles, and investors may demand a higher risk premium to buy and hold all forms of risky debt, even in countries not under attack. This makes it more expensive for emerging-market economies to borrow in international markets to finance longer-term projects. The average spread for Brady bonds over U.S. Treasuries widened significantly during the present crisis.

The crisis thus has the potential to adversely affect economic growth in emerging-market economies and, in turn, could negatively affect growth prospects in the OECD. If one factors in the deflationary impulses emanating from (1) slower economic growth in the emerging-market economies, (2) competitive devaluations in Asia and possibly elsewhere if the crisis spreads, and (3) overcapacity in a wide range of industries (including steel, petrochemicals, and electronics, as well as automobiles in Asia), then deflation will pose a greater risk than inflation to the global economy. For this reason, the current Asian currency crisis should be extremely positive for global bonds.

In terms of the outlook for the G-3 currencies, the Japanese Yen is clearly in the most vulnerable position. The Japanese economy, which is already beset with a number of internal problems, will be weakened even more by an economic slowdown in Asia. Japanese banks have lent heavily to Asia: an estimated $263 billion in loans are outstanding, representing 6.3% of Japan's nominal GDP. As a result, Japanese banks are heavily exposed if Asian growth falters. The market's concern about the health of the Japanese banking system is reflected in the slide in Japanese bank-share prices.

It is no wonder, then, that the Bank of Japan joined the Singapore and Indonesian monetary authorities in an intervention on behalf of the Indonesian Rupiah on November 3. By stabilizing the situation in Indonesia, the Japanese authorities were indirectly trying to stabilize the economic situation in Japan.

The yen is also vulnerable to an Asian slowdown because 44% of Japan's exports go to Asia. Japan needs strong export growth to foster a recovery, since growth is currently being dragged lower by weak domestic demand. But if export growth to Asia slows, Japanese growth prospects will suffer.

For these reasons, we see no reason to change our bearish outlook on the yen. The Japanese economy is weak, the equity market appears equally weak, and there are still major concerns about the health of the Japanese banking system. Hence, we continue to see the yen weakening to ¥/U.S.$ 125 in three months and ¥/U.S.$ 130 in six months' time.

Regarding the DM/U.S.$ exchange rate, we have been steadfast dollar bulls for over two years, and we remain so. We feel that the U.S. is in better fundamental shape than Germany, and therefore better able to absorb a negative external shock. Moreover, the marketplace will soon need to factor in the risk of a possible change in the German political landscape next year, with federal elections slated for September 1998.

However, we also need keep in mind that the U.S. current-account deficit could widen significantly if the Asian currency crisis spreads to other parts of the world. If one factors in the competitive devaluations that have taken place so far, and then assumes that other devaluations might take place in the future–and if one takes into account the fact that demand conditions are likely to be extremely weak in Asia and softer in Latin America–the U.S. current-account deficit could widen from $160 billion in 1997 to around $200 billion or perhaps higher in 1998. This need not stop the dollar from rising versus the Deutschemark, but it would likely temper its rise.

In addition to a possible negative trade-flow impact on the U.S. Dollar, interest- rate differentials are not likely to lend much support to the dollar in the year ahead. The deflationary winds blowing from Asia should help keep a lid on bond yields in the U.S., and for that matter in Germany as well, in the coming year. Since it is unlikely that real interest-rate differentials will move much in the year ahead, in favor of either the U.S. or Germany, and since the DM/U.S.$ exchange rate tends to move in sympathy with the trend in the U.S./German real long-term interest-rate differential, the dollar is unlikely to get as much interest-rate support as it has over the past two years.

For these reasons, the dollar's bullish long-term uptrend, while still very much intact, is likely to face some resistance in the coming year. Therefore, we are taking this occasion to temper somewhat our dollar bullishness versus the Deutschemark, by lowering our year-ahead projection for the Deutschemark to DM/U.S.$ 1.85 from the DM/U.S.$ 1.95-2.00 level that we were previously forecasting.

(Reprinted by permission. Copyright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated

November 6, 1997Michael R. Rosenberg

Merrill Lynch & Co.

International Fixed Income Research

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World Financial Center, New York, New York

Consensus National Futures and Financial On Line Index

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