Prepared by Merrill Lynch & Co.

International Fixed Income Research

The spreading Asian currency crisis continues to attract the lion's share of the foreign-exchange, global bond, and global equity markets' attention. The only difference from previous weeks is that attention is now being focused on North Asia instead of Southeast Asia. In particular, the markets are now fixated on the currency and banking-system problems afflicting the Japanese and Korean economies. While several pundits have tried to dismiss the economic effects of the Southeast Asian crisis because of the relatively small size of the ASEAN economies compared to the size of the global economy, it will not be as easy to dismiss the economic effects of the problems besetting Japan and Korea, since Japan is the world's second-largest industrial economy, and Korea is the world's eleventh-largest industrial economy.

Concerns about the fragility of the Korean banking system have led to a sharp slide in the Korean Won and equity markets. Since mid-June, the Korean won has weakened nearly 18% versus the dollar while Korean equity prices have fallen nearly 38%. With seven of the top thirty 30 conglomerate firms in Korea having failed this year, there has been a surge in nonperforming loans on Korean bank books. Korean firms are at risk if growth in Asia slows substantially, since many Korean firms are highly leveraged, with debt loads exceeding their equity positions by a factor of three or four to one.

The Korean authorities face a difficult task in defending the won, because higher interest rates, which are needed to stem speculative pressure against the currency, could slow the Korean economy down and make it difficult for Korean firms to repay their debts to Korean banks. At the same time, allowing the won to weaken would also create unique problems, because many Korean firms have extensive short-term dollar liabilities. Since this type of debt needs to be rolled over on a regular basis, the won's weakness would magnify funding problems for Korean firms and banks. Unfortunately, Korea is now getting the worst of both worlds. Not only is the won weakening sharply, but Korean short- and long-term interest rates have risen sharply in recent months as well.

In Japan, banking-sector problems have come to the forefront with the announcement that Hokkaido Takushoka Bank, the tenth-largest bank in Japan, has been declared insolvent. Japan's Deposit Insurance Corporation will buy the bank's bad debts, and the Bank of Japan will provide special loans to secure 100% of the bank's deposits and inter-bank liabilities. There were also reports that the Japanese government's postal savings and pension system may purchase up to ¥8 trillion in preferred shares of Japanese banks, to help boost the bank's capital so that they can more easily comply with internationally-accepted capital-adequacy guidelines.

While the willingness of the Japanese government to use public funds to deal with insolvent institutions is an important first step in dealing with Japan's banking-system problems, lingering problems remain as evidenced by the still large premium that Japanese banks are required to pay to obtain funds in London's inter-bank market. Moreover, it is becoming increasingly evident that the Bank of Japan may be called on to add liquidity aggressively on a more regular basis to insure the security of bank deposits and interbank liabilities at other troubled financial institutions.

This spells more trouble for the beleaguered yen. Since an aggressive easy monetary-policy stance normally leads to a decline in a currency's value, one should expect an extremely accommodative monetary policy to exert further downward pressure on the yen's value. In light of the fragile financial climate facing Japanese banks and policymakers, we are taking this occasion to revise our already bearish yen forecast to show even greater projected yen weakness in the months ahead. We now look for the yen to weaken to ¥/U.S.$ 130 in three months, 135 in six months, and 140 in twelve months.

If our 1998 ¥/$ forecast is correct, this could be problematic for the other currencies in the East Asian region, since it may trigger a second round of competitive devaluations in Asia sometime next year. After all, many believe that it was the yen's sharp decline in 1995-97, in addition to the 1994 devaluation of the Chinese Renminbi, that planted the seeds of this year's Asian currency crisis. This suggests that currency instability in East Asia may be with us for a good deal longer. Indeed, the Indonesian Rupiah, Malaysian Ringgit, and Thai Baht have all displayed new signs of weakness in the past two weeks as the yen and the Korean Won have come under heavy downward pressures.

All the East Asian countries whose currencies have come under attack this year have extensive banking system problems. Recent academic research (see G. Kaminsky and C. Reinhart, “The Twin Crisis: The Causes of Banking and Balance of Payments Problems,” Federal Reserve Board Staff Study, 1997) shows that banking crises often precede currency crises. The causes of most banking crises can be traced to an earlier lending boom that fueled a surge in economic activity, as well as a bubble in financial-asset and property prices. Once the bubble bursts, bankruptcies tend to increase, leading to a rise in nonperforming loans on bank books. A banking crisis arises when the amount of nonperforming loans far exceeds the bank's capital.

A banking crisis may compromise the conduct of monetary policy if a central bank needs to keep interest rates low to protect troubled banks. During times of crisis, central bankers are often faced with a dilemma: should they keep interest rates high to defend the currency, or keep them low to protect the banking system? In most cases, the need to protect the banking system gets a higher priority. Banking crises also often compromise the conduct of fiscal policy. A government may want to get its fiscal house in order by curbing government spending and raising taxes, but in times of banking crises, fiscal consolidation might not be possible if a major bank bailout package is required.

A decline in investor confidence in the stability of the banking system can also lead to a currency crisis, since depositors are likely to flee, causing a run on both the banks and the currency. Once set in motion, the combined effects of a banking and currency crisis are likely to amplify an economic downturn.

One of the intriguing questions concerning the current crisis is how will it affect growth prospects in Europe and North America. Most analysts' estimates suggest that its impact should be small, but we disagree. The crisis has negatively affected the entire East Asian region, from Japan to Indonesia. East Asia, excluding Japan, accounts for roughly 20% of world output; this may not seem like much, but because this region has experienced much higher growth rates than Europe and the Americas, estimates suggest that roughly one half of the gain in world output in the 1990's can be traced to the East Asian economies. It is possible that this magnified effect of East Asian growth on global growth could work in reverse if Asian growth slows.

Since the crisis has spread to other parts of the emerging-market world, economic growth is likely to be weaker than originally expected in both Eastern Europe and Latin America. In several cases, central banks have raised interest rates sharply to defend their currencies from speculative attack. For example, in Brazil, short-term interest rates rose from 20% to 43% when the Brazilian Real came under attack. With Brazilian inflation at a mere 4.2%, real interest rates in Brazil are now extremely high; if maintained for long, they will probably curtail growth significantly in the coming year.

Fiscal policies are also being tightened in several emerging-market economies to help restore confidence in their currencies. In Brazil, the government announced a series of bold austerity measures amounting to $18 billion, or 2.5% of GDP. This means that tight fiscal as well as tight monetary policies are likely to hurt real growth in Brazil, Latin America's largest economy. Given the large size of the Brazilian economy, a slowdown could adversely affect the economic performances of the other Latin American nations that trade extensively with Brazil. The more countries the crisis affects, the greater the toll it will take on Europe and North America.

One of the major risks to the global economic outlook is whether the competitive devaluations that have taken place so far will lead to a rise in protectionist policies in other parts of the world. Will policymakers in the U.S. or Europe feel compelled to erect higher tariff barriers to insulate domestic firms and labor from cheap Asian goods? If so, world trade could suffer. On this score, it is noteworthy that the Mercosur nations (Brazil, Argentina, Paraguay and Uruguay) just announced an increase in their common external tariff from 12% to 15%.

Given the increased volatility and declining liquidity associated with emerging-market investments in recent weeks, there is a real risk that private capital flows to emerging markets could slow down significantly next year. These capital flows have soared in the 1990's, from $50 billion in 1990 to $240 billion in 1996 and an estimated $300 billion in 1997. But there are now reports that emerging-market mutual funds are experiencing net withdrawals as investors seek greater safety. If capital flows to emerging markets decline, then less capital will be available for infrastructure, project finance, and capital investment. Growth in the emerging- market economies could therefore be far weaker than originally thought.

The combined effect of (1) a slowdown in the dynamic Asian economies, (2) competitive devaluations on the export market share of North American and European firms, (3) higher interest rates in a growing number of emerging market economies, coupled with wider spreads versus Treasuries on emerging-market debt, (4) tighter fiscal policies in a variety of emerging-market countries, (5) a potential rise in global protectionism, and (6) a possible decline in private capital flows to emerging markets could result in much slower global growth than what the market is currently expecting.

This is clearly positive for bonds. Indeed, the marketplace is coming around to the same way of thinking. For example, the U.S. bond market has shrugged off extremely positive data on the U.S. economy–a sharp decline in the U.S. unemployment rate, to 4.7%, and a significant rise in wages, to 4.2% p.a.–and has rallied instead. Normally, a sharp rise in U.S. hourly wages would trigger a rise in U.S. inflationary expectations and a bear market in U.S. bonds, but measured inflation expectations embedded in inflation-protected Treasury bonds have actually fallen. This suggests that the marketplace is more concerned with the potential deflationary winds blowing this way from Asia then they are with the recent rise in actual wage inflation.

Perhaps the marketplace believes that the increase in wage inflation will lead to a relative increase in the price of labor, and not to an absolute increase in the U.S. price level. Labor may get a bigger share of the economic pie, but this need not lead to a rise in the overall inflation rate, since overall inflation should be kept in check by imported Asian deflation. This suggests that profit margins will probably be eroded as the trend in wages rises relative to the trend in consumer prices. This will be negative for equities, which should lead investors to alter their asset allocation away from equities and toward bonds.

The fact that the Federal Reserves Federal Open Market Committee (FOMC) voted to keep policies unchanged at their latest meeting suggests that, for policymakers, the possible negative spillover effects of the Asian currency crisis carry more weight than the present strong state of the U.S. economy. In normal times, the FOMC might have voted to tighten policy, but these are not normal times.

Until recently, it was widely thought that the Bundesbank would guide German short-term interest rates upward to the average level of short-term rates for all of Europe. But the latest crisis is now likely to alter those expectations. Bundesbank President Tietmeyer suggested last week that German short-term interest rates will not be raised to meet the European average, and indicated that European short-term rates will instead have to be brought down toward the low rates prevailing in Germany, France, Belgium, the Netherlands and Austria. Tietmeyer's comments indicate an increase in official concern about the potential negative effects of the Asian currency crisis on European growth.

If OECD growth comes in weaker than expected next year, which bond markets stand to offer the best value? We would favor those markets with the steepest yield curves, since they are presently pricing in significant increases in short- term interest rates that, in all likelihood, will not materialize. We particularly like the two- to five-year sectors of the German, Japanese, Australian, French, and Swedish bond markets. All of these markets are pricing in a significant tightening in monetary policy that is unlikely to materialize if the Asian currency crisis adversely affects growth prospects in the West.

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

November 20, 1997Michael R. Rosenberg

Merrill Lynch & Co..

International Fixed Income Research

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