My Diary 479 --- Are We All Japan Now; Lessons from Japan; Health Check on China; The Difference from 2001

November 23, 2008

Citigold, Goldcity, Citisachs, or Sachs & Citi --- All sound amusing but this was part of why S&P went from 5yr low to 11yr low (752 on Thu < 768 on 10Oct) just after 1 trading session. The looming concerns over potential bankruptcies of Big Three, plus disappointing economic data (Housing/Job/Manufacturing) and a sharp decline in CPI (-1% Mom) were also the bear triggers. As a result, I saw commodities retrace, credit spreads blow out, and UST rise led by LT securities on risk aversion trade…Even Fed was no longer lagged behind as they cut their GDP growth forecasts…In addition, market rattled again by uncertainty over TARP program and clashes between Paulson and Pelosi over mortgage foreclosures and auto company bail-out …Despite whatever Mr. & Ms P said, the widening credit spreads now are  not just a function of year-end liquidity concerns or year-end forced deleveraging due to redemptions, instead there are growing concerns over the effectiveness of the US policy response to the crisis. Having said so, I think the new mission of TARP looks like a fund manager changing the mandate after raising money!

From broader market point of view, volatility over the past week has also come from CPs, where 17% of S&P500 stocks are classified as junk issuers and their bonds have an average yield of 21%. Not only VIX followed closing at 81 – new all time highs – with the LT vol closing higher, but also the volatility for the week in UST was truly mind-blowing and historical, with 10yr UST yield saw a 77bp move - almost equaling the entire range for the full year of 2005 but matching it on % basis. Certainly, Crude and FX were another story -- Oil crashed below $50, reaching into the level where production cut becomes an easy decision, while JPY closes at 94, an important line suggesting we could retest 90 in near term. In general, all these mover movements signaled to me that the stresses in the financial system have once again spread beyond equity markets and back into credit markets and broader FI markets. Not surprisingly, US authorities have come under fire once again, as the host of programs, actions and measures they have taken to date have failed to stop the bleeding in asset markets, let alone actually reverse the problem. There is clearly diminished confidence in the financial system and in ability of authorities to fix the problem. Market debate has shifted from whether we should allow Mr. Market itself to work out vs. greater govt involvement/ regulation to the fear of deflation and how much the neck-deep-in-water US and other governments can do to engineer a more sustained fix? This is why I think we should stay cautious as the fear over faith is the heart of the old world view of the end of the world…

Since cross my discussion over credit and equity, I want to put down a few quick thoughts here. Recently, credits have held up relatively well despite significant drop in equities. I.e. benchmark CDS are only wider by 50bps for a 6% fall in equities over the Thursday moves. Indeed, global equities are likely to hit new lows, given the dismal macroeconomic and corporate backdrop, as well widespread and deep earnings d/g ahead. However, it is interesting to look at the capital structure of B/S – at current levels, credit are pricing in close to recovery value of a company. Thus any incremental –ve news will affect the equity more than the credit since credit is more senior. In addition, companies now have intention to cutback on Capex and conserve cash, which again negatively affect equities though lower earnings but is positive for credit. Off late, there has been increased interest to buyback debt at discounted levels as well…Thus, I feel surprised to see investors reacting to the news of companies that are either increasing their dividend or buying back stocks…These names should worth a check for SHORT as  we are in a very bad recession and EBITDA for many companies might very well be halved over the next year or more…Management needs every penny they have to survive as cash is a necessity as the cycle/recession deepens…So whenever a stock looks “cheap”, one may want to check if the company has bonds (YTM >20%) and may want to buy that instead.

As usual, let us take a step back before moving ahead…For the week, global equity prices finished 9.5% lower than last Friday and currently sit at about 10% above the 2003 low.  Elsewhere, after hitting record lows on Thu, UST yields rebounded with 2yr added 12bp to 1.1% and 10yr ran up 18bp to 3.2%. 1MWTI oil edged up but closed the week still below $50/bbl. The price of oil declined $7 this week and is down $18 this month. USD continued along its upward trend, up 3.7% in Nov and about 18% since June. Against EUR, USD finished the week at $1.259, +1% this month and >20% since June. In contrast, the Dollar closed at 95.9 against YEN, down 2.5% this month and nearly 10% in 2H08.

Looking ahead, I think the better term to describe the recent phase of deleveraging is “illiquid deleverage” as before Mid-Oct08, it seemed that investor are selling assets very quickly ( the most liquid things), while they are dealing with less liquid ones like HY credits and SM cap equity, both underperforming recently. While IG used to lead prices, now it trades inline with it's normal correlation to stocks. I think B/S is less leveraged now, but bank stocks will continue to underperform as US govt slow down the pace of capital injections, an important way to deleveraging. But two other hot spots mentioned in previous diary are still there – 1) in FX/rates space, the focus is on sovereign risk in EM with CDS continue to move wider; 2) in the credit markets, attention (and widening) is shifting to real economy companies approaching covenant triggers.

All of these elements suggest caution here. In fact, I think everyone over the week has been waiting for and anchoring to 2002 lows in stocks in order to get long risk. But investors should ask themselves -- is there any reason other than technicals? The only other factor I can think about is mental anchor to "the last big low". But just think about investors who were anchoring to the 1990s levels in Japanese stocks ... They’re now sitting with an index that's back at 1981 levels…So Good Luck Again... In contrast, I do notice retail sentiment, as measured by AAII, has fallen back to its low for the year and CBOE equity put/call ratio hit an all-time high of 20D MAVG high of 0.949. Based on historical experience, that should set us up for a decent trading rally before year end. However, we should not lost sight by only looking at equity as system pressures remain intense as shown by the stalled improvement of TED and LIBOR-OIS spread. These spreads need to resume their downtrend if the support at 2002 low is to hold up. But the  first step is the markets need some clarification of how regulators plan to save Citi –-- Here we go today, with additional 306bn guarantee over Citi’s bad assets and additional 20bn equity injection, the stock in German Trading up 48%, but I can not help thinking what about BOA, Wells Fargo, and what would be the future of USD?... I am thinking of Gold again… Last thought here is given that markets have lost confidence in Paulson, and most view Bernanke as overly academic and slow, Geithner’s recent appointment and Obama with a potential 700bn stimulus package are seen as good news. But I would stick on my view that, if one getting long because of a rescue package, think TWICE … But if one getting long due to bigger pain tolerance or tighter stop loss, it makes some sense for going in December…Happy X-Mas Trading!

Are We All Japan Now

Concerns about deflation rose after US CPI fell last month by 1%, the most since records began in 1947, and core CPI moved down along with headline figure. In DMs, headline inflation has eased to 3.3% yoy in Oct, down from peak 4.4% in July. The descent in sequential inflation (%QoQ, saar) has been even swifter, with CPI inflation plummeting to an outright annualized contraction of 1.5% last month compared with a recent high of 7.8% in July. This phenomenon seems counter-intuitive as with interest rates falling sharply, a steep yield curve plus paper-currency debasement will ultimately generate inflation. However, there are several market signs pointing to the direction that over the coming year, the global economy faces risk of deflation. – 1) 2-10yr yield gap narrowed to 209bp, reflecting bets that lower inflation exp will support real returns in LT bonds; 2) 10yr BE inflation, which reflects the outlook for consumer prices, was 13bp, near the least since 1998; 3) Fed inflation forecasts were lowered substantially, both for headline and the core. Inflation is now expected to remain below the 2% target well into 2011. End of 2010 projections put core PCE between 1.3-1.8%. Moreover, Fed also reduced its forecasts for growth in 2009 (-0.2% to 1.1% vs. 2 - 2.8% forecasted in June) and unemployment (7.1 -7.6%). In fact, this still seems optimistic to me as if based on retail sales/IP proxy for real GDP, and it suggests that Q4 US GDP could shrink as much as 8%, similar to the imposition of credit controls in 2Q80 when the economy shrank by 8%. [Note: Deflation, or prolonged declines in prices, hurt the economy by making debts harder to pay off and lenders more reluctant to extend credit]

Beyond the border, the outlook is also gloomy. EU GDP contracted by 0.2% QoQ for the 2nd consecutive in 3Q08, meeting the technical definition of recession. Having narrowly avoided a sustained contraction in 2001, this is the first official recession since 1999 and the first for this set of countries since 1992-93. But I believe this won't just be a “technical” recession, it will be a deep recession. Furthermore, Japan October export volume also skidded 3.1% MoM for its 3rd consecutive decline. I think there is no doubt that the global boom has transitioned into a synchronized contraction, witnessed by that power demand in China is down, US retail sales numbers are dismal, EU countries, Japan and Hong Kong are in recession. With Beijing conceding that only 20% of its stimulus package will come from central government funding, the pressure is on provincial governments and SOE to step up to the plate and the question is how much of the spending is incremental.

One thing for sure is that real estate bear markets and subsequent banking sector stress always lead to a recession, followed by a multi-year sub-par growth (i.e. negative output gap). In turn, excess supply helps dramatically drive down core CPI inflation in the years that follow. But even it is true that falling demand encourages price discounting, core inflation normally adjusts gradually to changing economic conditions in the DMs, even in recessions. A reasonable alternative view is that the collapse of the commodity-price bubble is reverberating broadly through the pricing structure, quickly unwinding the pass-through from the previous boom in oil and agricultural prices. Indeed, the correlation between movements in oil prices and DM core inflation has jumped markedly since the middle of the decade, especially in US. Viewed in this light, the slide in core inflation does not justify fears that the global economy is moving into a period of sustained deflation.

Looking ahead, it is likely that the US CPI will be very low positive or even mildly negative, given the drag resulting from the recent plunge in food and energy prices. Headline inflation is less likely to turn negative in EU, given the rigidity of the price structure but a deflation scare is likely. The implication is that policymakers will continue to ease aggressively and then stay on hold for an extended period, supporting a long duration call. While the longer-term consequences of such actions may be inflationary, government bond yields will adjust lower in the near term. Going into 2009, given the limited room to cut rates further and limited benefits for the economy, policy setting is going in 2009 is likely to shift towards quantitative easing. In fact, The Fed is already doing it, but without announcing any explicit targets. Are we all Japan now? Just looking at the difference between 2yr UST and JGB, yield spread has narrowed to 53bp from 233bp at the start of the year. JGB 2yr has yielded 36bp on average since 2000.

Lessons from Japan

With US and Euro Zone are suffering from the collapse in asset prices and a banking crisis, the market has been doing comparison with the Japanese experience in the 1990s, of which the stagnant, deflationary, income-destroying 1990s decade is now the policy-makers textbook on how not to conduct policy. At the end of the 1980’s, the Japanese real estate and equity bubbles burst, damaging bank and corporate B/S. This created a powerful feedback loop where banks were unwilling to lend and corporates were unable to obtain credit, one of the key driving forces of Japanese deflation in the 1990s. Granted, an important difference this time is that it is mainly the US consumer that has to downsize its B/S. In addition, Japanese experience has proven that QE becomes more effective if the central bank promises to keep excess reserves in the system for an extended period of time. This gives banks the certainty of funds they need. Without sustained access to cash, banks are reluctant to lend it out.

From the reaction of central banks, the main difference between the US today and Japan in the1990s has been the much more rapid policy response by the Fed. The Fed's quick rate cuts moved policy rates below nominal GDP in mid-2007, which played an important role in weakening USD until this summer, supporting the US export. A growing concern now is whether US nominal GDP will begin to contract. A sharp recession and drop in inflation could lead to the first contraction in US GDP since the 1950s. Should nominal GDP contract on a sustained basis, even zero rates would not be deemed accommodative, as witnessed by Japan. This would raise the risk that the economy falls into a “liquidity trap” and require monetary policy to shift from targeting rates to targeting quantitative measures of liquidity, as mentioned by San Francisco Fed President Janet Yellen.

In fact, taking the target rate to 0% would not be costless for the Fed.  One concern that has been voiced in the past relates to the effect on MMFs.  But I do not think this cost is enough to constrain the Fed, in part because facilities such as MMIFF should help to provide a more orderly transition for this market. Another cost is the loss of public confidence if there is a perception that the Fed has "run out of ammo."  Here I also don't believe going to 0 implies that the Fed cannot do more. The near-term worry is that FOMC members are split between easing aggressively and taking a more measured approach. In reality the decision is out of their hands. The market is factoring a 100% chance of a 50bps rate cut at the December 16 FOMC meeting. The Fed will not disappoint…Furthermore, the economic recession and deflationary shock that typically follow global banking and real estate crises have traditionally kept policy on hold for extended periods of time. Based on data from Japan, Europe and the previous S&L crisis, the average time between the first rate cut and the subsequent rate hike is 63 months. The case this cycle should be no different, I think.

A Health Check on China

With S&P sliced through the 2002 low, the next low level on the screen is the 97 low at 730, and next-next is at 600. Below that we have the take-off point for the 1990s bull market at about 483…So take your pick…Anyway, we already have the worst year for the stock market since 1931. Back then, the problem for the bottom fishers (and likely now) is that the S&P did not bottom until Jun32, meaning that even after the 1931 disaster; it still had another 46% downside before it was all over. And this was not the only case in the history. Looking at historical work from 1917 on, when the Dow is down 15% for the year as of the close on 14Nov, there is a 90% chance of an average decline of 9% out to 20Dec.

To the local market, the Q is, if the S&P goes to 500, will HK follow? I think it is hard to imagine the recent low at 10,676 holding under such circumstances unless we get very good news from China. An equivalent move in HK would take HSI down to 8500-8900. Meanwhile, A-share markets have broken trend resistance and now crossed their 50D MAVG. All of which begs the question, which market should the H-shares follow? Statistically, it will be A-shares, as the rolling 50D correlation of daily changes in HSCEI and SHCOMP is 70% vs. that of HSCEI and S&P around 30%

Having said so, the macro China is deteriorating faster than I think. In October, output growth slowed significantly for all major industrial products except crude oil, and here are the number I summarized for my own records:

Ø  Steel recorded the worst output growth: -16.8% for pig iron, -17.0% for crude iron and -12.4% for steel products (-6.1%, -9.1% and -5.5% in September), due to cut production over severe overcapacity.

Ø  Electricity production shrank 4% yoy in Oct, the 1st decline since May 1998, due to the hard landing of power-intensive heavy industries, namely steel, chemical and non-ferrous metal industries are the three biggest power consumers.

Ø  Fiscal revenue shed 0.3% in Oct, the 1st time since 1996 and a significant decline from 33.3% growth in 1H08, which does not look promising in 2009. This is a strong evidence to my concerns over the funding of the RMB4tn investment package.

Ø  National wide, 100 major retailers saw volume growth at 8.2% yoy in Oct08 vs. +25.7% in Oct07. By category, Food sales growth rate slowed by 5.5%; apparel for women down 5.2%; jewelry down 20%; significant slow down in cosmetics; home appliance also down.

Ø  Employment wise, MHRSS said unemployment rate will rise to reach 4.5% by 2008. A survey on 84 cities showed 3Q08 labor demand dropped 5.5% yoy, 1st time over the past years. With net job opening became negative in Q308, there are more pressure in 2009 as the no of college graduates will rise by 9.1% yoy in 2009.

On the back of the WTE slow-down, I think it is impossible to see Chinese banks to deliver a further low of both NPL amount and NPL rate, as the current NPL (~2% for Big 4) has no more improvement room. However, I do believe that China has a great long-term consumption story; even though near-term I can see the risks of deteriorating employment conditions and lower income growth after years of double digits rises. In this environment, I think exposure staples (Want Want and Hengan) is the appropriate as most of which should record solid earnings growth going into 2009F, backed by resilient demand and margin gains from easing input prices. While discretionary retailers like GOME and CRE are risky bets. In addition, the recent outperformed sector may also tell us the shelters during market carnage -- IPPs, F&B, HK utilities, HK Property and Telecom (Pricing War in 2009?) vs. the sectors getting killed  --- Steel, Paper & Forest, Coal, Shipping, IT and Cement…Well, lastly, let us check the regional valuation metrics, MSCI China is now traded at 7.8XPE09 and 8.6% EPSG, CSI 300 at 12XPE09 and 13.9%EPSG, and H-shares at 7.5XPE09 and 6.3%EPSG, while regional market is traded at 8.7XPE09 and -6.3% EPSG

[Note: It is important to monitor foreign flows. Since May 21, Asian emerging markets have suffered 26 consecutive weeks of foreign outflows, totaling US$52bn. Even in Asian countries with large institutional and individual investor bases, domestic net buying has not been sufficient to offset foreign selling. For example, locals have bought equities in Japan and Korea for 8 consecutive weeks, but both markets are down more than 20% during this period. Since 2004, Asian markets go down almost 80% of the time when foreign investors are net sellers, and domestic investors are net buyers.]

The Difference from 2001

There are also important lessons for FX markets that we can draw from Japan in the early 1990s to help us understand what could lies ahead. One interesting point was that BoJ kept raising rates for almost a year after the equity bubble had burst. Then, even since BoJ began to cut rates, it was lagged the deterioration in the economy, as Japanese nominal GDP growth was decelerating much faster than the BoJ was cutting interest rates. Consequently, Japanese IR moved above nominal GDP growth, indicating a tightening policy stance. This helped lead to a whopping 87% YEN appreciation in the years following the 1990 peak in the stock market and real estate bubbles. It was not until 1995 that the BoJ managed to get IR back below nominal GDP growth, indicating an accommodative monetary policy. In turn, YEN peaked and depreciated materially in the years that followed. Today, with risks of nominal GDP contracting and FFTR @1%, there are now growing doubts whether Fed policy can remain appropriately deflationary. This is offering a lift to the dollar, just as the BoJ's belated policy responses supported YEN in the early 1990s.

Having discussed so, USD/AXJ is reaching new highs, with key drivers from slowing growth expectations and the global credit crisis, meaning real money continues to leave Asian markets. In fact, foreign investors have in every month since May been net sellers of AXJ equities in all markets, except for Indonesia and Vietnam, according to EFPR. To my mind, the question is how long this unwinding of long AXJ equity positions continue? A simple comparison with the experience in 2001 suggests it has further to go…Although S&P and MSCI EM Asia have lost -41.50% and -62.38% respectively from their peaks in Oct2007, both indices (at 850.75 and 214.70) remain significantly above the lows reached during the last US recession in 2001002 (768.63 and 109.98). More importantly, there are viable reasons to believe that the lows will be lower this time. In 2001, US and Japan suffered shallow recessions whereas the EU and the UK only experienced weak growth, but no recessions. This time, the markets expect US, EU, UK and Japan 2009 GDP to contract by -2%, -1%, -2% and -0.7%, much worse than the comparable figures in 2001…Yes, I agree EM Asia is in a better position this time than in 2001, given stronger domestic demand and larger intraregional trade, especially with stronger China and India. However, even based on the market consensus, we are going to see a sharp slowdown in China’s and India GDP09 growth to 8% and 6.3%. This is not far from the 2001 growth figures of 8.3% and 5.8%.

Moreover, a key difference vs. 2001 is the global credit crisis. Given massive liquidity injections and IR cuts by central banks, the liquidity crisis has receded. However, as I discussed above, the financial system still has significant problems and financial market participants will continue to de-leverage near term, particularly in the face of economic recession. Thus, AxJ currencies with CA/trade deficit will weaken further, such as KRW, INR, and IDR. This expectation will only change when global and Asian growth expectations bottom out and the credit crisis is through its worst….Say 2H09…

To commodity space, even $586bn spending by China can not slow the plunge in copper, the worst- performing metal, as global inventories more than doubled in the past four months as the economic slowdown spread At the mean time, US auto sales slumped 32% in Oct to the lowest level since January 1991, as well US builders broke ground on the fewest houses in at least a half century, curbing demand for cables, wires and pipes. China, the world's biggest copper user, is heading for its slowest growth in almost two decades. Copper is an indicator for the world economy and sets the pace for other industrial metals because an average 400 pounds (181 kilograms) are used in homes and 50 pounds in cars, according to the Copper Development Association. Prices collapsed after rising as high as $8,940 a metric ton on the London Metal Exchange July 2.

I think we will see more downside for industrial commodities, if global economic decline further. In terms of price outlook, according to Andrew Keen, a senior analyst at Sanford C. Bernstein Ltd. in London, a global contraction would likely mean a 665 drop in copper to $2,400/ton, from $7,090 this year. Under his assumptions, a 1.5% decline in GDP in OECD, and -2.5% growth everywhere else, would mean copper at $3,250/ton, coking coal at $110/ton,  aluminum at $1,850/ton, iron ore to $65/ton and thermal coal at $55/ton.

[Appendix]

1.  CDS Market Exposures

The Depository Trust & Clearing Corporation, which claims to match and confirm 90% of all credit derivatives traded globally, has begun publishing gross and net exposures in the CDS market broken down by name and product.

As of 7 Nov, the total gross exposure of the CDS market was $32.7tn, down by $11.3tn since end April 2008. Of this exposure, $15.4tn is in single name CDS, $13.9tn is in CDS indices and $3.4tn is in CDS index tranches. Looking at net exposure (more relevant than gross as explained in the note), largest single names are sovereign: Italy $17bn, Spain $14bn, Brazil $12bn.Next largest single name exposures are on financials: GE Capital $11.4bn, DB $9.1bn, MS $7.6bn, ML $6.6bn, GS $6.3bn, Countrywide $5.4bn, Barclays $5bn. Largest non-financial single name exposure are: Berkshire Hathaway $4.8bn, Deutsche Tel $4.8bn, Continental $4.1bn, Telefonica $4.1bn, France Tel $4bn.

2.  Bretton Woods II and Hyman Minsky

In recent weeks, some, including official sources, have blamed the Fed for the global credit crisis, suggesting it was overly loose Fed policy that caused the bubbles that have now burst. We beg to differ. Rather, we think that the so-called Bretton Woods II arrangement, which from our perspective was inherently unstable, may have played an important part. Under this, exchange rates were kept within ranges that would otherwise have been broken. Based on a system of global imbalances, the Asian current account surplus was recycled to provide cheap financing for the US current account deficit. The US consumed even more than it produced and simultaneously funded its budget deficit at cheaper rates. Strong Asian exports supported regional growth. For many years, this seemed a win/win situation for all and many economists suggested this happy state of affairs could last indefinitely. Alas, this was not to be. Indeed, if we borrow from Hyman Minsky’s Financial Instability Hypothesis (FIH), we see that such a framework could never have lasted, sowed the seeds of its own destruction and that efforts to revive it will similarly be ill fated. Using the FIH framework, it is clear that the Bretton Woods II arrangement helped keep US market interest rates lower than they would otherwise have been. This in turn encouraged credit expansion, initially leading to more profitable activity.

On the US side, low rates boosted domestic demand, widening the current account deficit. On the Asian side, FX reserves exploded. Some of the results of this were soaring money supply growth, the simultaneous rise of US asset markets and commodities, the carry trade and rising inflation in both the US and Asia. More generally under the FIH, the pace of debt accumulation accelerates until it exceeded borrowers’ ability to service the debt. Minsky’s FIH can therefore be summed up as follows: Stability inherently creates instability. Monetarists would argue it is central banks that allow for – or restrain – explosive credit expansion. Indeed, they suggest central banks kept interest rates too low for too long during the 2000s and it was this that led to a debt-fuelled boom. Monetarists and Keynesians will continue to debate this point for many years. However, it is the view of this column that in this more globalize world where global growth – and inflation – is increasingly a function of Emerging Markets (EM), G7 central bank monetary policy is both cause and effect. It is impacted as much as it impacts – and increasingly by EM. If we allow for this possibility, the Bretton Woods II arrangement distorted monetary policy, keeping rates too low, encouraging excessive borrowing and exacerbating existing global imbalances. The lesson is not that markets should be bound by another Bretton Woods framework, but on the contrary that attempts to restrict markets may inevitably create greater instability than such restrictions are seeking to avoid.

3.  30yr Swap Spread

The wild ride week came to an end with important reversals in both stocks and treasury yields. The volatility for the week was   truly mind blowing and historical - 10-year yields saw a 77 bps move   for the week - almost equaling the entire range for the full year of 2005 but matching it on a percentage basis.

The higher yields were a tell tale sign as stocks did go negative a few times during the day but treasuries never got much of a bid. There were other signs of reversal as the market leading 30-year swap headed even higher in yield. The seismic move over the past many sessions in the spread that took the tenor to 2.87% yield   at a -60 bps spread to treasury Thursday began with the delta-type hedging of structured products like CMS inversion notes. It then morphed into a duration grab because of the highly dysfunctional off-the-run treasury bond/government repo market and now increased fail penalties; there is not the same capital requirement for receiving in swaps over buying treasuries - plus it is all off balance sheet for those in the de-leveraging process. A further  factor, especially on Thursday, insurance/pension types that hold   highly illiquid corporate bonds but need to maintain long duration, have been paying in those maturities (say 7-year) and then receiving  in 30s which often does not require any cash commitment.

4.  Textbook of 1990 Japan

The first chapter of that textbook would obviously deal with the incredible lag from the bursting of the bubble-economy to the implementation of appropriate monetary and fiscal policy. As monetary policy rapidly loses traction in an environment where the banking system is impaired, the most potent policy weapon becomes fiscal policy. Japanese fiscal policy was actually tightened in the immediate aftermath of the bubble bursting.  If we take the change in government expenditures as a proxy for the stance of fiscal policy, in the six years immediately after asset prices turned down fiscal policy became progressively tighter. In the most ominous reminder for the G20, by leaving an appropriate easing of fiscal policy too late, Japan ultimately found fiscal policy to also be ineffective. Japan tried 10 fiscal stimulus packages over the lost decade totaling more than 100 trillion yen, and each failed to cure the recession. In terms of the monetary policy response, policy continued to be tightened for 18 months after the turn in the equity market and for a further 6 months after the turn in land prices.  The process of monetary policy easing was extraordinarily slow with the level of the OCR not returned to the level that was in place before policy attempted to deflate the bubble till March 1994 – or nearly five years after the turn in the equity market.

The G20 have clearly not repeated Japan’s mistakes on monetary policy. Perhaps because most G20 central banks, they are independent from the government leaders who met in Washington this weekend. Monetary policy easing has been deep and front loaded in response to this crisis. The global leaders' 11-page statement said very little of immediate substance and therefore consequence. They spoke of broad principles, before another summit meeting in April, presumably after Barack Obama assumes the US presidency. The G20 leaders have just walked past the greatest train wreck in history.  Rather than calling for the doctors and ambulances, they have phoned the engineers to talk about building a less bumpy railway sometime in the future.  The passengers are far from delighted.

Given the eventual 60% decline in the Nikkei and 75% decline in land prices, some economic pain was unavoidable.  However a decade of economic stagnation was.  The "lost decade" required a decade of persistently wrong policy decisions that ignored the lessons learned in America's Great Depression of the 1930s.

5.  Lessons from The Asian Crisis

The response of various regulators in Asia varied considerably. It ranged from a laissez faire approach that Thailand adopted to nationalization of pretty much the whole banking system in Indonesia. In all the responses, what was common was (with the exception of Thailand) that the state removed bad loans from the system through an asset purchase. In contrast, Thailand adopted an approach similar to TARP by agreeing to inject capital by matching privately raised capital (Siam Commercial was the main user with a THB32.5bn capital raising in Feb 99, supplemented with a like amount from the THB300bn fund). This delayed a recovery in Thai banking in contrast to other crisis hit countries. It was not until when Thaksin was elected that various troubled asset buying AMCs were set up (BAM, PAM, SAM etc) that credit started to flow. The following is a summary of Asian responses:

Ø indonesia - nationalized the banking system and exchanged NPLs for high coupon bonds issued by IBRA.

Ø Malaysia - set up twin agencies - Danharta to buy bad loans and Danamodal to inject capital

Ø Korea - Kamco acquired bad loans in exchange for prefs issued by banks

Ø China - 4 AMCs bought bad loans in exchange for state guaranteed bonds

Ø S&L crisis - RTC bought bad loans

Ø Thailand - In Sep 98 announced a capital injection fund of THB300bn. Only SCB utilized it while others such as KBank (Thaifarmers in those days) set up its own "good bank; bad bank" structure.

See the pattern above?  Unless bad loans are removed from the system, it becomes near impossible for banks to focus on lending again. It is not to suggest that loans be bought at book rather than market value - that is a decision on shareholder value impact - but unless loans are removed from the system, expecting banks to lend again is a fond hope.                    

Good night, my dear friends!