asian financial markets - nyupages.stern.nyu.edu/~nroubini/papers/afm199.pdf · morgan guaranty...

Morgan Guaranty Trust CompanyEconomic ResearchBernhard Eschweiler (65) [email protected]

SingaporeJanuary 29, 1999

Asian Financial Markets

Recovery is becoming a reality...

• Asian news over the last three months has been largely positive. The J.P.Morgan forecast that the region is moving from recession to stabilizationand recovery is becoming reality. The first building block was improve-ment in payment conditions. More recently, easy macro policies, reformprogress, and rising export volumes where currencies have dropped arebecoming the main drivers of output growth. Even so, the evolving re-covery will be generally moderate and uneven across countries.

...but will be moderate and uneven

• Korea is leading the recovery, followed at some distance by Thailandand the Philippines, while Hong Kong and Singapore trail behind. Politi-cal uncertainties will delay recovery in Indonesia and the government’sisolationist policy will do the same in Malaysia. Still, a more uniformgrowth pace of nearly 5% is likely to follow in 2000 and, if reforms con-tinue, 5%-to-6% long-term growth is still in reach for the next decade.

• China and Japan are the main outliers and risk factors. Both countrieshave used extensive policy stimulus, but with mixed results and at theexpense of structural reforms, while their corporate and financial sectorhealth continues to deteriorate. Slow progress on these fronts is likely tokeep Japan close to recession and to slow China in both 1999 and 2000.

Asia’s recovery is a modest plus for Australia and New Zealand

• While tight policies and the Asian crisis have pulled New Zealand intorecession, strong consumer spending has kept Australia rolling. Recov-ery in Asia is a plus for both countries, but while New Zealand shouldpick up, slackening domestic demand is set to slow Australia’s economy.

Market conditions to improve further, but not everywhere

• In the near term, markets are likely to focus on devaluation risks inChina, the implications for the Hong Kong peg, and the deterioration ofsupply and demand conditions in Japan’s government bond market. Eco-nomic recovery and falling interest rates, however, are likely to supportmarkets in much of the rest of Asia. Fallout from an emerging marketscrisis or a sharp correction in the U.S. equity market are risks, but areunlikely to derail the improving market fundamentals. Besides China andJapan, India and Taiwan are most at risk to disappoint.

Contents

Related J.P. Morgan research 2

Executive Summary 3

Essays

Asia’s uneven recovery 5

Restructuring progress in Korea and Thailand 13

Japan’s fiscal headaches 21

Regional economic outlook themes

Japan 29

Emerging Asia 35

Australia/New Zealand 47

Financial market implications

Foreign exchange and interest rates 51

Equities 54

Summary outlook table 56

First Quarter 1999

95

100

105

110

115

120

1997 1998

Korea

Japan

Industrial production1995=100, sa, 3-mo. mov. avg

Asian Financial Marketspage 2



Related J.P. Morgan Research productsEmerging Asia Daily UpdateDaily review of market developments andshort commentaries.

Credit Research Reports, ad hocAnalytical assessments of the creditworthi-ness of Asian corporates and financial insti-tutions, including J.P. Morgan ratings.

For more information please contact yourJ.P. Morgan client representative.

Global Market Outlook and StrategyBiweekly intermediate-term outlook for ma-jor fixed income markets, based on analysisby J.P. Morgan strategists and researchers.

Yen fixed-income quantitative, quarterlyMarket views and trading strategies for theyen fixed-income market, with an emphasison relative value trades.

Emerging Markets Outlook, monthlyMarket views and trading strategies foremerging markets (exchange rates, interestrates and external debt spreads).

Global Data Watch, weeklyEconomic intelligence and data forecasts forthose active day-to-day in the financial mar-kets of industrial and emerging economies.

World Financial Markets, quarterlyThemes and details of the J.P. Morgan glo-bal economic outlook, plus essays on topicsof broad economic, market, and policy sig-nificance for global financial markets.

Daily Economic CommentaryTimely analysis of economic developments,available on the World Wide Web.

J.P. Morgan Research in Asia/PacificCredit ResearchStephen A. Long, Tokyo(81-3) 5573-1456Financial Institutions

Natsumu Tsujino, Tokyo(81-3) 5573-1449Financial Institutions, Japan

Osamu Shimamura, Tokyo(81-3) 5573-1450Corporates, Japan

Merrit Maddux, Tokyo(81-3) 5573-1523Industrials, Emerging Asia

Jenny Wilson, Singapore(65) 326-9551Telecoms, Emerging Asia, Philippines

Kimberly Tan, Singapore(65) 326-9210Utilities, Emerging Asia, Hong Kong

Yong A. Kim, Singapore(822) 3705-6608Korea

Market ResearchBill Campbell, Tokyo(81-3) 5573-1075Head of Yen Fixed-Income Research

Akihiko Yokohama, Tokyo(81-3) 5573-1071Yen Fixed-Income Research

Andrew Skinner, Sydney(61-2) 551-6288Market Research Australia

Ronald Leven, Singapore(65) 326-9063Head of Asian Emerging Markets Research,China, Hong Kong, Korea, Taiwan

Ong Guat Cheng, Singapore(65) 326-9459Asian Emerging Markets Research, Malay-sia, Philippines

Hsin-Li Chia, Singapore(65) 326-9789Asian Emerging Markets Research, Indone-sia, Singapore, Thailand

Aashish Pitale, Mumbai(91-22) 270-2152Asian Emerging Markets Research, India

Economic ResearchBernhard Eschweiler, Singapore(65) 326-9026Head of Economic Research Asia/Pacific,India

James Malcolm, Tokyo(81-3) 5573-1170Japan

Yuki Funabashi, Tokyo(81-3) 5573-1168Japan, economic indicators

John Kyriakopoulos, Sydney(61-2) 9551-6467Australia, New Zealand

Joan Zheng, Hong Kong(852) 2841-1151China, Hong Kong, Taiwan

Vicky Wong, Hong Kong(852) 2973-5465Economic indicators

Ji-won Lim, Seoul(822) 3705-6649South Korea

David Fernandez, Singapore(65) 326-9452Indonesia, Philippines, Thailand

Sin-Beng Ong, Singapore(65) 326-9075Malaysia, Singapore




Executive Summary

It’s the real thing, but not for Japan• Asian markets are celebrating the first signs of

economic recovery

• But the recovery will be moderate and unevenand some countries will be left behind

• There is no quick fix for Japan’s predicament

The recent rally in Asian financial markets has sparkednew optimism, but also leaves doubts. Not all of themarket developments have been positive. In particular,the strength of the yen and the increase in Japanesegovernment bond yields are hardly harbingers of newlife in Asia’s largest economy. Nevertheless, a lot haschanged. There may be bumps still to come and recov-ery will be uneven, but this is the real thing.

Indeed, there is more to Asia’s market rally than justhope and a boost from Wall Street:

• Output has bottomed out and recovery is already re-ality in some parts of the region, notably Korea;

• Interest rates have dropped sharply, boosting liquid-ity and reducing interest expenses;

• Export volumes are rising from economies wherecurrencies have dropped, leading to inventory re-building and some new investments;

• Although constrained by social and political factorsand by poor institutional standards, reforms inAsia’s crisis countries are making progress.

With payments pressures largely gone, inflation on thedecline, and macro policies focused on stimulatinggrowth, these trends are likely to continue. The econo-mies likely to perform best will be those where sus-tained real currency depreciations combine with stimu-lative policies and progress in financial and structuralreforms. Still, there will be late comers and some maynever join the party, at least this year. Moreover, risksremain both inside and outside the region.

China and Japan will buck the trend

China and Japan are the biggest outliers and risk fac-tors in the regional growth outlook. Both countrieshave used extensive policy stimulus, but with mixedresults and at the expense of structural reforms, whiletheir corporate and financial sector health continues todeteriorate. Slow progress on these fronts is likely tokeep Japan close to recession and slow China’s growthperformance in both 1999 and 2000.

In the near term, however, markets are likely to focuson the devaluation risks of the Chinese renminbi (andtheir implication for the rest of the region, especiallyHong Kong) and on Japan’s difficulties in funding itsballooning budget deficit.

100

110

120

130

140

150

Jan 98 Apr 98 Jul 98 Oct 98 Jan 990.5

1.0

1.5

2.0

2.5

3.0yen/US$... against a strong yen and rising JGB yields

% p.a.

10-year JGB yield

Yen exchange rate

125

150

175

200

225

250

Jan 98 Apr 98 Jul 98 Oct 98 Jan 999000

10500

12000

13500

15000

16500

18000

Japan

Emerging Asia

Emerging Asian equities rally, while Japan’s struggleMSCI, local currency terms Nikkei 225




Renminbi adjustment is only a matter of time...

Given the drawbacks of the current stimulus policy andthe pressure on its exporters, China’s government hasmost likely accepted that a depreciation of the renminbiis inevitable. What matters is the timing. Thegovernment’s key concern seems to be the impact of acurrency adjustment on Hong Kong and the peg. True,there is no direct link between the two currencies,thanks to the renminbi’s lack of convertibility. But withthe economy weak, sentiment in Hong Kong is sensitiveto changes in China’s currency stance.

Thus, China will probably try to delay a policy changeuntil the second half of the year, hoping for signs firstof economic recovery in Hong Kong and further de-clines in U.S. interest rates. Moreover, it is likely toprefer a gradual depreciation, thereby shifting to a moreflexible exchange rate policy. Whether the adjustmentwill be smooth remains to be seen, but thegovernment’s ability to hold out and control the foreignexchange market should not be underestimated.

...and unlikely to derail the Hong Kong peg

For Hong Kong, the worst is probably over, but theSAR is suffering from outright deflation, high real in-terest rates, and a still-depressed property sector. Underthese conditions, Hong Kong is clearly vulnerable toshocks, whether they come from China, a sharp correc-tion in U.S. equity markets, or a new crisis in emergingmarkets. Still, the government will probably continue toview the dislocations from devaluation as potentiallymore damaging than the adjustment cost of maintainingthe peg. And with monetary balances remaining strongand U.S. interest rates biased downward, there is a highchance that it will succeed.

Should the BoJ absorb the government’s debt?

In Japan, market concerns have largely shifted from thepoor state of the economy to the government’s growingbudget deficit and the sharp decline of funds availableat the government’s Trust Fund Bureau for the purchaseof JGBs. While some of the fears are overblown – mostnotably, concerns that Japanese savers could withdrawlarge amounts of maturing deposits from the Post Officein coming years – the fundamental supply and demandequation for JGB is undoubtedly changing. That puts

the sustainability of Japan’s fiscal policy stance intoquestion and raises the issue of what higher yieldsmight mean for the rest of the economy.

Additional damage to the economy from higher yieldswould probably be limited, however, since the poorand deflationary state of the economy would likelykeep yields from rising much above current levels.Still, if the outcome is only rising debt yet no lastingrecovery, the sustainability of the current fiscal policystance must be in doubt. But what are the alternatives?

A popular and radical proposal is to inflate theeconomy at any price by forcing the Bank of Japan(BoJ) to absorb the government debt. But besidesmeeting resistance from the increasingly independent-minded BoJ, this proposal would probably not bringthe desired results. Investment in Japan is in a pro-longed trend downward, as companies adjust to thedecline in their long-term growth potential, and theresulting drag is compounded by paralysis and consoli-dation in the financial sector. Against this background,monetary and fiscal expansion lacks any multiplier ef-fects. Thus, absorbing the government debt wouldboost the monetary base, but probably do little to ac-celerate broad money supply and real GDP.

Instead, any successful solution will probably have tocombine easy fiscal and monetary policies with a se-ries of painful structural reforms that resolve the prob-lems of the financial sector and reduce subsidies toloss-making businesses, including public enterprises.But such adjustment will not come without substantialdislocations of the labor market, which are apt to testJapan’s political and social consensus.

-3

0

3

6

9

12

88 90 92 94 96 98

Monetary base

M2 plus CDs

BoJ has lost contril over broad money supply%oya, 3-month moving average




Asia’s uneven recovery• Recovery is a reality, but not everywhere

• Payments pressures and policies have eased andactivity surrounding the trade sector is rising

• Emerging Asia to return to 5% growth in 2000

• But Japan to stay close to recession and China toslow in both 1999 and 2000

By now, there is little question that Asia has reached abottom. Even the laggers are starting to stabilize andthere are already some signs of recovery, most notablyin Korea. The main forces behind the region’s outputstabilization are the fading of payments pressures andthe pump-priming in China and Japan. Going forward,easier macro policies, reform progress, and activitysurrounding the trade sector are likely to be the mainsources of growth. However, the region’s recoverywill be moderate and uneven.

• On the external side, global growth conditions areexpected to deteriorate, with world real GDP growthsliding from 1.6% in 1998 to roughly 1.0% in 1999.

• In Japan, the downward trend in private demand islikely to continue, despite the government’s desper-ate stimulus efforts, and the economy is expected tomove at best from recession back to stagnation.

• China will probably avoid recession, but its growthperformance is set to slip in both 1999 and 2000.

• Countries that experienced sharp currency devalua-tions and made tangible reform progress are likelyto lead the rebound – Korea, followed at some dis-tance by Thailand and the Philippines – while politi-cal uncertainties in Indonesia and Malaysia’s isola-tion policy are likely to delay recovery.

• Countries that maintained relatively strong curren-cies will lag the recovery – Hong Kong, Singapore,and Taiwan. At risk also is India, which in contrastto the rest of the region has suffered an unsustain-able deterioration in its external and fiscal accounts.

For the region as a whole, the J.P. Morgan forecast isnot much different from the consensus view. In con-trast to the consensus, however, Morgan expectsJapan’s fiscal stimulus to hold GDP flat in 1999, butthat another downturn will follow in 2000. For the restof the region, Morgan is more optimistic on the growthoutlook for those countries that have experienced deeprecessions, but predicts more weakness in those coun-tries that have largely escaped the regional crisis, mostnotably and importantly China.

Real GDP growth forecasts% year-on-year

1999f 2000fJ.P. Con- J.P. Con-

1998e Morgan sensus* Morgan sensus*

Asia -1.7 1.2 0.6 1.4 2.0Japan -2.9 0.0 -1.1 -1.0 0.1

Emerging Asia 0.1 3.0 3.1 4.9 4.8China 7.8 6.5 7.6 5.8 7.7

Korea -5.7 4.0 1.0 4.5 3.5Philippines -0.5 2.6 1.5 5.0 3.2Thailand -6.5 3.0 0.0 5.0 3.3Indonesia -13.7 -3.5 -3.2 5.0 2.3Malaysia -7.3 -1.0 0.0 5.0 2.7

Hong Kong -5.0 -1.5 -0.9 3.0 1.9Singapore 1.3 -1.0 -0.8 4.0 3.1Taiwan 4.8 3.2 4.5 4.5 4.9

India 4.0 2.5 5.0 5.0 5.4

* Consensus Economics Inc., January 11, 1999.

95

100

105

110

115

120

125

130

1997 1998

Japan

Korea

Malaysia

Industrial production1995=100, sa, 3-month moving average




Output figures have improved, but not uniformly

Quarterly real GDP and monthly industrial productionfigures generally improved in the second half of lastyear. For the region as a whole, output reached a bot-tom, following sharp contractions in the first half of1998. However, there are clear leaders and laggers anddifferent degrees of stability.

• Most impressive has been the rebound in Koreanindustrial production, which has nearly reversed theearlier declines. As a result, real GDP probablybounced above its 1998 average in the fourth quar-ter. The very high pace of output increases is set toease soon, but the decline in the inventory/sales ra-tio, the increase in capacity utilization, and the sta-bilization in labor market conditions will probablycontinue to support the recovery.

• In contrast, Japan’s output stabilization is fragile,despite the government’s massive fiscal stimulus.Inventory and capacity utilization conditions havenot improved and corporates’ financial position andlabor market conditions continue to deteriorate.

• China’s pump-priming efforts have been far moresuccessful than Japan’s. The quality of China’s out-put data is questionable, but even if the rate of out-put growth is overstated, there are clear signs ofreacceleration. However, excess inventory and ca-pacity problems have not disappeared and plungingprices have eroded corporates’ financial health.

• Hong Kong and Singapore are trailing the regionaltrend, with output and labor market conditions dete-riorating through most of the second half of 1998.

• Taiwan, which held up well through most of 1998,started to slip toward the end of last year.

• Output indicators in Indonesia, Malaysia, the Phil-ippines and Thailand are more volatile, but show astabilization in the second half of 1998 after thefree-fall in the first half. However, recovery is notyet a trend except perhaps for Thailand.

• Finally, India, which seemed isolated from the re-gional crisis, also started to show signs of weaknesstoward the end of 1998.

Output indicators% quarter-on-quarter, seas. adj. annualized, unless stated

Country Data 98Q1 98Q2 98Q3 Latest period*

Japan Real GDP -4.8 -2.9 -2.6 n.a.Ind. prod. -4.9 -18.9 -1.1 -3.2 98Q4

China** Real GDP 7.2 7.0 7.6 9.4 98Q4Ind. prod. 9.0 7.7 8.6 9.9 98Q4

Hong Kong Real GDP -12.8 -2.9 -6.4 n.a.India Ind. prod. -1.9 7.9 2.6 -2.9 OctIndonesia Real GDP -25.3 -32.1 -6.5 14.5 98Q4Korea Real GDP -21.4 -4.6 1.7 n.a.

Ind. prod. -37.8 -6.8 18.1 48.1 98Q4Malaysia Real GDP -24.8 -8.3 -3.7 n.a.

Ind. prod. -24.0 -10.4 -12.3 6.3 Oct-NovPhilippines Real GDP -4.7 -2.0 1.6 -1.6 98Q4Singapore Real GDP 0.7 -1.4 -3.5 -5.2 98Q4

Ind. prod. -9.3 -6.8 -6.3 13.2 98Q4Taiwan Real GDP 1.9 3.1 6.0 n.a.

Ind. prod. -8.9 4.9 9.9 -0.4 98Q4Thailand Ind. prod. -21.8 11.3 -6.7 9.9 98Q4

* Annualized % change of latest average from third-quarter average.** Average %oya change.

75

80

85

90

95

100

105

110

1997 1998

Japan

Korea

90

95

100

105

110

115

120

125

1997 1998

JapanKorea

Inventory/shipment ratios1995=100, 3-month moving average, sa

Capacity utilization1995=100, 3-month moving average, sa




The private demand meltdown is largely over

Except for Japan and Korea, there are few reliable andtimely domestic demand indicators. Still, the availabledata show a picture compatible with the recent outputtrends. Private consumption and investment spendingare largely stabilizing and even give some signs of re-covery. The main exceptions are investment spendingin Japan and private consumption in Hong Kong.

• Private consumption: Korean retail sales bouncedsmartly toward the end of last year, supported bystabilizing labor market conditions and improvingconsumer sentiment. In contrast, the Novemberjump in Japanese retail sales proved temporary, asemployment conditions and consumer sentimenthave continued to worsen. Chinese retail salessurged in the third quarter and their fourth-quarterdrop was largely payback. But retail sales in HongKong and, to a lesser extent, Singapore continued tofall through most of the second half of 1998. Fi-nally, Thai and Malaysian car sales data, althoughmore volatile, point to some stabilization and per-haps even recovery in private consumption.

• Private investment: Only Japan and Korea releaseprivate investment statistics. For Japan, the datashow continued – although somewhat more moder-ate – declines in construction orders, housing starts,and machinery orders. For Korea, the data are morevolatile, but show some stabilization in constructionand machinery orders while building permits contin-ued to decline until the end of last year.

Trade surpluses have peaked ...

Improved output conditions in China and Japan arelargely the result of government pump-priming efforts.Elsewhere, however, cyclical improvements reflect arapid easing of the payments pressures that forcedbusinesses and households to slash spending at the be-ginning of last year. The size and speed of the spend-ing cutbacks was visible in the region’s dramatic im-port and trade balance adjustment. Not surprisingly,with cyclical conditions now improving, the rise in re-gional trade surpluses has come to an end. However, arapid return to deficits is unlikely, while exports andinvestment in the trade sector are likely to drive recov-eries where currencies have dropped sharply.

Private consumption indicators% quarter-on-quarter, seas. adj. annualized


Japan Retail sales -3.3 -7.9 -4.8 -1.0 98Q4China Retail sales 7.6 3.7 15.3 -2.1 98Q4Hong Kong Retail sales -35.8 2.6 -20.1 -18.1 Oct-NovKorea Retail sales -32.0 -4.6 -5.8 19.5 Oct-NovMalaysia Car sales -93.3 -8.6 32.2 42.0 Oct-NovSingapore Retail sales -21.4 2.6 -20.8 -0.1 Oct-NovThailand Car sales -63.7 -25.1 -64.6 412.9 Oct

* Annualized % change of latest average from third-quarter average.

Private investment indicators% quarter-on-quarter, seas. adj. annualized


Japan Constr. orders 9.9 -54.7 23.6 -27.7 98Q4Housing starts 4.7 -22.6 -27.0 -10.2 Oct-NovMach. orders 5.5 -50.1 -3.3 -15.5 Oct-Nov

Korea Constr. orders 4.2 -89.4 49.2 -26.2 Oct-NovBldg. permits -69.8 -90.0 -58.8 -30.6 Oct-NovMach. orders -67.7 -26.4 150.7 -1.6 Oct-Nov

* Annualized % change of latest average from third-quarter average.

-6

-4

-2

0

2

4

6

8

10

1996 1997 1998

JapanChina

Asia ex China and Japan

0

2

4

6

8

10% of labor force, saUnemployment rates

1997 1998

Japan

KoreaHong Kong (unemployment and underemployment)

Taiwan

Asian trade balancesUS$ billion, per month, 3-month moving average, sa




...but volumes are likely to rise

Dollar-denominated trade statistics continue to show apicture of falling exports in most of the region exceptfor the Philippines. However, available volume datashow rising export activity in countries where curren-cies have devalued sharply and falling export activityin countries where currencies have remained strong.This trend is likely to continue through much of thisyear, with many Asian exporters carving out largermarket shares, although in a weaker global trade envi-ronment. An additional plus for Asia’s electronics ex-porters are recent signs of improving demand andprice conditions in the global electronics business.

Volume increases in the trade sector are also likely togenerate second-round effects, especially inventoryincreases and new investments in machinery andequipment. Most especially, foreign direct investmentin the trade sector is set to surge.

However, with inventories and investment starting torecover, import volumes are set to rise as well and willprobably outpace the increase in export volumes. Still,a rapid return to deficits is unlikely, as it will takemany years for domestic demand conditions to recoverfully, while prices of imported commodities are likelyto remain soft. The main exception is probably China,whose trade surplus is expected to fall faster this year,reflecting the policy-driven reacceleration of domesticdemand and exporters’ difficulties in maintaining pricecompetitiveness. Japan’s exports are also set to sufferfrom the yen’s appreciation, but the failure of thegovernment’s stimulus packages to boost private de-mand will probably keep imports at bay.

Policy conditions have eased...

A notable change and a plus for the region’s growthoutlook is the easing in monetary and fiscal policyconditions. Interest rates have fallen across the boardas payments pressures and inflation risks have disap-peared. The sole exception is India, where rising defi-cits and inflation pressures have forced a tightening ofmonetary policy. Besides China and Japan, HongKong, Korea, Malaysia, Singapore, and Taiwan havealso eased fiscal policy. Still, overall policy conditionsare not everywhere stimulative and, with inflation stillfalling, there is room for more interest rate cuts.

...but are not everywhere stimulative

For Japan, the main issue is not a lack of policy stimu-lus, but an absence of spending multiplier effects,which highlights the need for speedy structural re-forms. In the rest of the region, only Korea has trulyachieved an across-the-board stimulative policystance, which is no doubt starting to show up in itsgrowth performance.

500

1500

2500

3500

4500US$ million, per quarterKorea: foreign direct investment commitments

1997 1998

45

50

55

60

65

70

75

10

15

20

25

30

35

40US$ billion, per month, 3mma, sa, both scalesDollar-denominated export values

1997 1998

Asia ex China and Japan

Japan

China

85

90

95

100

105

110

115

120

125

1997 1998

Korea

Singapore

Export volumes1997=100, 3-month moving average, sa




China’s policy stance is polarized between pump-priming in the state enterprise sector and tight mon-etary conditions. The real effective exchange rate stillappears competitive, but at the cost of huge price de-clines that have undermined corporate financial posi-tions. How long the government can sustain this di-chotomy is unclear, but monetary easing and, stillmore, a gradual currency adjustment seem inevitable.

In Hong Kong, monetary conditions remain tight, al-though the solid expansion of the real monetary aggre-gates points to continued high official faith in thesustainability of the currency peg. And with inflationturning to deflation, there is a need for further interestrate declines, but the room for interest rates to fall alsodepends on the direction of U.S. interest rate policyand sentiment surrounding China.

In much of the rest of the region, monetary conditionsare just about neutral and there is clearly room formore interest rate declines, given the benign inflationprospects and low operating rates. In particular, Thai-land has more room for monetary ease, since thebaht’s appreciation has eroded much of its earlier com-petitiveness gains.

By contrast, Malaysia has little room to ease policyfurther since the government’s isolation and expan-sionary policies have undermined depositor confi-dence. Political uncertainties and the risk of depositorflight also limit the room for monetary easing in Indo-nesia. And India will probably first have to raise inter-est rates to stem the deterioration of its trade balanceand offset inflationary pressures before it can move onto relax policy again.

Monetary and fiscal conditionsMonetary conditions FiscalREER Real rates Real M2 Total stance

Japan 0 0/+ + 0/+ ++China 0 – 0/– 0/– ++Hong Kong – – – + – +India 0 0 + 0/+ 0Indonesia ++ – – – – – –Korea + + + + +Malaysia + + – – 0 +Philippines + 0 – 0 0Singapore 0 0 0 0 +Taiwan 0 – – 0/– +Thailand 0 + – 0 0

Nominal and real short-term interest rates% p.a.

Nominal interest rates Real interest rates*Dec 1997 Dec 1998 Dec 1998 1990-97

Japan 0.4 0.2 0.7 2.2China 8.6 6.3 4.9 0.6Hong Kong 9.4 5.4 8.2 -1.9India 7.2 9.6 2.6 2.1Indonesia 28.5 37.5 13.5 2.1Korea 35.0 6.6 5.0 8.9Malaysia 9.1 6.3 0.7 3.0Philippines 18.1 13.5 6.0 6.1Singapore 6.3 1.6 2.1 1.7Taiwan 8.4 5.9 7.1 4.4Thailand 27.0 7.3 3.9 6.6

* Nominal interest rate minus 12 months-forward average inflation.

Nominal and real money supply (M2) growth%oya

Nominal M2 growth Real M2 growth*Dec 1997 Nov 1998 Nov 1998 1990-97

Japan 3.8 3.9** 3.3** 2.1China*** 19.6 15.3 16.4 19.7Hong Kong 8.4 11.3 12.1 6.0India (M3) 16.7 19.5 11.2 8.1Indonesia 23.2 66.7 -11.5 18.2Korea 14.1 22.0** 18.0** 11.9Malaysia 22.7 4.5 -1.1 16.0Philippines (M3) 21.0 7.2 -3.6 10.5Singapore 10.3 7.5 9.0 10.0Taiwan 8.0 9.8 5.9 10.5Thailand 16.4 11.6 6.9 12.9

* Nominal M2 growth minus inflation rate.** Dec 1998.*** Quarterly data.

Real effective exchange rate1990=100

Dec 1997 Dec 1998 Last 5-year average

Japan 102.5 106.6 113.4China 89.6 78.4 81.1Hong Kong 138.4 131.3 123.6India 80.8 76.8 77.9Indonesia 62.4 70.5 89.4Korea 58.6 70.9 81.6Malaysia 84.9 81.8 103.1Philippines 90.9 95.7 104.5Singapore 114.4 108.6 112.9Taiwan 89.3 91.6 89.5Thailand 75.5 98.9 97.8




There are more signs of reform progress

Going forward, the economies that are likely to per-form best will be those where easier policies join withfinancial and structural reform progress. However, thisdoes not mean that recovery depends solely on the res-toration of corporate and financial sector health. Banklending, for example, is usually a lagging businesscycle indicator. In fact, the speed of economic recov-ery and the degree of monetary ease are key factorsdriving the process of restoring corporate and financialsector health. Even so, Japan’s experience highlightsthat stimulus alone can have little impact if structuralproblems remain unresolved.

Among the crisis countries in Emerging Asia, govern-ments were initially slow to recognize the need for re-forms, but then changed their tune rapidly amid thedramatic collapse in economic and financial conditionsand, in some places, political change – notably in Ko-rea and Thailand. Still, the structure of reforms andtheir progress vary widely across the region.

Korea and Thailand are generally viewed as leadingthe reform effort, even though their reform paths arevery different (see also: Restructuring progress in Ko-rea and Thailand, pages 13-20). Both countries movedswiftly to implement emergency measures, close andnationalize insolvent financial institutions, and restoredepositor confidence. However, the Korean govern-ment has been quick to shoulder much of the banks’bad loan problems, while the Thai government has laidout a plan that relies more on private-sector initiativesto clear the market and is tying banks’ access to publicfunds to strict restructuring guidelines.

Not surprisingly, Korea’s approach has deliveredfaster results, with banks starting to lend again, whileThailand’s market approach has suffered from the lackof an efficient legal infrastructure and banks’ reluc-tance to restructure their balance sheets. However,Thailand’s problems are mostly limited to the financialsector, while Korea faces a much broader challengethat links banking sector issues to inefficient allocationof capital and labor throughout the economy. Consid-ering the political and social constraints, Korea is onthe right track, but has a long way to go, while Thai-land needs to tighten the screws to enforce its reformplan and should ease banks’ access to public funds.

The structure of Indonesia’s problems is similar tothose in Thailand, but the damage is much worse andpolitical uncertainties continue to undermine reformprogress. Less noticed have been Malaysia’s financialrestructuring efforts, in which the government is ac-tively buying bad loans and providing banks with freshcapital. However, much of the banks’ loan problemsremain tied to the government’s preferential growthstrategy, which has so far remained unchanged.

Funding the restructuring needs

Although government financial involvement in the re-form process varies, the sheer size of the restructuringburden will have profound fiscal consequences. Inpractice, governments usually buy bad loans or bankshares in exchange for government bonds. By itself,this creates no additional net borrowing requirement,but boosts government interest expenses at a timewhen budget balances are already under pressure fromthe economic downturn and fiscal stimulus packages.

For the crisis economies in Emerging Asia, the abilityto fund the growing budget deficits will depend onpeople’s faith in the government and its reform policy.Despite the economic turmoil, saving rates have stayedhigh and even have increased in some countries. How-ever, in the absence of efficient bond markets, govern-ments rely largely on banks to give them loans or buytheir securities. This highlights the importance of de-positor confidence for both the accumulation and ac-cessibility of private savings. In Korea and Thailand,people have that faith, but not in Indonesia, while de-positors in Malaysia seem to be concerned over thegovernment’s isolation and expansion policies.

-3

0

3

6

9

12

15

1992 1993 1994

Real domestic credit

Industrial production

Korea: bank lending is lagging, not leading, recovery%oya, 3-month moving average




Growth gaps are likely to narrow in 2000...

All in all, the economies of Emerging Asia will vary intheir performance in 1999, but the laggers are ex-pected to catch up in the year 2000, producing a re-gional GDP growth average of nearly 5%. Unfavorableexternal events are a risk, but far less so than a yearago, given the improved balance of payments position.Instead, the main risks are likely to come from theregion’s two largest economies: Japan and China.

...but Japan will stay close to recession...

Japan’s adjustment is depressingly slow comparedwith the improvements in some parts of EmergingAsia – most notably Korea. The key drag on its growthis the downward adjustment of investment plans. Afterthe boom of the bubble years, Japan’s growth potentialhas declined and investment efficiency (ICOR*) in thetraditional manufacturing and construction areas hasdropped sharply. In response, companies have reducedcapital spending but have been slow to realize newgrowth opportunities in the service sector. Not surpris-ingly, investment efficiency has remained poor and,with capital spending still high relative to both outputand growth potential, the private investment slide islikely to continue another two years or more.

The prolonged capital stock adjustment is generatingnegative employment and consumption fallout. Thatfallout, combined with the paralysis in the bankingsector and growing popular concerns over the safety ofthe pension system, has depressed domestic privatedemand and will continue to do so. Against this back-ground, the government’s pump-priming efforts havefirst-round effects but fail to boost sentiment or lead tosecond-round spending.

Worse, the fiscal packages are designed only to easepain and actually reinforce many structural rigidities,especially in the overstaffed construction sector. Fi-nancial-sector reform progress has also remained slow.The provision of ¥60 trillion for bank recapitalizationpurposes is likely to limit systemic risks, but the gov-ernment still lacks a comprehensive strategy to iden-tify and solve banks’ bad loan problems.

Not surprisingly, the combination of fiscal expansionand a weak economy has boosted the budget deficit

* Incremental capital/output ratio: (Investment/GDP)/(Real GDP growth).

and put the sustainability of Japan’s fiscal policystance into question (see also: Japan’s fiscal head-aches, pages 21-28). Still, with an election approach-ing, fiscal pump-priming is likely to increase in 1999,keeping the economy about flat. However, an esti-mated fiscal deficit of nearly 10% of GDP will prob-ably limit the government’s ability to boost spendingmuch further in 2000, and could thus set the stage foranother downturn in the economy at large.

...and China will continue to slow

In contrast to Japan, China’s pump-priming effortshave had some success in stimulating domestic de-mand. However, this has come at the cost of haltingreforms in the state enterprise sector and the bankingsystem, while the stability of the renminbi has forcedexporters to cut prices and has undermined corporatefinancial health. The bankruptcy of GITIC highlightsthe government’s efforts to force the weakest financialinstitutions to adjust. But the much larger problem ofthe state enterprise sector and the state banks remainson the back burner and is unlikely to be addressedswiftly, given the huge labor market implications.

Instead, the government will probably continue itsstrategy of muddling through, relying on its still-potentability to steer the economy. This is likely to lead to amoderation of the pump-priming in the state sector anda gradual depreciation of the currency, provided HongKong continues to stabilize. On balance, however, fad-ing stimulus and mounting structural head winds areexpected to drag GDP growth further downward.

0

5

10

15 0

5

10

15

20

75 80 85 90 95

Equipment and plant investment, % of GDP

Real GDP growth

ICOR*

Japan’s investment efficiency has plungedratio, 5-year mov. avg. % p.a., 5-year mov. avg.




And what about the long haul?

In what ways and how fast China and Japan will re-solve their problems is unclear. Weakness in bothcountries is likely to have some restraining impact onthe rest of the region, but is unlikely to derail recover-ies or long-term growth prospects. However, movinginto the next decade, average growth is likely to belower than in the 1990s even if countries continue tomake sound improvements.

A feature common to most Asian countries in theboom years was overinvestment leading to efficiencylosses – rising ICORs. Going forward, sustainablelong-term growth should be built on lower investmentrates – although a few countries could invest more –together with some improvement in efficiency. Thatsaid, structural factors, such as the maturing of theregion’s more advanced economies and a lack ofskilled labor, are likely to cause efficiency losses insome parts of the region.

Thus, China, Korea, Malaysia, Singapore, and Thai-land are likely to see the largest declines in their long-term growth potential compared to their peak perfor-mances in the mid 1990s, while only the Philippineshas a good chance to raise its long-term growth rate.Moreover, much will depend on sustained reformprogress, especially in the region’s crisis countries andChina. Still, most countries are likely to outperform

Projecting long-term growth*percent annualized

Gross domestic fixed investment divided by Incremental capital output ratio equals Real GDP growth1987-96 1993-96 2001-10 1987-96 1993-96 2001-10 1987-96 1993-96 2001-10

China 30.5 33.2 32.0 3.0 2.9 4.0 10.0 11.6 8.0Hong Kong 28.2 31.1 28.0 4.8 6.1 7.0 5.9 5.1 4.0India 22.1 21.8 24.0 3.7 3.3 4.0 5.9 6.5 6.0Indonesia 26.6 28.5 26.0 3.9 3.8 4.0 6.9 7.5 6.5Korea 35.1 37.2 30.0 4.2 4.9 5.5 8.3 7.6 5.5Malaysia 35.2 42.6 30.0 4.2 4.8 5.0 6.5 8.8 6.0Philippines 21.1 23.2 24.0 5.7 5.5 4.0 3.7 4.2 6.0Singapore 33.9 36.3 30.0 3.8 4.0 6.0 9.0 9.1 5.0Taiwan 22.3 23.8 22.0 3.1 3.9 4.5 7.3 6.1 5.0Thailand 37.9 41.6 30.0 4.0 5.1 5.0 9.5 8.1 6.0

1981-90 1991-98 2001-10 1981-90 1991-98 2001-10 1981-90 1991-98 2001-10

Japan 28.3 30.1 22.0 7.5 28.3 11.0 4.0 1.4 2.0

* These projections are built on a simple model that rests on the view that the key factors separating high-growth from low-growth countries are the rateof investment relative to GDP and the efficiency of investment represented by the incremental capital/output ratio (ICOR). See also: Rethinking Asia’slong-term growth outlook, Asian Financial Markets, January 16, 1998, page 9.

their peers among other emerging economies, reflect-ing the region’s ongoing high propensity to save,openness to trade and technology, and emphasis oneducation and fiscal discipline.

For Japan, 2% long-term growth is probably the limit,and achieving even that much will require a major ef-fort in terms of a radical downsizing of inefficient in-vestment, especially in the public sector, and a reorien-tation to new growth opportunities in the service sec-tor. This adjustment will not come without substantialdislocations in the labor market, and these are apt totest Japan’s political and social consensus.

3.0

3.5

4.0

4.5

5.0

5.528 32 36 40 44

Singapore

Thailand

Malaysia

Korea

Investment boom eroded efficiency: 1987-92 vs. 1993-96ICOR

Investment, % of GDP


Morgan Guranty Trust CompanyEconomic ResearchDavid G. Fernandez (65) [email protected]


Restructuring progress in Korea and Thailand• Different approaches to financial sector restruc-

turing yield different results

• Korea’s more activist policy has produced mac-roeconomic benefits faster than in Thailand

• Thailand’s market-driven changes, if and whenthey come, may prove more resilient

• Deeper structural issues will likely linger in Korea

Despite renewed turbulence in global financial mar-kets, improved fundamentals have set the stage for therecovery of Emerging Asia’s battered economies. Bell-wethers in this healing process are Korea and Thai-land. In both countries, near-term economic recoveryand an eventual return toward potential growth mustbe supported by progress in restructuring and strength-ening of their banking systems. Comparing reformprogress in these countries is conceptually artificial –restructuring is not a horse race. But such a compari-son does shed light on where the processes currentlystand and on the countries’ macroeconomic prospects.

In a number of dimensions, bank restructuring hasbeen faster in Korea than Thailand. True, both tookquick action to close insolvent institutions and restoreconfidence in the banking system, but the willingnessof the Korean government to shoulder more of the re-structuring burden has meant that actions could betaken without waiting for the private market to clear.In particular, Korea has been able to remove a signifi-cant portion of nonperforming loans (NPLs) from itsremaining banks, shore up their balance sheets withgovernment-lent capital, and sell one of the banks thegovernment had taken over. On these important reformfronts, Thailand has yet to produce significant results.

In terms of macroeconomic adjustment, Korea alsoappears to be ahead. Korean data already started toshow a recovery in the manufacturing sector before theend of 1998, while Thai industrial production has notrisen above the firm floor it started building in the sec-ond quarter of last year.

So, one may easily be left with the impression that allis well in Korea and not in Thailand. But it is far tooearly to draw such a conclusion for two reasons. First,key aspects of the bank reform process, like recapital-ization and debt restructuring, are on the verge of pro-ducing results in Thailand. Second, the problems ofKorea’s banks are inextricably tied to a nexus of muchlarger issues – the role of the conglomerates, thegovernment’s involvement in business, even thebroader social compact – which may limit how far re-forms can realistically go.

Reform progress so farJ.P. Morgan estimates as of end-1998

Korea Thailand

Domestic credit (end-1996, % of GDP) 165 155% outstanding to manufacturing (end-1996) 40 24% outstanding to real estate (end-1996) 1 12Commercial banks

Number as of end-1996 26 15Closed 5 1Merged 2 3Nationalized 2 2Foreign sale/joint venture 1 2

Merchant banks/finance companiesNumber as of end-1996 30 91Closed 16 56Merged 1 16

Peak nonperforming loans (% of total) 25 50Current nonperforming loans (% of total) 15 46Government expenditure (% of GDP)

On NPL buyouts 4.7 0.0On recapitalization 5.0 3.7

85

90

95

100

105

110

1997 1998

Thailand

Korea

Industrial production1996=100, sa, 3-month moving average


Morgan Guaranty Trust CompanyEconomic ResearchJiwon Lim (82-2) [email protected]


Financial restructuring: the short and long of it

The process of financial sector reform is essentiallyabout stabilizing a distressed banking sector, returningit to profitability quickly, and making it more resilient.Accordingly, the reform processes in Korea and Thai-land can be broken down into actions designed tobring about short-run results and those with longer-rungoals in mind. The short-run measures include:

• Emergency steps to restore depositor confidence;

• Strengthening of the balance sheets of the remain-ing banks;

• Improvement of banks’ profitability so that lendingresumes.

Steps to improve the efficiency and resilience of thefinancial system in the long run include:

• Addressing problems in the industrial structure ofthe banking system;

• Improving regulatory and prudential standards;

• Strengthening the legal infrastructure;

• Increasing foreign participation.

The long-run steps present difficult issues involvingthe culture of banking and business practices gener-ally. The short-run measures are, in comparison, lesscontroversial. However, recent crises around the worldhave shown that there are myriad ways for govern-ments to try to revitalize their banks. In Chile duringthe early 1980s, the government simply bought thebad loans at par value. In 1995, Mexico, like Chile,paid banks generously when it bought their NPLs butin return forced them to recapitalize. In Sweden in theearly 1990s, the banks themselves formed asset man-agement companies (AMCs) to handle NPLs, with theAMCs funded by the government. In the UnitedStates, insolvent S&Ls were closed and their equitywiped out.

With these lessons in mind and under IMF tutelage,Korea and Thailand adopted different approaches torepairing their financial systems.

Emergency measures have been effective

Step one in the process is to stop systemic panic. Onthat score, both Korea and Thailand performed effec-tively. The key action was to remove the weakest fi-nancial institutions from the system and to do so in away that credibly signaled to depositors that those thatremained were sound. Korea shut down 16 merchantbanks, Thailand 56 finance companies, and both na-tionalized the weakest of their commercial banks.These actions, plus generous liquidity support fromthe central banks, allayed depositor fears. Though a“flight to quality” did occur among the surviving insti-tutions, overall, funds stayed within the country and,importantly, within the banking system.

Strengthening bank balance sheets

Step two is a big one: getting the remaining banks upto minimum prudential capital standards. Repairingbank balance sheets can be accomplished by reducingliabilities like deposits and other debts, increasing thevalue of existing assets, or raising new capital.

Reducing liabilities. In both countries, the route ofhelping the banks by reducing their liabilities has beenavoided. Forcing depositors to bear a significant por-tion of the burden was deemed politically unaccept-able. So far, the Korea Deposit Insurance Corporationhas spent won14.7 trillion on deposit repayment, basi-cally amounting to a full guarantee of deposits. How-ever, the law has been changed to reduce the amountof guaranteed principal and the categories of depositcovered, so a partial default on deposits and otherclaims may still occur. Thailand, which lacks a de-

100

105

110

115

120

125

130

1997 1998

Korea

Thailand

Real bank deposits1996=100, CPI adjusted




posit insurance system, issued a blanket guarantee toall depositors and creditors (irrespective of size) ofnon-suspended finance companies and banks, and amore limited guarantee for depositors and creditors ofsuspended finance companies.

Rehabilitating problem assets: Asserting control overbad loans is an important ingredient in the balance-sheet-rehabilitation process. Once NPLs are resolved,even at a discount, possible further losses to the bankare averted and capital is freed from serving as loan-loss provision.

Korea’s approach to dealing with its banks’ bad loansis to use public money to buy them, then resell them toinvestors at a later date. The government-owned Ko-rea Asset Management Corporation (KAMCO) buysNPLs at a discount, swapping them for KAMCObonds. So far, KAMCO has purchased about 37% ofexisting NPLs and that share is expected to rise above55%. Banks can manage their own NPLs if they thinkthey can do a better job (that is, get a higher recoveryrate) than KAMCO. However, up to this point, Koreanbanks have been entirely dependent on the govern-ment to dispose of their bad loans. Importantly,KAMCO’s NPL carve-outs have come with few con-ditions on the banks, which means the banks havelittle incentive to improve their lending practices.

In Thailand, the government has largely left the taskof loan workouts to the bank themselves. In theory,Thai banks should be better placed than a governmentAMC to resolve the NPLs, since they already have theloan files and some institutional knowledge of the bor-rower. Leaving the problem assets on the bank’s ownbalance sheet also increases its incentive to maximizethe value recovered and to avoid future losses by im-proving loan approval procedures. Finally, the Thaiapproach minimizes public sector involvement. Butleaving this process to individual banks and their debt-ors to work out has resulted in a very slow resolutionof Thailand’s NPL situation. Exacerbating the prob-lem is a legal infrastructure that gives creditors scantpower over delinquent debtors. This weak legal back-ground has allowed borrowers, regardless of their abil-ity to pay, to decide not to repay their loans becausethey know that there is little creditors can do. TheThais call these “strategic NPLs.” In August 1998, the

Corporate Debt Restructuring Advisory Committee(CDRAC) was established to facilitate resolution ofthe problem loans. However, while about baht674 bil-lion of loans in need of restructuring have been regis-tered with the CDRAC to date, only baht107 billionhave been resolved. Discouragingly, total NPLs areestimated at over baht2 trillion (note that this includesconsumer and other loans not covered by CDRAC).

One fast-moving process in Thailand that could nudgeforward NPL resolution at the surviving institutions isthe government’s auctions of the assets (mostlynonperforming) of the closed finance companies. TheFinancial Sector Restructuring Authority (FRA) hasalready sold over 30% of the baht860 billion of assetsit holds. Difficulties with the FRA auction design ledto a disappointing mega-auction late last year, but nev-

Government action on NPLs: buyer vs. facilitatorKorea carves out bad loans

The Korea Asset Management Corporation (KAMCO) has spentwon19.9 trillion to purchase won44 trillion face value of NPLs.In exchange for the NPLs, the banks receive KAMCO bondsthat pay a fixed coupon every three months. Banks can poten-tially liquidate these bonds anytime, but have no incentive to doso at the moment owing to the paucity of comparable instru-ments.

The discount rates at which KAMCO buys the NPLs differ byasset type. For example, KAMCO normally pays 45% of princi-pal for secured loans, but only 3% for unsecured loans. How-ever, if the assets are classified as “special category” (i.e. undercourt protection or involved in a restructuring process), the pric-ing depends on projected cashflows. Reportedly, the majority ofthe purchased NPLs are under special category.

Thailand tries to bring parties together

The goal of the Corporate Debt Restructuring Advisory Com-mittee (CDRAC) is to coordinate debt workouts, outside formalbankruptcy proceedings, by laying out a framework withinwhich debtors can negotiate with multiple creditors. CDRAC’sframework (which is based on the so-called “London approach”used in the United Kingdom) is nonbinding and nonstatutory.

The voluntary nature of Thai workouts, in the absence of re-formed bankruptcy and foreclosure laws, is the central reasonfor the slow progress of restructuring so far. However, the Bankof Thailand, which chairs CDRAC, has redoubled its efforts tohave the process move forward by broadening CDRAC’s focusaway from just large debts, lobbying for amendments to lawsthat hinder restructuring, and using moral suasion to break im-passes among creditors.




ertheless, the sale of these assets, at market-clearingprices, could help set price benchmarks in the debt ne-gotiations. But while the FRA auctions are construc-tive in this sense, real progress in the CDRAC willonly come about when the bankruptcy and foreclosurelaws are passed, and when the government facilitatorsuse their powers of moral suasion more liberally tohammer out agreements between debtors and theircreditors. Even so, KAMCO’s activities have quicklyhelped normalize the operations of Korea’s banks.

In Thailand, responsibility for bad loans lies with thebanks that made them. Unfortunately for Thailand,that means the loans themselves still lie there too.

Recapitalization: The third route to repairing a bank’sbalance sheet is for it to raise new capital. The Koreangovernment ordered banks whose BIS ratios were un-der 8% to submit rehabilitation plans with the expecta-tion that banks whose plans were deemed unrealisticwould be closed. However, seemingly operating on a“too big to fail” criterion, the government closed onlysmall and regional banks. It asked financially weak bigbanks to merge together, in the hope that their sizewould attract foreign capital. While the governmentwas heavily criticized for this decision, nonviablelarge banks have in fact announced merger plans withthe government directly injecting funds to recapitalizethem fully. Still, to the extent that the recapitalizationsupport has come with few conditions and no guaran-tee that the banks will fulfill the plans they submitted,the Korean recapitalization plan at this point still lookslike an unconditional bailout and threatens the cred-ibility of the reform process.

Similarly to its tack regarding the banks’ NPLs, Thai-land has not been nearly as activist as Korea in the re-capitalization process. Initially, Thailand simply re-laxed foreign ownership restrictions and told the banksthat they had to meet minimum capital requirements orbe closed. Early in 1998, Bangkok Bank and ThaiFarmers raised new capital by issuing shares and Bankof Asia and Thai Danu partnered up with foreignbanks. However, the other banks’ problems in raisingfunds precipitated a change in the government’shands-off approach. Last August, the Thai governmentunveiled a fortified financial sector restructuring planunder which it would buy into these banks. The catch

Plans for the nationalized banksKoreaTo be privatized: A majority stake in Korea First has alreadybeen sold and a deal for Seoul Bank could be struck soon.

Undetermined: The government has purchased large stakes inother banks through its recapitalization scheme, but plans to selloff the stakes so acquired have not yet been announced.

ThailandTo be privatized: Bangkok Metropolitan and Siam City willfully provision based on the end-2000 standards (see box onpage 19) and recapitalize themselves up to 8.5% of risk-weighted assets (through conversion of debts to the FIDF intoequity). The government hopes to sell the two banks this year.

Merged with government banks: First Bangkok City was mergedwith Krung Thai (KTB), Union Bank of Bangkok withKrungthai Thanakit Finance, and Laem Thong with the newly-formed Radhanasin. All three banks will be fully provisioned,recapitalized, and eventually privatized. The bidding process forRadhanasin is scheduled to begin next month.

Closed: Bangkok Bank of Commerce’s assets were split up –good assets were transferred to KTB (along with liabilities) andNPLs were used to form an asset management company.

is that to participate in the government’s recapitaliza-tion schemes, the banks must take some very painfulsteps. Under the Tier 1 scheme, a bank must first meetthe new loan-loss classification and provisioning rules(otherwise to be phased in gradually over the next twoyears). This would mean major increases in NPLs andforce write-downs of existing shareholders’ equity.Under the Tier 2 scheme, a bank must bite a differentbullet by restructuring corporate debt agreements, withthe government buying the bank’s debentures based onthe size of the write-down that the bank takes (net ofprevious provisions).

Equity or asset write-downs are bitter pills for banks toswallow. Nevertheless, if these banks cannot recapital-ize on their own, they have no other option. Earlierthis month, banks that were interested in participatingin either of the government’s recapitalization schemeswere required to submit Memoranda of Understandingto the Bank of Thailand, detailing their rehabilitationplans. At the moment, it appears that only Siam Com-mercial Bank and Nakornthorn bank will participate inthe Tier 1 scheme. While more banks are likely to par-ticipate in the Tier 2 scheme, the small amounts ap-plied for suggest that, overall, Thai banks aim to raisecapital on their own.




Making it profitable to be a bank again

Getting banks on solid ground by rehabilitating theirbalance sheets is one thing, but their income state-ments also need to be improved. Of course, the formerdoes help the latter: Actions to repair the balance sheetlower interest costs, reduce loan provisions or write-offs, raise revenue through loan recoveries, and im-prove income thanks to coupon payments from the

Raising capital: quick and dirty vs. slow and tidyKorea’s simple program

Korea’s recapitalization scheme is straighforward. Banks issuenew equity which the government buys in exchange for KoreaDeposit Insurance Company (KDIC) bonds and cash until thebank reaches a capital ratio of 10%. Banks qualify for the pro-gram if they have submitted a rehabilitation plan that is ap-proved by the Financial Supervisory Commission. Alternatively,if a healthy bank agrees to take over the assets of a nonviablebank, it also qualifies for recapitalization.

Thailand’s two-tiered program

The Thai government’s August 14 plan offers banks carrots, butalso harsh sticks. The Tier 1 scheme brings in new capital, withgovernment funds used to catalyze private sector capital, if abank cleans up its loan book. To qualify, banks must first provi-sion in accordance with the new loan classification and provi-sioning rules being phased-in by the end of 2000 (see box onpage 19). If the bank’s Tier 1 capital-adequacy ratio is below2.5% after meeting the new provisioning rules, the governmentwill inject capital to bring the ratio up to 2.5%. If the bank canattract Tier 1 capital from other sources, the government willmatch it one-for-one up to the 4% regulatory minimum.

The government will inject the Tier 1 capital by buying shares inexchange for tradable 10-year government bonds. The new gov-ernment and/or private capital is to pay a dividend 1 percentagepoint above the yield on the government bond and will havepreferred status over existing shareholders.

Thailand’s Tier 2 scheme is designed both to accelerate the cor-porate debt restructuring process and to ease the credit crunch.A bank will be eligible for Tier 2 capital from the governmentbased on two factors: (A) its total write-down, net of previousprovisions; and (B) the net increase in its lending to the privatesector. To encourage early action on both (A) and (B), the avail-ability of Tier 2 capital from the government (up to a maximumof 2% of risk-adjusted assets) is to decline over time.

Size of capital injection Available until(A + 0.2B) end-Jun 1999(A + 0.2B)x0.75 end-Dec 1999(A + 0.2B)x0.50 end-Jun 2000(A + 0.2B)x0.25 end-Dec 2000

The government will inject the Tier 2 capital by buying 10-yearbank debentures using nontradable 10-year government bonds.

government bonds. Government can also improve in-come by lowering banks’ cost of funds, which wouldallow banks to widen their interest spreads. This hasoccurred in both Korea and Thailand, where policyrates have come down aggressively. This reverses thesituation that prevailed in late 1997 and into 1998,when banks in both countries faced negative interestrate spreads.

Selling bad assets: waiting vs. rushingKorea’s KAMCO bides its time

So far, the Korea Asset Management Corporation (KAMCO) hason its books bad loans with a face value of almost won44 trillion($37.4 billion). In September 1998, KAMCO held its first, verysmall auction of won250 billion ($200 million) worth of loans.As the assets were without collateral, the recovery rate was only12% of face value. The second auction in December sold offwon541 billion ($460 million) of loans at 35.6% of face value.Dates for larger auctions are expected to be announced soon, butKAMCO has no set deadline for the liquidation of its assets.

KAMCO auction resultswon billion

Book AuctionDate value value

Unsecured loans Sep 250 30Secured loans Dec 541 193

Thailand’s FRA charges forward

Thailand’s Financial Sector Restructuring Authority (FRA) wasestablished in October 1997 to administer the liquidation of theassets of Thailand’s closed finance companies. From a total ofbaht860 billion ($23.4 billion) of loans, the FRA has already soldover baht230 billion ($6.3 billion) of its core assets, at an aver-age recovery rate of 32.5%. Earlier, smaller auctions of higher-quality loans yielded recovery rates close to 50%. But an attemptto sell over $10 billion worth of property-related loans on asingle day resulted in 60% of the loans being held back and anaverage recovery rate of only 25%.

The FRA’s original goal was to sell all of its assets before theend of 1998. The scheduling of another large auction for Marchindicates that the FRA still intends to close up shop soon, even ifthat means simply selling assets to another government entity.

FRA auction results and planned next salebaht billion

Book AuctionDate value value

Auto hire-purchase contracts Jun 25 52.0 24.9Residential mortgage loans Aug 13 24.6 11.5Non-core assets ongoing 27.7Business loans 1 Dec 15 155.7 39.0Business loans 2 Mar 10 231.1 –




Are the reforms working?

Quantifying the effectiveness of the reform programsis very difficult, but renewed bank lending should beviewed as a positive sign. Of course, even healthybanks may choose not to extend new loans if they be-lieve that there are no worthy borrowers. So, while theabsence of loan growth does not prove that the reformprocess has failed, its presence is evidence of success.On that score, Korea’s restructuring scheme seems tobe already bearing fruit, with loans now growing afterfalling for most of 1998. This incipient revival of lend-ing in Korea is difficult to interpret, however, becausethe government has clearly directed banks to extendmore loans to the corporate sector and at lower interestrates. But from a short-run macroeconomic point ofview, the motivation for lending is moot. The fact isthat the credit crunch is easing in Korea and not inThailand.

The causal link between Korea’s twin revivals of banklending and industrial production (and the continuedstagnation of these two variables in Thailand) is opento debate. Nevertheless, it is clear that for these twoeconomies, which depend heavily on bank intermedi-ated credit, a resumption of bank lending is a neces-sary condition to sustain economic recovery.

Before turning to the longer-term issues of bank re-structuring, it is worth touching on what these reformprograms are costing the governments and theiraffordability. In a nutshell, both Korea and Thailandcame into the crisis holding relatively low levels ofpublic sector debt. So, despite the large projected costsof their restructuring programs, it is fair to say thatboth countries can tolerably bear the fiscal burden en-tailed (see Funding Emerging Asia’s budget deficits,AFM, Fourth Quarter 1998).

Will the banking systems be stronger?

The conclusion, so far, is that the financial sector re-structuring process has gone further in Korea than inThailand. However, whether these positive short-runeffects can be sustained depends on these reforms ac-tually tackling the roots of the problems that allowedthe systems to fall into crisis in the first place. And onthis score, there is more reason to be concerned aboutKorea than about Thailand. For while Korea has made

Central government fiscal positions% of GDP

Budget balance Gross debt*1998 1999 1998 1999

Korea -5.0 -6.0 35 47Thailand** -4.5 -5.0 26 33

* End of period, including guarantees for state enterprise debts, finan-cial restructuring bonds, and loans to the central bank.

** October to September fiscal year.

5

10

15

20

25

30

35

40

1997 1998

Overnightcall rate

Generallending rate

6

10

14

18

22

26

30

1997 1998

1-monthinterbank rate

M inimum lending rate

Korea: interest rates% per annum

Thailand: interest rates% per annum

105

110

115

120

125

130

1997 1998

Korea

Thailand(less BIBF)

Commercial bank loans outstanding1996=100, seasonally adjusted




Strengthening regulatory and supervisory systemsBoth Korea and Thailand have strengthened their prudentialnorms, using NPL definitions and provisioning standards that areat or above globally-accepted standards. These new standards arenow in force in Korea, while they are being phased in at six-month intervals starting in mid-1998 in Thailand.

Provisioning levelMonths in Korea Thailandarrears (Jan 99) (end-2000)

< 1 0.5% 1%1 to 3 2% 2%3 to 6 20% 20% less 90% of collateral6 to 12 75% 50% less 90% of collateral> 12 100% 100% less 90% of collateral

Other positive changes include: In Korea, securities are nowclassified by maturity and marked to market each quarter and thelist of items to be disclosed (risk management measures and as-

significant progress in improving the legal and super-visory environments in which its banks operate, thatmodus operandi is deeply linked to Korea’s industrialstructure, specifically to the chaebol. Thailand, in con-trast, does not face this structural problem, yet isstruggling to pass crucial legislation to compel bor-rowers to repay their debts and is tightening its pru-dential rules only gradually. So, going forward, therisk remains that the underlying weaknesses of the fi-nancial systems may persist in both countries after thisphase of financial sector restructuring winds down.

Regulatory and legal changes

Korea has acted quickly to improve its bank regula-tory environment. Prudential norms such as NPL defi-nitions and provisioning requirements have beenraised even above prevailing global standards. Alsopositive is the transfer of most regulatory and supervi-sory responsibilities from various agencies to the newFinancial Supervisory Commission. Thailand, ratherdifferently, is letting its banks ease into its new loanclassification and provisioning rules. These rules arebeing introduced in phases, to be completed only bythe end of 2000, while reorganization of the Bank ofThailand will not be completed until the end of nextSeptember.

The legal infrastructures in both countries have his-torically favored debtors. This continues to be true inKorea, even after the revision of key laws in 1997.

However, the existence of KAMCO removes the im-mediate need for strengthening the creditors’ position.Thailand cannot afford such a luxury. Many of itsNPLs may simply be unviable, meaning that they can-not be restructured. Recoveries from these bad loanswill therefore involve seizing assets, which can onlyoccur if the country’s bankruptcy and foreclosure lawsare revamped. However, after a major legislativebreakthrough in April 1998 that amended Thailand’s1945 Bankruptcy Act, the legal reform drive hasbogged down. The deadline agreed with the IMF forpassing the new laws was moved from October 1998to mid-1999 and it is still questionable whether thenew deadline will be met.

Foreign participation still key

Competition imposes market discipline on banks andis a key part of strengthening the banking system. His-torically, both the Korean and Thai banking sectorshave prevented foreign banks from having a signifi-cant presence, thereby muting potential competitiveforces. On this score, both countries have now madesignificant moves to open their markets to foreign par-ticipation. As mentioned earlier, foreign banks so farhave become controlling shareholders in two Thaibanks. And more such buy-ins in Thailand may be onthe way. A watershed event occurred at the end of1998 when the Korean government sold a 51% stakein one of the banks it nationalized, Korea First, to aconsortium led by U.S.-based Newbridge Capital.

sets by country, for example) has been expanded; and in Thai-land, the practice of accruing, and recognizing as income, inter-est on accounts more than three months overdue has been abol-ished.

The way the governments examine and supervise their banks isalso changing. Korea established the Financial SupervisoryCommission to handle this task, assigning it duties formerly heldby the Bank of Korea. Korea also introduced a prompt correctiveaction (PCA) system in June 1998, under which the governmentwill monitor financial institutions with a BIS capital ratio of lessthan 4% for quality control on a quarterly basis. The most impor-tant indicators in the PCA system will be the capital ratio forbanks, the operational net capital ratio for securities companies,and the solvency margin ratio for insurance companies. Still, forthe time being, strict application of the PCA system is unlikely.Thailand, meanwhile, is in the midst of a reorganization of itscentral bank which should be completed later this year.




Both countries hope to sell other nationalized banksthis year. Korea is set to sell another bank, SeoulBank, soon and Thailand’s newly formed RadhanasinBank could be put on the block in February. However,prospects are more uncertain for two nationalized Thaibanks, Bangkok Metropolitan and Siam City, that thegovernment originally hoped to sell by the end of1998. Once again, the willingness of Korea’s govern-ment to intervene has been critical in moving thingsforward more quickly. In the case of Korea First, thegovernment offered to protect the buyer fully from ad-ditional NPL losses for one year and offered partialprotection in the second year. At this stage, suchsweeteners have not been offered by Thailand.

Industrial structure issues still loom

Despite the many dimensions in which reform has pro-gressed in Korea, one card remains that could trumpall the others already played – the very industrialstructure in which the banks operate. Fundamentally,the two countries’ financial sector crises differed intheir underlying nature. In Korea, the problem lay pri-marily with the big banks, whose lending practiceswere driven by the government, either through directgovernment involvement in lending decisions or indi-rectly through government support of large conglomer-ates. When the performance of these conglomeratesdeteriorated, they brought Korea’s banks down withthem. In Thailand, the liberalization of the financialsystem and the external capital account, without ad-equate strengthening of regulatory and supervisorysystems, led to the expansion of lending to riskier bor-rowers, typically in the nontraded goods sectors. Thislending activity led to asset-price inflation and thebursting of that bubble put Thailand’s finance compa-nies and banks into distress. In both countries, an im-plicit guarantee by the government of a stable ex-change rate made it attractive for the financial sectorto borrow short-term in foreign currency to fundlonger-term domestic loans.

So, in many ways, the bulk of Thailand’s problemswere solved immediately when the asset bubble burstand the exchange rate was allowed to float. In Korea,the problems run much deeper. To date, the design (to

say nothing of the results) of the Korean restructuringplan fails to recognize comprehensively the severityof this structural problem. Instead, Korea has avoidedasking single economic agents to suffer significantpain and has spread the costs of reform by having thegovernment take the lead. Given the labor market con-straints under which the government is operating, suchan approach is understandable. However, Korea’s reli-ance on government discretion, rather than market-based rules, plus the likelihood that the government-business-bank nexus will overall remain intact, couldresult in the persistence of systemic problems that willonly be revealed when the next crisis strikes.

Watch this space every day

Bear in mind that these restructuring processes in Ko-rea and Thailand are ongoing and important develop-ments are occurring by the day. To this point, the pro-cess has clearly moved forward more quickly in Ko-rea. But it is presently unclear whether Korea’s mo-mentum can be sustained and similarly unclear there-fore whether this is instead a “tortoise-and-the-hare”story in which Thailand ultimately takes the prize.

The Korea First storyEstablished in 1929, Korea First Bank (KFB) has long been oneof Korea’s leading commercial banks. It was nationalized in1962 and after two decades of state ownership was again priva-tized in 1982. During those 20 years, KFB participated in thegovernment’s interventionist policy to support certain desig-nated sectors and companies. But the government-directedpolicy lending, compounded by weak credit risk management,heavily burdened the bank, steadily eroding its asset quality.Still, in early 1990, the bank set itself ambitious targets andgrew rapidly.

For a while, KFB appeared to grow out of the asset-qualityproblem and restored its reputation as a leading Korean com-mercial bank. However, problems reemerged in the mid-1990sas the economic environment turned unfavorable. These be-came more serious during 1997-98 with the high-profile bank-ruptcies of corporates – starting with Hanbo Steel, SammiSteel, and Kia Motors – to which KFB had excessive expo-sures. By the end of 1997, it became clear that the bank couldnot survive on its own. The government then stepped in –KAMCO bought won2.4 trillion of bad loans at a 37% discountand bought a 93.8% stake in KFB for won1.5 trillion. It tookanother year to privatize KFB once again.

TokyoJanuary 29, 1999

J.P. Morgan Securities Asia Pte. Ltd.Economic ResearchJames Malcolm (81-3) [email protected]


Japan’s fiscal headaches• Worsening supply and demand conditions have

boosted JGB yields

• Surging budget deficits and lack of public-sectorbond demand caused the deterioration

• But hidden liabilities are as much a concern

• These trends are likely to continue, threateningthe sustainability of Japan’s fiscal policy stance

• Reforms are key to restore lasting growth

Japan’s fiscal position has deteriorated rapidly since1990, and the outlook remains bleak. The centralgovernment’s budget deficit will amount to nearly 7%of GDP by the time the current fiscal year (FY1998)ends on March 31, 1999. And it looks likely to exceed9% of GDP in FY1999 and reach nearly 11% of GDPin FY2000. Accordingly, J.P. Morgan projects that theconsolidated debt position of the public sector as awhole will hit 47.5% of GDP on a net basis, and 150%on a gross basis, by the end of FY2000. (The OECD’sforecast is only modestly more optimistic, calling foran 8.3%-of-GDP deficit by 2000. See chart at right.)

These figures are only the tip of an iceberg aroundwhich the government must navigate in order to sus-tain its debt. Much is known about the potential dan-gers represented by the country’s aging populationstructure. But other formidable obstacles are presentedby the cyclical trends already in place – governmentexpenditure growth far outstripping revenue growth asprivate sector demand endures a prolonged decline –and by rapidly mounting off-balance sheet liabilities.

One manifestation of the change is the government’srapidly waning ability to keep absorbing a large por-tion of its own debt. The fundamental requirement fordealing with all of these issues is the economy’s returnto autonomous growth, and for this more fiscal stimu-lus is, unfortunately, a prerequisite. A serious concern,however, is that the economy’s potential rate of long-term economic growth will be reduced in so far asmuch of the government’s present spending hinders

-50

0

50

100

150% of GDPGeneral government debt

70 75 80 85 90 95 2000

Gross debt

Net debt

J.P. Morgan forecast

-10

-8

-6

-4

-2

0

2

4% of GDP, OECD figuresGeneral government financial balances

82 84 86 88 90 92 94 96 98 00

UK

JapanUS

Germany

OECD forecast

U.K.

U.S.

65

70

75

80

85

90

95¥ trillionCentral government general account spending

90 92 94 96 9891 93 95 9997

J.P. Morganforecast

Initial budget

Revised budget




rather than promotes supply-side structural adjustmentthat would enhance the economy’s growth potential.

A worsening supply/demand balance for JGBs

The first real signs of market concern about the risingpublic sector debt burden came at the end of last year.Government bond yields jumped from historically lowlevels as several events called attention to the potentialfor developing oversupply:

• Moody’s announcement in November, that it wasdowngrading Japan’s sovereign debt rating, calledattention explicitly to concerns about the rapid risein central government debt.

• Government officials indicated that the Trust FundBureau (TFB) of the Ministry of Finance (MoF)would have to pull back from its traditional scale ofparticipation in the market. Initially, the news camethat the Bureau would reduce its primary market ab-sorption from 26% of total issuance in 1998 to just6% in 1999. Then followed rumors, subsequentlyconfirmed, that the TFB would cease altogether itsregular secondary-market purchases, which hadbeen running at ¥200 billion monthly.

• Market participants speculated about the PostOffice’s huge upcoming maturities – specifically,the high-yielding long-term deposits that come duein 2000 (chart). Concerns grew over the possibilitythat withdrawal of a large quantity of time depositsfrom the Post Office could adversely affect thegovernment’s ability to continue funding a large partof its own debt in coming years. The logic behindthis was that bond and debt portfolios held by thePost Office, directly or – in far larger magnitude –indirectly through the Post Office’s placements withthe TFB, might be liquidated in advance of 2000 inorder to repay investors.

• The Bank of Japan (BoJ) poured cold water onspeculation that it might step in to take up the slack.To be sure, BoJ monetary policy continues to aim atease in order to support the economy, which maywell entail large open market purchases of securi-ties. But BoJ officials are in no mood to prejudicetheir newly established policy independence by

Note: These estimates assume that no term deposits are cancelled beforematurity. Given that persons who deposited the maximum amount al-lowed per individual will be able to roll over only about half of the ma-turing sum, and since rollover interest rates will be much less attractivethan those paid on deposits from ten years ago, Morgan believes that thePost Office could lose as much as ¥100 trillion in term deposits in 2000if no action is taken by the government.

0

20

40

60

80

100

120¥ trillion, Nikkei figures and J.P. Morgan estimatesMaturity structure of fixed-term postal savings deposits

97 99 01 03 0598 00 02 04 06

Principal depositmade ten years ago

Maturing sum (principal plus interest compounded at then prevailing rate)

01020304050607080

1991 1992 1993 1994 1995 1996 1997 1998 1999

¥ trillionsAnnual JGB and T-bill issuance FY99

initialbudget

Issues to marketTotal issuance

Annual JGB and T-bill issuance¥ trillion

Outstanding JGBs by holder

End FY91 End FY96¥ tril % ¥ tril %

Total 189.5 100.0 257.3 100.0Government 77.7 36.0 95.2 34.2Bank of Japan 15.9 8.4 45.0 16.2Banks 27.7 14.6 28.0 10.3Other financial institutions 21.4 11.3 38.2 13.8Others 46.7 24.7 71.0 25.5




Accounting for the public sector

Japan’s public sector is vast and its multilayered accountsare fiendishly difficult to untangle – a situation that ana-lysts have long suspected is by design as much as by acci-dent. The country’s general government sector includesnumerous overlapping budgets, several of which are onlyfully revealed in their revised forms two years in arrears.This alone makes timely assessment of fiscal policy diffi-cult, especially when the fiscal stance is changing. How-ever, there also exists a myriad of public and quasi-publiccorporations, agencies and lending institutions (such as theJapan Development Bank) which receive funding directlyor indirectly from the government yet are left out of thegeneral government classification because their manage-ment is, nominally at least, independent.

Conceptually, though, the main tenets of the country’s gen-eral government budget are relatively straightforward. Thecentral government’s general account forms the shell forits regular budget, which is highly visible because it is sub-mitted to the Diet along with the annual Fiscal Investment

and Loan Program (FILP) budget. FILP is a state-adminis-tered program which appropriates public deposit funds forstrategic policy uses. Although FILP is part of the MoF’sTrust Fund Bureau (TFB), it falls outside of the “generalgovernment” classification because its resources belong toorgans such as the Post Office which, though public, aresupposed to have an arms’ length relationship with thegovernment.

The central government also has jurisdiction over 38 Spe-cial accounts through which a range of established pro-grams are operated. These include the various nationalhealth care and pensions (i.e., social security) programs,postal savings and postal life insurance fund managementactivities, national debt consolidation, mortgage financevia the Housing Loan Corporation, small business support,and various industrial and regional/infrastructure develop-ment projects. Local government accounts cover both pre-fectural and municipal finances and also pay transfers topublic enterprises.

Outstanding FILP funding by source¥ trillion, March 31, 1998

Postal savings 139Postal life insurance 99National pension fund 134Other 45

Total 395

0

20

40

60

80

100¥ trillionGovernment spending (unconsolidated)

70 75 80 85 90 95

FY99 budget Local

(ordinary a/c)

FILP

Central (general a/c)

Note: All accounts contain substantial overlap; in particular, the totalshown for “Special Accounts” of the central government is much largerthan the MoF’s own partially consolidated statements for central generaland special accounts together. The government does not publish consoli-dated figures covering central, local, and special accounts together.

Consolidated balance sheet of general government¥ trillion, March 31, 1997, official figures

Central Agencies Local Social sec. Total*

Gross assets 84.4 63.9 43.3 228.5 408.1(as % of GDP) 16.8 12.7 8.6 45.4 81.0

Gross liabilities 310.7 57.6 124.9 1.5 482.7(as % of GDP) 61.7 11.4 24.8 0.3 95.8

Net assets -226.4 6.3 -81.6 227.1 -74.6(as % of GDP) -45.0 1.3 -16.2 45.1 -14.8

* Figures may not add up because of consolidation.

Central governmentGeneral Account

¥81.9

Central governmentGeneral Account

¥81.9

Central governmentSpecial Accounts

¥289.5

FILP¥52.8

¥8.8

Taxtransfers

¥21.5

Local taxgrants¥13.5

¥9.4transfers

¥45.4transfers

General government FY99 initial budgetall figures in trillions




agreeing to JGB-buying targets set to meet othergoals – particularly goals set by the government –such as smoothing JGB market conditions.

Indeed, to the extent the BoJ has a legislated re-sponsibility for regular monetary operations that in-clude JGB purchases, those are to fund the “natu-ral” growth of money stock in line with the expand-ing economy, and can only be expected to slow inan environment of near-zero growth.

In fact, BoJ officials have recently begun to expressconcern about the central bank’s balance sheet,which has become increasingly illiquid as a resultof the accumulating BoJ loans to the Deposit Insur-ance Corporation – informally guaranteed by thegovernment but nevertheless not the sort of liquidasset that the central bank can use to meet opera-tional responsibilities – for emergency funding oftwo banks that were recently nationalized.

This new concern comes on top of the BoJ’s con-tinuing large holdings of illiquid short-term Financ-ing Bills (FBs) which the BoJ traditionally has beenrequired to take up at off-market prices. The MoFhas finally agreed to the BoJ’s long-standing re-quest to end that requirement, and will start issuingFBs at market auction in the coming fiscal year.While not directly related to the question of BoJmarket purchases of JGBs, this newly asserted pub-lic concern over the quality of the central bank’sbalance sheet has added to market jitters about fu-ture public demand for JGBs.

Responding to this combination of uncertainties, JGBmarket yields soared from a low of 0.7% to 2.0% inthe fourth quarter. And, in light of the potential forfurther declines in public sector holdings, the market’sconcern looks underdone if anything.

Japan’s existing public sector holdings of governmentliabilities are vast by international standards. The lat-est available figures show that public institutions helda whopping 61% of outstanding central governmentbonds and borrowings at the end of the end of March1997. This compares with a range of 1–16% for otherleading OECD economies. But having grown fromrelatively high to very high levels in recent years,

there is little scope for further expansion as outstand-ing debt rises.

The deteriorating fiscal balance

Japan’s fiscal position first worsened in the early1970s, when the government extended a broad rangeof social benefits to its population, bringing Japanroughly in line with other industrial countries in termsof unemployment, pension, and health care provisions.However, with the economy still growing at a real av-erage rate of 5%, the boost to government spending asa share of GDP was fairly quickly overcome duringthe 1970s and 1980s – and the government also ben-efited from capital gains taxes reaped in two asset in-flations during the mid-1970s and the late 1980s.

In the 1990s, however, the economy’s prolongedslump has changed the calculus entirely. And even be-

0

5

10

15

20

25% of total expendituresComponents of central government spending

60 65 70 75 80 85 90 95

Public works

Social security

Debt service

FY99 initial budget

0

20

40

60

80

100¥ trillionAnnual tax revenue

70 75 80 85 90 95

Total

Central

Local

FY99 initial budget




yond the current cyclical time frame, it has becomeobvious that the level of state provisions will have tobe cut and/or the level of private contributions in-creased to deal with the future escalation in pensionsand health care costs as the population ages. The chal-lenges which Japan faces on this front are quantita-tively larger as a result of its demographic structure,but not qualitatively different from those of otherOECD countries.

More concerning, however, is the plunge into red inkof the primary budget balance which began in 1992(chart) A second leg down got under way in 1998 as aresult of the recession and new countercyclical publicworks spending launched over the past year. And, thedeterioration looks set to continue for at least anotheryear: J.P. Morgan forecasts an extra ¥12 trillion inpump-priming measures to come during fiscal 1999 inthe form of supplementary budgets. But on the basis ofrecent experience, it seems unlikely that this will leadto anything but a temporary boost in domestic demand.The private sector has reacted with growing skepti-cism to recent stimulus packages precisely because thelatter have been transparently shortsighted (seeJapan’s prolonged investment slump, pages 29-34).

Hidden liabilities are ballooning

Another major threat to the public finances relates tothe increasing incidence of off-balance sheet publicsector liabilities. It is widely recognized that the gov-ernment is shouldering immense hidden liabilitieswhich only materialize when it is called upon to honorits explicitly or implicitly extended guarantees. A stel-lar example of this occurred last year when a largeportion of the debt accumulated by Japan NationalRailway, which was privatized in 1987, finally madeits way onto the state’s books: national debt was in-creased at a stroke by 5.4% of GDP (¥26.9 trillion).

Off-balance sheet liabilities have increased sharply asa result of repeated attempts to support the financialsystem and a large part of the real economy as notedabove. Notable recent developments include:

• A long-term increase in outstanding government-guaranteed bonds and FILP investments and loans(two charts at right show net lending increments of

Note: OECD estimates are based on submissions by member countries,and therefore use “official” assumptions of economic growth and onlyinitial budget estimates. Thus, they incorporate a conservative bias.

Note: Outstanding government guaranteed corporate bonds amounted to¥47.3 trillion as of March 31, 1997.

-10

-5

0

5

10% of GDP, OECD figuresPrimary budget balance of general government

85 87 89 91 93 95 97 99

Primary balance

Overall balance

25

30

35

40

45

50

1991 1992 1993 1994 1995 1996 1997 1998 1999

¥ trillionFILP investments and loans

J.P. Morgan estimateInitial budget Final budget

0.5

1.0

1.5

2.0

2.5

3.0¥ trillionNet new government guaranteed corporate bond issues

78 80 82 84 86 88 90 92 94 96




recent years). Many of FILP’s “investments”amount to little more than direct subsidies of other-wise economically nonviable projects, and as itslending rates are based on 10-year government bondyields, it has failed to generate returns above its ul-tra-low funding costs since fiscal 1995. (The fund-ing cost is based on the formula: 3-year postal de-posit rate x 0.95). Moody’s has estimated that FILPlosses could total 10% of GDP if nonperformingloans were properly accounted for.

• The financial stabilization fund, which was estab-lished at ¥30 trillion in March, then doubled to ¥60trillion in November. This money is to be used (i)boost the asset bases of existing financial institu-tions, (ii) protect depositors in the case of bank fail-ures, and (iii) fund the reconstruction/disposal offailed banks. In the last three months of 1998, BoJloans to the Deposit Insurance Corporation rose bymore than ¥6 trillion to ¥8 trillion, reflecting costsincurred in the process of the nationalization ofLong Term Credit Bank and Nippon Credit Bank.

• In October, the government increased the size of theprefectural credit guarantee system by ¥20 trillion,from its existing scale of around ¥15 trillion. Underthis scheme, small and medium-sized firms can bor-row up to ¥50 million in uncollateralized loans.During October and November alone, 400,000 ap-plications for almost ¥10 trillion of the additionalmoney reportedly were filed.

• In November, the BoJ established a ¥4.1 trilliontemporary lending facility to aid financial institu-tions which increase corporate lending in the run-upto the year end by increasing its commercial paperrepo operations. At the end of December its hold-ings of commercial paper had swollen to ¥80 tril-lion, approximately a quarter of all outstanding is-sues.

• Also in November, the government announced mea-sures to extend the lending functions of state-affili-ated financial institutions as part of a new ¥24 tril-lion economic stimulus package. A new credit-guar-antee system is thus to be established for small firmswhose main banks have failed. Also, the Japan De-velopment Bank’s (JDB) mandate was expanded to

allow it to provide operating funds to firms in non-strategic industries that are experiencing temporarydifficulty. ¥3 trillion was added to its annual lendingbudget, and it has been empowered to guarantee anadditional ¥2 trillion in loans extended by privatebanks.

Further, if the government sticks to its policy of di-rectly or indirectly supporting less competitive sectorsof the economy in order to minimize negative second-ary effects of restructuring, it will continue to accumu-late obligations. As the failure of Nissan Mutual Life(April 1997) showed, there is no shortage of candi-dates for potential injections of public funds and gov-ernment guarantees.

Net debt to rise to nearly 50% of GDP by FY2000

The combination outlined above – declining publicdemand for government debt, straightforward businesscycle and policy dynamics, and mounting incidence ofhidden liabilities – ensures that Japan’s public fi-nances will look weaker as time goes on. Within thenext two years alone, this is likely to push net generalgovernment debt to 47.5% of GDP and gross debt to150% of GDP.

Restoration of growth is key to sustain debt burden

As government debt grows and with interest rates nolonger in decline, debt servicing costs are bound to addto the level of government debt over time even if theyare relatively light now. Moreover, the situation will

0

5

10

15

20

0

5

10

15

20

25%

¥ trillion

70 75 80 85 90 95

FY99 initial budget

As proportion oftotal expenditure

Annual debt servicing cost

Central government debt servicing cost% ¥ trillion




How bad is Japan’s current debt level?

Snapshots of Japan’s relative fiscal health provide verydifferent images depending upon the definition adopted(see table and chart below). This makes it imperative thatanalysts choose a representative benchmark when assess-ing the extent of the damage. A net measure which ex-cludes social security assets and goes on to make someallowance for the write-down of other government assetsis arguably the best proxy for evaluating Japan’s relativestanding.

Gross unconsolidated measures are unsatisfactory becausethey fail to take account of double-counting. All govern-ments hold some proportion of their own debt, but the pro-portion varies considerably from country to country. Com-paring consolidated gross figures also poses problems be-cause of institutional differences. For example, Japan’sTFB owns about a third of outstanding government securi-ties, but is usually not considered part of the “general gov-ernment.” Still, the TFB’s programs support many of thegovernment’s strategic goals and its inclusion would haveraised Japan’s gross debt by around 10% in FY1996.

Net measures avoid this problem as the TFB holds no netassets of its own. However, comparing crude net figures ismisleading for other reasons. First, they treat social secu-rity assets as resources that can be redeployed by the gov-

ernment to cancel out debt obligations elsewhere on its bal-ance sheet. In fact, many countries’ current social securitysurpluses are earmarked to meet future pensions and wel-fare liabilities, so it is wrong simply to treat them as an or-dinary financial assets. A better approach is to exclude so-cial security surpluses from debt calculations altogether.

Second, crude net calculations also rely upon the dubiousassumption that the government’s other assets should belogged at 100% of face value. In reality, many of these as-sets are illiquid and their realization would incur substan-tial losses. Their true value is difficult to estimate in partbecause the solvency of many of the organizations thathave benefitted from public loans and investments is itselfdependent upon continuing state subsidies. Thus, it makessense to insist on applying some level of asset write-down.

While arbitrary, a 50% discount does not seem unreason-able. This penalizes Japan disproportionately for its largeasset holdings, but also benefits it by assuming (gener-ously) that its assets are of a similar quality to others.’ Thisbest “guesstimate” reveals Japan’s public finances to be inmuch worse state than its competitors. Even by the stan-dards of two years ago, adjusted net debt amounted to over70% of GDP against a range of 50%-60% for the UnitedStates, Germany, and the United Kingdom (table below).

-25

0

25

50

75

100

125% of GDPNet government debt

70 75 80 85 90 95 2000


Net debt

… excluding social security assets

… after asset write-down

Measures of on-balance sheet debt% of GDP, 1996, OECD figures and J.P. Morgan estimates

Japan U.S. Germany U.K.

Gross debt - unconsolidated* 85.7 84.6 64.4 65.4consolidated** 82.7 63.1 60.2 59.7

Net debt 15.4 48.4 48.1 44.0excl. social security balance 59.4 48.4 51.5 44.0after asset write-down*** 71.1 55.8 55.9 51.9

* OECD definition** Nets out proportion of assets (including social security assets)

which are also liabilities of other parts of general government*** Applies arbitrary write-down rate of 50% to other assets




worsen if the economy continues to perform poorlywhile the government continues to boost spending.

On the other hand, trying to stop the growth in govern-ment debt by tightening fiscal policy is not a feasiblesolution either. Given the high level of debt and im-plied interest expenditures, keeping the level of gov-ernment debt stable would imply shifting the primarybudget balance (excluding interest payments) into asurplus of at least 4% of GDP. Coming from a primarydeficit that is expected to rise from more than 3% ofGDP in FY1998 to nearly 7% of GDP in FY2000,such shift in the fiscal policy stance would imply atightening of at least 10% of GDP, which would fur-ther damage the state of the economy and, ultimately,the government’s fiscal position.

A return to lasting real GDP growth will be a prerequi-site for Japan to sustain the rising debt servicing costsin the coming decade and prevent an endless escala-tion of the level of government debt. This is becausesustained real GDP growth in excess of the real inter-est rate the government pays on its debt (1) will reducethe interest expense burden relative to GDP, and (2)will boost tax revenues and reduce transfer payments,such as unemployment benefits, leading to an im-provement of the primary budget balance.

Keep policy easy but promote structural reform

Thus, even though the government’s fiscal positionhas deteriorated, expanding fiscal policy now is easilyjustified if this gets the economy back on track. Theproblem with Japan’s fiscal stimulus packages, how-ever, is that they are designed to ease the pain but ac-tually reinforce many structural rigidities that preventthe economy from recovering. Indeed, business andconsumer confidence fell throughout last year despitethe announcement of several spending packages, high-lighting growing public awareness of the shortcomingsof the government’s fiscal policy approach.

The right mix will have to combine easy fiscal andmonetary policies with structural reforms. A great dealof attention has been paid to the issue of social secu-rity reform. This is undoubtedly important, but it isalso clear that reform will occur one way or the other.In fact, some changes have already been made and

other, more painful ones are actively discussed andgenerally well understood by the public. Less obviousis how adjustment will be made in other main areas:

• The high level of public works programs, whichonly maintains an artificially high level of employ-ment in the construction sector;

• The government’s various support schemes forsmall loss-making enterprises;

• And the government’s large holdings of mostly inef-ficient state enterprises.

Adjustments in these areas, along with more speedyreform in the financial sector, would surely cause hugedislocations in the labor market and test Japan’s politi-cal and social consensus. To ease the pain and acceler-ate the creation of new jobs, fiscal ease will have tocome through the provision of more unemploymentbenefits, spending on reeducation, and importantly,corporate and personal income tax reductions.

-10

-5

0

5

10

85 87 89 91 93 95 97 99

General government primary balance (% of GDP)

Real interest rate on government debt minus real GDP growth

30

32

34

36

38

40

42

44

46

-60

-50

-40

-30

-20

-10

0

10diffusion indexBusiness and consumer confidence

diffusion index

1996 1997 1998

Consumer sentiment

Business confidence

Japan’s deteriorating debt dynamicspercent




Key forecastscalendar years

1998e 1999f 2000f

Real GDP (%oya) -2.9 0.0 -1.0Consumer prices (%oya) 0.7 -0.4 -0.6Current account (US$ bil) 122.5 122.0 132.9Fiscal balance (% of GDP) -6.9 -9.2 -10.9Net government borrowing (¥ tril.) 34.0 45.5 53.03-mo. Eurodeposit rate (% p.a.)* 0.3 0.4 0.510-year bond yield (% p.a.)* 1.5 2.3 2.7Yen/US$* 131 133 135

* Year end.

Japan’s prolonged investment slump• Outlook remains weak despite some signs of out-

put stabilization and fiscal stimulus

• Capital stock adjustment leads to negative em-ployment and consumption effects

• Government’s stimulus policy will boost budgetdeficit, but with few multiplier effects on output

• With monetary policy also paralyzed, structuralreforms are the only way to lift growth outlook

• 1998 witnessed the worst recession in Japan’s post-war history. Assuming a flat fourth quarter, annualaverage real GDP probably fell 2.9%.

• Recently there have been some bright spots – indus-trial production and exports have stabilized, publicconstruction orders have risen, and even privateconsumption shows some signs of life.

• However, the rest of economy remains on a weaktrack. Inventories are high and sentiment is poor. Ofparticular concern is business investment, whichcontinues on its long-term downward trend.

• Fiscal initiatives are expected to accelerate in 1999as the government tries to revive the economy in therun-up to elections that must be held no later thanOctober 2000.

• The fiscal boost may be sufficient to stop the reces-sion, but a genuine economic recovery is unlikely tofollow. Moreover, the government’s ability to primethe pump is likely to fade in 2000, possibly leadingto another downturn in activity.

• A key problem of the government’s stimulus pack-ages is that they are designed to ease pain, but not topromote structural adjustment. Not surprisingly, thecombination of higher spending, lower tax rates, anda weak economy have severely undermined thegovernment’s fiscal balances.

Stimulus packages together may stop the economy shrinking, but are unlikely to achieve recovery

Quarterly real GDP profile and components%q/q, saar

98Q3 98Q4f 99Q1f 99Q2f

Real GDP -2.6 0.0 0.0 2.5Private consumption -1.1 2.0 0.0 3.0Business investment -17.3 -15.0 -5.0 0.0Residential construction -22.5 0.0 10.0 5.0Public investment 15.4 25.0 0.0 25.0Government consumption 3.5 1.0 1.0 1.0Exports of goods and services 6.7 -1.0 0.0 -5.0Imports of goods and services -1.4 1.0 0.0 3.0

Contributions to real GDPDomestic final sales -3.2 0.6 -0.3 4.1Inventories -0.4 -0.3 0.3 -0.5Net trade 1.0 -0.2 0.0 -1.0

-10

-5

0

5

10

15%q/q, saarReal GDP growth

1995 1996 1997 1998 1999 2000

Forecast




Industrial production has stabilized, but slow inventory adjustment leaves uncertainty

• Industrial production has largely stabilized since theJuly-September quarter. In the October-Decemberquarter, it was down only 0.4% (from the previousquarter, not annualized), and it is set to rise 0.6% inthe current quarter according to producers’ projec-tions for January and February.

• The still-high level of inventories, however, makesit difficult to argue for genuine production recovery.

• Inventory adjustment lost its momentum during lastquarter. The inventory to shipment ratio fell 1.4%compared to its 1.8% drop during the July-Septem-ber quarter.

• The difficulty for producers is a lack of supportfrom final demand. The level of inventories itselfhas been falling smoothly, but weakness in ship-ments has resulted in involuntary accumulation.

• The big question going forward is how much furtherinventories will have to fall before manufacturersstart to increase their production again.

• A clue can be found in the Bank of Japan (BoJ)’squarterly Tankan survey. The diffusion index (DI)related to producers’ perceptions of inventories hashardly improved as yet. The next survey is sched-uled for release in early April.

0

5

10

15

20

25

30

35

40diffusion index, BoJ Tankan, “excess” minus “shortage”Producers’ perceptions of inventories

90 92 94 96 98

85

90

95

100

105

110

115

120

1251995=100, sa, 3-month moving averageInventory to shipment ratio

1993 1994 1995 1996 1997 1998

Capital goods ex. transport

Consumer durable goods

90

95

100

105

1101995=100, saIndustrial production

1993 1994 1995 1996 1997 1998

3-month moving average

90

95

100

105

110

115

1201995=100, saProducers’ inventory

1993 1994 1995 1996 1997 1998

Inventory to shipment ratio

Inventory




Investment is in a prolonged downward trend

• The main drag on GDP growth comes from businessinvestment, which is caught in a prolonged down-ward trend as companies adjust to the lower growthpotential for output.

• Private core domestic machinery orders, regarded asthe best leading indicator of business investment,continue to fall. They will probably have fallen forthe third consecutive quarter in the October-Decem-ber period, although the pace of decline is no longeras sharp as occurred in late 1997 and early 1998.

• Looking ahead, the investment slide will likely con-tinue for a few more years as investment is still highrelative to output and growth potential.

• The downward trend in investment is aggravated bythe problems in the banking sector, which has led toa tightening of lending standards and an inefficientdistribution of credit.

• Despite a series of fiscal and financial packages,business confidence has failed to recover, highlight-ing the severety of the corporate slump and the on-going decline in profitability.

700

800

900

1000

1100

1200

1300¥ billion, excluding ships and electric generators, saPrivate domestic machinery orders

1993 1994 1995 1996 1997 1998


0

5

10

15

20percent, 5-year moving averageJapan’s over-investment

75 80 85 90 95

Investment/GDP

Nominal GDP growth,%oya

-60

-50

-40

-30

-20

-10

0

10DI, BOJ Tankan survey, “favorable” minus “unfavorable”Corporate confidence

1993 1994 1995 1996 1997 1998

Large nonmanufacturing

Large manufacturing

-20

-10

0

10

20

30%oya, nominal, MoF survey, fiscal year, 3-year moving average Current profit growth

75 80 85 90 95




Households are under ever-intensifying pressure

• Consumption-related indicators were strong in thefinal quarter of 1998. For example, real householdspending averaged 2.6% higher (not annualized) inOctober-November than its second-quarter level.However, this rise owed entirely to the special con-sumption tax rebate sale during November, whichboosted sales at major chain stores by 20% to 30%.Available December sales data already show somerenewed weakening.

• Underlying household fundamentals continued todeteriorate during 1998. The unemployment raterose to a new all-time high of 4.4%, and consumersentiment slipped, despite the government’s fiscalstimulus efforts. The rise in unemployment resultsin part from the downward structural trend in busi-ness investment. Its negative effect on householdspending is compounded by people’s worries overthe safety of their pension plans.

• Housing investment is also heading downward.Condominium building is the main drag here,whereas construction of owner-occupied houses hasbeen relatively strong thanks to increased loansfrom the government-affiliated Housing Loan Cor-poration (HLC).

• The HLC mortgage rate has been kept at 2.2%, butfears of higher interest rates will likely prompt somefront-loading of housing demand in the first half of1999, followed by a setback in the second half.

1.5

2.5

3.5

4.5

0.45

0.65

0.85

1.05

1.25

1.45

1.65% of labor force, saLabor market indicators

ratio, sa

80 82 84 86 88 90 92 94 96 98

Unemployment rate

Job offers/applicants ratio

1.0

1.2

1.4

1.6

1.8

2.0million units, saarHousing starts

1995 1996 1997 1998

90

95

100

105

110

1151995=100, saPrivate consumption

1995 1996 1997 1998

Retail sales

Household spending

-100

-90

-80

-70

-60

-50

1996 1997 1998

Consumers’ perceptions of economic conditionsdiffusion index, Dentsu survey, “good” minus “bad”




Rise in trade surplus has come to an end

• The November slump in the trade surplus was exag-gerated by the recent fall in the dollar/yen rate. Still,beyond the monthly volatility of the data, the tradesurplus seems to have peaked.

• Going forward, weaker global demand and a stron-ger yen will undermine exports. But the trade sur-plus is likely to remain relatively high as poor do-mestic demand conditions will keep imports weak.

1999 fiscal policy will be even more expansionary than 1998’s, with budget deficit worryingly high

• Considering its size (¥16 trillion, or 3% of GDP),the impact of last April’s package was surprisinglyshort-lived, being undermined by the financial diffi-culties of local governments. Public works orderssurged in September but fell back in October andNovember. The November package worth ¥24 tril-lion is expected to show up in the orders data in theApril-June quarter.

• The initial budget for fiscal 1999 was big, but fallswell short of final 1998 spending. Thus, J.P. Mor-gan expects to see two additional stimulus packagesworth ¥12 trillion during the course of 1999.

• However, the impact of fiscal stimulus on activity isexpected to remain handicapped by a lack of multi-plier effects and the poor fiscal position of localgovernments. Instead, much of the fiscal boost willserve only to boost the budget deficit. Overall,fiscalpolicy as currently conducted by the government isunlikely to achieve private recovery simply becauseit lacks a meaningful structural reform component.

0

500

1000

1500

2000¥ billion, saCustoms-cleared trade surplus

1993 1994 1995 1996 1997 1998


300

350

400

450

500

550

600

650

700¥billion, sa, 3-month moving averagePublic construction orders

1993 1994 1995 1996 1997 1998

-15

-10

-5

0

5

85 87 89 91 93 95 97 99


Budget deficitgeneral government, net borrowing as % of GDP




BoJ will stay accommodative

• The BoJ has tried to maintain an accommodativestance over the last six months. Measures to this endinclude the overnight call rate cut from 0.5% to0.25% in September, the liquidity injection aftertwo major banks were nationalized, and November’sannouncement of support for corporate finance.

• Despite all the BoJ’s efforts, the credit crunchshows no sign of easing. Private banks’ loans out-standing dropped 4.7% from a year ago in Decem-ber. True, their large decline in recent months owespartly to special factors, but even if these factors areexcluded the drop in bank loans is unprecedented.

• Furthermore, the rise in the yen and the surge inbond yields have clearly deepened the perception oftighter monetary conditions.

• Going forward, the BoJ is likely to maintain its ac-commodative policy stance and increase efforts toboost broad money supply growth. However, spe-cific government bond purchase programs to reduceJGB yields are unlikely.

• Financial reforms will be critical for the effective-ness of monetary policy. The good news here is theFinancial Supervision Agency (FSA) effort to applymore rigid conditions on capital injection intobanks. These could force banks to write off more oftheir nonperforming loans and otherwise to restruc-ture themselves. However, given the sheer size ofthe problem, the reform process is unlikely besmooth and will take a long time.

-6

-4

-2

0

2

4

6%oya, monthly averageBank loans outstanding

1992 1993 1994 1995 1996 1997 1998

0.0

0.5

1.0

1.5

2.0

2.5percent per annum, averageUncollateralized overnight call rate

1995 1996 1997 1998 1999

0102030405060708090

100

Bank of Japan’s assets¥ trillion

Jan 95 Oct 97 Dec 98

JGB

Other

Loans to DIC46.0

65.1

91.2

52.0

8.1

31.1

0.5

1.5

2.5

3.5

4.5

5.5

1995 1996 1997 1998 1999

J.P. Morgan 10-year government yielspercent per annum, constant maturity, end period



Morgan Guaranty Trust CompanyEconomic Research

Emerging Asia: Recovery prospects tentative• Output is stabilizing or picking up a little across

the region

• Very benign inflation, easy monetary policy, im-proving external positions are aiding the healing

• Healing of banking sectors is progressing mostrapidly in Korea and Malaysia

• Thailand’s market-driven approach to bank re-construction is losing some momentum

• In this area, Indonesia has barely begun the re-building process

The region’s economies are mostly recovering, but could yet go off the rails again

Sin Beng Ong (65) [email protected]

• By and large, output trends in Emerging Asia havemoved from stabilization to mild recovery.

• North Asia is faring quite well. Korean productionshows the greatest strength, with strong pickups insemiconductor and other electronics-related areas.

• China, making up more than a quarter of EmergingAsia’s economy, reports a marked reacceleration ofoutput. But this revival, based heavily on the au-thorities’ aggressive boosting of state fixed invest-ment (some 50% of all investment), may not provesustainable given the new foreign credit crunch andthe competitive pressures in the export sector.

• Taiwan, despite its strong trade linkages with therest of Asia, has not been drastically affected by theregional demand slowdown. Looking ahead, theslowdown in external demand will dent its exports(and the broader economy) but its niche position incertain markets will provide some buffer.

• Production trends in South Asia, while not as strongas in North Asia, nonetheless are turning for the bet-ter, especially in Thailand. Malaysia and Singapore,while stabilizing, have yet to show real recovery.

• The big risk to the 1999 recovery story for Emerg-ing Asia remains that of a sharper-than-expected fallin demand from Japan and outside the region.

Real GDP growth forecasts%oya, calendar years

1997 1998e 1999f 2000f

Emerging Asia (10) 6.1 -0.1 3.0 4.9China 8.8 7.8 6.5 5.8Hong Kong 5.3 -5.0 -1.5 3.0India* 5.0 4.0 2.5 5.0Indonesia 4.9 -13.7 -3.5 5.0Korea 5.5 -5.7 4.0 4.5Malaysia 7.8 -7.3 -1.0 5.0Philippines 5.2 -0.5 2.6 5.0Singapore 7.8 1.3 -1.0 4.0Taiwan 6.8 4.8 3.2 4.5Thailand -0.4 -6.5 3.0 5.0

* Fiscal year beginning Apr 1.

5

10

15

85

90

95

100

105

110%oyaNorth Asia: industrial production

1997=100, 3-month moving average, sa

1997 1998

China Taiwan

Korea

85

90

95

100

1051997=100, 3-month moving average, saSouth Asia: industrial production

1997 1998

Thailand

Singapore

Malaysia





• Supporting Asia’s recovery have been significantlyimproved external liquidity positions, much lower-than-expected inflation, and stimulative monetaryand fiscal policies that should aid the reform drive.

• However, despite the positive signs that stabilizationis giving way to a moderate upswing, significanthead winds could slow Asia’s recovery and restruc-turing process.

• The risks are both external and internal. Note first,though, that the central view that Emerging Asia ison the mend does not depend on a strong bounce inexports but rather on a gradual upward trend. Andwhile net trade is forecast to be a drag, GDP growthwill mainly occur through inventory restocking.

• That said, the global economy could deteriorate farmore than the otherwise already-cautious J.P. Mor-gan outlook supposes, say if Europe’s manufactur-ing keeps slowing and its consumers lose heart, or ifthe U.S. economy stumbles in a way no one pres-ently projects. In addition, a possible Chineserenminbi devaluation could have a negative enoughimpact on sentiment as to unleash another round ofregional financial market shocks.

• Besides the external environment, domestic uncer-tainties vis-à-vis the banking sector and corporatedebt restructuring remain a risk to GDP recovery.While carrots are generally in place across the re-gion to facilitate banking sector recapitalization andcorporate debt restructuring, sticks to compel con-structive outcomes are inadequate or even missingaltogether. Notably still missing are comprehensivebankruptcy and foreclosure laws to enable banks toforeclose on the assets of unwilling or insolventdebtors. Implementing such laws will be a crucialstep toward resolving overall banking sector issues.

• Perhaps especially disheartening in this area is thefailure of the Thais to complete new legislation.Similarly, Thailand’s failure to auction off fully theassets of the 56 foreclosed finance companies showsthat even where structures are in place to permit ra-tionalization of bad assets and the reestablishmentof market-clearing prices, resolve may flag in press-ing asset price deflation through to its painful butultimately constructive end.

Obstacles and head winds still impede vigorous GDP upswings

Emerging Asia: headline consumer prices%oya

Average1990-1996 Jun 97 Dec 97 Jun 98 Dec 98

North AsiaChina 10.7 2.8 0.4 -1.3 -1.0Hong Kong 8.9 5.4 4.8 4.0 -1.4

South Korea 6.4 4.0 6.6 7.5 4.0Taiwan 3.7 1.8 0.3 1.4 2.1

ASEAN Indonesia 8.9 5.3 10.3 56.7 77.6

Malaysia 3.8 2.2 2.9 6.2 5.3Philippines 10.8 5.7 7.3 10.7 10.4Singapore 2.5 1.7 2.0 -0.2 -1.5Thailand 5.1 4.4 7.6 10.7 4.3

-4

-2

0

2

4

6

8

1996 1997 1998

ASEAN

North Asia

Emerging Asia: trade balancesUS$ billion, 3-month moving average, sa

Emerging Asia: export performanceJan 1997=100, US$ terms, sa

Jun 97 Dec 97 Jun 98 Latest MonthNorth Asia

China 98.2 89.2 100.8 93.8 DecHong Kong (domestic) 98.6 99.7 97.7 83.7 NovSouth Korea 102.3 97.6 94.6 101.6 DecTaiwan 100.9 101.9 92.1 87.3 Dec

ASEANIndonesia (non-oil) 97.9 101.7 109.8 89.4 OctMalaysia 100.0 91.4 90.5 98.4 NovPhilippines 99.7 105.4 111.9 121.6 NovSingapore (non-oil dom.)101.6 99.7 90.8 91.3 DecThailand 98.9 102.2 94.1 91.23 Dec




-20

0

20

40

60

80yuan billion, cumulativeChina: state industry profits

Jan Mar May Jul Sep Nov

1995

1996

1997

1998

Joan Zheng (852) [email protected]

China has turned from a regional stabilizer to a regional risk factor

• While the rest of Emerging Asia is either stabilizingor recovering, China faces more uncertainty. Itslegacy from the past is equally sickly – a weak fi-nancial sector, overinvestment, and a heavily in-debted corporate sector. But its proactive monetarytightening in 1993, and monetary and fiscal stimula-tion since 1996, saved it from the regional crisis. YetChina’s flatter business cycle also makes its adjust-ment process longer, there being no alternative torestoring competitiveness. Meanwhile, the financialcrisis is intensifying and the global economic envi-ronment deteriorating. The pain is manifested in thecollapse of GITIC and other itics, the debt restruc-turing of Guangdong Enterprises, and the soured re-lationship with foreign creditors. And more badnews lies ahead as prices slide in the economy andthe corporate sector’s debt burdens grow.

• The deteriorating financial condition of corporateChina will continue to have serious implications forthe labor markets and the financial sector. Against abackdrop of sparse social welfare benefits, wide-spread and deep-rooted corruption, and extreme in-come inequality, the rising jobless rate and financialfailures could ignite social instability, especially inthis year of emotional anniversaries.

• Aware of this risk, and alarmed too by growing la-bor unrest in central China and the past year’s politi-cal and social developments in some other Asiancountries, top Chinese leaders have decided to putstability at the top of their agenda for 1999. This de-mands stable economic growth and hence continua-tion of last year’s fiscal pump-priming. And to limitfinancial risk, the government will continue to standfirmly behind its banks, while consolidating non-bank financial institutions.

• For now, the policy focus on stability also applies tothe currency. And the market is unlikely to force theofficial hand, despite the intensifying foreign creditcrunch. But at a later stage, the official will to main-tain currency stability may weaken. If China’s tradeand urban labor markets underperform official ex-pectations, currency depreciation may become aneasy remedy, especially if downward pressure on theHong Kong dollar eases significantly and no longerconstrains China’s exchange rate policy.

Government bonds issued in 1998

• Domestic bonds to retire maturing debt and finance budget deficit,announced in March as part of the FY98 budget: yuan280.8 billion

• Special domestic bonds: yuan100 billion to finance infrastructureinvestment; yuan270 billion to recapitalize the four largest statebanks

• Global bonds: US$1 billion• Domestic bonds of State Development Bank to finance investment:

yuan15 billionGovernment bonds to be issued in 1999

• Bonds to retire maturing debt and finance budget deficit, to be an-nounced in March as part of the FY99 budget: yuan 316.5 billion

• As in 1998, special bonds will likely be issued in addition

-40

-20

0

20

40

60

80

-4

-2

0

2

4

6

8

1993 1994 1995 1996 1997 1998 1999

China's exports

G-3 IP

China’s exports and G-3 industrial production%oya, 3-month moving average, both scales

China’s exports




Hong Kong still faces a bumpy road ahead

• By now, the worst is over for Hong Kong. Interestrates in 1999 should be much less volatile, certainlyless than they were last August, since the SAR hasimproved its liquidity management system, whilehedge funds are financially weakened.

• Even so, the road ahead may not be smooth androsy. First, amid intense deflationary pressures, realinterest rates may stay at historical highs for awhile, deterring investment and consumption. Giventhe China and Brazil uncertainties, the risk premiumon the Hong Kong dollar will persist and even jumpfrom time to time; in turn, prime rate can drop littlewithout further U.S. rate cuts, especially since HongKong banks are still battling rising nonperformingloans and plummeting profitability. Even if primerate continues to fall, access to nonmortgage loanswill remain tight, as banks remain risk-averse. In-deed, cutbacks by Japanese banks may offset anyloan expansion by local banks.

• Second, the labor market will continue to deterio-rate, and probably rapidly so in February, as manycompanies are expected to cease business after theChinese New Year, and even the lucky survivorswill have to learn to cope with the new environmentof deflation. With no offset from falling interestrates as in the past four months, the rising joblessrate may start to erode public confidence. Indeed,anecdotal evidence suggests that the house-buyingfrenzy is cooling. And housing prices may even cor-rect downward in the short term, given the largeamount of housing supply in the pipeline.

• Even while monetary conditions are constrained bythe currency board system, the upcoming fiscal bud-get for 1999/2000 can be only moderately stimula-tive. In turn, at least through the first half of 1999,the economy will lack any powerful engine to raiseit out of the doldrums. Hopes instead are pinned onthe closing months of the year, and will certainlybrighten if the U.S. Fed cuts rates in August and thefinancial markets stabilize in the rest of the world,assuming also that most of the bad news aboutChina has come out by then. And back at home, theproperty market and construction activity should befurther boosted later this year by the expected hous-ing shortage beyond the year 2000.


2

3

4

5

6

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5% of labor force %m/m, 3-month moving average

1997 1998

Unemployment rate

Labor force growth

Hong Kong: unemployment rate and labor force growth

* J.P. Morgan estimates.

15

20

25

30

35

40

45

-30

-20

-10

0

10

20

30

40

50

60

88 90 92 94 96 98 00

PricesNew supply

Hong Kong: private housing supply* and pricesthousand units %oya

4

6

8

10

12

14

16

Jan 98 Apr 98 Jul 98 Oct 98 Jan 99

3-mo. US$ LIBOR

3-mo. HIBOR

Hong Kong prime rate

U.S. and Hong Kong interest rates% p.a.




Taiwan: Battle continues between the government and market forces

• Like China, Taiwan has managed to steer clear ofthe regional financial crisis, but is not trouble-free.Late last year, it suffered a string of corporate andfinancial failures. While additional failures havebeen temporarily halted by government emergencymeasures, the stock market has been unable to over-come disappointment about corporate earnings andits fear of more corporate failures. Sinking stockprices will erode consumer confidence, given retailinvestors’ high presence in the market. Meanwhile,worsening asset quality means banks will stay risk-averse. So corporate Taiwan will face tight liquidityconditions for quite a while to come.

• But unlike China or the rest of Asia, Taiwan experi-enced no significant or widespread asset bubbleprior to the Asian crisis. True, oversupply still bur-dens its property market, and some companies inother sectors threw prudence to the wind by increas-ing their leverage to fund needless expansion. Butthe economy as a whole was not swept by “exuber-ance.” Granted, bank credit totals a lofty 150% ofGDP, as high as in Thailand or South Korea. Butcorporate Taiwan has relied much more on equityfunding, thereby limiting its overall leverage.

• Importantly, economic adjustment in Taiwan is un-likely to be as drastic as in the rest of Asia. Its ex-ports, while plunging, will ultimately be cushionedby a competitive high-tech industry. Moreover, ex-porters are benefiting from cheap commodities im-ported from overseas (65% of total imports). Andabsent significant downward pressure on the cur-rency, the government and the central bank will con-tinue to inject liquidity into the economy.

• Certainly, Taiwan’s financial sector is not as healthyas its counterparts in Hong Kong and Singapore. Butit is much stronger than those in the IMF-3 countriesand is not being pressured by any dramatic downturnin the overall economy. Within the financial sector,asset-quality problems may indeed face the largestate-owned domestic banks and the small financialinstitutions. But the former will continue to enjoythe government’s full backing, and hence depositors’confidence, while the latter are limited in scale.


Measures of banking sector strength: domestic banksend of period

1995 1996 1997 98Q3% of total loans and investmentExposure to real estate 37.0 37.3 35.8 35.1

Mortgage loans 27.5 29.2 28.1 27.2Construction sector 6.4 5.2 4.8 4.9Real estate sector 3.1 2.9 2.9 3.0

Exposure to stock marketStock trade margin funding 2.4 2.4 2.4 2.5

Nonperforming loans 2.9 3.6 2.9 5.0*Owners’ equity/risky assets, % ratio 13.6 12.9 11.4 11.6†Liquidity, % ratio 12.7 15.3 11.8 13.1†Loan/deposit, % ratio 85.7 82.5 82.5 83.6†* As of end-Oct. † As of end-Jun.

Taiwan: loan growth and overnight interest rate%oya % p.a.

2

4

6

8

10

12

14

4

5

6

7

8

9

1997 1998 1999

Loan growth

Overnight interest rate

Taiwan: stock index and retail sales1996=100 %oya, 3-month moving average

120

140

160

180

200

220

4

6

8

10

12

1997 1998 1999

Taiwan Weighted Stock Index

Retail sales




South Korea: Signs of recovery abound, but head winds linger

• After a year’s belt-tightening, Korea is now reapinggain for that earlier pain. The balance of paymentshas hugely improved, production growth has turnedpositive, and domestic demand is showing signs ofrecovery. Still, structural reform has a long way togo, and the head winds impeding reform progresswill never be negligible.

• The main engine for GDP growth has been exports,which will likely continue strong but volatile. True,the won has steadily appreciated against the green-back, undermining the competitiveness of Koreanexports. Also, fallout from Brazil’s troubles andtheir prospective contagion effect on the rest ofLatin America are certainly not positive. But ex-ports to Brazil have been only 1.2% of Korea’s totalexports, and importantly, within what is otherwise ableak outlook for external demand, the U.S. eco-nomic slowdown seems to have been delayed andAsian demand has been bottoming out. Moreover,the won is still 18% below its pre-devaluation aver-age in real trade-weighted terms.

• Strong exports have spurred a sharp rise in indus-trial production since last September. Going for-ward, the growth pace should continue vigorous forthe time being, not least because inventories havedropped drastically relative to sales, suggesting thatproducers will likely want to rebuild stocks.

• Interest rate cuts and an easing of the credit crunchhave improved domestic demand conditions. Retailsales look to have already hit bottom, and importdemand for both capital goods and materials hasstarted to pick up.

• Still, domestic demand will not be quick to recoveras the economy must travel a bumpy road of struc-tural reforms. Pressured by the requirement thatthey must reduce their debt ratios, companies willcontinue cautious about expanding investment. Andhousehold consumption is unlikely to pick upsharply, especially as the so-called big deals amonglarge conglomerates threaten workers’ job security.While government programs should be able to capthe jobless count, labor markets will remain slackand awareness of on-and-off labor strikes will dis-pel some of the present euphoria over the economy.

67

68

69

70

71

72

73

74

100

105

110

115

120won trillion, 1990 prices, sa South Korea: real GDP and industrial production

1995=100, sa

1997 1998


Real GDP

0

2

4

6

8

10% of labor forceSouth Korea: unemployment

1997 1998

Seasonally adjusted

Jiwon Lim (822) [email protected]

80

90

100

110

120

1301995=100, sa

1997 1998

Wholesale and retail trade

Import volume

South Korea: wholesale and retail trade and import volume




Indonesia is trying to prepare for further and historic political change

-20

-15

-10

-5

0

5

10

-40

-30

-20

-10

0

10

20

1996 1997 1998

Year-on-year

Quarter-on-quarter

Indonesia: government budgetrupiah trillion

FY98/99 FY99/00Expenditure 263.9 218.2

Civil services salaries/food allowances 24.8 32.0Goods procurement 11.4 11.0Regional subsidies 13.3 18.4Debt service payments 66.2 44.8

Domestic 1.9 0.4Foreign 64.3 44.4

Development spending 92.7 83.6Bank restructuring 15.0 18.0

Revenue 263.9 218.2Oil and gas receipts 49.7 21.0Other receipts 99.6 119.8Foreign sources 114.6 77.4

Program loans 74.0 47.4Project loans 340.5 30.0

* FY99/2000 assumptions: Oil price, $10.5/barrel; exchange rate, IDR7,500/$; real GDP growth, 0%; CPI inflation, 17%.

-3

0

3

6

9

12

15

18

1997 1998

Total

Food

• While monumental changes are simultaneously un-der way in Indonesia’s economic and financial land-scape, political change plainly trumps all else at themoment. The plan for elections on June 7 has beenkept on track by this week’s House (DPR) passageof new election laws. This is no real surprise, how-ever, since the DPR is still controlled by the rulingGolkar party. In any case, not only Golkar, but allmajor political forces in Indonesia, have agreed thatelections as scheduled are the only way for thecountry to move forward. The wild card in the deckis the possibility of general unrest and violencespreading across the sprawling archipelago, whichcould make the elections operationally impossible.

• The political turmoil contrasts with the official eco-nomic data and the government’s policy agenda. Onthe data front, things look remarkably stable. Whilereal GDP did shrink 13.7% in 1998 as a whole, thequarterly data imply a sharp pickup in the fourthquarter after five quarters of contraction. Presentinga similarly rosy appearance, the CPI data show in-flation cooling significantly of late after a series ofmenacingly high price increases earlier in 1998.

• The Habibie government’s policy agenda is strikingfor its orthodoxy. In turn, the budget proposal putforward earlier this month has been criticized byvarious DPR members (the criticism itself being un-precedented in Indonesia). The budget includesIDR18 trillion ($2.4 billion) for bank restructuringcosts, which assumes that the government can pullin IDR16 trillion ($2.1 billion) from asset sales.That assumption, and others, may be questioned,but on the whole the budget is a realistic, pragmatic,and modestly expansionary plan.

• The budget, as well as the bank restructuring planproper, is admirably responsible from the point ofview of economic policy, as too is the prudently re-strained stance of monetary policy. But the centralquestion remains: Who will be holding the reins ofpower actually to implement these policies (or oth-ers) by the end of 1999?

David G. Fernandez (65) [email protected]

Indonesia: gross domestic product%oya % q/q, saar

Indonesia: consumer prices% m/m, nsa




Malaysia: The doctor is in the house

• Stabilization now appears to have taken root morefirmly in Malaysia, at least judging by recent datareleases. In particular, some sort of output bottomhas formed, a bottom engineered by external de-mand, while domestic sentiment has improved, inturn engendering some revival of confidence in thebanking system. The global environment, however,remains volatile, while domestic demand still ap-pears weak, with employment indicators still wors-ening. Thus the overall outlook for the Malaysianeconomy remains uncertain and GDP may not stagemuch recovery in 1999.

• Recent moves by the authorities to limit bank expo-sure to the real-estate sector, and hints of furtherloosening of capital controls, are positive develop-ments in economic policymaking, developments thatmay engender some further return of confidence.So too is the generally well considered plan to healthe banking sector (see Are Malaysia’s banks on theroad to healing?, Global Data Watch, Jan 22).

• Although the bonds issued by the recapitalizationand Asset Management entities are zero-coupon,and therefore exert no short-term funding pressure,the longer-term funding needs should not be over-looked. In addition, data through last Novembersuggest no real pickup in bank deposits (though theymay have done so in December and January, judg-ing by the net foreign assets figures). In turn, theability of the authorities to tap the domestic capitalmarkets to fund their net borrowing requirementmay be limited. This highlights a return of foreignfunds as critical for bolstering the economy. Thatthey may not is a key risk now facing Malaysia.

• Note nonetheless that no change is likely in the un-derlying structure of Malaysia’s New EconomicPolicy, which aims to provide a racially more equi-table distribution of resources. This complicatescorporate debt restructuring, with the authorities insome cases reluctant to permit full rationalization.That they may not presents a medium-term risk in asmuch as the extant overcapacity in certain sectors ofthe economy may not be fully resolved.


85

90

95

100

105

-9

-6

-3

0

31997=100, sa %2m/2m, sa

1997 1998

2 month-over-2 month

Index level

Malaysia: industrial production

20

21

22

23

24

25

26

27

Jan 98 Apr 98 Jul 98 Oct 98

0.5

1.0

1.5

2.0Foreign reserves Trade balance

Malaysia: foreign reserves and trade balanceUS$ billion, eop US$ billion, nsa

-1

0

1

2

3

4

1997 1998

Thailand

Malaysia

Malaysia and Thailand: quasi-money%m/m, 3-mo. mov. avg., sa, local currency terms




Philippines: The government buys weather insurance

-20

-15

-10

-5

0

5

10

15

20

1996 1997 1998

nsa

sa, 3-monthmoving average

-1500

-1000

-500

0

500

1000

1997 1998

Current account

Merchandise trade

• The Philippines basically sidestepped the regionalcrisis, but could not avoid poor weather conditionslast year. Agriculture, which still contributes over20% of national output, was a severe drag on theeconomy in 1998. Excluding that sector, Philippinereal GDP would have grown 1.1%, instead of -0.5%.But barring another year of disastrous weather, GDPshould grow a respectable 2.6% in 1999.

• What shielded the Philippines from the full brunt ofthe regional crisis was its relatively strong bankingsystem and a consumer who never stopped spend-ing. Another key factor was that exports grew evenin dollar terms last year from the Philippines,whereas they stagnated from China and shrank fromall the other Asian countries.

• The strong exports owed to recent foreign invest-ments in the electronics industry and an export mar-ket orientation that looks beyond Asia. Expandingexports and declining imports carried both the cur-rent and trade accounts into the black in 1998. How-ever, with the U.S. economy poised to slow signifi-cantly and imports recovering, net trade will againbe a drag on the Philippines in 1999.

• In this fragile external environment, the governmentunderstandably intends to keep its countercyclicalfiscal policy stance in place. Last year’s deficit ap-pears to have breached the ceiling agreed with theIMF (PHP49 billion) and this year the governmentis planning on spending every peso it can, with itsdeficit likely to rise from 2.0% of GDP to around2.3%. Much of the deficit’s expansion will comefrom a scaling-back of expected revenues, but mod-est spending increases on education, health, hous-ing, and employment are also part of the plan.

• This month’s successful $1 billion two-tranche glo-bal bond offering will help fill the hole in the bud-get, but more external funding needs to be raised.The financing plan calling for official loans plusmore global bond issuance still looks achievable,however. Add to the fiscal plan an accommodativemonetary policy, and GDP growth in 1999 is all butassured – as long as the weather cooperates.


-4

-2

0

2

4

6%oyaPhilippines: gross domestic product

1998 1999

GDP growth

Agriculture contributionForecast

2000

Philippines: trade and current account balances$ million, nsa

Philippines: national government budget balancepesos billion




Singapore: Stabilization is under way but recovery remains uncertain

• Recent indicators from the island republic, includingDecember’s surprisingly big jump in manufacturingproduction suggest that some semblance of outputand export stabilization has emerged.

• However, there are several risks to the view thatSingapore’s exports have truly hit bottom. TheNorth Asian countries, specifically Korea, have re-cently begun aggressively to ramp up production ofsemiconductors. This tactic had a negative impacton global prices when last tried in 1997, and thistime could once again lead eventually to productioncutbacks. Already, Singapore’s electronics-relatedexport prices appear to be dipping again after firm-ing up in the middle of 1998.

• Going forward, the demand outlook is not reassur-ing. The U.S. economy (which takes 28% ofSingapore’s non-oil domestic exports) likely willaverage no better than 1.5%-2.5% real GDP growthin this first half of 1999, while activity in the EuroArea (which takes another 24%) looks to be slowingfaster than expected hitherto. If so, and especially inthe event of further supply pressure from NorthAsia, another production slowdown could ensue inSingapore.

• Because the outlook for both exports and theeconomy remains unclear, easy monetary policy willcontinue to be a central policy theme in Singapore.The inflation outlook likewise argues for monetaryease. Global goods prices are expected to continueto weaken as global demand slows in these earlymonths of 1999. With both foreign costs and domes-tic costs falling (especially once the labor cost cutsare implemented), headline consumer prices inSingapore are expected to fall further – indeed evenfaster going ahead than they did in the second halfof 1998. In turn, the authorities will continue to leantoward lower domestic interest rates.

• In recent months, the monetary authorities havebeen accumulating foreign reserves despite a stillweakish nominal exchange rate. The scale of suchintervention can be expected to escalate into 1999.


-2.5-2.0-1.5-1.0-0.50.00.51.01.52.0

%3m/3m, normalized in 1996-98 standard deviation units

Singapore: foreign reserves and nominal exchange rate

1997 1998

Nominal effective exchange rate

Foreign reserves, US$ terms

-1.0

-0.5

0.0

0.5

1.0%3m/3m, sa

Singapore: consumer prices

1997 1998

Nonfood

Food

All

4.25

4.75

5.25

5.75US$ billion, sa

Singapore: non-oil domestic exports

1996 1997 1998





Thailand: Stabilized, yes, but when will a real upswing begin?

• Thailand’s steadfast adherence to a clearly-enunci-ated, orthodox approach to the financial and eco-nomic crises is being tested. The Chuan administra-tion is now 15 months old, three months shy of theaverage duration of a Thai government since 1988.With the parliament’s latest confidence vote nowbehind it, Chuan and his team look likely to outlastthe mean. That said, their longer-term prospectswould be greatly enhanced by more visible resultsfrom their carefully crafted reform plans.

• Restructuring and reviving the financial sector con-tinues to be a priority for the government, but onthis critical front progress has been slow. Interestrates have come down, but until key legal reformsare passed and implemented, and corporate debtsrenegotiated, bank lending will continue to stagnate(see essay, pages 13-20).

• Nevertheless, there are reasons to be optimistic onthe real economy. The J.P. Morgan forecast of 3%real GDP growth in 1999 depends on a number ofpositive factors: interest rates remaining low, verymodest growth in exports, manufacturing productionincreasing to reverse inventory drawdowns, fiscalstimulus, and no further significant contractions inhousehold consumption and private investment. Atthis point, while the conditions are in place for thisoptimistic scenario to occur, data released so far sig-nal only stability – not revival.

• Thai exports have clearly benefited from the baht’sdepreciation, with volumes rising steadily eventhough their dollar value has fallen. The flatteningout of export volumes recently and the prospect of asoft external environment mean that any furthergains made this year will be modest. Note that therehas been nothing modest about the collapse of im-ports, which is the reason why Thailand now runs,and will continue to run, large trade surpluses.

• Even if the Morgan forecast becomes reality, thisdoes not mean that Thai consumers will prosper thisyear. More restructuring means more unemploy-ment, so spending, especially on big-ticket items,will continue to be dull.


50

60

70

80

90

100

110

1201996=100, sa, 3-month moving average

1996 1997 1998

Volume

Value, $ terms

50

60

70

80

90

100

110

1201996=100, sa, 3-month moving average

1996 1997 1998

Volume

Value, $ terms

0

5

10

15

20

0

20

40

60

80

100

120

140

1996 1997 1998

Cars

Motorcycles

Thailand: passenger car and motorcycle sales’000 units, sa, 3-month moving average, both scales

Thailand: exports

Thailand: imports




India expected to tighten monetary policy

• While economic conditions have started to stabilizein the rest of Asia, the prospects for the Indianeconomy have deteriorated. Economic growth issluggish and yet inflation, at least in consumerprices, was dramatically on the rise until very re-cently. Industrial production has continued toweaken while exports are facing ever keener compe-tition from Asia.

• On the fiscal side, the central government’s higherborrowing needs have been met to a certain extentthrough monetization. This, along with the cost-push effects of the weaker rupee, has helped fuelinflationary pressures. Indeed, pressures here haveboosted interest rates, and in turn are underminingeconomic activity.

• On the external side, the trade deficit between Apriland November nearly doubled from the same perioda year earlier, thanks to still uninspiring exports andrapidly rising imports. Although down 9% since thestart of the fiscal year last April, the rupee remainsuncompetitive in real terms, while domestic demandis stubbornly strong leading to a consistent widen-ing of the trade deficit.

• Taken together, the worsening budget deficit, a de-teriorating external position, and surging inflationare making the economic sustainability of monetarypolicy increasingly tenuous and may well force theReserve Bank to tighten rates

• The upshot of such policy tightening will be a slow-down in domestic demand, while poor operating re-sults in the corporate sector are likely to lead to ad-ditional investment cutbacks. All in all, real GDPgrowth should fall below 3% in the next fiscal year,with outright recession being a clear risk to the out-look. On the plus side, trade balances should im-prove and CPI inflation fall despite a weaker cur-rency. Less positively, the government will havetrouble reducing the overall budget deficit, thanks toa further shortfall in tax revenues.

0

5

10

15

20

25%oya

1994 1995 1996 1997 1998


M3

Bernhard Eschweiler (65) [email protected]

4

6

8

10

12

14

16

18

20%oya

91 92 93 94 95 96 97 98

India: consumer prices

2.5

3.0

3.5

4.0

1996 1997 1998

Imports

Exports

India: tradeUS$ billion, 3-month moving average, sa

India: industrial production and M3


SydneyJanuary 29, 1999

J.P. Morgan Australia Pty LtdEconomic ResearchJohn Kyriakopoulos (61-2) [email protected]

0

2

4

6

8

10%oya, trend valueRetail sales

90 92 94 96 98

Australia and New Zealand converge in 1999• Low interest rates continue to support growth,

strong in Australia, recovering in New Zealand

• But sharply lower commodity prices are still adrag on growth, through reduced export receipts

• Inflation will stay quiescent, judging by the scantpass-through of earlier currency depreciation

• Currencies are vulnerable while current accountdeficits remain high, but big tumbles are unlikely

Key forecastscalendar years, except fiscal balance: years ending June 30

1998 1999f 2000f

AustraliaReal GDP (%oya) 4.7 2.2 3.0Consumer prices (%oya) 0.9 2.0 2.8Current account (% of GDP) -4.7 -5.1 -4.1Fiscal balance (% of GDP) 2.8 1.5 2.2

New ZealandReal GDP (%oya) -0.5 2.0 3.8Consumer prices (%oya) 1.3 1.6 1.9Current account (% of GDP) -6.2 -5.3 -4.1Fiscal balance (% of GDP) 2.6 -0.3 -1.5

• Consumer spending and major infrastructureprojects have been the key contributors to economicgrowth, remaining strikingly robust in the face ofexternal head winds.

• The strong and steady growth in consumer spendingthrough 1998, and its expected continuing momen-tum into early 1999, is driven by record-low bor-rowing costs (at least in nominal terms), rising realwages, solid jobs growth, and windfall gains fromthe AMP demutualization.

• A sharp correction in equity prices or a weakeningof the labor market are the main threats that couldcause consumer spending to stumble.

• The July 2000 introduction of the new goods andservices tax (GST) will prompt households to delaypurchases of goods that will get cheaper – like autosand electrical goods. But household spending onnew homes, currently exempt from sales tax, will bebrought forward as the GST will raise their cost.

• Sydney-2000-Olympics-related and other infrastruc-ture construction (particularly new toll roads inSydney and Melbourne) boosted GDP growth byaround 0.5 percentage point in 1998. This boost(along with consumer spending) kept domestic de-mand resilient in the face of the sharp falls in manu-factures exports and commodity prices.

Australia’s consumer spending powers on...

500

1000

1500

2000

2500

-0.15

0.00

0.15

0.30

0.45

0.60A$ mil, 1996-97 prices, saEngineering construction - private

percentage points oya

90 92 94 96 98

Value of work done

Contribution toreal GDP growth




...but GDP growth will still slow in 1999, if to uncertain degree

• Despite recent upbeat economic reports suggestingcontinuing strength right now, GDP growth willslow in 1999, while still recording an eighth year ofexpansion. Sub-trend growth appears inevitable thisyear because published growth hitherto – to thethird quarter of 1998 – has remained above averagefor six quarters. Less certain is the degree to whichgrowth will moderate. This will have important im-plications for interest rates.

• The somewhat slower pace of overall spendinggrowth will result from an outright fall in businessequipment investment, a fading of the dynamism inconstruction, and a weakening of consumer spend-ing (though this last not until midyear).

• Mining investment will now be curtailed for severalyears at least, after growing at an average of 16%annually over the past five years, due to depressedcommodity prices (for coal, iron ore, gold, and basemetals). Mining investment was already downnearly 9% over the year to the third quarter of 1998,and it will remain weak in 1999. Fewer miningprojects will be viable unless commodity prices re-bound by at least 15%-20%. Still, depressed com-modity prices may prove a blessing in disguise tothe extent that a higher proportion of business in-vestment now occurs in high-tech manufacturingand high-value-added services – although such astructural shift may take several years to mature.

• Residential construction appears to have peakedaround the middle of 1998 and the slowdown herewill continue into the first half of 1999. However, asharp fall is not likely as new housing remains veryaffordable at the current record-low mortgage inter-est rates. Moreover, last year’s peak was relativelymodest compared with those in previous cycles, so abust now is less likely. In addition, recent news thatnet immigration in 1998 exceeded target by around25,000 people points to higher underlying demandfor new housing than earlier expected.

• Infrastructure construction will cool this year asOlympics-related spending moderates and work onmajor toll roads falls rapidly. Overall, the construc-tion sector in 1999 is not likely to repeat its 50,000(9%) surge in head count of 1998.

0

1

2

3

4

5

6

7

8A$ bil, 1996-97 prices, trendBusiness investment

91 92 93 94 95 96 97 98

Manufacturing

Mining

Other

-4

-2

0

2

4

6

8%oya, saReal GDP growth

90 92 94 96 98 00

Average 1980-1998

-20

-15

-10

-5

0

5

10

15

20

-100

-50

0

50

100

86 88 90 92 94 96 98

Real valueadded Employment

Construction%oya ch oya, 000s, sa




Inflation remains quiescent...

• Inflation is quiescent. Fears of sharply higher con-sumer prices from the Australian dollar’s 20% de-preciation against the greenback are proving mis-placed. Unit labor costs are steady despite the unem-ployment rate’s drop to an eight-year low.

• Traded goods prices to consumers have acceleratedlittle. The intense competition born of global over-capacity in manufacturing restrains pass-through ofhigher import prices to consumers. The plunge incrude oil and other commodity prices has also offsetthe Australian dollar’s decline. Indeed, the prices ofimported and domestically produced raw materialsused in manufacturing are actually falling.

The Reserve Bank will cut rates again when growth stalls

• The economy’s resilience could once again raisefears that the RBA may need to raise interest rates.But those fears would be misplaced. So long as theinflation outlook remains benign there is no reasonfor the RBA to apply even the hand brake.

• J.P. Morgan believes the bias of official interestrates is downward, so long as inflation forecastslook for a peak below 2.5%.

• With little evidence of any broad-based weakeningin economic growth, the RBA can remain patient.However, it is likely to act swiftly once domesticspending growth falters, as it inevitably will.

...but the large current account deficit needs to decline, and could well do so

• The current account deficit widened in 1998, pass-ing 5% of GDP in a few quarters. But while highcompared with most industrialized countries,Australia’s deficit was actually lower than its previ-ous cyclical peaks of 6%-7% of GDP.

• True, depressed commodity prices will continue tohurt export receipts this year, but improved interna-tional competitiveness – the real broad effective ex-change rate is 10% below average – and decliningmining investment (which is very import-intensive)will provide an offset. Indeed, the pace of growth inimport volumes has contracted sharply in responseto higher import prices.

70

80

90

100

110

1201990=100Real broad effective exchange rate

84 86 88 90 92 94 96 98

Average 1984-1996

0

2

4

6

8

10%oyaPrivate sector consumer prices

90 92 94 96 98

Goods

Services

-4

-2

0

2

4

6

-2

0

2

4

6

8% p.a.The yield curve and growth

%oya, trend

90 92 94 96 98

Nonfarm GDP10-year govt. bond less90-day T-bill yield




-500

0

500

1000

150096Q4 = 1000New Zealand: monetary conditions index

1992 1993 1994 1995 1996 1997 1998

Average 1992-1998

New Zealand emerges from recession...

• New Zealand’s recession appears to have been shortlived, lasting for just the first half of 1998 – al-though GDP did fall 1.8% – before a surprisinglystrong rebound in the third quarter. Overall, GDPgrowth will continue in 1999, but likely at a modestpace that keeps the output gap substantially negativeand inflation low.

• One reason for last year’s rapid turnaround was asharp drop in interest rates as the central bankplayed catch up and eased monetary conditions bythe equivalent of 1000 basis points during 1998.Business and consumer confidence responded wellto lower borrowing costs. Spending on autos alsobenefited from sharp price declines after the Maybudget abolished what were already low tariffs.Household spending was also boosted by income taxcuts (equal to 1% of GDP) from July 1998 and bywindfalls gains from the AMP demutualization.

• The bubble in house prices was pricked by a sharprise in interest rates through the first half of lastyear. Indeed, the decline in prices of around 6% ex-ceeded the fall during the 1991-92 recession. Whilecausing a great deal of pain to highly leveragedhouseholds, the sharp drop in house prices couldprevent another borrowing binge, if it has actuallytaught a valuable lesson. There is little doubt thatthe several successive years of double-digit growthin housing credit contributed to the sharp wideningin the current account deficit in 1996-98 and to thesubsequent rise in interest rates.

...and so the RBNZ will need to nurture the recovery

• Monetary conditions are now well supportive ofeconomic growth, and with the output gap likely toremain substantially negative through 1999, arelikely to remain so for some time yet.

• Apart from the lofty current account deficit, the big-gest risk to this benign outlook for interest ratescould well come from the election due by October-November. Opinion polls point to a likely victory bythe left-of-center opposition Labour Party, whosepolicy platform could unsettle financial markets.With 57% of government bonds held offshore, theattitude of foreign investors will be critical.

-2

0

2

4

6

8%y/yNew Zealand: real GDP growth

92 93 94 95 96 97 98 99

J.P. Morganforecast

50

60

70

80

90

100% of disposable income

91 92 93 94 95 96 97 98

New Zealand: household debt



Morgan Guaranty Trust CompanyAsian Market ResearchRonald Leven (65) [email protected]

Foreign exchange and interest rates

• A more sustained recovery in risk appetites isneeded before US$ can rally against yen

• With inflation under control, interest rates inEmerging Asia have room to fall further

• Recovery of economic growth in Asia will boostAUD and NZD

The tide is gradually turning in favor of the yen

During the fourth quarter, the Japanese governmentshifted away from an overt weak JPY policy. Themotivation for this shift was probably the scale of thebond issuance required by the fiscal expansion.Investors are loath to accumulate assets unless thegovernment is committed to protecting purchasingpower, so the consequence of a weak yen policy wouldlikely be still higher JGB rates. The governmentexpressed its intent to shift yen policy both throughpublic statements and by intervention when the USDwas still above 130.

More recently, when 110 was breached, the BoJshifted to buying dollars, so policy appears now to begeared to a steady yen, with a likely range of roughly110 to 120. While concerns for the CNY may haveinfluenced the BoJ to contain JPY weakness lastsummer, the CNY is probably no longer a significantfactor in JPY policy – a CNY devaluation would notprompt the BoJ to move back to a weak JPY policy.

For now, the risk of a range break is biased to thestrong dollar side. The surprising strength of the U.S.economy and stock market, and the consequent delayin any further Fed easing, should underpin the U.S.currency into the second quarter. However, the dollarwill encounter strong head winds above 120 and isunlikely to test its 1998 highs, not least because of thesimple arithmetic of supply and demand – dollarsupply will be increased by the rising Japanese tradesurplus and dollar demand will be capped by globaldeleveraging. With the JPY/USD rate thus constrainedon the upside, its actual movements should notreemerge as a driving factor for other Asiancurrencies.

Exchange rate and interest rate forecastsActual ForecastsJan-28 3 month 12 month

US$ exchange rateJapan 115.39 123 134Australia 0.63 0.62 0.65New Zealand 0.53 0.52 0.56China 8.28 8.28 8.67Hong Kong 7.75 7.75 7.77India 42.50 44.95 48.45Indonesia 9,213 8600 6700Malaysia 3.80 3.80 3.50Philippines 38.60 36.70 35.00Singapore 1.69 1.70 1.69South Korea 1,175 1,135 1,100Taiwan 32.33 32.15 33.00Thailand 36.89 35.70 32.003-month interest rate*United States 4.90 5.00 4.00Japan 0.78 0.40 0.60Australia 4.72 4.60 4.20New Zealand 4.53 4.30 4.20China 11.13 13.00 14.90Hong Kong 6.38 6.95 10.60India 12.17 16.30 15.70Indonesia 43.03 43.00 33.50Philippines 13.79 13.40 9.70Singapore 1.86 1.70 1.15South Korea 7.68 7.15 6.35Taiwan 6.89 6.45 6.35Thailand 8.51 7.70 6.5010-year gov. bond yields**United States 4.70 4.70 4.30Japan 1.86 2.25 2.70Australia 5.02 4.62 4.55New Zealand 5.51 5.30 4.50External debt spreads***EMBI**** 1,321 1,600 700China 06 243 275 225ICICI (India) 07 481 550 600Indonesia 06 1,125 902 703Korea 03 270 279 398Korea 08 303 309 399Petronas (Malaysia) 06 460 550 550Philippines 08 428 410 376Philippines 16 448 400 375Thailand 07 290 326 276Hutchison (Hong Kong) 07 262 600 350* % p.a., United States, Japan, Australia and New Zealand are de-

posit offer rates, all others are midlevel offshore money marketrates.

** % p.a., based on local convention.*** Basis points, spreads of dollar-denominated government (or corpo-

rate) bonds over U.S. treasury bonds.**** J.P. Morgan Emerging Markets Bond Index.




The U.S. recession that J.P. Morgan previouslyprojected has been postponed but not eliminated.Accordingly, as signs of a slowing U.S. economyemerge later this year, the dollar rally will lose steam,particularly since the current account deficit is apt toremain near record highs. And in a slowing economy,politicization of the U.S. deficit – the resurrection ofSuper 301, banana wars, etc. – will likely intensify,which traditionally has been a dollar negative.

JGBs have not quite hit bottom

Although last year’s fiscal package will strengthenJapan’s GDP growth in the second quarter, its bankbalance sheet problems and absence of inflation willremain as incentives for the BoJ to keep rates low –indeed, it will not hike them for the foreseeable future.Nevertheless, JGB yields are projected to make newhighs with the 10-year benchmark yield headingtoward 3.0%. JGBs will be hurt for now by indigestioncaused by surging supply and a resurgent dollar. Butthis dollar impact will fade by midyear and thedeflationary environment is expected to persist wellinto 2000. Continued low inflation and an eventualmarket adjustment to the higher supply should allowJGB yields to stabilize by the second half of this year.

China is not ready to devalue

Following the Brazilian real float, speculation pushedforward exchange rates for CNY and HKD sharplylower. Fears that these two currencies would devaluecreated a hiccup that weakened currencies and raisedinterest rates in other Asian markets.

Yet almost certainly, the Chinese will not devaluebefore the second half of 1998, and then only if thetrade surplus has disappeared. Insolvencies of moreitics and, perhaps, corporates will likely occur in themonths ahead. But, the impact on domestic creditshould be modest and a weaker CNY would onlyworsen debt burdens on these institutions in localcurrency terms. Even so, the market will be hard toconvince and a devaluation premium is likely to bepriced into the Chinese market indefinitely.

Concerns about China will be echoed in the HongKong market, but last year’s measures giving the

HKMA more flexibility in injecting liquidity aresuccessfully shielding the local market. While 12-month rates have shot up quickly in recent weeks,short-term rates were slower to react so the curve hassteepened and the typical crisis-generated front endinversion never materialized. As with China, a riskpremium will continue to be priced into the HKDcurve. But borrowing HKD is a relatively inexpensiveway to hedge against China risk, and investors shouldfund aggressively in HKD if rates converge to U.S.levels as they did at the start of the year.

Look for opportunities to go long Asian duration

Low inflation – if not outright deflation – will be adominant theme for 1999. The recent China anxiety-driven rise in interest rates has created opportunities to

2

4

6

8

10

12

14

16

18

PHP CNY SGD THB HKD TWD IDR KRW INR

End-1998Current

Implied 12-month interest rate in one year’s time% p.a.

60

70

80

90

100

110

120

130

140

HKD IDR KRW MYR PHP SGD TWD THB

One standard deviation range around 5-yr ma

Real trade-weighted exchange rates1990=100




buy duration in some Asian markets. A Chinesedevaluation might create temporary Asian currencyweakness but would not change the weak domesticdemand conditions across Asia that are the basis forlow inflation. Whether or not China devalues, Asiandemand will remain weak and inflation low. Asianrates will resume heading lower – particularly if theFed eases later this year – so any curve-steepeningshould generally be treated as a buying opportunity.

Particularly attractive as duration plays are the curvesin Singapore and Thailand which, unlike those in mostother Asian markets, slope upward and thus price inrising interest rates. Not only is this inconsistent withthe macroeconomic story, it also creates opportunity togo long duration and earn positive carry.

Although the TWD curve is flat, a general surge inlocal rates on the CNY devaluation scare make itanother attractive duration play. PHP, KRW, IDR,however, have inverted curves, pricing in decliningrate trends – while here too long duration should bethe objective, this is not the time to buy. The oneoutlier market is India, where aggressive monetary andfiscal stimulus and a rising current account deficitcreate risks of an INR breakdown and inflation. This isa market where duration should be avoided.

Asian currency appreciation should slow

The rebound of Asian currencies during the secondhalf of 1998 largely eliminated the cases of extremeundervaluation. Only the IDR and MYR remainsignificantly below their long-term real exchange ratetrends. Although current account surpluses across theregion continue to create a bias for currency strength,the pace of appreciation should slow as realundervaluation fades. Governments are becomingconcerned about loss of competitiveness and centralbanks are becoming more proactive at resistingappreciation of their currencies. But the central banks’only effective means to protest stronger currencies isto cut rates, a fact that bolsters the appeal of longduration.

The KRW has the greatest appreciation potential fornow because it remains relatively undervalued – seechart – and the prospects for economic growth in

Korea are particularly promising. Moreover, incontrast to other Asian markets, the CNY effect wason the KRW rather than rates and this should reverse.Turning to the PHP, the potential for appreciation ismore modest, but a bias remains toward strength andhigh short-term rates continue to make the currencyattractive from a carry perspective. In addition, lookfor further strength in the THB – J.P. Morgan seesThailand as making continued progress in market-oriented restructuring and has an above-consensusview of the country’s economic recovery prospects.

Although the SGD is arguably becoming undervalued,a potential for further weakness remains. Withovernight rates below 1%, a weaker currency isbecoming the MAS’s only vehicle to provide furthermonetary stimulus. And the government looks to betrying to reverse some of the real appreciation of theSGD that it engineered back in the early 1990s. TheSGD remains an attractive funding vehicle for thehigher-yielding Asian markets.

Indonesia and Malaysia remain “special cases”

The IDR has sold off sharply and offshore rates havejumped higher on a post-Ramadan pickup in violenceand uncertainty over the release of the election rules.With those rules now established, social unrest shouldfade, at least until the run-up to the event in June. Withthe economy expected to improve and inflation headedto single digits, the near-term prospects for IDRappreciation are excellent. Malaysia is expectedgradually to eliminate capital controls this year. Itappears that international investors will be more apt tobuy Malaysia as the market becomes tradable.

AUD and NZD have benefited from risk aversion

With commodity prices still in the doldrums, lowinflation and large external deficits leave little upsidefor the AUD and NZD, particularly as currencystrength would provide an opportunity to cut interestrates further. Absent a sustained AUD rebound, theRBA is expected to await a Fed move before cuttingrates again. The RNZ has more room to cut, given theNZD’s still-positive spread versus AUD and USD.Curves in both countries are quite flat, leaving littleroom for bonds to rally even if short-term rates are cut.




Equities

• Asia’s recent rally was not driven exclusively byWall Street and Fed easing

• Improved macro fundamentals support the mar-ket recovery

• Future upside depends on more good news, whileexternal factors pose a risk

• Japan, China, India, and Taiwan are expected tounderperform

Asian equity markets performed well in the last quar-ter of 1998. With the notable exception of Japan,China, India, and Taiwan, regional stock markets faroutperformed global standards, surging on average by50% in local currency terms and even more in U.S.dollar terms. Most impressive was the rally in the Ko-rean stock market, which essentially doubled in value.Since the start of 1999, however, the going has be-come tougher, with Asian markets essentially movingsideways and those of China and Hong Kong, espe-cially, struggling with devaluation rumors.

The direction of the U.S. stock market and the threeconsecutive rate cuts by the Federal Reserve have un-doubtedly been a force behind Asia’s recent marketperformance. Still, the region’s much improved macrofundamentals have been at least as important and areexpected to continue to support Asian markets even ifexternal factors – especially U.S. market conditions –deteriorate. Most important is the impact that the risein output and the drop in interest rates will have onearnings and asset quality. Still, like the economic out-look, Asia’s market performance will likely be uneven.

• Japan, Asia’s largest equity market, is expected tounderperform the rest of the region and could evenspark some negative surprises. In the economy, out-put has stabilized but the bottom is fragile and re-covery is not at hand. Corporate financial healthcontinues to worsen and consolidation in the finan-cial sector will likley create more negative fallout.

• In contrast, strong cyclical momentum is blowingbehind the sails of the Korean market. To be sure,the very high pace of economic and market recovery

Equity market moves% changes, eop, latest Jan 28, 1999

Sep to Dec 1998 Dec 1998 to dateLC-terms $-terms LC-terms $-terms

World* 18.6 20.7 1.1 0.4United States 17.1 17.1 1.1 1.1Japan 3.3 22.9 3.6 2.5Australia 8.8 12.5 2.3 4.8New Zealand 19.5 26.4 4.7 6.7

Emerging Markets** 14.2 17.4 3.0 -1.6Emerging Asia** 20.5 29.1 1.4 -0.8

China -17.3 -17.3 -14.0 -14.0Hong Kong 27.5 27.5 -6.9 -6.9India -1.5 -1.6 7.8 7.7Indonesia 44.1 92.8 2.3 -10.1Korea 81.3 108.5 1.7 4.7Malaysia 56.9 57.1 1.5 1.5Philippines 56.3 75.8 1.5 2.1Singapore 48.2 51.5 2.4 -0.1Taiwan -6.1 0.4 -5.6 -5.8Thailand 40.2 51.1 2.9 2.6

* Morgan Stanley Composite Index** MSCI, excludes Hong Kong and Singapore

7000

9000

11000

13000

15000

17000

19000

21000

100

150

200

250

300Nikkei 225Stock prices: Japan versus the rest of Asia

MSCI, local currency terms

1997 1998 1999

Japan

Emerging Asia

95

97

99

101

103

105

107

109

13000

14000

15000

16000

17000

18000

19000

20000

210001995=100, 3-month moving average, saJapan: Nikkei 225 and industrial production

index

1997 1998 1999


Nikkei 225




of the last few months is unlikely to be sustained formuch longer, but the news from the economic frontshould remain positive and support the market.

• Thailand and the Philippines are likely to followKorea’s trail, but with less momentum. Both coun-tries have room to cut interest rates further, butThailand’s equity market upside will clearly dependon the government’s ability to reinvigorate the fi-nancial reform drive in the next few months.

• Indonesia and Malaysia have performed surpris-ingly well over the last three months, but their eco-nomic prospects are weaker and contain more risks,especially in Indonesia.

• For Hong Kong and Singapore, much improvedliquidity conditions have been the key driver behindtheir recent market recoveries. In contrast, their eco-nomic adjustment is clearly delayed. And whileSingapore will probably succeed in keeping interestrates low by allowing the currency to weakenslightly, Hong Kong’s interest rate and market out-look will be closely tied to U.S. monetary and mar-ket conditions and to sentiment surrounding the peg.

• Developments in China will be important both forits own market and for others in Asia, notably HongKong’s. The J.P. Morgan forecast assumes that, pro-vided market conditions are favorable, China willgradually depreciate its currency in the second halfof this year. Still, even if that adjustment is smooth,the economy is expected to slow further while cor-porate financial health should remain poor.

• Taiwan has clearly lost its safe haven status, and itsequity market is likely to suffer as investors adjusttheir overweight positions in response to signs of aneconomic slowdown and some difficulties in the fi-nancial sector.

• The main risk for India’s market is the need formonetary tightening to stem the widening of thetrade deficit and quell the inflationary pressures inthe economy.

100

105

110

115

120

200

300

400

500

600

700

8001995=100, 3mma, saKorea: KOSPI and industrial production

index

1997 1998 1999


KOSPI

5

10

15

20

25

30 200

300

400

500

600

700

800%, p.a., inverted scaleThailand: Bangkok SET and 3-month interbank rate

index

1997 1998 1999

3-month interbank rate

Bangkok SET

5

7

9

11

13

15

17 7000

9000

11000

13000

15000

17000% p.a., inverted scaleHong Kong: Hang Seng and 3-month HIBOR

index

1997 1998 1999

3-month HIBOR

Hang Seng




The regional economic outlook in summary

Additional information is available upon request. Information herein is believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. Opinions and estimates constitute our judgment and are subjectto change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. J.P. Morgan may hold a positionor act as market maker in the financial instruments of any issuer discussed herein or act as advisor or lender to such issuer. Morgan Guaranty Trust Company is a member of FDIC and SFA. J.P. Morgan Securities AsiaPte. Ltd. is a member of the Japan Securities Dealers Association (JSDA). Copyright 1999 J.P. Morgan & Co. Incorporated. Clients should contact analysts at and execute transactions through a J.P. Morgan entity intheir home jurisdiction unless governing law permits otherwise.

1998 Nominal GDP in US$ Real GDP Consumer prices total % of per capita % year-on-year % year-on-year billion region 000s 1997 1998e 1999f 2000f 1997 1998e 1999f 2000f

Japan 3705 29.4 1.4 -2.9 0.0 -1.0 1.7 0.7 -0.4 -0.6Australia 363 19.5 3.9 4.7 2.2 3.0 0.3 0.9 2.0 2.8New Zealand 52 13.6 3.0 -0.5 2.0 3.8 1.2 1.2 1.6 1.9Emerging Asia 2485 100.0 0.9 6.1 0.1 3.0 4.9 4.2 8.9 4.0 4.5 China 966 38.9 0.8 8.8 7.8 6.5 5.8 2.8 -0.8 1.4 3.2 Hong Kong 168 6.8 25.2 5.3 -5.0 -1.5 3.0 5.7 2.6 -2.8 2.2 India 365 14.7 0.8 5.0 4.0 2.5 5.0 7.2 12.0 8.5 7.0 Indonesia 84 3.4 0.4 4.9 -13.7 -3.5 5.0 6.2 58.4 24.0 14.0 Korea 306 12.3 6.6 5.5 -5.7 4.0 4.5 4.4 7.5 1.6 3.8 M alaysia 65 2.6 3.0 7.8 -7.3 -1.0 5.0 2.7 5.3 3.3 3.4 Philippines 65 2.6 0.9 5.2 -0.5 2.6 5.0 5.0 9.0 7.5 5.0 Singapore 87 3.5 22.8 7.8 1.3 -1.0 4.0 2.0 -0.2 -0.5 1.5 Taiwan 258 10.4 11.7 6.8 4.8 3.2 4.5 0.9 1.7 -1.2 0.6 Thailand 119 4.8 1.9 -0.4 -6.5 3.0 5.0 5.6 8.1 3.4 5.0

Current account balance Foreign reserves US$ billion % of GDP US$ billion

1997 1998e 1999f 2000f 1997 1998e 1999f 2000f 1997 1998e 1999f 2000fJapan 94.2 122.5 122.0 132.9 2.2 3.2 3.3 3.7Australia -12.7 -17.3 -19.0 -17.6 -3.1 -4.7 -5.1 -4.1New Zealand -3.1 -3.2 -2.8 -2.6 -4.8 -6.2 -5.3 -4.1Emerging Asia 20.9 105.7 66.9 45.5 0.7 4.3 2.4 1.6 509.0 557.8 581.1 605.0 China 30.1 24.8 3.8 2.6 3.3 2.6 0.4 0.3 142.8 145.0 139.2 137.7 Hong Kong 1.4 5.5 3.7 2.1 0.8 3.3 2.3 1.3 93.2 88.9 92.8 97.4 India -6.5 -11.5 -6.4 -6.2 -1.8 -3.1 -1.7 -1.6 26.3 24.3 26.3 28.3 Indonesia -6.3 4.6 2.9 0.4 -2.9 5.4 2.2 0.2 20.5 23.9 26.4 27.4 Korea -7.9 42.1 26.9 11.7 -1.8 13.7 6.6 2.7 21.1 52.1 61.6 64.6 M alaysia -5.1 4.9 4.4 1.8 -5.2 7.5 6.6 2.3 20.8 26.2 30.9 34.4 Philippines -4.3 0.8 0.3 0.9 -5.2 1.2 0.3 1.0 7.3 10.9 12.9 13.9 Singapore 14.8 15.5 15.0 17.2 15.4 17.8 18.5 19.6 71.4 69.4 70.9 79.4 Taiwan 7.7 4.9 4.4 4.7 2.7 1.9 1.7 1.7 79.6 88.6 85.6 86.5 Thailand -3.0 14.0 11.9 10.2 -2.0 11.8 7.6 5.7 26.2 28.5 34.5 35.5

External debt Short-term foreign debt Government balance % of GDP, end of period US$ billion, end of period % of GDP, end of period

1997 1998e 1999f 2000f 1997 1998e 1999f 2000f 1997 1998e 1999f 2000fJapan -3.8 -6.9 -9.2 -10.9Australia 0.5 2.8 1.5 2.2New Zealand 2.0 2.6 -0.3 -1.5China 16.5 16.6 16.1 17.2 35.7 35.2 34.2 36.5 -0.7 -2.1 -3.3 -3.9Hong Kong 4.5 -3.5 -5.0 -1.5India 27.9 28.5 29.1 29.5 11.7 13.2 14.2 15.2 -6.1 -6.7 -6.3 -5.8Indonesia 62.3 168.6 110.4 84.0 36.8 27.3 20.3 18.8 1.2 -7.0 -6.0 -6.0Korea 35.8 50.5 34.8 28.7 68.6 31.0 29.0 27.5 -0.9 -5.0 -6.0 -7.0M alaysia 42.5 67.7 67.7 60.6 14.4 13.6 11.6 10.6 5.5 -1.0 -6.5 -3.0Philippines 61.3 80.1 72.5 63.3 11.1 10.0 11.0 11.5 -1.8 -3.6 -3.5 -1.0Singapore 6.0 -1.0 -2.0 -0.5Taiwan 15.2 17.4 18.6 18.1 29.2 29.5 29.8 30.2 -6.9 -7.0 -8.5 -7.8Thailand 63.5 77.1 54.1 42.1 30.0 23.3 17.3 15.3 -0.9 -4.5 -5.0 -4.0

asian financial markets - nyupages.stern.nyu.edu/~nroubini/papers/afm199.pdf · morgan guaranty...

Documents