Churchouse Letter
June 2012               by Peter Churchouse

An Asian Guide to European Financial Redemption

Inside This Issue:
The Asian Financial Crisis Provides some lessons for the European Debt Crisis, but potential application is limited.
Hong Kong's experience during the Asian Financial Crisis may be more pertinent for countries remaining in the Euro, and without the ability to devalue: the road to recovery will be long and painful.
Europe does not have the luxury of being bailed out by a buoyant external economy the way Asia did in the late 1990's.
The fate of some euro zone countries may be similar to that of Hong Kong, but likely will be much worse.
China Real Estate: the taps are gently turned on again, several positive signals.
REITS in a risk-off environment.

As the Euro crisis drags on, and on, and on, … it is staggering, from the perspective of someone from the other side of the world, that there is so much head in the sand thinking on solutions to the current woeful state of affairs. The simple fact of the matter is that most of Europe (and in fact much of the west) has been living beyond its means, with profligacy financed by borrowing, at Government, corporate and household level. Figure 1 illustrates the size and structure of debt for the core European countries, including other major western economies plus Japan. The first point to note is that only 1/3 of these countries carry a debt burden of less than 300% of GDP! Japan’s staggering 456% total debt to GDP has been well documented of late.

Majority of OECD countries running Debt/GDP ratios in excess of 300%

Of note is that all of the larger European countries included here with the exception of Germany have total debt in excess of 300% of GDP, but that a few smaller countries INCLUDING GREECE carry total debt of less than 300%. Greece’s total debt to GDP at 262% is very similar to that of the USA. But it is not the corporate or household sector that is highly indebted in Greece, both at the low end of the rankings, rather the public sector’s 132% debt to GDP ratio that stands out.

Greece's total debt to GDP in fact relatively low compared to much of Europe

Do As I Say, Not As I Do!

The global double standards that often prevail in the halls of finance and government in these situations I find somewhat galling. When Asian economies found themselves in a similar debt induced predicament in the late 1990’s they were faced with stern lectures from the IMF, World Bank, ADB and most western governments that they should take the pain, restructure their economies, pay down their debts, bite the bullet! The western world was extremely forward in telling Asian governments to toughen up, but now seem hugely reluctant to do so themselves when confronted with a similar state of affairs. International agencies and western central banks were quick to condemn Asian economic folly, and impose a regime of very hard-to- swallow medicine. Asian governments and companies were given little choice but to take it – and try to smile! Now when the shoe is on the other foot, we do not see quite the same willingness to swallow that medicine. But we do see European leaders showing some impatience now with being lectured by the likes of the USA, UK, and even China over its inability (unwillingness?) to fix its current shambolic state of affairs.

Figures 2 and 3 are a compelling profile of events leading into the Asian financial crisis. It illustrates a measure of Asian economic profligacy going back decades, with most Asian countries running consistent and quite deep current account deficits for many years. Again, Asia spending more than it was earning, as has been the case in many western countries over the past decade or so. In the 1990’s, the gap was made up to some extent by inflows of investment, both direct and indirect through capital markets as Asian stock markets caught the attention of investors in North America and Europe.

Deep Asian current account deficits in the run up to the AFC of 1997

Moreover, Asian countries “managed” their currencies in the 1990’s, effectively linking them to the USD. This can seem to make some sense when the US is the key destination of Asia’s exports. The managed currency regimes has similarities to the Euro zone. For example, if Greece’s currency was not fixed to the Euro, there is every likelihood that it would have for years traded at a level much lower than its current position in the currency league tables, and would have endured much higher interest rates than those prevailing in the Euro zone. The Euro simply allows certain countries to borrow at rates very much lower than would be the case based on their domestic economies, their fiscal situations and central bank regimes.

Clear pre and post Asia Financial Crisis Current Account Balance regimes

Carry Trades Made the Asian Financial Crisis Particularly Brutal.

The carry trades of the 1990’s exacerbated the impending problems of Asian countries as corporations in countries such as Thailand, Indonesia, Malaysia, Philippines borrowed in low interest rate currencies such as Yen, USD, Swiss Franc to fund investment (and consumption) in their home countries. Real estate development was at the core of the investment wave with massive construction booms on a scale that would inevitably lead to massive oversupply and huge vacancies. (It is chilling how often real estate is at the core of major financial meltdowns and recession. Well not real estate per se, but more normally the huge borrowing that goes into it.) Moreover, that real estate was being sold in local currency, while much of the borrowing was in foreign currency laying banks, developers and consumers open to substantial, and as it turned out, devastating currency risk.

Lesson For Greece…… and Others.

Asian Devaluations Were Huge!

The Asian experience of the 1990’s provides potentially very pertinent lessons relevant to the current situation in Europe. As in Asia in the 1990’s, the status quo is unsustainable. The piper has to be paid. In the Asian case, Thailand blinked first in the face of huge debts and current account deficits and on 2nd July 1997 abandoned the fixed link of the Thai Baht to the USD. In the ensuing months, other southeast Asian countries did likewise, and currencies plummeted. For Thailand and Philippines, the currencies dropped from around Baht 22 – 24 local to around Baht 50 against the USD, a depreciation of around 50%. Indonesia’s case was even more devastating, with the Rupiah falling from around 2,300 to the USD to around 11,000, a fall of at least 75%. Malaysia imposed capital controls, much to the chagrin of the global investment community, who have never really gone back to that market in any substantial way. Investors sometimes have memories like an elephant!

Massive currency devaluations across Asia facilitated a pressure value release

Risk Reality of Carry Trade Borrowing.

Just imagine an Indonesian business or property developer borrowing US$ to fund a housing project in Jakarta for example. They might have been able to borrow at say 6% per annum, much less than the 16% plus for domestic currency borrowing. Seems like a great deal – “Aren’t I smart, saving 1000bp of interest cost!” The houses and apartments sell in local Rupiah to domestic consumers. Suddenly the crisis erupts and the currency rate moves from Rp2,200 to one USD to Rp11,000 to one USD. That means our borrower needs to find five times as many Rupiah to repay his dollar of borrowing. And to add insult to injury, of course, the property market in the local currency collapses, with sales volumes slowing to a trickle, and prices in domestic currency falling by 50% or so.

Clearly an impossible situation, and default is the inevitable consequence.

I still shudder today whenever I see companies and individuals borrowing in “cheap” interest rate currencies (rates are generally low for a good reason) to fund business or consumption in a high interest rate environment where any income to repay borrowing is in local currency. It still amazes me how often I find real estate punters boasting of how they are funding say UK/Australian real estate investment with say Yen borrowings, believing themselves to be so clever in saving a few percentage points of interest cost, apparently oblivious to the much greater risks of an adverse move in the currency that would easily wipe out many multiples of the interest cost saving.

As an aside, I still find the so called Japan “Mrs Watanabe” carry trade worrying. This is the perhaps somewhat disparaging handle given to the practice of Japanese retail investors selling Yen and buying say Australian dollars which get lent to Australian borrowers (again largely property related in all probability). And then perhaps doubling up the trade by borrowing yen in multiples of original principal to enhance the yield return. In a zero interest rate environment that has been the misfortune of Japan’s retail investors for years, the temptation to seek yield in this way is perhaps understandable. But as we have seen before, just a very small adverse move in the relative currency rates will more than wipe out any gains from a higher interest rate and may make very big holes in the original principal.

There are Better Yield Opportunities for Low Interest Rate Markets than Carry Trades.

For the Japanese investor getting no interest on deposits, why not simply buy J-REITs – high yield securities in local currency – which will give a “coupon” of around 4% - 5% per annum (way better than virtually zero on bank deposits) and take no currency risk. And if the investor wants to take a little more risk by borrowing to enhance returns, at least it is in local currency and is not going to lead to potentially devastating exchange rate risk.

REIT yield remains an attractive proposition for JPY investors

But that is an aside – regular readers will have heard this line before!

The point here is that this may prove to be the fate of some of the Euro zone countries if exit from the Euro is forced or volunteered. Devaluations are likely to be at least of an order of magnitude similar to those in Asia in the late 1990’s. If Greece were to exit the Euro, and remaining in is still not guaranteed following the recent elections, I would hazard, if the Asian experience is anything to judge by, the new Drachma would likely settle at around 30% of its previous level – maybe even lower.

Asian Devaluations Worked! But Were Hugely Painful.

In Asia’s case the tough regime quite quickly proved effective and it was not long before deep current account deficits were turned to solid current account surpluses. Corporate debt was rolled back, and households endured deep pain including deep deflation and forfeiture of assets.

Thailand was rife with “yuppies” pitching up at car showrooms, handing back their car keys of their recently purchased BMW or Mercedes and walking away. Reminiscent of recent “key behavior” in the US sub-prime debacle. There were huge bargains to be had in many Asian cities in consumer goods as companies fell over themselves to raise whatever cash they could. I don’t think rubies, sapphires and diamonds have ever sold so cheaply in modern times as they did in the shops of Bangkok at the time. There were cases of budding Hong Kong entrepreneurs rushing to Thailand, buying up large numbers of foreclosed high end cars at bargain basement prices and shipping them back to Hong Kong or elsewhere for re-sale.

That Old “It’s Different This Time” Refrain.

Asia's debt overhang was private, not governmental which made restructuring easier

It is possible to claim that Asia’s case was very different from that of Europe. Asia’s debt was largely in private hands – corporate and individual, while in Europe the core problem is sovereign debt. Asian governments did not carry high debt levels and did not socialize the debt of its citizens the way that the US has and the that Europe’s citizens seem to expect. What is government there for if not to provide me with all the material goods and living conditions that I think I am due by birthright? Restructuring private debt is a lot easier for lenders than restructuring sovereign debt. Private citizens and companies have less ability to push back. Governments have better negotiating clout with lenders. Because governments were not highly indebted in Asia, it can be argued that they had some firepower to ease the economic rebalancing. Maybe so, but there has not been a massive build-up of sovereign debt in Asia as a result of the financial crisis of the 1990’s.

The fixed currency regime of Europe is quite similar to that of many Asian currencies during the 1990’s where a managed float against the US$ was the norm.

Just as the debt of European countries has been financed by lending from abroad, so the Asian carry trade of the 1990’s has similar characteristics. In this case the difference is that for Europe, debt in one country has to a considerable extent been financed by lending from another Euro zone country, making the currency risk issue somewhat less for European markets and lenders/borrowers. Perhaps one reason why Japan’s huge debt has been sustainable – at least so far – is that it is very largely bought by locals not foreigners.

One of the more sobering differences between the Asian financial crisis and that which we are witnessing in the developed world is simply that Asia was a herring not a whale in the global economy. A monkey not a gorilla! The financial crisis in Asia was in a group of economies that represented less than 15% of the global economy at the time. The scale of financial assets that needed to be restructured and dealt with was probably about the scale of Ireland’s current problems when all was added up – Thailand, Indonesia, Philippines, Malaysia, Taiwan, Korea, Hong Kong and Singapore. Ireland would not bring down the global banking system, but clearly put together with Portugal, Greece, Spain, Italy, and possibly even France, with the US debt overhang still lurking in the background, the risks are hugely higher for the global financial system and the global economy.

Asian Financial Crisis countries only represented some 15% of the global economy at the time

Europe Does Not Have the Luxury of being Bailed out by a Buoyant External Economy the Way Asia Did in the Late 1990’s...

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