A silver lining for cloudy Asia.

Opportunities in the wake of the economic storm are there - but watch out for hidden shocks.

The financial crisis in Southeast Asia and Korea is moving into its second year - and it's far from over. Massive declines in asset prices in local currencies combined with a sharp decline in the foreign exchange value of these currencies presents attractive investment opportunities for U.S. and European firms - as well as a major challenge. With local firms and financial institutions short of cash, assets are for sale at amounts far below their reproduction costs. Furthermore, because the countries are short of equity, governments - Korea's in particular - are relaxing restrictions on foreign purchases of domestic securities and assets. The challenge is to minimize profit declines associated with the turbulence in asset markets and the foreign exchange market.

TINY BUBBLES

What spurred the crisis was that the banks headquartered in Seoul, Jakarta, Hong Kong, Shanghai, Kuala Lumpur, Bangkok, and Manila were involved in Ponzi finance, much as the banks in Tokyo and Osaka had been in the late 1980s. Borrowers were using cash from new bank loans to pay the interest on outstanding loans, enjoying a process of "evergreen finance." This rapid expansion of domestic credit attracted funds from investors and banks in the U.S., Japan, and Europe. As total foreign indebtedness climbed to $350 billion for those countries as a group, the flow of billions in new foreign money each year enabled these countries to finance trade deficits that ranged to 8 percent of their GNPs.

With the exception of Korea, each of these countries had a bubble in its real estate market. Once foreign investors realized the scope of overbuilding, the flow of new foreign money to Southeast Asia and Korea declined sharply, and Indonesia, Thailand, Malaysia, and Korea were no longer able to finance their trade deficits. When it became apparent that banks would incur large loan losses, a "flight to quality" ensued as individuals and firms moved funds from domestic banks into currency, foreign banks, and foreign currencies. Foreign investors and banks, particularly Japanese banks, followed suit, seeking to reduce their loan exposures.

BALANCING ACTS 

But today, trade balances in the region have improved, initially because of a sharp decline in imports. Within months, exports will surge as currency depreciations drive a striking improvement in competitive price position. As rising exports place firms in China, Hong Kong, and Taiwan in a less advantageous competitive position, their export volumes and unit export prices will decline. China's exports have increased rapidly since the effective devaluation of the Chinese yuan at the end of 1994, and the country's massive trade surplus - five times larger than that of Japan when scaled to GNP - provides millions of jobs for individuals who would otherwise be unemployed. When the decline in its trade surplus spawns a significant loss of jobs, China may accept the shift - or it may not.

Meanwhile, Hong Kong's lure as a regional financial and tourism Mecca has diminished as its currency appreciated relative to most in the neighborhood. To lure investors, interest rates on Hong Kong dollar securities have been increased by 300 to 400 basis points. Recent buyers of Hong Kong real estate are now suffering a cash flow problem - ponying up interest payments much higher than their rental income. As some are forced to sell, prices will tumble further. Moreover, the sharp decline in rents in Shanghai - thanks to that city's continuing construction boom - has dealt a further blow to Hong Kong's real estate market by prompting some firms to shift office staff from Hong Kong to Shanghai.

The Hong Kong Monetary Authority now faces a traditional dilemma: the interest rates required to induce investors to hold Hong Kong dollars will put real estate under considerable downward price pressure. As a result, the equity of real estate investors will shrink rapidly.

Another economic process underway in the region involves deleveraging. The equity of both banks and firms has declined sharply for three reasons - the large revaluation losses on loans denominated in the U.S. dollar, the Japanese yen, or one of the European currencies; the significant decline in prices of domestic assets, particularly real estate; and the operating losses in a period of slow economic growth and high real interest rates.

One of the paradoxes is that although the savings rates in Korea and its neighbors are among the highest in the world, firms and banks have relatively little equity and have been highly leveraged - apparently because the founding families believe that issuing more shares to the public would lead to loss of control.

To reduce leverage, assets are being sold. Cash-strapped firms in Southeast Asia and Korea have been selling some of their most attractive assets in the last several months - largely because their "doggy" assets are not salable. Thus, the aircraft fleets in this part of the world will shrink, firms will sell part or all of their franchise operations to the franchisers, and more construction equipment and other mobile capital assets will go on the block.

The need to deleverage means that these countries have become much more open to foreign capital. The coupling of low asset prices and low values for their currencies in the foreign exchange market presents a once-in-a-lifetime investment opportunity for U.S. and foreign firms.

The combination of high savings rates, industrial discipline, and entrepreneurial vigor suggests that Korea and Thailand and their neighbors will again grow rapidly once their financial structures have been repaired. Yet, at the same time, Japan's experience suggests that repairing the financial structure can be an extended process. One significant difference is that the implosion of the asset price bubble in Japan had only a modest impact on Japanese industrial firms, since they had little, if any, foreign debt. Instead, Japanese banks incurred massive losses on their loans to real estate and construction companies.

Korea, Thailand, et. al. need to rebuild the equity of both their industrial firms and their banks and financial institutions. Part of the necessary increase in equity will come from the inflow of foreign investment; but these inflows are likely to be only a small part of the needed equity. Most will come from privatization by the government after it has acquired these firms as part of the recapitalization process.

That the countries are a long way from stability is evident from the much sharper decline in the foreign exchange values of their currencies than of the increase in their domestic price levels. Although the Korean won and Thai baht have recently appreciated, these currencies are still significantly undervalued. Most of these countries will suffer higher inflation in response to the boost in local currency price of imported goods coupled with a bump in prices of primary products like petroleum and rice. As inflation rates increase, nominal interest rates and real interest rates are likely to surge, which, in turn, will lead to a further decline in asset prices - at least until the inflation rates begin to decline.

In the short term, economic growth will be enhanced by the increase in net exports. Yet it is much easier for one country to pursue a policy of export-led growth than for these countries to do so as a group. Trade among these countries is extensive; half of Korea's exports go to other Asian countries.

STABILITY ROCKS

The return to financial and economic stability in Mexico after the foreign exchange debacle at the end of 1994 took 18 to 24 months. By the time the economy stabilized, the peso had lost about half its value - and Mexico did not have to be concerned that depreciation of a neighboring nation's currency would unravel its own improved position.

In Southeast Asia, the pace of the return to stability will depend on developments in China and Japan. One major looming uncertainty is whether the Beijing government will accept the significant decline in the international competitive position of its domestic firms as its contribution to financial stability in the region. A devaluation of the Chinese yuan - which seems inevitable within a year or two - will complicate the ability of Indonesia and Thailand to rely on exports as the major stimulus for income growth. A climb in the rate of economic growth in Japan would facilitate an increase in exports from Korea and other Southeastern countries, in part to satisfy domestic demand, and in part because an accelerated growth rate will lead to an appreciation of the yen.

The combination of the decline in asset prices in Thailand, Korea, Indonesia, and Malaysia and the decline in the foreign exchange value of their currencies presents a remarkable investment opportunity for U.S. and European firms. Asset prices are likely to continue to decline because the domestic banks will reduce loans and cash inflation rates in these countries will eventually necessitate increases in their interest rates; in turn spurring a further decline in asset prices. Thus, while growth will return to the region, regaining economic stability is likely to take several years as financial institutions recapitalize.

Robert Z. Aliber is professor of international economics and finance at the University of Chicago.