Blindsided by Asia.

The Southeast Asian crisis is primarily responsible for slowing worldwide economic growth from 4 percent in 1997 to 2 percent in 1998. In 1999, world growth is likely to be negative - and all Asian economies appear to be getting worse. The crisis has alarmed investors, causing capital flight from developing nations. To protect their currencies, governments of developing nations have raised interest rates, further stunting economic growth.

The main engine for economic activity in Asia is Japan. Its problems are so great, there's concern as to whether it can turn its economy around. Furthermore, China's economy is affected by the declining value of the yen. If the yen continues its descent, China may be forced to devalue its currency, which will send a financial tsunami around the world.

White Knight With No Horse

Japan's problems are many: decreased consumer spending, a weakening yen and plummeting stock market, real estate collapse, banks with huge portfolios of bad loans and largely unprofitable good loans and a government slow to address growing bad news. The combination of a drop-off in capital outlays, mounting inventories, falling prices and a postwar high unemployment rate of 4.3 percent among Japanese men indicate its economy may decline further.

As the yen weakens, Japanese exports (representing 70 percent of the region's gross domestic product) become relatively cheaper in overseas markets compared to the goods of other Asian countries - a situation which becomes particularly difficult for those East Asian countries attempting to export their way out of their financial crisis. Increased competition caused by the weakened yen may pressure other nations to devalue their currencies, thus touching off a new downward trend in the already unstable Asian economy.

Perhaps the main problem is the number of bad loans held by Japan's banks. According to Japan's newly created Financial Supervisory Agency, as of March 31, 1998, its 954 deposit-taking institutions had a combined total of $625 billion in questionable loans - excluding an estimated $600 billion in other non-performing loans (those which haven't been serviced in at least three months). Prime Minister Keizo Obuchi said in August he wouldn't make public the results of an audit of the nation's 19 largest banks, as it could upset market order.

And Japan's economy appears to be getting worse. Gross domestic product fell 0.8 percent in the April-June period from the previous quarter for an annualized decline in economic activity of 3.3 percent. Capital investment declined 20 percent, the second dip in a row; exports were off 0.4 percent. Recently, the government lowered the interest rate it charges banks from 0.5 percent to 0.25 percent. The interest rate was already so low the decline will have little or no effect. Japan has positioned itself into what could be called a Keynesian liquidity trap. Monetary policy has become ineffective and the country must rely on fiscal policy. Given the demographics of an older population with a high savings rate, a stimulus package should be closer to $400 billion rather than the proposed $100 billion.

The economy of every country in Southeast Asia is in decline; there's no clear sign of a turnaround. If the decline of the yen cuts into China's economic growth rate, it could cause another round of devastating currency devaluations.

Dark Knight on a Big Horse

Sluggish domestic consumption and rising unemployment, plus a drop-off in exports and a flood of East Asian imports, have caused economic growth in China to slow to 7 percent in the first half of 1998. Consumer spending in the first six months of the year decreased by half from a year ago as unemployment rose to 8 percent, according to some estimates. The inventories of China's 370,000 state-run companies were up about 10 percent, while the profits of state industrial companies were down nearly 50 percent year-on-year in the first five months of 1998. Bootleg imports - particularly of oil-compound the problem. More important, though, the exponential rise in cheap imports from other Southeast Asian countries is overwhelming Chinese manufacturers. For example, Korean steel imports were up over 40 percent in the first four months of 1998.

The crisis also has cut China's export growth. Total export growth for the first half of the year declined to 7.6 percent from 20 percent in 1997; exports to South Korea, Japan and Southeast Asia were off as much as 50 percent. The drop in China's regional exports was only partly offset by the increase in exports to the U.S., Western Europe and Africa.

Increasing deflationary tensions and a weakening Japanese yen are pressuring the Chinese government to devalue its currency. So far, the government has insisted it will not devalue the renminbi or the Hong Kong dollar. However, in June the vice foreign trade minister, Sun Zhenyu, stated if the yen continues to weaken, China would be under greater pressure to devalue.

To combat that possibility, the Chinese central bank raised the interest rate it pays on Hong Kong dollar bank deposits from 6.25 percent to 7.35 percent. At the same time, it lowered the rate it pays on U.S. dollar deposits from 5 percent to 4.875 percent. These moves were designed to dissuade the Chinese from converting local currency to U.S. dollars.

China's State Administration of Foreign Exchange also reduced its exposure to the yen by gradually selling billions of dollars of holdings denominated in the weakening Japanese currency. This is designed to prevent China's foreign exchange reserves, estimated at $140 billion, from losing value. So far, China has reduced the amount of yen-denominated holdings from about one-third of its portfolio to less than one-quarter.

Current releases from China show an economic uptick from the government's stimulus package. It's hard to know if this information is propaganda or fact, so follow China closely. If the economy appears to deteriorate enough to cause political turmoil, which, in turn, would threaten China's regime, the Chinese government probably will devalue its currency. Hong Kong and Taiwan most likely will follow.

Humpty Dumpty 

The Federal Reserve Board's shift away from a concern about inflation to one of deflation should be a wake-up call. After the G-7 ministers met in September and didn't decide on a coordinated global cut in interest rates, Federal Reserve Board Chairman Alan Greenspan told Congress, "At the moment, there is no endeavor to coordinate interest rate cuts." The next day, the world's stock markets were off significantly.

The main impact from the Asian crisis is likely to hit the U.S. in the fourth quarter of 1998 and be felt through 1999. Manufacturing is beginning to slow; the stock market is gyrating down due to lower corporate earnings. Consumers are heavily burdened with debt and credit card delinquencies; personal bankruptcies are at an all-time high. A further significant decline in the stock market which stays at low levels for three to six months is likely to cause a negative consumer wealth effect. This, plus the economic effects of Southeast Asia, probably will move the U.S. toward a recession in 1999. Since the United States is now the main engine of economic growth for many countries whose exports it receives, a U.S. economic downturn would slow imports, impacting the economies of Southeast Asia, Latin and South America and Canada.

It's therefore imperative that the U.S. and Europe maintain strong economies to give Southeast Asia time to turn its economies around. Events of the past 18 months reinforce how interdependent economies are. It's in everyone's interest to maintain worldwide financial stability.

Treasury managers and financial officers should closely follow country risk and bank solvency. In Russia, no bank is solvent. China may have one or two solvent banks. Korea may have one. However, there is no sound bank in Thailand, Indonesia or Malaysia.

Conditions aren't as bad in Latin and South America, though there's a possibility of a devaluation in Brazil. There are significant differences in the condition of the banks, in part due to foreign ownership. In Argentina, deposits of banks haven't left the country because of the one-to-one conversion of its currency to the dollar. We give most of its large banks investment-grade ratings.

When in doubt, secure letters of credit or hedge a large currency position with a well-rated bank.

Barron Putnam, Ph.D. is president and financial economist of LACE Financial Corp., a foreign and domestic bank rating service in Frederick, Md.