Will the U.S. catch the Asian flu?

Oddly, the crisis in Asian financial markets may lead to a more open, transparent international finance system - even if it means clipping U.S. GDP by a few basis points.

As various Asian economies imploded last fall, the perception of an "Asian flu" quickly settled in over the markets. Respected economists across Wall Street began to talk about slower growth and deflationary pressures. How accurate were the gloomy headlines? Clearly, many were sensational, but underlying the hype of the Asian turmoil exist fundamental transparency and corporate governance issues, which remain unresolved.

Even when the dust settles on this Asian chapter, we will still not have a complete understanding. "Crony capitalism" is certainly one of the culprits, but the necessary vantage points will only be apparent once we have transparency and accuracy permeating the financial systems of the countries and companies involved. Unless changes are made now, more currency instability is inevitable. In order for a true recovery to evolve, those in a position to influence policy should seize the opportunity of the current malaise to reform Asia's markets. Now is the time to take turmoil and turn it into opportunity, so that the next boom is not vulnerable to the weak foundation of "neo-capitalism."

Two main practices need to be employed: providing full, fair, and timely disclosure for investors; and strong oversight from boards of directors who adhere to international standards of corporate governance.

THE OUTBREAK

Starting with the collapse of the Thai baht late last summer, currencies plummeted across Asia. But was this just a correction long overdue? After all, despite efforts to the contrary, no country has yet successfully repealed the economic law of business cycles.

There is an old Asian expression: "Markets go up like an escalator but down like an elevator." Hindsight is easy, but many Asian economies were more focused on building market share than on building net income. Many Asian enterprises had debt-to-equity ratios of 3-to-1, with some as high as 10-to-1. Pegged to the U.S. dollar, some Asian currencies had a tendency to be overvalued. Speculation was certainly the theme of the day.

In many cases, there was no strong disclosure foundation to protect investors in these situations. So as things began crumbling, the psychology of the region quickly flipped from the "Asian miracle" to the "Emperor has no clothes."

As the epidemic began to spread to the U.S. shores, the popular business press was quick to associate almost every jitter in the markets with the turmoil in the Asian economies. For example, in early December, Oracle saw a third of its market capitalization disappear in 48 hours after it missed quarterly projections. Some analysts were quick to infer that recent Asian woes caused Oracle's poor results. Household names, including Boeing, Microsoft, J.P. Morgan, 3Com, Nike, and others, jumped on that line of reasoning and preannounced that they would miss quarterly expectations.

Like the Washington press corps on a Clinton scandal, Wall Street quickly engaged in a self-inflicted feeding frenzy. A number of rating agencies and investment bank research analysts were called on the carpet for not better estimating the true effects of the Asia turmoil.

But were some members of the media, and some of the affected companies, using Asia as a superficial diagnosis? Many firms that pre-announced earnings disappointments had additional, more fundamental issues affecting their bottom lines. From a major staff shake-up at Oracle to production line snafus at Boeing, more than just the Asian flu was at work. In fact, earnings analysts at First Call, IBES, and Zacks have pointed out that the number of negative pre-announcements was no higher than usual at that juncture in the earnings cycle.

Furthermore, much of the selling in late October and November was normal year-end selling by institutional investors locking in their profits after a good year. One should also consider that much of the market's volatility was on relatively average volume. Record days of billion-plus trades occurred during a very brief period in October, not in December, when headlines blared about the deepening affliction of the perceived flu.

INEFFECTIVE REMEDIES

Hype aside, perhaps most unsettling is that the current remedy being applied to the Asian flu may be as ill-conceived as the misperception of the turmoil itself. The IMF has put together an unprecedented string of bailouts, in excess of $100 billion to cover South Korea, Indonesia, and Thailand. In an effort to further bolster the IMF bailout, regulators around the world have persuaded banks from both the U.S. and Europe to ease the repayment deadlines for the short-term loans to the government and private banks in South Korea and other afflicted countries. In addition, the same regulators are asking the same 100-plus banks to consider providing more than $10 billion in fresh capital, in the form of long-term loans, to these Asian economies. But is this massive amount of money being well spent? The IMF may just be papering over a larger problem if it doesn't help settle the fundamental weaknesses this time around.

The IMF is structured to deal with liquidity crises, but recent events in Asia are not necessarily focused on liquidity. As currency experts, such as Johns Hopkins University economist Steve Hanke, have noted, the Asian turmoil is more of a solvency crisis. Many of the Asian speculators not only made bad investments, but the assets and liabilities of those weak investments are mismatched in terms of both duration and currency. The currency mismatch is especially painful, given the massive devaluation of the local currencies.

Asian countries don't need the IMF's prescription of higher taxes or excessive interest rates suffocating their economies. What they need, of course, is to reignite robust economic growth. And that evolution begins with growth capital. In order for certain countries to reobtain that growth capital, they need to immediately institute transparency and accuracy in their financial practices. Foreign investors will not return to their markets to help fuel the necessary growth until they can see a firm's entire financial picture. No more hidden liabilities, no more subsidiary shell games. Investors need to be able to see a firm's full exposure in advance. The easy growth capital has already been locked up. The sell will be harder during this next round.

Asia's main weakness is a confidence problem, as investors across the world are leery of what might be hidden in the ledgers. The speed at which Asia transforms into a financial culture more focused on the full disclosure of assets and liabilities and proper corporate governance practices, is the speed at which it - and the world - will recover from this flu. Here is where the IMF can truly exhibit leadership; as part of its packages, the IMF should demand that Asian governments, markets, and firms adopt true disclosure reform and establish strong corporate governance practices.

A PRESCRIPTION FOR RECOVERY

Once Asian firms are more focused on profits and less on the pursuit of market share, the overall environment will change for the better. As companies become more transparent, this will lead to an increased level of confidence, which will become mandatory in order to re-attract substantial amounts of foreign capital. Granted, foreign capital will never replace domestic savings as the primary engine of an economics growth. But on the margin, it's the incremental variable to sustainable robust growth in open economies.

Investors looking to step back into Asia for the long-term should look for key elements. As a former SEC commissioner, I would suggest that Asia's markets - and, for that matter, other markets around the world - would be well served to focus on certain objectives. First, enhanced securities regulations must set forth clear guidelines and standards. Second, reliable and consistent enforcement of these enhanced rules is mandatory. Third, the input of all the different market participants involved - investors, domestic financial institutions, foreign firms - must be considered in the mix, in order to provide the required flexibility and liquidity. Finally, in order to provide investors with the utmost confidence, securities regulators must be equipped with a broad range of investigatory powers and enforcement remedies.

This does not mean over-enforcement, which can be just as dangerous, if not more so, than under-enforcement. Instead of a Big Brother approach, Asian countries need to create the perception of a level playing field for all participants. The first line of defense is a strong board of directors with strong audit committees. In addition, a healthy, free, and investigative press can be of invaluable assistance. Self-regulatory organizations can also play a critical role. Institutions must gain the confidence of the markets by their actions; a toothless tiger will do nothing to restore confidence in these weakened systems.

Stable and transparent markets are what inspire investor confidence; both domestic and foreign. Clear and comprehensive disclosure and accounting standards are vital and must be implemented. Effective enforcement structures are the next crucial developments, both civil and criminal. Asia already maintains high-levels of domestic savings and a good level of individual participation. By providing full and fair disclosure of the material facts of their indigenous firms, in a timely fashion, Asian governments will provide the cornerstone for rebuilding the confidence that foreign investors need in order to begin investing in the region again. This is the tried and true remedy.

LONG-TERM PREVENTION

Pundits like economist Paul Craig Roberts have pointed out that Asia's much vaunted industrial policy - managed capitalism, where the social aspects of targeted investments were equal to return-on-equity - has failed. Under industrial policy, Asia allocated capital under intense political pressure. Crony capitalism emerged in some countries, where industry and government became so cozy that an environment of pay-offs and cover-ups bloomed. Currencies tended to be fine-tuned to expectations, not reality. In the end, the shallow economies collapsed like a house of cards. America's system of open, fluid, and profit-oriented capitalism has prevailed.

Extending the groundwork of open and fair systems is a way to turn the current turmoil into long-term opportunity. Some positive steps have already been taken. In mid-December, the World Trade Organization (WTO) reached a landmark pact to liberalize the world's financial industries. Banks, insurance companies, and other financial institutions worldwide - especially in the troubled Asian region - will now be more open to foreign investment, and even ownership. Almost $18 trillion in global securities assets, $38 billion in bank lending, and $2.2 trillion in worldwide insurance premiums will now be freer from restrictions than ever before. That's a good start.

With the double standard between domestic and foreign investors now evaporating, the groundwork is laid for a more stable and lucent global economy to emerge. Instead of markets racing forward with reckless abandon to attract any and all investors, the "race to the top" will now begin in earnest.

As Asia works to regain economic growth, the competition for capital will continue to be intense. Waves of capital are still flowing all around the globe looking for attractive open markets. However, it is fair to say that this capital is likely to have a motto of "once burned, twice shy." Only those capital markets that truly provide a level playing field will win the race to the top - and more specifically, the top of the charts in attracting the type of high-quality capital that becomes a long-term partner in a country's economic growth. Asia's lasting "Field of Dreams" will be created if the playing surface is seeded with full, fair and timely disclosure and nurtured by strong corporate governance practices.

As U.S. corporations and investors continue to look for opportunities in the Asian theater, let's not just consider investing in the region with stop-gap packages of loan forgiveness and financial aid. Let's do them, and ourselves, a favor and take a look at the long term. Let's work with Asia, and other emerging markets, on the disclosure and corporate governance principles that promote the deep, liquid, and transparent markets needed to attract new growth equity - which will develop stronger, sounder, and deeper markets.

RELATED ARTICLE: How Contagious is the Asian Flu?

Best Case

International Trade: Exports hold up. Imports rise moderately. Slow increase in trade deficit does not generate strong political repercussions.

U.S. Economy: Domestic companies benefit from cheaper imported components. Limited inroads of lower-priced Asian goods in U.S. markets. Overall economy keeps growing while inflation remains in check. Profit margins stable.

Finance: Federal Reserve continues to hold off raising interest rates. Dollar remains strong. Asian currencies gradually recover.

* Financial markets heave a sigh of relief.

Middling Case

International Trade: Exports to Asia decline and imports rise. Trade deficit does not increase to alarming proportions.

U.S. Economy: High-tech industries suffer loss of Asian markets, while low-tech companies benefit from cheaper imported components. U.S. profit margins are squeezed by lower foreign sales and higher labor costs. Overall economy slows to a crawl.

Finance: Federal Reserve belatedly starts lowering interest rates, a modest 1/4 percent at a time. Dollar moves up and down with little trend. Some sell off Treasuries by Asian holders.

* Uncertainty characterizes financial markets.

Worst Case

International Trade: Exports to Asia plummet, while imports rise sharply. U.S. trade deficit soars. Protectionist pressures grow.

U.S. Economy: Production and employment drop because of massive Asian imports and loss of foreign markets. Profit levels decline with lower volumes and higher unit costs. Talk of import restrictions is heard more frequently in Congress. U.S. slides into recession.

Finance: Initially Federal Reserve raises rates because of rising labor costs. As economy worsens, Fed shifts to ease, lowering interest rates 1/2 percent at a time. Dollar weakens. European and Asian currencies strengthen. Foreign investors sell Treasuries and other American securities. Financial markets are confused and destabalized.

* Feelings of gloom become pervasive.

J. Carter Beese, Jr. is a former chairman of Alex. Brown International and a former SEC Commissioner. He is currently a senior advisor to the Center for Strategic and International Studies.