Expanding on the Deleveraging Theme

HONG KONG -- It's a stock-broking cliche, but Asian ex-Japan stock markets continue to display "healthy consolidation." The roughly 30% drop in trading volumes around the region since Asian markets peaked in early May may not please trading desks, but it is a sign of robust sentiment when share prices drift lower in light volume.

A high-volume stampede out of the markets following the gains of April is the last thing anyone needs after the volatility of the past two years. If sentiment is against chasing share prices up on the secondary market, there is little doubt that the appetite remains for large-scale placements.

This is the message of the successful Korea Telecom (KTC) deal. The bull theme in Asia is deleveraging. We have entered the capital-raising part of the cycle, which should mean a golden period for investment bankers. Fund managers will subscribe to the issues, providing the issuing corporation walks the walk and talks the talk in terms of deferring to the prevailing orthodoxies about shareholder value, etc., precisely because the bull argument rests on the deleveraging theme. There is also no reason why corporations shouldn't respond to this incentive.

Asia ex-Japan, therefore, continues to offer the most potential in the global equity universe, which is why Greed & Fear continues to subscribe to this view: The worm has turned, namely that global funds should overweight Asia and that Asia ex-Japan will continue to outperform Japan. This week has seen sentiment turn bearish again in the Japanese government bond market. In a consensus-driven market, the price moves are always big in JGBs when the mood swings. This has again been the case with the benchmark JGB yield jumping from 1.23% on May 10 to 1.67% on June 2.

The bond market's concern is clear. With the Japanese government looking unlikely to meet its target of 0.5% GDP growth this fiscal year, pressure is growing for a new fiscal stimulus package for the second half of this year, likely to total at least 10 trillion yen. The risk is that such a package could turn out to be counterproductive, from the point of view of stimulating a moribund economy, if it reignites supply concerns, thereby pushing up long-term interest rates. This week's market action suggests the risks are not academic.

The fiscal problems confronting an aging Japan remain hard to exaggerate. Greed & Fear has gleaned some interesting comparative numbers from the draft of an MIT research paper comparing Japan's fiscal predicament with those of Canada and Italy, two countries whose government is notorious for having to shoulder large welfare burdens. In 1997 the central government's debt service obligation as a percentage of retained tax revenue was 44% in Japan, compared with 25% in both Italy and Canada. The Japanese figure is projected to have risen to 48% in 1998. Likewise, total government debt as a percentage of tax revenue was 933% in Japan in 1997, compared with 744% in Italy and 235% in Canada. That figure is projected last year to have risen to 1,132% for Japan. Finally, net central government bond issuance as a percentage of GDP was 48% in Japan in 1997, compared with 17% in Italy and 4% in Canada. Most alarmingly, this figure is projected to have risen to a stunning 95% in 1998 and is likely to rise to over 100% this year and next.

The reason for Japan's fiscal problems lies less on the spending side, the usual area of focus, than in the lack of revenue, reflecting the fundamental weakness of the economy. It is true that a supply-side shock is urgently needed in Japan, but that in the short term at least implies still lower tax revenue.

So, the way out for Japan from a fiscal standpoint is not to raise taxes but rather to cut spending and sell off public-sector assets in a privatization drive, such as the 66% stake still held in NTT (NTT) (worth 12.5 trillion yen). Meanwhile, the fast-deteriorating fiscal position puts further pressure on the Bank of Japan. If the present policy of zero interest rates proves ineffective in stimulating the economy, then the central bank is likely to face more pressure to go toward pure printing of money, namely buying bonds direct from the Ministry of Finance, as advocated by various high-profile chatterbox economists. This policy has so far been resisted by the central bank for the good reason that it is an invitation to the politicians to keep spending. Hyperinflation may be the last thing anybody is worrying about in Tokyo today. But it is the logical consequence of sustained fiscal irresponsibility.

Fortunately Japan's demographics and fiscal predicament are not shared by the rest of Asia. This is why Asia ex-Japan can decouple from the continuing problems in Japan. The Asian market with the most risk of turning into an emerging market version of Japan is, as discussed last week, China. Still, the authorities are displaying more focus on dealing with their intense deflationary problems than seen in Japan for most of the past nine years. The latest evidence of this has been the resuscitation of the B share market caused by talk of a new market stimulus package.

The wave of reform in part includes undoing some of the antispeculation measures implemented by Zhu Rongji in the summer of 1997. Thus, it has become easier again for domestic securities firms to borrow from banks. The maturity of interbank borrowings available to broking firms will also be lengthened. These measures will significantly improve liquidity. Zhu Rongji's U-turn, in terms of adopting measures specifically to boost the stock market, would also seem to have a political motive, namely to instill a feelgood factor and thereby divert domestic investors' sentiment away from upcoming political anniversaries.

There are also some significant longer-term changes being discussed. Most important is talk of allowing state-approved domestic mutual funds to invest in B shares, which are at present only meant to be bought by foreigners. Greed & Fear hears there is a good chance of this policy being formally adopted, which is why the rally in B shares has been driven in reality by domestic Chinese investors, both institutional and retail. The authorities have turned a blind eye to this domestic trading in a market that is meant to be the preserve of foreigners. If such a reform is adopted it will provide the first signal for a long time of official support for the long-moribund B share market. The opportunity is clearly the arbitrage between the two markets. At present the A share market is trading at a prospective multiple of about 35, compared with 8 for B shares. Another worthwhile reform being floated is allowing insurance companies (including foreign-owned insurers) to invest in the mainland stock market.

The renewed activism in China is likely to be complemented by another cut in interest rates and yet more fiscal stimulus in China. There are constraints on the authorities, however. Renminbi deposit interest rates are already lower than dollar ones, even before any possible Federal Reserve rate hike. A one-year renminbi deposit yields 3.78%, compared with 4.44% on a one-year dollar deposit in China. In this sense the Chinese authorities have to tread warily, given the threat of the ultimate-scare scenario in terms of money pouring out of the banking system and into dollars. Capital outflows must remain a concern in China at a time when both the country's trade surplus and foreign direct investment is declining. The trade surplus dropped by 66% year over year between January and April, to $5.2 billion from $15.2 billion in the same period last year. Foreign direct investment fell 15% in the first quarter. This is likely to mark the beginning of a long-term trend.

The foreign direct investment figures also risk being misleading. Instead of new green-field projects involving the setting up of new capacity, foreign direct investment is likely to consist of foreign entities buying existing foreign-owned capacity at knock-down prices. This may be formally described as foreign investment, but in reality one foreign owner is being replaced by another. Hopefully, the new owner will put the capacity to better use. Indeed, the last thing China needs is new production capacity.

So China remains the one country in Asia, outside Japan, where things can still go badly wrong. Meanwhile Zhu Rongji's reform initiative has been badly compromised both by the U.S. government's leaking of the concessions he made on the World Trade Organization when visiting the U.S. and by the Belgrade embassy bombing. Prospects for WTO entry late this year or early next are now at best only 50%. It would also be wrong to assume that all the concessions made by Zhu Rongji during his trip to America are still on the table. Political realities clearly demand a toughening of China's negotiating stance.

In this sense the Kosovo exercise has proved costly for Washington on all fronts, be it in terms of the Sino-U.S. relationship or, more intangibly, the blow to American prestige. In a supposedly "virtual" world it is perhaps not surprising that America should have become the first country in world history to launch a full-scale war without being prepared to see any of its own military personnel killed. The flawed logic behind this tactic explains why Greed & Fear is not surprised to hear from Washington contacts that the present unspoken strategy is to try to do a deal with Milosevic while at the same time declaring him a war criminal. Meanwhile, if the Russians manage to broker a face-saving settlement that gets NATO off the hook, they will be able to demand significant debt relief from the West. Such an outcome remains likely since all three compromised parties -- Milosevic, NATO and Russia -- want out.

Liquidity is always important for every stock market. So it is worth noting the improving liquidity context in Taiwan. Monetary and loan data released in April provide further evidence that the credit crunch has ended as the excess reserves in the banking system begin to be put to work. Excess bank reserves held at the central bank now total T$115 billion, the largest ever. Meanwhile, the domestic banks' loan deposit ratio is 100.6, the lowest level since 1991. This improving liquidity position provides a powerful support to the retail-driven stock market.

Another positive is the policy shift in the banking sector in the sense that the authorities now realize that the lack of profitability in the banking sector is a structural problem that is damaging the development of the economy. Further evidence of the government's desire to improve the banking system before it leads to a Japanese or Thai-like disaster came this week. The Ministry of Finance announced it is revising the rules on the use of stock as collateral to make sure it is based on the net worth of the company, not the market share price. This is to address the common practice in Taiwan, deployed especially in the case of more illiquid securities, whereby a company or major shareholders ramp a stock and then take out a loan against the inflated market value.

This week's statement by Hong Kong Financial Secretary Donald Tsang in the strange context of a television interview that he wants the Exchange Fund to start disposing of some of its holding of shares "soon" should not exactly help the short-term prospects of the Hang Seng. Cheung Kong, New World Development and Swire Pacific are the most vulnerable stocks in terms of the percentage of the free float owned by the government. Still, the stock market will not be as badly hit as would have been the case a year ago, since most of the major absolute-return investors have lost their appetite for shorting stocks in Asia.

Nevertheless, Greed & Fear will use this opportunity to increase its underweight in Hong Kong to 29%. Part of the money will be placed in Taiwan, moving the allocation there to 18%. That means an overweight position in Taiwan. The Philippines' and Thailand's weightings will also be adjusted to 5% and 6%, respectively, in order to return to a zero-cash position.

Greed & Fear is no longer borrowing money in the asset allocation, though this does not imply a less bullish view on the region. It is simply because certain institutional investors, who manage money against an index, view borrowing money as unfair because they cannot do it themselves. This is quite reasonable.

The leverage investment Greed & Fear now recommends to absolute-return investors is Indonesian equities, financed by a yen carry trade. Indonesia is in the midst of turning from a vicious cycle into a virtuous cycle, whereby the currency goes up, interest rates come down, and share prices go up. The more the rupiah rallies, the less is the indebtedness in U.S. dollar terms. It should be emphasized the election campaign has so far proceeded as smoothly as anyone could hope to expect. All three major opposition parties -- PDI-P, PAN and PKB -- advocate orthodox economic polices consistent with continued adherence to the IMF program.

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