Crumbling Japan Raises Specter of Broader Asian Decline

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If you are going to worry about something, worry about Japan. That, increasingly, is the message you hear on Wall Street.

Small wonder. Even the anemic performance of Japan's stock market -- up 2.5% this year, compared with 12.7% for the

S&P 500

-- is inadequate in describing the malaise that has beset the country. The Japanese economy carries all the hallmarks of a recession -- if not worse.

Wages, prices, demand and profits are falling. The yield on the benchmark 10-year government bond recently hit a new low of 1.115%. In the minutes of its April 9 meeting, the

Bank of Japan

aired the possibility of

lowering

the official discount rate of 0.5%. Clearly, there isn't very far to go. Concerns about the bad loan problems at Japanese banks came to the fore again last week, when

Moody's

downgraded its credit ratings and financial-strength ratings for five major Japanese banks and put four other banks on review for possible downgrade. Japanese bad loans, already heavy before the Asian economic crisis, are even worse now given the banks' exposure to the region. Bad loans are, conservatively, in excess of 75 trillion yen ($540 billion) -- more than 16% of Japan's gross domestic product.

Pundits looking for the proverbial black ships necessary to shake Japan out of its lethargy have not had far to look, but a policy paralysis in Tokyo has kept the hoped-for change at bay. The country's leaders have indeed gotten themselves between a rock and a hard place -- as the tepid reaction to numerous economic stimulus programs has shown. The money put forth for these programs has gone either to public-works spending or tax cuts, neither of which has done much good. Public-works spending often goes to pork projects that have little effect on the overall economy. And faced with an unsteady future, Japanese consumers appear to be as likely to salt away tax cuts as spend them -- not what the flagging economy needs.

This didn't matter all that much, as far as the world's economies and capital markets were concerned, until quite recently. If anything, slowed growth in Japan, and the resulting dip in demand for commodities, may have kept world inflation in check. But the world's second-largest economy does not exist in a vacuum. People have been talking for some time about how Asia needs Japan to help drive it out of its morass, and have lamented that Japan's economy is not up to the task. Now the danger is that Japan may actually pull the entire region lower, and that could have a deleterious effect on the rest of the world.

The First Domino

"Japan, in many ways, is the key to Asia, and Asia is a large part of this world's economy," said Don Fine, chief market analyst at

Chase Asset Management

. "Asia in dire straits is not good for anybody's economy. You can't expect the U.S. to grow by leaps and bounds if the rest of the world is imploding."

These concerns have seemed somewhat theoretical, but the yen's recent downward spiral has raised the specter of another leg down in the Asian economic crisis. While he remains fundamentally bullish on the U.S., Jeffrey Applegate, chief investment strategist at

Lehman Brothers

, thinks that if investors must stay up late worrying, the yen's weakness is a good thing to fixate on.

"The latest iterations of Asia's political economic distress are reverberating negatively on all equity markets, mature and emerging, to varying degrees," Applegate wrote in a recent research note. "The worst-case Asian recession scenario is roughly as follows -- a further big swoon for the yen, China devalues, Hong Kong loses the peg, and another large downdraft in Asian equities -- all of which leads to a big enough decline in U.S. and rest-of-world equities to warrant raising cash." He went on, "Should the dollar/yen cross rate weaken considerably past 140 and beggar-thy-neighbor currency devaluations engulf Asia, the damage visited on U.S. and other equity markets could make the 1997 global equity correction appear modest."

"The market is now saying 140-150," said Marc Chandler, currency strategist at

Deutsche Morgan Grenfell

and a

TSC

contributor. "If people are concerned that the weak yen is going to cause further Asian weakness, we're looking at further Asian weakness."

A Few (Billion) Suits Too Many

The yen weakness puts pressure on the Chinese renminbi (also called the yuan) and comes at a time when worries that China will devalue the renminbi are heating up -- the result of the country's worsening export situation. A recent memorandum from

Morgan Stanley Dean Witter

chief money-market economist Bill Sullivan cited a report from the

China National Garment Association

to highlight the problem. According to the association, state factories in China have stockpiled more than 4.9 billion men's suits and 1.5 billion shirts.

"Initially, the totals sound amusing," wrote Sullivan. "But, in reality, it could be a signal that the Chinese economic miracle -- touted by many -- is less than meets the eye. Specifically, a good deal of recent output had no market and the story of excess garments of course raises the specter that other areas of the Chinese economy have massively overproduced, creating imbalances that effect the social fabric of the nation, not to mention the exchange value of the yuan." Should that happen, Sullivan pointed out, other Asian countries might have to further devalue their currencies, with all that would portend.

You can see why Applegate has taken notice of this potential worst-case scenario. You can also see why he thinks the whole scenario is pretty unlikely.

Hold Off on the Fugu -- for Now

The yen may weaken further, but a downdraft in dollar/yen is unlikely to come right away. The dollar lost some of its ground against the yen over the last couple of days on expectations that

G7

deputy finance ministers will take advantage of next week's

Organization of Economic Cooperation and Development

meeting in Paris to get together and chat. Even after that, dollar bulls may not buy too aggressively: U.S. markets will be closed Friday, July 3, and worries will heat up ahead of the holiday that the

Bank of Japan

will repeat its Easter action, when it intervened on dollar/yen while other markets were closed.

Also dampening the downside on the yen, the BOJ has launched something of a campaign for the beleaguered currency, and has been busy singing its praises for the likes of

Johnson-Smick

and

Medley Advisors

. The BOJ is apparently saying that a U.S. Treasury team is in Tokyo helping formulate a savings-and-loan-style bailout for Japan's banks, and that

Prime Minister Ryutaro Hashimoto

is ready to get serious about that bailout after the July upper-house elections. That's the carrot. The BOJ says that it has $30 billion to $40 billion on hand for further solitary interventions. That's the stick. If the yen does weaken, it appears that it will do so at a leisurely pace.

"It's important to remember that a gradual decline in the yen is not likely to be as severe for Asia," said Bob Lynch, currency strategist at

Paribas

. Lynch points out that while further yen weakness would certainly put pressure on the Chinese renminbi, China is unlikely to buckle under. "Chinese officials have made clear their intentions not to revalue," he said. "Excessive further weakness would make it difficult for them to hold current renminbi levels, but that doesn't mean that they don't have the resources to do so." And with the limited outside market in the renminbi, it is not as if speculators can easily push values lower.