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Watching the Deleveraging Process Work in Asia

With cash calls and placements rising in Asian equity markets, it's time to worry, right? Wrong.

JAKARTA -- When does a growth scare turn into an inflation scare? This is presently the $1 trillion question in world financial markets. Growth scares are bullish for cyclical stocks, commodity producers and emerging markets. Inflation scares are bearish because they mean higher U.S. interest rates.

It is true that the U.S. bond market is becoming more jittery. Still Greed and Fear continues to assume, like prolific ABN Down Under


watcher Gerald Minack, that the bond markets will not suffer 1994-like turbulence.

As inflation overheating concerns mount, it is worth noting that the pace of U.S. money supply growth, defined both narrowly and broadly, has been slowing in recent months. This is not an inflationary signal. Fears of overheating will also subside if Y2K is proved to have any semblance of an impact on the real world in the run-up to the millennium. Greed and Fear is an agnostic on this much-discussed issue out of sheer ignorance. Still one point is clear. Bureaucracies, both public- and private-sector, have been rushing to make themselves Y2K-compliant by the end of July this year, at the latest. That suggests demand has been front-end loaded.

Listening to the Quacking

"When the ducks quack, feed them." Such is a favorite saying of seasoned stockbrokers when it comes to the art of placing out shares. Such offers of shares are normally taken as signs of at least short-term stock market tops. With cash calls and placements rising in Asian equity markets, this is surely a worrying sign. This time, it is not. While an increase in the supply of stock is not normally good news, rights issues and the like in Asia today are, in many instances, extremely bullish. They often signal that cash-strapped companies or banks are able to raise equity on terms that would have seemed unthinkable a few months ago. Thus,

Siam Commercial Bank's

share price rose 65% on completion of its rights issue last week.

Successful equity-raising is therefore proof that the deleveraging process is working. Asia's dramatic bull run since the beginning of the second quarter is all about deleveraging. This is an infinitely more sexy story in the Asian-specific context, in terms of the potential for upside, than the global reflation theme that is moving cyclical stocks worldwide. The reason is that deleveraging can occur, and the resulting debt swapped for equity, without the need for economic growth, though growth is, admittedly, a nice plus.

By contrast, a bet on global reflation remains a cyclical bet against the dominant secular trend, which remains, contrary to current consensus, deflationary. And deleveraging fits nicely with the deflationary theme because cash flows are worth more in this environment. In this context, the trendy tool of discounted cash flow analysis, taught to eager young business-school graduates throughout the world, is coming back into use as risk premiums collapse. Obliterated as a worthwhile valuation parameter during the Asian crisis, "fair values" can now be redeployed in the art of selling shares.

The deleveraging story in Asia is most dramatic in Korea, which is one important reason why it has been the best performing of Asia's major stock markets. The bull point on Korea continues to be that the government is committed to pursuing restructuring.

President Kim Dae Jung

has not let the momentum to restructure slip with the two biggest chaebol holdouts,

Hyundai Motors



, being put under particular pressure last month to change their ingrained expansionist habits. These were the only two chaebol that actually increased their debt levels in 1998. The result has been to force both companies to announce specific debt-reduction targets.

Daewoo's chairman went public in late April, saying the group would even sell such core companies as

Daewoo Heavy Shipbuilding

. Daewoo has pledged to its main creditor bank,

Korea First Bank

, that it will redeem a total of 29 trillion won worth of debt this year through asset sales and rights issues. The government's leverage on Daewoo's management comes from its control of Korea First Bank. Since Daewoo announced its plan, its share price has sprung to life. The stock has risen 79% since the announcement. This is one of the best regional examples of the deleveraging theme at work in the marketplace. Likewise, Hyundai has reconfirmed its willingness to change with a plan to cut debt levels by 20 trillion won through rights issues and asset sales.

The Korean government's goal continues to be for the chaebol to meet the 200% debt-to-equity ratio by the end of 1999. Importantly, the government has also made it clear that it will not accept asset revaluation as a way of achieving this target. The willingness of Koreans to sell assets becomes more believable as the level of foreign direct investment rises. In the first three months of this year, there were 389 committed cases of foreign direct investment, worth some $2 billion, but these figures do not represent the sum of asset sales. In many cases, local subsidiaries of the foreign buyer finance the transaction via debt.

Monetary Tightening Is Off Agenda

The restructuring theme in Korea continues to be supported by a benign liquidity picture. At the macroeconomic level, the government is already uncomfortable with the strength of the currency as a result of buoyant capital inflows. Monetary tightening is therefore off the agenda for now, despite efforts by the

Bank of Korea

last week to talk down the stock market by threatening interest-rate rises. Further monetary easing is likely in coming months in order to take upward pressure off the currency, while inflation remains all but invisible. CPI rose by a mere 0.4% year on year in April, while producer prices have declined for four consecutive months.

ABN Amro's

official year-end target for the corporate bond yield is 5.5%, compared with 7.9% at present.

The Korean economy is undergoing a fundamental structural shift away from being investment-led, as the chaebol finally realize that capital spending should not be viewed as the equivalent of a corporate virility symbol. This should mean permanently lower levels of real interest rates.

If the macroeconomic liquidity story remains benign, so does it at the stock market level. Customer deposits continue to rise at Korean securities companies and now total 9.1 trillion won, an all-time high. Likewise, margin debt of 645 billion won is way below peak levels reached at the end of 1997. Finally, local investment trusts are extremely underweight equities. At the end of last week, they had only 6% of their total assets of 260 trillion won invested in equities, with the rest in bond-related instruments. This compares with more than 50% back in 1990.

If the Korean story remains in play, Taiwan is also showing signs of picking up steam after being the comparative regional laggard so far in the second quarter. Local retail investors look at the 7,300 level on the


as the key technical breakout point. So we are at an important level from the point of view of retail investor sentiment. Greed and Fear raised Taiwan to neutral in our asset allocation Tuesday to take advantage of the recent laggard performance. With WTO looking like it has at least a 60% chance of happening this year and with a

MSCI China Free Index

100% weighting of Taiwan on the horizon, there is now too big a risk of standing in front of the proverbial train, given the bullish regional context. Still, Taiwan does not have the upside of some other places in Asia because many of the better listed corporates do not have the same sort of scary leverage.

Befitting the global relation theme, investors are now moving out of electronics stocks into cyclicals like

Formosa Plastic


China Steel

. This momentum shift makes sense, given the likelihood of Y2K-related equipment-purchase slow downs later this year. ABN Amro recently lowered estimated PC unit growth to 10% in 1999, down from an originally assumed 15% increase in global PC shipments, as a result of this factor. In line with this trend, Taiwan's foundry producers are seeing a slowdown in orders for the third quarter.

Reflecting the shift in investor sentiment, electronics shares are now only accounting for about 30% of trading volume, compared with 60% at the start of the year. Bank stocks will also remain in favor. Liquidity will remain favorable, given that we appear to be at the beginning of a new economic cycle. Loan growth also appears to be recovering. This suggests the credit crunch is easing, though a trend shift is far from proven. Foreign investors are still extremely underweight in bank shares.

Finally, it should be noted that


entry will accelerate direct transport links with mainland China. It will also mean that Taiwan will have to liberalize the financial and telecom sectors much faster than planned. The potential for opening in both sectors is clearly enormous.

The regional deleveraging theme goes hand in hand with falling interest rates. Interest rates have gone about as low as they can in Hong Kong and Singapore, but there is still potential for further falls elsewhere in the region. Indonesia is the country with the greatest potential for interest rates to decline.

Christopher Wood is the global emerging market strategist for ABN Amro and the author of The End of Japan Inc. (Simon & Schuster, 1994). Under no circumstances is this to be used or considered as an offer to sell, or a solicitation or recommendation of any offer to buy. While Wood cannot provide investment advice or recommendations, he welcomes your feedback at