asd Submerging Economies Investment Policy Turmoil in Southeast Asia to have little impact on most U.S. multinationals Highlights

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1 Investment Policy asd Submerging Economies Turmoil in Southeast Asia to have little impact on most U.S. multinationals Highlights Impact of turmoil in Southeast Asia on most U.S. multinationals should be minimal, even less than impact of 1995 upheaval in Latin America. Most at risk: industrials vulnerable to slower capital spending and global competitors of Southeast Asian commodity producers, rather than consumer non-durable companies. Economic growth in Asia should slow but still be positive in 1997 and And U.S. not affected significantly: Exports to five troubled Southeast Asian economies account for only a small fraction (7-8%) of total U.S. exports, and total exports are only about 12% of U.S. GDP. U.S. corporate profits would be impacted somewhat more. Japan is much more vulnerable to Southeast Asian slowdown than U.S. Big question: Will Hong Kong, and even China, be dragged down too? Unlikely. Chaos reigns! I am currently in Asia visiting clients, with a definite feeling of deja vu. As was the case in 1995, there is strong concern today that turmoil in a particular country that spills over into an entire region will have serious negative implications not just for these markets but for all large U.S. multinationals. In 1995, the country was Mexico and the area of concern was Latin America. (The lead story in The Wall Street Journal of January 5, 1995 stated that companies in the U.S. are feeling the pinch of Mexico s currency crisis as the troubled peso hobbles exports and forces writedowns of assets. ) In 1997, turmoil in Thailand has put the spotlight on not only the problems of certain Southeast Asian economies, but also on Japan. We pointed out recently that while nervousness over faltering Southeast Asian markets may present a threat to some large multinationals, multinationals are just that multi-nationals (see Chimps, September 17, 1997). Southeast Asia may be troubled today, but far more important to the success of many U.S. multinationals are the bright prospects in South America. Furthermore, in Europe the outlook may not be robust, but it certainly is no worse than over the past few years. Strength in some regions that offsets weakness in other areas is how many big multinationals consistently churn out solid earnings gains year after year. (And, with U.S. unemployment at just 4.9% and capacity utilization high, it is most likely a positive for the global capital markets that not all the world s major economic regions are booming at the same time.) Remember that in 1995, despite the upheaval in Latin America and sluggishness in Europe, S&P 500 operating EPS rose 18% and stock prices surged 34%! Chart 1 Current account deficits as a percent of GDP Indonesia Malaysia Philippines South Korea Thailand Argentina Mexico October 23, 1997 Edward M. Kerschner, CFA (212) {INV1023EMK Michael Geraghty (212)

2 2 asd Thailand: Deja vu The similarities that Thailand in 1997 has with Mexico in 1994 are an overvalued exchange rate, a large current account deficit and heavy foreign borrowing (Chart 1). And as was the case in late 1994 and early 1995 when a currency crisis spread through the rest of Latin America after the Mexican debacle neighboring countries (such as Indonesia, Malaysia and the Philippines) have also come under intense scrutiny, have experienced stock market volatility and have been forced to defend their currencies. A decade of economic growth averaging around 8% per year masked Thailand s financial problems, many of which were related to the baht s peg to a basket of currencies dominated by the dollar. Local companies and financial institutions piled up foreign debt because the fixed-exchange-rate regime encouraged borrowing in foreign currencies at much lower interest rates than borrowing baht. Much of that foreign debt financed a building boom that turned into a property bubble. However, to maintain the baht s value, the Thai Central Bank had to raise interest rates to ever-higher levels, crippling property developers, their financiers and some manufacturers. As companies were unable to meet their debt payments, the banking system threatened to collapse. In response to this, the central bank lent $19 billion or more than 10% of GDP to keep Thailand s 91 finance companies afloat. And as the economy slowed, the government s budget slipped into deficit for the first time in more than ten years. On July 2, the Thai Central Bank was finally forced to float the baht. (Since then it has fallen in value by more than 30%.) On July 28, Thailand announced it was entering into talks with the International Monetary Fund about an infusion of capital to stem a slide into national bankruptcy. As the condition for this aid, the IMF has demanded austerity in Thailand: The current-account deficit will be cut from 8% of GDP in 1996 to 3% of GDP in To reach a targeted budget surplus of 1% of GDP in 1998, the government will have to slash several billion dollars from next year s spending. Value-added tax is being raised to 10% from 7%. 42 finance companies have been suspended, adding to the 16 already closed for business while they look for a buyer or a partner for a merger. Thailand is not having much difficulty in securing the loans it needs. Japan, whose banks have lent the Thai private sector more than half its foreign debt, will be the biggest single official creditor (Chart 2). Along with the IMF, China, other Southeast Asian countries and the Asian Development Bank are also contributing. The region has a keen interest in seeing confidence restored, as the Thai crisis has put pressure on other currencies and stock markets. Chart 2 Japanese banks share of external private debts 60% Thailand Indonesia Malaysia South Philippines Korea But, even with these loans, it will take some time before Thailand shows signs of stabilizing. On October 19, the Thai finance minister said he would step down because he lacked the power to implement the tough reforms needed to solve the country s economic and financial crisis. For example, days after announcing the outline of emergency decrees needed for a comprehensive overhaul of the country s financial system, the government said that these decrees were to be delayed because of legal technicalities. And after an outcry following the announced rise in the oil tax in order to raise revenues, the government also revoked the oil tax decision. Philippines, Indonesia, Malaysia: Unhealthy symptoms The Philippines, Indonesia and Malaysia have also been under pressure because those countries have many of the symptoms of the Thai complaint, principally large current-account deficits (Chart 1) and sizable foreign debts (Chart 3). In addition, Indonesia and Malaysia also have property gluts because of over-generous bank lending. Not surprisingly, just weeks after Thailand s July 2 devaluation, the Philippines and then Indonesia and Malaysia each succumbed to the intense pressures and effectively floated their currencies. But, as is the case in Thailand, these devaluations have done little to remedy the underlying problems.

3 asd 3 Chart 3 Gross external debt as a percent of GDP Indonesia Malaysia Philippines South Korea Thailand Argentina Mexico Consequently, earlier this month Indonesia said that it, too, was seeking assistance from the IMF; following a review, that country is also expected to receive a large IMF loan. And Malaysia, usually considered among the region s stronger economies, remains vulnerable to further declines in the exchange rate, higher interest rates, and skeptical foreign investors given its large current account deficit and the controversial statements of its prime minister, Mahathir Mohamad. Investors clearly remain doubtful about Malaysia, as evidenced recently by the sell-off in the stock market following the release of the 1998 budget plan. South Korea: Don t bank on it South Korea, too, has an uncomfortably large currentaccount deficit. In addition, a rash of defaults by big companies hurt by downturns in semiconductors, metals and petrochemicals has left banks with bad debts and losses. Six of the country s chaebol the powerful conglomerates have gone bankrupt in the last nine months. More than 170 large South Korean companies have debt-to-equity ratios of more than 500%; the average of the largest 300 companies is about 400%. The chaebol have always borrowed a lot, indulged by banks that were encouraged to make such loans by the government. Simply servicing the debt has become the greatest burden of the chaebol the Bank of Korea estimates that as of June, South Korean firms had borrowed $126 billion from commercial banks to cover their ongoing expenses. The financial condition of the South Korean banks continues to deteriorate, and the Korean central bank has had to lend $4.2 billion to banks finding it difficult to borrow abroad. And the latest tremors in South Korea have come from a unique group of financial institutions: the merchant banks. Of Korea s 30 merchant banks, 24 are short-term lenders, mainly to companies too frail to issue bonds or obtain loans from commercial banks. Amid a spreading economic crisis, many of these banks clients are having difficulties. So the merchant banks, like the commercial banks, have turned to the government for a bailout. Hong Kong: Cause for concern? Thursday Hong Kong's Hang Seng Index collapsed by 1,211 points (10.41%) in the biggest single-day point drop in the exchange's history. The Hang Seng index has fallen by about 40% in the last two months as investors have become concerned about (i) the knock-on effects of the Southeast Asian turmoil on Hong Kong s tourism, retail sales, banks and exports, (ii) rising interest rates, (iii) the property sector, (iv) red chip stocks, and (v) the stability of the Hong Kong dollar. While Hong Kong s problems are relatively minor in comparison to its Southeast Asian neighbors, there are some valid grounds for concern. First, the appreciation of the trade-weighted Hong Kong dollar is likely to have a negative impact on domestic exports and the merchandise trade balance as Hong Kong s products become less competitive throughout Asia. Second, while Hong Kong s interest rates have historically maintained a spread of basis points above U.S. rates, that spread has widened lately as the perceived risk of Asian currencies in general has increased. Higher interest rates are clearly negative for the property sector, which is a key part of the Hong Kong economy property-related activities are estimated to have accounted for around 40% of all investment in Red chip stocks (Hong Kong-listed companies with strong ties to China) have also been hit hard by the generally bearish sentiment the Hang Seng China Affiliated Corporations Index of red chips is down by over 50% since late August. However, the pullback in red chips has come on the heels of an equally fast run-up the red chip index increased 133% in 1996 and surged an additional 89% in the first six months of We had cautioned recently that the run-up in red chip prices is certainly raising some investors eyebrows. Though concerns over the potential fallout of disappointing ultra-high expectations exist, few expect this to filter through to valuations until later this year at the earliest (see America s Red Chips, July 27, 1997). It s now later this year and, as is usually the case in Hong Kong, fear has not filtered through, but has come crashing through the floodgates.

4 4 asd Finally, there has been concern about the stability of the Hong Kong dollar, even though the currency would appear to be immune to the turmoil roiling other Asian currencies for two key reasons. First, few economists think the Hong Kong dollar is overvalued relative to the greenback. Second, speculating against the Hong Kong dollar is extremely difficult thanks to the working of its peg to the U.S. dollar and its rigid rate of HK$7.80. Importantly, Hong Kong s Monetary Authority does not print the currency. Instead, three commercial banks do, but only after they have handed the exact amount of American dollars to the Authority. The Authority also guarantees to buy Hong Kong dollars at the HK$7.80 rate. So, a bank or speculator trading Hong Kong dollars in the market for much less than HK$7.80 would be gutsy: not only does the Hong Kong government have reserves of over $80 billion to back the system, but the Chinese government is adamant, too, that it does not want a currency crisis in Hong Kong just months after its takeover it has promised its $120 billion in reserves as firepower. However, if Hong Kong s merchandise deficit does widen appreciably, this may be the signal for investors to launch a speculative attack on the dollar. Hong Kong dollar devaluation bad politics Nor do political considerations argue for a devaluing of the Hong Kong dollar less than four months after China has regained control of Hong Kong from the British. Further, with China s leaders arriving in the U.S. next week to discuss trade issues, it seems highly unlikely that either immediately prior to nor anytime soon thereafter would China devalue the Hong Kong dollar (or its own currency), further exacerbating its trade surplus with the U.S. and undoing any good will established during the Washington meetings. But even a stabilization of the Hong Kong dollar will not necessarily mean an enduring stabilization of the Hong Kong stock market; although at least initially it should calm the market. The Hong Kong stock market has long been one given to extreme movements. Probably nowhere is the herd effect more prevalent. And just as one and all charged into the market to play the benefits of reunion with China with the red chips the obvious prime beneficiary one and all are now rushing out, as those benefits are likely to come at a more measured pace than the spirit of the moment had suggested. Taiwan: Making things worse Taiwan, too, has mounting problems. On the one hand, its economy is in relatively good shape: Its current account surplus is forecast at 3.4% of 1997 GDP and its central bank has $80 billion in foreign reserves. On the other hand, its dollar has fallen to a ten-year low against the greenback, and its stock market is down over 30% in just two months. The problem has been that, in trying to protect itself from the currency crisis sweeping the region, the central bank tried to hold the exchange rate stable, both by spending several billion dollars of its reserves and by raising interest rates (which hurt the stock market). On October 18, the Taiwanese admitted defeat and abandoned support of the currency, which then plunged to its lowest level in a decade. But, in trying to ward off the currency crisis, the central bank has likely worsened the situation consumption could slow given that one in three Taiwanese is a stock market investor, higher rates are weighing on businesses, and the central bank has lost credibility (as well as several billion dollars) by devaluing the currency after insisting that it would not. Japan: More vulnerable than the U.S. Southeast Asia is an area where the U.S. has seen increasing exports in recent years. While trade with the currency contagion countries has risen, it is still relatively small (Chart 4). But if the Asian devaluations hold, this could imply a deteriorating U.S. trade position with this region. Chart 4 U.S. and Japanese exports to Indonesia, Malaysia, Philippines, South Korea and Thailand as percent of total exports 20% US Japan But the real wildcard is what happens to Japan s trade. Over 40% of Japanese exports go to other Asian countries; 20% of exports go to Indonesia, Malaysia, the Philippines, South Korea and Thailand. In September, Japanese exports to Thailand dropped by 18%, while

5 asd 5 export growth to Malaysia and Korea slowed to just 6% and 5%, respectively. Yen appreciation relative to Southeast Asian currencies is clearly unwelcome for Japanese exporters. Not only is demand hit in the countries concerned, but exports from these economies will now pose a greater competitive threat in third markets to Japanese-produced exports. Furthermore, as noted, many countries in the region, particularly Thailand and Indonesia, have Yendenominated debt to service. Any increase in loan loss provisions would only add to the woes of the Japanese banking system. Chart 5 Investment from Japan as a percent of total 1996 foreign direct investment 30% Thailand Malaysia Indonesia Philippines South Korea Overall, Japan is particularly vulnerable to the turmoil in the Southeast Asian countries given: Its strong trade ties with the region. Its heavy debt exposure. Its large fixed investments. During the period of dramatic dollar depreciation (Yen appreciation) of the 1980s, the incentive for Japanese manufacturers to establish cheaper bases through foreign direct investment in Southeast Asia rose dramatically. And heavy Japanese investment in Southeast Asian countries has continued in recent years (Chart 5). No Mexican meltdown, but no sharp rebound either How bad will things get in Asia? Who really knows? But even the most pessimistic forecasts do not call for a repeat of the 1995 Mexican meltdown. From Mexico s December 1994 devaluation of the peso to mid- November 1995, the currency fell 55%. Real GDP shrank 6.9% while inflation soared to 52%. Interest rates at auctions for benchmark 28-day cetes surged as high as 83% and averaged 49% for the year. Other Latin American economies were hit too: Real GDP in Argentina fell 4.4% in 1995, while call money rates rose as high as 25.9%. But while the Mexican meltdown was relatively short and sharp, the longer the financial crisis continues in Southeast Asia, the more prolonged the economic slowdown. And, unlike Mexico, the Southeast Asian region is today paying the price for the excesses incurred during a multi-year boom, particularly in the real estate and infrastructure sectors. But, perhaps the key difference between Mexico in 1995 and Southeast Asia today is that there is no dominant power in the region that has an interest in ensuring a rapid economic rebound and also has the financial resources to engineer one. While Japan has a unique relationship with the Southeast Asian Dragons, in much the same way that the U.S. has a unique relationship with Mexico, Japan is clearly not in a strong enough economic position today to bail out the entire region. Despite these problems, most forecasters are still predicting positive growth in the region in 1997 and On September 16, the IMF released its World Economic Outlook report containing its latest forecasts for economic growth on a country-by-country basis. (See Table 1. Note that the IMF does not provide 1998 GDP growth forecasts for all countries.) While a 1998 growth rate of 2.5% will be an agonizing crawl for a country such as Thailand used to growth rates of around 8%, it is still a positive rate of growth. Similarly, while Japan's economy looks substantially weaker than it did earlier in the year, growth this year is still estimated at a positive %. Table 1 Real GDP growth rates e 1998e Indonesia 7.8% 7.0% 6.2%* Malaysia * Philippines * South Korea Thailand Japan China * Hong Kong Taiwan Sources: IMF, ING Barings*

6 6 asd Multinationals are multi-nationals The impact of the turmoil in Southeast Asia for U.S. multinationals should be minimal for most companies and will likely have even less of an impact than did the upheaval in Latin America in There are three key reasons why: As noted, while economic growth in many Asian countries in 1997 and 1998 will likely be slower than in previous years, it should still be positive. Exports to five troubled Southeast Asian economies account for only a small fraction (7-8%) of total U.S. exports. And remember, the U.S. is not a trade-driven economy: Exports account for only about 12% of GDP. Admittedly, the profit impact would be greater than the GDP impact, with around 45% of the sales of U.S. multinationals outside the U.S. i.e., the sales of U.S. corporations foreign subsidiaries. Slightly more than half of these foreign sales are in Europe with the rest split between Asia and Latin America. (These figures complement government data on U.S. foreign investment abroad that show that 51% of U.S. direct investment abroad is in Europe, while 18% is in Asia and 17% in Latin America.) So sales to Asia are an important part but certainly not the largest part of the sales of U.S. multinationals. And Asia, of course, includes China, which is expected to enjoy close to double-digit growth this year and next, although the risk is, of course, that the turmoil in the other Asian economies could cause this growth to slow somewhat. But while a Southeast Asian slowdown should not be a major negative for S&P EPS as a whole, individual companies with heavy exposure to the region could be adversely affected. Many U.S. consumer non-durable companies have a large exposure to the region, but just as is the domestic case that demand for these companies products does not slow significantly when the U.S. slides into recession it is unlikely that consumer demand for products ranging from soft drinks to salty chips to shampoo will change much because of a slowing in economic growth. Remember, as Table 1 illustrates, negative GDP growth (i.e., a recession) still seems very unlikely in any of the Southeast Asian economies. Thailand s new generation of yuppies may be purchasing fewer luxury cars, but they ll still drink their sodas, eat their chips and wash their hair. Table 2 Primary exports of Southeast Asian economies Indonesia Petroleum & natural gas, textiles, leather, wood Malaysia Semiconductors, consumer electronics, computers & peripherals, petroleum, logs & timber Philippines Semiconductors, garments South Korea Semiconductors, autos, ships Thailand Textiles, rubber, rice Industries that may be hurt by the slowdown are principally selected industrial, capital goods and construction companies, which might be vulnerable given that many infrastructure projects have been put on hold in the region. And while many of these projects are typically undertaken by Asian companies (particularly Japanese and Korean), some U.S. industrial companies have long had significant involvement in Southeast Asia. Falling global prices are bullish for U.S. bonds... The currency crisis in Southeast Asia is likely bullish for U.S. bonds in that it should result in: A lower cost of imported finished goods, as well as cheaper raw material imports from these countries. A flight to quality into U.S. fixed income securities given mounting concerns about the creditworthiness of many countries in the region. An increased demand for U.S. dollars as more trade is conducted in one of the world s most respected currencies.... but could be bearish for U.S. companies that face global competition However, while lower prices for some imported goods is clearly a positive for the inflation outlook, cheaper imports will pressure those U.S. companies that compete in these sectors. Table 2 lists the primary exports of the Southeast Asian economies. With a greater supply of these products likely to flood global markets at lower prices, some U.S. companies particularly producers of commodity products will likely be adversely affected.

7 asd 7 Chart 6 Mexican Peso per U.S. $ Chart 8 Chinese Renminbi per U.S. $ Chart 10 Hong Kong Dollar per U.S. $ Chart 7 Mexican IPC Index Chart 9 Shenzhen B Index; Shanghai B Index Shanghai Shenzhen Chart 11 Hang Seng Index (left scale); Red Chips (right scale) 17,500 15,000 12,500 10,000 Hang Seng Red Chips ,500 5,000 Chart 12 Indonesian Rupiah per U.S. $ Chart 14 Japanese Yen per U.S. $ Chart 13 Jakarta Stock Exchange Index Chart 15 Nikkei 225 Index 24,000 22,000 20,000 18,000 16,000 14,000

8 8 asd Chart 16 Malaysian Ringgit per U.S. $ Chart 18 Philippine Peso per U.S. $ Chart 20 South Korean Won per U.S. $ Chart 22 New Taiwan Dollar per U.S. $ Chart 24 Thai Baht per U.S. $ Chart 17 Kuala Lumpur Stock Exchange Composite Index Chart 19 Philippines Composite Index Chart 21 South Korea Composite Index Chart 23 Taiwan Weighted Index 11,000 9,000 7,000 5,000 3,000 Chart 25 Thai SET Index The information contained herein is based on sources we believe to be reliable, but its accuracy is not guaranteed. PaineWebber Incorporated and/or Mitchell Hutchins Asset Management Inc., affiliated companies and/or their officers, directors, employees or stockholders may at times have a position, including an arbitrage or option position, in the securities described herein and may sell or buy them to or from customers. These companies may from time to time act as a consultant to a company being reported upon. Copyright 1997 by PaineWebber Incorporated, all rights reserved