A Crisis Is Brewing

March 5, 2001 – Every once in a while one can almost sense that something is wrong in the financial system. We are at one of those moments. The system everywhere is groaning and quaking under the stress that continues to build. I believe that a financial crisis is in the making.

I’ve been alluding to a developing crisis of some sort over the past couple of months. See, for example, Financial Tension in Letter No. 278. The financial stress mentioned in that article has in recent weeks become even more palpable. Consider some of the following flash points.

The Nasdaq has continued to collapse, taking with it several hundred billions of wealth formerly in investors’ portfolios. Consumer confidence continues to fall lock-step with the Nasdaq, with the result that the economy appears to be in a downward spiral. The US is now probably in a recession, which will in time expose the soft under-belly of the banking system, putting banks at risk because of the imprudent loans made during the boom.

The Turkish Lira has collapsed. This turmoil creates the possibility of a spreading currency crisis to other countries with balance sheets stretched to the limit with debt, such as South Africa, Indonesia and any number of Latin American countries (and maybe even to the currency of the biggest debtor of them all, the United States?).

Perhaps most importantly, there is last week’s swoon in the Japanese stock market. I’d like to focus on this last point. In recent weeks, I have been trying to identify the trigger that would most likely cause what I believe is the developing financial crisis. There are any number of possible choices, but Japan always keeps returning to the top of my list. The unfolding scenario goes something like this.

The Nikkei average breaks below 12,500 causing much angst and consternation within the banking community. Investors also start selling stocks, pushing this important index lower still. Then as the panic grows, there is a rush for the exits to raise liquidity, which leads to a run on banks throughout Japan. This growing domestic panic then develops international repercussions as non-Japanese banks reduce/pull their lines of credit to Japan. As the liquidity crisis deepens, Japanese investors begin selling their huge portfolio of US government debt instruments, remitting the proceeds back to Japan to help plug the growing holes in damaged balance sheets. These debt instrument sales not only drive up interest rates in the US, but they lead to a weak Dollar as the proceeds are used to purchase Yen. This selling pressure on the Dollar then leads to a much wider flight from the Dollar by overseas investors. As the Dollar tanks, and worries about Japanese banks deepen, the panic would then enter a killer stage by spreading to the US banks. When that happens, a world-wide financial crisis may very well become unmanageable given the horrific excesses of boom-time debt and mal-investment so rampant throughout the global economy. But it all begins in Japan, with their stock market.

The reason for focusing on the Nikkei is that stock portfolios are a major asset in Japanese banks, and as the value of these stocks decline, the banking community’s net worth goes down with it. This wouldn’t be so bad if were it an isolated problem, but it is not.

The Japanese banks already have severe bad loan problems, which make the 1980’s S&L crisis in the States look mild by comparison. To put the magnitude of these bank problems into perspective, the S&L’s lost some $100 billion, but estimates of the problem in Japan generally begin at $300 billion by the government’s own figures, and the bad loans are increasing by at least $10 billion per year as their economy remains weak andrealestateprices continue to decline. The enormity of these losses take on even greater import when one considers that Japanese economic output is only slightly more than one-half the size of that of the US.

I’ve seen some estimates that put the bad loan problem of the banks closer to $400 billion, but it could even be more. The Japanese parliament has already set aside $500 billion to deal with any financial crisis arising from the banking problems, so one has to wonder why they would set aside this amount unless they knew something not generally reported in the press. The upshot of all this is that the Japanese banks are insolvent because these bad loans at face value are greater than the aggregate net worth of all the Japanese banks.

The banks in Japan have so far managed to avoid a disastrous collapse because of repeated and prolific government intervention. Some insolvent institutions have been propped up financially. Others have been merged. And some have been taken over by the government in order to try preventing the rot from spreading.

The banks have also managed to buy time because bad loans can often be hidden and/or disguised; however, collapsing stock values cannot be obscured or shrouded behind accounting sleight-of-hand. When the stock market tanks every one sees it. Moreover, the fall in the stock market has some important knock-on effects. One of these is that collapsing stocks break consumer confidence.

When consumer confidence slides, so does confidence in the banking system. If the banking system already is fragile, as is presently the case in Japan, sliding consumer confidence can easily lead to a banking panic. And it appears that we are headed toward a banking panic in Japan.

If a crisis does occur, it will probably strike within the next several weeks. The reason is that Japanese banks report their annual financial statements as of March 31st. Therefore, the banks try to make their books look as good/solvent as possible for that date, but this year they have an uphill task. The Nikkei closed this past Friday at 12,261, a fifteen year low. As a result, the stock portfolios of most banks are now registering losses.

The Japanese economy has been burdened with substandard growth, slipping in and out of recession-like conditions since the stock market bubble there burst in 1990. It therefore will not take much to cause consumers in Japan to despair about the banks and worry about the safety of their deposits. Last week’s break in the Nikkei may have already been bad enough to push the system over the edge. But also consider some of the other bad news of recent weeks.

Japanese corporate bankruptcies in January were up 61% from the previous year, leaving unpaid a monthly record of $8.4 billion of debt. Two weeks ago Standard & Poors lowered the credit rating of the Japanese government’s debt from AAA to AA+. This followed two similar moves by Moody’s Investor Services, which now rates this debt at Aa2. Then there is the uncertain political situation.

Rumors are running rampant that bad economic conditions and a shocking corruption scandal in the ruling-party will soon force the unpopular Yoshiro Mori, the prime minister, to resign. Also, taxpayers are becoming increasingly resentful of using government funds to bail-out the banks, so further largesse is seen as an unpalatable alternative of a government already under pressure as it faces elections this summer. Meanwhile, pressure is building on the Bank of Japan to further ease monetary policy. But with the bank’s discount rate already set at a minuscule 0.35%, it is widely recognized and accepted that there is little the BoJ can do.

Therefore, batten down the hatches. I expect that there will be some rough sailing over the next several weeks. We are entering the danger zone with severe weather expected. This danger zone begins now as we approach the March 31st fiscal date of the Japanese banks and will last for several weeks thereafter as the damage to the banks is assessed by investors and Japanese consumers. And the ripple effects from this rough weather in Japan will undoubtedly be felt throughout the global economy.