In markets, the worst rarely happens. But don't count on it

Andreas Whittam Smith infernal machines
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Finally, the bad news from the world's financial markets has got to me. I didn't worry in October, when the newspapers were full of articles demonstrating the uncanny similarity between current conditions and those of October 1987, the last occasion when the world's stockmarkets fell out of bed. Nor was I alarmed when a copycat shake-out duly appeared, right on cue. Since then, after all, Wall Street and London and the main European bourses have regained some of the ground they gave up.

Until now, I have shrugged off Thailand's banking crisis. In the case of Indonesia, I have been unmoved by the massive support package which the International Monetary Fund has had to make available. The fact that poor President Suharto has had to close down banks owned by his relatives I found perversely encouraging. I accepted the comment from an economist in Singapore who was quoted as saying that "the Indonesian Government seems very much committed to the reform package and things should move along".

But then I perceived a dangerous phenomenon which occasionally appears in the financial markets. I call it an "infernal machine", in the dictionary definition of the phrase - an apparatus, usually disguised, for producing an explosion to destroy life or property. This is a good description of what is happening to Japanese banks. They are being destroyed.

What is the infernal machine which is responsible? A substantial part of the reserves of Japanese banks comprises shares in Japanese companies. As the Japanese stockmarket has deteriorated, dropping by a quarter since June, so the reserves that Japanese banks hold have shrunk. By law, however, Japanese banks are required to maintain their resources at a level sufficient to repay depositors should there be unusual demands for cash.

Sensing this squeeze, investors in Japanese shares have grown frightened and sold more shares. The stockmarket falls again. The squeeze intensifies. The banks call in their loans. Their customers begin to feel the pain. And the infernal machine, disguised as it is, starts to explode the Japanese banking system and with it property, in the sense that the value of all assets declines sharply.

Just as I was reflecting on this mechanism, there came the news of the collapse of Japan's tenth largest bank, Hokkaido Takushoku. Yesterday the bank announced that it was going out of business. Here was the test. Only governments have the power to break the vicious circle. What would the Japanese government do? It decided to protect depositors by advancing funds for that purpose alone. In relief the Japanese stockmarket registered big gains.

But this is the single response that governments can make to such a crisis. Even if they have to print banknotes, they can make sure that depositors are repaid. They cannot do much about the other ill consequences. They cannot overnight restore a healthy banking system which provides working capital for successful companies and finance for international trade. They cannot prevent the substantial slowing down in economic activity that a banking crisis necessarily entails.

Moreover, in the rest of Asia where banks have developed weaknesses and started to rock on their foundations - in an area stretching from South Korea via Hong Kong (which has witnessed sporadic panic withdrawals of deposits) through Thailand and Malaysia, and down to Indonesia - governments are not behaving as decisively as the Japanese. In Indonesia, where 16 private banks have recently failed, individual depositors and businesses can only retrieve $5,700 from their accounts. Repayment of additional amounts must wait until the bank's assets are sold off - which may take years and yield little. It is because of developments like this that an entire economic region, until recently so vibrant, one of the motors of the world economy, is losing speed.

Panic, we know, is contagious. Even so, I have been surprised to find how badly South America has been affected by what is happening in Asia. The trading links between the two regions are not particularly close. In fact the virus has been carried across the Pacific by international investors. Weakness in Asia's fabled economies has been taken as a signal to get out of South America's more pedestrian business sectors. The effects have been dramatic and disturbing.

Last week the Brazilian stockmarket dropped 10 per cent in a single day, bringing the cumulative decline to 40 per cent in three weeks. The government has responded with the familiar medicine, which makes the patient feel much worse in the initial stages. It has doubled interest rates, cut government spending and increased taxes. Brazil, one of the biggest economies in the world, plays a pivotal role in South America. For example it takes half of Argentina's exports.

But something even more worrying happened at the same time. The countries that make up the South American trade group (Brazil, Argentina, Uruguay and Paraguay) raised their external tariff from 12 per cent to 15 per cent in response to the turmoil in world markets. Were they affected by the clear sign, given by the American congress ten days ago, that it had lost its appetite for promoting free trade, when it refused to give President Clinton the negotiating authority he requires, the so-called fast track legislation? Do not forget that high trade barriers were a major factor in the Depression of the 1930s.

However, I am glad to say that no signs of panic can be found in North America and Europe. Admirable sang froid is being displayed by everybody, from the chairman of the US Federal Reserve, Alan Greenspan, down to the humble investor. It is, of course, the invariable response of governments to crises to say that there is no crisis. In testimony to Congress, Mr Greenspan went even further, saying that the difficulties that had created such volatility in stockmarkets around the world could even benefit the United States by helping in a small way to suppress inflation. And then the chairman summarised his thinking in the form of a striking double negative: "To date, the direct impact of these developments on the American economy has been modest, but it can be expected not to be negligible."

Not negligible; I can accept that judgement so long as the infernal machine demolishing the Japanese banking system can be stopped. For it has an even more dreadful power to wreak damage. It can work internationally. Suppose the Japanese stockmarket reverses this week's gains and begins to sink again. As a result the shortage of bank credit for companies outside the first league, and the absence of liquidity for institutions with large stockmarket holdings, would grow more acute. At this point they might begin to sell part of their massive holdings on Wall Street, where they have huge profits, magnified by currency movements, ripe for the taking. This is how it works. Japanese investors sell a bit of their American portfolios. Wall Street prices fall. The Japanese investors think that they had better hurry up. They sell some more stocks. And so on. The infernal machine is once again destroying value.

Alarmist? Undoubtedly. Will it happen? Probably not; the worst rarely happens. All the same, Japanese investors were net sellers of foreign stocks and bonds in September. That is one more reason why I have started to worry.