The process of tying emerging markets to the global economy offers great rewards to all, but it does not come without pain and cost, if these emerging markets are not ready or do not have adequate “immune systems” in place.
0 100 200 300 400 500 600
1990 1991 1992 1993 1994 1995 1996 1997 1998
ASSET BUBBLES PRECEDED THAILAND S CRISIS Index values for real estate and the stock market
Property sector price index
Stock market price index
Crisis
Source: IFS; Bloomberg; Datastream; McKinsey analysis
FIGURE 3.14 Asset bubbles preceded Thailand’s crisis.
We believe that several significant crises might lie ahead. It is almost pre- ordained that this should be the case. As markets develop and expand to areas of the world in which they had not traditionally had a major role, it is highly likely that crises will grow in frequency as well as in magnitude and intensity.
The benefits of joining the world economy far outweigh the costs, but there is much that investors, managers, regulators, and governments can do to safeguard economies from crisis and to react intelligently when crisis con- ditions begin to manifest themselves.
Many observers believe that there might be at least three major financial storms brewing in the world economy. These are likely to be among the largest experienced to date:
1. Japan, which The Economist in early 2002 called the “non-performing economy,” has delayed needed reforms for a very long time and caused enormous unresolved pressures to build in its banking system and macro- economy.23The costs to the Japanese people and to the world of this con- tinued inattention are likely to be bigger than anything previously experienced. (See Box 3.3: Japan: The Rising Cost of Delayed Reforms.)
BOX 3.3: JAPAN: THE RISING COST OF DELAYED REFORMS
The Japanese economy continues to stumble. Since its initial stock mar- ket crash in 1990, Japan has failed to develop a recipe for revitalization.
Instead of tackling necessary reforms, the government has allowed a gradual decline, one that may now be reaching crisis proportions. This makes Japan a rather different case from some of the others that we have analyzed, since its problems are not masked by the overvaluation and enthusiasm of a growing economy. There is no asset bubble, the yen continues on a several-months’ decline, and there is no excess of foreign funding as of this writing. However, the potential for crisis is evident in three of the five economic loops described in Chapter 3: the real economy, the financial sector, and macroeconomic policy.
Real Sector Economy In the real sector, value destruction is evident, driven primarily by slumping demand and overcapacity. This is particu- larly true in the construction and retail sectors, and has led to an increased number of bankruptcies over the last several years. While bankruptcies are increasing, Japan’s bankruptcy rate remains relatively
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low at 1.2 percent in 2000, just above rates observed in the U.S. and Germany (0.7 and 1.1 percent respectively).1This is due to a banking sector that continues to prop up companies that are not profitable by providing debt at exceedingly low interest rates (short-term interest rates approach zero percent).2These low interest rates (the result of Japan’s current deflationary period) make value destruction in the Japanese economy undetectable through traditional analyses. However, using the opportunity cost of debt facing Japanese investors and financial institu- tions, value destruction is evident.
To make matters worse, Japan’s productivity is also lagging. The Japanese are 31 percent less productive than Americans in terms of labor and 39 percent less productive in terms of capital.3 Although Japan’s labor and capital inputs have grown steadily, surpassing U.S.
and European levels, its lower productivity levels have offset any poten- tial positive impact on GDP growth.
Financial Sector Japan’s financial sector is also struggling. Taxpayers’
funds are propping up weak banks and inefficient public financial institu- tions, and there is little incentive to solve the financial sector problem. It has been left “holding the bag” as companies have gone bankrupt instead of paying their debts. NPLs are currently estimated at $500 billion to $600 billion and increasing, well above the warning threshold.4As a result, the banking sector’s ROA averaged –0.1 percent in 2000.5Moreover, given recent regulatory changes, the situation is unlikely to improve in the near term. As of April 1, 2002, the banking sector is required to record its equity holdings, which are often substantial, at market value. Since many of these equities were purchased at higher prices, banks will face signif- icant losses. This change, coupled with changes in government deposit insurance, may cause investors and depositors to flee already shaky banks, although it is difficult to see any signs of capital flight as we write this book.6This transition moment could actually spark a currency deprecia- tion if Japanese savers come to the conclusion that their savings would be safer in institutions outside of Japan than in other Japanese institutions.
Macroeconomy From a macroeconomic perspective, Japan is plagued by deflation and depressed spending. A continuous fall in consumer prices and retail sales over the past two years has contributed to a fall
2. A similar, albeit smaller, storm might be taking shape in China, where years of rapid credit portfolio buildup to state-owned enterprises (SOEs) has created an NPL portfolio estimated at more than $600 bil- lion to accrue.24 The catalyst of a potential Chinese storm might be allowing Chinese depositors to move their deposits freely within China or make investments outside the country. (See Box 3.4: China: Plugging into the Global Economy.)
3. Another, fortunately smaller, event of similar characteristics might be taking shape in India, where decades-long protection accorded to ineffi- cient SOEs might eventually lead to an economic reckoning. Here the likely precipitating event could be further trade liberalization that exposes ancient behemoths to more intense competitive pressure. (See Box 3.5: India: Seeking a Second Generation of Reforms.)
in GDP both in nominal and real terms. The deflationary period itself can be attributed to government inaction following the collapsed asset bubble in the Asian crisis of 1997. In addition, the government’s inade- quate fiscal policies—low tax revenue compared to high spending—
have contributed to a public debt that is 130 percent of GDP, and that is expected to rise above 140 percent in the coming year.7 To date, Japan’s government has avoided a fiscal crisis due to the unusually low interest rates. However, should interest rates on government debt rise to more empirically normal levels—about 6 percent—the true state of Japan’s fiscal nightmare would be revealed. Doing so would show that Japan’s debt would consume 28 percent of total government spending.8Japan’s poor fiscal position has already prompted domestic credit rating downgrades by several ratings agencies, including Moody’s and Standard & Poor’s.9
Japan has muddled through its financial and economic problems for over ten years. Whether a crisis looms on the horizon is unclear, but many of the warning signs are flashing. The stalemate continues. The bad debt problem is both a real economy and a political problem, given the unwillingness to allow excess capacity to be eliminated and the fear of rising unemployment. Consequently, growth rates are likely to remain unattractive for years to come. Only time will tell whether the private sector and the government are ready and able to finally take the steps necessary to jump-start the economy—their track record to date, however, is not reassuring.
BOX 3.4: CHINA: PLUGGING INTO THE GLOBAL ECONOMY
Despite impressive economic growth and progress toward integration into the global economy, China might be prone to a future financial storm. Whether and when the storm materializes depends on several key factors, predominantly in the real sector and the financial loops of its economy, but the macroeconomy as well.
Using the information available on publicly traded companies, we find that there has been value creation in the real economy over the last five years, with the exception of 1999. These figures, however, probably mask problems in other parts of the economy as well. SOEs and other nontraded corporations are thought to have systematically destroyed value throughout this period, in large measure neutralizing the contri- butions of the healthier publicly traded companies. It is thought that 41 percent of SOEs are generating losses, as are 20 to 30 percent of Chi- nese private companies.1
The performance of the real economy is further hindered by a lack of available capital (despite high domestic savings rates that flow mostly into deposits) for commercially-driven firms that have the potential to create economic value. These companies are “crowded out” by lending to the less sustainable, but politically important, SOEs and by other
“policy” lending targeted at developing or ailing sectors of the econ- omy. By starving those companies that create value and subsidizing those that do not, China is further increasing its chances for financial problems in the future.
Financial Sector The potential for problems is also evident in China’s financial sector. According to Standard and Poor’s, the Chinese banking sector is “technically insolvent.”2Market estimates of NPLs are as high as 44 percent of GDP in 2001, largely due to the preponderance of lend- ing to financially unsustainable SOEs.3 As a result, the ROA of the banking system is a low .05 percent and ROE is 1.6 percent.4These metrics provide clear warning signs of problems brewing.
Solvency issues of the banking system notwithstanding, the liquid- ity of the financial system is very high. Annually, Chinese customers save 39 percent of GDP, continually replenishing the losses of the bank- ing system.5Moreover, since the banking system has not been liberal- ized and capital outflows are strictly regulated, these high savings rates
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The pressures building in these three economies and in those of many others are daunting. Liberalization is gradually reaching all of Eastern Europe, South- east Asia, and Africa. Further deregulation is likely in the developed markets of Europe and North America as pension reform, bank deregulation, and financial services convergence continue. Moreover, the linkages between the world’s economies are increasing, as corporations globalize, more institutions and individuals invest outside their own countries, and financial institutions become more interconnected through payment systems, syndicated loans, repurchase agreements, interbank lending, and capital market investments.
All of these events will keep managers busy tracking the crisis warning signs that are flashing in many dangerous markets. Executives also should start now to take the precautionary measures essential to weather the first hundred days of a financial storm.
might continue to fund the questionable loans being made by the bank- ing system. Although NPLs are estimated at 44 percent, when all is said and done the crisis might be contained by the unflagging willingness of the Chinese to save, especially if domestic depositors decide to maintain their savings in the banking system rather than move their resources elsewhere.
Macroeconomic Macroeconomic factors are mixed and are also a cause for worry. As in Japan, as of 2002 China has experienced deflation for four years. Meanwhile, estimates of government debt are as high as 75 percent of GDP, fueled by potential state bank loan bailouts and pension liabilities.6 Moreover, China, like many emerging economies, continues to lack transparent, market-driven “rules of the game,”
which are vital for future economic stability. Offsetting this are China’s impressive growth of above 7 percent annually over the past decade, considerable trade surpluses and export growth, and one of the largest flows of foreign direct investment into any emerging economy, which has accelerated since its entry into the World Trade Organization.
China’s foreign exchange reserves currently are in excess of $200 billion.
Historically, China has been slow to address these critical issues, although WTO membership may force its hand to accelerate the neces- sary reforms to prevent a future crisis before it is too late.
BOX 3.5: INDIA: SEEKING A SECOND GENERATION OF REFORMS
Ten years ago the Indian government embarked upon reform, liberaliz- ing the economy to open it to global markets. Today, this liberalization effort is showing mixed results. Despite strong GDP growth (averaging 5 to 6 percent annually), a reasonably low current account deficit (less than 2 percent of GDP), and ample foreign reserves (over $55 billion), an analysis of India’s economy shows indications of distortions in three areas: the real economy, the financial sector, and macroeconomic policy.
India is considering a “second generation of reforms” to further liberal- ize the economy and correct these market distortions, but if distortions remain unchecked, a financial crisis could emerge.1
Real Economy In the real economy, steady value destruction has been evident over the past eight years. A comparison of ROIC with the cost of debt over the years 1995 to 2000 reveals a corporate sector unable to service its cost of debt (with ROIC averaging 8 percent compared to a cost of debt at 10 percent) as shown in Figure 3.15. This value destruc- tion is due to the fact that 80 percent of available capital is directed at
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14.0 -7.5
7.0 Figure 3-16
VALUE IS BEING DESTROYED IN INDIA DUE TO CAPITAL MISALLOCATION
Sectors with negative incremental
ROIC
Sectors with positive ROIC
< COD
Sectors with ROIC > COD
•Steel
•Paper
•Textiles
•Chemicals
•Automobiles
•Fertilizers
•Mining
•Petroleum
•Machinery
•Diversified
•Services
•Electricity
•Drugs
•Food
Examples Incremental ROIC Percent
Percentage of incremental capital
29.1%
48.4%
22.5%
Cost of debt 10%
1995-2000
Average 4.3%
ROIC
Value destroyed
7.9 9.4 10.1
8.1
7.2 7.1 9.6 9.6 9.6 10.1 9.6 10.2
0 2 4 6 8 10 12 14
1995 1996 1997 1998 1999 2000 After tax cost of
debt (average 10%) After-tax COD (average 10%)
After tax ROIC After-tax ROIC (average 8.1%)
Source: CMIE; McKinsey analysis
FIGURE 3.15 Value is being destroyed in India due to capital misallocation.
nonprofitable sectors, a trend that is unlikely to change in the near future due to government-directed lending regulations, high transaction costs, and depressed market conditions. Additionally, declining growth in the industrial sector, coupled with a reliance on the volatile agricul- tural sector (tied to unpredictable monsoons) that still accounts for 25 percent of GDP, have contributed to poor real economic perform- ance. Finally, the corporate governance structure is in urgent need of reform—public sector banks are governed abysmally, family-owned businesses are still a mainstay in the private sector, and the voices of minority shareholders are frequently neglected.2
Financial Sector The financial sector also appears weak—as of 1998, 46 percent of financial institutions had ROAs of less than 1 percent, and the banking average was 0.55 percent in 2001.3This poor performance of the banking sector is compounded by low productivity and a lack of fee revenue. Gross NPLs are estimated to be as high as 30 percent of total loans in the banking system and, as a result, it is likely that the banking system has already lost most of its capital and that profits are overstated. This is a consequence of poor credit risk skills in domestic banks as well as high levels of government-directed lending (40 percent of total loans are priority-sector directed).4Bank credit has been largely misallocated to nonprofitable sectors, including iron and steel, sugar, cement, and paper industries.5
Macroeconomy Both the real and financial sectors are impeded by poor macroeconomic policies. The Indian government exercises significant ownership and control over the economy, directly owning 60 percent of assets in the real sector and 75 percent of assets in the financial sector.6 In addition to a strong presence in the economy, the Indian government has been very active intervening in the economy through fiscal policy and monetary measures to maintain liquidity and the exchange rate, and to support weak institutions. In the past six years, over $6 billion in support has been provided to recapitalize weak banking institutions and force the merging of weak and strong domestic banks. Many observers are concerned about the quality of the government’s spend- ing.7In addition, as a result of such poor spending, central and state government deficits amount to approximately 11 percent of GDP.8
APPENDIX 3.1: Ten Warning Signs of a Financial Crisis
No one would argue that financial crises are easy to predict. As one former IMF official conceded, “The IMF has predicted fifteen of the last six crises.”1
Still, we believe that they are not impossible to predict. For this reason, we list below the ten best indicators (that we have found) of impending cri- sis. As we explain in this chapter, most come from the microeconomic side of the economy, not the macro side.
To be sure, judgment and common sense must be used to make sense of these warning signs, and care must be taken that the data from which they are drawn is accurate, timely, and complete. They may not be perfect, but they are the ones we typically use in our client work to form a judgment about the vulnerability of a financial system to crisis.