Japan might hold the key to the fate of the U.S. stock market.
While many market observers predict a fall in U.S. stock prices, whether Japan lives up to its June 17 commitment to turbocharge its economy and rationalize its ailing banks could spell the difference between a moderate U.S. correction and a 25% to 30% tumble.
Equity markets around the world could plummet. "We're getting more nervous," said Gerald Smith, head of Asia-Pacific equities at Baillie, Gifford & Co., Edinburgh.
The worst-case scenario: Japan fails to overhaul its ailing banking system and stimulate its economy. The yen goes into a freefall, plunging below 160 to the dollar. China passes its pain threshold and devalues the renminbi, triggering another wave of devaluations across Southeast Asia. Asian imports, already flooding Western economies, drive prices lower, spreading deflationary pressure into Western markets. Jobs are shifted to Asia and U.S. corporate profits decline, making price-to-earnings ratios now approaching 30 totally unsustainable.
The upshot: widespread falls in emerging markets and a 25% to 30% plunge in U.S. market prices -- wiping out $1.8 trillion to $2.2 trillion in wealth. That scenario could threaten the U.S. economy, some observers believe.
That's why all eyes are on Japan. But many managers are skeptical that Prime Minister Ryutaro Hashimoto will deliver on promises to overhaul Japan's creaking banking system, push deregulation and stimulate the economy.
"I can't imagine it," said Douglas Polunin, director and senior investment management at Pictet Asset Management UK Ltd., London.
Added Mr. Smith: "If you look at their track record on that, you can't be too optimistic."
Analysts at Bridgewater Associates, Wilton, Conn., believe the Japanese situation will not respond to conventional monetary policy. They argue Japan has plunged into depression, which can be alleviated only by a reduction in corporate debt. The recent Japanese statements will only buy the government some time, they say.
Other experts said U.S. intervention to support the yen -- a flip-flop from previous policy -- will only delay further tests of the yen to later this year, perhaps at the 150 or 160 level.
ENTER THE GOVERNMENT
But some believe the Japanese government will step in after the July 12 elections for Japan's Upper House.
"The restructuring and reliquefication of the Japanese banking systems has to happen," said Alan McFarlane, managing director of Global Asset Management Ltd.'s institutional arm, London.
The message -- in the form of the yen's decline to a low of 146.60 on June 15 from 80 just three years ago -- has been heard "loud and clear," he said.
Echoed Eric Taze-Bernard, head of strategy and asset allocation for Indocam Asset Management, Paris: "We think now the Japanese authorities have no real choice."
The truth may lie somewhere in between. Tony Thomson, chief executive of Nikko Capital Management (U.K.) Ltd., London, said he thinks "the Japanese will do what is required" but not along the lines that markets want.
"It will be messy and murky and complicated and there will be a lot of moaning along the way," he said.
Meanwhile, the fates of most Asian countries rest in Japan's hands.
Asia's troubles stem from a high level of domestic debt, equivalent to roughly 150% of gross domestic product, according to James Lister-Cheese, global strategist with Independent Strategy Ltd., a London-based research firm.
Those high debt levels are driving interest rates to choking levels -- for example, to 50% to 60% in Indonesia, with inflation at 45% to 50%, he said. Pacific Basin stock prices have declined 35% so far this year, according to Morgan Stanley Capital International's Pacific Free index -- including declines of 48% in Indonesia (free), 51% in China (free), 66% in Korea and 30.7% in Japan.
Asia needs Japan to soak up more exports. But Japanese imports are shrinking at a 15% clip, on a year-on-year basis, Mr. Lister-Cheese said. Nor can the U.S. pump money into the system, given the danger of an overheating economy, he added.
"So U.S. hands are pretty much tied. If Japan doesn't step in, it's up to China," Mr. Lister-Cheese said.
The dilemma is that China has plenty of its own problems, and having already withstood a lot of pain from the Asian crisis, some managers wonder how much more China will take.
About 15% to 20% of China's exports go to Japan, and 55% of total Chinese exports go to Asia, said Ashok Shah, senior portfolio manager at Old Mutual Asset Managers (UK) Ltd., London. But imports from those trading partners are down 35%, he said.
"China's exports now are going to a hit a wall," Mr. Shah said.
That means China will not be able to hit its target 8% growth rate -- a level needed to avoid massive unemployment and social unrest as China attempts to overhaul its economy.
Managers are divided as to whether China will act on its veiled threat to devalue its currency.
"It's inevitable that China will devalue at some stage," depending on how quickly and how far the yen falls in value, said Pictet's Mr. Polunin.
Suzanne Hudson, international economist at American Express Asset Management, London, agreed the question is a matter of timing, noting a fall to 160 yen could trigger a devaluation.
Others, however, question what China would gain. Any Chinese devaluation would kick off a second round of Asian devaluations, leaving Chinese Asian exports no better off.
Plus, devaluation would not help China compete against Japan in exporting to the West. China's exports typically are low-tech, compared with the high-tech products from Japan.
"The link between a weak yen and Chinese devaluation is not that strong, simply because China and Japan don't compete," said Dick Howard, senior economist at Julius Baer Investments Ltd., London.
What's more, China's stature in the world has been greatly enhanced by the Asian crisis. Nick Sargen, global market strategist for J.P. Morgan's private client business in New York, noted the G7 group of industrialized countries went out of its way to pat China on the back for the role it has played.
China "is becoming the world leader of Asia. That's important to them," said Sheila Coco, executive vice president and chair of the global investment committee at Fiduciary Trust International, New York. "We don't think China will devalue."
In addition, experts say China is not under pressure to devalue, given its huge currency reserves. Plus, a devaluation of the renminbi most likely would undo the peg between the Hong Kong dollar and the U.S. dollar, which would not be in China's interests.
If nothing else, the situation looks dire for emerging markets: The contagion already has spread to Russia, Brazil and South Africa.
"We think it's a global emerging markets crisis and think the whole asset class will get swamped by deteriorating conditions," Mr. Lister-Cheese said.
In fact, Fiduciary Trust International has eliminated its global equity portfolio holdings in Latin America and Asia, previously at 4% and 2%, respectively, Ms. Coco said.
Mr. Lister-Cheese and others believe the Asian crisis eventually will affect Western economies. With subsequent job losses and declines in corporate profitability, U.S. stock prices could plunge 25% to 30%, a level that some managers agree is realistic. His firm, Independent Strategy, earlier this year predicted a 30% to 40% plunge in global equity prices.
The only way out for Asia is if Japan steps into the breach, he said.
"If Japan would take 20% to 30% of Asian exports, China would not devalue," he said. There still would be a lot of pain, corporate bankruptcies and unemployment "but at least you avoid the Armageddon scenario."