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The impact of Wall Street's scandals on
Japan
By Scott B MacDonald
On June 26, WorldCom dropped a bomb on global
markets in the form of financial fraud amounting to
US$3.9 billion. Wall Street took a pounding, while
bankruptcy is now a likely outcome for one of Wall
Street's former high flyers. It is also a blow to the
confidence in the US economy and could force the US
dollar lower. Sadly WorldCom was not alone. In the
following weeks, Qwest came under a federal criminal
investigation, concerns were raised over Merck's
accounting practices, and doubts emerged over Wyeth's
hormone replacement drug.
While it is obvious
that confidence in the US stock market has been hit, it
is not as clear why policy makers in Tokyo should be
concerned. But they should be.
Thus far the US
dollar's long-predicted fall is seen as a largely
positive trend for the United States and the world
economy. For the United States it is helping
manufacturers, though without pushing up inflation or
threatening a rise in interest rates. The dollar's
gradual fall is not leading to a stampede of foreign
investors (though foreign investment is down, especially
in securities). For Europe, the dollar's fall is good
news for the long-battered euro, now finally showing
that it is a reflection of the European Union's 11
economies.
Three key assumptions held up the
dollar. These were that the US high-tech sector would
quickly rebound from the recession and return the US
economy to growth superior to that of other large
economies (much as happened during the 1990s);
geopolitical conditions and economic policy would remain
supportive; and interest rates in the United States
would move subsequently higher, making US investments
more attractive.
Instead what we are seeing is
that high tech remains bogged down in a recession and
accounting issues, geopolitical concerns have not gone
away (new threats of terrorist attacks abound and the
Middle East remains explosive), US economic policy has
become more protectionist and the fiscal picture is
deteriorating, and it does not appear that the Federal
Reserve is going to move any time soon to raise interest
rates. In addition, there is little confidence in the
ability of Treasury Secretary Paul O'Neill to soothe
markets. There is a feeling that he will follow his
often-stated preference for letting markets forces act
on their own and miss the chance to calm markets at the
right juncture. His comments about US taxpayers not
throwing any more money into Brazil, while perhaps
reflecting common sense, certainly made a bad situation
worse. O'Neill should be aware that the United States'
current-account deficit is expected to be around 5
percent of gross domestic product (GDP) this year, a
large number that partially depends on outside
investment to help pay the bills.
The loss of
confidence with Wall Street threatens to accelerate the
US dollar's decline in two ways. Scandals with Enron,
Arthur Andersen, Tyco International and WorldCom have
done much to instill investors with a destructive
sentiment that management and accountants lie,
investment-bank research analysts misrepresent and chief
executive officers operate in a fog. Investors, both
foreign and domestic, are increasingly leery of the US
corporate sector and apprehensive of when the next Enron
or WorldCom will blow up.
Equally important,
WorldCom and other recent scandals bolster a negative
perception about the US corporate world at a time when
the economy is struggling to recover and needs ongoing
foreign investment. The loss of confidence on Wall
Street could lead foreign investors to demand a premium
for holding US corporate assets to offset higher credit
risks. European corporations, most of which have not
benefited from as extensive deregulation, could look
more attractive. As funds leave the US, those foreign
investors who remain could also ask for a premium to
offset currency risk.
For Japan, a steep decline
in the dollar will be bad. The "recovery" in the
Japanese economy thus far is limited to the export
sector. Much of the domestic sector is still struggling,
and remains inefficient and protected. Moreover,
government finances are overshadowed by sizable and
ongoing fiscal deficits and an increasingly onerous (yet
still serviceable) public-sector debt equal to about
140% of GDP - the highest of the Group of Seven (G7)
economies. The reform process of the Junichiro Koizumi
government is continuing at a glacier-like pace.
Consequently, export growth remains critical to Japan's
economic prospects. If the dollar falls to 115 yen,
which is where it is heading, it will be hard to see how
Japanese exports to US markets will be able to maintain
momentum. If that happens, there is a major risk that
Japan's growth will come to a sputtering end. Unlike in
the United States, consumer demand in Japan remains
considerably weaker. Indeed, Japan's consumer confidence
fell in June for the first time in four months,
reflecting the shallow nature of the economic recovery.
While Japan has an estimated $420 billion in
foreign-exchange reserves, ongoing foreign-exchange
interventions are going to be costly. The Bank of Japan
has been active in intervening in foreign-currency
markets over the past several weeks. However, the trend
line is toward 115-yen-to-dollar parity. Ultimately
intervention is not going to work.
We expect
that as the dollar continues to fall, there will be
greater pressure on the yen to strengthen and for more
intervention. If the dollar falls too quickly, however,
Bank of Japan intervention will not be enough and Japan
will run the risk of cooling exports. This would
certainly put the Koizumi administration in a difficult
situation, especially considering its decline in public
popularity and ongoing opposition to reform by
conservative hardliners in the ruling Liberal Democratic
Party.
Wall Street scandals are impossible to
foresee. However, the boom that began in the 1990s and
ended in 2001 allowed for excesses, including the
erosion of accounting standards and corporate
governance. The pendulum is now swinging the other way.
That was evident when Republican President George W Bush
called for harsher enforcement measures for breaches in
corporate governance.
There is a great clamor to
clean up the sleaze on Wall Street. No doubt we will see
other corporate scandals. Sadly, although the vast
majority of corporate America is not corrupt, the stench
from Arthur Andersen, WorldCom, and Enron is likely to
linger and hurt investment and further weaken the
dollar. For Japan this raises tough issues on the pace
and scope of reform, the heavy dependence on export
growth as the sole pillar for economic recovery, and
ultimately the fate of the Koizumi government. The rest
of the year will be interesting indeed.
Dr
Scott B MacDonald is the director of research for
Aladdin Capital and co-author of a forthcoming book,
Carnival on Wall Street: Global Capital Markets in the
1990s (John Wiley & Sons).
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