Russell Napier On Lessons From The 1998 Crisis And Why Situation Is Not Dire

RUSSELL NAPIER: Well it's a period I hadn't revisited but I’d lived through it and I thought obviously having lived through it I knew all the lessons. I then began to write a much longer book looking at everything I'd written, but I’d find so much material in just the Asian economic crisis that I thought it was worth bringing it up again. Of course the crucial thing is, to me anyway, is this period was all about managed exchange rate regimes, and how they are really very different from floating exchange rate regimes, I mean for investors, I mean for equity investors, for bond investors, and I still feel that that lesson has not been learned; that people who particularly people who come from the west and go to India or China, kind of use the same analytical tools as they would if they were managing money in the U.S. I think that's the lesson of the Asian financial crisis that when a managed exchange rate is in place and India has, I mean you can see that by the rapid rise in its foreign exchange reserves that we need to think along different lines and different rules. So, in reading the material I thought, well actually we didn't learn these lessons from this particular episode, so this is a book, this is not a chapter. This is a whole book and the other thing it had lots of very good data in it on your bottom-up micro data on valuations. One of the things I find frustrating as a financial historian is when I'm reading financial history, there's no reference to the price to book ratios or the P/E ratios or whatever, and everybody who's watching this will know that price is what you pay, is what you get, to quote Mr. Buffett, so I thought it was important to focus on the shift in s during that period as well. So, that's why the book is written. The timing, because it's 25 years since I started writing, but the timing really is once again we're ignoring some of the lessons that apply, I think, in particular in managed exchange rate regimes.

RUSSELL NAPIER: Absolutely right and that's the question the Queen of England asked as well, but the last question is why did nobody see it coming? I mean, there's a long answer in that which is to do with incentives. If the incentives are long and if the incentives are too short term, it's very easy to ignore some very big warning signals so there's an issue of incentives which is not something I do particularly cover in the book. In terms of you'd like the fundamentals, it was really very easy people saw that the price earnings ratio was steadily going down so we had this great rise in markets up until the end of 1993 and the earnings continued to come through and the basic of the stock markets were going sideways. So, people were looking at the historical range of the price earnings ratio and they were saying well look they're getting cheaper and cheaper and cheaper, why wouldn't we want to buy these things that are getting cheaper and cheaper and cheaper? By the book that I was writing and this book was saying, look, this earnings that you're looking at a lot of which were coming in banking, a lot of which were coming in property, these are a product of a monetary and credit system which is entirely driven by the external accounts and currency management regimes and those earnings are entirely illusionary, they're not real earnings if this thing starts to go in the wrong direction and interest rates start to rise. So, one of the fundamental things is that people were looking at that it and it's really fascinating to look back because this obviously is the same time, when the internet boom is beginning, it's 1995 and Netflix was listed, which was the starting point for this and there was huge scepticism about that and that was supposed to be all nonsense and the internet was supposed to be just a joke. But you can see you can see Netflix trading on an infinite P/E, and you can see Asian stocks, maybe trading on 15 times when they'd been on 19 times, and that illusion of valuation was a key driver for this but that's really what the book is about, why that was an illusion in a managed exchange rate regime. So, absolutely I keep saying over and over again it’s normal isn't it, it is smart people who make stupid decisions. This book and my last book is looking at why smart people make stupid decisions, so beyond incentives that was the reason why people were. It was a valuation it turned out to be a great trap, it was probably the biggest trap of all time because people didn't understand how fragile the earnings actually were.

RUSSELL NAPIER: Yeah, a little bit, I mean I think you could’ve been more focused. Remember this was a period when Asia was running huge current account deficits, which had to be funded. That's not really where we are today. So there's a really strong fundamental improvement in this. You'll also know that foreign exchange reserves are so much bigger than they were then. But the one I want to focus on is really China more than India, and North Asia, in 1995-1998. So as this crisis began remember, it begins on the July 2, 1997. It rages really strongly but it has no impact in North Asia by which I would mean, particularly Taiwan and Korea until October. Now that may seem like a short period of time but when you're a market participant, that's a very long period of time and nobody realised what was going to happen in North Asia and for those who don't know the story, it's in the book, Korea is really bankrupt by Christmas of that year. So that's October to Christmas, I mean that's pretty dramatic stuff. But the reason that we didn't really worry about these things is these countries had current account surpluses and they had some of the biggest foreign exchange reserves in the world, and looking at them they looked almost like fortresses, but it turned out that the weakness was as follows. The local corporates were highly geared and also, there were enough foreigners in there that when their money was pulled out, they pushed interest rates higher. So, I can go through the mechanism if you like but if you want to defend your exchange rate at a time when capital is exiting, then, ultimately, it means tighter liquidity, but it turns out that the domestic corporates in particular were so fragile that as this foreign capital withdrew, even though they had current account surpluses, even though they had very large foreign exchange reserves the rise in interest rates was enough to create quite a lot of chaos and the authorities decided that that was just too much and they stepped away from their exchange rates. So, the great shock of the crisis was not the that Taiwan ded but because by the time it came, I think, on the bounce of probabilities most people expected it. It was that Korea and Taiwan were forced to follow suit so obviously I'm looking at that in a Chinese context and it looks like a fortress balance sheet in Japan or China. You've got your current account surplus you've got these huge reserves but ultimately if capital goes the wrong way, it starts putting interest rates up and that's the key question. Do the local authorities accept interest rates being dictated to them, or do they prefer moving to a more flexible exchange rate where they determine their own interest rates? So, I'm pointing the finger at China and saying this is not the Asian crisis, it's not that they're being forced to do this, but it could illustrate to the Chinese that they've opened their accounts wide enough that foreigners play a role in interest rate determination, and they may want to step away from that. Stepping away from that in the Chinese context means a more flexible exchange rate.

RUSSELL NAPIER: The repression, I think, when I try to explain it to anybody in the world what repression is it ultimately takes you to a kind of ‘Licence Raj’ situation, which everybody in India will be very familiar with, but funnily enough, you're more familiar with repression than the British or the Americans or the French because you’ve had to suffer it more recently. So, Indians intuitively grasp what that system is like, but we have to go back to why you would choose that policy. In my opinion and it may be wrong is that India will not choose it. The reason that you choose a policy of repression is because you've got far much debt relative to GDP, and you need to create a system where interest rates stay permanently lower than inflation and that may sound fairly innocuous but actually to get to that you inevitably end up with a sort of ‘Licence Raj’ situation. India doesn't have that much debt. I mean it's debt to GDP ratio it is one of the lower in the world, certainly way below in the developed world and even by emerging markets standards, it's fairly low. So, my first position would be this. Every developed world country has to do financial repression, but India doesn't and actually there are very few emerging markets apart from China, that do have to do financial repression. So, the question is if the West gets into financial repression, what is going to be the impact on India? That's the key thing, that's what we're really talking about. So, where I would be mistaken as if India itself goes through repression in which case I'd have to revise all my opinions but if it doesn't, and the West does, then I think what you obviously you're going to get higher inflation, that's just a fact. I mean if the whole developed world is generating inflation, it is inevitable that India will get that somewhat higher inflation and you have to live with higher inflation. My belief is if you don't believe in repression in India, interest rates are allowed to rise to reflect that higher—so that's not good for us in markets in the short term. That's a normal sort of cyclical situation where inflation is going up, and interest rates are going up but then we have this final caveat—in a world when interest rates are significantly and structurally negative in the West people will be very keen to put money into India even. When the first rule of a financial repression is get your money out of the country. Now, it's funny when I talk to developed world investors about that they say, well, where else could we put it, we can't put it in Germany, France, United Kingdom, America, and I say well what about India? They sort of laugh, and then you can see that light bulb going on above their head and they're thinking, well, wait a minute, it may not be the right answer but it's something worth investigating here. It won't be just India there will be other emerging markets as well who do not do repression, you should be attracting a fairly significant amount of capital. So, I know the reason why people are concerned about capital inflows into China because we might try and restrict those coming out of the developed world, but the market for us will be for money to flow from repressed regimes to non-repressed regimes and as long as policymakers in India step back and stay away from repression, I think India will continue to attract it. In fact, one of the problems may be attracting too much capital, at least for the first few years. So, that's a very long answer to a very simple question, but really one of the biggest questions we've all got to ask is, where will my money not be repressed and I say, India, not everybody agrees, most people watching this won’t either but they will make their own decisions. If India doesn't repress it could be actually a significant beneficiary of significant capital inflows.

RUSSELL NAPIER: I think they should, and therefore I think they will. I think it'll be in great contrast to what's happening so you've kind of hit the nail on the head here. Imagine the West that doesn't raise interest rates to tackle inflation but in India you would probably be attracting quite a lot of capital. So that is the very core of the call that there won't be financial repression that the Reserve Bank of India will react to inflation the way it did last year, two years ago, three years ago, four years and five years ago, where the developed world won't. So, it's quite a big call anybody who's watching this who has a different opinion will come to very different conclusions to me but in my opinion, no repression in India, which means the central bank has the relationship between interest rates and inflation that it's had for the last 10-15 years. That to me is a very positive thing for India and if it falls short of that, and besides that it's the West, some sort of central banking geniuses and they follow these mistakes, I think, if they follow the mistakes of the West, then all bets are off, but I have some degree of confidence the Reserve Bank of India will play its own course. This needs a great political backing of course as well because in the West, it'll look like it's a very smart thing to do and why wouldn't you want negative real interest rates but if with the right political backing, and the right central bank, I think India can tackle inflation that isn't good for us at markets in the short run. I think we all know that but look in the long run it's just wonderful because we realise that this is an outlier in global markets and a place where the rules that relate inflation to interest rates to asset prices, still run the way they used to run. So, there is pain associated with that in the short run but it's incredibly positive in the long run if politicians and central bankers have the guts in India to do it, then I think they have the ability to do it. The West doesn't have the ability to do it there's far too much debt so they're kind of being forced on that path but I think India has a choice, and it's a wonderful choice to have and I think can reap huge benefits for India in the long term.

RUSSELL NAPIER: I'm not unduly concerned about that and it depends where you start with on your debt to GDP ratio. If you are France, and you're on 374% of GDP, then you've got a problem there if you're still borrowing too much, or even if your economy is growing quite sharply but if you're an economy below 200% of GDP, which is where India is then growth can get out of that mess. This is the crucial thing, there are certain levels of debt to GDP or growth will get you out of it and of course we want that to happen as soon as possible, but the economies will rebound, extremely quickly, but you don't have to grow at 8 or 9-10% to shift your debt burden if the debt burden is relatively low. So, I think a nice example is Germany post the great financial crisis and after about three years the debt to GDP ratio began to decline but it wasn't running excessively high levels of nominal GDP growth, but it just happened to have that GDP ratio below 200. So I'm pretty confident that all of the emerging markets or nearly all the emerging markets with a debt to GDP ratio so low will have a level of nominal GDP growth, that means their debt to GDP ratios will start to come down. I'm not confident about that at all because the developed world started on much higher numbers so if we keep coming back to this debt to GDP ratio and there's much more flexibility for policy. Then the final thing is if the West is holding its interest rates really low, which I think it will be right across the yield curve, it does give emerging markets an opportunity to borrow at relatively cheap real rates, and you combine that with good growth and low debt to GDP ratios and emerging markets are in a really good position. I don't get concerned about fiscal deficit being too big, and that can change very quickly once we get to the other side of this dreadful disease.

RUSSELL NAPIER: Yes, I mean it's a separate discussion but it’s a very big discussion and as important if not more important on everything we've discussed so far which is what are the developed world's long-term relationships with China and those relationships have clearly soared, and we see that in so many ways, whether its relationship with Huawei, which is a foreign attack on the Chinese corporation, or Ant which is a Chinese attack on a Chinese corporation with pushing in the U.S. Congress to try and stop pension funds investing into China. So this is becoming a capital war, and it is becoming increasingly risky for any developed world investor to invest in China and in a capital war because you can get these tit for tat movements which means that the returns on your capital in China could be under attack. Even getting return off capital can be difficult but there's a risk associated with that which we simply don't associate with India. I mean we did associate that with India 40-50 years ago, but we don't associate it with India today. I think the contrast will be there and become clearer and clearer and nearly all other emerging markets will benefit from the fact that China is not getting as large a capital inflow. In portfolio assets, probably more importantly in foreign direct investment that foreign direct investment will have to look elsewhere, we'll have to look for shorter supply chains, we'll have to look for more robust supply chains. So, I think we talked earlier if you liked interest rate arbitrage money coming to India, people discontented with the level of rates relative inflation that Americans are looking to come to India. But there is another flow which you highlighted here, which could be FDI, as we begin to construct a world which is less reliant on China, I wouldn't like to forecast what percentage of that India will get, but the point is it will get some of it, and some of it is important for India. India has struggled for a long time, used to struggle and not be able to attract enough capital, so anything that adds to attracting enough—and perhaps, I still stick to the case that likely it's going to attract too much, but the changing China relationship, definitely plays into the ability of India to attract more capital.

RUSSELL NAPIER: We are talking about the whole globe now and the whole point about this book is divide the world into two bits, which is those bits affected by exchange rate management, and those that aren't. So, those that aren't that is the entire developed world, have got excessive credit cycles, and that's why it's got record high debt to GDP ratios, and the only way to deal with that is high inflation. So, that doesn't bring everything to a grinding halt, I mean this is not a collapse. As long as interest rates aren't allowed to rise to reflect the higher inflation, that is the plan, it is to move towards financial repression, that doesn't mean to say that equities go up forever. What it means is eventually you have to force savings institutions to hold this yield curve down and when you force the savings institutions that buys government debt, they sell equities and it comes down, but that's a very different mechanism from the traditional cyclical credit-credit growth and credit collapses. That's not what I think is going to happen in the West, and it's a much more long-term, insidious negative impact as you force savings institutions to sell equities and buy bonds. But to be clear, none of that necessarily has to happen in the emerging markets. I think it'll be seen as a good thing, interest rates will rise, credit will slow... it remains a pure system and that pure system continues to attract capital. So, it's not the kind of boom-bust scenario and repression is something very different from boom-bust. Boom-bust is usually two years, this repression that the West is getting is going to last 15 years, but it would take about 15 years to get debt to GDP to a low level. India may have to see sharply higher interest rates to contain inflation, that's a problem for a year-and-a-half to three years, but the structure of India remains in a much more attractive basis. So, the timeline here is very important, but it's not your classic boom-bust because actually repression has already stopped from there being a bust, because they realise the consequences of high interest rates in the West. So, it's a more difficult and insidious system and as I said, your viewers should think of the West slipping into a ‘License Raj’, rather than a 1929-1932 collapse. Actually, which one is worse? I don't know I think we have to ask your viewers which is worse because I'm not sure that one, the License Raj scenario isn't worse than the first one, it's a different opinion, it's not a bust. It's this new structure, which ultimately is probably worse for the economy.

RUSSELL NAPIER: But in terms of just looking for triggers I mean obviously the problem is, we've got the success of debt. Now you have to look for triggers, and one trigger would be a flexible Chinese exchange rate. I mean I've been saying it's going to happen for quite a long time, it hasn't happened yet and may not happen for two years it might happen in two months but when it happens, the Chinese will step away from their exchange rate, so they’ll have a truly genuine and a completely independent monetary policy. Then I think we all realise it's going to fall. Now, on that day, I think the markets will be incredibly terrified of deflation and of China wreaking havoc upon the world because one of the things about this book gives me a chance to wave it around, of course, so is that one of the great things laying behind the Asian financial crisis was the devaluation of the Chinese currency of 94 decimated. There's lots of ways I go in the book through how decimated the Asian financial markets took a while, but it happened, and anyway, that's one lesson from the Asian financial crisis. I think that people would instantly jump on. Oh, my goodness, the Chinese currency is falling, incredibly bad for emerging markets and I'm sure we would see a major slump in Indian equities and all emerging market equities. Now, in my opinion that will be a wonderful buying opportunity. This isn't going to bring deflation because China's too big an economy today it wouldn't be allowed to export all these cheap products and undermine Indian manufacturers, and ultimately, it's doing this to print more money and have higher a nominal GDP growth and higher inflation, anyway and then finally, it would really be the very clear start of a Cold War, where that capital realignment that we've already discussed would accelerate and wouldn't be flowing into China. So, the bad news is that the real trigger I think is that, and that would bring the markets down steeply, but I think that would be a wonderful buying opportunity. So, we can only talk about the known-unknowns, the unknown-unknowns obviously will forever be beyond us. But I would flag that one up as a potential important one, but otherwise I think, if I'm wrong in interest rates and they'll let interest rates in the West to find their own level that would be a shock. I mean if I think inflation is going to be four, where will the 10-year bond yield be? And if the 10-year bond yield was at that level, we'd have absolute chaos in financial markets, and most people who read textbooks would say well that has to happen if inflation is at four, interest rates have to be at five. I don't think it has to happen at all, but if it did happen if I was wrong on that and they let market rates find their own level, eventually it may take another year or so, then we'd have chaos there. I think that's the one that frightens most people is that interest rates reflect inflation, that would give us very high nominal rates on a crisis, but I do think that's very unlikely in the developed world.

RUSSELL NAPIER: We can look at the history of the cycles. Interest rates go up and the market just ignores it until it doesn't. So that's the thing, and really, it's only when the market starts to pay attention to it do the Feds work it. We like to focus on equity markets but you should really be looking at spreads on corporate bonds. When the Feds are notching those rates up, they'll be looking at the spread on corporate bonds and concluding that until the spread on corporate bonds start to widen, or until bank credit begins to slow dramatically that it actually isn't working. So, in my opinion, all you know is in the cycle. It is the early movements when the interest rates don't work. There are going to be more, and they do increasingly work through the transmission mechanism or financial markets, or the corporate bond markets and then obviously the equity market. So you can definitely have a period where, let's say inflation is rising faster than interest rates and the market really kind of ignores it but that tells you the Fed is failing. So back to the basics. I don't think that's what's going to happen, that will be your normal cycle where the Fed is always behind the ball and then suddenly it's ahead of it and the markets come down, that's your standard cycle. So, you can make money absolutely as interest rates go up, but in this occasion, I don't think rates will go up at all or let me rephrase that. Throughout this cycle inflation will be rising faster with interest rates and the Fed will never get ahead of it because it can't afford the damage that comes with it. So, it's going to be a huge structure of the way things work. But anybody who's just looking at an old traditional cycle you can see that, that would be the path, maybe a year or a year-and-a-half and then the Fed panics and suddenly gets shot up. I don't think that's what's going to happen.

RUSSELL NAPIER: That's a really great question because I think in my entire career, I've never seen the consensus more wrong. I would argue, and there's a very good reason for that. Nearly everybody in our industry now has been in the business school, and they've been in the marketplace since the late 1970s or in the case of India since 1991 market forces are wanting to play more of role, government forces play less of a role, and your entire background is analysing that situation. Our entire discussion is about how we don't live in that world anymore, at least in the developed world, but if that's the skill set you have you will insist on applying it even though the world has moved to a very different place, to me that's the problem. I would have said that most of the stories I read in the financial press are looking at a world that used to exist. A world where central bankers were independent, a world where inflation was crescent, a world where governments were stepping aside and markets were getting more important, and everything is still in that framework. There's a legacy of analysis which is still in our framework and we've left it behind and we've gone to a very different world which is this world of financial repression. So, in terms of anybody who's watching this, I would suggest to them really strongly that they read a lot about financial repression and Carmen Reinhart is the academic expert in that lots of her work is online but just generally, and then begin to think, if this is genuinely the system we're moving into all the stuff I'm talking about over here about central bankers and independence and interest rate is any of it relevant? Because the Fed has been an entirely irrelevant institution in its history. I mean, they would say that themselves. There have been periods in history when it's been entirely irrelevant, and yet they are the top five stories on Bloomberg every day, maybe not top five but you know what I mean. So I think that's the fundamental problem here, we're still trying to play by the old rules and the rules have changed and we need to re-educate ourselves... This time I'm saying the markets are wrong because it doesn't understand that we are an entirely different structure, so if I can quote from The Wizard Of Oz, “We're not in Kansas anymore”, but everyone's determined to pretend we're still in Kansas and we're not and we're in a different place. This shift in relationship between markets, government, and people, I think the potential beauty of this is that relationship in India hasn't changed very much. It really just hasn't changed very much, it has changed a little bit, but we've got literally a revolution in the relationship between those three factors on the way elsewhere and maybe a small shift in India. So that's where consensus is most wrong, it's just hasn't worked out, but this is a new system. So, this book will definitely help but also read on the internet about financial repression and think through for yourself whether all the questions people are asking the right questions. What I said about this book, and I also run a course in finances, we probably don't have the right answers, but we think we can find the right questions and so the answer to your last question is, I think people are asking the wrong questions. This book might help ask some of the right questions.