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& EST. 1995 N A IN M SaratogaRIM

V T E N ST ME

2018 Quarterly Report, October 5, 2018

Q3

Unintended Outcomes

Source: FactSet (Sept. 30), Federal Reserve, Market Statistics * Spot prices (Sept. 30)

Stocks Yields (%) Commodities

DJIA 26,458.31 Fed Funds 2.25 US Tr. 3-Y 2.88 Baltic Dry Index 1,540

P/E ratio 21.89 Disc. Rate 2.75 US Tr. 5-Y 2.95 Gold ($/oz) 1,191.50

S&P 500 2,913.98 Libor 1-Mo 2.26 US Tr. 10-Y 3.05 Silver ($/oz) 14.31

P/E ratio 20.16 US Tr. 1-Y 2.58 US Tr. 30-Y 3.20 Crude ($/bbl)* 73.25 (NYM Light Sweet Crude) Fig. 1: SaratogaRIM Large Cap Quality & Focus Over the 12 months that ended September 30th, vs. S&P 500 TR 9/30/17 - 9/30/18 net of fees, the SaratogaRIM Large Cap Quality composite generated a total return of 14.03% and 30.00 our Focus composite earned 22.06%. Over the SaratogaRIM Large Cap Quality same period, the S&P 500 Total Return generat- ed 17.91%, the Russell 1000 Growth rose SaratogaRIM Focus 26.30%, the Russell 1000 Value was up 9.45% 25.00 and the MSCI World Index returned 11.24%. Per- S&P 500 TR formance was consistent with what we would ex- 22.74 pect at this point in the economic and market cy- cles. The SEC requires that we remind you past 20.00 performance is no guarantee of future returns 17.91 (see full disclosures at the end of this report).

15.00 14.65

10.00 Trailing 12-Month Gross Performance (%) Performance Gross 12-Month Trailing

5.00

-- EST. 1995

Past performance is no guarantee of future returns. All returns presented gross of (before) fees. This chart is supplemental and comprises daily return esti- mates calculated by FactSet utilizing month-end holdings data and may differ from actual daily performance. See full disclosures at the end of this report.

Contents Page

Letter to Investors…………………………………………………….…………………………..…..……….……. 1 Darwinism in Reverse - The growing menace of zombie companies…………………………………………. 3 Red Tide - Chinese zombies have proliferated at an alarming rate……………………………….….……….. 4 SaratogaRIM Composite Overviews……………………………………………………………………………… 8 Disclosures……………………………………………………………………………………………..….……….... 10

Letter to Investors

hink in terms of ranges. That, in a nutshell, is Fig. 2: % of Zombies in the S&P 1500 T what I emphasize when our investment team discusses the all-important topic of valuation 16% analysis. Given an uncertain future, it’s essential to think about valuation across a spectrum of po- 14% tential outcomes. Our scenario analysis seeks to apply a mental process where alternative future 12% returns are probability weighted and evaluated 10% within a range of potentialities. Thinking this way puts us in a better position to judge the adequacy 8% of margins of safety and to incorporate potentially asymmetrical exposures to risk and reward into 6% our decision making process. 4%

Last quarter, Marc Crosby examined a scenario 2% that all long-term investors should consider as they ponder the future. If global interest rates nor- 0% malize over the next few years – IF being the crit- ical component here – then the discount rates 6/30/2009 6/30/2000 6/30/2015 6/30/2006 6/30/2018 6/29/2012 6/30/2003 12/31/2013 12/31/2010 12/31/2004 12/31/2007 now being applied (both on and beyond Wall 12/31/2001 12/30/2016 Street) to price risky assets are way too low. Source: SaratogaRIM. See full disclosures at the end of this report. WHEN (not if) gravity reasserts itself, investors will have no choice but to reprice risk as discount rates rise and present-value calculations fall, tak- stability and fragility. Minsky’s famed observation ing asset prices down with them. It’s simple math that “stability breeds instability” is but a taste of with predictable consequences. his theoretical framework. Minsky was posthu- mously immortalized when PIMCO economist In the essay that follows, George Wehrfritz delves Paul McCully coined the phrase “Minsky moment” deep into another dark scenario worth pondering: in his analysis of the asset price implosion during the non-trivial probability of a globalized corpo- the fast-evolving Russian financial crisis of 1998. rate zombie apocalypse. George first examined the rise of zombie companies in his January 2002 A Minsky moment is the point in a credit or busi- Newsweek cover story on the slow collapse of ness cycle when asset values suddenly collapse Japan’s largest retailer (the article can be found under their own weight. Minsky theorized that immediately following the digital version of this long periods of prosperity and increasing valua- report). tions foster speculation and the piling on of bor-

Of the many unintended outcomes created by rowed money – which is to say that stability leads radical central bank policies enacted in response to corporate and investor risk-taking and, ulti- to the 2007-09 financial crisis, ballooning corpo- mately, systemic instability. Minsky’s work was rate debt has become an important potential discovered anew when financial markets shud- breaking point to watch. As Figure 2 illustrates, dered in 2007 then completely froze up in 2008 the number of companies now unable to earn as the financial crisis unfolded. enough to sustain even the interest payments on their debt is astounding. Minsky describes a credit cycle which starts from a point of stability and equilibrium which he dubs

“hedge finance.” In such an environment compa- Perhaps the most interesting angle on this is nies can borrow and invest with the expectation found in the teachings of American economist of covering both interest and principal out of cash Hyman Philip Minsky, who died in relative obscu- flows generated by the new investment. As the rity back in 1996. His research focused on the cycle moves forward into what Minsky terms causes and characteristics of financial crises – “speculative finance,” confidence and optimism which he attributed to cyclical swings between drive market prices higher. In this phase, higher

Saratoga Research & Investment Management 2018 Q3 Report - 1 Fig. 3: Minsky Moment Cycle radical policies – zero or even negative interest rates, gargantuan corporate bailouts and outright money printing through Quantitative Easing, all intended to stop Minsky’s cycle in its tracks. Minksy Moment And stop it did. By suppressing interest rates and flooding the world with liquidity, leading central

Ponzi Finance banks drove asset prices higher and prevented the liquidation phase that should have occurred CREDIT at the end of the last cycle – supercharging the SpecuůĂƟve Finance proliferation of zombie corporations portrayed in GDP Figure 2.

Hedge Finance How this all ends is a timely question. Following in the Fed’s footsteps, Europe’s Quantitative Eas- ing program appears set to begin winding down. One by one, as the world’s central banks seek to

Time revert to more normalized monetary policies, the conditions that have enabled zombies to persist

Source: SaratogaRIM. See full disclosures at the end of this report. will cease to exist. As that happens, we will learn whether a Minsky-style liquidation was truly avoided or simply delayed for a decade. prices reduce expected returns from the new in- vestment to the point where only interest can be For those who find thinking about volatile scenari- serviced from income but returns are insufficient os disturbing, welcome to our world. Neverthe- to repay principal. In the final phase, dubbed less, we understand that the future is not written, “Ponzi finance,” cash flows can’t even meet inter- and note that even today the so-called Goldilocks est obligations and are clearly inadequate to pay scenario – in which the economy plugs ahead off the debt taken on to acquire them. “Zombie neither too hot nor too cold – surely has more ad- finance,” a term coined in Japan in the 1990s, herents than those Marc and George have articu- refers to treadmill lending that enables deeply in- lated. While we will only experience one future, debted companies to forestall insolvency by ser- it’s still important to understand that there are vicing old debts with new loans. many different paths it could take. What Marc and George describe are just that: potential pathways. As losses proliferate, lenders retrench and call in They are scenarios we think about and seek to their loans. At this point a cash crunch occurs be- cause borrowers shift from complacency to panic work into our bottom-up, company-by-company and seek to avoid insolvency by liquidating as- analysis. sets. Graphically, Minsky moments resemble the instant when Wile E. Coyote dashes off a preci- Ending on a positive note, the types of environ- pice, looks down and sees nothing below him but ments that tend to get tagged with Minsky’s name air; with similar suddenness, in Minsky’s model, have also proven to be the most fertile buying op- liquidity dries up and the Ponzi phase collapses. portunities for long-term, value-oriented investors When that happens, the over-leveraged are – provided they have access to liquidity. We do, forced to sell even their least-speculative posi- and we’re always ready. Come what may. tions to make good on their loans. Respectfully, That was precisely the environment former Fed- eral Reserve Chairman Ben Bernanke, Treasury Secretary Hank Paulson and their global brother- hood of financial policymakers faced at the height of the financial crisis a decade ago. Their collec- Kevin Tanner tive response was a hodgepodge of untested and Chairman, CEO & Chief Investment Officer

Saratoga Research & Investment Management 2018 Q3 Report - 2 Darwinism in Reverse The growing menace of zombie companies By George Wehrfritz

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6DUDWRJD5HVHDUFK ,QYHVWPHQW0DQDJHPHQW 45HSRUW stage for future growth. Too often, though, gov- The Edge of Lawful Power ernments seek to manipulate this process with countercyclical monetary and fiscal schemes Most researchers concur that zombies owe their crafted to prevent recessions – undeterred by very existence to central banks. Handmaidens to strong evidence that the cure is worse than the this zombie creation: political leaders unwilling to illness. refuse corporate handouts or restrain government spending. Monetary easing and fiscal largesse Indeed, zombies are born of efforts to subvert the blunt recessions and counteract business cycles very capitalist forces Smith extolls. For example, so that too few companies fail. By preventing bad Japan’s post-WWII system of “convoy capitalism” firms from dying, interventions also forestall new, preserved laggard companies (particularly small dynamic businesses rising. banks) via protection or even rescue from bigger ships in the national ‘flotilla’ on the logic that no Keynesian-style deficit spending dates back to company was too compromised not to founder. the 1930s. Yet a major shift in scale occurred be- Over time, misguided collectivism stalled Japan’s ginning 2007, when the Federal Reserve coordi- entire financial system; innovation in all but a few nated efforts with the Department of Treasury to key industries slowed to the pace of a rusty ring-fence the subprime mortgage crisis before it barge, incapable of dynamism or reform. hobbled the entire U.S. economy. The problem: Investment banks and non-bank financial institu- To define our terms, a zombie is a business that tions had larded billions of complex mortgage- can’t pay the interest on its debts as determined backed securities onto their books and, to mini- the ratio EBIT/Interest Expense slipping below mize reserve requirements, categorized them as 1.0 for an extended period. As money-losers, investment-grade assets based on the self- these companies lurch forward in pursuit of the serving thesis that a synchronized decline in real next friendly loan, junk bond sale or public estate values could never happen. handout to feed their cash hunger. Per the OECD, zombies display “a declining ability or in- It all went wrong once key banks recognized the centives … to adopt best practices” and hog re- true nature of the messes hidden on their books, sources better deployed elsewhere, which has all and to suspect (rightly) that counterparties held -but halted productivity gains in some industries. similar junk in the shadows. Soon, everybody Suppressed dynamism lowers business startup stopped lending to everybody else as a system rates, weakens job creation and reduces worker increasingly underpinned by securitization and mobility, all the while raising the “survival proba- derivatives froze like an engine suddenly denied bility of marginal firms.” In other words, zombies oil. “Simply stated,” former Fed Chairman Paul beget more zombies. Volcker explained during a speech to The Eco- nomic Club of New York in April 2008, “the bright new financial system – for all its talented partici- Fig. 4: Research Note

RED TIDE: Chinese zombies have proliferated at an alarming rate

Even the world’s fastest-growing major economy is not without its own class of profitless serial borrowers. In point of fact – albeit, one obscured by the glitz and din of pell-mell modernization – China’s zombie problem rivals Japan’s in the 1990s. The differences tell the story. Whereas Japan’s debt woes rose from corporate group-think and bank-led re- sistance to bankruptcies, China’s is born of the still-vast state-owned economy – the key pillar of “socialism with Chinese characteristics.” Strongman Xi Jinping is merely the latest leader to sustain the critical role state-owned enterprises (SOEs) play in maintaining social stability through job-creation and provision of services that often still include medical care and housing. SOEs also facilitate Beijing’s long-range industrial policies (as with high tech manufacturing, which China aims to dominate by 2025). “The real advantage of China’s system of state ownership isn’t that the cleanup is easier than in market economies,” argues Dinny McMahon, who spent a decade as a finan- cial journalist in China. “It’s that the cleanup is easier to put off.”

The surfeit of loss-making companies is as old as China’s economic reforms; Beijing maintains it is under control. Yet even though talk of competitiveness reforms date back a decade, SOEs are increasingly leveraged and thus reliant on cheap money. And that is dangerous in an era of rising interest rates initiated by the U.S. Federal Re- serve last year due to the yuan’s soft peg to the dollar, which could add “enormous pressure” on indebted Chinese firms, Bloomberg warned in mid-August. The International Monetary Fund’s most conservative estimates of zombie

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$ $ 3 Yr Ann Standard Dev Gross Net S&P 500 Median Standard Quality S&P 500 Number of % Non- Fee End of Period Pct of Firm Number of End of Period Year TWR TWR Total Return TWR Deviation Composite Total Return Portfolios Paying Accts Total Assets Assets Firm Portfolios* Total Firm Assets 2000 (2/29) 32.49 31.45 -2.45 n/a n/a - - 48 0.0% 14,909,737.56 55.76 62 26,739,561.04 2001 -1.62 -2.56 -11.93 -1.65 3.58 - - 64 0.0% 30,514,640.98 82.74 72 36,880,627.71 2002 -9.37 -10.17 -22.06 -11.06 3.01 - - 89 0.0% 34,000,857.47 86.67 102 39,231,009.50 2003 18.24 17.18 28.68 16.69 2.44 - - 96 0.0% 42,848,809.47 81.77 120 52,403,457.10 2004 1.58 0.66 10.88 -0.29 2.96 - - 103 0.2% 47,681,947.54 82.16 129 58,032,372.36 2005 7.11 6.13 4.91 5.54 2.39 - - 105 0.2% 50,517,691.96 82.30 130 61,384,012.72 2006 16.94 15.87 15.80 14.48 2.82 - - 99 0.2% 56,390,733.75 76.99 127 73,239,570.68 2007 12.06 11.02 5.49 10.29 3.31 - - 99 0.2% 61,759,766.08 77.97 130 79,206,822.92 2008 -11.91 -12.74 -37.00 -12.32 4.20 - - 126 0.5% 63,833,081.54 78.86 162 80,940,276.85 2009 24.77 23.65 26.46 23.89 2.18 - - 259 0.4% 149,451,161.47 81.46 300 183,475,713.20 2010 14.27 13.43 15.06 13.89 0.76 - - 494 0.3% 308,594,397.72 72.87 544 423,498,666.41 2011 4.31 3.69 2.11 3.27 0.53 11.86 18.71 1,176 0.4% 675,644,949.35 89.07 1,306 758,587,627.80 2012 9.93 9.30 16.00 9.33 0.61 9.98 15.09 1,539 0.4% 952,297,851.47 91.19 1,689 1,044,258,285.00 2013 21.65 20.98 32.39 21.10 1.63 7.85 11.94 1,823 0.3% 1,260,548,699.31 89.81 2,033 1,403,561,317.89 2014 10.58 9.98 13.69 10.37 0.94 6.30 8.97 1,912 0.7% 1,338,762,813.12 82.94 2,163 1,614,090,178.92 2015 1.77 1.22 1.38 1.07 1.00 6.96 10.47 1,989 1.6% 1,268,091,067.90 77.41 2,298 1,638,083,262.30 2016 6.94 6.36 11.96 6.32 0.89 6.48 10.59 2,194 1.8% 1,329,975,377.78 73.85 2,573 1,800,854,794.70 2017 17.71 17.08 21.83 16.93 1.52 6.15 9.92 2,380 2.0% 1,481,470,247.11 70.11 2,887 2,113,099,369.12 09/30/18 7.71 7.28 10.56 n/a n/a 5.55 9.05 2,463 2.2% 1,520,318,995.78 68.98 3,043 2,204,116,438.99

3 Yr Ann Standard Dev Gross Net S&P 500 Median Standard Focus S&P 500 Number of % Non- Fee End of Period Pct of Firm Number of End of Period Year TWR TWR Total Return TWR Deviation Composite Total Return Portfolios Paying Accts Total Assets Assets Firm Portfolios* Total Firm Assets 2014 (8/31) 6.95 6.71 3.46 n/a n/a - - 31 0.0% 59,408,640.33 3.68 2,163 1,614,090,178.92 2015 2.84 2.28 1.38 2.70 0.25 - - 88 0.0% 122,809,323.37 7.50 2,298 1,638,083,262.30 2016 11.93 11.33 11.96 11.18 0.63 - - 151 0.0% 198,406,978.21 11.02 2,573 1,800,854,794.70 2017 28.21 27.49 21.83 27.49 0.55 8.70 9.92 287 0.1% 362,440,319.53 17.15 2,887 2,113,099,369.12 09/30/18 11.82 11.35 10.56 n/a n/a 8.78 9.05 362 0.2% 416,401,575.40 18.89 3,043 2,204,116,438.99  Disclosures 6DUDWRJD5HVHDUFK ,QYHVWPHQW0DQDJHPHQWIRXQGHGLQLVD6(&5HJLVWHUHG,QYHVWPHQW$GYLVRUVSHFLDOL]LQJLQ FRQVWUXFWLQJDQGPDQDJLQJHTXLW\SRUWIROLRVFRPSRVHGRIKLJKFDOLEHUEXVLQHVVHVXWLOL]LQJFRPPRQVHQVHLQYHVWPHQW SULQFLSOHVIRULQGLYLGXDODQGLQVWLWXWLRQDOLQYHVWRUV3ULRUWR0DUFK6DUDWRJD5HVHDUFK ,QYHVWPHQW0DQDJH PHQWZDVNQRZQDV7DQQHU $VVRFLDWHV$VVHW0DQDJHPHQW  7KHRSLQLRQVKHUHLQDUHWKRVHRI6DUDWRJD5HVHDUFK ,QYHVWPHQW0DQDJHPHQW DOVRUHIHUUHGWRZLWKLQWKLVGRFXPHQW DV³6DUDWRJD5,0´DQG³WKH)LUP´ 7KHFRQWHQWVRIWKLVUHSRUWDUHRQO\DSRUWLRQRIWKHRULJLQDOPDWHULDODQGUHVHDUFKDQG VKRXOGQRWEHUHOLHGXSRQLQPDNLQJLQYHVWPHQWGHFLVLRQV7KH)LUP¶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Š DQGKDVSUHVHQWHGWKLVUHSRUWLQFRPSOLDQFHZLWKWKH*,36VWDQGDUGV6DUDWRJD5,0KDVEHHQLQGH SHQGHQWO\YHULILHGIRUWKHSHULRGRI0DUFKWKURXJK'HFHPEHU9HULILFDWLRQDVVHVVHVZKHWKHU  WKH ILUPKDVFRPSOLHGZLWKDOOWKHFRPSRVLWHFRQVWUXFWLRQUHTXLUHPHQWVRIWKH*,36VWDQGDUGVRQDILUPZLGHEDVLVDQG   WKHILUP¶VSROLFLHVDQGSURFHGXUHVDUHGHVLJQHGWRFDOFXODWHDQGSUHVHQWSHUIRUPDQFHLQFRPSOLDQFHZLWKWKH*,36 VWDQGDUGV9HULILFDWLRQGRHVQRWHQVXUHWKHDFFXUDF\RIDQ\VSHFLILFFRPSRVLWHSUHVHQWDWLRQ  6DUDWRJD5,0/DUJH&DS4XDOLW\)RFXV&RPSRVLWH6DUDWRJD5,0FODLPVFRPSOLDQFHZLWKWKH*OREDO,QYHVWPHQW3HUIRU PDQFH6WDQGDUGV *,36Š DQGKDVSUHSDUHGDQGSUHVHQWHGWKLVUHSRUWLQFRPSOLDQFHZLWKWKH*,36VWDQGDUGV6DUD WRJD5,0KDVEHHQLQGHSHQGHQWO\YHULILHGIRUWKHSHULRGRI0DUFKWKURXJK'HFHPEHU9HULILFDWLRQDV VHVVHVZKHWKHU  WKHILUPKDVFRPSOLHGZLWKDOOWKHFRPSRVLWHFRQVWUXFWLRQUHTXLUHPHQWVRIWKH*,36VWDQGDUGVRQD ILUPZLGHEDVLVDQG  WKHILUP¶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an “It” Happen Again? 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cuss his ouster. "I'm from a generation that most to foreign buyers, in deals that revital- will be forced to forgive more than $ 10 billion believes that generals should not talk about ized South Korea. The problem, says of Daiei debt, a stagge1ing loss. "Even that is lost wars," he told NEWSWEEK. Portrait of a Crisis Chung Jae-Ryong, KAMCO chairman and no solution,"hesays, since Daiei would be left The casualty count is not yet complete. Japan's bad loans have grown to a size that CEO, is that ''.Japan is scared of going with barely enough money to "clean the en- According to Daiei spokeswoman Kikue dwarfs other countries' earlier debt crises. tlu·ough this, so they're pushing tl1e debt trances and toilets" at its faded retail stores. Inoue, top management had hoped to hold CRISIS llADDEBTSAS crisis forward to the next generation." At 81, Daiei's legendary founder is fight- COUNTRY PERIOD A%0FGDP on only to solid businesses and allow dis- Recent histo1y shows that restructuring ing to stave off an ignominious unraveling tressed operations to fail. It was the Japan 1990-2005 can work in Japan. The freshest example: of his empire. Though Nakauchi officially bankers, she says, who insisted that Daiei Argentina 1980-1982 Renault's successful turnaround of ailing retired in 2000, he still appears at critical be kept whole. "Logically it made sense to Israel 1977-1983 automaker Nissan, which under foreign junctures. Most recently, in October, he divide them," says Minorn Nakano of Mexico 1995 management has battled back from near lobbied banks to continue supporting the Teikoku Databank in Tokyo, "but the trou- through company after Moody's lowered its credit Sweden 1991 bankrnptcy cost-cutting and better ble ,vith Daiei is that the banks know that if design. Yet Nissan is an exception to the rating to junk status. In his autobiography, United States it goes under, they may go under too." 1984-1991 rule. Mergers and acquisitions remain both Nakauchi pledged to fo!Jow the path of a DOMESTIC PRIVATE· BAD DEBTS That's a real risk. Koizumi is trying to rare and 1isky. The main players are foreign mythological samurai from Kobe who was SECTOR LOANS GOOD ■ ]11 t rillions weed out the worst debtors without pro- DOMINATE BAD DEBTS DEBTS investment banks, which still get over- killed in battle but reborn seven times: 'TIJ -- -- voking a full-scale bank crisis. Last month TOTAL LOANS ¥698.4 whelmingly bad press in Japan for doing stay in active service as long as I live." the Parliament strengthened the Resolu- ¥1,048. 7 trillion their jobs. Ripplewood Holdings of New Daiei may not have long. Most analysts tion and Collection Corp., the agency (US $7.9 trillion) Jersey has been a whipping boy since it ac- believe Nakauchi's multibillion-dollar shop - PRIVATE SOURCES• ANAL YTlCA JAPAN, charged with cleaning up the loan debacle, BOJ ANO THE WORLD BANK ... SECTOR quired the failed Long-Term Credit Bank in is running out of loans and lives. The end, making it easier for the institution to buy 2000. In October the FSA scolded tl1e bank when and if it comes, would hit hardest in bad debt. Separately, the government has for doing exactly what all sma1t lenders do: the small towns that are the hea1tland of issued new mies intended to allow banks to now amounts to a whopping $19 trillion, or 44 denying credit to weak companies. Japan's domestic economy and the favored fix bad companies while preventing messy percent ofJapan's GDP. Officially,Japan's po- Can Koizumi transform this bad-debt cul- location of Daiei stores. "I don't tl1ink tl1ere disruptions for suppliers and employees. sition has been that foreign analysts were Shigeharu Shiraishi of SG Yamaichi Asset ed the economy. Their distress swallowed ture? Breaking up Daiei would send a strong is a single housewife in Japan who hasn't "Many reporters have asked me if these grossly exaggerating the problem, but that Management Co. in Tokyo. "Under these cir- bank reserves and froze many of Korea's message, and there are signs an endgame is bought a radish from Daiei," says biograph- rules were tailored for Daiei," says lawyer may be changing. Last week Daiei confirmed cumstances, it is vety difficult for Japan to es- prime assets. To revive the economy, Presi- near. In December Sentaku magazine rep01t- er Shinichi Sano. "When it collapses, all of Shinjiro Takagi, principal author of the that it is negotiating with its four main banks, cape the [bad loan] ctisis." dent Kim Dae Jung nationalized more than ed that "like rats fleeing a sinking ship, [ sup- the Japanese people will have to face the fact workout scheme. "They weren't, of course, meaning one of two things: another stopgap There is a clear example for Japanese 40 failed banks and empowered a special pliers] have begun to leave Daiei." Last week that we really must do something about this but sometimes I imagined it." rescue or Daiei's breakup. Investors, betting politicians to follow right neJ..t door in agency to shut down or sell off the heaviest Japan's financial pages b1immed with specu- economy." For all its prowess on tl1e global It will be impossible, however, to clean up that the company will survive, drn ve its share South Korea, which was forced to seek a debtors. The Korean Asset Management lation that Daiei might be forced to sell major stage, Japan can no longer afford to subsi- this mess without pain. Stephen Church of p1ice up more than 20 percent last week. "The humiliating IMF bailout in 1997. As in Company, or KAMCO, has since disposed assets, including its baseball team and stadi- dize incompetence at home. That's one bit- Analytica Financial fi gures bad corporatedebt banks can't just say no and cut off ties;' says Japan, family-run conglomerates dominat- of some $44 billion in distressed assets, um. One analyst told NEWSWEEK that banks ter lesson that can come none too soon. ■

ness. Just as Argentina clung huge companies that together is set to stop insuring bank de- Could rich Tokyo go the way of rioting Buenos Aires? to the untenable (the peso's owe enough to bring down posits larger than 10 million Well, not quite all the way. BY GEORGE WEHRFRITZ hard peg to the U.S. dollar), their banks. Despite its purely yen. Makin predicts "the in- Japan still hopes against all domestic nature,Japan's bad evitable outcome" will be the logic for an economic soft debts, by some estimates, now "the failure ofthe banking sys- landing. "Japan is stuck in a exceed 60 percent of the GDP, tem." He also warns that, as in place where there is no solu- compared to about 52 percent Latin America and Russia be- JAPAN AS ARGENTINA tion," says one constiuction- of GDP in Argentina. And fore, credit-ratings agencies T MAY SEEM OUTRAGEOUS bonds and yen. Such a rush for fore the recent devaluation. industry analyst in Tokyo. "We while Argentina's crisis has not won't raise a red flag about to compare the gathering the door, warns Takeshi Kimu- "This is the pattern often seen need a c1isis of control. We destabilized its neighbors, Japan because they're afraid to crisis in Japan to the chaos ra, head ofthe international when a developing nation's need the IMF to set policy. We Japan's larger debt bomb could hasten the coming crisis. of Mexico in the '80s or Ar- accounting firm KPMG in economy implodes;' Kimura needgaiatsu [foreign pres- prove much more dangerous. Nobody expects riots or gentinaI today. Japan is so Tokyo, could be enough to up- wrote in a recent KPMG sure] to reorganize our na- Researcher John Makin of bloodshed oftl1ekind that has much more modern, wealthy set the precarious equilibrium newsletter. tional economy." the American Enterp1ise Insti- engulfed Argentina in recent and, one would think, stable. in an economy burdened by Japan is no developing Japan and Argentina aren't tute predicted earlier this weeks. But capital flight, Yet serious analysts are start- massive debts. The money flow economy, to be sure. Yet it has clones-far from it. But reject- month that Japan will fail to Kimura's doomsdayscena1io, ing to draw just such compar- out ofJapan would accelerate assumed that ro]e oflate, ing their similarities out of disarm the bomb in time. could be mere months away. isons. Here's how the Third the weakening of the yen, in- threatening the global finan- hand-as the IMF's own No. 2 Tokyo, he forecasts, will dally IS TOKYO NEXT? Bank runs recently hit Buenos Aires The decisive factor: Prime ,,VorJd-crisis scena1io might creasing the cost ofimpo1ts cial system like a moody man in Asia did last week in until several major banks fail MinisterJunichiro Koizurni's play out in Japan. and reversing the deflation that emerging market. Its cmrency Toh.')'o, declaring: "I don't think abrnptly, forcing tl1e govern- As in Argentina, average dollar terms since September. ability to reformJapan's finan- It begins with foreign has ravaged Japan oflate. is unstable. Its banks are un- there is any compa1ison"- ment to spend up to $1 billion folks would be tl1e biggest If enough of them opt to shel- cial system and revive the hedge-fund managers losing The endgame could leave dercapitalized. Its neighbors blurs the big picture. Take bailing out the financial sys- losers in any crisis. Tradition- ter assets elsewhere, Tokyo world's second largest econo- what little confidence they Japan in new, perhaps even are nervous that what ails debt. Argentina crnmbled un- tem-enough to sink the yen ally strong savers, Japanese might look a lot like Buenos my. On Jan. 4 he pledged "to have left in Japan Inc. more dire straits. Exports Tokyo might jump borders. der massive foreign borrowing, and collapse Japan's bond households keep much of their Aires when locals began queu- use eYe1y available means to Spooked, say, by a downturn in would fall even faster, but with Japan and Argentina share an- whereas Japan, in contrast, re- market. ''.Japan's deflation and net wortl1 in yen-denominated ing outside banks to ,:vithdraw prevent a financial crisis." Japan's trade surplus, they rising prices at home-creating other trait, too, one that spells mains a huge international debt crisis," he argues, "now bank accounts. Depreciation all the money they could. That Should he fail, the damage might issue "sell" orders on bil- a condition of stagflation headaches for the Internation- creditor. Tokyo's debt woes constitute systemic risk to the already has cut the value of risk, albeit slight, will intensif), might prove Argentine in mag- l ions in Japanese stocks and roughly akin to Argentina's be- al Monetary Fund: stubborn- emanate from several dozen global economy." their savings by 10 percent in after March 31, tl1e day Japan nitude-or even worse. ■

40 NEWSWEEK JANUARY 21, 2002 NEWSWEEK JANUARY 2I, 2002 41