A storm in the markets

April 13 1987

A storm in the markets

April 13 1987

A storm in the markets


In the middle of the tumultuous week, with currency, credit and commercial markets in disarray, stock broker Bob Christopherson assessed the potential damage but looked on the bright side. During a buzz of telephone calls in his highrise office in downtown Toronto, the Wood Gundy Inc. account executive said that the decline of the American dollar could cut into the profit margins of Canadian exporters. The expansion of the U.S. money supply and debts could spur future inflation, he said. At the same time, he discounted the apparent inflationary danger of last week’s rise in U.S. interest rates and the answering plunge in corporate share values. “It was a high, jittery market looking for any excuse to come down,” said Christopherson. “I think it was overreaction.” By week’s end investors appeared to agree. Stock markets rallied to regain lost ground and rise to new heights, resuming the confident climb that began in January.

Still, despite the optimism displayed in the stock markets, a widening quarrel over world trade and currency exchange rates threatened to undermine the sustained if spotty economic expansion that has been under way in much of the industrial world during the past five years. Exerting heavy strains is Washington’s determination to reduce its burgeoning deficit in trade with the rest of the world—notably with Japan, but also with Canada and Western Europe. To accomplish its goal, the United States has been putting pressure on its main trading partners to expand purchases of American products and to curb exports to the United States.

Reinforcing that effort since the beginning of the year is a sharp decline in the exchange rate of the U.S. dollar which makes American goods cheaper to buy in foreign markets and foreign goods more expensive in the United States. Washington’s commercial allies protest that such actions will simply shift U.S. economic burdens—including the inflationary effects of a stubbornly high federal budget deficit— onto their economies, retarding growth and menacing everybody’s living standards.

The trigger for last week’s turmoil in the markets was Washington’s

March 27 announcement of punitive trade sanctions against Japan. Citing the flood of Japanese electronic microchips into U.S. and world markets as a breach of a 1986 Tokyo-Washington trade agreement, Washington announced plans to retaliate with 100per-cent import duties on a range of Japanese products from television sets to pocket calculators, effective on April 15. The action staggered Japanese government and industry officials

at a time of rising unemployment and a squeeze on export earnings generated by the yen’s rising exchange rate in relation to the U.S. dollar. Said Eishiro Saito, chairman of Japan’s Federation of Economic Organizations: “The Japanese economy is now in an extremely grave condition.”

Japan also came under increased pressure from Europe, where many members of the European Economic Community share Washington’s irritation over what they regard as unfair

Japanese limits on imports and foreign investment. In Britain, the government threatened to invoke a drastic legal provision to expel Japanese companies operating in Britain to retaliate against Japan’s restrictions against British companies. At the same time, British Chancellor of the Exchequer Nigel Lawson insisted: “We have no interest whatsoever in a trade war and there are no signs of a desire for protectionism in Britain.”

But the prospect of a global trade war disturbed financial markets early in the week. Investors and speculators reacted with alarm in dealings last Monday. Traders sold off U.S. dollars, driving the currency down to a record low exchange rate of less than 145 yen at one stage. That led some analysts to speculate that U.S. monetary authorities might react by raising interest rates in order to attract more foreign investment to support the dollar and offset the U.S. deficit in trade. Panicky dealers dumped corporate shares and bonds on markets around the world. Values plunged steeply. Then, on Tuesday, two New York banks—Citibank and Chase Manhattan —announced quarter-point increases in their prime lending rates to 7.75 per cent, the first increases since 1984. Other American banks soon followed suit. The dollar rose against the yen, but the rise of interest rates provoked more investor uncertainty in midweek.

At first, the action by the banks seemed to reinforce the speculation in financial markets that the cost of borrowing money, after declining for three years, was going up again. In theory at least, that would increase the cost of doing business and cut into corporate profits, making stocks less attractive and encouraging a shift of

investment funds into higher-yielding long-term bonds. That speculation generated more uncertainty in the stock markets.

But some dealers, including Wood Gundy’s Christopherson, discounted the rise in American prime rates as any portent of a general increase in the cost of credit. Said Christopherson: “The major move in interest rates is over—we are fooling around at the bottom of the market.” In Ottawa, the

Bank of Canada’s basic interest rate moved up only marginally, to 7.15 from 7.05 per cent, while Canadian chartered banks were trimming back consumer rates on credit cards. Amid the turmoil elsewhere, the Canadian dollar remained buoyant on exchange markets. Since the beginning of this year, the dollar has gained more than four cents to about 76.5 cents against its U.S. counterpart. Indeed, end-of-March statistics on Canada’s foreign exchange reserves disclosed that Ottawa has been intervening heavily in international currency markets to prevent the dollar’s value from rising too rapidly and making Canadian exports too expensive to foreign buyers.

By week’s end many analysts shared the view that the increase in American lending rates was simply an attempt by the U.S. banks to shore up their sagging earnings. Massive outstanding loans by Western banks to Brazil—and that nation’s decision in February to suspend interest payments on $90 billion of its foreign debt—are a drag on banking profits.

Indeed, last Thursday major U.S. banks and the Bank of Montreal unveiled measures that are designed to partly offset the negative impact of the Brazilian liabilities. At the same time, Brazil’s Finance Minister Dilson

Japan earned more than three times as much in U.S. sales as it spent on American imports—an imbalance that Washington wants to correct

Funaro announced that he would try to reduce the cost of carrying the foreign debt—a total of $140 billion, including $6.8 billion owed to Canadian banks—in negotiations this week with the creditor banks in the United States.

Funaro is attempting to work Brazil’s economy out of a nightmarish situation in which simply meeting interest payments on its foreign debt—the biggest in the developing world—has

siphoned off a substantial proportion of the country’s productive wealth. The cost of servicing the debt has drained $55.8 billion over the past five years from an economy that is generating a gross domestic product at an annual rate in excess of $200 billion.

But after buoyant growth last year, the Brazilian economy is slowing down and inflation is expected to reach a rate of 800 per cent this year. Now, in a five-year recovery plan, the finance minister aims to reorganize the foreign debt—including further borrowings of $26 billion in the five years—to reduce the rate of repayments and sustain economic growth at a powerful seven per cent annually.

Even as Funaro outlined his plan in Brazil’s Congress, major creditor banks in the United States announced measures to reclassify part of the Brazilian debts on their books in a way that reduces current profit statements but serves notice that the banks intend to collect overdue payments in the future. At the same time, the U.S. bank regulators reduced Brazil’s credit rating to “substandard” from “risk problem”—a signal that Funaro would have a difficult time trying to borrow more money.

The Bank of Montreal, with outstanding Brazilian loans of about $1.3 billion, took a more positive line. Bank chairman William Mulholland announced at a New York City press conference that he will seek to convert up to about $130 million of the debt into ownership shares in Brazilian enterprises. The plan to convert the debt into equity investments in Brazilian currency would reduce Brazil’s requirements for dollars to service the debt, but it would increase foreign ownership of Brazilian industry. The proposal requires approval from the Central Bank of Brazil. Mulholland suggested that his plan would help Brazil’s economy to grow, producing wealth that would help the country to meet its debt obligations. Said Mulholland: “If we do not take creative action to develop Brazil’s economic potential, then we are simply going to condemn ourselves to stay mired in the debt problem.”

The debt problem—in world trade and national budgets as well as in the major banks—is the chief challenge that faced the finance ministers of the seven leading industrial nations, known as the G-7 group, as they prepared to meet in Washington this week for the second time in just under two months. Underlying the problem facing the representatives of the United States, Japan, Britain, France, West Germany, Italy and Canada was the growing threat of a showdown over trade, notably between the United States and Japan. Said Britain’s Lawson: “The United States and Japan have a heavy responsibility to avoid a trade war.” □