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Global financial crisis may hit hardest outside U.S.

By David J. Lynch, USA TODAY

It's a measure of the global economy's current frailty that the prospect of a financial meltdown in nuclear-armed Pakistan is almost getting lost amid an ever-lengthening list of countries in trouble.

In Europe, Hungary and Ukraine require multibillion-dollar International Monetary Fund rescues while Standard & Poor's lowers neighbor Romania's credit rating to junk status. Argentina's government is trying to close a financial gap by putting private pension funds under government control. And Asian nations with unsustainable finances such as Vietnam and the Philippines are braced for harder times.

Like tremors before an earthquake, these financial ills hint at the tangible economic toll to come in lost jobs, income and factory orders. "What has not even started is the effect on the real economy. … The situation is going to get very, very dire," says Marino Valensise, chief investment officer for Baring Asset Management in London.

If the first wave of the financial crisis hit the United States hardest, the second blow seems set to punish foreign lands. Global pain now is spreading from the United Kingdom, where the economy already is shrinking, through Middle Eastern oil producers pinched by crude's price plunge, to Japan where the government said Tuesday that September's retail sales were lower than a year ago.

Suddenly, after six consecutive years of expansion, the world economy appears to rest on quicksand. Signs of economic wobbling are evident in Germany, where automaker Daimler said Monday it is shuttering 14 plants for a month because of evaporating demand. Even China's growth is slowing sharply, from nearly 12% in mid-2007 to 7.9% or less next year, according to Standard Chartered Bank.

The potential consequences of economic turmoil are especially worrisome in Pakistan, where the economy is in a "state of crisis," according to the Economist Intelligence Unit. Soaring food and oil prices coupled with runaway spending have made a mess of the government budget. Inflation is expected to top 15% next year, and the IMF is in talks with Pakistani officials about emergency financing.

"Every day that passes, things get worse. … The economy is in a downspin," said Zubair Iqbal, a retired IMF economist now at the Middle East Institute in Washington, D.C.

Pakistan in recent years attracted ample foreign investment and registered strong economic growth. But its economic heft remains modest. The South Asian nation's global significance is geopolitical: Pakistan is a sometimes-uncertain U.S. ally against Islamic extremists based in the country's tribal regions along the Afghanistan border.

Selig Harrison, an expert on the region at the Center for International Policy, says further economic deterioration would exacerbate ethnic tensions and undermine already fragile support for the country's new civilian government. "From a U.S. point of view, the political fallout from an economic collapse would be very, very dangerous," he said.

Despite Pakistan's daunting economic and security challenges, Iqbal is optimistic that a poverty-driven surge in extremism and instability can be avoided. So far in this crisis, however, it's the pessimists who have been proved right time and again.

IMF has a gloomy outlook

In April, for example, the IMF was criticized as unduly negative for an economic forecast that said the global economy would grow about 3.7% next year. This month, the organization issued a revised forecast that was even gloomier. Now, the IMF says the world economy will expand just 3% next year, its slowest pace since 2002 and right on the edge of what the world body considers a global recession. Other forecasters, such as Morgan Stanley's economists, say that recession already has begun.

A true global recession would be certain to hit commodity producers in the developing world especially hard. In the 1980-82 downdraft, non-fuel commodity prices fell almost 57%, says Vincent Truglia, managing director for research at NewOak Capital in New York. That's bad news for countries from Kenya to Argentina.

Oil producers with large populations — such as Iran, Venezuela and Russia — also face difficulties. In Russia, authorities are burning through financial reserves in a desperate bid to prop up the ruble. S&P last week lowered its outlook on Russian government credit to "negative," reflecting the danger of a downgrade prompted by the rising cost of Moscow's financial bailout. Russia has committed 15% of gross domestic product to recapitalize its financial sector, S&P said. But the ratings agency said it expects corporate defaults to increase as economic growth slows to less than 3% next year. And it expressed concern that the state's increasing hold on the economy might not be temporary.

Some investors remain sanguine. John Connor, portfolio manager for the Third Millennium Russia fund, says Russian consumers are relatively unencumbered by debt, so robust retail spending should keep the economy afloat. "I don't see any long-term problem. … It's a panic."

Countries worldwide share the pain

After the Sept. 15 Lehman Bros. bankruptcy intensified the credit crunch, some foreign officials seemed to delight in the USA's plight. Awash in debt and laid low by a Wall Street culture of heedless risk-taking, the U.S. had gotten what it deserved: "The U.S. will lose its status as the superpower of the global financial system. …Wall Street will never be what it was," German Finance Minister Peer Steinbrueck crowed in September.

Amid today's deepening gloom, that sense of schadenfreude— taking pleasure in others' misfortune — is long gone. Now everyone realizes they are in this global mess together. Reflecting that shared fate, Asian and European leaders gathered Saturday in Beijing to brainstorm ahead of a Nov. 15 international financial summit in Washington, D.C.

Likewise, G-7 finance ministers met in Tokyo as currency markets issued the latest signals of something gone terribly awry in the globe's financial mechanism. As hedge funds and other institutions cash out profitable stakes in developing countries, they are shifting to the relative safety of the U.S. dollar. It closed Wednesday at $1.28 against the euro, up 18% since the end of July. Morgan Stanley now likens the troubled U.S. economy to "the best house in a bad neighborhood."

Still, the soaring yen is the immediate focus of international concern. The Japanese currency is appreciating as investors hasten to unwind so-called carry trades — borrowing one currency at low interest rates to lend in a second country at much higher rates. It's a profitable trade, so long as the first currency doesn't unexpectedly appreciate, which is what is happening to the yen.

The yen Monday reached 93.93 to the dollar, its strongest in 13 years, before settling Wednesday at 97.38. The stronger yen is a critical blow to Japan, hammering its exporters by making their goods more expensive for Americans and Europeans; the past two years, net exports contributed more than half the economy's growth. "We are concerned about the recent excessive volatility in the exchange rate of the yen and its possible adverse implications for economic and financial stability," the G-7 finance ministers said Monday, hinting at intervention to stem the yen's increasing strength.

Other financial weaknesses being exposed

The financial crisis may have begun with subprime mortgage loans in the United States. But it's now exposing financial vulnerabilities that have little to do with mortgages or the United States.

Chief among them: Eastern Europe's financial problems. Hungary, for example, has seen its currency, the forint, sag almost 50% against the dollar since July. Even a sudden 3-percentage-point increase in interest rates this week failed to arrest the decline. To stave off a potential default on Hungary's foreign debt, the IMF on Wednesday announced an extraordinary $25 billion loan package for the country. The rescue also includes funds from the European Union and World Bank.

That follows word of a $16.5 billion IMF credit line for Ukraine and $2 billion for Iceland, the first developed nation to seek such assistance since 1976. IMF funding is aimed at getting those economies back on a sustainable path. But even though the loans likely won't include the onerous requirements IMF aid carried in earlier crises, they will certainly lead to painful belt-tightening in the short term. Example: Iceland on Tuesday boosted its interest rates by 6 percentage points to 18%.

The IMF's resurgent role in backstopping troubled economies may be set to expand. Stephen Jen, Morgan Stanley currency strategist, predicted in a client note on Sunday that "the list of (emerging market) economies receiving assistance from the IMF will eventually grow to more than a dozen."

Hungary's financial malady — a dependence on foreign lenders that no longer are interested in making loans — is mirrored by other countries in the region, including Bulgaria, Romania, Turkey, Latvia, Estonia and Lithuania. Those economies, by themselves, aren't enormous. Every nine days, the U.S. produces goods and services equal to the total annual output of Hungary, Bulgaria and Romania. But the danger is that if these countries defaulted on their debts, major European banks would be caught in the downdraft, further imperiling already shaky credit channels.

Of Eastern Europe's $1.6 trillion in foreign bank debt, $1.5 trillion was borrowed from European banks, according to Morgan Stanley Research. Overall, European and U.K. banks have five times as much exposure to emerging markets as U.S. banks. Loans to these fast-developing countries equal 21% of European gross domestic product vs. just 4% of U.S. output.

Globalization undergoes transformation

The remarkable recent volatility in currency markets is a function of two broad transformations remaking both the global economy and global finance. First, institutions are undergoing a painful "deleveraging," or debt-repayment. That's causing mutual funds, hedge funds and banks to sell assets where they can to make up for losses elsewhere. The net result is to drive down the prices of most assets in most markets.

At the same time, a model of globalization that depended upon the U.S. as the consumer of last resort has broken down. American households have lost an estimated $5 trillion in wealth from the housing market collapse, which will cut annual consumption by more than $400 billion, according to the Center for Economic and Policy Research.

That means foreign factories can expect to sell significantly fewer toys, clothes and electronics to U.S. consumers.

Over time, countries such as China or South Korea could reorient their economies to rely more upon domestic consumption. But that transformation, once expected to occur over several years, now needs to happen immediately to replace vanishing export orders.

"The export model that's so dominant in the emerging markets is at risk. That's the vulnerability in the international system. …We're seeing an end to that model of globalization," says David Smick, a global financial strategist based in Washington, D.C.

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