Connected Turmoil

Stephen DeAngelis

November 7, 2008

I’m a supporter of both globalization and connectivity. However, I’m not such a zealot that I see only their benefits and ignore their risks. The current financial crisis, which began with financial charlatans in the U.S. offering easy credit and liar loans to unqualified people, has swept around the globe and placed many economies in jeopardy. World leaders continue to scramble to stop the economic hemorrhaging and prevent a likely recession from developing into a full-blown depression. They would also like to ensure that progress made by emerging market countries is not reversed. As I wrote yesterday, credit for countries is just as important as is it for businesses and individuals and the West is trying to guarantee that developing countries continue to have access to credit [“West Is in Talks on Credit to Aid Poorer Nations,” by Mark Landler, New York Times, 24 October 2008].

“With the financial crisis engulfing developing countries from Latin America to Central Europe, raising the specter of market panic and even social unrest, Western officials are weighing coordinated action to try to stabilize these economies. The International Monetary Fund, which is in negotiations with several countries to provide emergency loans, is also working to arrange a huge credit line that would allow other countries desperate for foreign capital to borrow dollars, according to several officials. The list of countries under threat is growing by the day, and now includes such emerging-market stalwarts as Brazil, South Africa and Turkey. They have become collateral damage in a crisis that began in the American subprime housing market. The fast-growing economies of the developing world depend on money from Western banks to build factories, buy machinery and export goods to the United States and Europe. When those banks stop lending and the money dries up, as it has in recent weeks, investor confidence vanishes and the countries suddenly find themselves in crisis.”

Many Americans who are worried about their economic futures wonder why they should be concerned about someone else’s financial crisis half a world away. There are a number of reasons. It was the building boom in China that resurrected the slumping heavy machinery business in the United States. It has been consumers in emerging market countries who have helped ease America’s trade deficit over the past several months. Emerging market countries are the West’s best hope for reigniting a growing global economy and keeping them afloat so that they can continue to progress is critical.

“Details of the arrangement are still being worked out, but it could be supported by Japan and several oil-producing countries, a fund official said. The fund has not yet approached the Federal Reserve, according to officials, although the Treasury Department has expressed interest. Two weeks ago, the Fed set up unlimited swap agreements with the European Central Bank, the Bank of England and other central banks to ease the severe credit turmoil in Western Europe. This time, the focus would be on emerging markets, with good economic records, which are having trouble borrowing dollars. ‘There needs to be some action to help these countries,’ said Neil Dougall, chief economist for emerging markets at Dresdner Kleinwort in London. ‘There has been a severe drying up of liquidity there, and it is early days. The tsunami has only just reached their shores.’ The monetary fund has about $250 billion available for all types of loans. That could be supplemented by funds from central banks, officials said, though they dismissed a rumor that circled the globe on Thursday that the fund was arranging a $1 trillion credit line.”

The irony of the situation is that sub-prime credit crisis is affecting emerging market countries even though banks in those countries “bought few of the mortgage-related securities that undermined the financial system.” However, credit, like oil, is fungible. A credit crisis somewhere in the world affects credit everywhere.

“As banks stopped lending — either to each other or anyone else — that credit squeeze has hit emerging markets hard. Stock markets and currencies have plunged, foreign capital has fled, trade flows have slowed, and in an echo of past financial crises, investors have begun to worry about governments’ defaulting. Many have heavy debts in foreign currencies, but the cost of repaying that debt has increased as their home currencies’ values have declined. To compensate, they are seeking dollars to repay the loans.”

The list of “endangered countries” countries contains some surprising names, like Russia, Iceland, and, as I noted yesterday, Romania. Others on the list are not as surprising: Hungary, Ukraine, Pakistan, Turkey, South Africa, Argentina, Estonia, Latvia, Lithuania, and Bulgaria.

“The economic woes of these countries could reverberate back to the United States, experts say, because many of them are trading partners, at a time when exports are one of the few bright spots in the American economy. ‘Our whole economic prospects are going to turn on whether the emerging markets keep growing,’ said C. Fred Bergsten, the director of the Peterson Institute for International Economics. ‘It could be the difference between a moderate downturn and a deep downturn.'”

Landler explains that many companies (and some individuals, like those in Romania) became the victims of the financial crisis because they made loans in foreign currencies (like U.S. dollars) but must use their local currency (the one they deal with most often) to pay back the loans. As credit tightened, local currencies plummeted thus making it much more difficult to pay back the loans. Even thriving companies, Landler reports, were “bewildered by the sudden reversal in their fortunes.” Countries that believed they had invested wisely and avoided shaky financial instruments like sub-prime loans were shocked to find themselves pulled into economic eddy that swallowing global credit.

“‘We were not an obvious target,’ said Peter Akos Bod, a former governor of the Hungarian central bank. ‘I could not see major problems in Hungary’s economic outlook. But there is sort of a panic.’ Economists say the inability to borrow foreign currency is dangerous because it can quickly turn healthy economies into sick ones, as companies and even potentially governments default on loans. ‘Right now, it’s a liquidity problem, but if it goes on long enough, it can become a solvency problem,’ said Yusuke Horiguchi, the chief economist of the Institute for International Finance. Mr. Horiguchi said that developed economies bear responsibility for easing this problem, because it stems from the crisis in their banking system. Indeed, the financial rescue packages announced by the United States and European countries have aggravated the problem. Safeguards like attempts to stabilize their banks and government guarantees behind some bank lending have made banks in developing countries look less secure.”

The anger that has risen among the general public in the U.S. about the government’s rescue plan demonstrates that they don’t understand the difference between liquidity and solvency. The Treasury is trying to ensure liquidity so that insolvency doesn’t become a bigger challenger than it already is. Insolvent companies are going to fail, but they need not drag down the entire economy. President Bush has called for an international meeting to address the global crisis; but Landler notes that “there is a limit to what the United States can do to solve the problems of these countries” because it is wrestling with major financial problems of its own.

“‘The most important thing the United States can do is stabilize its financial system,’ Mr. Lowery, of the Treasury, said. ‘The other thing we can do is to support the actions taken by emerging-market countries.'”

Emerging market countries are working to help themselves.

“The central banks of Brazil and Mexico intervened heavily in the foreign exchange market to support their currencies. Hungary obtained a loan of up to 5 billion euros from the European Central Bank. And Hungary — along with Iceland, Pakistan, Belarus and Ukraine — has overcome deep reluctance and begun negotiations with the International Monetary Fund for emergency loans. Countries are traditionally averse to such loans because they come with strict conditions.”

Pakistan’s president even made an overture to China for financial support to stave off bankruptcy. The IMF doesn’t control enough funds to ease credit on its own. Landler reports that it will need the support of central banks to free up enough credit to keep the global economy liquid. Most economists agree that efforts to support emerging market countries are critical. Let’s hope world leaders understand that helping others is in their own best interests. It almost always is.