Times online 25 Ottobre 2008

Britain and America have been hit hard by the credit crunch. But greater havoc will ravage the world's weaker economies

The financial earthquakes in America, Britain and Western Europe are rumbling on, but after the government rescues that began with Gordon Brown's bank bailout, there is no doubt that the basic structures of these advanced economies will remain intact, as they have after previous crises. In the past week, however, a series of powerful aftershocks has been shaking Hungary, Ukraine, Russia, Argentina and many other countries on the periphery of the global financial system, threatening not only their economies, but even their systems of government.

To see why this has happened and what it may mean for the world economy we need to understand why the unequivocal bank guarantees that the US and Western European governments belatedly offered two weeks ago have much less chance of working in emerging countries.

The core problem in every banking crisis is that all financial systems throughout history have ultimately been based, literally, on a confidence trick. No bank in history has ever had enough money immediately available to repay all its depositors: once confidence in the banking system starts to falter, it can collapse instantly and completely. When this happens there is only one way to avert catastrophe - for government to guarantee all banks. Only government can do this because it has the unique ability to print money without limit to repay its debts.

But the very success of these actions in America and Western Europe in the past two weeks has focused attention on other countries where government actions to stabilise their financial systems could well have the opposite effect.

In the past 48 hours, Hungary has been forced to raise its interest rates by 3 percentage points, at a time when big interest rates reductions are obviously needed to avert collapse. Ukraine, Belarus and Iceland have been forced not only to seek IMF funding, but probably to submit to Russian geopolitical tutelage. The Government in Argentina has triggered panic by nationalising private pension savings. And even Russia, owner of the world's third-largest foreign exchange reserves, has suddenly found itself in such financial trouble that serious questions can be raised about the stability of Vladimir Putin's regime.

The unhappy countries where government support for banks can aggravate financial panic fall into three types. The first are those with big trade deficits or large-scale borrowings in foreign currencies - for example, Hungary, whose trade deficit is more than 5 per cent of national income and where almost 60 per cent of consumer and business borrowing is not just provided by foreign sources but is also owed in foreign currencies, mostly euros or Swiss francs. Because these countries are totally dependent on inflows of foreign capital, government support for their banks is unlikely to work.

After all, the Hungarian Government's access to foreign credit depends ultimately on its ability to extract dollars or euros from the private sector. If the private sector is already drowning in foreign debts that it can find no means of repaying, why should anyone lend euros or Swiss francs to a government that can only draw foreign currencies from the same depleted pool as its own citizens?

The most obvious victim of this malaise is Hungary, because of the Hungarians' notorious propensity to take out mortgages and car loans in Swiss francs instead of local forints, without any apparent regard to the risk that these loans could suddenly start to grow by 5 per cent a day, as they have in the past week. This has made Hungary the world's leading candidate for devaluation and financial meltdown in the style of Thailand (1997), South Korea and Indonesia (1998) or Argentina (2002).

But behind Hungary there is a phalanx of other countries in Central Europe - Bulgaria, Romania, Latvia, Estonia and Ukraine - with similar financial profiles. Bigger EU members such as Poland, Slovakia and the Czech Republic are certainly stronger, but a devaluation in Hungary could quickly suck in its neighbours, as in the Asian crisis, which began with Thailand's devaluation in June 1997.

Government support can also destabilise banks in small countries with disproportionately large banking systems - the second type. The most obvious example is Iceland. What distinguishes Iceland from a rock-solid financial centre such as Switzerland is the tiny size of the economy and the big deficit on its current account. Unlike the Swiss Federation, Iceland's Government simply has no credibility as an international borrower in its own right. Similar problems could arise in Liechtenstein, Andorra or Cyprus if their local banks got overextended.

Thirdly, there are countries with trade surpluses and strong reserve positions, but terrible records of past monetary mismanagement. The archetype here is Russia, but Argentina and several other Latin American could fall into this group. Russia's $560billion of foreign exchange reserves are easily sufficient to refinance the foreign currency debts of its private sector (and in the process cut oligarchs such as Oleg Deripaska down to size). And even if Russia's trade moves into modest deficit should the oil price stay at $70, this in itself would not be a problem after five years in which the country has recorded trade surpluses even bigger than Japan's or China's in relation to its GDP.

But the financial crisis has revealed its Achilles' heel: Russia's savers have been robbed repeatedly by their Government, either through hyperinflation or deliberate expropriations and defaults. The risk therefore is that if the Government took over responsibility for the country's banks accounts, international creditors might be satisfied, but domestic savers could well panic. How would the average Russian react if he heard that banks were to be saved by nationalisation and that the Government would print money without limit to save the system? Maybe he would be reassured and entrust all his savings to the newly guaranteed institutions. But he might wonder whether all those newly printed roubles would suffer the same inflationary fate as they did in 1998 - and that it would be prudent to change some roubles into dollars.

If Russians decided en masse to convert their roubles into dollars the Government's $560billion of foreign exchange reserves would be sufficient in theory to replace the entire money supply, worth $553billion at today's exchange rates. In practice, however, the Government would inevitably have to devalue and might even suspend the rouble's convertibility with exchange controls, rather than tolerate such a run on the domestic currency. After all, gambling the country's entire reserves in a defence of the rouble would probably be fruitless and, with oil prices falling, these reserves once exhausted would be impossible to rebuild. The Government's prestige would be shattered and what could be more humiliating to Russia's newly assertive leaders than to see their economy “dollarised”?

A mass flight from the rouble is still fairly unlikely, assuming oil prices stabilise at somewhere near current levels. But there are several economies with long histories of currency mismanagement - Argentina and Ukraine are the most prominent examples - where this process is already under way. If you lived in such a benighted country, wouldn't you want to change some of your savings out of the local currency into dollars or euros or pounds while you still could?

In Eastern Europe and Latin America that question will decide the fate not just of banking systems but entire nations.

by Anatole Kaletsky

Source >  TIMES online | oct 24