By PETER S. GOODMAN
Published: March 8, 2009

As the world is seized with anxiety in the face of a spreading financial crisis, the one place having a considerably easier time attracting money is, perversely enough, the same place that started much of the trouble: the United States.

American investors are ditching foreign ventures and bringing their dollars home, entrusting them to the supposed bedrock safety of United States government bonds. And China continues to buy staggering quantities of American debt.

These actions are lifting the value of the dollar and providing the Obama administration with a crucial infusion of financing as it directs trillions of dollars toward rescuing banks and stimulating the economy, enabling the government to pay for these efforts without lifting interest rates.

And yet in a global economy crippled by a lack of confidence and capital, with lending and investment mechanisms dysfunctional from Milan to Manila, the tilt of money toward the United States appears to be exacerbating the crisis elsewhere.

The pursuit of capital suddenly seems like a zero sum game. A dollar invested by foreign central banks and investors in American government bonds is a dollar that is not available to Eastern European countries desperately seeking to refinance debt. It is a dollar that cannot reach Africa, where many countries are struggling with the loss of aid and foreign investment.

“Virtually all of the low-income countries are in very serious trouble,” said Eswar Prasad, a former official at the International Monetary Fund and a senior fellow at the Brookings Institution, the liberal-leaning research organization in Washington.

He went on: “This is the third wave of the financial crisis. Low-income countries are getting hit very hard. The flow of private capital to the emerging market has dried up.”

Private money invested in so-called emerging countries plunged from $928 billion in 2007 to $466 billion last year and is likely to fall to $165 billion this year, according to the Institute of International Finance.

Not that the United States is enjoying a great influx of money. Globally, investors are holding tight to cash and extracting it as quickly as they can from risky ventures.

In the United States, investments by foreigners have slowed markedly. But as Americans eschew foreign deals and keep their dollars at home, and as foreign central banks — especially China — buy Treasury bills, the United States is absorbing money that used to be scattered around the globe. And that is making money tighter elsewhere in the world.

The most immediate crisis appears to be in Eastern Europe, where investors borrowed exuberantly in foreign currencies — notably the euro and the Swiss franc — using those funds to build office towers and factories. Their debts are growing as their currencies decline in value, leading to bank losses and requiring government bailouts along with aid from the I.M.F..

Economists liken this episode to the financial crisis that assaulted much of Asia in the late 1990s. Then, as now, investors borrowed in foreign currencies. When investment left the region, local currencies plummeted, particularly in Thailand and Indonesia, setting off defaults and sowing job losses and poverty.

“Eastern Europe looks incredibly similar to Asia in the 1990s,” said Brad Setser, an economist at the Council on Foreign Relations in New York.

In one key regard, this crisis is more problematic: In the 1990s, the rest of the global economy was growing vigorously. Once danger abated, Asian countries were able to resume growth by selling goods to the United States, Europe, Japan and China.

Indeed, the very plunge in currencies that precipitated the crisis also provided a fix, making Thai, Malaysian, Indonesian and Korean goods that much cheaper on world markets.

This time, as many low-income countries again see their currencies fall, they are confronting a world beset by recession, in which demand for their products is weak and falling.

In a report released Sunday, the World Bank predicted that the global economy would shrink in 2009 for the first time in more than half a century and forecast that global trade would decline for the first time since the early 1980s.

“Depreciation isn’t enough now to offset the global contraction,” said Mr. Setser, noting that export powers like Japan, Korea, Taiwan and Brazil have had rapid declines in sales in recent months. “Everybody’s looking vulnerable. All commodity exporters are potentially subject to currency crises.”

Fears are growing that a much broader group of countries will plunge into trouble. Mr. Prasad’s list of potential danger zones includes Vietnam, the Philippines, Malaysia and Indonesia, as well as Pakistan and Ecuador.

In the Asian financial crisis, countries at the center of the storm were particularly vulnerable because the values of their currencies were mostly pegged to the dollar. Once central banks ran out of dollars to exchange for their own currencies, they lost their ability to influence the exchange rate. As a result, their currencies fell, turning already large debts into impossible debts.

Many more countries now allow their currencies to float with the whims of the market, removing this grim chain of events. Still, as economic activity slows and banks are stuck with larger losses, the damage could swell beyond the ability of governments to finance bailouts, said Kenneth S. Rogoff, a former chief economist at the I.M.F. and now a professor at Harvard.

“Debt collapses are going to wreak havoc with exchange rates,” Mr. Rogoff predicted. “A lot of countries in Europe are already on the brink of default.”

Only two years ago, many analysts were suggesting that the I.M.F. — created more than 60 years ago to rescue countries in financial distress — no longer had a clear reason to exist. Now, the fund is scrambling for contributions from developed nations to bolster its $350 billion war chest. Mr. Setser suggested it needed $1 trillion for all that might yet unfold.

Because worries are deeper nearly everywhere else, the United States and the dollar have essentially benefited from the worldwide panic. In the last year, the dollar has risen 13 percent against major foreign currencies after adjusting for inflation, according to Federal Reserve data. Foreign holdings of Treasury bills rose by $456 billion in 2008.

“It’s a huge safe haven effect,” said William R. Cline, a senior fellow at the Peterson Institute for International Economics in Washington. “The basic assumption that people are making is that the U.S. government will never default on its debt.”

As the dominant flavor of money used in business worldwide, the dollar has once again been affirmed as the global reserve currency.

Only last year, some analysts said that as the American economy sagged, foreign central banks would be reluctant to sink national savings into the dollar. That has been soundly debunked.

In ordinary times, the rise of the dollar would provoke American worries that it would crimp exports by making goods more expensive on world markets. But for American policy makers, what matters now is attracting enough buyers of American debt to finance the rescue plans, and if the dollar must rise along the way, that is a cost worth paying.

“The fact that we can still borrow at lower interest rates is saving us from much more severe adjustments,” Mr. Rogoff said. “We’re really still staring down an abyss.”

Julia Werdigier contributed reporting.

By Stefan Wagstyl, February 25 2009

This should have been a year of celebration in central and eastern Europe. It is 20 years since the Berlin Wall fell, the 10th anniversary of Nato’s eastward expansion and five years after the European Union began its enlargement into the region: from the Baltic to the Black Sea, the countries that escaped from Soviet rule have much to commemorate.

But the global economic crisis has spoilt the party. Instead of building on the achievements of the past two decades, the region’s leaders are feeling the economic foundations shaking under their feet.

All of Europe is heading towards its worst economic crisis since the 1930s. But compared with the wealthy west, central and east European nations are in a weaker position to respond. The dangers are so great that European Union leaders meeting in Berlin last Sunday agreed to back a doubling of International Monetary Fund resources to $500bn (£348bn, €391bn) to support the CEE countries in what Angela Merkel, German chancellor, called an “extraordinary international crisis”.

At risk is not only the economic development of vulnerable countries but even their political stability. Nobody expects a repeat of 1930s evils. But mounting anger over recession, unemployment and debt could fuel populism with unpredictable consequences. As in western Europe, there could be social and ethnic tensions. Reformist governments, multinational companies and banks could all become the targets of public protest when livelihoods are threatened. “The economic crisis will impact … eastern Europe more than western Europe because the political and economic systems in eastern Europe are more vulnerable,” says Carl Bildt, Sweden’s foreign minister.

The EU itself, the region’s political and economic lodestone, is running into trouble amid signs of western leaders responding to the crisis by putting national interests before Union-wide solidarity, notably over state aid for finance and industry. Having worked hard to bring their countries into the globalised European mainstream, some central and east European leaders feel betrayed. Pavol Demes, a former Slovak foreign minister and head of the CEE office of the German Marshall Fund, a US think-tank, says: “People are questioning liberal democracy, the markets and the EU. They see countries like France going for national solutions when international solutions are needed. They feel excluded.”

He and others applaud the Czech Republic, holder of the EU’s rotating presidency, for challenging Nicolas Sarkozy, the French president, over suggestions that aid to France’s carmakers might be tied to preserving French jobs rather than those the marques provide in central Europe. Mirek Topolanek, Czech prime minister, spoke for many in the CEE region when he said the response of eurozone countries “has deformed the joint project of the euro more than any other imaginable event”.

For all the anti-government demonstrations in Bulgaria and Lithuania, violent protests in Latvia and a surge in anti-Roma rhetoric in Hungary, however, CEE is not a region about to collapse into disorder. Despite the worries about EU solidarity, the 27-nation bloc’s new members remain committed to enhancing their integration. Poland, for example, is accelerating plans to join the eurozone. “What we need is more Europe, not less Europe,” says Eugeniusz Smolar, head of Warsaw’s Centre for International Relations.

Whatever happens, different countries are likely to go through the crisis with widely differing results. At one extreme are nations under particularly severe financial pressures, headed by Hungary, Latvia and Ukraine, which have secured IMF rescue packages. At the other stand Poland, the Czech Republic and Slovakia, a base of relative economic stability in the central European heartland. Manfred Wimmer, chief financial officer of Erste Group, the Austrian bank with big CEE operations, warns: “What’s been lost in this crisis very often has been the ability of people to differentiate.”

Still, there is a sense of gathering gloom even in countries that have so far escaped the worst. In Croatia, record numbers of skiers have holiday­ed abroad this winter, property prices on the Adriatic coast remain high and the nightspots of Zagreb, the capital, are busy. But all is not well, says Davor Butkovic, a commentator at the daily Jutarnji List. Speaking in Zagreb’s fashionable Bulldog bar, he says: “We don’t have an economic crisis yet but there’s a feeling that something bad is coming. At Jutarnji List there is a 30 per cent drop in advertising this year.”

After nearly a decade of rapid growth, still at nearly 5 per cent last year, gross domestic  product in the region – including central and south-east Europe and Ukraine but excluding Russia – is set to fall in 2009 for the first time since the post-communist chaos of the early 1990s. Migrants are returning home from the faltering economies of western Europe and Russia. Foreign direct investment is being postponed, as with Fiat’s €1bn ($1.3bn, £890m) plan to modernise Serbia’s Zastava car plant.

Worse, some of the international banks that fuelled the recent economic growth are struggling to fund local subsidiaries, raising fears of collapses in credit. According to the Bank for International Settlements, the central banks’ grouping, at the end of September eastern Europe’s loans from foreign banks (local and foreign currency) were $1,656bn – three times more than in 2005 and mostly borrowed from west European banks.

This month’s market turmoil has highlighted the dangers. The European Bank for Reconstruction and Development, the region’s multilateral bank, estimates the banking sector needs $200bn in refinancing this year and $100bn-$150bn to recapitalise in order to cope with bad loans. The question is how much of the loan books turn sour as economies slow and currencies fall. Foreign exchange loans, ranging to 90 per cent of lending in Latvia, are a particular concern because of the extra burden on borrowers who make repayments out of local currency earnings.

If banks cover only 70 per cent of their subsidiaries’ needs, governments and multilateral institutions might face demands for about $100bn – a big sum but not overwhelming given the scale of west European and US bank bail-outs. Robert Zoellick, the World Bank president who has estimated a lower figure of $40bn-$45bn, is urging EU governments to support the IMF, the World Bank and the EBRD in raising funds, saying the issue is crucial to Europe’s future. He told a German newspaper this week: “I would consider it an immense tragedy if Europe were to break into two parts again.”

Not everybody is queuing at the IMF, however. Slovakia and Slovenia are safely inside the eurozone. Poland and the Czech Republic insist they need no support and say recent market upheavals are partly due to panicked investors mistakenly viewing the region as an undifferentiated disaster zone.

The social and political impact of the crisis will also vary. Latvia’s government collapsed last week over IMF-mandated austerity. In Ukraine, the economic turmoil has become the latest battleground between President Viktor Yushchenko and Yulia Tymoshenko, his prime minister. In Bulgaria the crisis has boosted support for Gerb, a populist anti-corruption grouping that hopes to win power in elections this summer. Elsewhere, however, the crisis has strengthened governments. Donald Tusk, Poland’s liberal prime minister, is more popular today than when he took power in 2007.

But these are short-term developments. A prolonged crisis could undermine support for market-oriented policies and generate conflict and confusion. Krisztian Szabados, head of the Political Capital Institute, a Budapest research group, worries about increased far-right activity, particularly in countries with significant gypsy minorities. “The right wing is on the rise,” he says, pointing to Jobbik, a far-right Hungarian party that won 8.5 per cent of the vote in a local election last month.

A bigger test for the likes of Jobbik will come in this summer’s European parliament elections. The issue for CEE leaders may not be the size of the extremist vote. After all, few rightwing parties in the region have done as well over time as France’s National Front. But managing shows of extremism will be hard. Public institutions are weaker than in the west and officials are sometimes unable or unwilling to impose their authority. Mr Szabados cites the example of the recession-hit Hungarian city of Miskolc where a police chief, removed for blaming gypsies for a crime wave, was reinstated after demonstrations in his support.

Ivan Krastev, head of the Centre for Liberal Studies in Bulgaria, worries about a collapse in middle-class morale if people lose their jobs and are engulfed by their mortgages: “These people identified with the west and now feel betrayed. ‘We did our best,’ they say. ‘We followed the best practices and now we are told these were the worst practices.’ And no other models are available.”

He draws parallels with the 1998 Russian financial crisis, where middle-class people who lost their savings turned their backs on liberal democracy and came to support the authoritarian Vladimir Putin. “There could be a loss of faith in the west, as there was in Russia,” Mr Krastev says.

But this seems too apocalyptic a view for most of the CEE region. With the benefits of EU membership in full flow, from farm aid to political security, elites will fight hard against populist efforts to change course. Democratic and market-oriented institutions are far stronger than in 1990s Russia.

Also, even in recession, the region’s economies are this year forecast to perform better than those of western Europe. CEE’s advantage of low-cost, high-quality labour remains in place. As Erik Berglof, the EBRD’s chief economist, says: “Despite the crisis, the long-term integration of central and eastern Europe with western Europe will go on. The development model is the right one.”

AUSTRIAN BANKS:

Exposed Vienna tries to put a brave face on its neighbours’ misfortunes

The fall of communism in eastern Europe marked the beginning of a long bonanza for Austria, writes Eric Frey. From the late 1990s it recorded growth rates well above the eurozone average thanks to its massive engagement in the economies of its by then booming neighbours. As recently as January this year, the European Commission predicted that the country would be less affected by the global economic downturn than Germany or Italy.

Yet Austria’s luck may have finally run out. Of particular concern is the huge exposure of the three major banks, Bank Austria, Erste Bank and Raiffeisen, to central and eastern European economies now in the grip of a deepening financial crisis. Shares of Erste Bank and Raiffeisen International, once the heavyweights on the Vienna stock exchange, have tumbled over the past two weeks, losing about 90 per cent from its 1997 peaks before recovering slightly.

Austrian banks have lent a total of $300bn (€210bn, £235bn) to clients in the region, equivalent to 68 per cent of Austrian gross domestic product, according to the Bank for International Settlements (BIS). If Bank Austria, which is owned by Italy’s Unicredit, were included, the figure would rise to about 100 per cent, by far the highest of any west European country.

An economic collapse in the east would wipe out the capital of Austria’s banks and force the government to launch a hugely expensive bail-out. It would also hurt hundreds of industrial groups, retailers and other service companies that either invested in eastern Europe or rely on sales in the region.

Market jitters about the crisis in eastern Europe have driven up the spreads on Austrian state debt over German bunds since the beginning of the year. Last week they widened sharply amid talk that Austria might lose its triple-A credit rating.

These reactions may be overdone, according to some analysts. “Even a wave of defaults in the east similar to the Asian crisis would not affect Austria’s ability to service its debt,” says Dirk Schumacher, an economist at Goldman Sachs in Frankfurt.

Most Austrian bankers and economists argue that the country’s links with eastern Europe remain an asset for the economy, at least in the long run. Ewald Nowotny, the governor of the Austrian National Bank, points to the relatively solid economies of the Czech Republic and Slovakia, two of Austria’s main economic partners. “Austria is most exposed in those countries that are still expected to grow,” he says.

The two main trouble-spots are Ukraine, where Raiffeisen has a large exposure, and Romania, where Erste Bank has been the market leader since it acquired Banca Comerciala Romana in 2005. Both countries are suffering from high private debt burdens and are projected to see a surge in default rates.

But Andreas Treichl, Erste Bank’s chief executive, says: “Ninety-eight per cent of our clients make their interest payments on time. I don’t see that it is dangerous for Austrian banks to be in central and eastern Europe. We made huge investments in the region, but we invested in the real economy.” So far neither Erste Bank nor Raiffeisen have accepted capital injections offered by the government because they have not yet agreed on terms.

Yet there is plenty of anxiety in government and financial circles. The banks have lobbied the European Commission for a special aid programme for institutions exposed in central and eastern Europe, while Josef Pröll, Austria’s finance minister, this month toured the region in an attempt to mobilise support for a co-ordinated approach.

By Stefan Wagstyl in London, Alan Beattie in Washington, and Aline van Duyn in New York

Fears of banking upheavals in eastern Europe and the potential fallout on western Europe yesterday triggered widespread turmoil in global financial markets.

Sharp declines in east European equities and currencies prompted drops in west European bourses and the euro as investors fled for the safety of bonds, the US dollar and gold.

The turmoil was prompted by a report from Moody’s, the credit rating agency, which warned that west European banks with east European subsidiaries risked rating downgrades because of the growing vulnerability of eastern Europe’s banking systems. Standard & Poor’s, a rival agency, later issued a similar caution.

This raised fears that the European economy as a whole could suffer from the deepening difficulties of those east European states that are struggling to raise credit for their debt-financed economies and of those western European banks that have long been the region’s main source of funds.

“This is reminiscent of the Asian crisis of 1998,” said Michael Wang, an emerging market strategist at Morgan Stanley, the investment bank.

“We are seeing what used to happen in emerging markets, where during the years of global expansion countries borrowed heavily and built up large external imbalances, only to face downward pressure on currencies and growth once the cycle turned and foreign capital inflows dried up.”

The euro fell 1.5 per cent to a two-month low of $1.2599 against the US dollar. The Swedish krona fared even worse, falling 2.7 per cent to SKr8.7815 against the dollar. The Polish zloty slumped to a five-year low of 4.93 zlotys against the euro, prompting Donald Tusk, the prime minister, to say the government may sell euros if the zloty fell to 5 against the euro – the first time Warsaw has published an exchange rate floor. The Hungarian forint fell to a record low of Ft309.60 and the Czech koruna, the Romanian leu and the Russian rouble were all down.

Polish and Czech shares dropped to their lowest level in five years, while other equity markets in the region came under pressure.

In Moscow, trading was temporarily suspended amid sharp price drops, provoked partly by the government cutting its 2009 economic forecast from a contraction of 0.2 per cent to one of 2.2 per cent.

The turmoil in eastern Europe spread west, with much attention focused on banks with east European operations.

Italy’s Unicredit closed 7.3 per cent lower. In Austria, Raiffeisen International plunged 13.5 per cent and Erste fell 18 per cent.

Global investor sentiment was dented by a US report showing manufacturing activity in the New York region sliding to a record low in February.

The S&P 500 had fallen 4.2 per cent by late afternoon trading to 792.53, the first time it has fallen below the 800 level since November, while the FTSE Eurofirst 300 index shed 2.5 per cent.

Government bonds rallied, with the yield on the 10-year US Treasury sliding 20 basis points to 2.69 per cent and the 10-year German Bund yield falling 5bp to 2.99 per cent.

Gold hit a seven-month high above $970 an ounce.

Additional reporting by Adrian Cox, Miles Johnson, Dave Shellock and Peter Garnham in London, Jan Cienski in Warsaw and Thomas Escritt in Bucharest