U.S. turmoil churns up an ill wind worldwide

On the third floor of an office building tucked into one of this city's most fashionable shopping areas, a team of financial sentries stands watch.

Beneath clocks giving the time in London, New York and Seoul, they scan flickering computer screens, alert to any unusual events or market movements. To enter their cubicle-lined workspace, they must press their thumbs against an electronic pad that recognizes their fingerprints.

In 1997, a financial crisis roared out of southeast Asia and claimed South Korea's then-miracle economy as one of its highest-profile victims. In the aftermath, the South Korean government established this early warning center to guard against a repeat occurrence.

Now, with global markets yo-yoing in response to financial turmoil in the United States, the specialists at the Korean Center for International Finance are especially vigilant. Along with daily market tracking, economists here run a monthly computer simulation based on a classified list of 21 economic variables. The model rates the risk of a repeat crisis within the next year on a 1-to-5 scale, with 5 meaning red alert. Recipients of the center's reports include the presidential Blue House, the central bank and the South Korean Central Intelligence Agency.

"We run around the clock. … If a currency crisis happens without our warning, I am supposed to lose my job," says Chang Seok Oh, 48, the economist who heads the unusual center, only half-kidding.

Across Asia, people are watching the U.S. financial crisis the way coastal residents regard an approaching Category 5 hurricane. There's no question the storm on the horizon is dangerous and is headed this way. The only debate is over how much damage it'll do once it arrives and exactly what it will hit. "We are very concerned about the current situation. We are watching the U.S. financial markets every day," says Yook Dong-Han, director general of the Ministry of Finance's economic policy bureau.

The current crisis may have begun in early 2007 with mortgage excesses in the U.S. But it long since has demonstrated global reach: Icelandic banks, Spanish home sales, Chinese factories and stock markets from Milan to Bombay, all have been sideswiped by the runaway U.S. financial locomotive. Global growth is expected to downshift from an annual rate of 4.8% in the fourth quarter of 2007 to 3% during the same period this year, according to the International Monetary Fund.

The South Korean economy — the world's 13th largest — is tightly linked to global trade, so a prolonged U.S. recession would be certain to do significant damage. Under pressure from high oil prices and softening demand, the economy already is slowing to an annual growth rate of around 4%, down from 5% last year. Monthly job growth is slumping and household debt is rising sharply, though it remains nowhere near perilous U.S. levels.

In recent weeks, fears of a new crisis here soared as foreign investors fled Korean markets. The won has lost almost 29% of its value against the dollar in a year-long rout, while the benchmark Kospi stock index is down a similar amount since last October. "It makes me nervous," says Lee Si Su, 57, sitting with a friend on an outdoor plaza.

Lee, who's been unable to find full-time work since his small business failed during Korea's financial crisis a decade ago, gestures toward his benchmate and says, "We were just talking about Lehman Bros., which was 100 years old, filing for bankruptcy. I'm worried about that happening to other companies."

An exodus of cash

Foreign investors have been bailing out of South Korean assets for months, less because of concern over the domestic economy than out of a pronounced need for cash. U.S. and European institutions that lost money on the asset-backed securities at the heart of the global tumult need cash to repair their balance sheets. The Korean market, which rose 32% in 2007, is an easy place to take profits. The past 12 months, foreigners have sold nearly $50 billion in Korean stocks, according to the International Monetary Fund.

As foreign investors, who hold almost one-third of the local market, sold their won-denominated holdings, they drove down the value of the South Korean currency against the dollar. The won's pronounced decline, representing the financial storm's initial impact, caught many Korean companies by surprise. Last year, as the U.S. began reeling from the first wave of the subprime mortgage crisis, the conventional wisdom called for the dollar to continue its multiyear decline in value against the won.

To insulate themselves from the won's anticipated appreciation, more than 500 small and midsize companies bought a sophisticated derivatives contract called "Kiko." But the won didn't rise; instead, amid the U.S. crisis, it sank like a rock and ripped holes in balance sheets across Korea.

Of the 519 firms that employed the Kiko hedging device, 244 incurred losses and 130 firms reported "severe losses," according to the Korea Chamber of Commerce and Industry. One company, a maker of LCD displays called Taesan, filed for bankruptcy because of its Kiko-related losses. Economywide, total losses on the Kiko contracts could reach 2 trillion won or $2 billion.

Korean banks themselves aren't directly exposed to major losses from the type of complex securities that have blown up several U.S. financial institutions. They remain far healthier than at the time of the 1997 crisis, with a Bank for International Settlements capital adequacy ratio of more than 11% vs. around 7% at the time of the 1997 crisis.

But one economist here, Minkyoo Jun of Korea Investment and Securities, is warning of significant dangers in the growing indebtedness of Korean banks, including the local branches of major foreign banks. Korean banks' short-term external debt topped $127 billion at the end of the second quarter compared with $58.4 billion at the end of 2005. Foreign bank branches' debt rose to $83.1 billion from $25 billion over the same period.

Much of that borrowing stemmed from Korean banks' need for dollars to satisfy the foreign investors cashing in their domestic stock holdings. Jun says if foreign lenders refuse to provide continued short-term funding for Korean banks, the government could be forced to provide the banks with dollars. Even if that worst-case scenario doesn't materialize, Jun says, Korean markets are in for unusual volatility.

"The U.S. financial turmoil is causing big instability in the Korean market, especially the foreign-exchange market," he says.

The International Monetary Fund's latest assessment of the South Korean economy, released this month, also warned that Korean banks could be in trouble if the global credit crisis worsens, though it described the risk as "moderate." South Korean authorities have been tracking banks' external debt on a daily basis for more than a year in response, the IMF report said.

Still, most experts here say there is little risk of South Korea suffering a repeat of the contraction it suffered in the regional financial tumult of the late 1990s. In 1998, the economy shrank by almost 7% while unemployment rose, peaking at a level almost three times the 1996 figure.

S. Korea's in a better place now

Like other so-called emerging markets that found themselves at the mercy of international capital flows, the South Koreans learned important lessons from the episode. Major corporations also reduced their debt loads. To armor the economy against future attacks, the government beefed up its foreign-exchange reserves to more than $243 billion vs. just $8.8 billion at the end of 1997.

"The situation is totally different than 1997-98. … A 1997-type crisis is extremely improbable," says Park Hyun-Soo of the Samsung Economic Research Institute.

The big unknown is how much damage the U.S. financial crisis will do to foreign demand for Korea's cars, computer displays, cellphones and other products. By one measure, the country today is less vulnerable to a U.S. downturn than ever. In 1986, the U.S. bought 40% of Korea's exports, but today, less than 11% of the country's overseas sales end up in the U.S. China is Korea's largest customer, accounting for more than twice the share of exports.

But perhaps half of the products South Korea ships to China are components that are used to make products that end up in America. So the health of the U.S. economy remains critical.

Tapped-out U.S. consumers, reeling from too much debt, are certain to cut spending, says Park. The resulting economic downturn could last into 2010, dealing a heavy blow to countries such as South Korea, the USA's seventh-largest trading partner. "There could be a severe negative effect on Korean exports," he says.

At Hyundai Motors, Korea's largest automaker, executives are girding for a stagnant U.S. market through 2009, says Kim Dong-Jin, until last month the company's CEO. The first half of this year, exports accounted for nearly 60% of its total sales, and Kim says the U.S. market remains its top priority: "Not only Hyundai but also many other global automakers are suffering from the global financial crisis. … Until the end of next year, we will see very tough market conditions."

Will U.S. plan be enough?

Meanwhile, as the U.S. struggles to cauterize the self-inflicted wounds on its financial system, some here question whether the proposed financial bailout, which remains stalled in Congress, will be sufficient. Park Yung-Chul, a former government official and influential Korea University economist, says the $700 billion package is far short of the $2 trillion needed to recapitalize damaged financial institutions.

Park, who also has taught at Harvard and the Massachusetts Institute of Technology, expresses the frustration many here feel watching their longtime ally flounder in financial distress. "On finance, you're becoming a second-class economy," he says. "How could you do so badly managing your economy and managing international affairs? And now you've created this global financial crisis for which everyone is going to suffer!"