Global financial crisis may hit hardest outside U.S.

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.

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