The Ghost of Argentina What Happens when Countries Go Bankrupt?

First it was mortgage lenders. Then large banks began to wobble. Now, entire countries, including Ukraine and Pakistan, are facing financial ruin. The International Monetary Fund is there to help, but its pockets are only so deep.

No, Alexander Lukyanchenko told reporters at a hastily convened press conference last Tuesday, there is "no reason whatsoever to spread panic." Anyone who was caught trying to throw people out into the street, he warned, would have the authorities to deal with.

Lukyanchenko is the mayor of Donetsk, a city in eastern Ukraine with a population of a little more than one million. For generations, the residents of Donetsk have earned a living in the surrounding coalmines and steel mills, a rather profitable industry in the recent past. Donetsksta, a local steel producer, earned €1.3 billion ($1.65 billion) in revenues last year.

But last Tuesday the mayor, returning from a meeting with business leaders, had bad news: two-thousand metalworkers would have to be furloughed. Lukyanchenko doesn't use the word furlough, instead noting that the workers will be doing "other, similar work." But every other blast furnace has already been shut down, and one of the city's largest holding companies is apparently gearing up for mass layoffs.

Under these conditions, how could panic not be rampant in Donetsk, the capital of Ukraine's industrial heartland? In Mariupol, a steelworking city, a third of the workers have already been let go. The chemical industry, Ukraine's second-largest source of export revenue, is also ailing. In the capital Kiev, booming until recently, construction cranes are at a standstill while crowds jostle in front of currency exchange offices, eager to convert their assets into US dollars.

Donetsk is in eastern Ukraine, 8,100 kilometers (5,030 miles) from New York's Wall Street and 2,700 kilometers (1,677 miles) from Canary Wharf, London's financial center. But such distances are now relative. The world financial crisis has reached a new level. No longer limited to banks and companies, it is now spreading like wildfire and engulfing entire economies. It has reached Asia and Latin America, Eastern Europe, Iceland the Seychelles, the Balkan nation of Serbia and Africa's southernmost country, South Africa.

It is a development that has investors and speculators alike holding their breath. Some are pulling their money out of troubled countries, while others are betting on a continued decline -- and in doing so are only accelerating the downturn. Central banks are desperately trying to halt the downward trend, but in many cases the plunge seems unstoppable.

At first, it seemed as if the crash could be limited to Iceland. But now countries like Ukraine, Pakistan and Argentina are proving to be almost as vulnerable as the small island nation in the North Atlantic. It seems as though another country is added to the growing list of nations on the verge of collapse almost daily.

A national bankruptcy isn't just some theoretical construct. Argentina experienced it in 2001 and Russia three years earlier. Germany has gone bankrupt twice in its more recent history, once in 1923 and the second time after 1945. A country has reached this final stage if, as a result of war or blatant mismanagement, it has gambled away all trust, can no longer service its debt or convince anyone to lend it any money, no matter how high an interest rate it promises to pay.

This is what is currently happening to Iceland. The central bank in the capital Reykjavik increased its prime rate by six points to 18 percent last week. Venezuela, where inflation is also high, is now offering 20 percent to stimulate interest in its government bonds. At the moment, however, investors are shying away from all risk.

In the end, the rating agencies will have no choice but to downgrade the problem countries to their lowest level of creditworthiness. When that happens, lenders will have no choice but to write off much of their money. For citizens, national bankruptcy would probably lead to massive inflation.

The threshold countries, described until recently as "emerging" economies, are in for an especially rough ride. "The dream that they would be spared seems to have come to an end," says Rolf Langhammer, vice-president of the Kiel Institute for the World Economy.

Countries like Russia and Brazil owe their recent success in large part to the boom in commodities the world has experienced in recent years. But now prices for oil, copper, wheat and corn have plunged and a giant spiral of debt has begun to turn. The companies and banks that borrowed vast amounts of money abroad for their investments can no longer service their debt, and investors are pulling out their capital. As foreign currency becomes scarce and imports unaffordable, the currencies of these countries are losing value, which only increases the mountain of debt.

According to Stephen Jen, a currency specialist with the US bank Morgan Stanley, the flow of capital to threshold countries could drop by more than half -- from the current level of €575 billion ($730 billion) to €230-270 billion ($292-343 billion) -- if world economic growth drops to only 1 percent in 2009. The demise of these countries, says Jen, represents the new "epicenter of the global crisis."

The looming crisis has the countries in most dire need lining up for emergency loans from the International Monetary Fund (IMF). But all they are doing is buying time -- a few weeks, or perhaps even months -- and hoping that the general situation will soon improve.

The Ghost of Buenos Aires

The signs of looming national bankruptcy are plentiful, and bankers in the Uruguayan capital of Montevideo know them well. In late 2001, they were the first to see the coming crash in Argentina. Men traveled across the Rio de la Plata, from Buenos Aires to Montevideo, carrying suitcases filled with US dollars. They stood in long lines at the city's banks, depositing the contents of their suitcases into accounts and safe deposit boxes there. Uruguay is South America's Switzerland, a safe haven for money in times of crisis. No one asks about where the millions come from.

Once the Argentine businessmen had transferred their dollars abroad, the second phase of the collapse began. The Argentine government froze all bank accounts, capping the maximum amount an accountholder could withdraw at only $250 (€198) a week. Small investors, those who had left their money in the banks, were the hardest hit. Tens of thousands of desperate citizens stormed the banks, and many spent nights sleeping in front of the automated teller machines.

The last phase of the downturn began in the Buenos Aires suburbs. After consumption had dropped by 60 percent, young men began looting supermarkets. In December 2001, 40,000 people gathered on Plaza de Mayo in front of the Casa Rosada, the presidential palace. There, they banged pots and pans together day and night, until an unnerved President Fernando de la Rúa fled by helicopter.

The image of the fleeing president has burned itself into the collective memory of Argentineans. It marks the worst financial crisis of the last 100 years. De la Rúa's successor allowed the peso to float free on the world currency-exchange markets after it had been pegged to the US dollar at a ratio of 1:1. Tens of thousands of small business owners, who had incurred debt when the peso was still pegged to the dollar, filed for bankruptcy. Unemployment quickly ballooned to 25 percent.

Five presidents passed through the Casa Rosada in the space of two weeks, until Nestor Kirchner, a provincial governor until then, assumed the presidency in 2003. Kirchner informed the country's international creditors that Argentina would not be able to repay its $145 billion (€115 billion) in foreign debt.

Is history repeating itself today?

Economic experts have been warning for months that Argentina is again heading toward national bankruptcy. Men are traveling to Uruguay once again with suitcases filled with cash. In the space of only three weeks, more than $700 million (€553 million) was withdrawn from Argentine bank accounts. Government bonds have lost more than half of their value. ATMs are no longer giving out more than 300 pesos, and inflation is running rampant.

Bailing Out a Sinking Ship with a Bowl

And the sound of pots and pans being banged together is back. President Cristina Fernandez, who succeeded her husband Nestor Kirchner in 2007, increasingly resembles the hapless de la Rúa. Last week, she presented her version of the "Corralito" -- the term used to describe the freezing of bank accounts in 2001 -- when she ordered the nationalization of private pension funds, allegedly to prevent the funds from going bankrupt.

But economic experts believed that Fernandez's true objective in nationalizing the private deposits, which are worth $30 billion (€24 billion), is to avert a government bankruptcy. Columnist Mario Grondona criticized the president, likening her to "a captain trying to save a sinking ship by bailing it out with a bowl from the kitchen."

Her husband was more decisive. He defied the IMF, which has sought to impose drastic rules on the country. He alienated international creditors by offering to buy back government bonds for only 25 percent of their face value. Since then, Argentina has received almost no new loans in the global financial marketplace.

Nevertheless, the country recovered from the crash with astonishing speed. In recent years, the Argentine economy has grown at impressive rates of 7 to 9 percent. At the first signs of the impending end of the boom, Venezuelan President Hugo Chavez came to the country's rescue by buying up Argentine bonds. But now the authoritarian Venezuelan leader can no longer serve as Argentina's savior. With oil prices sharply in decline, Venezuela itself is seen as yet another candidate for economic disaster.

This has prompted President Fernandez to discreetly seek rapprochement with the hated IMF and the Club de Paris, a group of lending nations made up of some of the world's richest countries, in an attempt to reconnect Argentina to the international lending cycle.

The European Union's Achilles Heel

Hungary is another country being hit hard by the financial crisis. Until recently, the Hungarian government would not have dreamed it would be forced to accept aid from the IMF. But in recent days Hungary barely avoided sliding into national bankruptcy, and only a €12.5 billion ($15.9 billion) IMF rescue package -- bolstered by billions more from the European Union and the World Bank -- prevented it from happening.

The incident has historic significance. Hungary is the first country in the European Union obliged to accept an IMF loan of this nature. The conservative newspaper Magyar Nemzet writes that the move will turn Hungary into the "only colony of the International Monetary Fund" within the EU. The opposition party calls the plan "a disgrace." Brussels's contribution was €6.5 billion ($8.26 billion), while the World Bank contributed another €1 billion ($1.27 billion). The measures represent the most comprehensive international rescue package assembled in the current financial crisis.

How could this have happened, an EU member finding itself in such difficulties?

Much of the blame for Hungary's current debacle lies with the failings of the past. The once-successful nation of 10 million people lived beyond its means for years. With government finances spinning out of control, the national debt ballooned to two-thirds of the country's GDP. "The funding for our excessively high standard of living came from other countries," admits András Simor, the governor of the central bank, not without a dose of self-criticism.

The Hungarians have always been considered shopaholics. Hundreds of thousands bought themselves big cars and went on shopping sprees in the chic boutiques on Váci Utca in Budapest -- all on credit. The real estate market boomed, turning close to 90 percent of Hungarian apartments are privately owned. Most mortgage loans were denominated in euros and Swiss francs. But that practice has taken its toll. As the Hungarian forint plunges in value, mortgage holders are suddenly paying astronomical interest rates. It was primarily this dependency on other countries that has fueled the crisis in Hungary. Ironically, Budapest was once seen as a role model for other countries seeking EU membership. But instead of following in the footsteps of the Czech Republic and Slovakia, and introducing structural reforms after the collapse of communism, the Hungarians kept growing their national debt. A few days before the runoff vote in the 2002 parliamentary election, the conservative government of then Prime Minister Viktor Orban increased pensions by a substantial amount. Orban's successor, Peter Medgyessy, a socialist, introduced a 50 percent salary hike for teachers and healthcare workers.

The current premier, Ferenc Gyurcsány, also chose borrowing as his preferred method, at least initially. Only when the planned introduction of the euro threatened to become a more distant possibility for his country did Gyurcsány change course and encourage saving, at least to the extent possible. The opposition fought against the necessary reforms with missionary zeal. A referendum eventually broke the deadlock, and Gyurcsány was forced to put his savings plans on ice.

Nevertheless, the socialist was able to celebrate a few modest successes. The country's public deficit was brought down from more than 9 percent of gross domestic product in 2006 to about 3 percent more recently. But this was still not enough to help the country withstand the tremors of the financial crisis. "Before we were able to reach a safe harbor," says central bank Governor Simor, "the hurricane caught up with United States"

After receiving international credit assurances, neighboring Austria can finally breathe a sigh of relief. Its financial institutions, including Erste Bank, the Raiffeisen savings bank and Austria-Creditanstalt, have a strong presence in Hungary, where they control 22 percent of the banking sector. These days, it is quite possible that a crisis in small countries could end up pulling larger ones into its vortex.

Ukrainian Crash

Further east, the Ukrainian Central Bank last Thursday set the official exchange for the country's currency at 5.70 hryvna per US dollar. But its effort was in vain. By noon, currency traders in Odessa were already charging 9 hryvna for a dollar, until they were forced to close when their supply of greenbacks ran out. Ukrainians with rents to pay in dollars -- a common practice in many parts of the country -- suddenly faced the prospect that they couldn't pay their landlords come Nov. 1.

Europeans are familiar with the constant trouble between Yulia Tymoshenko, the prime minister, and President Viktor Yushchenko, her curmudgeonly rival. But it is less well known that Ukraine was in a better economic position than Hungary until recently.

Massive amounts of foreign capital began flowing into the country in 2007. The Ukrainian market was attractive and brought in unexpectedly large investments. At the same time, the price of steel, Ukraine's top export, was ballooning on the world market. The price of a ton of steel in July, €189 ($240), was already €55 ($70) higher than at the beginning of the year.

After the government had forecast 6.5 percent GDP growth, the precipitous drop in Ukraine's economy came as a shock to Kiev's political elite, especially in a country that was barely integrated into the global financial system. Ukraine was in a "state of euphoria," and yet it was unable to cope with the massive influx of capital, say the Eastern Europe specialists at the University of Bremen. Pensions and wages were raised, in some cases savings accounts lost at the end of the Soviet era were replaced and banks issued loans without examining their borrowers' creditworthiness. This stimulated consumption, with consumers increasingly spending their newfound riches on imports. But then the price of steel plummeted.

Could the IMF Run Out of Money?

In only one year, the foreign debt rose from €27 billion ($34.3 billion) to €78 billion ($99 billion), of which €23 billion ($29 billion) is due by the end of 2009. But Kiev is no longer receiving any loans from abroad, while Ukrainians are withdrawing their savings from domestic banks to the greatest extent possible.

Europe's largest nation is a textbook example of how an economic cycle can collapse in only a few months. The Ukraine specialists in Bremen assume that the country could face "a deep national crisis" in 2009, the "consequences of which are difficult to predict."

A vicious circle has already been put in place, now that steel mills are cancelling their coal orders. The coals mines, most of which survive on loans, can no longer pay the utilities, which in turn are shutting off the power supply. Winter is around the corner and Kiev has not yet reached a definitive agreement with Moscow over natural gas prices. Indeed, Moscow could be tempted, once again, to take advantage of the plight of its reviled neighbor.

It is "like a tornado" that increases in strength every day, says one industry leader. Some are already calling for a return of the barter economy, an antiquated system of trading among companies, which was implemented in the early 1990s when money was scarce. "It would be like turning away from the market economy," warns former President Leonid Kravchuk.

The head of the Ukrainian central bank characterizes the €13 billion ($16.5 billion) that the IMF is now providing as "technical bankruptcy." But the IMF is also attaching conditions to its bailout for Ukraine. They include a freeze on social services, increasing natural gas prices, privatizing government-owned businesses and eliminating subsidies.

Last week, the Ukrainian parliament held a heated debate over a crisis program. But the president and the prime minister did what they have been doing for months, taking advantage of the crisis to continue their duel. Tymoshenko, with her populist politics, is to blame for the plight, Yushchenko complained. Tymoshenko promptly responded by calling the president's decision to schedule new elections now "criminal."

Ukraine never fulfilled obligations, warns one of the country's former leading economists. In an article titled "Kiev's Crackup," the Wall Street Journal writes that Ukraine's only hope for success is to find new political leaders.

Concerns of a Pakistani Meltdown

Thousands of miles away last Wednesday, a powerful earthquake struck in Pakistan, killing about 300 people in poverty-stricken Beluchistan Province. It was yet another blow to country whose troubles are myriad and serious. The nuclear-armed country has been plagued by suicide bombings, corruption scandals and radical Islamists -- and now by the financial crisis.

On the day before the quake, German Foreign Minister Frank-Walter Steinmeier was in Pakistan, on a visit that signaled Islamabad's importance for the West. Although Pakistan does not occupy a key position in the global financial system, the fear that this country, of all places, could collapse sends a cold shiver down the spines of observers.

Last Tuesday, according to reports, there were only two to three weeks separating Pakistan, a nation of 165 million, from bankruptcy. Pakistan, says Steinmeier, "was hit hard." He supports an immediate IMF loan to Pakistan to the tune of several billion euros.

Islamabad's economy has been in a free fall for months. Skyrocketing prices for oil and food drove up the inflation rate, while ongoing terrorist attacks by Islamist extremists drove away investors. Few doubt that the current situation could lead to anarchy in Pakistan, a country already under stress from numerous forces. If the government fails completely, the consequences will be more serious that in other nation threatened by the financial crisis.

In speeches to business leaders in Lahore and Karachi Shaukat Tarin, a former banker at Citibank and the current financial advisor to Pakistan's prime minister, promised an entire package of measures. But without money they are not feasible. They include government subsidies for agriculture, expansion of the energy sector to do away with the country's chronic power outages and simplification of the tax system.

In addition, President Asif Ali Zardari is proposing a program he calls the "Benazir Card," named after his murdered wife Benazir Bhutto, which would entitle seven million needy citizens to monthly welfare benefits. Poverty is a mounting problem in Pakistan, where inflation is at 25 percent and a budget deficit and shortage of currency reserves have led to significant subsidy cuts and growing hunger.

Quick action is needed. It would be catastrophic were the unity of Pakistan threatened -- a unity already fragile given the lack of authority the government and its representatives has in many tribal regions. An estimated €11.5 billion ($14.6 billion) in aid will be needed for the next two years, although Shaukat Tarin puts that number at only €2.3 billion ($2.9 billion). Commitments so far, however, include only €1 billion ($1.27 billion) from the World Bank and the Asian Development Bank. Now that China has only offered to build two nuclear power plants, instead of contributing a hoped-for $1 billion (€790 million) financial injection, the only remaining big spender is the unpopular IMF.

An IMF loan would be tied to savings requirements, but these would not necessarily apply to the defense budget. The army is the only stabilizing force in the country. Weakening it would not be helpful in the war on terror.

Pakistan's military has already put a stop to the construction of its €160 million ($203 million) new headquarters in Islamabad. But irking the keepers of the country's nuclear bombs with additional savings requirements would be dangerous. The West's greatest concern is that Pakistan's nuclear arsenal (an estimated 60 warheads and 70 delivery missiles) could end up in the wrong hands.

Only foreign capital can prevent more and more of the poor seeking their salvation among the radical mullahs. Pakistan cannot be allowed to become insolvent, and for this reason the IMF's offer of assistance is inescapable. Indeed, there is already evidence of improvement for Pakistan. In two weeks, a group called Friends of Democratic Pakistan, which includes the United States, the EU, Japan and a few Gulf nations, will meet in Abu Dhabi. And now that the German foreign minister paid a visit to Saudi Arabia last week, the wealthy oil-producing nation is also on board. Steinmeier had urged the hesitant Saudi king to take part in the Pakistan rescue program, apparently with success.

Can the IMF Keep Up?

But what happens if the IMF runs out of money? The Washington-based financial fire department has already promised to pony up €27 billion ($34.3 billion) for Iceland, Ukraine and Hungary. This is about one-fifth of the funds the IMF currently has available for such packages, and Pakistan is looming.

Should the virus of financial failure continue to spread, the €156 billion currently available to the IMF would soon be exhausted. If that happened, the major industrialized nations would have to inject additional funds and provide the IMF, possibly through loans, with fresh capital for the high-risk countries. Global investors would hardly be interested.

And what happens if capital flight from the faltering threshold countries fuels the greed of speculators even further? For months now, they have been betting their money on, not just the ruin of banks and insurance companies, but the demise of entire countries. "It's blood in the water for the hedge fund sharks," wrote Britain's Sunday Telegraph, noting that economies like Hungary's are simply too weak to resist.

"Major players in the foreign currency market, like hedge funds and banks, are betting on the further decline of Eastern European currencies," says Hans-Günter Redeker, chief strategist with the foreign currency division of French banking conglomerate BNP Paribas. The gamblers have also set their sights on Ukraine, Poland, the Czech Republic, Romania and Turkey. Even Russia, the natural resource paradise, is seen as a worthwhile bet, because it will hardly be able to defend the ruble for much longer, given the massive exodus of capital.

The entire world is currently spooked by the Argentine ghost. Even if wealthy countries reach out to ailing nations, some governments will not survive the storm. Even this would not be truly dramatic. But if the industrialized nations then decide to leave the threshold countries to their own devices, the ensuing wildfire will burn indefinitely.

By Beat Balzli, Rüdiger Falksohn, Jens Glüsing, Alexander Jung, Marion Kraske and Christian Neef

Translated from the German by Christopher Sultan

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