What's That Cracking Noise?

By Barbara Rudolph

After all the gloomy forecasts, all the frenzied selling of the first few days, the mood of the world's financial markets brightened a bit last week -- from near hysteria to mere anxiety. War could still erupt in the Persian Gulf; oil prices could remain relatively high. Yet for the moment it appears that ahead lies not a global depression of historic proportions but an old- fashioned recession -- painful, though probably not fatal. Saddam Hussein's oil shock has not destroyed the foundations of the world economy, but it has exposed serious weaknesses in the beams.

Even the most pessimistic forecasters were cheered when OPEC decided last week to allow its 13 members to increase production to make up the shortfall of roughly 4.6 million bbl. a day lost in the U.N.-mandated embargo on Iraqi and Kuwaiti crude. In the wake of the cartel's action -- Iraq and Libya did not attend the meeting in Vienna -- petroleum prices dropped about $2 in one day, to $26 per bbl. Toward week's end, however, traders began fretting once again about a possible gulf confrontation and a disruption in energy supplies; with that, the price for October delivery closed at $27.32 per bbl., down 12% for the week.

No sooner had OPEC made its announcement than the Bank of Japan raised another cause for concern: it upped its discount rate 0.75%, to 6%. The central bank's fifth such increase in little more than a year, it should not greatly slow the potent Japanese economy, which is growing at a rate of more than 4% a year. But investors are worried that the move could spark a worldwide run-up in interest rates. Since rates on long-term government bonds have risen 55% in Japan and more than 36% in West Germany in the past two years, a new round of hikes could cause a worldwide credit crunch.

The parlous state of the U.S. economy is likely to weaken even the healthiest of countries, since so much of the world relies on Americans to buy its goods -- from Sony camcorders to BMW cars. The U.S. recession either is about to begin or has just started, and rising oil prices promise even slower growth and, simultaneously, higher inflation.

Some economies will weather the coming storms, while others look fragile.

EUROPE AND THE SOVIET UNION. Partly because the European Community relies on oil for only 40% of its energy needs today, vs. 60% during the oil shock of 1973, most West European economies are on relatively solid ground. None are more robust than West Germany's, which is expected to grow 4% this year, despite the financial burdens of unification. More remarkably, a united German economy should still expand 3.5% in 1991, predicts Peter Pietsch, an economist at Frankfurt's Commerzbank. Bonn has been bolstered by a strong deutsche mark, which this year has gained 8% in value against the dollar, the currency in which oil trading is done. Nevertheless, energy will be one of the many problems facing a united Germany. Says Robert Hormats, vice chairman of Goldman Sachs International: "West Germany is merging with one of the most wasteful consumers of energy around."

Though France's extensive nuclear-energy program has reduced its reliance on oil, growth will drop from 3.7% last year to around 2.5% this year, but is projected to rise to 2.9% in 1991. Italy, which banned the construction of nuclear plants in 1987 and is the E.C.'s largest oil importer, is more exposed. Britain is the Community's only significant crude producer; its inflation rate, already 9.8% annually, is likely to climb higher, at least in the short term. But next year, some British forecasters predict, prices could start falling.

Eastern Europe's economies may face the struggle of their lives. For the first time in decades, they will have to pay the market price for energy instead of relying on subsidized oil from the Soviet Union; they must also make do with a 30% cut in Soviet supplies. Even with oil at only $20 per bbl., Bulgaria would be forced to use 80% and Czechoslovakia 60% of hard-currency reserves to pay for supplies. Though the Soviet Union stands to gain an additional $7.5 billion in hard-currency earnings as a result of the price run-up, Moscow cannot expect a bonanza: its oil industry is so inefficient that production will decline this year and next.

THE PACIFIC RIM. Japan justifiably claims credit for reducing its dependence on oil imports, down from 77% of total energy supplies in 1973 to 58% today. But ballooning petroleum prices risk sparking inflation. The official inflation rate of 2.5% is understated, since it does not reflect property values that have risen to unprecedented heights in the past five years. Moreover, with the country's rapidly aging population, Japanese companies face a severe labor shortage that threatens to drive up wages and, eventually, prices.

To fight inflation, the Bank of Japan is using the only weapon in its arsenal: higher interest rates. A credit squeeze seems likely. John Hickling, portfolio manager of Fidelity Investments' Pacific Basin Fund, thinks the liquidity drought has arrived. Since nothing spooks stock-market investors like the prospect of rising interest rates and a credit crunch, Japanese shareholders have been cleaning out their portfolios, driving the Nikkei average on the Tokyo exchange down more than 30% from its late December high.

That leaves Japanese banks in a precarious spot: they could suffer losses on their extensive securities holdings just when other major assets -- loans to overleveraged property developers -- sour. In Japan real estate can be used as collateral to buy stocks, and vice versa -- a cozy arrangement until values crumble. If losses were to mount, banks would be forced to cut their loans to businesses. Firms would in turn reduce capital spending, and a recession would soon be under way.

Many Asian countries, with the exception of Indonesia, China, Malaysia and Brunei, import nearly all their crude. Since they rely almost entirely on export markets to fuel their growth, they remain especially sensitive to the economic well-being of their trading partners. With oil prices rising and the U.S. economy slowing down, traders in the smaller stock markets are looking glum: in Taipei, shares have plummeted 65% from their year-end high, while the Bangkok market has slipped 40% in just two weeks.

THE THIRD WORLD. The latest upheaval, like others in the past, will cause the greatest suffering in the Third World. Aside from a handful of oil producers, such as Venezuela, Mexico, Nigeria and Libya, most of Africa and Latin America will be left with higher energy prices and softer markets for their exports. Double-digit inflation could turn into triple digits, recessions could become depressions, and foreign debt would go unpaid.

With less than three months' supply of foreign-exchange reserves, much of Africa will have trouble paying its energy bills. Sub-Saharan Africa is already finding it difficult to handle the interest on its $135 billion foreign debt. Even the more stable economies will be badly hurt by the energy price hike. Kenya, for example, will see its oil-import bill increase from $300 million to $400 million a year if the price settles at $25 per bbl. Says Ross Wilson, a consultant at Deloitte, Haskins & Sells in Nairobi: "The question for Kenya is, How many loads can the camel take?"

In Brazil the oil shock strikes just as President Collor de Mello's radical anti-inflation regime, which includes a tight monetary policy, is beginning to show results. Inflation, which hit 73% a month before the plan took effect last March, has cooled to less than 13%. Government officials predict that Brazil will lose $3.3 billion because of higher oil costs and loss of exports through 1991. If prices stay at $25 per bbl., next year's energy bill will grow $2 billion. As a result, Brazil may not resume payments on its foreign debt of $115 billion.

As Latin America's leading oil producers, Mexico and Venezuela will benefit from the price hike. Mexico might pocket an additional $2 billion in hard- currency earnings, Venezuela perhaps $2.4 billion. But for Mexico particularly, the gains could be erased if a recession in the U.S. cripples its best market: America traditionally buys 65% of Mexico's exports.

The petroleum producers of the Middle East, with the exception of Iraq and Kuwait, stand to gain the most. Even if the production level were not increased, Saudi Arabia should sweep in an extra $38 million a day if prices stabilize at $25 per bbl., while the United Arab Emirates should increase its take by about $18 million. The biggest winner may be Libya, which will collect an additional $9 million a day and, unlike the Saudis and other gulf states, will not pay part of any bill for keeping U.S. and other forces in the gulf. It is one of the ironies of the current crisis that Muammar Gaddafi, the man perhaps most feared by Westerners until Saddam Hussein took his place, should profit so handsomely from the showdown in the gulf.

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CREDIT: TIME Charts

CAPTION: ECONOMIES IN LIMBO

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CREDIT: TIME Charts

[TMFONT 1 d #666666 d {Source: AP, Lundberg Letter and TIME correspondents}]CAPTION: THINK YOU PAY A LOT AT THE PUMPS?

With reporting by Seiichi Kanise/Tokyo and John Maier/Rio de Janeiro, with other bureaus