A CASE OF NERVES

By Michael S. Serrill

In Argentina international financing for free-market reform is in jeopardy. In India foreign institutional investors have dumped their holdings, sending the stock market into a steep plunge. In Japan a sharp increase in the damage estimate of the Kobe earthquake has sent the Tokyo market tumbling as money managers expect the country to cash in some of its foreign holdings to pay for reconstruction. In the U.S. investors are pulling back even further in anticipation of yet another interest-rate hike, which would make overseas capital markets even less attractive than they are today.

Around the globe, investors were nervous and markets jittery last week as billions of dollars were being pulled out of countries suddenly considered at risk, especially developing nations that were the darlings of money managers just a few months ago. ``What we're seeing around the world is a flight from risk and thus a flight from emerging markets,'' said Paul Horne, an economist with the investment firm Smith Barney in Paris. ``Investors have become concerned with countries in which the triple threat of a high deficit, high public debt and high unemployment is a problem.''

The problem making for jumpy nerves was evident: Mexico, and the hurdles the Clinton Administration was facing in trying to pull together a $40 billion loan-guarantee package for the battered neighbor. The scare that had afflicted financial markets in the wake of Mexico's debilitating Dec. 20 devaluation of the peso was developing into something more serious: a general skittishness about markets in countries embracing tariff cutting, deregulation and the sale of state-owned assets on the road to modernization. The new, skeptical mood was in fact spreading beyond the Third World to affect countries like Spain, Italy and Sweden, which have seen their currencies come under heavy pressure since the Mexican crisis broke.

The peso devaluation ``raised the premium for emerging markets,'' said Peter Churchouse, managing director of Morgan Stanley Asia Ltd. in Hong Kong. ``American investors in particular got into them in a wave of euphoria. A lot of the new investors were naive to the risks. What Mexico has done is to hit everyone over the head and say, `Look, there are risks!' ''

Anxiety was fueled by political tussling in Washington, where the White House was striving mightily, and unsuccessfully, to persuade a majority in the U.S. Congress to endorse proposed loan guarantees for Mexico. ``Failure to act could have grave consequences for the Mexicans, for Latin America, for the entire developing world,'' warned President Clinton, who got support from both the Democratic and Republican leadership as well as from Wall Street and the always cautious Federal Reserve Chairman Alan Greenspan. Greenspan urged Congress ``to halt the erosion in Mexico's financial capabilities before it has dramatic impacts far beyond those already evidenced around the world.''

Some irony was attached to that plea since the Fed's six increases of U.S. interest rates during the previous 11 months had helped create the Mexican crisis. As it was, the chairman's effort had only limited impact on Congress, where populist Republicans have been joining forces with anti-free trade Democrats to make passage of the bailout package unlikely in the near future. Democratic Senator Ernest Hollings of South Carolina denounced the loan-guarantee legislation as a ``billionaire bailout'' to save the fortunes of rich investors on both sides of the border. Though House Speaker Newt Gingrich expressed backing for the Clinton proposal, he said, ``It's clear from polling data that there's just no base of popular support out there.''

If there is no bailout, Mexico is likely to face further destabilization--as may Latin America as a whole. Already the uncertainty about Washington's course of action is accelerating the Mexican economy's downturn. Some 4,000 businesses closed in the first four weeks of 1995 because of high interest rates, lack of sales and tight credit since the peso crash. Predictions of the annual inflation rate for 1995 run to 20% or more, and many economists expect the economy to shrink at least 2%, even if the U.S. guarantee is approved. Government and private analysts contend that while direct foreign investment will fall only slightly below last year's $7.5 billion, portfolio investment--funds directed toward the stock and bond markets--is likely to decline from $10 billion to $1 billion.

At midweek, Mexico got a measure of relief when the International Monetary Fund approved a $7.8 billion loan, the largest it has ever made, to help stabilize the peso. Argentina, Brazil, Chile and Colombia also jointly opened a $1 billion credit line for Mexico. But the infusions were not large enough to solve Mexico's most serious challenge: finding sufficient funds to pay off or refinance $26 billion in mostly foreign-owned short-term bonds maturing during 1995. The government got a hint of the difficulties ahead last week when it put at auction $400 million in U.S. dollar-denominated bonds called tesobonos and sold only $275 million worth, despite a proffered interest rate of 27%.

Mexico is not the only victim of the crisis of confidence. Emerging nations that have been relying on foreign investment to underpin financial reform and build prosperity will have to do with less as a result of the cooling of investor ardor. Argentina, which like Mexico has an overvalued currency and carries substantial foreign debt, has watched $1.8 billion flee the country since the Mexican devaluation, despite firm promises by the government that the Argentine peso will not be devalued. Last year $11 billion flowed into Argentina in direct and indirect investment; this year the amount is expected to drop by as much as half. ``There is a crisis of confidence and some fears that Argentina might have trouble paying its debt,'' says Pablo Gerchunoff, an economist at the Instituto di Tella in Buenos Aires. ``These fears may only be partly justifiable, but unjustified fears can sometimes become self-fulfilling prophecies.''

The impact has also been felt in Asia, though less severely, largely because the region's traditionally high savings rate allows it to finance growth and expansion without heavy foreign borrowing. Investor nervousness grew last week when private damage estimates for the Kobe earthquake were raised to $100 billion--and possibly as much as $400 billion. Repairing the quake damage ``will cause a bigger cash drain away from the stock market'' than originally anticipated, says Jason James, an analyst in the Tokyo office of James Capel, the Hong Kong investment bank. ``The current stock prices don't reflect this. If bigger damage estimates come out, then the market could fall another 1,000 points. Then individual investors may despair and give up.''

In China, the nation with the world's biggest inflow of foreign investment, the Mexico crisis followed by the Kobe quake hit the Shanghai ``B shares'' market hard, slicing 17% off its value. That came atop a 38% nationwide decline in total foreign investment in 1994, to $68 billion. There is no telling the effect of additional uncertainties when Deng Xiaoping, the fast-fading longtime leader, passes from the scene.

The surge in U.S. overseas investment that began in the early 1990s was in fact already ebbing before the Mexican meltdown. According to the Goldman Sachs investment firm in New York City, Americans sank $125 billion into non-U.S. stocks and bonds in 1993, but only $50 billion in 1994 as Greenspan raised U.S. interest rates and other international lenders followed suit. ``The main reason many of these investments went overseas was in search of higher yields,'' says Larry Chimerine, managing director of the Economic Strategy Institute in Washington. ``Higher interest rates here and in Europe have made that less necessary.''

The crunch has hit unevenly around the world. In Eastern Europe it has had less impact, largely because the former communist-bloc countries have been receiving relatively little of the outside money that has been pouring into nontraditional stock and bond markets. Most of the investment in Eastern Europe has been in the form of outright purchases or construction of factories, power plants and communications nets. The East European country that looks most vulnerable in the current climate is Hungary, which so far has garnered $7 billion, or 55% of foreign investment in the region. Hungary's foreign debt is larger than Mexico's--$27 billion, or 67% of GDP, and it has high current-account and budget deficits that have been dragging down the value of its currency. Yet because most of foreign investment is in infrastructure and the debt is mostly medium or long term, Budapest has not been rocked hard by the effects of the Mexican crash. ``The first half of 1995 will be a very risky time in Hungary,'' says Janos Kovago of the Budapest branch of GiroCredit, an Austrian bank. ``But I am positive that by the second half of the year the situation will have improved drastically.''

One thing is certain: developing countries eager to retain past levels of investor interest will have to change their ways. ``The crisis in Mexico and a rise in interest rates only put more pressure on these countries to get their act together,'' says Jeffrey E. Garten, Undersecretary for International Trade at the U.S. Commerce Department. ``They have no choice.'' Their first priority, Garten says, should be continuation of privatization of state industries. ``Brazil, for example, has been historically reluctant to privatize, but now you will see a major acceleration,'' he explains. ``India, where there has virtually been no privatization, is now looking at this with great intensity. Poland and Turkey and South Africa will all accelerate.''

To Riordon Roett, senior political analyst at the Chase Manhattan Bank in New York City, the current upheaval in the markets is part of a predictable cycle. ``Some argue that an adjustment was needed to re-evaluate where investors should be,'' he says. That kind of re-evaluation is clearly under way--and promises to be painful for many. Reported by Jay Branegan/Brussels, Laura Lopez/Mexico City and Stacy Perman/New York, with other bureaus

With reporting by JAY BRANEGAN/BRUSSELS, LAURA LOPEZ/MEXICO CITY AND STACY PERMAN/NEW YORK, WITH OTHER BUREAUS