STUMBLING GIANTS

By FRANK GIBNEY/TOKYO

First came the Asian Miracle, as booming Pacific Rim countries showed the rest of the world how to grow. Now comes the Asian Meltdown, as turmoil across the region shakes markets from Hong Kong to Wall Street. Last week it was Japan and South Korea that gave the world a jolt. No sooner had rumors of a possible South Korean collapse swept out of Seoul than the Japanese yen and the Tokyo stock market plunged to their lowest levels in two years. Across the Pacific, the ill winds from Asia blew the Dow Jones industrial average into a 157-point drop on Wednesday. "The real problem in East Asia is not Thailand, Indonesia or the Philippines," says Kenneth Courtis, chief Asia-Pacific strategist for Deutsche Morgan Grenfell. "It is Japan and Korea."

It wasn't supposed to be this way. On the eve of the Pacific century, Asia's two most powerful economies were supposed to be pumping out wealth for the rest of the world--not threatening to suck it dry. But banks in Japan and South Korea now groan with bad debts that could push both countries into deep, prolonged downturns. In Japan, public confidence is at a postwar low and nobody wants to spend a yen. Korea is cash strapped and politically rudderless, with a presidential election just four weeks off.

U.S. leaders have been eyeing both countries with growing alarm. In a letter to his Japanese counterpart two weeks ago, Treasury Secretary Robert Rubin reportedly urged Tokyo to move swiftly to regenerate the Japanese economy and warned against flooding the U.S. with exports as a way to solve Japanese problems. And with concerns rising in Congress, Federal Reserve Chairman Alan Greenspan testified last week that Asia's problems, while not yet "serious threats" to the U.S. economy, could become so if they are not defused properly. To do that, Deputy Treasury Secretary Lawrence Summers was to meet with Japanese officials in Tokyo this week to discuss an emergency bailout fund for the region.

The stakes for the U.S. are particularly high in Japan and Korea. Banking collapses in either country would pull back gobs of capital from the U.S. and possibly slay the bull market. At the same time, a sharp drop in demand for U.S. exports could slow or stall the soundest peacetime expansion in recent American history. Perhaps more worrisome is the danger Rubin warned against--that Japan and Korea might slash prices of exports to the U.S. to restart their economic engines, and thereby ignite a trade war.

So what happened to Asia's two key economies? Korea's rise was until recently the stuff of legend. Like Japan, Korea prospered from the cooperation among its banks, politicians and large conglomerates, known as chaebol. Politicians picked industries to support; business leaders duly invested in them; and banks put up the money.

But as growth slowed and Seoul opened its economy to foreign competition, the fat profit margins of Korean companies suddenly became anorexic. Manufacturers like carmaker Kia Motors and steelcaster Hanbo have collapsed. Yet the chaebol kept begging for money, and their bankers kept obliging. Result: loans to Korean companies have reached an amount equal to 165% of Korea's GDP, and rumors abound that the country may seek an International Monetary Fund rescue. Seoul, however, denies it.

For Japan, which has been in a slump for most of this decade, the turmoil in Korea and the rest of the region ends any hope for a near-term recovery. Toyota said this month that it will temporarily close two huge auto plants in Thailand and conglomerates like Mitsubishi Heavy Industries have been slashing profit forecasts.

Japan's plight is especially worrisome because Japan is the world's most important investor. But with corporate bankruptcies climbing there, nobody in Japan is willing to invest much in anything. "We have banks desperate to get rid of bad loans," says a top official at the Foreign Affairs Ministry, "and they will not fund anything until they have done that."

Therein lies the core of Japan's current perplexity. During the go-go years of the 1980s, Japanese banks handed out money no matter how grandiose the project. Now the banks must write off hundreds of billions of dollars of bad loans even as more companies tumble into bankruptcy. And with the stock market's Nikkei average threatening to drop below 15,000--vs. its peak of 38,915 in December 1989, when the bubble burst--many banks face massive losses on their stock portfolios. If the Nikkei index sinks toward 14,000, as many economists fully expect, Japan's top 20 lenders could face an additional $100 billion in portfolio losses. "The whole system is in trouble," says Masaru Kakutani, a Moody's Japan representative director.

Such setbacks could force Japanese banks to dump foreign holdings for cash, which would swiftly be felt across the Pacific. The Dow Jones average tumbled last June when Japanese Prime Minister Ryutaro Hashimoto said in jest that his country might begin to liquidate its U.S. Treasury bill holdings. "If they did that, there would be a substantial downtick in our market prices, our equity prices and probably in our real estate prices," says Carl Weinberg, chief economist for High Frequency Economics in Valhalla, N.Y.

In any case, Japan and Korea can count on the falling value of their currency to increase exports to the U.S., a prospect that worries American companies. Shares of Texas Instruments fell 13% last week on fears of growing Asian competition in the market for computer chips. If exports from Korea and Japan do balloon, America's trade deficit will also. That in turn would strengthen the protectionist forces in Congress that last week forced Bill Clinton to withdraw his fast-track trade measure.

The turmoil in Asia has already cooled prospects for the U.S. economy next year, which helps explain why Greenspan last week declined again to raise interest rates. Japan and Korea must now put their own economic houses in order--Japan was to unveil a new stimulus package this week--without waiting for miracles. --With reporting by Rahul Jacob/Seoul, Sachiko Sakamaki/Tokyo, Jane Van Tassel/New York and Adam Zagorin/Washington

With reporting by RAHUL JACOB/SEOUL, SACHIKO SAKAMAKI/ TOKYO, JANE VAN TASSEL/NEW YORK AND ADAM ZAGORIN/ WASHINGTON