Central Banks Inject Liquidity As Credit Problems Escalate

Reality Check

Global equity markets have endured a tumultuous 24 hours, with heavy U.S. and Asian losses being followed today by sharp falls in London (United Kingdom) and other European markets. The spark was news yesterday that France's BNP Paribas (the Eurozone's second-biggest bank) was freezing three funds exposed to the U.S. sub-prime mortgage market. This was the strongest indication yet of the toll that crisis is taking on overseas lenders. In the meantime it was becoming clear that liquidity was drying up in the huge interbank market, and the European Central Bank (ECB) decided to act. It injected 94.8 billion euro (US$130 billion)-worth of funds, and also made unlimited amounts of cash available through its 4% discount facility. This has been followed by a further 61.05-billion-euro (US$83.61-billion) three-day tender today. What banks were charging to lend overnight to one another had risen sharply to 4.7% (well above the 4% target) and there were concerns over their access to vital short-term funds. The Japanese and Australian central banks quickly followed the ECB's lead and made their own more modest interventions (reportedly to the tune of US$8.45 billion and US$4.19 billion, respectively).

These interventions were a welcome sign that the central banks are ready to stem the contagion, and the overnight interbank lending rates fell into more normal territory. However, this did not stop the ongoing stock sell-off. Financial stocks unsurprisingly fell furthest, particularly hedge funds and private equity. BNP Paribas's problems are rooted in the U.S. sub-prime crisis, but there are also some concerns about the domestic exposure of European banks to high risk mortgage debt. This is hitting high street banks' shares. As would be expected, government bonds jumped yesterday as investors fled to safer ground. The yield on 30-day commercial paper Treasury bonds rose to 5.32%, the highest since 2001.

ECB Makes Record Intervention, Will Fed Follow Suit?

The ECB's 94.8-billion-euro injection (plus 61.05 billion euro today) is the largest it has made in its history, even exceeding the 69.3 billion euro pumped in after the terrorist attacks of 11 September 2001 in the United States (as well as an additional 40.5 billion euro on the second day). The bank also set a new precedent when it made a one-day pledge to meet 100% of funding requests from financial institutions. The bank did not give detailed reasons for its surprise move, merely saying that it wanted to "assure orderly conditions in the euro money market". It still seems that the ECB is convinced that the problems are largely financial; it has not felt the need to cut interest rates and stimulate the real economy (which is currently in good shape overall). This is not to say the remainder of the economy is immune should the banks' problems mount. If businesses and consumers struggle to obtain cash, investment and consumption would be hit, and given that capital expenditure has been a key driving force for European growth, this would be a concern. Could the fact that ECB moved so determinedly yesterday betray wider financial-sector problems than have yet been divulged publicly? It is impossible to say, but it is essential that the ECB keeps a close eye on the liquidity situation. The global interbank market is based in Europe, so any problems there have a knock-on effect on bank funding around the world.

Attention turns today to the U.S. Federal Reserve, to see whether it follows its counterparts' precedent. It did not take any emergency steps yesterday, although it did inject an unusually large US$24 billion via scheduled open market operations. This was somewhat more than normal, but well short of inducing panic. The Bank of Canada meanwhile pledged yesterday to "provide liquidity to support the stability of the Canadian financial system and the continued functioning of financial markets". It injected some C$1.64 billion (US$1.55 billion) during the day. The Fed has been at pains of late to stress the broadly robust state of the economy. Growth is slower, but in the statement following the 7 August Federal Open Market Committee (FOMC) meeting, the tone was cautiously optimistic. The economy is facing additional headwinds from the general tightening in credit conditions, and there are more downside risks to the outlook than what the Fed had thought at the end of June. Nevertheless, the Fed believes that the economy is capable of moderate growth, and it elected to keep interest rates unchanged.

Outlook and Implications

At the height of the sell-off yesterday, there was some talk of a fresh crisis to rival that seen in 1998, but such talk is much too premature. On one hand, the extent of the U.S. sub-prime crisis itself should not be exaggerated, while on the other the global economy is relatively well placed to take the strain. Federal Reserve chairman Ben Bernanke told Congress on 19 July that when looking at potential sub-prime losses "some estimates are on the order of between $50 billion and $100 billion." This is not a big number in a US$13-trillion economy, especially since the losses will be spread out over several years. Also, central banks are now offering timely reassurance about their willingness to act pre-emptively and see off a wider crisis.