Central Bank Credit Has Worked For Now

Source : The Business Times, Mon, Aug 13, 2007

IN the past year, central banks have studied various models on how to cope with a 'systemic' global financial crisis. They are now being tested.

'So far, the first step of central bank credit to banks appears to have worked,' said Brendan Brown, the London-based chief economist of Mitsubishi UFJ Securities International.

But the main worries are that tighter bank credit and higher interest rates could cause a further market slide, he said.

This could lead to further hedge fund and other financial failures. Coupled with a downturn in the real estate market, the US and European economies could slow down or experience recession, he feared. This, in turn, would dampen the exports and economic growth of Singapore and other Asian economies.

In the initial rescue phase, global central banks have pumped more than US$300 billion into financial markets. These loans appear to have eased panic in the European, US and Asian interbank markets. Such were the fears about the financial health of counterparties that banks, especially in Europe, became nervous about lending money to each other. Credit dried up and interbank interest rates soared as lending banks demanded a higher risk premium.

Last Thursday and Friday, the European Central Bank (ECB) supplied US$214 billion to loosen the squeeze on vulnerable European banks. The US Federal Reserve Bank funnelled US$62 billion into the US financial markets. Alongside efforts of the Bank of Japan and Asian central banks, a credit crunch and bank failure has so far been avoided.

After an initial slump of several hundred points, the Dow Jones index last Friday ended up 58 points on the week. With Asian central banks at the ready to support their banks, there is hope that their markets will stabilise and possibly recover today. But the underlying problems are still very serious.

The next step is how central banks, regulators and investors deal with two parallel crises, economists said. The first relates to excessive loans on residential real estate and rising defaults. The most publicised is the so-called sub-prime crisis in the US where figures of potential defaults of US$100 billion are being bandied about. Real estate prices are tumbling.

But there are also huge and potentially doubtful loans to property owners in Britain, France, Spain, Eastern Europe and, more recently, Asia. Some economists believe that Spanish banks are particularly at risk as prices there have already begun to fall.

In England's north and midlands, property prices have already begun to slip. The current debacle has a good chance of ending London's financial boom, which would cap the city's heady property prices.

Parallel to this problem is an acute crisis in the US$1.6 trillion global hedge fund industry. Leverage, or borrowings of thousands of hedge funds, have raised their market exposure to US$3-4 trillion, estimated Dresdner Kleinwort. Economists and other analysts believed the unwinding of these positions are the root cause of the current crisis, the worst since the failure of the hedge fund Long Term Capital Management in 1998.

The inevitable result has been panic among investors who placed money in hedge funds. Many now want to withdraw their money, forcing the managers to dump shares and other assets on the market. This has created a vicious circle, causing stock market falls, further hedge fund losses, more withdrawals, leading to inevitable closures.

The dilemma facing central banks is whether to allow the free market to dish out bad medicine, causing failures and a painful adjustment. They are aware that if they continue to pour money into the market and slash interest rates to save reckless banks and hedge funds, they could spur inflation. That would stem today's financial crisis, but an ultimate one could be much worse.