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Crisis gives central banks no respite
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Financial crisis beginning in United States in August last year spreading to rest of world.
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The so-called subprime mortgage crisis began in August last year. The origin of the problem was the granting of mortgage loans in the United States to customers with low solvency without having carried out suitable risk controls. These mortgages were securitized and in this way passed on to a wide range of financial agents that were scarcely aware of the risks they were taking on. The sudden increase in default of these products set off a crisis of confidence among financial institutions that brought about restriction on the granting of loans, liquidity problems and heavy losses in balance sheets. The financial upsets, which have respected neither markets nor borders, have continued ever since.
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In the United States, the increase in default and the drop in the capital ratios of banks has meant bank credit is harder to get. In interbank markets, where banks lend to each other, the situation has meant an increase in interest rates.
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Federal Reserve adopts series of measures to inject liquidity.
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In view of the turn taken by the liquidity crisis, which finally had become a banking crisis, the Federal Reserve, the US central bank, at its meeting on monetary policy on March 18, decided to further cut its reference rate, this time by 75 basis points, to 2.25%. In its press release following that meeting, Fed members underlined the sharp decline in economic activity.
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Before this cut in the official rate, the Fed adopted a series of measures aimed at easing its effects. The ultimate aim of these measures was to increase liquidity, especially in the interbank market and in the market for assets backed by mortgage securities.
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At the beginning of March it created a new «liquidity window» to which US investment banks that had no access to the discount window could apply, as was the case for other deposit-taking banks. Secondly, the Federal Reserve decided to accept as collateral or security for that liquidity not only Treasury bonds but also bonds issued by the federal agencies Freddie Mac and Fannie Mae and even mortgage-backed bonds issued by private companies with high credit rating.
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In addition, the Fed announced an increase in swaps with the ECB and the Swiss central bank. A swap of this kind is a financial exchange in which the Fed puts dollars at the disposal of those two central banks so that they may make those dollars available to European commercial banks. In return, the Fed obtains assets in euros.
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The liquidity provided under all these measures amounts to 336 billion dollars. Is this enough? It represents nearly 2% of the US gross domestic product and is nearly double the fiscal plan approved by the Administration, which amounts to 170 billion dollars. This is indeed an extraordinary injection of liquidity that reflects the difficulties being experienced by the US financial system.
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Measures turn out to be insufficient and Fed obliged to rescue a private bank.
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In any case, all these moves failed to avoid rumours about the lack of liquidity in the fifth largest investment bank in the United States, namely Bear Stearns. A number of its counterparts in the interbank market decided to cut the their lines with this bank. In view of the problem of its financial viability, the Fed arranged the acquisition of Bear Stearns by the JP Morgan commercial bank.
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In Europe, ECB maintains interest rate at 4% and warns about inflation risk.
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In the Euro Area, for the moment there are different concerns. At the meeting of its Governing Council on March 6, the European Central Bank (ECB) kept the official interest rate at 4%. Economic information becoming known since its previous meeting confirmed the existence of strong price pressures over the short term which showed up in the central bank’s upward revision of inflation forecasts. It also pointed to an increase in uncertainty about the future course of economic activity.
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At the press conference following the meeting of the Governing Council, ECB president Jean-Claude Trichet referred to the risk from the impact of the financial upsets on the granting of loans to companies and households. With regard to non-financial companies, he cited the 14.6% annual increase in credit which, in his words, represented very strong growth. In the case of households, the slowdown in loans granted was consistent with the rise in reference interest rates beginning in December 2005. Finally, he discounted the possibility of there being a sharp drop in credit in coming months.
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Credit granted to companies and households in Euro Area showing notable growth.
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Furthermore, Trichet confirmed that, in spite of the financial crisis and in contrast to the Fed, the ECB had not modified the list of securities or guarantee assets it would accept in order to provide liquid funds. This had not been changed since the launching of the euro on January 1, 1999. In addition, he stated that the ECB was very strictly monitoring the credit quality of those guarantees.
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The Euro Area central bank again reminded all economic agents of its concern about wage increases that could mean worse prospects on inflation. The ECB announced it was carrying out the monitoring of wage negotiations and was concerned about arrangements under which nominal wages were indexed to the consumer price index.
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China again raises cash ratio for banks in fight against inflation.
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Elsewhere, concern in China about the increase in inflation has forced the central bank to make a move. The bank has ordained an increase in the cash ratio by a half percentage point, from 15.0% to 15.5%. This move follows the warning by Chinese prime minister Wen, at his annual press conference following the close of the National Popular Assembly in Beijing, when he indicated that the government would make a strong fight against inflation.
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In this respect, governor Zhou of China’s central bank indicated his readiness to raise the reference rate. For the moment, so far this year the central bank has avoided raising the rate following the six increases last year that put the official rate at 7.47%. Inflation, however, has reached 8.7% so that real interest rates in China are negative. Why not quickly raise the interest rate? The reason is the risk of a sharp appreciation of the currency that would make companies lose competitiveness. Furthermore, social stability in China demands the creation of between 2-4 million jobs a year in order to absorb the shift of people from rural areas to the cities.
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In Japan, central bank awaits appointment of new governor.
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Finally, in Japan, what seemed like an easy transition at the central bank has become complicated by the absence of a consensus between the government and the opposition about who should succeed to the present governor Fukui who leaves following expiry of his term. The crisis arose with the refusal of the opposition party to accept the second candidate proposed by the government, Tanami, currently president of the Japanese Bank for International Cooperation and former minister of economy. The opposition has stated that Tanami’s credentials were similar to those of the first candidate proposed, Muto, vice-chairman of the Bank of Japan but with his 37 years as minister of economy this made him too close to the government thus putting his independence in doubt. This deadlock situation leaves leadership of the Bank of Japan wide open at a critical moment with the risk of damaging the credibility of both the central bank and the government in the midst of sharp upsets in international financial markets.
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Interest rates suffer from financial upsets
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Interest rates reflect reduction of credit, worse growth prospects and flight to quality.
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Interest rates are keenly reflecting the increase in uncertainty. The volatile fluctuations are being brought about with the increase or decrease in the extent of the US subprime mortgage crisis which has become a crisis affecting the solvency and stability of the financial system.
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Further rise in one-year Euribor just when downward trend appeared firm.
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Over the past month, interest rate curves have been subject to the influence of various factors. Short-term interest rates were affected by a further reduction in the availability of credit in interbank markets. As may be seen in the following table, in the Euro Area the one-year Euribor has again gone above 4.6% levels when it seemed that the highs of 4.78% in the final months of last year had been a thing of the past. Following injections of liquidity by the ECB, interest rates were beginning to moderate and in January went to levels that could be said to show some normalization.
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February was a month of transition but liquidity was down in March, which again brought pressures in interbank markets. This trend is reflected in the sharp reduction in the availablity of bank credit in view of the need to increase liquidity in bank balance sheets in order to deal with a potential weakening of capitalization ratios. Lending institutions are trying to accumulate liquidity and are less ready to lend money in the interbank market. As a result, the lower availability of credit is raising the price of funds, that is, raising interest rates in the interbank market.
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Interest rates on long-term government bonds still depressed.
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On the other hand, medium and long-term interest rates have been affected by the sharp worsening of growth prospects in the United States and the flight to quality, two factors difficult to separate that both have been operating since the outbreak of the subprime mortgage crisis and that were again showing strong in March. With regard to US growth prospects, if an investor feels that economic activity will slacken, he/she will wait until inflation ends up dropping. In this context, the investor will put confidence in a cut in the central bank reference rate shifting to the interest rate curve of government bonds. With these expectations, the demand for government bonds will rise and thus bond yields will drop, given that price and return move in opposite directions.
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Furthermore, in this context there develops a move to buy high quality government bonds, which act as a refuge asset in a crisis situation. In view of the sharp drop in world stock markets, investors prefer to reduce risk in their investment portfolios by selling assets with high risk and giving preference to positions in high quality government bonds.
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Investors differentiating between government bond issuers according to credit rating.
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The following graph shows the downward trend in the price of US 10-year government bonds. Taking into account that inflation in the United States is 4% and that government bonds are offering 3.3% interest, at this time we are seeing negative real long-term interest rates which are discounting an economic situation of recession. Yields have also dropped on long-term government bonds in the Euro Area but these are offering 40 basis points (100 basis points equals 1%) more than US bonds.
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This may be seen in the widespread drop in long-term government bond yields not only in the United States and the Euro Area but also in Japan, United Kingdom and Switzerland. The decreases, however, have not all been of the same size as investors have made distinctions in bond quality. For example, a 10-year government bond issued in Italy is paying interest of 4.32%, that is, 55 basis points more than German bonds. The German bond has a maximum rating of AAA/Aaa whereas the Italian bond has a lower credit rating of Aa2/A+.
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It is normal for higher risk to imply a demand for higher yield but the 0.55% differential is an all-time high since the launching of the euro. In the middle of last year the differential was only 0.2%. There are two factors that help to explain the rise in this differential. In the first place, there are the unknowns about the new Italian government and its budgetary plans. Secondly, when there is a flight to quality, investors take refuge in German bonds because of the strength and liquidity of that market. Nevertheless, it should be remembered that there is no currency risk as both bonds are expressed in euros and having to pay more than a half-percentage point each year for 10 years implies very strong risk aversion.
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Should we halt the drop in the dollar?
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The International Monetary Fund (IMF) has advised that it has increased the risk of a drop in growth due to the fact that the volatility in foreign currency markets could provoke a sharper adjustment of trade imbalances. For example, since January 1 the dollar has depreciated by 7.2% against the euro and 12.4% against the Japanese yen.
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Trichet and Juncker express concern about dollar exchange rate...
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Along the same lines, following the sharp depreciation of the dollar, the chairman of the IMF and the primeminister of Luxembourg both referred publicly in Brussels to the US policy of a strong dollar. Trichet repeated his message more sharply at a press conference on March 6 and again on March 10. Nevertheless, the result of these comments was nil, seeing that foreign currency markets took no notice of the remarks by the leading figures responsible for monetary policy and the euro.
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Nevertheless, there are some discordant voices on the matter. The Bundesbank, the German central bank, believes that German exports depend on the growth of its export markets and the attractiveness of a product rather than simply its price. Furthermore, the IMF director general, Strauss-Kahn, while pointing out the risk of the collapse of the dollar to growth, considered that in the present situation there was no need for concerted intervention on the part of the central banks to halt the drop of the dollar.
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…but no unanimity on how to halt collapse of dollar.
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Perhaps this absence of consensus stopped the ECB chairman from making further comment on the situation of the euro against the dollar. Or perhaps it was the nil result of his comments seeing that finally the dollar dropped further against the euro going to an exchange rate of 1.59 at the session on March 17.
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The most interesting comment on the market came from the deputy governor of the Bank of England with the objective observation the dollar had depreciated less against the currencies of those countries with the highest trade surpluses, a fact that posed some risks. For example, there was the risk that a reduction of the US trade deficit might not equal the drop in the trade surplus of countries like China but rather translate into an increase in the trade deficit with other countries. In reality, through control of their currencies, China and the rest of Asia are re-exporting the US trade deficit to the Euro Area.
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Yen exchange rate complicates situation for Japanese exporting companies.
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Another spectacular movement in foreign exchange markets was the exchange rate of the yen against the dollar which broke through the floor of 100 yen to the dollar. This creates a serious problem for Japanese exporters. Central Bank of Japan carries out the most important industrial survey in the country, known as the Tankan index. The latest survey was carried out in November and December last year and more than 10,000 companies took part. The survey asked what was their forecast for the yen-dollar exchange rate in 2008. The average of the responses came to 116.1. The present rate of 99.4 thus represents a level 17% lower than the level expected by Japan’s business managers.
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Equity markets go dizzy
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Stock market stability depends on growth in United States and normalization of interbank markets.
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The doubts arising about the future of the world economy have shifted to stock market quotations. Whereas in February, following the sharp drop the month before, the stock markets were in a situation of watch and wait, in March investors turned their back on equity assets.
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Monthly drops of 9% in the German stock market and 10.9% in Japan do not happen very month and well reflect the lack of enthusiasm among international investors who see how the negative economic news piles up, in spite of the efforts of central banks and governments to control the pernicious effects of the present financial crisis. Since the beginning of the year, some stock markets have dropped more than 20%, a level at which stock market operators feel they have entered a bear market.
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IBEX performs better than other indices in Europe.
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We should mention the movement in the IBEX 35, the Spanish stock market reference index, which has shown a relatively better performance than others in Europe. There are two factors behind this difference. In the first place, there was the increase in price of some company shares because of rumours about corporate mergers or acquisitions. Secondly, in the present environment, investors see Spanish banks as among the strongest on the European continent because of their tough risk control, high provisions and good capitalization.
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Now, the big question is whether current prices have already discounted the worst possible scenario or whether, while creating a buying opportunity, it has not yet hit bottom. Everything depends on the answer to two questions. First, whether the US economy will be able to recover in the second half of this year and maintain that recovery in 2009. Secondly, what time will be needed to restore normalcy to the interbank markets. The risk of a continuation of the present situation for many more months would lie in further tightening of terms for companies and households to obtain finance.
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