Coordinated Move of Central Banks Necessary But Temporary Panacea
The Federal Reserve Bank, European Central Bank, Bank of England, Bank of Canada, Swiss National Bank, and Sveriges Riksbank (Bank of Sweden) implemented a coordinated cut of their main policy rates this morning. Excluding the Swiss National Bank, the other central banks reduced the benchmark rates 50 bps. The People’s Bank of China eased monetary policy 27 bps and the central bank of the United Arab Emirates lowered the repo rate 50 bps, while the Bank of Japan issued a statement of support. Norges Bank (central bank of Norway) sat out today’s round but announced it would bring its next policy meeting forward by two weeks, to October 15, when it will “consider rates” in the face of recent developments.
The most important message from this historic action is that central banks are standing ready to provide liquidity to prevent a systemic implosion of the global financial infrastructure arising from growing perceptions of counterparty risk. The world’s major central banks are using all tools at their disposal to prevent a replay of the Great Depression. Is today’s action the elixir that will fix the wide array of financial and economic problems that have crept across the globe? The honest answer is “no”. Are additional coordinated actions likely? Possible, but the nature of the action will be related to the monetary policy options available to each nation.
State Actions to Reassure Depositors
Several major central banks have taken steps to guarantee deposits to prevent bank runs from withdrawals due to panic. On October 3, the U.S. Congress increased the Federal Deposit Insurance protection to $250,000 from $100,000 per depositor through the end of 2009. On October 3, the UK raised the level of savings guaranteed by the government to £50,000 from £35,000. Germany announced, on October 5, a blanket guarantee to funds in private German bank accounts. Austria said it will pursue Germany’s policy of guaranteeing retail deposits. On September 30, the Irish government declared it would guarantee both retail and wholesale deposits at the six biggest banks, to the tune of €400 billion, until 2010. This triggered an outflow of funds from British banks into “protected” Irish accounts and has been condemned as anti-competitive by other EU members. As of October 6, the Danish government guaranteed all bank deposits and set up a Dkr35bn ($6.5 billion) liquidation fund. Yesterday, Spain announced a US-style €50 billion government fund to buy toxic assets off bank balance sheets. Italy this morning hinted it is working on its own plan. The finance minister of Greece announced deposits of all banks that operate in the country would be guaranteed. With the EU members taking unilateral actions – and doubtless fearing more Dublin-style sweeping guarantees – EU finance ministers today announced an increase in the minimum level of bank deposit insurance across the 27 member countries, to €50,000, and issued a statement that “We all commit to take all necessary measures to enhance the soundness and stability of our banking system and to protect the deposits of individual savers.”
The UK today unveiled its own plan. The government has set aside at least ₤50 billion to buy stakes in UK banks to improve their capital strength. Banks will be able to draw on ₤25 billion in the form of preference shares by the end of the year, and the government will assist in raising ordinary equity if asked and stands ready to provide a minimum of ₤25 billion in additional support. The Bank of England will ensure that its Special Liquidity Scheme (a swap arrangement to take illiquid assets off banks’ balance sheets) will be at least ₤200 billion. And, the Bank will make changes to the operations of its money markets next week, including the introduction of an explicit Discount Window.
The Federal Reserve Bank has implemented various innovative programs in the past few months to support financial markets, with the main objective of providing liquidity and unclogging credit and money markets. As of October 7, the Fed indicated it will sidestep financial institutions and lend directly to firms, as the commercial paper market has nearly shutdown, under a new program called Commercial Paper Funding Facility. Firms tap the commercial paper market to finance their everyday operations such as meeting payroll payments and inventory obligations, and so on. On October 3, the Treasury’s Troubled Asset Relief Program (TARP) was signed into law authorizing the U.S. Treasury $700 billion to purchase illiquid and distressed assets of financial institutions. The program will help financial institutions recognize losses and clean up their balance sheets. But, the program falls short of addressing the issue of recapitalization of banks which is the crux of the problem. Capitalizing banks will need to be addressed immediately if the credit engine has to resume working in the U.S. economy.
The Road Ahead
The manner in which the crisis is being tackled has moved from rescuing institutions to country level actions and now to the world economy. Today’s coordinated action by major central banks is a significant step to stop the financial market turmoil from translating into an intractable recession. The industrialized world has recognized that what started out two years ago as a mild infection in the US sub-prime market is developing into a full-blown pandemic that could force a global recession. However, different countries will show different symptoms depending on their regions, their degree of trade dependency relative to their economy, and how many resources they have – financial and otherwise – to bolster their immune systems against the sickness to come. At one end of the spectrum is the U.S. economy which, along with some smaller European nations such as Ireland and the Baltics, will likely be stricken with a bad case of economic ‘flu. Also likely to suffer will be the “twin deficit” emerging markets – those such as Argentina, Hungary, and Turkey, that have both significant current account deficits and large fiscal shortfalls, and so are particularly dependent on capital inflows to pay the bills. At the other extreme are some major and emerging markets that may only need remedies for a cold.
In the U.S., real GDP declined in the fourth quarter of 2007, followed by two quarters of gains in real GDP. We are predicting a contraction of U.S. real GDP for four quarters in a row, starting in the third quarter of 2008. The depth and duration of the recession in the U.S. will be strongly influenced by the massive deleveraging of the financial and household sectors. In addition, the recession will be marked with the significant weakness in consumer spending, which is a new headwind because consumer spending, the largest component of GDP, last declined in the 1990-91 recession.
This is significant for the performance of the rest of the world in addition to the ongoing financial market woes. U.S. nominal imports of goods and services were 6.6% of the rest of the world’s nominal GDP in 2006, up from 4.5% 10 years earlier in 1996. With U.S. imports contracting in real terms, both year over year and quarter to quarter, the rest of the world will feel the impact.
The UK saw flat real GDP growth in Q2 but will likely turn negative in Q3 and more so in Q4. Given the importance of the financial services industry for the overall UK economy, and the fact that the country is suffering through the bursting of its own housing market bubble, it will be at least Q2 next year before the economy starts to regain momentum, and next year as a whole is likely to look very subdued. The fifteen-member Euro-zone slipped into negative territory in Q2 and will likely also be negative in Q3 and Q4 but should have bottomed out by Q1 2009. However, there are marked variations across the ‘zone. Germany is likely to see a shallower downturn while Spain – which actually managed positive real GDP in Q2 – will see steeper contractions going forward and may not hit recovery mode until the end of 2009, as its housing market collapses, bringing the construction industry down with it. Ireland is also in for a rough few quarters as its housing market contracts.
Meanwhile, the emerging nations of central/eastern Europe , which have seen very robust rates of growth in recent years, started to slow in Q3 as demand from their critical export markets in neighboring countries started to ease back. The little Baltics have already crashed into recession as their frothy credit markets seized up and investment inflows stalled. They do have some protection from the market storm, however, in that all three have currency boards and trade within the ERM-2 exchange rate regime. Of greater concern are the likes of Hungary and Romania, which will not only suffer from the drop in export demand and a falloff in investment inflows, but also have very high levels of unhedged foreign-currency-denominated borrowing among households and corporations. Along with non-EU member Croatia, these markets may experience their own financial crises in 2009.
Over in Asia the outlook is also mixed. The region’s emerging markets sit atop a mountain of reserves, so short-term liquidity issues should not be a problem. The near-term issue for an Asian exporting country is its capacity to weather a sustained slowdown in demand from key markets along with a possible exodus of foreign portfolio investment. The degree of narrowing in the external surpluses will be a crucial barometer in gauging how these countries fare. A decade of reforms has put Asia’s financial sector in a better position than before the 1997 financial crisis, but the economic stress from a global recession combined with foreign flight to quality will challenge even the more robust systems. China does not have a secure, sophisticated financial sector by any means, but it does possess $1.8 trillion in reserves and the means to shore up any faltering institutions. The slowdown in exports, and thus the manufacturing sector, will be severe and the government will have to actively manage the economy’s sharp deceleration in order to maintain social stability. More open, hardy financial hubs such as Hong Kong, Singapore and perhaps Australia could become regional financial safe havens, even as their trade-dependent economies stumble into hard recessions as the result of reduced trade activity. However, those with more creaky, strained banking systems, such as Taiwan and Malaysia, could experience significant financial stress alongside an economic slowdown. Smaller developing countries such as Thailand and Indonesia might have to rely on their reserves and possibly drastic policy moves to endure a prolonged slowdown in growth, and given their unstable socio-ethnic situations, a recession could be a springboard to further problems.
As far as Latin America is concerned, commodity prices are the Achilles heel of the region. The robust growth in many of these countries in recent years has been driven by commodity production. Should demand and/or prices collapse, severe financing difficulties would begin to surface. As with emerging markets in Europe and Asia, the difference between a nasty head cold and the ‘flu will depend on external debt levels, short-term financing requirements, foreign exchange reserve levels and fiscal balances. Among the best-prepared will be Chile, with a solid fiscal balance, well-managed external position, and well-regulated financial sector. At the other extreme is Argentina with an already-high external debt level, shaky fiscal position, and the potential for default – again.
