Central Banks ‘Bazooka’
05/12/2011
The much-vaunted big ‘bazooka' so long expected of Europe's policymakers turned up unexpectedly last week and from an equally unexpected source: world central banks. Up until Wednesday morning, shortly before the announcement of a co-ordinated move to flood the system with dollars, the premium that banks had to pay to convert their euros into dollars shot higher to a level not seen since October 2008, a month after the collapse of Lehman Brothers. Known as the ‘euro-dollar basis swap', the figure is a closely watched indicator of stress in the banking sector and having reached 1.6% (more usually the spread is around 0.5%) it was flashing on ‘Danger'.
European lenders need to be able to source dollars and other types of funding to help finance hefty liabilities that are denominated in the US currency. However, US money market funds, traditionally a major source of dollar funding, have over recent months been trimming their lending to Europe's banks as they became ever wary of the escalating credit risk.
In essence, a breakdown of trust between the banks themselves and the likes of money market funds meant Europe's banks faced a significant risk of a financing freeze, with all the ramifications for the eurozone economy. Faced with this dilemma, banks have increasingly turned to the European Central Bank (ECB) as a source of borrowing - just over a week ago, lending by the ECB rose to its highest level this year, some €8.4bn, triggering alarm bells. Traders took the view that the jump in overnight lending highlighted the inability of virtually all eurozone banks, with the exception of the very strongest, to obtain funding from the markets. Against this backdrop of elevated ECB lending and rising premiums or spreads for borrowers, some of the world's central banks, including the ECB, US Federal Reserve, Bank of Japan, the central banks of Switzerland and Canada and the Bank of England, announced a huge increase in liquidity. Leading the way, the Fed slashed the rate it charges the ECB for short-term dollar loans from about 1.1% to 0.6%. This would enable the ECB in turn to provide cheaper dollar loans, via swaps, to European commercial banks.
The six central banks involved also agreed to create temporary bilateral swap programmes so funding can be provided in any of the currencies if needed. The new pricing arrangements start today and will remain in place until February 2013. Also, as part of the deal, the ECB is widely expected to offer Europe's banks two-year or three-year loans to ease financing pressures and it could also accept more types of collateral in return for its loans. Alongside the announcement, the Federal Reserve said US financial companies do not currently have difficulty in obtaining liquidity in short-term funding markets. It also added, pre-emptively, that were conditions to deteriorate, it had a range of tools available to provide an effective liquidity backstop for such institutions.
Two hours before the Fed announcement, China cut the amount of cash that the nation's banks must set aside as reserves, for the first time since 2008. The level for the largest lenders was cut by 0.5% from a record 21.5%, based on past statements. The move by Beijing was interpreted that it finally believed it has beaten stubbornly high inflation and also indicated the degree to which it has become concerned about a slowdown in the world's second-largest economy.
