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Ambrose Evans-Pritchard: More liquidity without inflation?

Section: Daily Dispatches

World Bankers Resort to Firebreak

By Ambrose Evans-Pritchard
The Telegraph, London
Thursday, December 13, 2007

Never before have the central banks of North America, Europe, and Britain acted together as such a unified phalanx, but never before have transatlantic credit markets seized up with such violent effect.

"This is a drastic action. The central banks want to place a firebreak to stop credit tensions spilling over into the broader markets and becoming the catalyst for a global economic crunch," said Ian Stannard, an economist at BNP Paribas.

While yesterday's joint move was sketched at the G20 a month ago and fine-tuned in encrypted telephoned calls over the past month, the final trigger seems to have been the spike in the crucial three-month money rates that lubricate finance. Dollar and sterling Libor spreads have vaulted in recent days. Euribor spreads reached an all-time high of 99 yesterday morning.

"A co-ordinated move like this has the 'wow factor,'" said Paul Mackel, currency strategist at HSBC. "But there's a lot of scepticism over whether this will be enough medicine to end the credit crisis. Is it already too late?"

Ben Bernanke, chairman of the US Federal Reserve, made his academic name studying the "credit channel" causes of depressions. He must have watched with growing alarm as the debt markets limped from one mini-crisis to another, failing to recover from their August heart attack despite three emergency rate cuts.

The asset-backed commercial paper market in the US has now shrunk for 17 weeks in a row, shedding almost $400 billion (L196 billion). Lenders are refusing to roll over short-term loans as they fall due, leaving borrowers desperately searching for other sources of money.

The crucial elements in the Fed's move yesterday is not so much the sum of money on offer -- $20 billion next week, $20 billion the week after -- but that all depository banks in America can draw from the tap anonymously, without the risk of being found out.

"People looked at what happened to Northern Rock in Britain and said 'we're not going to risk that,' so hardly anybody has been using the Fed facilities," said Bernard Connolly, global strategist at Banque AIG.

The Fed is now spreading the net wider by allowing all US banks to use the Term Auction Facility, which offers secrecy and allows them to hand in a much wider set of investments as collateral to raise money, including mortgage securities. Perhaps some credit will at last reach those in urgent need.

The Bank of England's L20 billion injection over the next two months has a different flavour. It fires a double-barrelled dose of liquidity: priced by auction at far below the penal rate of 6.5 percent, and eligible to any lender with half-decent collateral and -- crucially -- securities backed by housing and credit card debt. Northern Rock might have escaped a deposit run if all this had been on offer in the summer.

Officials denied the worldwide action was orchestrated to pressure the Bank of England to open its credit spigot, giving Threadneedle Street global "cover" for what amounts to a major volte-face. The Fed vice chairman, Donald Kohn, said two weeks ago that "strong bids by foreign banks in the dollar-funding markets" had complicated efforts by the US authorities to manage the liquidity problems. It is unclear whether British lenders were the culprits.

In Frankfurt officials are seething at the enormous scale of borrowing by British banks at the European Central Bank's window, calling much of it "central bank arbitrage." There is irritation that the British are trying to have their cake and eat it too, dipping in and out of the eurozone when it pleases them. The bad blood has undoubtedly strengthened the push by EU insiders for more EU-wide financial rules.

The ECB ($20 billion) and the Swiss National Bank ($4 billion) are playing a support role in the latest joint action, backing the US move by offering dollar liquidity to European banks caught in the sub-prime mess. Part of the problem in August was that the Fed and ECB lacked swap arrangements, causing a mad scramble by European banks to obtain dollars. "The Europeans are acting simply as agents of the Fed," said Neil MacKinnon, a strategist at the ECU hedge fund group.

"There's a real danger that this may not work. Both the Fed and the ECB have injected a lot of liquidity before, but the banks are hoarding it. We're still seeing all the signs of stress with Libor and the VIX [fear gauge] at very elevated levels. The reason is that people still don't know where the bodies are buried," he said. "This may be a made-in-America credit crisis but the Americans have cleverly exported their sub-prime cancer to pension funds all over the world. The risk now is a recession on both sides of the Atlantic," he said.

Julian Jessop, chief economist at Capital Economics, said the move was a stop-gap measure. "These measures should tide the markets through the potentially awkward new-year period but do not and cannot address the underlying imbalances threatening the world economy. Risk premiums are likely to remain permanently higher after the excesses of the last few years, and it will still be harder to obtain credit," he said.

For now, investors and hedge funds are scrambling to buy risky assets again, renewing bets on the yen "carry trade," piling back into equities and pushing up commodity futures. Gold jumped $12 to $814 an ounce. They forget that central banks are having to fight two battles at once: against the credit crunch and against inflation. The liquidity rescue has its limits.

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