Credit Crunch

Following yesterday's injection of €95 billion in emergency credit by the ECB into the money markets, other central banks rapidly followed suit: The US Federal Reserve put in $24 billion, the Bank of Japan put in 1 trillion yen ($8.5 billion), the Reserve Bank of Australia put in A$ 4.95 billion and Canada's central bank put in C$1.64 billion ($1.55 billion). Central banks of South Korea, Phillipines and Indonesia all signalled willingness to inject money if necessary, and the ECB has followed up this morning with more money. Central Banks are lenders of last resort, and essentially what they are saying to the market is, if you need to borrow money, we will lend it, at the base rate.

What has caused the crunch? Simply, investors who had borrowed money to finance their securities found their credit lines drying up, so they went to the money markets for cash, and the additional demand caused the inter-bank rates to shoot up way above base rates.

The root cause behind all this is the the sub-prime lending debacle in the USA, but that of course has been simmering for months. The immediate cause of the current crunch was Tuesday's US Federal Reserve statement, where Fed Chairman Ben Bernanke signalled unwillingness to cut interest rates to bail out financial investors in distress and put more emphasis on inflation. The markets had been hopeful for a cut, and it caused lenders everywhere to rethink and tighten and in some cases close credit lines.

What does this mean for the real world? The last time something like this happened was 1998, when the hedge fund Long-Term Capital Management went bust, casuing fall-out among those in the financial industry who were exposed to their fund, and whose who had lent to it. Alan Greenspan, who was US Federal Rererve Chairman at the time, not only supplied liquidity to the markets, he cut interest rates three times that year, and didn't raise rates again till May 1999. Cutting rates turned out to be a mistake. The real economy had not been affected by the hedge fund bust, and cutting rates simply stimulated a massive boom, with the tech/telecom/dot.com sectors soaring. Then came a massive bust in 2001. It was the cutting of interest rates that had affected the real economy, not the collapse of Long-Term Capital Management.

My guess is that this time Central Banks will play it cool. They will continue to supply as much liquidity as is needed to the market, lending at or slightly above the base rate, but they will not cut the base rate. If turmoil continues to roil the markets though, they may be persuaded to stay their hands in continuing to raise rates till things calm down. They'll cut only if they are persuaded that the real economy was suffering. Given that global growth is at it's strongest for decades, cuts look unlikely.