Weekly Indicators - Nov 1

Nov 1st 2007
From The Economist print edition

The Federal Reserve cut its target for the federal funds rate to 4.5%. One member of the Fed's rate-setting committee voted to keep rates unchanged at 4.75%.

Other central banks followed a different path. Sweden's Riksbank raised its benchmark interest rate by 0.25 percentage points to 4% and said further increases were likely. India's central bank left rates unchanged but raised the cash reserves that banks need to keep with it from 7% to 7.5% of total lending. Central banks in Japan, Norway, Hungary, Poland and Malaysia all kept their key interest rates unchanged.

America's GDP rose at an annualised rate of 3.9% in the third quarter, according to an initial estimate. The stronger-than-expected increase owed much to an improved trade performance, which almost offset the adverse effects on growth of falling housebuilding. The S&P/Case-Shiller house-price index that covers 20 large American cities fell by 4.4% in the year to August.

Consumer prices in Japan fell by 0.2% in the year to September. Prices excluding fresh food fell by 0.1% from a year earlier. The unemployment rate rose from 3.8% to 4%.

Consumer prices in the euro area rose by 2.6% in the year to October, according to a preliminary estimate, compared with 2.1% in the year to August. The unemployment rate fell to 7.3%. The figure for August was revised from 6.9% to 7.4%, owing to changes to the way Germany's jobless are counted.

Weekly Indicators - Oct 4

Oct 4th 2007
From The Economist print edition

American manufacturing grew more slowly in September, according to the Institute for Supply Management. Its activity index slipped to 52 from 52.9 in August.

Consumer prices in the euro area rose by 2.1% in the year to September, according to a preliminary estimate, sharply faster than the 1.7% in the year to August. The currency zone's unemployment rate was 6.9% in August, unchanged from July.

Australia's central bank left its benchmark interest rate at 6.5% on October 2nd.

Manufacturers in Japan remain confident despite recent gyrations in financial markets, according to the central bank's quarterly Tankan survey. The percentage balance of large firms reporting “favourable” over “unfavourable” business conditions was 23, the same as in June.

Industrial production in South Korea rose by 11.2% in the year to August, thanks to strong global demand for its cars, semiconductors and machinery goods. Consumer prices rose by 2.3% in the year to September.

In Britain the number of loans approved for purchasing homes dropped to 109,000 in August from 115,000 in July.

The outlook for rich-world economies is gloomier, according to the The Economist's monthly poll of forecasters (see article). Forecasts for GDP growth in 2008 have been marked down in most countries. The one exception is Australia.

Weekly Indicators - Sep 20

Sep 20th 2007
From The Economist print edition

The Federal Reserve cut its benchmark interest rate by half a percentage point, to 4.75%. The reduction came amid a further weakening in America's housing market. The National Association of Home Builders index of expected sales fell to a 16-year low. Housing starts fell 2.6% in August to their lowest level since June 1995.

Consumer prices in America fell by 0.1% in August, leaving them 2.0% higher than a year earlier. The core measure, which excludes food and energy, rose by 2.1% in the year to August, the lowest rate in 17 months.

China's central bank raised its one-year lending and deposit rates by 0.27 percentage points, to 7.29% and 3.87% respectively. The move followed the biggest rise in consumer prices in more than a decade.

The Bank of Japan's policy board voted to keep its benchmark interest rate unchanged at 0.5% on September 19th.

Consumer prices in Britain rose by 1.8% in the year to August, down from 1.9% in July and the lowest rate in over a year. There was a downward effect on inflation from falls in the cost of financial services, following new guidelines for home mortgage charges by Britain's financial regulator.

The euro area's trade surplus rose to €4.6 billion in July from €1.1 billion a year earlier.

Switzerland's central bank raised its three-month interest-rate target by a quarter of a percentage point, to 2.75%.

IMF sees no U.S. recession, world weathering storm

Sep 12, 2007 - U.S. slowdown, but not recession, is what the International Monetary Fund expects, and the rest of the world should weather that problem, IMF chief economist Simon Johnson said on Wednesday.

Nobody can say for now, however, to what extent the economy of one or other part of the world will be damaged by a credit crunch in financial markets, which politicians and regulators will now have to address, focusing on banks, he said.

"We don't see any reason to think that this is any more than a mild slowdown in the United States," Johnson, on a brief visit to Europe from the IMF's Washington headquarters, said when asked if he ruled out recession.

"Our position on the U.S. economy is that other fundamentals remain strong," he said, noting resilient consumer spending and investment levels despite a housing downturn that has proven worse than first thought and which would take time to ease off.

Things could pick up in the second half of 2008, he told reporters at a briefing.

While the IMF's recently increased forecast of 5.2 percent economic growth now looked unattainable, the emerging market economies of the world, notably in Asia, were strong and should stay so, and Europe was in relatively good shape, he said.

"The wild card is financial market turmoil," he said, acknowledging that the IMF had failed, like most others, to spot the trouble that snowballed into a markets crisis in August from what was previously a debt defaults crisis in the high-risk, subprime, segment of the U.S. mortgage market.

"This is an important wake-up call for all of us. There's a serious problem with the plumbing. But the house is not on fire."

Johnson said Europe was "a big question now" given second quarter growth figures had come in surprisingly weak, at 0.3 percent quarter-on-quarter, or less than half of the pace registed in the first three months of the year.

The IMF publishes its next series of forecasts in its World Economic Outlook in the days preceding the IMF's October meetings in Washington and Johnson acknowledged that it might be equally difficult then to quantify how much financial market turmoil could cost in lost economic growth.

In July, the IMF raised its growth forecasts for the world, mainly China, India and Russia but also Europe, adding that the risks if anything were that European growth would end up stronger than it was predicting.

"We don't think that now," he said, adding that the IMF was "very comfortable" with the European Central Bank's decision to keep interest rates in the euro zone on hold while the future remains uncertain because of continuing turmoil in markets.

He remained sanguine, however, predicting lower U.S. interest rates would help a rebound there and that the rest of the world was in better shape.

"We think the underlying strength of the real economy around the world will pull it through," he said.


TIME TO RESPOND TO TURMOIL

Johnson said the IMF and political leaders worldwide were now looking for a response after discovering that nobody can identify just where the risks and exposure lies after years of rapid growth in debt derivatives and asset-backed securities markets.

One of the main features of that development in markets was that banks got heavily involved in financing operations which did not have to be booked on their balance sheets and things had perhaps got unwieldy.

"Hedge funds this time round are not the central issue," he said. "Letting regulated banks go off and make money off-balance-sheet -- that's something we should look at now," he said.

European finance ministers are expected to start looking at the issue when they meet in Portugal later this week and U.S. Treasury Secretary Henry Paulson meets french and German leaders on a trip to Europe next week.

Weekly Indicators - Sep 6

Sep 6th 2007
From The Economist print edition

More bad news came from America's housing market, amid fresh concerns about the availability of mortgage finance. The number of home sales agreed on but not yet completed fell by 12.2% in July, according to the National Association of Realtors.

GDP in America rose at an annualised rate of 4% in the second quarter, revised up from 3.4%. The Institute of Supply Management's index of manufacturing activity fell from 53.8 to 52.9 in August.

Consumer prices in the euro area rose by 1.8% in the year to August, according to a preliminary official estimate, the same rate as in July. The currency zone's unemployment rate was stable at 6.9% in July.

Japan's unemployment rate edged down from 3.7% to 3.6% in July, the lowest level since December 1997. Core consumer prices, which exclude volatile fresh-food prices, fell by 0.1% in the year to July.

Australia's GDP rose by 0.9% in the second quarter and by 4.3% compared with the same period a year earlier. Despite a strengthening economy, Australia's central bank left its benchmark interest rate at 6.5%.

The Bank of Canada left its key policy rate at 4.5%. In a statement, the bank said that the economy in the first half of the year had been stronger than it had expected, but that the recent tightening in credit conditions should restrain future growth. Canada's GDP rose by 0.8% in the second quarter and by 2.5% from a year earlier.

Emerging Markets 2 - A shrug is not a shudder

Aug 23rd 2007 SÃO PAULO

From The Economist print edition

Brazil is the clearest example of Latin America's newfound financial stability

IN FINANCIAL circles, Latin America has long had a reputation as something of a “subprime” continent that periodically struggles to repay the money lent to it by reckless creditors. One might therefore expect Brazilians, who remember the crises of 2002, 1999 and 1998, to respond to America's current woes with empathy—and not a little fear.

Sure enough, Brazil's main stockmarket index, the Ibovespa, lost 17% of its value from July 23rd to August 16th. The Brazilian real has also fallen beyond the symbolic rate of two to the dollar. But despite this, investors and analysts seem to share the sunny attitude of the country's president, Luiz Inácio Lula da Silva. “Brazil is not afraid of this crisis,” he said this week. It is, he insists, “an eminently American crisis” caused by people trying to make a lot of “third-class money”.

Such contemptible folk have also left their mark on Brazil, of course. Its stockmarket has attracted foreign speculators, and its bonds have proved attractive to hedge funds, betting that Brazilian interest rates would continue to fall. Some of these investors have now been forced to pull out of Brazil to cover obligations elsewhere. But many are staying put. Yields on Brazil's sovereign debt have risen, but not by much. They remain just 2.17 percentage points above those on American Treasuries. And although foreigners were probably responsible for the bulk of Brazil's stockmarket losses, the Ibovespa is still up about 20% for the year in dollar terms.

That markets have not sunk further is testimony to Brazil's newfound macroeconomic buoyancy. The government's budget surplus, before debt payments, beat its first-half target this year. Thanks to booming commodity prices, the country also enjoys a healthy current-account surplus, which has helped the central bank to accumulate about $160 billion in reserves. In fact, Brazil is now a net dollar creditor, which means it has much less to fear from a fall in the real against the greenback. Indeed, a weaker Brazilian currency would help manufacturing exporters, who have been complaining of late that the real is too dear.

Nuno Camara of Dresdner Kleinwort, an investment bank, believes that the current turmoil may even hasten Brazil's attainment of investment-grade status. Once the dust has settled, he says, those countries that have “done their homework”, running up current-account surpluses and reserves, will see the money come back. This diligent group includes Chile, which has run bigger current-account surpluses than Brazil, and Peru. Mexico has been “medium-nice”, according to André Cappon of the CBM Group, a New York-based consultancy. It has kept its public finances in order and its prices stable, but it still has an external deficit and its economy is more exposed to a downturn in America. Other Latin American countries—namely Argentina, Ecuador and Venezuela—have been less strait-laced. Their risk premiums have risen significantly.

In the shakier past, a quick outflow of money from Brazil and its neighbours might have triggered weaker currencies, higher debt costs, faster inflation and punitive interest rates. But if Lula is right, that grisly economic plotline may no longer be so eminently Latin American.

Emerging Markets 1 - Full of Eastern Promise

Aug 23rd 2007 HONG KONG

From The Economist print edition

Could Asian shares provide a safe haven for global investors?

IT OFTEN seems that everything is made in China, but certainly not the latest turmoil in financial markets. Over the past four weeks, as world share prices have plunged, Chinese A-shares have leapt by over 20%. And as central banks elsewhere worry about a credit crunch, China's central bank this week raised interest rates for the fourth time this year.

Foreigners cannot buy A-shares, which means they cannot dump them either. The rest of Asia is less snugly insulated. Last week its markets suffered their biggest weekly fall for 17 years, and they remain 12% below their peak. Big financial losses in mortgage-linked securities have forced global investors to pull money out of emerging markets to raise cash and reduce the “risk” in their portfolios.

But the notion that all emerging-market shares are risky is looking out of date. Based on fundamentals, Asian shares are now arguably less risky than many American ones. Although Asian financial firms have suffered some losses from securities linked to American subprime mortgages, their direct exposure is thought to be relatively small.

Moreover, Asian share prices look good value compared with those elsewhere. Despite a surge over the past few years, most markets are still below their mid-1990s peaks in dollar terms, including the Chinese shares that foreigners can buy. Yet profits have soared since then. One legacy of the 1997-98 Asian crisis is that firms now focus on making money rather than maximising market share or assets.

The price-earnings (p/e) ratio for the region is below its 20-year average (see chart) and lower than that in America, even though faster growth in output and profits should justify a higher p/e. On many counts Asia is in a better position than other emerging markets, though some of them, too, are better prepared than they used to be (see article). Since the start of the global bull market in 2003 emerging Asian shares have gained 210% in dollar terms, compared with an average of 440% in Latin America. Yet Asia has by far the better growth prospects. The IMF forecasts that developing Asia will grow by an annual average of 8% over the next five years, Latin America by 4%.

Most Asian economies are also much less vulnerable to capital outflows than they used to be, enjoying a current-account surplus and a large hoard of currency reserves. Foreign investors need worry less about an exchange-rate loss than in the past as many currencies are if anything undervalued. Asia also shows few signs of excess. Bank lending is growing much more slowly than a decade ago, and Asia is one of few parts of the world not experiencing a housing bubble. A recent study by the IMF finds that in most Asian countries house prices have not kept pace with incomes since 1999.

The glaring exception to all of this is India, which unlike the rest of Asia has a housing bubble, a borrowing binge and a current-account deficit. By most measures, Indian shares also look pricier relative to their historical trend than anywhere else in Asia.

One big concern is that if Asian stockmarkets still dance to the same beat as Wall Street, they will also trip up if America sinks into recession. Economists continue to argue fiercely about whether Asia can decouple from the world's biggest economy. But to some extent it already has. The growth in America's domestic demand has slowed from 4.4% in 2004 to only 1.3% in the year to the second quarter, and imports fell in the second quarter. Yet Asia continues to boom, with most economies accelerating in recent months. Exports to America have slowed sharply, but this has been offset by faster growth in exports to the European Union and to other emerging economies, and stronger domestic demand. This year, for the first time, China and most other Asian emerging economies are exporting more to the European Union than to America.

Under its own steam
Nobody is suggesting that Asia would escape unscathed from a sharp American downturn. But it is less vulnerable than in the past thanks to a reduced dependence on the American market and stronger domestic spending. China's retail sales surged by over 16% in the year to July, and even without the boost from net exports China's GDP growth would still be an impressive 9% this year. On the other hand, domestic demand remains weak in Taiwan and Thailand.

If exports were to collapse, governments in emerging Asia could loosen their purse strings. Most have small budget deficits, some even have surpluses, giving them plenty of scope to ease policy to boost domestic demand. (India, again, is the big exception.) Central banks in India and South Korea, as well as China, have been tightening monetary policy this year to cool their economies. If need be, they could relax their grip.

Asia's prudence in the past ten years now offers global investors a relatively safe haven. Investors who have recently dumped Asian shares may well kick themselves in a year's time. But then many of them are the same prescient investors who jumped into subprime mortgages.

Monetary Policy: Hazardous Times

Aug 23rd 2007

From The Economist print edition

The Fed has a new problem: convincing investors it does not need to cut interest rates yet

LEND freely but at penal rates was Walter Bagehot's advice to central bankers in a liquidity crisis. Lend freely and reduce interest rates has been the panicky demand of many investors shocked by the speed with which a crisis among low-quality mortgage borrowers in America has ricocheted around the world. So far the central banks, led by America's Federal Reserve, have tried to have it both ways. The Fed has lent freely, not always at penal rates. Meanwhile, it has talked a cautious game: no firm promise that any interest rate will be cut, but the odd hint that all the options are open in monetary policy, especially when it comes to protecting the real economy from the turbulence on the markets.

From many investors' point of view, this has worked a treat. Stockmarkets, which seemed in a state of panic on August 16th, have recovered some of their poise. More importantly, the credit markets, especially the ones where banks lend to each other, look more relaxed. Yet much of this relief is based on a single expectation: that the Fed will cut interest rates soon, perhaps even before its next rate-setting meeting on September 18th. This looks doubly dangerous: a rate cut is not certain; it would also, quite possibly, be the wrong thing to do. Hence, the increasingly urgent need for the Fed's chairman, Ben Bernanke, to let down his new admirers gently.

The willingness of investors to pin their hopes on a rate cut is understandable: after all, that has been the response of the Fed to every financial panic since the stockmarket crash of 1987. The Fed has also craftily encouraged that belief, while not yet committing itself. On August 17th, in addition to cutting the discount rate which banks pay it for emergency lending, the Fed's rate-setters acknowledged that financial turmoil now posed a risk to America's economy. The tone was so different from the Fed's statement just ten days before, when inflation was its biggest concern, that markets automatically assumed a rate cut was imminent. But was that wise?

House of cards
Begin with the fact that both the Fed and the markets have an overwhelming long-term interest in risk being priced correctly. The new model of financing, in which debt is repackaged and risk is dispersed through a web of derivative contracts, has much merit. But it plainly has had an unhappy consequence: when a problem emerged (in this case, in subprime mortgages), it was harder to work out whom it was safe to do business with. Banks became wary of lending to each other. The outcome was frighteningly similar to a bank run, but one that affected the entire wholesale money market.

From this perspective, it certainly made sense for central banks to stop that run by supplying short-term money. Nobody wants a temporary cash shortage to turn into a solvency crisis, where otherwise valuable assets are sold cheaply into a market gripped by fear. Temporary loans to the banking system should grease the market's wheels and enable it to grind out its own solutions.

However, a shift in the longer-term stance of monetary policy, by lowering the benchmark price of money, is a very different proposition. A rate cut does not just increase the supply of cash; it directly influences people's calculations about risk. Cheaper money makes other assets look more attractive—an undesirable consequence at a moment when risk is being repriced after many years of lax lending. It is not surprising that some investors think the Fed is setting a floor under asset prices. But letting that belief pass unchallenged blesses reckless speculation and reinforces moral hazard.

Let them down gradually
Clearly, there may be limits to a policy of tough love. If, for instance, the banking system were indeed in danger, then the Fed should step in. More realistically, if the current credit crunch were to intensify, economic growth show signs of faltering and inflation disappear as a threat, the Fed would also have reason to cut rates. But Mr Bernanke should be driven by his remit to support economic stability, not by the whiplash from financial markets. That, arguably, was the mistake that Alan Greenspan made when the Fed lowered rates three times in 1998 as financial markets seized up in response to the collapse of Long-Term Capital Management, a hedge fund.

This time, it is too soon to tell how deeply the financial crisis has affected the American economy. Some argue that it could benefit from some pain too (see article). In fact, plenty of the normal mechanisms markets have for correcting themselves have yet to swing into action: there is plenty of cash still hoping to pour into financial markets when they become cheap enough, whether from oil-rich governments, vulture funds, canny investors such as Warren Buffett or cash-rich companies still churning out profits. Already, Bank of America has snapped up a $2 billion stake in Countrywide, a troubled mortgage lender. To cut rates too soon would imply that the financial system cannot work without bail-outs. That would be the worst legacy of all.

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Weekly Indicators - Aug 23, 2007

Aug 23rd 2007
From The Economist print edition

In a bid to stabilise money markets, the Federal Reserve cut its discount rate, the charge it makes for emergency loans to banks, from 6.25% to 5.75% on August 17th.

In a separate statement, the Fed's rate-setters said the downside risks to economic growth had “increased appreciably” and that they were “prepared to act as needed” to prevent financial turmoil from hurting America's economy. Forty-five out of 63 economists polled by Reuters this week said they expect the Fed to cut its main policy rate by at least a quarter of a percentage point at—or even before—its next scheduled policy meeting on September 18th.

China's central bank unexpectedly raised its benchmark interest rate on loans from 6.84% to 7.02%. Deposit rates rose from 3.33% to 3.6%, a bigger increase. The changes came a week after official figures showed consumer-price inflation had jumped to a ten-year high of 5.6% in July.

The Bank of Japan kept its key interest rate at 0.5% on August 23rd.

Oil prices weakened on fears that financial turmoil might hurt the global economy. The price of a barrel of the benchmark Brent crude, which had briefly topped $77 last month, fell to $68.70 on August 22nd.

In Canada, consumer prices rose by 0.1% in July and by 2.2% from a year earlier.

GDP in Mexico rose by 2.8% in the year to the second quarter.

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Bernanke's Strategy of Increasing Liquidity Survives

By Craig Torres

Aug. 22 (Bloomberg) -- The Federal Reserve's strategy of increasing liquidity rather than resorting to a cut in the benchmark interest rate survived a third day.

Yields on Treasury bills rose yesterday after the New York Fed lowered the cost of borrowing securities from its own portfolio to ease a shortage in the market. The action followed a reduction in the Fed's rate on direct loans to banks on Aug. 17, the impact of which officials said they need time to assess.

Chairman Ben S. Bernanke wants to avoid an emergency easing of monetary policy, contrasting with predecessor Alan Greenspan, who cut the federal funds rate target three times in 1998 after the collapse of Long Term Capital Management LP. Richmond Fed Bank President Jeffrey Lacker said yesterday that policy must be guided by the outlook for economic growth and prices, not entirely by markets.

"We did use the fed funds rate and that may have been a mistake,'' said former Fed Vice Chairman Alice Rivlin, who voted for the 1998 rate cuts. "It might have been smarter to try what they are trying.''

Lacker said in a speech to a conference in Charlotte, North Carolina, yesterday that while the credit crunch and gyrations in financial markets have the potential to hurt growth, signs so far indicate business and consumer spending will continue.

In response to a question, Lacker also underscored the Federal Open Market Committee's determination not to insure poor investments with a cut in the federal funds rate. Ten-year U.S. Treasury notes fell in response, pushing the yield up 7 basis points to 4.66 percent at 9:45 a.m. in New York.

'Market Determined'

"The Federal Reserve isn't responsible for the size of credit spreads,'' he said. "We leave those to be market determined. Our responsibility and what we are capable of influencing on a sustained basis is inflation and growth.''

Some financial markets offer encouraging signs to policy makers. The Standard & Poor's 500 stock index has held the gains posted on Aug. 17, when the benchmark had its biggest one-day jump in four years. Lenders are also starting to write more "jumbo'' mortgages as the market for loans above $417,000 improves, Treasury Secretary Henry Paulson said yesterday.

"When we look at the markets over the last couple of days, I've been encouraged to see signs that there's more liquidity in the jumbo'' mortgage market, Paulson said in an interview with CNBC. "We're looking at all the markets, and you know, obviously, the equity markets, the sovereign-debt markets, the high quality credit markets, are all fully operational.''

1998 Criticism

After the rate cuts in 1998, the economy strengthened and stock prices soared, Rivlin noted, leaving the Fed open to criticism that the reductions were a mistake. Rivlin is now director of the economic studies program at the Brookings Institution in Washington.

The Fed's current strategy showed some signs of success yesterday as yields on three-month Treasury bills climbed the most since 2000 and those on commercial paper backed by assets such as mortgages slipped.

The three-month bill yield increased 0.52 percentage point to 3.61 percent late yesterday as demand for the shortest-dated government debt waned. Top-rated asset-backed commercial paper maturing in one day yielded 5.92 percent, down from 5.99 percent, posting the first drop in three trading days.

"The flight to safety may be diminishing a bit,'' said Holly Liss, a bond saleswoman in Chicago at Citigroup Global Markets Inc. "We're seeing more calming of the market as T-bill rates come back to normal.''

Jury 'Still Out'

Lacker said the "jury is still out'' on whether the Fed has done enough to improve trading in the $1.1 trillion market for asset-backed commercial paper.

"The markets that are under more stress are the high-yield market, non-agency mortgage markets, collateralized debt obligations and collateralized loan obligations markets and extendible asset-backed paper,'' said Paulson, a former Goldman Sachs Group Inc. chief executive officer. "Those are markets that we're watching closely.''

Investors and economists still bet that Bernanke will have to reduce the benchmark lending rate between banks, now at 5.25 percent, by at least a quarter point on or before the Sept. 18 meeting.

"Financial volatility and the seizing up of credit markets raises the probability'' of a recession, said Steven Einhorn, vice chairman of New York hedge fund Omega Partners Inc. "The Fed needs to be proactive and not wait.''

Einhorn said slowing inflation and growth of around 2 percent to 2.5 percent give the Fed room to cut interest rates.

'All' Tools

Senate Banking Committee Chairman Christopher Dodd said Bernanke agreed to use "all of the tools at his disposal'' to restore stability in markets roiled by the subprime mortgage crisis. He added that he didn't ask Bernanke to cut the federal funds rate and that the Fed chief didn't pledge to do so.

Dodd, a Connecticut Democrat who is seeking his party's presidential nomination, said banks should take advantage of lower borrowing costs at the discount window. He spoke after meeting with Bernanke and U.S. Treasury Secretary Henry Paulson.

Yesterday, the New York Fed reduced the so-called minimum fee rate that bond dealers pay to borrow its Treasuries to 0.5 percent from 1 percent.

"We are doing it to provide additional liquidity to the Treasury financing market,'' said Andrew Williams, a spokesman for the New York Fed. He said the rate was the lowest in the history of the program, which has existed in its current form since 1999.

Discount Rate

The central bank on Aug. 17 cut the so-called discount rate half a percentage point to 5.75 percent to direct more cash to companies starved for short-term financing while avoiding an emergency reduction in its broader lending-rate target.

Banks can borrow at the discount rate with a wide variety of collateral, including everything from mortgages -- the market that sparked the credit crunch after defaults rose to the highest in five years -- to municipal bonds.

Lacker told risk managers yesterday that the Fed's district banks would even accept boat loans as collateral. It's up to the banks to establish a value for the assets as they make the loan, he said.

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Fed Moves To Calm Investor Panic

Fed Moves To Calm Investor Panic
Evelyn M. Rusli, 21 August 2007, 6:00 PM ET

The Fed moved to soothe the savage Wall Street beast on Tuesday.

Droves of wary investors fled risky investments and not-so-risky investments for the safe haven of Treasury bills on Tuesday morning. To quell the stampede, the New York Fed slashed a fee bond dealers pay to borrow Treasuries to 0.5% from 1.0% during afternoon trading. By lowering the borrowing cost, the Fed made Treasury bills easier for banks to acquire, helping to satiate frenzied demand for these securities.

Before the Fed action, the yield on the three-month Treasury bill had plunged to 2.93% in morning trading, the first time it was below 3% in two years. Investors were exhibiting a lack of confidence in commercial paper, the mainstay of money-market funds and one of the safest private-sector investments. These short-term loans to corporations are trading at about 5.34% for three-month maturities, far above the slightly safer T-bill rate. After the Fed acted, the three-month Treasuries rebounded to 3.64%, up from 3.18% late on Monday.

The recent exodus from bond-market investments with practically any risk underscores a systemic trust crisis plaguing U.S. markets. The credit crunch that arose from the meltdown in the subprime mortgage market has hit a swath of financial institutions hard and fast, leaving investors with sky-high losses. As the hemorrhaging continues, investors have grown leery of the banks, the rating agencies, mortgage players, and even the Federal Reserve itself.

"The public has lost confidence in the integrity of investment and mortgage bankers," University of Maryland Business Professor Peter Morici said on Tuesday. "A lot of people with conflicting interests exaggerated the quality of the paper they were selling."

Mortgage-backed securities created from loans to borrowers with limited creditworthiness were treated as relatively safe investments by the ratings agencies and financial firms that packaged the bonds in the past few years. Early this year, when some borrowers began defaulting on their loans and housing prices started to fall -- meaning that the homeowners couldn't sell their homes at profits to pay off their debts -- investors began fleeing subprime-backed securities and then all kinds of mortgage-backed bonds.

In this era of skepticism, investors have rushed to place cash in the safest vehicles. Suddenly, low-yielding but highly dependable government bonds look like a hot investment. On Tuesday, yields across the Treasury maturity spectrum extended their recent tumble. The return on the six-month bill fell to 3.79% on Tuesday from 3.89% on Monday, while the benchmark 10-year note dropped to 4.60% from 4.63%. But the most notable decline was the three-month issue at 2.93%, down from 3.18% on Monday and around 4.80% a month ago.(See: "Wall Street Sidelined By Flight To T-Bills." )

Read full article here

Subprime Infects $300 Billion of Money Market Funds, Hikes Risk

By David Evans
Aug 20, 2007 (Bloomberg)

Money market funds were invented 37 years ago to offer investors better returns than bank savings accounts while providing a high degree of safety. Most of the $2.5 trillion sitting in these funds is invested in such assets as U.S. Treasury bills, certificates of deposit and short-term commercial debt.

Unlike bank accounts, money market funds aren't insured by the federal government. They almost never fail.

Unbeknownst to most investors, some of the largest money market funds today are putting part of their cash into one of the riskiest debt investments in the world: collateralized debt obligations backed by subprime mortgage loans.

CDOs are packages of bonds and loans, and almost half of all CDOs sold in the U.S. in 2006 contained subprime debt, according to a March report by Moody's Investors Service.

U.S. money market funds run by Bank of America Corp., Credit Suisse Group, Fidelity Investments and Morgan Stanley held more than $6 billion of CDOs with subprime debt in June, according to fund managers and filings with the U.S. Securities and Exchange Commission. Money market funds with total assets of $300 billion have invested in subprime debt this year.

The danger of owning even highly rated CDOs containing subprime loans was thrown into sharp relief in June, when two Bear Stearns Cos. hedge funds that were holding subprime CDOs collapsed.

Under SEC rules, money market managers must invest in securities with "minimal credit risks.'' Joseph Mason, a finance professor at Drexel University in Philadelphia and a former economist at the U.S. Treasury Department, says subprime debt in money market funds is far from safe.

"This creates tremendous risk for today's money market investors,'' says Mason, who wrote an 84-page report on CDOs this year. "Right now, I'm not comfortable investing anything in CDOs.''
Global financial markets were rocked in July and August, first by the collapse of the Bear Stearns hedge funds and then when banks and insurance companies worldwide disclosed their U.S. subprime debt holdings.

On Aug. 9, BNP Paribas SA, France's biggest bank by market value, froze withdrawals on three investment funds with assets of 2 billion euros because the bank couldn't find a way to value its U.S. subprime bonds and other assets. CDOs aren't bought and sold on exchanges and their trading has little transparency.

During the first two weeks in August, central banks in Europe, Japan and Australia and the U.S. Federal Reserve lent more than $300 billion to banks to stem a collapse in credit markets.
On Friday, the Federal Reserve lowered the interest rate it charges to banks to 5.75 percent from 6.25 percent in an attempt to contain the subprime mortgage collapse.

Until recently, CDOs had been the fasted-growing debt market -- outpacing corporate and municipal bond sales by dollar total -- with about $500 billion sold in 2006, up from $99 billion in 2003, according to Morgan Stanley.

CDO Slump

About a quarter of the content of all CDOs sold last year in the U.S. was made up of securitized subprime mortgage loans. CDO sales slumped to $11.9 billion in July from $36.9 billion in June, according to JPMorgan Chase & Co.

Each time a bank or financial firm creates a CDO, it forms a free-standing company incorporated offshore, usually in the Cayman Islands, which doesn't tax corporations. All CDOs have a trustee, usually a bank, that prepares monthly reports on the changing contents of the debt package.

The trail that connects subprime debt to money market funds usually starts with a mortgage broker who makes a loan to a homebuyer with poor credit. A middleman then bundles hundreds of these subprime mortgages into so-called asset-backed securities.

Next, a CDO manager buys hundreds of these securities for collateral for a CDO. Some CDOs issue commercial paper, and brokers can then sell that paper to money market funds.

Commercial paper, which is typically issued by banks and large companies, is debt maturing in less than 270 days.

Commercial paper pays relatively low interest rates, which averaged about 5.3 percent in June and July, because it rarely defaults. There have been occasional exceptions, such as paper issued by Enron Corp. and WorldCom Inc., both of which filed for bankruptcy earlier in this decade.
CDO commercial paper, often loaded with subprime debt, pays higher returns than corporate paper, and it paid as much as 6.5 percent in August.

This year, CDOs have sold more than $11 billion in the form of investment-grade commercial paper to money market funds, SEC filings show. The paper has the highest credit rating because Fitch Ratings, Moody's and S&P give AAA or Aaa ratings to the top portions of CDOs, which are the source of all CDO commercial paper.

Investors are accustomed to treating money market funds as if they were bank savings accounts. The last thing they expect is that the subprime debt turmoil would enter their safe cash havens. And now it has.

Read full article here

The first cut is the deepest

Aug 17th 2007
From Economist.com

The Fed reduces its discount rate and hints at a change in its policy rate too

DOES an interest-rate cut always imply looser monetary policy? That was the question economists were pondering after the Federal Reserve cut its discount rate from 6.25% to 5.75% on Friday August 17th. This is the price at which banks can borrow reserves from the Fed in a pinch. But the central bank kept its main policy instrument—the Fed funds target rate, which sets the price at which banks can borrow overnight from each other—at 5.25%. The cut came after requests from two of the Fed’s regional banks in New York and San Francisco and was the latest attempt by the central bank to lubricate the banking system to prevent it seizing up.

The Fed also announced that, in a departure from its usual practice, it would provide discount lending for up to 30 days. This was a tacit acknowledgement that recent money-market interventions had failed to cap the unusually high rates banks were charging each other for one-month and three-month loans. By extending the terms of emergency lending, the Fed sought to reassure banks that the supply of dollars was not about to dry up.

It was not the only salve on offer. A separate statement from the Fed’s Open Market Committee hinted that policy rates might be on their way down soon as well. Turmoil in financial markets and tighter credit conditions could hurt the economy, it said, and the Fed was “prepared to act as needed” to prevent this. Bruce Kasman, chief economist at JPMorgan, said he now expects the Fed to cut its policy rate from 5.25% to 5% at its next scheduled meeting on September 18th with a further reduction likely on October 31st.

Does the cut in the discount rate mean the Fed has already loosened policy? Lending at the discount window is supposed to be penal to discourage its use. The charge is usually a full percentage point higher than the policy rate. In normal circumstances a bank would be loth to use the discount facility as, by doing so, it reveals that it cannot find funding at a reasonable price from peers—a hint of possible insolvency.

These are not normal times, however. A climate of suspicion in the interbank lending market has driven up interest rates. The creeping way in which losses in the subprime mortgage market have emerged had made banks wary of extending credit to each other. Big cash injections by central banks had helped offset the worst effects of this cash hoarding, bringing overnight lending rates down toward policy targets. But securing funds for longer periods is still difficult and pricey. Three-month interbank rates were more than 1.4 percentage points higher than government bills of the same maturity this week. The spread, which reflects the perceived risk of lending to banks, is usually around half a percentage point.

The charitable conclusion is that the Fed’s actions were necessary to open another channel of liquidity to the money markets, which were not functioning because of fear and mistrust. The discount facility bypasses the money markets and allows a far wider range of depository institutions to borrow cash directly from the Fed, with a broader range of assets as collateral. Reducing the penalty rate does not alter the overall stance of monetary policy. And the changes are temporary. The Fed says they will remain in place until it judges that market liquidity has “improved materially”.

The less charitable interpretation is that the central bank has softened the penalty for banks that have funded purchases of very illiquid assets with short-term paper. If it loosens policy while markets are only in the early stages of adjusting and before the economic risks are real, it will seem like a reward for banks and hedge funds that took on too much risk.

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Weekly Indicators - Aug 16, 2007

Aug 16th 2007
From The Economist print edition

GDP in the euro area rose by 0.3% in the second quarter, a smaller-than-expected increase, leaving it 2.5% higher than a year earlier. The second-quarter increase in GDP in both France and Germany was in line with the euro-area average. Spain's GDP rose by 0.8% in the same period.

Consumer prices in America rose by 0.1% in July and by 2.4% from a year earlier. Prices excluding food and energy rose by 0.2% in the month, the same as in June. Both industrial output and the value of retail sales rose by 0.3% in July.

Japan's GDP rose by 0.1% in the second quarter and by 2.3% from a year earlier.

In Britain consumer prices rose by 1.9% in the year to July, down from a 2.4% rate in June and below the government's 2% target for the first time since March 2006. The unemployment rate was 5.4% in the three months to June, down from 5.5% in the three months to March. Average earnings rose 3.3% in the year to the second quarter, the lowest increase for nearly four years.

China's consumer prices rose by 5.6% in the year to July, the biggest increase for ten years, because of sharp rises in the cost of meat. The inflation rate excluding food prices was a less alarming 0.9%.

Norway's central bank raised its benchmark interest rate from 4.5% to 4.75% on August 15th. The bank said that financial-market turbulence did not warrant a departure from its monetary strategy set out in June.

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Surviving the markets

Aug 16th 2007
From The Economist print edition

The new financial order is undergoing its harshest test. It will not be pretty, but it is necessary

THE lifeguards had been scanning the horizon for an oil-price shock, a bankrupt buy-out or a terrorist attack. But when the big wave struck last week it surprised them by coming from inside the financial system and threatening to swamp an unlikely shore, the money markets where banks lend to each other to help cover their daily operations. Investors have been asking for years if the frantic innovation in finance, especially the securitisation of just about every form of debt into a tradable asset, was a way to spread risk efficiently, or whether this left the financial system prone to rare—but cataclysmic—failures. It looks as if investors are about to find out.

Over the past week central banks have lent tens of billions of dollars to restore confidence to the markets (see article). But it is already clear that this mess is about more than a bit of rash mortgage lending to Americans who were in the habit of falling behind with their monthly payments. Hedge funds and private-equity firms, kings of the boom, are nursing big losses. Debt markets that once handed out cash to all comers are tight or closed altogether. In almost every asset market, investors are scurrying to reprice risk—which mostly means to reduce it.

The gravest and most immediate threat is to the banking system. For the time being, banks no longer trust other banks enough to lend them money except on onerous terms; equally worryingly, they lack confidence that other banks will trust them if they want to borrow. It is alarming when the very outfits that exist to supply the economy with credit start to hoard it from each other. At best this tightens monetary policy; at worst, a shortage of cash will cripple the payments system and cause runs on otherwise solvent banks and businesses that cannot rapidly raise funds.

Underneath all the new technology and the fancy derivatives with strange acronyms is a dilemma as old as banking itself. Anyone who thinks that lending has been too loose—and many bankers do—should welcome a purge: better now than later when the imbalances would be bigger and the economy probably weaker. But if good banks fail and money for good companies dries up, the purge will wreak huge and wasteful damage on healthy parts of the economy. How likely is that?

Fear of the deep
Financial crises are always about the way people do business, and not just the deals they have struck. Yet this one goes deeper than most. The spreading panic has shown up weaknesses in some of the foundations of modern finance. The past 20 years have created untold wealth. As securities and markets have steadily taken the place of old-style bank managers, the number of potential investors has grown and the cost of capital has fallen. Much good has come of that.

But there is a price that is only now becoming apparent. Because lenders expected to be able to sell on the risk of default to someone else, they lent too easily. After all, they would not have to pick up the pieces. In theory, that risk should have been borne by the people best able to carry it. But with everybody having sold on the risk to everyone else—and the risk often being carved up, repackaged and sold again—nobody is sure where the losses are. The fear is that some risks ended up with those who least understood what they were getting into, and fear is a potent force in this disintermediated world. In the interbank market, every counterparty was potentially vulnerable. Even small amounts of bad credit can drive out good.

In theory, ratings agencies and mathematical models help investors price the risk they are taking on, even if the securities they are buying are scarcely traded. Yet when some supposedly good-quality assets proved to be worth little, people lost faith in the models and the ratings. Across the board, investors had failed to take account of how fast and how far asset prices fall when everyone wants to sell at the same time. Hard-to-sell long-term securities had been bought with short-lived debt, which left borrowers vulnerable to a change in sentiment every time the debt fell due. It does nothing to restore confidence when the biggest model-driven hedge funds had to get in new money. The people at Goldman Sachs lost a packet when something happened that their computers told them should occur only once every 100 millennia.

Reassess, reprice and then rebound
The retreat to a new level of risk was never going to be orderly or free of casualties. Neither should it be. Bankers and investors need to suffer precisely because the methods of modern finance have been found wanting. It sounds Darwinian, but the brutal demonstration that you pay for your sins is what leads the system to evolve. Markets learn from their mistakes. Only fear will spur investors to price risks better and get them to put more effort into monitoring their counterparties.

If these lessons are to sink in, central bankers must stand back—as, by and large, they have done. Every intervention now will be taken as a sign of what the regulators will do next time. If they bail out banks that have mispriced risk, the mispricing will continue. And when the central banks do step in, it should not be to save the financiers. The cost of intervention is warranted only to save the rest of the economy from the financiers' folly. By that test, central banks were right to lend money to the banks in recent days, because it ensured that a liquidity crisis did not become a solvency crisis. They may yet have to take over a failed bank, though only if that is needed to stop a run. It is still far too soon to cut interest rates.

Because this crisis taps so deeply into the newly devised structures of finance, anyone who says the worst is definitely over is either a fool or someone with a position to protect. As risk has become bewilderingly dispersed, so too has information. Nobody yet knows who will bear what losses from mortgages—because nobody can be sure what those loans are really worth. Nobody knows if tighter lending standards will oblige borrowers to raise more capital, triggering more sales in stockmarkets and more pain. Nobody knows how messy the inevitable bankruptcies will turn out to be. What markets need now is time to piece that information back together. Time before the next wave strikes.

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Credit contagion

Is the worst over? Fortune's Peter Gumbel offers a 10-point guide to understanding two harrowing weeks - and what's likely to happen next.

By Peter Gumbel, Fortune
August 14 2007: 10:36 AM EDT

PARIS (Fortune) -- Relax! There's really no need to panic! That's the soothing message being put out this week by key players in financial markets after two harrowing weeks in which credit markets in Europe all but dried up, prompting massive injections of funds into the system by the European Central Bank, the U.S. Federal Reserve and the Bank of Japan.

Overnight borrowing rates have come back down after spiking wildly and stock and bond markets have been bouncing back around the world. The European Central Bank, which continued to inject funds into the market on Tuesday, albeit less than one-tenth the amount at the peak of the crisis last week, says that money-market conditions are "normalizing." And Tuen Draaisma, Morgan Stanley's chief European equity strategist, for one, recommended in a note to clients that they should go "overweight" in equities because "we may already be at the point of maximum bearishness and uncertainty, which by definition is the right moment to buy."

So is the worst over? Even the most die-hard optimists concede that it'll take a lot more than a few days of calm to restore confidence among financial institutions and retail investors. "The market is concerned pretty much across the board," says Gerry Rawcliffe, a managing director in the banking group at Fitch Ratings in London.

Here's a 10-point guide to what we know and don't know about the troubles, and what the repercussions are likely to be:

Why did America's subprime mortgage woes have such a big impact on world financial markets?

Because these mortgages were lumped together in packages and sold as asset-backed securities all over the world, particularly in Europe. Often the initial securities were themselves put into new packages, leveraged up and resold as so-called collateralized debt obligations (CDOs). They are a sort of derivative play on the underlying mortgages, just as futures and options are a play on stocks and commodities. Big banks have whole securitization departments who create these instruments. They do so to profit from the difference between the long-term returns these investment vehicles produce and their more plain vanilla short-term borrowing, and to earn fees.

Who bought them?

Everyone, and that's the problem. The CDO market has exploded in recent years: More than $100 billion worth of structured cash CDOs were issued in the fourth quarter of last year alone, according to CreditFlux Data+, a London firm that tracks them (and that doesn't include the even more arcane "synthetic" CDOs). Banks, institutional investors and hedge funds have been the main customers, but some retail investors have also bought into them through the asset-backed securities, or ABS, funds that some of the biggest European banks sell to the public. Everyone who bought these securities was given the same pitch, namely that they were a relatively safe bet, since much of the paper had AAA ratings, but offered higher returns than regular corporate bonds.

So what went wrong?

The number of delinquencies in the U.S. subprime mortgage market has been rising and is now substantially larger than anyone expected - about 14 percent of the total, up from about 10 percent in 2004 and 2005. That means there's a strong likelihood that some of the securities holders, especially those where the underlying mortgages were taken out in the past couple of years, are sitting on losses.

Those troubles have been massively compounded by the aggressive use of leverage in CDO packages. When U.S. blue chip financial players like Bear Stearns and then a variety of European banks began reporting problems, panic quickly gripped the markets. That turned into a vicious circle: These debt instruments have now become impossible to price because nobody wants to buy them any longer. And since they can't be priced, the size of the losses aren't clear, which in turn has given rise to more rumors about financial players in trouble. Banks in continental Europe especially simply stopped lending to one another, which is why the liquidity dried up in the credit markets as a whole and the European Central Bank had to jump in.

How big is the problem, really?

Nobody is quite sure. Patrick Artus, an economist at Natixis in Paris, reckons the total damage inflicted by subprime woes is a relatively manageable $45 billion, which is the difference between the expected rate of mortgage delinquencies and the current much higher rate. Another French bank that is an important player in the derivatives market, Sociéte Générale, reckons that even if things really turn sour, the worst will be losses of about $100 billion. That may sound like a lot, but it's the equivalent of about 1 percent of the total market capitalization of the S&P 500.

Such calculations highlight the real issue here, that the panic has been due more to a collapse of confidence than to any financial cataclysm. "We're still primarily looking at a liquidity crisis rather than a credit or a solvency crisis," says Fitch's Rawcliffe.

Is it really over?

No. The market "remains very, very fragile," says a top executive at one of the leading European banks. Some confidence has been restored into the international banking system and its overnight lending patterns by the big injections of central-bank funds, but nobody has yet dared to start buying that subprime paper in any sizeable quantities. And because there's so little transparency about who is sitting on what size losses, the rumors continue to swirl.

Nouriel Roubini, an economics professor at New York University's Stern School of Business, who has long warned about the risk of financial contagion, reckons some other parts of the U.S. housing market including home equity loans and second mortgages are starting to display what he calls the same "toxic characteristics" as the subprime sector. More optimistically, Neil McLeish, the chief European credit strategist at Morgan Stanley, says that, "we have passed the absolute peak of that anxiety and uncertainty." But even he believes that credit market conditions will be more difficult in the coming months and, "there is still some risk of additional volatility" at least for the next month or so.

Who are the biggest casualties?

Banks and financial market players across the world are starting to come clean about their exposure and losses, partly in order to help restore confidence in the market. The losses incurred by Wall Street titans Bear Stearns and Goldman Sachs, which this week announced it is putting $2 billion into one of its hedge funds, have received the most publicity. Outside the United States, firms such as insurer AXA and BNP Paribas in France have frozen or shut problem funds, while a range of banks including NIBC of the Netherlands and Commerzbank in Germany have detailed their exposure and expected losses.

The biggest international victim to date is a mid-sized German bank called IKB Deutsche Industriebank that its peers, including a government-owned bank, stepped in to rescue earlier this month, taking over $11 billion of credit lines and putting up a $4.7 billion funding package. IKB had been an aggressive player in the CDO market, through two off-balance sheet firms that it used to pump up its commission income and advisory fees. In the end, its exposure to dodgy securities through these two firms far exceeded the bank's liquidity and equity capital.

Is anyone safe?

Not completely, but barring some huge problem nobody yet knows about, major banks seem in the best position to weather this storm because they have the strongest balance sheets and are able to refinance their operations most easily thanks to the extra liquidity that central banks have put into the market in the past week. "Being a bank and having access to the central bank (credit) windows is key at the moment," says the top European banker.

Hedge funds are another story, as the Goldman Sachs-run one that was bailed out this week shows, although some of these funds foresaw the troubles and have been aggressively shorting the subprime sector and any securities relating to it.

Why didn't central banks cut interest rates in response?

Some critics of the European Central Bank, especially in France, are saying that its interest rate policy, which has consisted of regular rate hikes to counteract inflation, has partly fueled this crisis. "One can ask if the ECB isn't becoming a prisoner of its rate-increase strategy," Thierry Breton, the former French finance minister said this week. But bank economists are generally more supportive and say that the ECB acted smartly with its three consecutive days of huge money-market interventions - the biggest of which was a whopping $130 billion injection last Thursday. "It's a demonstration of the financial system operating as it should," said James Nixon, a London-based economist at France's Société Générale, who says that the troubles primarily affect the financial sector rather than the wider economy.

While the Fed did cut rates in 1998 during the last derivatives meltdown, involving Long Term Capital Management, central banks may not need to this time if markets continue to calm down. Indeed, the big question now is whether the ECB and the Bank of Japan will go ahead and raise rates in the next month, as they had signaled before the crisis. Roubini isn't sure, and thinks that the Fed may well move to reduce U.S. rates quite soon. "The likelihood of a cut in rates is now much higher," he says.

What does this mean for the world economy?

So far, not all that much - but keep your fingers crossed. Growth in Europe and Asia remains buoyant, even if the U.S. outlook is unclear. Some borrowing by companies and individuals is bound to get more expensive as markets adjust and restore a risk premium. But "it's not obvious that the repricing will lead to an economic slowdown," says Société Générale's Nixon, although there's a possibility that Britain's economy, which has thrived because of its heavy dependence on financial services, may be vulnerable. Roubini thinks the United States will bear the brunt of what he sees as an inevitable slowdown of consumer spending related to the housing woes, and reckons that this could ultimately spill over to the global economy if it's sufficiently severe. "The effect on the real economy in the rest of the world depends on whether there's a hard landing in the U.S." he says.

Will there be any regulatory fall out?

This is almost inevitable, especially in Europe where it's now clear that many of the purchasers of these securities didn't fully appreciate the risks they were taking. Look for the first moves to come in Germany, where bank bail-outs are exceedingly rare. The last time a bank got into serious trouble there was in 1974, when the Herstatt Bank collapsed after some disastrous forays into foreign-exchange trading that bear some similarity to IKB's woes. Regulators quickly followed up with an overhaul of the national banking system. It's not clear that IKB's rescue will have the same dramatic repercussions, but it's already prompting tough questions about how a mid-sized bank could end up with such an enormous exposure to risky assets via an off-balance-sheet firm.

"I suspect that at the end of this, regulators will ask themselves if this very rapid expansion (of transactions involving asset-backed securities) has been a good thing for banks, or if the risk comes back to haunt you," says Fitch's Rawcliffe. Watch also for credit agencies to come under pressure to do a better job at assessing the market risk of exotic financial instruments.

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Are there 'safe' emerging-market currencies?

Are some emerging-market currencies less vulnerable to the credit-market turmoil that has prompted investors to slash exposure to risky assets and cover losses elsewhere?

Most emerging-market currencies pared losses, but remained under heavy selling pressure on Wednesday. The Turkish lira fell 2.5% against the dollar, the South African rand dropped 0.8%, the Brazilian real shed 0.6%, and the Icelandic krona dropped 1.2%.

"There is not conviction that this credit market turmoil has run its course," said Paul Biszko, senior emerging markets analyst at RBC Capital Markets. "We continue to advocate a defensive approach in the very short term."

"If you want to stay defensive, stick to the Russian ruble or the Czech koruna, which are purely defensive plays," Biszko said. Low-yielding currencies such as the ruble, koruna and Chilean peso are in the less vulnerable group, he said.

The Japanese yen has rallied against other major currencies Wednesday, as investors unwound carry trades, in which investors borrow low-yielding currencies like the yen to reinvest in higher yielding currencies.

"Super high-yielders, such as the Brazilian real, the Turkish lira, and the Icelandic krona, suffer when carry trades unwind," Biszko said.

"These currencies are high [volatility] plays," he said. However, "in the event of stabilization, they are the ones that will come back aggressively, especially the Turkish lira and the Brazilian real."

Mid-yielding currencies are the Mexican peso, the South African rand and the Hungarian forint.

"They are selling off, but they are not coming back as quickly as those other [super high yielders] ones," Biszko said.

Current account deficits increase vulnerability

"We don't think it is right to just jump in and buy risky assets back, but there are a couple of ways that we might look to trade," said Steve Barrow, chief currency strategist at Bear Stearns, in a research note Wednesday. "Perhaps an obvious one is to buy 'safe' emerging market currencies and sell 'riskier' ones."

Riskier countries, according to Barrow, are those with large current account deficits and also countries with less depth to their foreign-exchange market.
"The countries that seem most vulnerable are Turkey, Hungary, Iceland and South Africa," Barrow said. "Hence one strategy is to sell these currencies but buy other 'safer' emerging-market currencies rather than the dollar. Candidates here might include the Brazilian real or Singapore dollar."

Biszko of RBC Capital Markets also said that higher current account deficits increase the vulnerability of emerging-market currencies. The South African rand is one of the more vulnerable, since the country is running a big current account deficit, which is mainly financed by volatile foreign portfolio inflows. Turkey is also vulnerable to some degree, but strong foreign direct investment inflows are covering its deficit.

As for Brazil, it is running sizeable trade and current account surpluses, which are coupled with very strong capital inflows.

"The real, of the high-yield currencies, is the best position," Biszko said.

Sub-prime crisis: Central bank credit has worked for now

But tighter credit, higher interest rates can cause market to slide further: analyst

By NEIL BEHRMANN IN LONDON
Published August 13, 2007

IN the past year, central banks have studied various models on how to cope with a 'systemic' global financial crisis. They are now being tested.
'So far, the first step of central bank credit to banks appears to have worked,' said Brendan Brown, the London-based chief economist of Mitsubishi UFJ Securities International.
But the main worries are that tighter bank credit and higher interest rates could cause a further market slide, he said.

This could lead to further hedge fund and other financial failures. Coupled with a downturn in the real estate market, the US and European economies could slow down or experience recession, he feared. This, in turn, would dampen the exports and economic growth of Singapore and other Asian economies.

In the initial rescue phase, global central banks have pumped more than US$300 billion into financial markets. These loans appear to have eased panic in the European, US and Asian interbank markets. Such were the fears about the financial health of counterparties that banks, especially in Europe, became nervous about lending money to each other. Credit dried up and interbank interest rates soared as lending banks demanded a higher risk premium.

Last Thursday and Friday, the European Central Bank (ECB) supplied US$214 billion to loosen the squeeze on vulnerable European banks. The US Federal Reserve Bank funnelled US$62 billion into the US financial markets. Alongside efforts of the Bank of Japan and Asian central banks, a credit crunch and bank failure has so far been avoided.

After an initial slump of several hundred points, the Dow Jones index last Friday ended up 58 points on the week. With Asian central banks at the ready to support their banks, there is hope that their markets will stabilise and possibly recover today. But the underlying problems are still very serious.

The next step is how central banks, regulators and investors deal with two parallel crises, economists said. The first relates to excessive loans on residential real estate and rising defaults. The most publicised is the so-called sub-prime crisis in the US where figures of potential defaults of US$100 billion are being bandied about. Real estate prices are tumbling.

But there are also huge and potentially doubtful loans to property owners in Britain, France, Spain, Eastern Europe and, more recently, Asia. Some economists believe that Spanish banks are particularly at risk as prices there have already begun to fall.

In England's north and midlands, property prices have already begun to slip. The current debacle has a good chance of ending London's financial boom, which would cap the city's heady property prices.

Parallel to this problem is an acute crisis in the US$1.6 trillion global hedge fund industry. Leverage, or borrowings of thousands of hedge funds, have raised their market exposure to US$3-4 trillion, estimated Dresdner Kleinwort. Economists and other analysts believed the unwinding of these positions are the root cause of the current crisis, the worst since the failure of the hedge fund Long Term Capital Management in 1998.

The inevitable result has been panic among investors who placed money in hedge funds. Many now want to withdraw their money, forcing the managers to dump shares and other assets on the market. This has created a vicious circle, causing stock market falls, further hedge fund losses, more withdrawals, leading to inevitable closures.

The dilemma facing central banks is whether to allow the free market to dish out bad medicine, causing failures and a painful adjustment. They are aware that if they continue to pour money into the market and slash interest rates to save reckless banks and hedge funds, they could spur inflation. That would stem today's financial crisis, but an ultimate one could be much worse.

Weekly Indicators - Aug 9, 2007

From The Economist print edition
Aug 9th 2007

The Federal Reserve decided to keep its benchmark interest rate unchanged at 5.25% on August 7th. America's central bank acknowledged that financial markets had been “volatile” and that the risks to growth had “increased somewhat”, but insisted that its main policy concern was that inflation would “fail to moderate as expected”.

The unemployment rate in America rose from 4.5% in June to 4.6% in July. Labour productivity in nonfarm businesses rose at an annualised rate of 1.8% in the second quarter, according to first estimates. The annualised increase in unit labour costs was 2.1%.

The Reserve Bank of Australia raised its key interest rate from 6.25% to 6.5%, the highest level since November 1996.

Surprisingly, South Korea's central bank raised interest rates for the second month running. The Bank of Korea put rates up by a quarter-point, to 5%. Lending has been growing rapidly and the memory of a credit bubble, which burst in 2004, is still fresh.

In its quarterly Inflation Report, Britain's central bank forecast that inflation would stabilise close to the 2% target, if market expectations that interest rates would peak at 6% were fulfilled. Britain's industrial production rose by 0.6% in the second quarter.

Germany's trade surplus fell from €17.4 billion ($23.5 billion) in May to €14.9 billion in June, largely because of a surge of imports. France's trade deficit narrowed to €3 billion in June from €3.2 billion in May.