Markets rally as six central banks reduce costs of borrowing dollars

MARKETS RALLIED yesterday after the world’s leading central banks moved to cut the price of supplying US dollars to liquidity-starved European banks.

The euro and European shares surged on news of the co-ordinated action to reduce dollar lending costs, calming market nerves after a euro zone finance ministers’ agreement to boost the EFSF (European Financial Stability Fund) bailout fund fell short of initial ambitions.

The new measures, operational from next Monday, effectively cut the cost to banks of borrowing dollars by half a percentage point.

“The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity,” said the statement issued by the Federal Reserve, the European Central Bank, the Bank of England and the central banks of Japan, Canada and Switzerland.

These so-called “temporary bilateral swap arrangements” are to operate between the six central banks, as market conditions dictate, until the end of January. The banks have agreed to open currency channels between their countries, allowing any liquidity shortfalls in one country to be eased by a central bank in another.

The central banks said they saw no need for such liquidity “at present” but deemed it “prudent” to have such liquidity support operations ready to go into action “quickly should the need arise”.

US treasury secretary Timothy Geithner said he hoped the move would ease pressure on European banks and “help foster the global economic recovery”.

Taoiseach Enda Kenny expressed hope that the resulting reduction in financial market pressure would concentrate minds on reaching a political deal on the euro zone crisis at next week’s EU summit. The move carried echoes of similar co-ordinated action by the banks three years ago to lower their benchmark interest rates in the wake of the collapse of Lehman Brothers.

Yesterday’s announcement was a knock-on effect of the euro zone crisis which has seen some banks struggling to access liquidity at affordable prices. The reluctance of banks to lend to one another has closed the liquidity tap even tighter to levels not seen since 2008. Overnight deposits at the European Central Bank have tripled to €300 billion in the last two weeks.

“There has been evidence of clear financial difficulties with banks,” said Johannes Müller, chief economist of DWS bank.

“That could lead to a serious credit shortage, with a knock-on effect on economies, so the central banks are tackling the problem.”

Across Europe, the announcement helped stock markets close with considerable gains: Germany’s DAX index up 5 per cent, France’s Cac up 4.2 per cent and the FTSE 100 rising 3 per cent.

The news boosted bank shares, too: Credit Agricole of France closed 8.4 per cent up, Royal Bank of Scotland ended up 7 per cent, Deutsche Bank recorded a 6.2 per cent rise. By the close of European trading yesterday, Standard & Poor’s credit-rating cut of 16 big US and European banks on Tuesday appeared forgotten.

In addition to the co-ordinated measures, each bank announced its own particular measures. The Federal Reserve insisted US banks were not facing a liquidity shortfall in short-term money markets, but said it had the necessary tools to intervene if necessary to extend credit to business and home-owners.

Some analysts tempered the euphoria yesterday with a reminder that the announcement treated the symptoms rather than the cause of economic illness.

“The dollar funding (highs) in the euro zone is symptomatic of a broader liquidity squeeze,” said Capital Economics in a note. “Even if banks in the eurozone have less of a liquidity problem on their hands today than in they did in late 2008, they have a greater solvency problem.”