Era of low interest rates means new dangers for global financial institutions

Last night's reduction in US interest rates is but the latest indication that we are entering an era of exceptionally low interest…

Last night's reduction in US interest rates is but the latest indication that we are entering an era of exceptionally low interest rates. But the flip side of the coin may be that many financial institutions are dangerously exposed.

A key danger is that if enough banks start to cut back on the amounts they lend and to call in doubtful debts, further downward pressure on international growth will inevitably result. A year ago, the talk was of higher interest rates internationally and it was seen as only a matter of time before the US Federal Reserve Board - its central bank - moved to push rates higher to combat the threat of increasing inflation.

Now the mood is completely different and Wall Street actually fell after news of the 0.25 per cent drop, due to disappointment that the reduction was not even larger. The argument for low international interest rates is strong. The threat of inflation has subsided significantly because of falling international demand and the collapse in the price of commodities such as oil. Such has been the impact of the crisis of the past year that some analysts have even warned of a period of 1930s-style deflation, with price levels actually falling.

This seems unlikely, but low interest rates seem here to stay for a prolonged period, as fears remain for the outlook for international growth.

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How low is low? The fall in US interest rates looks unlikely to be followed in Europe. Despite calls for reductions from the leaders of the victorious German SPD, the Bundesbank looks most unlikely to further reduce German rates, already at a very low 3.3 per cent. However, the present crisis means that an increase in interest rates in Germany and France is now off the agenda. In turn, this means that when the euro is born next January, interest rates across the single currency zone will fall to Franco/German levels, meaning sharp falls in borrowing costs in states like Spain and Ireland.

Six months ago, there was speculation that some increase in core EU rates and some fall in rates among the peripheral economies would allow the two to meet in the middle. Now even the EU Central Bank President, Mr Wim Duisenberg, concedes that even if the bank would have preferred a higher rate level, borrowing costs across the euro zone are now set to converge down to the lowest levels.

Low interest rates, it is hoped, will help to support the demand for money from borrowers and to sustain the economies of Europe and the US. But now another danger is emerging in the financial system.

It is that the fall-out of the financial crisis on the international banking system will inhibit the ability of financial institutions to lend out money. The resulting international credit squeeze, if it happens, would move the economic crisis onto a new and more dangerous level.

Signs of financial pressure are everywhere. Japan is stitching together a rescue programme for its banks. Investment funds and financial institutions pulled billions of pounds out of Asian markets over the past year and a similar capital flight has affected Russia. The fear now is that major Latin American economies could face the same fate. If they do, the European banking sector will find itself heavily exposed, to the tune of over $100 billion lent to the region, according to one estimate. Investors are frantically selling anything which has the faintest smell of risk about it and putting money into safe havens such as US government bonds. The serious falls in major international stock markets over the past year has both reflected this trend and in itself has helped feed it, by cutting the returns to investors.

Many major investment banks sustained heavy losses in Russia and Asia. But the way the crisis can spread through the international financial system was most clearly illustrated by the collapse of the US hedge fund, Long-Term Capital Management. From an initial capital of less than $5 billion, it managed to generate an exposure of $200 billion through complex bets on financial markets which started to go wrong. The New York Federal Reserve Bank cobbled together a $3.6 billion rescue package, fearing that a collapse of LTCM would set off a devastating domino effect among the investment banks which had given it money and throughout the financial community.

LTCM engaged in highly complex "bets" based on the difference in prices between products on financial markets. It got into trouble as investors pulled money out of emerging markets and out of a range of what were perceived as higher risk investments - leaving the fund with losing bets. In effect, it was the victim of the nervousness which has clutched international markets. Its near-collapse also highlights how financial problems can spread around the world. Europe's biggest bank, UBS of Switzerland, has written off over £400 million as a result and it is no exaggeration to say that the collapse of LTCM would have posed a threat to the international financial system.

The flashing red danger signals in the international financial system are not being met with a co-ordinated policy response. Japan is struggling to reform its banking sector, but the task is enormous as it becomes clear that the whole structure is built on shaky foundations. The crises in the other Asian economies and in Russia have raised major questions about how investors piled so much money in the first place into economies with shaky financial systems, unsustainable currency pegs and investments in projects which were never going to yield an economic return. Much greater transparency and much less risk will be demanded in future. And the LTCM debacle illustrates how the Western financial system is itself highly vulnerable.

While they may not figure on the formal agenda, these matters will preoccupy the financiers from around the world who will gather in Washington next week for the annual meetings of the International Monetary Fund and the World Bank. These institutions themselves are looking increasingly unable to police the flow of international finance and step in to prevent problems emerging and help countries in difficulty. The IMF itself is now seriously short of money and may have no firepower if the crisis deepens in, say, Brazil.

Tomorrow: the impact of the crisis on Ireland.