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Central banks: Rocks ahoy!

Sep 24, 2007

Technology is a wonderful resource - over the last two decades, the communication barriers between regions, between producers and consumers have come down significantly. This allowed almost instantaneous responses to global phenomena, helping to utilise scarce resources efficiently in terms of time as well as money. Inflationary spirals across the world economies have been smoother as supply shocks have been minimised. What it also spawned was a much larger movement of funds worldwide. Newer forms of securitisation of old debts allowed leverages that meant consumers as well as investors raised money many times their present incomes. And with money being fungible, a lot of layering of ownership on a single asset has happened on a worldwide basis. Lower inflation had allowed a much laxer monetary policy in most of the world's developed countries. Continuous income growth, coupled with low interest rates and lower inflation over time has kept the credit party going.

Unfortunately, the central banks seem to have had lapses in their function of keeping an eagle eye on the financial markets. Plenty of dubious paper was allowed to be floated without the requisite collateral, especially in the world's two largest centres of finance, London and the US. The resultant crises in the form of the house prices spiraling downwards in the US and in the UK was followed by the run on the Northern Rock, a mortgage lender based in Newcastle, UK. Banks suddenly grew wary about lending to one another in a belated move to stop the contagion from spreading further into their balance sheets.

Rather than depend on the old trusted deposits that take time and trust to garner, the Northern Rock had raised a majority of its funds on the money market at very cheap rates when the going was good. As a result it became Too Big To Fail when the inter-bank funds dried up. Bank of England (BoE) recently had to backtrack on its stated policy of 'non-intervention' and announce a state guarantee on all the deposits of this wayward lender to douse public fears. It also has widened the portfolio of securities it allows as collateral to help ease the money markets. The three-month LIBOR rates that had inched up to 7%, have now eased to 6.5%. The problem seems to be far from over as most banks would rather hold cash for themselves what with the gap between loans given out and deposits being at 530 bn (US$1 trillion)!!

Party continues across the Atlantic
A day later, some 3,000 miles away, Mr. Bernanke has had the stock markets in whoops as he lowered short-term federal funds rate by half a percent rather than the more expected quarter percent. Meanwhile, the US government-sponsored mortgage lenders Fannie Mae and Freddie Mac too announced stepping in to help the beleaguered in the ongoing housing mortgage squeeze. We hope it was concern for the US economy getting hurt rather than the demand of the financial markets holding him to ransom on the issue that made him reduce the rates to the extent to which he did.

Both these central banks managed to buy time and breathing space for their economies - they might have gone into a tailspin thanks to lapses in monitoring of the financial markets. In the long run, the mismanagement is bound to haunt the markets as more threads are unraveled. The problem with short-term rates going up was less of availability of credit than of refusal to lend as concerns over the collateral got sharper. As such how much would a rate cut help, when the global funds prefer coming to pricier, riskier shores like India (last week's frenzied buying by the Foreign Institutional Investors (FIIs) stands testimony to it) than lend in the US and UK markets?

India as a beacon
Sensible central banks like the Reserve Bank of India (RBI) stand out in this mad mayhem. Inflation has to be the priority of the central banks' policy, if it means it has to nip asset price bubbles, it has to do just that. And if not done in time, the issue snowballs into a crisis of unmanageable proportions that compromise the health and security of not just one nation, maybe scores of them. Banks are happier to extend credit and growth is more broad-based if the underlying security's risk is priced right. And it is the role of the central bank to provide that security. In a world growing smaller by leaps and bounds, it is almost like trying to step on several stones at the same time, difficult to say the least, but necessary.

As we see ahead, there will be many more 'Rocks' in this turbulent sea. The real test is to keep one's economy open to the right kind of funds and be ever vigilant.

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