At a time when nation states are finding it increasingly difficult to act in concert to address global problems, there was interesting example of united action by a few Central Banks early this month. In what could be the fore runner of many similar events, the Central Banks of America, England, Europe, Canada and Switzerland got together early this month, and announced a joint plan to ease the global liquidity crisis by co-ordinating their different monetary interventions. The central Banks of Japan and Sweden too threw in their support for this Plan.
Given the unwillingness or inability of nation states to bring themselves to agree on important issues of global concern, ranging from climate change to world trade, this was an exceptional achievement. The Bank of England described the efforts as an attempt to "demonstrate that central banks are working together to try to forestall any prospective sharp tightening of credit conditions". In the super sensitive, symbol reading world of financial markets, this was a very important positive signal and calming influence. In many ways the Central Banks rescue Plan was a testimony to what professionaly competent agencies, acting independent of political baggage and compulsions, can achieve.
This unprecedented united action, at the sidelines of the Global Central Bankers meeting in Cape Town, seeks to open alternate avenues for injecting liquidity into the global financial markets, especially the short-term money market, without compromising on the reputations of the borrowers. The inter-bank market has been getting increasingly starved of liquidity, as manifested by the widening spreads between the inter-bank lending rates and the policy rates in the dollar (federal funds rate), euro and sterling markets. In fact, in the US the inter-bank market and the traditional discount window through which the Federal Reserve lends directly to the banks, had effectively dried up. With many banks sitting on a very high proportion of dubious quality and even toxic asset backed securities (ABS) and with no mechanism to detect them, banks have been showing increasing reluctance to lend.
It was in this context that the Central Banks agreed to inject more liquidity by auctioning funds at rates banks are willing to offer. Though banks can borrow on the discount window of the Central Bank, they generally rely on the inter-bank market to raise their temporary fund requirements during normal times. Approaching the traditional discount window of borrowing identifies the borrowing bank, and exposes them before the market as being vunerable. At a time when rumours can fly in all directions, this has the potential to create a run on the bank. Auctions, in contrast, keeps out the identity of individual banks and also helps many banks borrow at the same time.
The Fed went further and introduced an exclusive Term Auction Facility (TAF), through which all banks eligible to borrow from the discount window could bid for short term, one-month money. With collaterals declining in value and credibility, the Fed also decided to dilute the collateral requirements for accessing the TAF. It quickly announced a schedule for auctioning off $40 bn in two instalments, and proceeded to do the same.
The plan may or may not succeed. In fact, it is most likely to have very limited impact on the huge credit problems, given that the total amount proposed for auctions, not more than $100 bn, is a small drop in the ocean. More fundamentally, it does nothing to solve the more fundamental solvency problems facing many banks, saddled with dubious quality ABS. Central Bank interventions and credit infusions may be able to contain a liquidity crisis, but not a solvency crisis. The deep seated problems will take more than window dressing or credit infusions, it may need a full fledged recession to wring out all the excesses and bad debts. With the sub-prime bubble not fully deflated, the banks will have to immediately absorb and then get over the ever increasing losses in both their direct balance sheets and that of their off-balance sheet SIVs. The moral hazard concerns inherent in such actions is all too obvious to be repeated.
Apart from the merits of these measures, what is significant is the resolve and the success of these autonomous institutions in coming together and agreeing to a unified action plan. It is an acknowledgement of the futility of individual economies or Central Banks acting alone against the massive economic forces unleashed by financial liberalization and globalization. It is also a testament of the fact that global financial markets are much more integrated than the real economy, and hence its problems demand concerted action.
It is also an indictment of international bureaucracies like the IMF or WTO, which regularly fail to achieve agreement among its members and respond effectively to global challenges. After all, there have been numerous examples of the IMF failing miserably in agreeing to respond effectively to both pre-empting and managing macroeconomic instability in many parts of the world. Unlike these international agencies, which face hostility from nation states in pooling their sovereignty, the Central Banks are direct representatives of their nations. The fact that they are professional and independent bodies, confers on them certain advantages and flexibility in acting when circumstances demand collective action. That they are, by and large, insulated from political compulsions, is a critical factor in their freedom of action.
Has the time come for setting up Climate Change Boards, with professional experts and endowed with some level of independence, that represents nation states at meetings like the recently concluded International Climate Change Conference? Do we need to have professional Anti-terrorism Agencies, which pools the expertise and intelligence resources of nation states, to address global security challenges like terrorism? Do we have the rudiments of a model for taking collective decisions on global challenges?
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