High drama


Exciting times in the world of finance. What strikes me as much as the elevator in freefall is the US Fed decision that caught it. A three-quarters-of-a-percentage-point cut in one go, and outside the regular meeting schedule. The Fed tends to move its rate more boldly than lesser central banks like the Reserve Bank of Australia. But this is bigger than normal. Things are looking pretty shaky here, with brokers foisting a record volume of margin calls on their clients. That means clients who have borrowed money to put in the market have to increase their deposit to cover their losses, or sell out completely. That’s the stuff of chain reactions. Still, things seem to have stabilised.

Sharemarkets play a much bigger role in popular consciousness than they do in the economy and you can’t read much off what happens in them. They’re volatile by nature. It’s surprising to me though that the Fed is catering so much to the market – it indicates that central bankers are very worried. It also shows that the idea of a smooth menu of monetary policy options, from ‘tight’ to ‘loose’, is a myth. In a crisis there is no middle. Central bankers are worried about a financial collapse so they have been forced to pump liquidity into the system. Much more than they would like to be given that inflation is still a threat. What’s happening in the financial markets can diverge from what’s happening in the ‘real’ economy. But financial trouble forces the authorities’ hand. This happened in the aftermath of the dot com boom – a sharemarket bubble burst, Greenspan cut rates to soften the downturn, and an unintended consequence was the housing bubble, which has itself now burst.

This dilemma is manifesting in a different way in Australia. In the States a recession is obviously on the cards, so the Fed wants to cut rates anyway, though not as rapidly as it is. Here the RBA is more worried about inflation than recession, as we can see from Governor Glenn Stevens’ speech the other day. He hinted that he thought financiers were bullying other central banks into lowering rates:

I believe that central banks everywhere are acutely conscious of this [inflation risk]. I would venture, however, that the tolerance among some parts of the investment community for a cautious approach by policy is not high, if some of the commentary we read is any guide. This, too, adds to the delicacy of the tasks facing policy‑makers.

Stevens argues that there are two ways America’s (and to a lesser extent, Europe’s) problems could come to Australia, which is undoubtedly still booming. There’s the potential transmissions through ‘real’ trade links – a slowdown in American consumption hitting Asian exports, which puts Asia into recession, with both developments hitting Australian exports. Then there’s the potential for the same financial pressures at work in the US and Europe to work here.

To start with the trade link possibility: the authorities and other optimists (who are still in a majority about Australia’s ‘fundamentals’) think that at least that path will take some time to take effect here, so the immediate problem is still inflation. However, previous RBA research has suggested that world business cycles have become increasingly synchronised – much more than can be explained by the trade link. The researchers were puzzled as to why, but speculated that it might be due to financial transmission.

Which brings us to the second possibility. Asian sharemarkets fell as much as anywhere over the past week; investors are jittery there too. But that may not mean much. The world credit crunch was transmitted into the Australian money market, as I described back in August. But it has so far been milder.

Last week the RBA put out an excellent primer for anyone who wants to get up to speed on how the asset-backed commercial paper (ABCP) markets work and what has been happening. It backs up my story, but these writers have put in figures where I had no idea about the magnitudes. They show that banks in Australia have not been directly exposed to the players in the ABCP markets to the extent of those in America. In the States the banks have been forced to provide back-up credit (because of prior contracts) worth 10 per cent of their total assets (weighted as per Basel guidelines for risk). Here the figure is only 2.3 per cent. Furthermore, the RBA has taken the unusual step of removing some of the burden by purchasing some of the paper itself, with repo agreements that the other party will buy them back eventually. That has supported the market such that a much higher proportion of commercial paper is still outstanding in Australia than in the US, where more than a third of ABCP outstanding prior to the crisis has been redeemed.

That has helped banks deal with the other way they are exposed – by their own borrowing on the money markets. Much of the banks’ prior borrowing on American markets has been rolled over into the domestic market, which would not have happened without the help of the Reserve Bank. Banks have faced higher borrowing costs and have passed some of it on into mortgage and business lending rates, which they are able to do thanks to the fact that their finance company competitors are still winded.

The classic way in which a financial or banking crisis leads to a real recession is by cutting back firms’ access to credit and thereby lowering investment. But these days firms are not that indebted – there’s an unprecedented amount of outstanding debt, but most of it is owed by households. So this is a different situation to the storms of the 1980s, and really quite new. The question is how consumer spending will be affected by tougher credit and higher interest rates, if in fact credit conditions do toughen (though corporate lending is certainly not irrelevant.) So far in Australia there isn’t much sign of a slowdown in lending – athough the official credit stats are only available up to November. I think the RBA and the government will continue to worry about inflation for a while.

One little footnote: An interesting side-effect of the repatriation of bank borrowing has been a sudden fall in official foreign currency and other international reserves. They have fallen from a high point in May of $84,610 million to $30,523 million in December. They’ve been more than halved since this all broke out in August. According to the RBA, this is due to the unwinding of repurchase agreements with the private banks. To repay their overseas obligations and renew them in Australia, they needed their foreign currency back. Domestic assets were switched with the RBA.

John Edwards, chief economist at HSBC Australia and once Keating adviser and biographer, wrote an op-ed in the Australian Financial Review just before Christmas saying this was something to worry about, that the central bank was funding the current account deficit out of reserves and that this was unsustainable. An RBA economist wrote back saying it was nothing to worry about. Unfortunately the AFR has an ass-backwards internet policy such that I can’t even access them via a library database – so no link and I’m not able to jog my memory about the argument. So I’m just noting it. The Keating association does not exactly enhance Edwards’ credibility on this issue, given Keating’s disastrous obsession with the current account deficit. (Though, to be fair, Edwards didn’t become chief adviser until well into the recession we had to have.)

Published in: on 24 January, 2008 at 12:55 pm  Leave a Comment  

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