Breakingviews.com | Setting up a defence against fiscal doom

Breakingviews.com | Setting up a defence against fiscal doom
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First Published: Fri, Aug 10 2007. 12 18 AM IST
For most of last week, investors thought the world’s financial glass was half-empty and draining fast. They were somewhat worried about future losses for US subprime mortgage lenders. They were more worried that many markets would take fright and seize up.
But the retreat from risky assets threatened to create exactly the sort of general havoc that each individual risk-averse investor hoped to avoid.
Central bankers are supposed to fight against this sort of self-fulfilling prophecy of financial doom. And the first calming technique usually is to put the market’s problems in perspective. So the eurozone’s European Central Bank (ECB), the US Federal Reserve Board and the Bank of England all made it clear that there was no need to consider a cut in the overnight interest rate, or even a delay in interest rate increases.
At least until Thursday morning, this resolve was enough to encourage investors to take on a little more risk. The bellwether Itraxx index of credit risk, which had risen from 190 to 460 basis points in a month, dropped back to 335. The S&P 500 index of US stocks jumped by 4% in four days. The price of US treasury bonds, usually considered an ultra-safe asset, fell.
But the confidence is fragile. Thursday morning’s news that BNP Paribas was suspending liquidity in some of its money market funds caused equity markets in Europe to tumble by almost 2% and short-term rates to spike up. ECB resorted to a central bank’s second line of defence against panic: an emergency offer of as much liquidity as the market needed at a low rate.
The market took €95 billion (Rs5.3 trillion). That’s more than Ben Bernanke, the Fed chairman, has identified as the upper limit of subprime losses. The sharp gyrations are a response to a double uncertainty. No one knows how big the losses from US housing will prove, or who will suffer them.
It’s certainly distressing to discover that supposedly low-risk investments such as money market funds could be hit. Until investors know a good bit more, they are likely to keep on alternating between fear and calm.
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First Published: Fri, Aug 10 2007. 12 18 AM IST