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Commentary

World Markets Rejoice as Central Banks Do …. Something.

Nearly all markets are up 3% or more on the news that the six big central banks – the US Fed, the ECB, Swiss National Bank, Bank of England, Bank of Japan and the Canadian Central Bank – made it cheaper to borrow dollars in an emergency.

Worldwide, corporates tend to borrow in dollars because the rates are cheap. Banks then borrow dollars in the interbank market – and this is filled with European and Japanese banks as well. These are short term loans, which are usually repaid by borrowing more, at a traded interest rate. Normally, this is not a problem.

Recently, as the economic crisis in Europe worsened, banks weren’t playing ball in the interbank markets. They refused to lend to other banks, causing some sort of dollar shortage, and like in the US and in India, the European central bank had to become the lender of last resort. Unfortunately, the ECB has no dollars to give; it can only print Euros. So it gives the US Fed euros, and takes dollars in exchange. The US Fed earns some interest on this “swap” which is of the order of 1%.  (See CNBC for a great explanation)

The new agreement changes this dollar swap rate to about 0.50%. So it makes it cheaper – not that 1% is not bloody cheap already – for the other central banks to borrow dollars, and offer it to their banks for the short term. If a bank goes under, then its obligations to the corresponding central bank remain, but there is no risk to the US Fed because the ECB or other central banks are not going to default.

The important piece is this:

The six central banks also agreed to create temporary bilateral swap programs so funding can be provided in any of the currencies “should market conditions so warrant.” Those swap lines were also authorized through Feb. 1, 2013.

Oh, so why now? I’m thinking it’s because something deep and dark is going to happen, like a European bank going under or something. The swap lines will be a way for liquidity to flow from places less effected to those in turmoil. I say we should hear of some big blow up – either about to happen, or temporarily averted, due to this announcement.

Markets have gone up because – well, I don’t know. The point is that a 50 bps cut in the inter-central-bank swap rate isn’t going to help Italy or Spain or Greece bridge their deficits. The ECB isn’t going to be able to use this money to buy Greek or other bonds – Germany will throw a hissy fit.

Nothing has changed; that central banks would pump liquidity is now a preemptive action (earlier, it used to be post-event). Even in India, RBI is conducting OMO auctions to buy government bonds to augment liquidity in the system – though today they just bought just 5,800 cr. out of the 10,000 cr. they said they would buy.

Liquidity is good…

but it solves only this problem

a) You lend money for N years or buy stuff that matures after N years

b) To finance that you borrow in the short term, from overnight to a few months maturity. Every time the loans come up for maturity you borrow again (“roll the loans over”) from the same ecosystem, which is happy to lend it to you.

c) At some point people think you’re a bloody risk. So they refuse to roll over their loans.

d) You go bankrupt because you can’t roll over.

This is a liquidity problem, that can be solved by

d) there is a “lender of last resort”, the central bank, which gives you money until the system recovers.

But what if…

c) The person you lent your money to, is not able to pay back.

d) Other people realize this and say dude, we ain’t rolling over our loans.

Now, even if you get liquidity, you still have a problem – you have a default on the other side, which means you have no chance of recovering all of it back. This is a solvency problem.

You can’t solve a solvency problem with liquidity. You can hide it for a while, but eventually all you are doing is transferring risk.

In the European example, the inter-bank lending system made some banks assume the risk of others defaulting. Now, with the ECB coming in, the risk is now at the ECB level which means all European taxpayers. The problem is of solvency – the european banks own loans which are more or less kaput, like Greek bonds or recently, Italian bonds.

Therefore, the current solution – of reducing a swap rate – is not of much consequence in the long term. The rebound, I think, is a short term move; it will require more than this to really fix the problem, and honestly, I think it can only be fixed by a default by some of these countries. But in the short term, there has been a lack of good news, so markets will attempt to ride up the news as much as possible.