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S. Venkitaramanan

The central bankers of the world, who met in Cape Town in connection with the G-20 Conference early this month, appear to have decided on a series of actions to counter the effect of a severe credit squeeze, which has imposed serious risks on the US economy and hence the world in general.

It is not the first time in recent years that the central banks of the developed world, viz. the Federal Reserve of the US, the Bank of England, the Swiss National Bank, the Bank of Canada etc., have joined together to make an assault on a serious crisis. They have done so before, resulting in the Plaza Agreement of the 1980s.

This time, the central bankers have decided to offer liquidity assistance to various bankers, following a new procedure, viz. auction of funds at rates of interest that the bankers are willing to offer.

The first auction will be conducted by the Federal Reserve for a total of $40 billion, to be followed by another auction.

It will be accompanied by a transfer of dollars of an equivalent amount to the European Central Bank, which will also then conduct auction to put the dollars in the hands of various bankers’ constituents.

The auction method has been decided in order to avoid a stigma of identifying banks that approach the central banks for assistance (this is often taken to be an admission of distress). In fact, newspaper reports indicate that during the last few months, the discount window of the Federal Reserve has been relatively idle.

The auction method has the advantage that the banks can refrain from identifying themselves and signifying that they have approached the central banks for assistance, which might be considered as a mark of weakness by investors.

One other liberalisation that the Federal Reserve has made is in accepting certain types of collateral, which it did not routinely accept for previous forms of liquidity assistance. This is considered an important liberalisation, because banks are short of accumulation of collateral of high quality, especially in the aftermath of sub-prime crisis.

This dilution of standards may expose the central bankers to the criticism that they are opening themselves to moral hazard.

This criticism refers to the fact that the expectation that such rescue is available in the current circumstances may induce further risk-taking by bankers, who are keen to obtain high profits and take more risks. This could, after all, trigger a sub-prime crisis.

The central bankers of the world have, by this decision, shown themselves willing to extend a life line to bankers of the world.

This should considerably relieve the crisis of liquidity and of loss of confidence, which has hit the markets of the developed world and, as a linked consequence, those of the developing world also.

There have been other criticisms that the central bankers have virtually resorted to a measure, which is equivalent to dropping money from a helicopter, so to say, to all those who have sinned.

But, this allegation does not take into account the extent and the depth of the crisis of the markets of the US and Europe.

The depth of distress can be shown by the fact that banks, like Citibank and UBS, have had to disclose large losses in their accounts.

One of the Sovereign Wealth Funds has taken over a substantial stake in the Union Bank of Switzerland also.

Such rescues only show that the extent of the distress of illiquidity is serious and lead to contraction of credit on the part of many banks and trigger a recession.

There have been suggestions that the central bankers of the world have been perhaps slack in taking this decision, which they should have taken at least a few months earlier.

This is a criticism that can be offered for many such steps. The central banks’ latest decision has received mixed reaction of the marketmen.

It is also a sign of the time that it has become customary to expect central banks to become providers of liquidity even when the crisis is caught by errors of speculative behaviour on the part of investment bankers.

There had been similar resort to central bank’s largesse in the last two or three decades. One such happened when the Long-Term Capital Management of New York, a hedge fund operated by a Nobel Prize Winner among others, threatened to bring the financial system of the world into jeopardy following the Russian collapse. Similar was the reaction of the Federal Reserve following the Dot.Com collapse of the 1990s.

The former Fed chief Mr Alan Greenspan has, in his writings, been at pains to point out that if he had not come to the rescue of the market at this time with the infusion of liquidity and reduction of interest rates, the US’ economy may have got into recession.

Mr Greenspan may well be right, but he has also to take upon himself part of the responsibility for the fact that reduction of Fed funds’ interest rates to as low as 1 per cent in his regime laid the foundation for unscrupulous lending practices and risk-taking without proper supervision of the borrowers’ credentials.

In a way, Mr Greenspan’s liberality may have been at the root of further mortgage crisis. The present central bank action is, after all, trying a remedy for the resultant ills.

As in all cases of economic decision, it is difficult to be sure of what the consequences of a certain action or inaction will be. It is also possible that central banks’ largesse alone cannot undo all the effects of bad lending for houses. That will take time.

Our own central banker, Dr Y.V. Reddy, who was also at the Cape Town Summit, may have participated in the confabulations that led to the decision announced last week.

The lesson that the latest charge of the central bankers on the invisible enemy of market collapse has for India is that central bankers cannot keep too distant from what happens in the crises in the stock market.

Increasingly, as a market seizes up, central bankers have to take the place of the market to provide capital for industry and business. It is, therefore, in the interests of the central banker to ensure that markets operate reasonably efficiently, but of course subject to standards of good governance and disclosures.

The Cape Town group of central bankers has literally diluted the orthodoxy of rules regarding provision of funds for the needy banks. They have reduced the conditions precedent to their providing funds to banks in distress. Will the RBI learn to be equally generous?

What will the central bankers’ latest charge achieve? An amount of $40-80 billion, proposed for auction by the Federal Reserve is small compared to the size of the US stock markets, which runs into thousands of billions of dollars.

But the central bankers’ action is a sign that they are not standing by idly watching the crisis to unfold. They are ready to do their best to let the markets function unhampered by temporary erosion of liquidity.

It is to be hoped that the decisions following the Cape Town Summit will result in improvement of global economic condition and avert the need for further central bank action to mitigate a global recession.

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