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Q&A: dollar swaps – why central banks are acting together on eurozone crisis

Ben Bernanke, US Federal Reserve chairman, is hoping that the central banks' concerted action will prevent a cash squeeze worsening eurozone banks' problems. Photo: Stefan Zaklin/EPA

Why did six of the world's central banks, including the US Federal Reserve and the Bank of England, announce new co-ordinated action on Wednesday?
• What are the central banks doing?
They are taking action together to prevent the markets' panic about the future of the eurozone and the health of the banking sector from turning into a full-blown credit crunch, when banks refuse to lend to each other.
• How will they do that?
The Federal Reserve will make it cheaper for other central banks to borrow dollars; they will in turn lend those dollars on more cheaply to their own banks, cutting the interest rate on so-called "dollar swaps" by half a percentage point. In effect, it is an interest rate cut for banks. Although these so-called dollar swaps are available in all the countries involved, they are aimed specifically at tackling a shortage of dollars among the eurozone banks.
All the central banks have also agreed "temporary bilateral liquidity swap arrangements", so that if their domestic banks are running short of any currency, the central banks will be able to provide it at short notice.
• Why do European banks need dollars?
They have been lent large amounts by US investors, including banks and retail money market funds. Many of these investors have been pulling out over the past few months, as the eurozone debt crisis has exacerbated concerns about the solvency of eurozone banks.
That means the European banks need to pay them back, in dollars. They can only get hold of those by attracting dollar-denominated deposits, or by borrowing dollars in the financial markets. That has become more difficult and more expensive for banks during the crisis, amid growing doubts about their solvency.
• Who's involved?
Most of the world's major central banks: the Bank of England, the European Central Bank, the Federal Reserve, the Bank of Japan, the Bank of Canada and the Swiss National Bank.
• How does this affect British banks?
The Bank of England had a dollar swap arrangement in place during the crisis, which was reinstated in May this year, as the strains in the eurozone began to show.
Since then, no British bank has used it, suggesting that they are not running short of dollars, but the lower price may tempt some to borrow from the Bank, rather than in the open markets. These measures are aimed mainly at the health of the eurozone banks – and the US investors exposed to them.
• Does this solve the problem in the eurozone?
No, it should help to ensure that European banks are not driven to the brink of collapse by a short-term cash squeeze. However, it does nothing to deal with the underlying issue: the heavy debt burden built up by some eurozone countries during the good times, which few analysts now think they will be able to repay.
• What happens next?
Financial markets will be watching the (latest) crucial meeting of eurozone finance ministers next week, as they battle to devise a sustainable solution to the crisis. The European economic and monetary affairs commissioner, Olli Rehn, warned ministers on Wednesday that they have 10 days to save the single currency.
• Is Europe on the brink of recession?
Yes, share prices rocketed on news of the central banks' intervention but the co-ordinated action was a sign that Sir Mervyn King, Ben Bernanke and their counterparts around the world are deeply concerned about the impact of the banking squeeze on the real economy. Already, the Bank of England has warned that there is evidence that eurozone banks are pulling back on loans to businesses and households – and that hits demand. Most economists believe a recession in the eurozone is now all but inevitable. The Organisation for Economic Co-operation and Development said this week that it may already have started.

Euro zone's political bumbling risks global gloom

L'ISLE-SUR-LA-SORGUE, France (Reuters) - The euro zone's repeated failure to tackle its debt crisis is catapulting the bloc toward recession, raising the specter of dangerous spillovers to the rest of the world economy.

Whittling down the euro area's mountain of debt was always going to be a long slog, even without the unpredictable political dramas in Greece and Italy that overshadowed last week's summit of the Group of 20 major economies in Cannes on the French Riviera.

But the inability of euro zone leaders to convince their G20 counterparts that they were getting a grip on events has made the task that much harder. Confidence, already fragile, has frayed further.

"It's no wonder that people aren't spending when all you hear every day is about 'the crisis'," said Michel Quintao, co-owner of a wrought-iron workshop in this corner of southeast France, some 200 km (125 miles) from Cannes.

Even before the G20 meeting and an inconclusive pair of euro zone debt-crisis summits last month, the corrosive effect of flagging confidence was taking a toll on growth.

The euro zone's composite purchasing managers' index, a timely gauge of business sentiment, fell sharply in October to 46.5 from 49.1 in September, while German manufacturing orders slumped 4.3 percent in September.

Jim O'Neill, chairman of Goldman Sachs Asset Management, said the figures suggested the 17-member euro zone was already in, or close to, recession - explaining why the European Central Bank cut interest rates last Thursday, to the surprise of many investors.

O'Neill said the spread of economic weakness from the periphery to the core of the euro zone was in large part due to contagion via the financial markets, especially the relentless pressure on Italian bonds.

"They desperately need somehow to stabilize Italian financial markets," O'Neill said.

MEANINGFUL RISKS

Undermined by market mistrust of Prime Minister Silvio Berlusconi's government, Italy's 10-year bonds yields soared to a euro era high of 6.4 percent last week.

That is close to levels that made the debt-service burdens of Greece, Ireland and Portugal unsustainably onerous and triggered bailouts by the euro zone and the International Monetary Fund. But Italy, with 1.9 trillion euros in public debt, is simply too large to bail out.

O'Neill said it boiled down to vanishing confidence. After all, until July, Italy was relatively untouched by the maelstrom despite weak growth that has averaged just 0.6 percent a year since the euro was created in 1999. Even now, its cyclically adjusted budget position is one of the strongest of any major economy.

"It's a crisis of confidence: Italy needs leadership and supply side reforms to boost growth," O'Neill said.

As Europe bumbles, the rest of the world is watching anxiously, fearful of the fallout.

The United States is perhaps only half-way through its own debt workout. Recovery from the 2008/2009 recession is the weakest on record and, even though economists have marked up their forecasts for fourth-quarter growth, a slump in Europe could revive fears of a relapse.

"The risks associated with the euro area's slide into recession are meaningful," economists at J.P. Morgan wrote in their weekly Global Data Watch publication.

Asia is currently the region with the strongest economy, but it too would not escape unscathed if Europe took a big hit.

Indeed, Rob Subbaraman, Nomura's chief Asian economist based in Hong Kong, said sentiment was already being tested. Companies and the man in the street were anxious.

"Growth is cooling but it's not collapsing," Subbaraman said. Still, he said it was fanciful to imagine that Asia could decouple from its major Western markets. "Asia is very much integrated into the global economy, and if things deteriorate, we'll get hit hard again," Subbaraman said.

CONFIDENCE TRICK

It was telling that Australia, whose reliance on commodity exports makes it a good barometer of global demand, saw fit to cut interest rates last week for the first time since April 2009. The Reserve Bank of Australia (RBA), the central bank, said a 'mildly restrictive' policy was no longer appropriate.

"The RBA has a very good track record on monetary policy, yet they felt compelled to take their foot off the brake," Subbaraman said.

China, which sends 20 percent of its exports to the European Union, has tirelessly pressed for a resolution to the euro zone's problems, although President Hu Jintao, like other G20 leaders, conspicuously declined in Cannes to contribute to the bloc's rescue fund.

Ting Lu, a Bank of America Merrill Lynch economist based in Hong Kong, is forecasting robust 8.7 percent year-on-year growth for China this quarter and 8.6 percent in 2012. But he said a sharp slowdown could not be ruled out in the event of an economic slump in Europe or a break-up of the euro.

"Our central case is a soft landing. We do have a scenario for a hard landing, but it's not because of domestic Chinese issues," Lu said.

In short, the world economy is increasingly hostage to the fast-changing politics of the euro zone. For want of leadership, uncertainty and fear are sapping the spirits of entrepreneurs, investors and consumers.

"Let me be clear," Canadian Prime Minister Stephen Harper said in Cannes. "Moving the European plan forward remains critical to restoring confidence and growth in the global economy."

(Editing by Erica Billingham)