Central banks add global liquidity - What does it mean?

August 15, 2007

Over the past week, central banks in the EU, the U.S. and Japan have added liquidity to the global banking system to reassure stock markets that have been dropping all month. (See Global markets drop again, 8/1/07). In the EU area, the interest rates on money-market funds that banks loan each other spiked above the ECB's target. In response:

• The ECB injected €204 billion, or about $300 billion.
• The Federal Reserve injected $64 billion.
• The Bank of Japan injected $5.1 billion.
• The ECB will ask the Fed to swap dollars for euros. The ECB will loan these dollars to those European banks with dollar-denominated loans that are coming due in the next few days if U.S. banks will not. (Source: WSJ.com, ECB,BOJ,Fed Again Add Liquidity to Markets, 8/13/07; FT.com, Central banks seek to unblock markets, 8/13/07)

Why the central banks added liquidity now:

Panic selling gripped the markets as investors became afraid that credit would dry up thanks to:

1. The collapse of the leveraged buyout (LBO) market.
2. The potential $11 billion loss to European banks from bad investments in U.S. real estate loans. (See U.S. subprime mortgage mess spreads to Europe, 8/1/07).
3. Fears that the $1.9 billion lost to investors from the collapse of various hedge funds was only the tip of the iceberg.(See Bear Stearns hedge fund collapse, 8/8/07).

Central banks had been tightening credit to forestall inflation. Interest rates in Europe are now higher than in the U.S., thanks to continued ECB and Bank of England credit tightening.

Most experts say that Asia will not be as affected by the U.S. subprime mortgage mess as Europe. However, Asian countries rely heavily on exports to the U.S., and investments from U.S. companies and banks. If money dries up in the U.S., this will affect Asian economies.

Furthermore, the Bank of Japan had been expected to raise its prime rate to .75 at its August meeting to increase the value of the yen, thus slowing down the yen carry trade. However, the BOJ might not raise the rate if it senses that Japan's economy could slow as a result of Japanese banks' exposure to U.S. subprime mortgages. (Source: BusinessWeek,  U.S. Housing Woes Only Singe Asia, 8/7/07; Japan Times, "BOJ injects ¥1 trillion into markets, 8/11/07)

Action Steps:
This correction in the global stock markets and credit markets have been long overdue. Hopefully, you have already moved any money you need in the short-term to a money market account, as I suggested in June (See Trade surpluses driving asset bubbles, 6/27/07).

The best way to withstand market volatility is with a well-diversified portfolio. Find out how to protect yourself with my home study course, “Retirement Planning 101.” This course will guide you through building a diversified portfolio using the same steps I took to retire at age 50.

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