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International Economic Update

October 30, 2008

The Financial Crisis Intensifies and Spreads

The financial crisis that started in the United States has spread to European financial markets and now threatens emerging economies. Expectations for global growth have declined as a result of the turmoil, and weakened demand is causing inflationary pressures to subside.

Financial Crisis

European banks were drawn into the financial crisis in part due to their exposure to U.S. subprime mortgages.[1] As banks have had to write off losses from subprime loans, fear and uncertainty have spread regarding which banks still have bad loans and whether they have enough capital to pay off their debt obligations.[2] The uncertainty has caused interbank interest rates to increase as banks are reluctant to lend money to each other. Instead, banks and other investors are opting to invest their money in government Treasury bills and other low-risk/low-yield instruments. The blue area in Chart 1 shows the difference between the three-month euro interbank offered rate (Euribor) and the three-month euro overnight index average (Eonia) swap rate. The Euribor rate measures the liquidity and default risk over the next three months, while the Eonia swap rate closely tracks the central bank policy rate. The increased spread in August 2007 and September 2008 reflects the financial developments that decreased the willingness of banks to lend money to each other. Conversely the difference between the three-month French Treasury bill and the Eonia swap rate (the red area of Chart 1) shows a flight to quality as investors are seeking the safety of government bonds and are willing to accept lower interest rates in return.

With commercial banks increasingly distrustful of each other, they are choosing to do business with the central banks instead. Chart 2 shows deposits and borrowing from the national central banks within the Eurosystem. Typically those facilities are not used because the lending rate is 1 percent higher than the market rate and the deposit rate is 1 percent lower. In late September commercial banks began borrowing and depositing funds at unprecedented levels. On Oct. 9 the European Central Bank lowered the penalty to 0.5 percent above and below the market rate, further increasing the use of those facilities.

Many European governments are stepping in to try injecting liquidity into the markets. Most notable was a coordinated announcement on Oct. 8 by six central banks (U.S., Euro-area, U.K., Canada, Switzerland and Sweden) to cut official policy rates by 50 basis points. Many other central banks followed suit with similar policy rate cuts, including: China, Australia, Hong Kong, Israel, Korea and Taiwan.

Measures by individual governments have been similar to those of the United States and include four major components.

1. Governments are raising the amount of guaranteed deposits. Ireland guaranteed all deposits at its six largest banks, and many other European governments have raised guaranteed deposits on individual accounts from €20,000 to €50,000 or more to prevent massive withdrawals and possible bank runs.
2. They are providing large amounts of capital to financial institutions in exchange for shares of equity.
3. Many governments are guaranteeing a certain amount of interbank loans.
4. They are taking illiquid mortgage-backed securities from banks in exchange for Treasury bills that are easier to trade and have shorter maturities.
   

Due to these government measures, credit default swap (CDS) spreads for commercial banks have come down considerably, as seen in Chart 3. CDS spreads measure the risk of an institution defaulting on a loan. As the financial news broke, the spreads rose considerably for individual banks. When the U.K. government announced its rescue plan, those spreads lowered. At the same time, sovereign CDS spreads for the U.K. government rose as risk was transferred from individual banks to the government.

There has been some marginal success so far in increasing liquidity into the financial markets. It is true that the Euribor/Eonia spread shown in Chart 1 has not come down from its peak on Oct. 10. That picture is a little deceiving, however, because the Euribor rate itself came down 46 basis points since then. The reason we see no movement in this spread is that the Eonia swap rate has also come down 46 basis points, likely reflecting declines in the policy rate. So while the Euribor/Eonia spread has not declined, the interbank lending rate has come down a little, making it cheaper for banks to lend to each other.

Global Growth Expected to Decline

As banks find it difficult to raise capital and deleverage, the pains are being felt across the nonfinancial sector. Companies that issue commercial paper are either unable to issue debt or are paying higher interest rates. As corporations find it difficult to borrow money, the effects will be felt in the real economy. The global nature of the financial crisis is expected to cause GDP growth to decline worldwide. According to forecasts by the International Monetary Fund, global GDP growth, which was 5 percent in 2007, is expected to slow to 3.9 percent in 2008 and 3 percent in 2009.[3] The forecast for advanced economies is even bleaker, with sharp downward revisions just over the past month (Chart 4). While emerging economies had not been hit hard by the financial crisis until recently, they are heavily reliant on exports to fuel their economic growth. As the financial crisis slows demand in the advanced economies, the emerging markets will face a slowdown as well. Unemployment rates had started to climb across Europe even before the latest financial news hit, reaching as high as 11.3 percent in August for Spain. During the first half of 2008, housing prices fell by 5–6 percent in the U.K., Spain, Sweden and Canada, by over 3 percent in Australia and France, and by 1.9 percent in Japan.

Inflationary Pressures Likely to Subside

The upside is that weakening global demand is causing inflationary pressures to decline. Chart 5 shows commodity prices falling. The decline is most notable in energy prices, which have fallen 51 percent since their peak on July 4. Also helping contain inflationary pressures in the U.S. is the recent appreciation of the dollar, which is keeping the price of imports low. The U.S. dollar/euro exchange rate dropped from 1.59 on July 15 to 1.24 on Oct. 27. Similarly the U.S. dollar/pound has dropped from 2.00 to 1.55 over the same dates. The Japanese yen is one of the few currencies appreciating against the dollar.[4]

U.S. Trade

Net exports have been the largest contributor to U.S. GDP growth in each of the past five quarters. This trend is not likely to continue, however. The recent appreciation of the U.S. dollar, coupled with the economic slowdown of its major trade partners, is likely to reduce the contribution of net exports to GDP growth in the coming quarters.

—Patrick Roy

About the Author

Roy is a research analyst in the Research Department at the Federal Reserve Bank of Dallas.

Notes

1. The European banking system has had other problems as well. For example, Northern Rock, a U.K. mortgage bank, has had trouble raising capital in the money markets after the U.S. subprime crisis hit. In September 2007, the bank had to take an emergency loan from the Bank of England. This triggered a run on the bank, further exacerbating its liquidity problems and eventually leading to the nationalization of the bank in January 2008.
2. To give some examples, German bank BayernLB has requested state aid, anticipating €3 billion of losses on its €24 billion portfolio of asset-backed securities. HSBC was writing off $51 million of subprime loans a day. Royal Bank of Scotland wrote off £5.9 billion on investments in the first half of 2008.
3. The 90 percent confidence interval for the 2009 forecast is approximately 1.1 percent to 4 percent. This reflects both the uncertainty in their forecasts and that the downside risk to global growth outweighs the upside risk.
4. The dollar and the yen have been heavily borrowed against, due to their low interest rates to buy higher-yielding currencies. The financial crisis has caused many investors to liquidate those risky positions. The yen and dollar appreciations have also been fueled by the expectation that interest rates in Europe will be cut further in response to an economic downturn.

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