Policy makers scramble for answers

Fears of a global economic meltdown grew Friday, increasing pressure on top politicians and policy makers to take unprecedented actions aimed at thawing frozen credit markets.

Finance ministers and central bankers from the Group of Seven nations meeting Friday in Washington are expected to begin hammering out a round of coordinated, uniform measures designed to salvage the financial sector and encourage banks to resume providing loans to each other.

With global equity markets in virtual free fall to close out the week, the odds of coordinated action ‘are increasing by the hour.’

Brian Hilliard, Societe Generale

Economists widely agree the measures should include sweeping guarantees of bank deposits and interbank lending, as well as direct injections of taxpayer money to recapitalize ailing banks.  

“They have to deliver the goods because the markets are just not going to stabilize unless they do. And the goods are government guarantees of deposits,” said Brian Hilliard, head of economic research at Societe Generale.

And with global equity markets in virtual free fall to close out the week, the odds of coordinated action “are increasing by the hour,” Hilliard said. “The gravity of the situation is just obvious to everybody.”

U.S. authorities are weighing a plan to guarantee billions in bank debt and insure all U.S. bank deposits for a temporary period, according to a Wall Street Journal report.  

Treasury Secretary Henry Paulson is also weighing whether to use his authority under the recently enacted U.S. bank-bailout plan to inject taxpayer funds into troubled banks.

Looking to London

Meanwhile, some of the eagerly sought measures have been attempted by individual countries, perhaps most comprehensively by Great Britain. The government this week said it was prepared to inject as much as 50 billion pounds into troubled banks in return for preference shares.

The U.K. also moved to guarantee up to 250 billion pounds in new short- and medium-term debt issued by qualified banks, backstopping the interbank lending market.

British Prime Minister Gordon Brown and Chancellor of the Exchequer Alistair Darling, the nation’s finance minister, are expected to keep pressure on finance officials and leaders to implement similar measures.

“We must now act for the long term with coordinated national actions,” Brown said in a guest column published in Friday’s Times of London. Earlier this week, Brown wrote to fellow G7 leaders calling for a coordinated effort to guarantee interbank loans, news reports said.

German news reports Friday said Berlin was weighing a rescue plan similar to the British plan, including debt guarantees of more than 100 billion euros and a big capital injection, according to Reuters.

The G7 officials will meet on the sidelines of the annual meetings of the International Monetary Fund and World Bank. G7 finance ministers are also scheduled to meet with President Bush on Saturday. The IMF and World Bank meetings also provide opportunities for wider discussions.

The G7 includes the United States, Japan, Germany, France, Italy, Great Britain and Canada.

Objective: Avoiding ‘bailout arbitrage’

IMF Managing Director Dominique Strauss-Kahn on Thursday urged officials to come together on a coordinated plan to tackle the crisis.

No one country can solve this problem by itself, he said, urging European countries in particular to work together. “Cooperation and coordination is the price of success,” Strauss-Kahn said.  

Uniform actions on deposit guarantees and other measures are important, economists say, in order to avoid a form of “bailout arbitrage.”

“You want savings flows, money flows to be driven by the fundamentals,” said Societe Generale’s Hilliard.

Such measures are aimed at easing worries about counterparty risk. Banks have virtually stopped making short-term loans to each other out of fear that borrowers could fail, and year-end pressures have exacerbated the desire to hoard cash.

That’s put stress on banks as they seek to meet short-term funding needs. It’s also shrunk the commercial paper market that many companies rely on to fund a range of day-to-day and short-term necessities.

“If the U.S. government guarantees bank debt, it would imply that the government is guaranteeing interbank lending,” wrote economists at BNP Paribas.

Central banks have pumped massive amounts of cash into the financial system through overnight and short-term money loans to alleviate the drought, but banks have largely used the funds to shore up their own balance sheets.

Earlier this week, a rare round of coordinated interest-rate cuts by the world’s major central banks failed to jumpstart the crucial interbank lending markets.

Keying on Libor

Key short-term interest rates were mixed Friday, but the London interbank offered rate, or Libor, for three-month dollar loans continued to rise. It was fixed at 4.81875%, up from 4.75% Thursday.

The spread between three-month Libor and overnight index swaps, a closely watched measure of tensions in money markets, continued to widen.

“In sum, interbank liquidity tightened further … No one trusts that anyone will be in business a month from now let alone three months,” wrote analysts at broker Ried Thunberg ICAP.

In a somewhat encouraging sign, however, rates on one-day asset-backed commercial paper fell 99 basis points to 3.51%, just a basis point from a roughly 1-month low, said Tony Crescenzi, chief bond strategist at Miller Tabak & Co

Global equity markets plunged ahead of the meeting. Asian stocks tanked early Friday, following on from steep losses on Wall Street. Europe quickly followed suit.

U.S. stocks have seen sharp swings in volatile trading conditions. The Dow Jones Industrial Average ($INDU) lost nearly 700 points in early action before bouncing back then returning to negative territory.  

In some ways, the steep sell-off in stocks is worse than a panic, said Stephen Gallo, head of market analysis at Schneider Foreign Exchange.

That’s because the waves of selling can be thought of as a “rational” response to the prospect of a world in which credit markets have ceased to function.

“Really, the only hope of preventing a global depression now in the West is to unclog the credit markets,” Gallo said. “And if that doesn’t happen there really is no reason why equities should rebound or why optimism should get any better.”

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