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Central Banks Slashing Rates As Investors Flee
Global Pullback Could Affect Currency Markets

By Anthony Faiola and Neil Irwin
Washington Post Staff Writers
Tuesday, October 28, 2008

Central banks around the world are moving to further slash interest rates as they seek to contain the damage from the bursting of the biggest credit bubble in history.

The Federal Reserve is poised to cut its benchmark rate for the second time in two weeks at a pivotal meeting in Washington on Wednesday, and the European Central Bank yesterday suggested that it would do the same next week. South Korea announced a dramatic rate cut yesterday, by three-fourths of a percentage point.

Governments worldwide have already approved massive bailouts and stimulus packages to halt financial meltdowns. But the trouble spots in the United States and abroad continue to multiply. Yesterday, there were growing signs that the U.S. Treasury Department was close to extending its $700 billion rescue program to cover the ailing auto industry.

Analysts said governments are trying to manage what has become the biggest threat to the global financial system -- a massive pullout by panicked investors from any holding they see as remotely risky. From consumers to multibillion-dollar hedge funds, investors are cashing out to cover losses or guard against further damage by moving into safe havens such as U.S. Treasurys.

Rate cuts, however, are not packing their usual punch. Normally, when central banks cut rates, it becomes cheaper for businesses and consumers to borrow money. But now, with banks and other financial institutions experiencing a severe crisis, lenders have been reluctant to extend credit at any price.

The pullback by investors, known as deleveraging, is extending massive losses on global stock markets; the Hong Kong stock market on Monday had its biggest one-day percentage drop since 1989, and Tokyo's Nikkei fell to its lowest level in 26 years.

Officials are growing increasingly concerned that the pullback is affecting currency markets, with economists warning of a growing disequilibrium in global exchange rates.

Although confidence may be shaken in the American economy, foreign investors still see the U.S. dollar as more reliable than most other currencies, with the rush to the dollar sending its value soaring against the euro, the British pound and a host of emerging-market coins in recent weeks. As currencies weaken in emerging markets including Brazil, Mexico and South Korea, corporations in those countries that have foreign loans or other bets in dollars are being slammed as debts suddenly become more expensive to pay back.

In Japan, the reverse is happening. Investors are burrowing into the yen, rapidly driving up its price against both the dollar and the euro.

For much of the past decade, investors have borrowed yen -- at Japan's very low interest rates -- to buy positions in other currencies in emerging economies such as South Africa and Brazil, where yields have been far higher. The financial crisis has soured many of those bets. Investors are rushing back to the security of the yen and, in the process, driving up the currency's value.

Just as the surge in the dollar is making Ford and General Motors cars more expensive overseas, the gain in the yen is doing the same to Sony televisions and Canon cameras just as global demand for them dwindles.

The yen's swing has been so sharp that the Group of Seven industrialized nations warned yesterday of "possible adverse implications for economic and financial stability." That statement hinted at a possible joint intervention in currency markets to stabilize the yen, in a move similar to actions taken by central banks in 1995 and 1998.

As early as Wednesday, the International Monetary Fund is set to rule on the creation of an emergency program to rush hard currency to emerging markets that have been burning through billions of dollars' worth of reserves in recent weeks to defend their currencies. The pool of money available, sources close to the talks said, could be augmented by contributions from nations sitting on trillions of dollars in cash reserves, such as Japan, China and the oil-rich Gulf states.

The concern is that the rapidly falling emerging-market currencies could trigger the same kind of debt defaults and financial system collapses that swept across Asia in 1997, adding another layer to the globe's already severe financial problems. The IMF has already reached preliminary agreements on emergency loans for Hungary and Ukraine; the fund is additionally in talks to extend lifelines to Pakistan and several other developing nations hit hard by the crisis.

"As their currencies go down, the debt in dollars for emerging economies is going up substantially, and that is very much like what happened 10 years ago in the Asian financial crisis," said C. Fred Bergsten, director of the Peterson Institute for International Economics. "Of course, it's a fear that that could happen again."

Deleveraging is complicating attempts to stem the financial bleeding from the crisis. Asian banks, for instance, are reducing their holdings in the U.S. mortgage giants Fannie Mae and Freddie Mac. Yields on the bonds for the companies have recently jumped to their highest levels in more than seven months, driving up their cost of borrowing. That, in turn, could make mortgage rates for Americans more expensive.

Global regulators are now looking for relief through monetary policy.

Two weeks ago, the Fed was part of an emergency, coordinated rate cut that also included the European Central Bank, the Bank of England and several others. The head of the ECB, Jean-Claude Trichet, yesterday said that a cut is "possible" at next week's meeting, an extraordinarily direct statement from a central banker. Meanwhile, after announcing South Korea's emergency interest rate cut, the country's central bank said more cuts were likely.

"Domestic demand is faltering amid financial turmoil, and exports will likely slow down," said Lee Seong-tae, governor of the Bank of Korea.

When the Federal Reserve's policymaking committee meets today and tomorrow, analysts widely believe, it will cut the target for the federal funds rate -- the rate at which banks lend to each other -- to 1 percent from 1.5 percent. If it does so, the rate would match the lowest level ever, reached in 2003. Such a move would signal the bank's resolve to combat the crisis using all possible means.

In a speech two weeks ago, Fed Chairman Ben S. Bernanke affirmed that the central bank was willing to take unusually aggressive action, saying: "We will not stand down until we have achieved our goals of repairing and reforming our financial system and restoring prosperity."

Ethan Harris, an economist at Barclays Capital, said the Fed is now mounting "a frontal assault on the credit crunch."

That assault includes cutting rates; endorsing a fiscal stimulus package, which Bernanke did last week; and rolling out a wide range of programs to help bolster the flow of credit, such as one that began functioning yesterday to buy commercial paper, or short-term loans issued by companies.

"You don't keep your powder dry," said Harris, noting that Bernanke as an academic years ago endorsed the idea of moving aggressively during a financial crisis.

Another reason to cut rates is that inflation appears to be falling rapidly. That means Fed leaders don't need to worry as much about rising prices in the near future.

There is a chance, though, that the central bank would cut its target only to 1.25 percent, given that it just cut rates by half a percentage point in an emergency meeting two weeks ago and it is unclear how much rate cuts are helping the economy.

Post Correspondent Blaine Harden in Tokyo contributed to this report.

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