On August 7, 2007, US central bank policy makers came up with a declaration that inflation remained their primary target. In other words, it also meant that Federal Reserve's monetary stance would remain tight until they succeed in containing inflation.
Surprisingly, the announcement was made despite strong signs emerging from the US market of Subprime mortgage market collapse. Estimates suggest that total asset investment in Subprime, the 10th largest loan provider in the US,debt this year could be $300 billion.
The size of the US market for mortgage is said to be a little over $2 trillion industry. In July, disclosure made by Bear Sterns head fund of its Subprime debt holdings rocked the financial market. But announcement by BNP Paribas on August 9 that the bank had decided to freeze withdrawal on three investment funds with assets of euros two billion ($2.7 billion) added fuel to fire, leading to the current turmoil.
Soon after 9/11, the Fed decided to ease its credit stance and funds started rolling into the economy, finding way into equity, bonds, housing and commercial paper. US money market fund is said to be a $2.6 trillion industry, while estimates suggest hedge fund is under $2 trillion market.
Banks regularly hedge their exposure by means of derivatives. The size of derivative market is believed to be around $20 trillion. But funds such as short-term commercial paper, which has a $1.1 trillion market, CD's and US treasury bills, which are $2 trillion industries, are not hedged.
How quickly things change. Fed, which never stops thinking about inflation, has suddenly stopped talking about inflation. In a short span of 10 days, ie on August 17, the turmoil in the global financial market forced Fed to lower its discount rate by 1/2 percentage to 5.75 percent in an effort to provide liquidity after failing to lift the market, despite injection of $350 billion (approximately) by the global Central Bank.
Fed's discount window will provide 30 days loan facility to all home mortgages and its related assets. Generally, banks avoid using this facility as the market perception is that if a financial institution approaches the Fed discount window, it is seen in trouble.
During the Gulf war in the early 1990s, overnight Fed fund rates soared to 90 percent, yet couple of banks were said to have preferred borrowing from the market rather than approaching the Fed window.
Is it not very strange that frequent interventions by Central Bank are quite contrary to the general perception of a free market economy? When a Central Bank steps in to intervene in an underdeveloped country, such market is called an unregulated market.
Hence, it is not considered a free economy and the so-called experts make a lot of hue and cry. But in the present circumstances, the so-called financial gurus must be full of praise for the Central Bank's act. If the turmoil further aggravates, they will be looking for more such support in future.
Apparently, it looks as if the market is moving towards stability. This could be temporary, but it may not be very encouraging until the market is aware of the US financial market fiasco. It is likely to witness more volatility before getting back to normal.
Big names such as Citibank, J.P. Morgan, BOA, BNP Paribas, UBS, Credit Suisse and a large number of other good banks and financial institutions have been badly hit and the damage is intensive, which has spilled over to big parts of Europe, Canada, Australia, Japan and South Asian economies.
It is a worrisome news to know that French President Sarkozy in an urgent letter addressed to German Chancellor Merkel has shown his concern about the financial market turmoil and has questioned the rating agencies failure to issue warning against a state of great anxiety and confusion in the market.
Creditworthiness of the two rating agencies Standard and Poor's and Moody's Investors Service has been badly damaged for giving credit derivatives Triple-A ratings, which indicated that they were as safe as US Treasuries.
So far it has lost 30 percent of its value. This year, the share prices of two rating agencies, Moody's and S&P, too, have declined by 28 percent and 24 percent respectively.
Except for the 1st Sukook bond worth $600 million issued by the Government of Pakistan on January 27 2005, which was agreed on a six-month floating rate basis, which has to bear the price volatility due to rising US interest rate, and now due to global liquidity crunch, the LIBOR rates have been pushed higher. But discount rate cut of 50 basis points suggests that Fed could ease its Fed fund rate either before or by September 18 when FOMC meets. Any slash in US interest rates usually favours borrowing cost.
While, the remaining of the euro bonds floated by Pakistan are fixed and therefore will have no negative financial impact, the holders of bonds are nevertheless the risk takers. The turmoil pushed bond yields substantially. As of August 15, Pakistan's Euro bond with coupon rate of 6.75 percent that matures on February 19, 2009, rose by 1.806 percent to 8.556 percent.
Euro bond with coupon rate of 7.125 percent, maturing on March 31, 2016, was up by 2.769 percent to 9.894 percent. Bond maturing on June 1, 2017, with coupon rate 6.875 percent jumped up by 2.27 percent to 9.145 percent and 30-year Euro bond maturing on March 31, 2036, was up by 1.663 percent to 9.538 percent.
The spike in short term yield is in line of demand in the international market arising from short dated funds. In real terms, Pakistan is currently better placed by floating $800 million Euro bond in March 2007 and presently is a net gainer by over 100 basis points (approximately).
Pakistan may not enjoy the same type of spread if it decides to float Euro bond, since the rating agency S&P has shifted Pakistan's outlook from positive to stable, (positive means possibility of upward revision to high whereas stable stands for neutral outlook).
Some risk could be seen in Pakistan's equity market, which out of $1.2 billion SCRA funds could have 25 percent to 30 percent hot money. With Pakistan's forex reserves comfortably hovering around $12 billion, it should not be a matter concern.
Banks could be sitting with small risk, as available funds in F.E. 25 is Rs 2.3 billion, which is a residual quantity of liquidity for overseas investments, but these funds are invested with the financial institutions, so risk could be minimal.
The Fed would be watching the market carefully until its next FOMC policy meeting due on September 18. Stability would be the key factor for easing of Fed rate. In 1997, when the issue of Long Term Capital Management rose, Fed cut its rate by 25 basis points on three occasions.
European Central Bank's President Jean-Claude Trichet is said to be reconsidering ECB's rate policy. European rate is currently 4 percent. While ECB is alert to take further steps to avert credit squeeze and to stem the turmoil, it would be interesting to note if the European Central Bank follows in Fed's footsteps to ensure stability.
Another tool available with the Central Bank is that Fed could do a currency swap with Europe to provide liquidity to the market. Euro could still be the currency of choice due to healthy interest rate spread and wide corporate profit in Europe. This could push euro to 1.4350 against the dollar.
Meanwhile, Japanese yen, which gained sharply on unwinding of carry trade, is taking a breather. There is a huge risk of unwinding of carry trade positions that could further strengthen yen to 107 per dollar by year-end.
However, the big question that remains to be answered is that how the world would know that the global financial crisis is over, as the turmoil in the credit market still looks far from over? The true consequences of global financial turmoil will only be known several months or years hence.