Confidence in the world’s credit markets has been severely dented. And it has not improved as evidenced by the unprecedented gap between what banks and the U.S. government pay to borrow money.
The difference between the London interbank offered rate, or Libor, that banks charge each other for three-month loans and Treasury bill rates is six times wider than before markets began to seize up in June 2007. Even prices of contracts to borrow money months from now show investors do not expect lending to recover until at least the second half of 2009 based on the difference between Libor and the expected average federal funds rate over the next three months, known as the Libor-OIS spread, which is about 1.60 percentage points. It would need to narrow to about 0.25 percent for lending to return to normal.
Short-term funding spreads are all still very wide relative to historical norms. There is a massive pullback going on in the private sector. Investors remain wary of any securities except Treasuries. As banks hoard cash, businesses are struggling to refinance debt and consumers can not get loans.
In the US, about 85 percent of domestic banks tightened lending standards on commercial and industrial loans, the highest since 1991 as the risks of a deeper economic downturn increased.
Personal bankruptcies rose 34 percent in the third quarter from the same period last year. Consumer credit fell $6.4 billion in August and $3.5 billion in October, making 2008 the first year with at least two declines since 1992. August’s decline was the biggest in at least 65 years.
Corporate defaults are expected to surge threefold to 11.4 percent in the next 12 months. Bond sales by companies rated below investment-grade fell 57 percent to $63.3 billion this year from 2007. The extra yield investors demand to own the debt instead of Treasuries recently rose to a record 21.4 percentage points from 1.32 percent 18 months ago.
Instead, investors are committing more money to government bonds. Treasury three-month bill rates fell below zero percent for the first time two weeks ago, meaning investors were willing to pay the government to protect them from further losses.
Moreover, confidence in the world economy significantly fell in December as a recession spread beyond the U.S. and growth weakened in China and Latin America. To help solve the world’s problem which originated from itself, the Federal Reserve has embarked on an ambitious mission to restore confidence by cutting interest rates to as low as zero and pledging to buy unlimited quantities of securities. The aim is to kick-start borrowing and spending to propel the economy toward a recovery by the middle of next year.
The Fed realizes that it is going to take a combination of fiscal and monetary stimulus to successfully rescue the economy. It has signaled it will make sure that the fiscal stimulus package is fully supported and in effect financed by the Fed.
Likely steps by the Fed in coming months include financing for a new package to shore up the housing ndustry, and expanding a $200 billion program to undergird credit card and student loans. Among new ideas the Fed is open to is buying lower-rated securities, with backing from the Treasury.
One drawback is that the new plan is deemed risky as market pricing could be distorted for months or years, with insolvent borrowers kept afloat as central bankers force yields below levels investors deem appropriate given the risks. And, the availability of Fed credit might deter private credit. The lender of last resort may become the lender of only resort.
By Chodechai Suwanaporn
Source: Fiscal Policy Office / www.fpo.go.th