Central Banks Are Battling To Keep Credit Flowing

Overnight money market strains eased in Europe on the first day of the new financial quarter but longer-term rates remained in a state of near paralysis.

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The mixed start to the fourth quarter came as U.S. lawmakers prepared to vote on a revised bailout plan for troubled banks, reviving hopes of stemming the global credit crisis.

Having ramped up liquidity supplies to help banks balance their end-of-quarter books, the Bank of England and the European Central Bank announced plans to drain excess overnight funds in local currencies.

But they joined the Swiss National Bank in offering more dollar liquidity as part of joint efforts with the U.S. Federal Reserve to ease shortages in dollar funding, although these have had limited success in persuading banks to lend to each other.

Money markets have frozen up since the bankruptcy of Lehman Brothers and nationalization of other major financial institutions in the United States and Europe has made banks very wary of lending to each other.

A day earlier overnight dollar LIBOR spiked 4.3 percentage points, a record one-day rise, to 6.875 percent as financial firms had trouble getting the dollars they needed to close their books on the July-September quarter. LIBOR is the London Interbank Offered Rate, the benchmark for many interest rates around the world.

Wednesday morning the interbank cost of borrowing dollars for three months rose to 4.15 percent from 4.05 percent on Tuesday.

• Get Key LIBOR and Credit Spreads Here

Central banks globally have unleashed billions of dollars into money markets hoping to loosen the paralysis.

Some analysts have said central banks may consider cutting interest rates in a coordinated move to help give a boost to investors and limit the economic fallout from the crisis, but a solution to the money market breakdown remained elusive.

"It's not going to solve the core problem -- no one is lending to each other. I don't know how to fix that," said Gerrard Katz, head of North Asia currency trading at Standard Chartered in Hong Kong. "If people can't fund themselves through the money market or swaps, they have to go out and buy dollars. That's what we've descended into."

In Europe, overnight money market rates eased from the high levels seen on Tuesday, when benchmark dollar London interbank offered rates (Libor) soared to nearly 7 percent -- the highest in at least 7-1/2 years.

But massive liquidity injections pushed traded rates close to zero at one point and the Fed Funds rate dropped to 1.5 percent, below the Fed's 2.0 percent target.

"Yesterday was month-end, it's down a lot from those real stress levels, but still not back to normal," a trader at one euro-zone bank said of overnight dollar conditions.

Traders in Asia quoted overnight dollar borrowings seesawing as high as 6 percent. Activity was limited due to holidays in Singapore and other financial centres.

The BoE logged muted demand at its dollar tenders on Wednesday, lending $7.5 billion in daily funds from an available $10 billion.

It found takers for less than half the $30 billion weekly offer, lending out $13.4 billion. But euro-zone and Swiss banks showed strong demand.

The ECB could have lent out the $50 billion it had on offer almost 1-1/2 times over and charged rates of 3.25 percent and higher, while the SNB lent $10 billion at an average rate of 2.44 percent.

At the same time, the ECB said it would drain 200 billion euros ($282.5 billion) from overnight markets after banks swamped its overnight deposit facility with more than 100 billion euros, preferring to offload excess supplies at the central bank than lending it to rivals.

The BoE also drained ovenight cash, mopping up 10 billion pounds.

In Asia, the Bank of Japan and the Reserve Bank of Australia kept the money flowing, injecting extra funds into their markets as banks still had trouble securing cash.

The BoJ injected 1.6 trillion yen ($15 billion) of one-week funds, responding to big demand from foreign banks.

But it also drained 400 billion yen overnight as Japanese banks remained awash in funds, causing the overnight call rate (JPONMU-RR) to fall slightly below the 0.5 percent target.

Since the demise of Lehman Brothers last month, Japanese banks have turned cautious about lending funds to foreign institutions.

India felt the spread of the global credit crisis as its rupee overnight cash rates jumped above 17 percent on Wednesday, the highest level since April 2007.

The central bank has intervened regularly to sell dollars to try to support the rupee (INR-IN), which has slumped 16 percent against the dollar this year, partly as foreign investors sell off emerging market assets.

That has squeezed cash in the domestic money market.

Hong Kong announced measures as tight conditions in the U.S. dollar market sparked a jump in its short-term rates.

The Hong Kong Monetary Authority lengthened the duration of its operations and accepted a wider array of collateral in return for cash.

Copyright 2008 Reuters. Click for restrictions.