08 September 2011

Julie Chon: G7 faces three-front battle against contagion

The US is focused on domestic issues, but many of the economic problems are global. G7 officials meet tomorrow, and Julie Chon, Atlantic Council senior fellow and former Senate Banking Committee senior adviser, says they must work to battle contagion.

Tomorrow, finance ministers and central bankers from seven wealthy countries in the developed world will convene in Marseilles, France for their regular meeting to assess the health of the global economy. After a few global gatherings when the economic outlook appeared more promising in 2009 and 2010, the G7 agenda is back to battling contagion — negative spillovers from one financial institution, market or country to another. Recent volatility stemming from European bank funding concerns, protracted fiscal consolidation debates and sharp movements in exchange rates threaten to upend the global recovery. The G7’s ability to cooperate on these three issues will determine the course of contagion — either recurrence or remission. Therefore, during a week when the US President is rightly focused on job creation, managing contagion will be as much a priority for the G7 as promoting growth.

The issue of European bank funding and capitalisation should be watched closely because of the threat it poses to global financial stability and global policy coordination. With the European Commission standing by the adequacy of bank stress test programs while the Federal Reserve, IMF Managing Director, Deutsche Bank CEO and US money market mutual funds call attention to the ability of European banks to cope with sovereign debt strains, the issue could become the biggest source of policy divergence among major economies. Further close cooperation across national boundaries and between policymakers and market participants is necessary to allay concerns about systemically important European banks.

Already, questions about the damage sovereign debt holdings could inflict on bank balance sheets have driven US money market mutual funds, which hold nearly half of their assets in short-term European bank paper, to curtail their exposure. Some funds reported avoiding lending to banks in France, Spain and Italy entirely. Others stopped rolling over maturing short-term loans. As crucial sources of short-term funding pared back, the cost of borrowing for European banks rose. The spread between forward rate agreements and the overnight indexed swap rate in Europe, a proxy for the future premium banks will charge each other for loans, widened to the highest level since early 2009. Both European and American banks reported a steady climb in the cost of 3-month dollar loans in August. And, the cost of insuring against the default of financials spiked to a record high in recent weeks, as evident in five-year credit default swap indices. Spreads have improved at times, on the back of encouraging news such as the German Constitutional Court’s decision to uphold that country’s participation in European sovereign rescues. Still, insufficient, opaque and divergent policy responses to concerns about European bank balance sheets could drive borrowing costs higher, putting more pressure on bank funding. The pressure may not be as severe as it was in September 2008, but enough to constrain credit and risk-taking during a period when both are needed to support the recovery.

Full article (appeared in WSJ)

© Julie Chon