Central banks turn on the taps

The world's major central banks have cleared a path for their political masters to finally resolve the European debt crisis.

Led by the U.S. Federal Reserve, a total of six official lenders – including the Bank of Canada – made a joint pledge to lower the cost of emergency loans of U.S. dollars, a powerful statement that central banks stand ready to ensure the global banking system remains flush with the cash needed to issue credit and make good on any obligations.

Global stock markets surged as investors bet the central bank move serves as a breakthrough for a solution to rampant debt woes in the euro zone, reducing the risk that Europe's woes trigger a global recession. The S&P/TSX composite index jumped 4 per cent, to 12,204.11, and the Canadian dollar jumped nearly a penny against the U.S. dollar.

While the co-ordinated action – an echo of moves taken during the 2008 financial crisis – was celebrated by investors, analysts cautioned that fundamental problems in Europe remain far from fixed. The central bank moves are aimed at preventing credit from seizing up, but won't address staggering government debt loads, sharply elevated financing costs and stagnant economic activity.

During the financial crisis three years ago, central banks moved in unison to prime global credit markets after fear-stricken private lenders started hoarding cash out of fear that loans to shaky financial institutions wouldn't be repaid.

Financial markets aren't as panicked today as they were following the bankruptcy of Lehman Brothers Holdings Inc. three years ago.

However, certain credit markets were showing strain in recent months, including the cost for European banks to borrow U.S. dollars, which had risen to its highest levels since the Lehman collapse Wednesday before the central banks made their move.

"Finally, global action!" declared Andrew Busch, global currency and public policy strategist at Bank of Montreal's investment arm in Chicago, reflecting investors' deep frustration with the protracted efforts of European politicians and their allies in the Group of 20 major economies to provide a backstop for struggling countries such as Italy and Spain.

Central banks are "signalling that they recognize there is a problem within the European banking system," said Phillip Swagel, a professor of international economic policy at the University of Maryland. "It's helpful as a signal, but it doesn't solve the problem. Until the solvency problem is solved, the European banking system will remain under pressure."

A central bank statement said "the purpose of these actions is to ease strains on financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity."

Last month in London, Bank of Canada Governor Mark Carney used a speech to flag his worry that Europe's debt crisis might be spreading to the broader global economy. "As global liquidity recedes, volatility is increasing and activity falling," he said on Nov. 8. "The effect on the real economy will soon be felt."

The Bank of Canada is regularly in touch with the Canadian banks on interlending to see how the market is doing, but the discussions have been happening more frequently over the past two weeks amid growing concerns from Europe.

European banks are under heavy pressure because they are big holders of government debt that has fallen sharply in value. That has created funding problems for the banks and made them reluctant to extend loans.

The tightened credit environment has started to affect business and trade. Marius Kloppers, CEO of Australian mining giant BHP Billiton, said this week that trade finance – a corner of the international banking industry long dominated by European lenders – has become harder to get.

The Federal Reserve risks further criticism at home over its aggressive policies to exchange dollars for euros with the European Central Bank at a rate that is half a percentage point lower than their previous arrangement. The Fed renewed similar swap lines with the Bank of England, the Bank of Japan, the Swiss National Bank and the Bank of Canada. The funding will remain in place until February 2013.

Meanwhile, European officials continued to edge toward further steps Wednesday.

German Finance Minister Wolfgang Schaeuble indicated at a meeting with his counterparts in Brussels that he was open to increasing the resources of the International Monetary Fund, a reversal that could open the door to a greater global response to Europe's problems.

With files from reporters Jeremy Torobin and Grant Robertson