Central banks ease liquidity. Did they avert meltdown?

Central banks in a surprise announcement Wednesday announce moves to ease strains in the global financial system. Central banks' moves should ease concerns over European banks but does not begin to solve long-term problems of European debt.

Did the Federal Reserve and five other central banks just avert another financial market meltdown?

In a surprise announcement Wednesday, six of the world’s most important central banks announced they would “enhance their capacity” to provide liquidity to the global financial system. Their aim: to ease strains in the financial markets since bankers had started to pull back on their lending to each other as well as to households and businesses.

The news of the central bank actions jolted the world stock markets. The German market moved up 4 percent and by mid-morning the Dow Jones Industrial Average had gained nearly 400 points.

Independent economists believe the main goal of the central bankers’ actions is to help provide European commercial banks with access to US dollars. In recent months, US money market funds have curtailed their lending to European banks because of concerns over their holding of sovereign debt of such countries as Greece and Italy. This has forced them to scramble to get funding for themselves.

“If the European banks are really in bad shape, this could be helpful,” says Robert Brusca, of Fact & Opinion Economics in New York. “But it does not solve any of the longer-term problems. It does not provide funding for countries that need it.”

At the same time, China surprised the financial markets by cutting its reserve requirements for its domestic banks. This is the first time in three years that China has made a move to stimulate its economy, which had been slowing.

“China’s growth rate apparently has slowed to a level that worries central planners who realize they need to see their GDP [gross domestic product] grow at a 10 percent or greater rate to achieve long-term employment goals,” writes Fred Dickson, chief investment strategist at D.A. Davidson & Co. in Lake Oswego, Ore.

Mr. Dickson says the move by China is a positive event for the world economy since China has been a major market for both US and European countries. “Chinese growth could offset growing concern about Europe falling into a nasty recession in coming months due to the ongoing European financial crisis,” he writes in an analysis.

The US markets were also stimulated by some by better-than-expected US economic news. ADP, a payroll-processing firm, estimated the US economy created 206,000 private sector jobs in November. Although ADP’s numbers are not always accurate, they often pick up the direction correctly. On Friday, the US will report the November jobs data.

The central banks involved in the effort to provide liquidity to European banks include the Federal Reserve, the European Central Bank, the Bank of Canada, the Bank of England, the Bank of Japan, and the Swiss National Bank.

Specifically, the central banks agreed to lower the pricing on already existing temporary US dollar swap arrangements. These swap lines basically allow the Fed to lend dollars to other European central banks. Those central banks in turn lend the dollars to commercial banks that need the dollars to fund their US operations or make loans in dollars.

In addition, the swap lines – which were originally set up during the 2008 financial crisis – were extended until February 2013. The moves to ease liquidity for the global financial system pose little risk to the Fed, Mr. Brusca says, since the loans are to other central banks, not troubled banks themselves.

Even with the central bank actions, some analysts say they still did not address the basic problem in Europe: Few lenders are willing to lend money to some of the sovereign borrowers.

“The risk of a true sovereign debt crisis is increasing by the day,” says Eric Stein, a vice president at Eaton Vance Investment Managers in Boston. “The latest actions may smooth over things at the margin, but there is a reason the European banks are having trouble getting funding.”

“This is not a panacea for everything by any stretch of the imagination,” he adds.