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ECB and BOE Inject Billions, Bank of China Cuts Rates as Central Banks Cope with Lehman Fallout

By , Money Morning •

By Jason Simpkins
Associate Editor

Central banks around the world, including the European Central Bank (ECB), the Bank of England (BOE) and the People’s Bank of China, scrambled yesterday (Monday) to shore up liquidity and protect domestic markets against the fallout from the collapse of Lehman Bros Holdings Inc. (LEH).

The Bank of England and the European Central Bank injected billions of dollars into global money markets and the Bank of China cut interest rates for the first time in six years and lowered capital reserve requirements for its smaller banks.

The ECB allotted roughly $43 billion (30 billion euros) in a one-day money-market auction that was more than three times oversubscribed, Bloomberg News reported. The ECB injected the funds at a rate of 4.25%. The bank also said it would be prepared to take further action if necessary and “stands ready to contribute to orderly market conditions.”

The infusion was virtually identical to action taken by the ECB in August 2007, when the bank offered up $56 billion (40 billion euros) to calm jittery markets. The ECB has put roughly $134 billion (95 billion euros) on the market in the past 13 months, fearful that banks would abandon the interbank lending market and cease lending to one another.

"Sunday's events mark a turning point in the crisis, but the fundamental premise is the same as it's been since last year," Michael Schubert, an economist with Commerzbank AG (OTC ADR: CRZBY) in Frankfurt told The Wall Street Journal. "Banks still do not know how much liquidity they need themselves and there's even more uncertainty regarding other banks."

The Bank of England said that it would take necessary measures to boost liquidity as well, and lend out an additional $9 billion (5 billion pounds) at a 5% rate over the next several days.

“The Bank of England will be monitoring carefully the conditions in sterling money markets and will take appropriate actions if necessary to stabilize those markets,” the BOE said in a statement.

Like the ECB offer, the BOE loans were oversubscribed, as Banks bid for $42 billion (24 billion pounds). Of that, 20.75% was allocated.

“This is significantly oversubscribed,” Philip Shaw, chief economist at Investec Securities in London, told Bloomberg. “It largely reflects the tension in the money market after the announcements over the weekend. It's very welcome to see the Bank of England respond with extra liquidity.”

Still, there’s a distinct possibility that the BOE will have to go a step further and cut interest rates if it hopes to restore confidence to the markets and revitalize growth.

The Confederation of British Industry (CBI) said yesterday that the BOE should cut its benchmark interest rate from to 4.5% by the end of this year, and to 4% in early 2009. The bank has held the rate steady at 5% since April, intent on taming inflation.  The European Commission said earlier this month that the United Kingdom has already entered a recession, its first since 1991, after gross domestic product (GDP) growth fell flat in the second quarter. The EC predicts GDP will shrink by 0.2% in both the third and fourth quarters.

The CBI said the U.K. economy contracted 0.2% between July and September compared to the same period last year, and would suffer a 0.1% decline in the final quarter of 2008. However, the group was upbeat on the economy’s 2009 prospects.

“Having experienced a rapid loss of momentum in the economy over the first half of 2008, the U.K. may have entered a mild recession that will hopefully prove short lived," said CBI Director-General Richard Lambert. "This is not a return to the 1990s, when job cuts and a slump in demand were far more prolonged."

Bank of China Cuts Rates

The Bank of China cut its interest rates for the first time in six years yesterday, and reduced the amount banks are required to keep in reserve as Lehman’s collapse roiled credit markets and a depleted global economy weakened the outlook for Chinese exports.

The BOC cut its one-year lending rate to 7.2% from 7.47% and lowered the reserve ratio for the nation’s smallest banks by one percentage point. However, for China’s largest banks (Bank of China Ltd. (PINK: BACHF), Industrial and Commercial Bank of China, Agricultural Bank of China, and others) the reserve requirement will remain at 17.5%.

The bank said the measures are intended to “help solve important problems in [the] economy for its continued stable and fast development.”

The People’s Bank has done nothing but raise rates for the past six years, as the economy routinely posted digit growth rates. But an economy that many were beginning to think of as impervious has shown some weakness as of late, and financial turmoil abroad further dampens its outlook.

China’s 10.1% second-quarter expansion was strong, but it was also a drop from the 10.6% growth posted in the first quarter and down substantially from 2007’s 11.9% growth. Standard Chartered Bank has said China’s rate of growth will slow to 9.9% in 2008 and 8.6% in 2009.

China’s statistics bureau said last week that export growth slowed to 21.1% year-over-year in August, down from 26.9% in July.

“There is an increasing pressure on central banks to act,” Ken Wattret, chief Europe economist at BNP Paribas SA (OTC ADR: BNPQY), told the New York Times.

Of course the BOC had room to act, as inflation eased to a rate of 4.9% in August – a 14-month low. The U.S. Federal Reserve and ECB may find the task of reducing rates slightly more difficult.

“The Fed is more likely to cut rates than the ECB,” said Wattret. “What the Fed doesn’t want is a sustained drop in house and equity prices at the same time. The ECB won’t be at the forefront of cutting rates because it remains focused on inflation.”

[Please click here for a related story on what action the U.S. Federal Reserve will take going forward.]

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