Statement on Monetary Policy – November 2008 International and Foreign Exchange Markets

Turbulence in international financial markets has increased significantly since the time of the last Statement, to be greater than at any time since the current financial turmoil began in the middle of last year. During September, the largest participants in the US mortgage market were placed under conservatorship, the US Government announced its intention to effectively nationalise one of the world's largest insurance companies, a large US investment bank filed for bankruptcy while the other major investment banks were either taken over or became deposit-taking banks. These events saw a general deterioration in confidence in financial markets and institutions. As a result, counterparty risk increased significantly, with interbank lending rates in most currencies spiking higher, and the deleveraging process escalated further, with many asset prices falling sharply as investors wound down leveraged positions.

Governments and central banks responded with an extensive array of support measures to stabilise the financial system. Government actions generally consisted of steps to: increase protection for retail deposits; guarantee various types of wholesale lending; and strengthen the capital position of banks. Central banks introduced further measures to improve liquidity in money markets and many lowered official interest rates.

While these actions have generated some improvement, sentiment remains fragile, with the release of weak economic data refocusing financial markets on the deteriorating outlook for the global economy and contributing to further declines in global markets. This, in conjunction with ongoing financial turmoil, has led to equity markets falling substantially, yields on government debt in many major economies declining, spreads on corporate debt moving sharply higher, and an appreciation of the yen and the US dollar against most currencies.

Capital markets and policy responses

As discussed in previous Statements, the initial trigger for the current financial turmoil was the collapse of investor confidence in securities backed by US mortgages, particularly sub-prime mortgages. Data for the June quarter, released since the last Statement, show a further deterioration in the US housing sector, with delinquencies and foreclosures continuing to rise (Graph 1). The subsequent decline in the value of mortgage-related assets has seen major financial institutions continue to make substantial write-offs although, recently, capital raisings have been boosted by governments taking stakes in a number of institutions (Graph 2). Financial institutions have also been setting aside larger provisions, reflecting the more general decline in loan quality.

In early September, the two largest participants in the US mortgage market, Fannie Mae and Freddie Mac (the agencies), were placed under conservatorship by US regulators. In conjunction with this action, the US Government announced a support package which included a pledge to keep the institutions solvent (via Treasury capital injections) and measures to enhance liquidity. Together, these actions effectively resulted in these institutions being nationalised. These events followed worse-than-expected losses in the June quarter of US$2.3 billion and US$0.8 billion for Fannie Mae and Freddie Mac, including write-downs of US$5.3 billion and US$2.8 billion, respectively. The share prices of the two entities had fallen precipitously and the spreads between yields on their debt and yields on US government debt had widened considerably (Graph 3). After the announcement of government initiatives, spreads on agency debt and mortgage-backed securities (MBS) relative to US Treasuries narrowed but subsequently, with the dislocation in financial markets escalating, spreads rose to over 100 basis points. Reflecting this and the financial turmoil more generally, mortgage rates remain high in the United States despite the reduction in policy rates (Graph 4).

As a result of being placed under conservatorship, a credit event was triggered on credit default swaps (CDS) written on agency debt. But with prices for Fannie Mae and Freddie Mac senior debt settling at US$92 and US$94, respectively, (net) CDS payouts were limited to around US$8 and US$6 per US$100 of protection.

The US Government's agency support package did not prevent conditions in financial markets from deteriorating further. Around a week after the agencies' nationalisation, Lehman Brothers, the fourth-largest investment bank in the United States, filed for bankruptcy. Shortly thereafter, one of the world's largest insurance companies, American International Group (AIG), had its credit rating downgraded; subsequently the Fed extended more than US$120 billion through a revolving credit facility. While this facility spared AIG from bankruptcy, the US Government announced its intention to assume a 79.9 per cent equity interest in the company, effectively nationalising it. Subsequently, the remaining large independent US investment banks were either taken over by deposit-taking banks or, in the case of Goldman Sachs and Morgan Stanley, became deposit-taking banks themselves. In the United Kingdom, Lloyds TSB announced it would take over Bank of Scotland (formerly HBOS), a large UK mortgage lender, in order to prevent that company's collapse.

In September, several US money market mutual funds (MMMFs) incurred principal losses, in part because some funds had exposure to paper issued by Lehman Brothers. Net asset values falling below US$1 per dollar invested (‘breaking the buck’) triggered sizable redemptions from other MMMFs and strong demand for US Treasuries. These events caused severe market dislocation as MMMFs in the United States hold around 40 per cent of all commercial paper and bank acceptances outstanding. In order to provide a liquidity backstop for funds to meet redemption requests and to stabilise short-term funding markets, the US Treasury and the Fed took a number of steps. The US Treasury guaranteed all existing holdings and the Fed extended loans to US depository institutions to finance the purchase of high-quality asset-backed commercial paper from the MMMFs (see Box A). Subsequently, a number of other facilities were put in place to assist the money market funds and the commercial paper market.

The culmination of the US rescue plan for the financial system was the US$700 billion Troubled Asset Relief Program to purchase distressed bank assets. While the draft legislation was initially rejected by the US House of Representatives, a revised form of the package, the Emergency Economic Stabilization Act (EESA), was passed into law in early October. The Act allows the US Treasury to provide capital to financial institutions and to purchase troubled assets. It also allows the Federal Reserve to start remunerating reserve balances.

Around this time a number of deposit-taking financial institutions across the United States, Europe and the United Kingdom encountered severe financial difficulties. US regulators took control of Washington Mutual and sold its assets while Wachovia was taken over by Wells Fargo. European financial group Fortis received government support while the governments of Belgium, France and Luxembourg, in conjunction with existing shareholders, injected €6.4 billion of capital into financial services group Dexia. A consortium of German banks joined the German Government to rescue Hypo Real Estate, a large German commercial property lender. In the United Kingdom, Bradford & Bingley, a large lender to landlords, had its retail deposit business and branch network sold to Abbey National by UK authorities.

Despite the passage of the EESA, conditions in financial markets continued to deteriorate. Liquidity in short-term money markets was extremely low for terms any longer than one week and demand for high-quality assets in the United States rose. As a result, yields on short-term US Treasuries fell to levels not seen since the 1940s (Graph 5), and the spread between 3-month US dollar LIBOR and yields on US Treasuries rose to a record 460 basis points (Graph 6). As stress mounted in European financial systems, commercial banks chose to hold a growing proportion of assets as reserve balances at central banks despite the interest penalty of doing so. Reserve balances at the European Central Bank (ECB) almost reached a record €300 billion.

In response to these rising tensions, governments around the world took steps to address strains in the financial system. In particular, governments: increased protection for retail deposits; introduced guarantees on wholesale lending; and took steps to strengthen the capital position of banks.

On 30 September, the Irish Government put in place a two-year program to guarantee all deposits at six major Irish banks. Following this, the UK Government increased its protection on bank deposits to £50,000 from £35,000. The German Government legislated a guarantee on deposits up to €100,000 and many other European countries also announced changes to their deposit guarantee arrangements. To ensure co-ordination, the European Union finance ministers agreed to raise the minimum level of deposit guarantees in Europe to at least €50,000 from €20,000. In the United States, the EESA temporarily increased the guarantee on deposits to US$250,000 from US$100,000. Governments in other industrialised nations and emerging economies also increased the level of protection for deposits.

To ensure the stability of its financial system, the UK Government announced that it would facilitate the recapitalisation of its banking industry and guarantee new short- and medium-term debt issuance of eligible institutions on commercial terms. The fee for this guarantee is risk-sensitive, being based on an institution's past CDS premia plus a margin. Eight institutions have confirmed their participation in the scheme. To qualify for the debt guarantee, institutions must raise their Tier 1 capital by the amount, and in the form, that the UK Government considers appropriate. While a number of financial institutions have been able to meet the requirements without having to add to capital, several others will raise capital with the assistance of the UK Government.

In order to stabilise their financial systems, European governments also announced various measures that included the guarantee of debt issuance and the purchase of equity in banks. For Germany, France, Spain and the Netherlands, the combined value of capital injections and debt guarantee facilities exceeds €1 trillion: the German package will guarantee up to €400 billion of new bank debt and provide up to €80 billion to recapitalise banks; the French Government will guarantee up to €320 billion of new bank debt and provide up to €40 billion to recapitalise banks; the Spanish Government approved measures to guarantee up to €100 billion of new bank debt and authorised the purchase of shares in banks in need of capital; and the Dutch Government will guarantee up to €200 billion of new bank debt. Other European nations have also made various announcements to support their domestic financial systems.

In mid October, the US Government announced a plan to lend further support to its key financial institutions by recapitalising various banks and guaranteeing all senior unsecured debt issued by eligible financial institutions. As part of this, the US Treasury revealed a US$250 billion Capital Purchase Program, made possible under the EESA, which will allow eligible financial institutions to sell senior preferred shares to the US Government. At the time of the announcement, nine major financial institutions had agreed to participate. The US Treasury will invest a maximum of US$25 billion per institution and will receive preference shares paying 5 per cent for the first five years, and 9 per cent thereafter. At the same time, the Federal Deposit Insurance Corporation introduced the Temporary Liquidity Guarantee Program which guarantees newly issued senior unsecured debt of banks, thrifts and certain holding companies for a non-risk-sensitive annualised fee of 75 basis points.

Many central banks, in addition to reducing policy rates (see below), responded to the rising tensions by expanding their existing liquidity facilities. Actions taken included: widening the range of eligible collateral; broadening the list of participants eligible to access these facilities; and lengthening the maturity of market operations. Some also introduced new measures targeting specific markets. To address the dislocation of the foreign exchange swap market, there was a marked increase in the availability of US dollars to non-US central banks through foreign exchange swap facilities with the Fed (Box B). In particular, a number of central banks were willing to provide unlimited US dollars at a fixed price. This step in particular appears to have contributed to a large improvement in the functioning of foreign exchange swap markets.

Some central banks also entered into arrangements tailored to individual financial institutions. Notably, the Swiss National Bank (SNB) and UBS set up a special-purpose vehicle (SPV) to facilitate the orderly liquidation of up to US$60 billion of illiquid securities and other troubled assets held by UBS. In this initiative, the SNB will grant the SPV a loan of up to US$54 billion, secured by a claim on all the SPV's assets, for a term of 8 years (but extendable to 12 years). UBS will provide the other US$6 billion in equity, serving as a first level of protection against any losses. The loan to the SPV will pay interest at the 1-month US dollar LIBOR rate plus 250 basis points, and profits will be shared according to an agreed formula.

Following the announcement of these policy actions designed to improve confidence in financial systems, US dollar term spreads began to narrow in mid to late October and there has been increased debt issuance in money markets at terms longer than one week. CDS premia on commercial banks in the United States, Europe and the United Kingdom have also narrowed noticeably (Graph 7). In contrast, CDS on non-financials have continued to rise, with aggregate indices remaining around the highest levels seen since the current crisis. However, the CDS market has also been affected by a lack of liquidity, which has reduced the precision of pricing.

Official policy rates

The escalation in financial market turmoil since the previous Statement has led a number of central banks in industrialised nations to reduce their policy rates amid rising downside risks to growth and moderating inflationary pressures (Table 1). Expectations of the future path for policy rates have shifted even lower. A number of emerging market central banks also reduced rates for the first time in several years.

The Fed, the ECB, the Bank of England (BoE), Bank of Canada (BoC), the SNB and the Riksbank all took part in a co-ordinated rate cut in early October. Each central bank reduced their policy rate by 50 basis points. In their joint decision, the central banks noted that downside risks to growth had increased as the financial crisis intensified and inflationary pressures had diminished, warranting some easing in monetary conditions. Most of these central banks also cited a significant tightening in credit conditions in their statements. The Fed and the Riksbank reduced their policy rates by a further 50 basis points and the BoC cut by a further 25 basis points at their next scheduled meetings. While the Bank of Japan (BoJ) did not reduce its policy rate along with these central banks, it expressed strong support for the co-ordinated action. At the end of October, the BoJ cut policy rates by 20 basis points, reflecting deteriorating conditions.

Separately, the Reserve Bank of New Zealand lowered its policy rate by a total of 150 basis points to 6½ per cent in two moves, noting that the domestic economy is experiencing a marked slowdown, primarily due to the deteriorating global outlook. The Norges Bank reduced its policy rate by 100 basis points to 4¾ per cent, but in contrast the central bank in Denmark raised rates to support its currency. With the major dislocation in the Icelandic banking system (whose assets amount to around 10 times the country's GDP), the central bank in Iceland lowered rates by 350 basis points to 12 per cent before raising them two weeks later by 600 basis points as part of an International Monetary Fund (IMF) program.

Notwithstanding reductions in policy rates, expectations of future policy paths have shifted even lower for most industrialised economies, including the United States (Graphs 8 and 9). In the next half year, reductions totalling 100 basis points are expected from the ECB. In the United Kingdom, markets are expecting cuts totalling 200 basis points. The BoC is expected to reduce its policy rate by 75 basis points. In New Zealand, a cumulative 150 basis points of further cuts are expected.

Since the previous Statement, a number of central banks in emerging markets – especially those in Asia – have eased policy (Table 2). The People's Bank of China (PBoC) lowered its lending and deposit rates for the first time since 2002 to 6.66 per cent and 3.60 per cent respectively, and reduced its required reserves ratio for the first time since 1999 (Graph 10). The central banks of India, Israel, Korea and Taiwan also reduced their policy rates. The Hong Kong Monetary Authority (HKMA) cut the spread between its policy rate and the Fed's policy rate from 150 to 50 basis points which, combined with the Fed's rate reductions, means that the HKMA's policy rate was reduced by a total of 200 basis points over the month. Rates were also reduced in the Czech Republic amid concerns about the koruna's appreciation against the euro.

In contrast, continued inflationary concerns have led Bank Indonesia to raise its policy rate twice since the previous Statement. Most Latin American central banks also remained concerned about inflation, with a number of them raising interest rates in recent months. Hungary's central bank raised its policy rate at an unscheduled meeting by 300 basis points to 11.5 per cent to support its currency.

Bond yields

Developments in credit markets have led to sharp movements in bonds yields since the last Statement, with volatility higher than it was in March following the collapse of Bear Stearns. Yields were buffeted by the opposing forces of increased concerns about global growth on the one hand, and increased concerns about the fiscal implications of financial rescue packages and other support programs on the other. The increase in volatility was particularly noticeable at shorter maturities, such as 3-month US Treasury bills.

Yields on 10-year US government bonds have traded in a very wide range of 70 basis points since the last Statement (Graph 11). Yields declined by over 30 basis points on the day Lehman Brothers collapsed to around levels seen in mid March, while yields on 3-month US Treasury bills and 2-year US government bonds fell by 60 and 50 basis points, respectively. In the wake of the proposed nationalisation of AIG, yields on 3-month US Treasury bills fell by over 60 basis points – for the second time in less than a week – to be below 0.1 per cent for the first time since the early 1940s. Yields on 2-year US government bonds have fallen by over 100 basis points since the last Statement. With falls in yields of shorter-term bonds greater than those on longer-dated Treasuries, the yield curve in the United States has steepened since the last Statement.

At the peak of investor concerns, spreads between the yields on sovereign debt in Italy, France, Spain and the Netherlands and yields on German bunds widened to the highest levels seen since the formation of the European Monetary Union (Graph 12). These spreads narrowed somewhat following the unprecedented action by governments and central banks, though they have since moved higher again.

The deterioration of credit market conditions and the failure of several large financial institutions saw corporate debt yields increase significantly through September and October as default risk concerns escalated. Spreads on corporate debt surpassed their mid-March highs and 2000 peaks, most notably on sub-investment grade debt (Graph 13). Consistent with this, defaults on speculative-grade debt have increased sharply and, if rating agencies' expectations of default on this debt are realised, will rise substantially further.

Corporate bond issuance in the United States was very weak in the September quarter and well below the already subdued level of issuance seen earlier in 2008; issuance was around three times less than in the June quarter for both financials and non-financials, reflecting the current very difficult conditions for longer-term funding (Graph 14). Issuance of MBS also remains very weak in all countries where financial institutions had previously relied heavily on securitisation. There has been virtually no private issuance in the United States, while agency issuance has slowed considerably. Issuance in the United Kingdom was again boosted by financial institutions creating securities that can be used to access the BoE's liquidity facilities (self-securitisations).

In emerging markets, spreads on US-dollar-denominated sovereign debt rose sharply on heightened risk and global growth concerns (Graph 15). This was particularly true of spreads on Argentina's sovereign debt, reflecting concerns the Government may default on its debt again; late in October the Government announced plans to take over private pension funds. As pressures on emerging markets intensified, the IMF has been approached by several governments for assistance. Assistance packages have been put in place for Hungary, Iceland and Ukraine while a number of other countries are expected to take up some form of international support in the coming months.


Global equity markets are sharply lower and have been extremely volatile since the last Statement, amid severe turmoil in global financial markets and worse-than-expected economic data raising concerns about the prospects for global economic growth (Graph 16, Table 3). There have been significant declines across all sectors. In the United States and Europe, equity markets fell back to levels briefly reached in 2003 and before then in 1997, while in Japan equities fell back to levels of the early 1980s. The large decline in equity prices has seen the price/earnings (P/E) ratio for the S&P 500 fall back to around its long-term average (Graph 17). P/E ratios in Europe and Japan are well below their average levels.

In the United States, share prices have fallen sharply since the last Statement in very volatile conditions. The S&P 500 recorded some of its biggest daily moves in history, with the rebounds on 13 and 28 October being the largest since the 1930s, and the decline on 15 October being the biggest since the 1987 stock market crash (Table 4). The implied volatility of the S&P 500 reached levels not seen since October 1987. European and Japanese markets were similarly volatile.

Emerging market equities have also been subject to sharp falls as economic prospects have deteriorated, with exports to industrialised countries expected to slow further (Graph 18). Share prices in emerging Europe, which includes Russia, have declined rapidly due to the fall in oil and commodities prices, as well as the spill-over of strains in the financial sector. Large falls saw trading on the Russian exchanges suspended for several days.

Foreign exchange

Volatility in currency markets also picked up to historically high levels in October (Graph 19). There was evidence of deleveraging and flows associated with hedging activity contributing to sharp movements in illiquid markets. The volatility on Friday, 24 October was one of the most extreme, with the US dollar depreciating by as much as 8 per cent against the yen during the day, and the euro depreciating by 12 per cent.

The yen appreciated against all currencies as carry trades were further unwound and Japanese investors repatriated their investments. The US dollar appreciated against most other currencies, except the yen, as US investment vehicles repatriated their investments, in some cases due to forced liquidations, and as foreign investors adjusted their hedges on US dollar assets (Graph 20, Table 5). The appreciation of the US dollar comes after a long period of depreciation. On a nominal trade-weighted basis the US dollar is 15 per cent above the low it reached in March this year, while in real terms it is 16 per cent higher (Graph 21).

Emerging market currencies have depreciated significantly against the US dollar since the last Statement. Falling commodity prices and concerns about US economic growth weighed on a number of currencies, including the South African rand, Brazilian real and Mexican peso. These currencies were also affected by the unwinding of leveraged portfolios. The Korean won continued to depreciate against the US dollar, and in October reached its lowest level since the Asian financial crisis. Foreign repatriation of equities, and concerns over the ability of Korean banks to finance dollar-denominated debt, were important factors weighing on the won. In response, Korean authorities intervened in foreign exchange markets to support the currency. More recently, the Bank of Korea announced that it will undertake foreign exchange swaps directly with financial institutions to address US dollar liquidity issues. Other Asian currencies were generally lower on concerns the global slowdown will dampen domestic growth in the region (Graph 22).

The slow and steady appreciation of the Chinese renminbi against the US dollar, which began with its revaluation in mid 2005, has not continued in recent weeks. While the renminbi has been little changed against the US dollar, it has appreciated significantly against the euro and depreciated sharply against the yen. On a trade-weighted basis, China's currency has appreciated by 9 per cent in nominal terms and by 11 per cent in real terms over the three months to October. For the first time since late 2002, pricing in the non-deliverable forwards market indicates that the renminbi is expected to depreciate over the coming year.

Australian dollar

The deterioration in the global growth outlook, declines in commodity prices and general unwinding of leveraged positions caused a further sharp depreciation of the Australian dollar in recent months. Some investors appear to have exited Australian dollar positions as a proxy for unwinding positions in other less liquid markets, including emerging market currencies. At the low point in late October, the dollar had depreciated by as much as 27 per cent on a trade-weighted basis since the last Statement. It has since rebounded somewhat, appreciating by 13 per cent against the US dollar and by 9 per cent on a trade-weighted basis to be 6 per cent below its long-run average (Graph 23, Table 6). The dollar has depreciated particularly sharply against the Japanese yen which, as noted above, had been a favoured currency for funding leveraged positions in high-interest-rate currencies.

Volatility in the exchange rate reached unprecedented levels with a number of particularly sharp downward movements in October, largely reflecting risk retrenchment associated with falls in US equity markets (Graph 24). The currency has moved in large intraday ranges in line with general volatility in global equity and foreign exchange markets (Graph 25). The increase in Australian dollar volatility is broadly comparable with that seen in other commodity-related currencies.

The disorderly conditions in the foreign exchange market on a number of occasions in October led the Bank to use its foreign reserves to provide liquidity to the market. While the US dollar value of foreign reserves declined as a result of these interventions, valuation effects have increased net reserves by $6 billion in Australian dollar terms, to around $45 billion since the last Statement.