Federal Reserve boosts flow of dollars to European Central Bank

By Neil Irwin and and Michael Birnbaum, Friday, September 16, 9:08 AM

Worried that a mounting debt crisis in Europe could trip up the global economy, the Federal Reserve opened its vault Thursday to the central banks of other countries in an effort to head off a crippling shortage of dollars.

The main recipient of the Fed’s money is the European Central Bank, which will in turn extend dollar loans to banks in the countries that use the euro currency. Those banks do significant business in dollars — such as making loans to customers who operate around the world — and have been finding it difficult to raise dollars from anxious investors.

The initiative, which entails temporarily swapping dollars for foreign currencies, also involves the central banks of Britain, Switzerland and Japan, underlining the extent of international concern about Europe’s deteriorating financial system. By tapping the Fed for dollars, the other central banks are taking advantage of arrangements that were put in place at the outset of the global financial crisis four years ago to prevent bank lending from freezing up.

Global stock markets surged on the news of the coordinated response. The Standard & Poor’s 500-stock index in the United States rose 1.7 percent Thursday, and the German stock market closed up 3.2 percent. The value of the euro increased on greater optimism that the European debt crisis can be resolved.

At the heart of Europe’s financial problems are the hundreds of billions of dollars’ worth of risky government bonds held by the banks. Those bonds were issued by cash-strapped countries such as Greece and Portugal, and if the governments default, the banks could face massive losses. As concerns turn to the health of the banks, investors are becoming wary of lending them money, at least at the previously low rates.

The Fed will make short-term dollar loans to the ECB and other central banks through “swap lines,” swapping dollars for an equivalent amount of euros, British pounds, Swiss francs and Japanese yen. The ECB will, in turn, make those dollars available to euro-zone banks. The Bank of England will do the same for British banks, and so on, all in the form of three-month loans at a fixed interest rate.

Although these loans would not ease any losses the banks could suffer from a government default, the initiative lubricates the European financial system, preventing temporary shortages of cash from further weakening banks and choking growth.

This step comes at an especially delicate time for the banks as they prepare for their year-end reports. Before they disclose their financial positions, banks have traditionally shifted some of their assets into cash and away from riskier choices as a way of buffing their appearance. This year, however, cheap dollars are increasingly hard to come by.

European banks have often raised dollars by borrowing from U.S. money-market funds. But those funds have cut back, responding in part to their own investors’ anxiety.

U.S. officials view the action as a way to support Europe’s efforts to contain its crisis while incurring no real risks to the United States. It is the other central banks that are extending loans to ailing European banks.

“The major European banks are having trouble funding themselves in dollars,” said Brian Bethune, an economist at Amherst College. “This puts that fire out but doesn’t solve the underlying problem of the financial institutions’ having large and unknown exposure to Greece and the other problematic countries like Portugal and Spain.”

The Fed previously provided dollars to European banks via swap lines on several occasions in 2008 during some of the worst periods of the financial crisis. This received little public attention in the United States during the Fed’s bailout of American International Group and the other extraordinary steps to salvage the financial system. But ECB President Jean-Claude Trichet has described the swap lines as critical to avoiding a much deeper crisis in the world banking system.

The new lending program comes as European leaders are struggling to reach agreement on how to address the debt crisis.

In Athens, the Greek cabinet held a tense meeting Thursday about budget cuts and further austerity measures that the European Union is requiring in return for providing more bailout money. German Chancellor Angela Merkel and French President Nicolas Sarkozy told Greek Prime Minister George Papandreou on Wednesday that they would support his country as long as it met the tough spending goals.

On Thursday, Merkel again criticized one tool that could help resolve the crisis: eurobonds that individual European governments could use to borrow money at a relatively low interest rate because the entire euro zone would stand behind them. Such eurobonds, which would rely heavily on Germany’s financial backing, are “absolutely wrong,” Merkel said, according to wire services.

Speaking at the Frankfurt Auto Show, she said that no “onetime thunderbolt” would do the trick and added that stabilizing the euro area would take time. But she stressed that her country had a “duty and responsibility” to secure the future of the euro.

European finance ministers are scheduled to meet Friday in Poland, and U.S. Treasury Secretary Timothy F. Geithner is to attend as an invited guest. He has been pushing senior European officials to take faster and more dramatic action to stem the chill spreading across the continent’s financial system.

European heads of state decided in July on new measures to address the threat of a government default. But those have yet to be put in place.

The session will give Geithner a chance to speak to the group and lobby individual ministers.