World markets tumble on OECD warning

MARKETS in Europe and the US fell into triple-digit declines last night after the Paris-based Organisation of Economic Co-operation and Development (OECD) said the recent subprime mortgage crisis would cut world and US economic growth.

The respected think-tank said in its mid-point assessment that the world's seven leading economies - the G7 - would grow by just 2.2 per cent this year, down 0.1 of a percentage point on earlier predictions. Growth will fall to 2.0 per cent in Q3 and 1.5 per cent in Q4 from the 4 per cent between April and June.

Jean-Philippe Cotis, the OECD's chief economist, warned that the risks of even lower growth were "ominous" given that financial market conditions were likely to remain tighter, adding it was clear there was a need for improved regulation to correct "serious imperfections" in both the US housing and global financial markets.

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He said this should include a more active fight against "predatory lending", as well as "more pugnacious" rating agencies.

The report was published as new figures from the US National Association of Realtors showed that contracts for future US home sales fell to a six-year low in July, illustrating the continuing weakness in the market, down 12.2 per cent on the month before and 16.1 per cent lower than July 2006.

Cotis added that the OECD now expected the US to grow at 1.9 per cent, against earlier projection of 2.2 per cent, as the housing sector exerted a "longer and more potent-than-expected drag".

He recommended that the Federal Reserve cut interest rates immediately by a quarter percentage point to limit the fallout from a housing and mortgage market slump, but without going so far as to give foolhardy investors the idea that public authorities would always be there to bail them out by cutting the cost of credit.

He also said interest rates should not be raised for the moment in Japan or the 13-country euro currency zone.

Cotis emphasised that the OECD was not predicting a US recession, but was not discounting the possibility either.

"Our diagnosis is a slowdown," Cotis said, conceding that the downturn was bigger than the OECD had expected. "We cannot rule out a recession," he added.

Turning to Europe, the OECD said its leading economies were less vulnerable to a housing-led slowdown. This was because their mortgage markets had fewer structural "imbalances" while inflationary pressures were generally lower.

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As a result, the transatlantic economic impact of a US slowdown would not be as severe as that following the dot-com crisis at the start of the decade.

"We don't think there will be the same extent of contagion in Europe as in 2001," Cotis said in the report.

However, Cotis added that the case for further rises in European Central Bank rates for the eurozone was valid, but not until it became clearer how the gyrations in fragile and fear-riven financial markets would pan out over time.

"For now, 'stay put'," he said of rate policy ahead of today's meeting of the ECB, which has been steadily raising rates since December 2005 as the economy of the eurozone began to pull out of the doldrums.

He offered no advice to the Bank of England on interest rates, which is also making its decision today, but raised the growth forecast for Britain markedly, to 3.1 per cent from 2.7 per cent.

Bank of England prepared to offer UK banks 4.4bn lending facility

THE Bank of England has come to the rescue of British banks suffering liquidity problems, offering to pump an extra 4.4 billion into the system on top of the 17.6bn already requested for the next month.

The Bank also announced a significant relaxation of the rules governing the way it lends short-term funds to banks.

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"The increase in reserve balances should help to relieve some pressure on interest rates for overnight borrowing which have, at times over the past month, been unusually high relative to Bank Rate," it said.

The crisis sparked by the US subprime mortgage disaster has led to a liquidity famine among banks, which have been hoarding their own cash and liquid assets and have been reluctant to lend to one another.

The three-month interbank interest rate, LIBOR, has now climbed to almost 6.8 per cent, more than a percentage point above the 5.75 per cent base rate.

The central bank said it will also pay interest on excess funds kept in commercial banks' accounts with it at the end of the monthly reserve period, a break with the usual practice of not paying interest on any extra money held in reserve that may encourage banks to borrow from it even if they don't expect to use the money. The Bank said the new measures were not intended to narrow the gap between LIBOR and the base rate.

"The source of these problems does not lie in a lack of central bank liquidity," it said, adding that the problem was down to "the difficulty of valuing a variety of asset-backed instruments", a reference hundreds of billions of dollars worth of mortgage-backed securities whose value may have been hit by the subprime setback.

It is the first time the Bank has moved to appease credit markets since the subprime crisis. The measures stop short of those taken by the European Central Bank and the Federal Reserve, which added emergency funds to markets between 9 and 14 August.

Tom Vosa, the director of economic research at National Australia Bank in London, said: "They've done the minimum to make sure markets keep functioning without creating moral hazard. They have essentially told banks that three-month rates aren't something they have to deal with. Those will return to normal when banks decide there aren't any more dead bodies out there."