Policymakers struggle to restore market composure

By Jamie McGeever and Vidya Ranganathan

LONDON/SINGAPORE (Reuters) - Central banks struggled to restore confidence on financial markets for a third day running on Wednesday after the United States agreed to rescue insurance giant AIG, the latest casualty in a crisis sweeping Wall Street.

Asian central banks ploughed extra liquidity into short-term funding markets, although central banks in Europe took their foot off the pedal amid signs of respite to some of the sharpest surges in short-term borrowing costs of the previous two days.

Dominique Strauss-Kahn, head of the International Monetary Fund, said there could well be more trouble yet in what former U.S. Treasury Secretary Robert Rubin called "the worst crisis since the 1930s."

"The consequences for some financial institutions are still in front of us," Strauss-Kahn told reporters in Jeddah after talks with Gulf Arab finance ministers and central bank governors.

Overnight, news broke that the U.S. authorities had come up with the rescue of American International Group (AIG) just two days after choosing to let investment bank Lehman Brothers file for bankruptcy.

The bailout, in which the New York Federal Reserve offers up to $85 billion in loans in return for a stake of nearly 80 percent in AIG, sparked a recovery in stock markets from Asia to Europe from the losses of previous day after it was announced.

COUNTING THE COST

But interbank lending and credit markets remained stressed.

The bank-to-bank cost of overnight borrowing in dollars fell more than a percentage point but it rose for longer three-month funding, according to the latest London interbank offered rate (LIBOR) published by the British Bankers Association.

Overnight dollar Libor was fixed at 5.03125 percent compared with 6.43750 percent on Tuesday.

Earlier, such funding was quoted as costing nearer 8 percent in Europe, after levels in excess of 10 percent on Tuesday.

For three-month funding, however, LIBOR fixed almost 20 basis points higher at 3.06250 percent, versus 2.87625 percent on Tuesday.

The AIG bailout pushes the tab to more than $900 billion so far in government rescues and mortgage market intervention since the housing and sub-prime mortgage markets collapsed, triggering a global credit crunch that is now in its second year.

German Chancellor Angela Merkel joined a lengthening list of political leaders expressing belief or hope that Europe would be spared some of the economic pain which is likely to follow the troubles of the big financial institutions.

"The effects until now on the real economy in Germany have been moderate," she told parliament. "However, an open economy like Germany's will not be able to escape completely unscathed."

In Britain, HBOS Plc bank confirmed it was in advanced talks that may lead to a takeover by domestic rival Lloyds TSB . News of the talks surfaced after shares in HBOS, Britain's biggest home mortgage lender, were battered for a sixth consecutive day due to fears about its funding position.

ASIA PUMPING, RUSSIA SHAKING

Japan, Australia and India pumped $33 billion into money markets on Wednesday. Across Asia, which has been largely shielded so far from the worst of the credit crisis, central banks were bracing for more market turmoil.

The Bank of Korea warned that foreign funds would keep flowing out of the domestic bond market.

India added an extra money market operation to improve banks' access to funds while Taiwan made lending easier by lowering the ratio of time deposits banks must keep in reserve on Tuesday.

Australia's central bank supplied the banking system with extra cash for the third day, more than doubling the previous day's injection to A$4.285 billion ($3.4 billion).

The Bank of Japan pumped 3 trillion yen ($28.58 billion) into the market in two moves, matching a record from March 31, after overnight rates jumped above 0.7 percent, 20 basis points higher than the central bank's target rate.

Bank of Korea Governor Lee Seong-tae said the credit crisis triggered last year by U.S. mortgage defaults would drag on and hurt the global economy. "We need to prepare for potential foreign fund outflow from the bond markets in the medium term," he said.

Capital has been fleeing emerging markets as investors stung by the upheaval on Wall Street shun risky assets. Seoul has spent more than $30 billion this year to support the won, which has tumbled 17 percent in 2008 against the dollar.

Russia looked particularly fragile. Russian stocks plumbed new lows in the worst decline in at least a decade and the central bank injected a record 340 billion roubles of one-day funds in a Wednesday repo auction.

Trading on Russia's MICEX <.MCX> and RTS <.IRTS> exchanges was suspended after their indexes tumbled 10 and 6 percent respectively on the day, reversing earlier gains and marking the biggest percentage fall for the MICEX index since the Russian financial system collapsed in 1998.

(Writing by Brian Love, with reporting by correspondents across Asia, Europe and Middle East; editing by David Stamp)

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