Liquidity is one of those things whose value is easily forgotten — until it’s gone. That’s a lesson that all financial firms have been reminded of in recent weeks as credit markets have seized up. What remains to be seen is how painful that lesson is for the rest of the economy.

After the late-summer turmoil in the credit markets, which saw the Bank of Canada and other central bankers add liquidity to the system, the market appears to be improving, says David Longworth, deputy governor of the Bank of Canada. “It’s not consistently better day to day,” he says, “but on a week-to-week basis, it is getting better.”

Nevertheless, he notes, the BoC has considered whether it should be doing more to return the credit markets to normal. Ultimately, though, it has decided that the best course of action is to let markets work things out for themselves.

“Markets, if they are working, can usually find — eventually — a way to work better as they gain confidence,” explains Longworth. “There’s always a danger that an intervention will actually replace the market, as opposed to boost the market.”

In the meantime, the BoC will concentrate on keeping monetary conditions ripe for recovery.

The latest evidence of credit-crunch pain has come in confessional statements from some large global financial institutions. In early October, U.S. financial giant Citigroup Inc. announced that it will be taking about US$5.9 billion in writedowns and losses on its exposure to troubled mortgage and credit markets. Third-quarter profits are expected to come in 60% lower than a year ago.

Similarly, Swiss banking giant UBS AG says that it is likely to record a third-quarter loss of between 600 million and 800 million Swiss francs because of its exposure to these same issues.

And Deutsche Bank says it will face writedowns of about 2.2 billion euros; but should still manage to turn in a quarterly pre-tax profit of about 1.2 billion euros.

The banks that have already issued warnings are scheduled to announce their actual results later this month. And in the meantime, analysts have been busily revising down their earnings estimates for other banks and brokerages that have yet to issue warnings but are believed to have problems of their own.

So far, Canada’s big financial institutions seem barely touched. Those that have suffered are those that are heavily involved with non-bank asset-backed commercial paper.

For now, the financial sector’s problems — although large and unwelcome in certain quarters — appear to be manageable. The big question for economists and policy-makers is to what extent these problems may spill over to the rest of the economy. Although the heavy losses appear to be fairly contained, the fact is that the turmoil in the financial markets has fostered wider credit spreads, which means financing becomes more expensive.

According to National Bank Financial Ltd. , the rate on three-month prime corporate paper is at its highest level since January 2001. And, NBF reports, short-term financing costs have increased by more than 70 basis points since the end of July. These conditions could start to bite corporate strategies and hit bottom lines. NBF points out that, between the higher funding costs and the stronger Canadian dollar, Canadian exporters are particularly suffering — and, it suggests, this could yet motivate the BoC to cut rates at its Oct. 16 meeting.

Ahead of that meeting, the BoC is not giving away much about its intentions. Longworth spoke to the Investment Indus-try Association of Canada in early October, stressing that the BoC’s primary objective remains keeping inflation low and stable. He says that the best thing the BoC can do for the credit turmoil to subdue inflation via its rate-setting activity and ensure that the overnight rate stays close to the BoC’s target.

Keeping the overnight rate near its target has taken some doing. Toward the end of September, the BoC stepped in to add liquidity through its special purchase and resale agreement (SPRA) mechanism to reinforce the target rate. It added around $1 billion per day in the last couple of days of September; and the need for liquidity injections continued into early October, albeit at progressively lower levels. The need for these injections, Longworth suggests, is due to technical factors largely unrelated to the credit crunch.

@page_break@Although when credit markets began showing signs of stress in early August, the BoC and various other central banks around the world did supply liquidity then, too, to ensure that markets remained functional. For a brief period, the BoC also relaxed collateral requirements for SPRA transactions in an effort to support liquidity. It reverted back to normal collateral requirements in early September, as markets seemed to be working better.

In fact, some analysts think that recovery is well underway already. CIBC World Markets Inc. has just increased the allocation to bonds in its recommended asset mix by two percentage points to 29%, dropping cash to just 3%, saying, “We are becoming more confident that the worst in credit markets may now be in the rearview mirror.”

Longworth doesn’t necessarily expect that there will be a definitive signal that credit markets have recovered. Nor is he willing to predict how long it might take to work out the problems. But, he suggests, once credit spreads narrow substantially, and the banks and investment banks have delivered all of their earnings confessions: “Then the probability of a significant worsening is probably a lot lower.”

Indeed, it’s this fear of the unknown that has played a part in the credit market disruption. This latest string of earnings warnings and analyst downgrades is really the second wave of troubles emanating from the credit market turmoil. The first wave was the losses that emerged in several hedge funds and other institutions based on their exposure to securitized products such as mortgage-backed securities and collateralized debt obligations with underlying subprime assets.

Those revelations led to the evaporation of liquidity as banks and others began scurrying to assess their possible demons. Banks grew nervous about how to value credit risk, and fears were sparked of counterparty risk (a major bank or broker might have fatal losses on its books). Longworth says that as more financial firms reveal their exposures, fears around counterparty risk should subside and credit spreads should finally narrow. For now though, firms are seemingly still engaged in what he terms “precautionary hoarding”. IE