G7 meets in white heat of Clinton crisis

Markets fear that political problems will swamp efforts to avert financial disaster

CITY traders arriving at their work stations tomorrow morning will keep one eye cocked on Washington, where President Bill Clinton is fighting impeachment, and the other on an emergency G7 meeting in London - called to tackle the Russian crisis.

"It's like 1974 when Watergate incapacitated the West's response to OPEC's oil price hikes," said Allied Kemper Financial analyst, David Hale. "There's a crisis of political leadership at a time of profound economic turmoil."

World stock markets were subdued on Friday after frightening falls on Wednesday and Thursday. The FTSE 100 Index closed down 18 at 5,119 after briefly dipping through 5,000. The Dow Jones Industrial Average closed up 180 points. or 2.4 per cent, at 7,795.

What traders will attempt to assess as they arrive in their offices is whether there are more market shocks to come or whether the time has arrived to begin assessing the damage against a manageable background of deteriorating sentiment and economic growth.

City sentiment is distinctly bearish. A Nomura economist, James Mitchell, said: "There is a growing risk of a recession in the US. If things get out of hand, it could last a few years."

City traders last week speculated about a co-ordinated cut in interest rates by the G7. The Federal Reserve chairman, Alan Greenspan, said in a speech in California a fortnight ago that the US central bank was no longer biased toward an increase in interest rates. On Wednesday, Japan cut a key interest from 0.5 per cent to 0.25 per cent, although a BT Alex. Brown currency strategist, Pippa Malmgren, dismissed the move as an emergency measure to shore up the Japanese banking system which is staggering under at least $500bn (pounds 300bn) of bad debts.

On Thursday, the Bank of England's Monetary Policy Committee announced there would be no change in the 7.5 per cent base rate this month, but hinted that it might cut rates in future if the international situation warranted it.

Still, even a cut in interest rates might not reverse City sentiment. "The UK and US can cut interest rates, but it would only stop the markets from falling for a while," Nomura's James Mitchell said.

Others worried that hints about interest rate cuts are being prompted by central bankers' fears that liquidity in the international financial system is drying up. The International Monetary Fund has insufficient reserves left to bail out Brazil, the largest economy in Latin America, now facing a run on its currency. There were also fears in the City last week that Western banks could get caught in the liquidity crunch.

On Friday, Lehman Brothers issued a statement asserting that it was financially sound after rumours swept the City and Wall Street that the US investment bank might be forced to file for bankruptcy.

But bankers said that several top Wall Street banks had suspended lines of credit to the firm. Russia's National Reserve Bank threatened legal action against Lehman before collecting $6m owed it.

"We did a yen-dollar swap with Lehman," said Yuri Kudimov, NRB's first deputy chairman. "When the yen fell against the dollar we made margin calls. When the yen came back against the dollar, we asked for the margin calls back. They refused." Lehman is understood to have now returned the cash.

In the face of turmoil on multiple political and financial fronts, investors have retreated to the safety of government bonds in their home markets. There has been a strong rally in US Treasuries over the past few days.

On Friday, the yield on Germany's benchmark 10-year government bonds fell to 3.99 per cent, the first time ever below 4 per cent.

If the political melodrama in Washington resolves itself in a restoration of confidence in the authority of the White House, and if the G7 meeting reassures investors that the industrial nations are making effective moves to stabilise the financial system and stem the panic in emerging markets, then the worst of the financial crisis could be over.