30 June 2008
After a number of years of strong global growth, low inflation and stable financial markets, the situation deteriorated rapidly in the period under review. Most notable was the onset of turmoil in the US market for subprime mortgages, which rapidly affected many other financial markets and eventually called into question the adequacy of capital at a number of large US and European banks. At the same time, US growth slowed markedly, reflecting setbacks in the housing market, while global inflation rose significantly under the particular influence of higher commodity prices.
This sudden change in financial conditions was blamed by some on shortcomings in the extension of the long-standing originate-to-distribute model to new mortgage products in recent years. Others, however, noted that the sudden deterioration in both financial and macroeconomic conditions looked more like a typical “bust” after a credit “boom”. Indeed, several factors seem to support this second hypothesis: the previous rapid growth of global monetary and credit aggregates; an extended period of low real interest rates; the unusually high price of many assets (both financial and real); and the way in which spending patterns in different countries (the United States and China in particular) reflected their different stages of financial development (encouraging consumption and investment respectively).
While central banks in all the major financial centres took action to reliquefy financial markets, the setting of policy rates diverged markedly in light of domestic macroeconomic circumstances. Some central banks were more concerned about actual inflation and raised policy rates, whereas others focused on the disinflationary pressures likely to emerge as growth slowed, and lowered policy rates instead.
Chapter II: The global economy
The global economy has slowed since the second half of 2007 against the backdrop of the financial turmoil and a deepening US downturn. At the same time, global inflation has risen, led by rapid increases in prices of energy and key food items. The current consensus view is still that the global economy will slow only modestly further in 2008. Developments up to the first quarter have been broadly consistent with this view as growth in the euro area, Japan and major emerging market economies continued to be strong.
Unfolding developments at the core of the global financial system have, however, also created great uncertainty about future economic prospects. Banks in several advanced industrial economies have been tightening lending standards, and thus a generalised squeeze in the availability of credit remains a distinct possibility, with potentially more severe implications for demand than are reflected in consensus forecasts. These developments have been compounded by the recent rapid rise in oil prices and increased inflation expectations in a number of major economies.
The extent to which households with overstretched balance sheets in the United States and some other advanced industrial economies will have to retrench in the face of these negative shocks is hard to predict. While a substantial rise in US household saving could bring about a further sizeable reduction in the US current account deficit, it would do so at the price of weakening demand in the rest of the world. At the same time, inflation risks are greater than they have been for many years.
Chapter III: Emerging market economies
Growth in emerging market economies (EMEs) last year once again significantly exceeded that in the rest of the world. Foreign currency inflows were large, reflecting continued growth in current account surpluses and capital inflows in 2007. Nevertheless, the potential knock on effects of financial market turmoil in the major centres increased the risk of a slowdown in EMEs. At the same time, recent increases in headline inflation have caused inflation targets to be breached in many EMEs, reflecting the impact of steep increases in oil and food prices. As in the advanced industrial economies, these conflicting forces have created a major dilemma for monetary policy. Efforts to resist currency appreciation have introduced additional complications, having been associated with a sharp increase in foreign reserves and in credit growth in a number of EMEs.
Developments in the advanced industrial economies could also pose major challenges. First, a pronounced slowdown in the United States would hurt the EMEs which, although remarkably resilient so far, still depend significantly on external demand. Second, tighter conditions in global financial markets could constrain EMEs with large current account deficits, particularly those relying on more volatile portfolio financing. Countries heavily dependent on cross-border bank borrowing could also be especially vulnerable.
Monetary policy in the advanced industrial economies faced two conflicting challenges during the period under review. On the one hand, tensions in financial markets threatened to spill over into the real economy by way of tighter credit conditions and a loss in confidence. On the other hand, inflationary pressures that stemmed from rising commodity prices, together with high capacity utilisation and tight labour markets in many economies, threatened to feed into longer-term inflation expectations. Differences in the manifestation of these challenges across countries and regions can explain, at least in part, why central banks dealt with them in different ways. For example, the Federal Reserve reacted forcefully by cutting its policy rate from 5.25% to 2%, whereas the ECB and the Bank of Japan kept their policy rates unchanged.
Changes in interest rates were only one measure through which central banks responded to the dislocation in financial markets. Even before the turbulence led to any changes in policy targets, central banks in several countries had adjusted their operations in a number of extraordinary and unprecedented ways to keep reference rates near targets and to provide financing in markets where liquidity had evaporated. The various types of operations and the reasoning behind them are discussed in the final section of the chapter.
Chapter V: Foreign exchange markets
Foreign exchange market volatility picked up sharply in the latter half of 2007 and has remained at elevated levels since. This was associated with a faster rate of decline of the US dollar as well as a substantial appreciation of the euro, yen and Swiss franc. As carry trades became less attractive, expected growth differentials became more of a focal point for market sentiment than prevailing levels of interest rates. While exchange rate policies continued to shape the behaviour of some emerging market currencies, developments in commodity prices and specific trends in capital flows also exerted a considerable influence on exchange rates.
Notwithstanding some significant exchange rate movements and tensions in certain foreign exchange swap and cross-currency swap markets, foreign exchange spot markets generally continued to function smoothly throughout the period of higher volatility. From a longer-term perspective, there have been a number of notable developments that could potentially have a bearing on the resilience of foreign exchange markets. These include higher turnover, greater diversity in foreign exchange market activity and improvements in the risk management infrastructure. While generally positive, it is possible that the full implications of these developments for market dynamics at times of stress have not yet become apparent. It is important, therefore, to sustain the impetus for better risk management practices in foreign exchange markets going forward.
Chapter VI: Financial markets
During the period from June 2007 to mid-May 2008, concerns over losses on US subprime mortgage loans escalated into widespread financial stress. What initially appeared to be a contained problem quickly spread across other credit segments and broader financial markets to the point where sizeable parts of the financial system became largely dysfunctional. Surging demand for liquidity, coupled with growing concerns about counterparty risk, led to unprecedented pressures in major interbank markets, while bond yields in advanced industrial economies tumbled as investors sought safe havens amid fears that economic growth would weaken. Equity markets in advanced industrial countries were also weak, with financial shares selling off particularly sharply. A brighter spot was emerging financial markets, which in contrast to previous episodes of broad-based asset market weakness proved to be more resilient than those in the advanced industrial economies.
The financial market turmoil unfolded in six stages, starting in mid-June 2007: (i) a dramatic widening of spreads on subprime mortgage products following large-scale rating downgrades on mortgage-backed securities and the closure of a number of hedge funds with subprime exposure; (ii) the extension of the sell-off to a wide variety of credit and other markets from mid-July, including structured products more generally; (iii) the expansion of the turmoil into short-term credit and, particularly, interbank money markets from end-July; (iv) broader problems for the financial sector from mid-October, including for companies acting as financial guarantors; (v) increasingly dysfunctional markets, against the backdrop of a marked worsening of the US macroeconomic outlook from early 2008, accompanied by rising fears about systemic risks which caused spreads of even the highest-quality assets to move out to unusually wide levels; (vi) recovery, except in the interbank term market, in the wake of the Federal Reserve-facilitated takeover of a troubled US investment bank in March 2008.
Several years of growth and enhanced profitability for financial firms came to an abrupt halt during the period under review as strains stemming primarily from exposures to residential real estate spread throughout the financial system. What had started as a problem specific to the US subprime mortgage market became a source of outsize losses for financial firms worldwide on their holdings of related securities. Uncertainty about the size and distribution of losses was exacerbated by the complexity of the new structures used in the securitisation process. Retrenchment from risk-taking led to illiquidity, exposing weaknesses in the funding arrangements of many financial firms. Indeed, the situation was punctuated by the near failure of sizeable financial firms, prompting intervention by the public sector to avert potential systemic repercussions from a disorderly collapse.
With many financial institutions nursing weakened balance sheets, even as the macroeconomic environment continues to worsen, a turn in the credit cycle seems likely to imply persistent headwinds for economic activity. How the situation will evolve depends critically on the dynamic interactions between the financial sector and the macroeconomy. Reduced credit availability, due to efforts by the financial sector to preserve its capital base, could prolong the period of weak profitability by affecting aggregate spending, economic activity and asset quality. These effects could also be transmitted across borders if weakened banking systems tend to cut back on their international exposures. Beyond the cyclical implications, this period of intense stress also heralds some structural shifts. Financial firms are revisiting assumptions that supported a move towards a business model focused on origination and distribution of loans through securitisation. At the same time, policymakers are reviewing aspects of the prudential framework that failed to perform as intended.
Chapter VIII: Conclusion: the difficult task of damage control
In the aftermath of a long credit-driven boom, it would not be surprising to see turmoil in financial markets, slowing real growth and temporarily rising inflation. The crucial questions at the present juncture have to do with the severity of these individual trends as they now appear and how they might interact. While difficult to predict, their interaction does appear to point to a deeper and more protracted global downturn than the consensus view seems to expect. At the same time, inflationary forces, particularly in emerging market economies, could also prove unexpectedly strong and persistent. A major factor in inflation prospects everywhere is likely to be the behaviour of wages, but in some countries the effect of a depreciating exchange rate on domestic prices could also play an unwelcome role.
With inflation a clear and present threat, and with real policy rates in most countries very low by historical standards, a global bias towards monetary tightening would seem appropriate. That said, the circumstances of different countries, both actual and prospective, currently rule out a "one size fits all" response. Moreover, should the global economy slow sharply and inflationary pressures recede, the bias to tightening would evidently also be reduced.
In the current and prospective environment, it should nonetheless be borne in mind that the effectiveness of a lowering of policy rates might be significantly reduced in the aftermath of a credit-induced spending boom. In view of the potential negative side effects of such a policy, not least the risk of encouraging further financial imbalances and misallocations of real resources, complementary policies might be envisaged to avoid overburdening monetary easing. Expansionary fiscal policy could have some merit, but in many countries current debt levels mean there is little room for manoeuvre. Steps to recognise and deal with losses and debt overhang problems, in a timely and orderly way, and subject to conditionality, must then be a high priority.
Perhaps the principal conclusion to be drawn from today's policy challenges is that it would have been better to avoid the build-up of credit excesses in the first place. In future, this could be done through the establishment of a new macrofinancial stability framework, which would call for both monetary and macroprudential policies to "lean against the wind" of the credit cycle. Recognising that cycles can be attenuated but not eliminated, a number of preparatory steps are also suggested that would allow periods of financial turmoil or crisis to be more effectively managed.
This chapter provides an overview of the internal organisation and governance of the Bank for International Settlements. It also reviews the activities of the Bank, and of the international groups it hosts, over the past financial year. These activities focus on promoting cooperation among central banks and other financial authorities, and on providing financial services to central bank customers.
Many of the Bank's activities were refocused in the second half of the year to deal with the financial market turmoil that emerged in August 2007. In addition to an acceleration and modification of committees' work plans, other notable responses to the turmoil were:
Furthermore, the BIS took a number of measures in its banking and risk management activities to address the challenges that have emerged as a result of the financial turmoil.
The Bank's balance sheet grew to SDR 311 billion (USD 511 billion) at end-March 2008, representing a year-on-year increase of 15%. Some SDR 236 billion (USD 388 billion) of official foreign exchange reserves are deposited with the BIS, around 6% of the world's total. Net profits for the Bank's 78th financial year amounted to SDR 545 million (USD 847 million), compared with SDR 619 million (USD 920 million) in the preceding year.