International Banking and Financial Market Developments - Third Quarter 2000
27 November 2000
Between summer and early autumn 2000, the climate in financial markets seemed to change from cautious optimism to unease. Equity and debt markets during the summer were sustained by macroeconomic data releases and policy measures signalling a more or less benign financial environment. In September, however, as macroeconomic and corporate earnings forecasts were revised downwards and oil prices continued to rise, market participants began to reconsider their earlier assumptions. In the equity market, a brief rally in August was decisively reversed in September, and the price decline continued in October. Unease spread to the corporate bond market, which saw wider credit spreads and increased scrutiny of highly leveraged issuers, including telecommunications firms. Spreads then rose on the debt of developing countries, partly in response to political uncertainty in several important borrowing countries.
In contrast to earlier episodes of widening credit spreads, growing credit concerns about non-financial companies have not been associated with a decline in market liquidity. Moreover, the recent stability of swap and liquidity spreads are a sign that fixed income markets are adapting to the declining supply of new government issues, after being preoccupied with the question for much of the first half of the year. Three special features - on market liquidity and stress, size and liquidity of government bond markets, and hedge funds - provide a longer-term perspective on factors affecting liquidity.
The international debt securities market
Despite rising credit spreads and turbulent equity and foreign exchange markets, net issuance of international debt securities in the third quarter of 2000 reached $259 billion, only slightly below that of the previous quarter. Corporations lacking triple-A ratings and European financial institutions slowed down their issuance. Nonetheless, aggregate fund-raising activity was maintained, in part because the US housing finance agencies took advantage of their high credit ratings to step up their issuance of long-term fixed rate debt. In contrast, telecommunications firms found that they could reduce the effect of credit spreads on their borrowing costs by issuing bonds that could be exchanged for equity. Other corporate issuers found similar advantages by issuing floating rate notes rather than straight fixed rate debt.
Net issuance in the US dollar was nearly double that in the euro. This marks a return to a long-standing pattern in the international debt securities market, whereby borrowers tend to issue in relatively strong or strengthening currencies. In 1999, when net issuance in euros exceeded that in US dollars despite the euro's weakening trend, this departure from the usual pattern may have been due to a desire by large issuers to "establish a presence" in the market for bonds denominated in the new currency. During 2000, and particularly in the third quarter, borrowers reverted to their former tendency and dollar-denominated net issuance rose to 57% of the third quarter total.
Developing country borrowers raised a net $7.8 billion from the international debt securities market in the third quarter, slightly more than in the second quarter and keeping issuance in the first three quarters close to last year's pace. Argentina, Brazil and Mexico were especially active issuers in the third quarter. However, the generally less favourable climate in international financial markets may portend a decline in issuance going forward.
The international banking market
International banking activity continued to expand in the second quarter of 2000, propelled by banks' purchases of securities and the return of Japanese banks to the international banking market. The cross-border claims of banks in the reporting area increased by $110 billion. This was stronger activity than the average for 1998 and 1999, although lower than in the first quarter when the rechannelling of funds through the interbank market to non-bank borrowers in Europe resulted in exceptionally large bank flows. Banks' securities purchases alone amounted to $129 billion in the second quarter. Claims on offshore centres increased modestly in the second quarter, but claims on developing countries turned negative again as repayments continued with little new borrowing.
Lending flows to non-bank borrowers slowed sharply in the second quarter, with US borrowers replacing euro area borrowers as the largest recipient group. The weakness of lending flows in part reflected a slowdown in syndicated lending to telecommunications firms in Europe. More recent data from the international market for syndicated credits suggest that direct lending to non-banks recovered in the third quarter. A surge in lending to telecom firms contributed to an exceptionally active third quarter in the syndicated credit market. A total of $324 billion worth of facilities were arranged.
Renewed lending from Japanese banks in the second quarter partially offset a fall-off in European banks' lending to non-bank borrowers. The cross-border claims of banks in Japan increased by $47 billion in the second quarter of this year, accounting for almost half of the $110 billion increase in the total claims of reporting banks. While past increases in international activity reported by banks in Japan tended to reflect inter-office transactions, the increase in the second quarter arose from transactions with unrelated borrowers.
Even though net repayments by developing countries bottomed out in the final quarter of 1999, no clear upward trend in bank lending to developing countries has yet emerged. Banks in the reporting area reduced their claims on developing country borrowers by a further $4 billion in the second quarter, with Asia experiencing the largest reduction. Nevertheless, claims on a select few developing countries, most notably Mexico and Turkey, continued to expand in the first half of 2000. Another notable development in the first half of the year was a sharp increase in deposit flows from developing countries to international banks, arising largely from an improvement in the external position of oil-exporting countries.
The most recent data published by the BIS on the global over-the-counter (OTC) derivatives market show a further significant increase in notional amounts outstanding in the first half of 2000. This contrasts with the pattern of activity seen on exchanges, where open interest increased modestly over the same period. The OTC market's growth was led by activity in forward-type contracts, particularly interest rate swaps, outright forwards and foreign exchange swaps. In terms of broad market risk categories, interest rate, foreign exchange and commodity contracts expanded at about the same pace while equity contracts declined.
The new data also reveal a number of developments cutting across the different risk categories. In the currency breakdowns, the data show a continued rise in the share of euro-denominated transactions, particularly in interest rate swaps, where the euro has extended its lead as the largest currency segment. At the same time, the rate of expansion of yen-denominated contracts slowed down considerably relative to the previous review period. The data also show that non-financial customers have become more prominent in the market. Among the different counterparties, business with non-financial customers expanded the fastest, although this business remains much smaller than that with other reporting dealers or with other financial institutions.
Market liquidity and stress
A feature article explores some of the issues raised by the perceived decline in market liquidity since autumn 1998, when turbulence engulfed financial markets in mature economies. Liquidity has attracted increasing attention on the part of market participants, central banks and regulatory and supervisory authorities. Of particular concern is whether a reduction in liquidity in a number of financial markets has made them more vulnerable to financial disturbances. In drawing lessons from past episodes of market turmoil, the note argues that the interaction of order imbalances with cash liquidity constraints and counterparty risk plays a critical role in the behaviour of liquidity at times of stress. Hence, both leverage and risk management procedures are especially important factors affecting liquidity. While some factors may contribute to liquidity in normal times, these can actually make markets more vulnerable under stress. The note concludes by considering some policy implications.
Size and liquidity of government bond markets
A second feature article analyses the importance of size for the liquidity of government bond markets. Most governments have revealed a common interest in fostering market liquidity and policymakers have regarded the size of the government securities market as a key consideration. In industrial countries where budget surpluses are shrinking debt, the authorities are trying to preserve liquidity by maintaining gross issuance in specific securities even as net issuance in all securities declines. At the same time, authorities in emerging market countries view growing debt as providing an opportunity to develop domestic bond markets. Such markets would help reduce not only the cost of borrowing but also reliance on overseas financing in foreign currency. Bigger is not always better, however. Where the supply of government debt is determined by deficits, any benefits from the emergence of government bonds as pricing benchmarks and hedging instruments can be lost if the government crowds out private borrowing.
Evolution of hedge funds
A third feature article describes some of the salient characteristics of hedge funds and discusses their apparent involvement in various episodes of financial market turmoil, culminating in the near failure of Long-Term Capital Management in September 1998. That episode highlighted the potential risks to financial markets from hedge fund activity and prompted a broad reassessment of the appropriate operating framework for this activity. It also affected the attitudes of counterparties, creditors and the industry itself towards the quantity and quality of information disclosed by hedge funds and the practices governing their business transactions. Since autumn 1998, some of the most celebrated hedge fund names have withdrawn from the front stage of the investment world and the macro fund sector has experienced a haemorrhage of investors' funds. Yet the hedge fund industry has continued to expand and is today an established part of the financial landscape.