BIS Quarterly Review, March 2001
5 March 2001
Signs of a slowdown cast a shadow over markets
During the fourth quarter of 2000, investors expectations of a slowing global economy contributed to a downward shift in yield curves, a widening of credit spreads and further declines in already weak equity markets. Market attention focused on the United States, where macroeconomic data reinforced the view that a slowdown was likely in the first half of 2001. Profit warnings and credit downgrades also weighed heavily on the equity and debt markets and signalled problems of excessive leverage in the corporate sector. Even the normally stable commercial paper markets experienced unusually wide and volatile credit spreads.
Market movements also revealed the extent to which the US outlook led to a re-evaluation of growth prospects in other regions. An appreciation of the euro suggested that investors viewed the European economy as likely to maintain momentum, although a downward shift in the euro swaps curve also indicated a potential exposure to the impact of a US slowdown. A depreciation of the yen and a decline in the Tokyo stock market reflected perceptions of a return to weaker growth in Japan. Divergent sovereign spreads corresponded to distinctions investors made in their judgments about the outlook for the emerging economies, with some countries seen as facing severe challenges and others as experiencing an uneven but persistent recovery from recent crises.
Markets in general turned around in January. A surprise 50 basis point reduction in the Federal Reserves target for the federal funds rate on 3 January 2001, followed by a further 50 basis point cut on 31 January, buoyed both the equity and bond markets, at least temporarily. A steepening of yield curves, a strong initial rally in equity markets and a narrowing of credit spreads all suggested that market participants expected any slowdown to be relatively brief. The easing of market conditions revived debt issuance by low-rated borrowers and emerging economies. By mid-February, however, equity markets had given up many of their gains, amidst new evidence of weakness in the earnings of technology firms.
The international banking market
The third quarter of 2000 saw emerging market countries deposit a record $54 billion with banks that report to the BIS. In contrast to the 1970s, when petrodollars deposited with international banks had supported an increase in cross-border lending to developing countries, recent deposit flows were not recycled back into those countries. Indeed cross-border claims on developing countries remained broadly unchanged in the quarter, with further repayments from Asia offsetting modest amounts of credit extended to Argentina, Brazil, Turkey and a few other emerging market countries. Developing countries access to the syndicated loan market continued to improve, with $34 billion worth of facilities arranged in the fourth quarter, the largest amount since 1997. However, this improvement has not yet resulted in a sustained increase in cross-border claims. Credit to industrialised countries accounted for most of the $184 billion increase in reporting banks cross-border claims in the third quarter. Lending to non-bank borrowers in those countries picked up again after having contracted in the second quarter. Much of this lending was related to drawdowns of large syndicated credits arranged for European telecommunications companies. Banks continued to purchase substantial amounts of debt securities and other assets issued by US and European residents. Japanese banks in particular were active buyers of US agency and corporate securities.
The international debt securities market
The deterioration in borrowing conditions in the fourth quarter of 2000 was reflected in the way funds were raised in the international debt securities market. While aggregate net issuance actually rose 21% from the previous quarter, reaching $328 billion, the increase was concentrated in the money market, where the widening of credit spreads was less pronounced. Moreover, issuance of long-term fixed rate instruments declined significantly, as lower-rated borrowers reduced their presence in the market. That issuing activity in the long-term market did not weaken more was due to the fact that highly rated European banks and US agencies continued to issue large amounts of debt. Also, there was apparently some front-loading of issuance by large borrowers who thought credit conditions might worsen further in the coming months. Net issuance by emerging market borrowers as a group also fell. In the face of wide sovereign spreads, Turkey and Brazil raised funds in the yen market to reduce borrowing costs. Some Asian countries faced relatively attractive spreads, but their current account surpluses gave them little reason to turn to the international debt markets for hard currency.
The dollar value of exchange-traded derivatives activity increased by 6% in the fourth quarter, with equity contracts leading the expansion. Driven by declines and volatility in the underlying cash markets, trading in derivatives on technology stock indices was especially buoyant. In particular, the value of turnover on the CBOEs Nasdaq 100 contract expanded by 77% in the quarter.
In the fixed income segment, an increase in the turnover of money market contracts more than offset a decline in government bond contracts, leading to a moderate increase in business. Aggregate activity in fixed income instruments has remained on the plateau reached in the third quarter of 1998, with some benchmark contracts gaining at the expense of others. In the US market, the long dominant Treasury bond contract lost ground to the 10-year Treasury note contract, reflecting shifts in the issuance of the underlying assets.
Benchmark tipping in the money and bond markets
A feature article sheds light on how the broad US dollar fixed income market might operate as the stock of US Treasury securities shrinks. The analysis draws parallels from the changing roles of Treasury and other obligations in the dollar money market in the 1980s. The author finds that the market followed a "tipping" process, in which market participants shifted from one benchmark to another, specifically from the Treasury bill to the eurodollar. More recently, bond market participants have shifted from government securities to swaps, with the Long Term Capital Management episode in 1998 playing a role similar to that of the run on Continental Illinois in 1984. The author explains the choice of swaps over other alternatives and argues that the shift might well have taken place even had there been no decline in the issuance of US Treasury securities.
Implementation of international standards
In the wake of recent financial crises, the development and implementation of standards to promote sounder policies and stronger institutional and market underpinnings have been central to the international communitys efforts to safeguard financial stability. Against this background, a second feature article discusses key elements needed for the implementation of such international standards. The article draws on the work of a task force established by the Financial Stability Forum in 2000 to help frame a strategy for supporting the implementation of standards. The main elements of this strategy include fostering country ownership, setting priorities, undertaking regular assessments, providing official and market incentives, and mobilising human and financial resources.