BIS Quarterly Review December 2004
6 December 2004
The BIS Quarterly Review released today is divided into two parts. The first analyses recent developments in financial markets, financing flows in banking and debt securities markets, and activity on derivatives markets. The second part presents four articles: one on new perspectives of country risk, another on the surge in foreign exchange trading as shown by the 2004 triennial survey, a third on the structure and development of the syndicated loan market, and a fourth on the nature of credit risk in project finance.
Markets rally as confidence returns
Improved macroeconomic data and the stabilisation of oil prices encouraged investors to become more optimistic about the strength of the global economy. Equity, credit and emerging debt markets all rallied in response to signs of a firming of growth, most notably in the United States, as well as a decline in risk aversion. By the end of November, many markets had approached the highs reached earlier in the year. Similar factors helped to drive volatility down to unusually low levels. A sharp run-up in oil prices interrupted the rally in October but equity and credit markets quickly rebounded when concerns about oil supplies eased. Not even the poor performance of corporate profits relative to expectations seemed to dampen investors' confidence.
Despite unexpectedly strong macroeconomic releases in the United States in November, the US dollar fell to new lows against many currencies. The catalyst for the drop seemed to be renewed concern about the US current account deficit. The depreciation of the dollar and differing trends in growth expectations caused yen and especially euro bond yields to diverge from dollar yields to a greater extent than they had earlier in the year.
The international debt securities market
Issuance of international debt securities in the third quarter of 2004 slowed for the second consecutive period, albeit from an exceptionally high level. Gross bond and note issuance fell to $755 billion from $771 billion in the second quarter, and net issuance (after repayments) to $307 billion from $348 billion. The slowdown was to some extent seasonal, reflecting the usual decline in borrowing by governments in the euro area in the second half of the year. Refinancing activity remained strong, as borrowers took advantage of low long-term interest rates to reduce their financing costs. Borrowing by lower-rated entities also remained robust, fuelled by the narrowing of spreads on high-yield bonds during the third quarter. The more settled interest rate environment supported a moderate shift from floating to fixed rate structures.
Borrowing by emerging markets in the international debt securities market remained on track to equal its previous high of 1997. Gross bond and note issuance in the third quarter totalled $35 billion, comparable to the amount raised in the second quarter. However, more than half of these funds were used to repay maturing debt, resulting in a decline in net issuance in the third quarter. Asian borrowers were again the most active, with the Philippine government raising $1.4 billion even as its spreads moved wider. Some emerging market issuers, particularly Latin American sovereigns, made use of the opportunity provided by the receptive market environment to extend the maturity of their international debt.
After remarkably strong activity in the first half of 2004, the turnover of exchange-traded derivatives contracts declined by 5% in the third quarter, to $288 trillion. This decline appeared to be driven by a convergence of views about the likely path of monetary policy in the major economies after the first increase in US policy rates in June. The turnover of stock index derivatives fell the most, by 11%, followed by interest rate derivatives, down 5%. By contrast, activity in currency derivatives rose by 10%.
Activity in commodity markets also fell during the third quarter, with the number of contracts traded declining by 11%. Non-precious metals, precious metals and agricultural products were all down in turnover terms. The one exception to the general trend was energy derivatives, where turnover rose by 8%. The volatility of oil prices appears to have led to an increase in the use of oil derivatives for speculative and hedging purposes.
The international banking market
Following an exceptionally large pickup in the first quarter of 2004, cross-border activity in the international banking market was subdued in the second quarter. The sharp rise in long-term yields in the major economies during the second quarter apparently led investors to unwind positions and shorten the duration of their fixed income portfolios. This appears to have contributed to a decline in credit to non-bank borrowers, especially securities firms in the United States.
Credit from banks in the reporting area to emerging markets exceeded placements of deposits for the first time in several quarters. This resulted in a net inflow of $4 billion to these markets. The largest inflows went to Asia, driven by a further increase in lending to the region. The largest outflows were from Latin America, reflecting repayments and writedowns of loans. Despite the high level of oil prices, oil-exporting countries withdrew deposits from banks in the reporting area in the second quarter. Over the past three years, oil revenues have not been channelled into the international banking system to the same extent as they were during previous periods of rising oil prices. Furthermore, a growing share of deposits from oil-producing countries has been denominated in currencies other than the US dollar, most notably the euro.
Assessing new perspectives on country risk
A number of new perspectives on country risk have come to prominence in recent years. One perspective focuses on the impact of a country's history of economic mismanagement on its ability to sustain debt ("debt intolerance"), another on the ability of a country to borrow abroad in its own currency ("original sin"), and a third on the sensitivity of a country's net worth to exchange rate fluctuations ("currency mismatches"). Claudio Borio and Frank Packer of the BIS explore the empirical relevance of these perspectives, using sovereign credit ratings as a proxy for country risk. They improve on existing statistical tests by controlling for a broader set of factors that might affect country risk and by employing better data, in particular drawing on the BIS banking, securities and derivatives statistics. They find evidence supporting various aspects of the three perspectives but note a number of qualifications and open questions. They conclude that sound domestic macroeconomic and structural policies hold the key to addressing country risk.
Why has FX trading surged? Explaining the 2004 triennial survey
According to the latest Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, turnover in traditional foreign exchange markets averaged $1.9 trillion a day in April 2004. This represents a 36% increase in activity (at constant exchange rates) compared to April 2001 and more than reverses the fall in global trading volumes between 1998 and 2001. Gabriele Galati of the BIS and Michael Melvin of Arizona State University analyse the factors behind this surge in activity. They emphasise the importance of momentum trading and carry trades by institutional and leveraged investors, largely motivated by a search for yield. Hedging activity also appears to have supported the surge in turnover, as firms and investors sought to protect themselves against an expected depreciation of the US dollar.
The syndicated loan market: structure, development and implications
Syndicated loans are hybrid instruments combining features of relationship lending and publicly traded debt. They allow the sharing of credit risk between various financial institutions without the disclosure and marketing burden that bond issuers face. Syndicated credits are a very significant source of financing, accounting for no less than a third of funds raised in international debt markets. Blaise Gadanecz of the BIS analyses the development and functioning of the syndicated loan market, focusing on major participants, pricing mechanisms, primary market origination, secondary market trading and geographical integration.
The nature of credit risk in project finance
Infrastructure projects usually require lenders to commit financing for much longer maturities than is typical for other types of syndicated loans. This is because large-scale capital-intensive projects require substantial investments up front, whereas revenues sufficient to cover their costs are only generated in the long term. While, for most forms of debt, credit spreads increase with maturity, Marco Sorge of the BIS finds that this is not necessarily true of project finance loans. Even controlling for guarantees at the long end, the term structure of spreads on such loans is hump-shaped, suggesting that longer-maturity project finance is not necessarily perceived by lenders to be more risky than shorter-term credits. In emerging markets, political risk guarantees offered by multilateral development banks or export credit agencies significantly reduce spreads on longer-term project loans.