Quarterly Review, December 2006
11 December 2006
The BIS Quarterly Review released today is divided into two parts. The first presents an overview of recent developments in financial markets, before turning in more detail to highlights from the latest BIS data on international banking and financial market activity. The second part presents five special feature articles: one on tracking capital flows in the international banking markets; another on the internationalisation of a currency and lessons from the Australian experience; a third on the structure of housing finance markets and house prices in Asia; a fourth on the role of government-supported housing finance agencies in Asia; and a fifth on corporate credit guarantees in Asia.
Markets anticipate an orderly slowdown
While at times sending mixed signals, markets appeared to be largely optimistic about global economic prospects and the likelihood of a soft landing for the US economy. Prices of risky assets increased in most markets from September to late November. In contrast, government bond yields struggled to find direction as investors reacted to conflicting news about growth prospects and the outlook for monetary policy, in particular in the United States.
This general confidence could also be discerned in the behaviour of a number of market indicators. In mid-November, implied volatilities in bond and stock markets reached their lowest levels in years, while measures of risk appetite showed that the retrenchment by investors after the sell-off in May and June had been largely reversed. Not even events such as the reported $6 billion loss by a large hedge fund or several instances of political instability in emerging markets in September seemed to dent investors' confidence.
The overall positive sentiment among market participants was briefly tested in late November, when sharp movements in the foreign exchange market and a string of data surprises led to abrupt declines in many risky asset prices. While losses in many markets were subsequently largely recouped, implied equity market volatilities at end-November remained above earlier levels, albeit low by historical standards.
Highlights of international banking and financial market activity
In the international debt securities market, gross issuance was robust at $1.1 trillion in the third quarter of 2006, even as net issuance of bonds and notes slowed more than normal seasonal patterns would have suggested, to $506 billion. The United Kingdom was one of the few developed countries to see strong growth in net bond and note issuance. This was consistent with the longer-term trend which has seen the United Kingdom account for an increasing proportion of international debt. Issuance by emerging market sovereigns was also firm in the third quarter, on both a gross and a net basis.
Activity on the international derivatives exchanges slowed in the third quarter of 2006. Combined turnover of interest rate, currency and stock index derivatives fell by 4% to $465 trillion between July and September. Much of the slowdown appeared to be related to seasonal factors, which tend to depress trading in interest rate contracts in the second half of the year.
The volumes outstanding of over-the-counter (OTC) derivatives expanded at a very brisk pace in the first half of 2006. Notional amounts of all OTC contracts stood at $370 trillion at the end of June, 24% higher than six months before. Growth in credit default swaps (CDSs) was particularly strong; positions in these instruments increased by 46%. The rate of increase in this segment would have been even higher had it not been for a rise in the volume of multilateral terminations of such contracts.
In the international banking market, the total stock of cross-border claims of BIS reporting banks increased by 15% year-on-year in the second quarter of 2006 to $24 trillion. The pace of expansion was more modest than in previous quarters, amidst decelerating growth in the claims of banks in the euro area and the United Kingdom. At the same time, the growth in net claims on emerging market countries turned positive for the first time in five quarters. The stock of yen-denominated claims decreased for a second consecutive quarter, primarily as a result of a reduction in claims of banks located in the United Kingdom, offshore centres and the euro area.
The consolidated banking statistics, which are compiled according to the nationality of reporting banks and net out inter-office positions, show an expansion of foreign claims in the second quarter of 2006. This was largely driven by Dutch, French and German banks. Measured on an ultimate risk basis, banks in the BIS reporting area raised their exposures to most countries, despite the broad sell-off in financial markets during May and June. Lending through local offices continued to be an important phenomenon, accounting for more than 40% of reporting banks" foreign claims.
Activity in the international banking market has grown rapidly in recent years, both in absolute terms and relative to aggregate measures of economic activity and liquidity. Drawing on the BIS international banking statistics, Patrick McGuire and Nikola Tarashev of the BIS highlight the network of bilateral linkages between international banking centres or particular regions, and go on to analyse the net flow of bank credit between ultimate lenders and borrowers. The authors show that an increasingly significant amount of these flows is channelled through banks in international banking centres such as the United Kingdom, and in Asian and Caribbean offshore centres. They also document the extent to which regional external positions, as captured by current account balances, covary with financing flows through the international banking system.
Many policymakers in Asia are giving greater consideration to allowing their currencies to be used by non-residents. Relying in part on BIS data to measure the internationalisation of a currency, Robert McCauley of the BIS documents that the Australian dollar is more internationalised than most. Tracing the transition of the currency in the late 1970s and 1980s from initial insularity to its current state, he argues that strong domestic bond and money markets, an active currency swap market and the offer of a yield pickup were important in the currency's internationalisation. The author conjectures that internationalisation may have led on balance to a stronger currency and lower yields, as well as to a heightened covariation of bond yields with those of other major markets.
Over the past decade, emerging Asia has witnessed rapid growth of private housing and market-based housing finance. In an analysis of the structure of housing finance markets in the region, Haibin Zhu of the BIS documents that market development – as captured by characteristics such as contractual arrangements, overall market infrastructure and market liquidity – has been uneven across countries. The author presents econometric evidence that, in those economies with more flexible housing finance markets, house prices are more responsive to overall changes in market conditions, particularly equity price movements. He concludes that the development of a more flexible housing market facilitates transactions and may enhance the role of housing as a tradable investment asset.
A number of countries in Asia have established government housing finance agencies, in part to help develop their domestic housing finance markets and associated bond markets. Eric Chan and Jacob Gyntelberg of the BIS and Michael Davies of the Reserve Bank of Australia examine the role, mandates and risk management practices of five such housing finance agencies in Asia. They document that in many cases housing agencies have helped to eliminate barriers to securitisation, initiated more systematic issuance of mortgage-backed securities (MBSs), and improved access to housing finance for households. The authors also note that several of the housing agencies have recently broadened the scope of their operations by providing mortgage insurance on loans and credit enhancement on MBSs. However, the overall risks assumed by the agencies still appear small relative to the economy as a whole.
In many Asian countries, government institutions have played an important role in guaranteeing loans extended to small and medium-sized enterprises. In a review of the public institutions that guarantee corporate credit in selected Asian countries, Ilhyock Shim of the BIS documents lacklustre operating performance at most of these institutions across a number of measures. Two failures of guarantee companies in the region highlight the importance of sufficient capitalisation and prudent risk management, as well as the difficulty borrowers have in making a transition away from reliance on credit guarantees. The author concludes that the effects of guarantees on borrower and lender incentives should be carefully considered in the design of guarantee institutions.