Quarterly Review, June 2007
11 June 2007
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 four special feature articles: one on the bond market term premium; another on the BIS statistics on payments and settlements; a third on recent episodes of credit card distress in Asia; and a fourth on liquidity in the Brazilian domestic government bond market.
Markets rebound after sell-off1
Global financial markets quickly recovered following a sell-off in late February and early March 2007, and valuations in many asset classes headed for new highs. In this environment, government bond yields in major industrialised economies rose between late February and the beginning of June. Euro yields increased the most as the outlook for economic growth in the euro area improved further. US yields were slower to display a sustained rise, reflecting investors' gradual upward adjustment of the US economic outlook, which gathered pace only towards the end of the period under review. In addition to the effects of perceived improvements in growth prospects, increasing term premia contributed to the rise in bond yields.
The rally in global equity markets continued during the period, despite the broad market repricing in late February and early March. Although brief, the bout of turbulence lifted implied volatilities in most markets from their near historical lows. Nonetheless, the major US and European equity indices quickly recovered, reaching fresh six-year highs by mid-April. In contrast, the rally in Japanese equity markets, which had started in November 2006, stalled during the period under review.
Credit markets were somewhat slower to recover from the sell-off than equities. By end-May, however, US dollar and euro credit markets had more than recouped their losses, with high-yield credit spreads touching new lows in some markets. While the spillover from the problems in the US subprime housing market was thought to be limited, investors remained concerned about the effect that further problems might have in some CDO markets.
In emerging markets, spreads tightened to new lows and equity prices climbed further during the period under review. While good economic performance contributed to these favourable developments, high risk tolerance among market participants may also have played an important role. Compared to US corporate spreads, emerging market spreads of similar credit rating continued to trade at tighter levels.
Highlights of international banking and financial market activity
In the international debt securities markets, net issuance was subdued in the first quarter of 2007, declining by 2% to $866 billion. In the advanced economies, strong net issuance in the United Kingdom was offset by declines in the United States and euro area. Robust borrowing in the United Kingdom was mostly driven by the activity of issuers located there but whose parent company is domiciled abroad. In emerging markets, banks were the busiest issuers, with borrowers from emerging Asia and Europe being much more active than in the past.
Trading on the international derivatives exchanges accelerated in the first quarter of 2007. Combined turnover of interest rate, currency and stock index derivatives increased by 24% to $533 trillion in the first quarter, after declining by 7% in the previous one. Activity was strong across risk categories with the exception of commodities. Heavy trading during the turbulence in international financial markets in late February and March boosted growth in the equity (33%) and foreign exchange (26%) segments. Activity in interest rate derivatives also increased (22%), but primarily due to seasonal factors.
Growth in the over-the-counter (OTC) derivatives market reverted to a pace in line with the long-term average in the second half of 2006. Notional amounts increased by 12% to $415 trillion at the end of December, after rising 24% in the first half of the year. Growth remained very strong in the credit segment (46%), but fell to rates in the range of 511% in other risk categories. These data provide only mixed support for an expansion in carry trade activity during the period under review: while there were sizeable increases in positions in Swiss francs and pounds sterling, positions in yen were unchanged. Concentration in OTC derivatives markets has increased since 1998, although it remains low in the major market segments.
In the international banking market, total cross-border claims expanded by $1 trillion in the fourth quarter of 2006, the result of a pickup in interbank claims and a surge in credit to non-banks. Credit to offshore financial centres continued to grow at a brisk pace, as did credit to borrowers in emerging economies. At the same time, residents of emerging economies placed even more in deposits in BIS reporting banks. Deposits by OPEC member states, while largely in dollars, were placed primarily with banks located in Europe and in offshore centres.
The BIS consolidated banking statistics, which are compiled according to the nationality of reporting banks and net out inter-office positions, show a noticeable rise in foreign claims on US residents in the fourth quarter of 2006. Claims on residents in emerging Europe were up as well, while the growth in claims on residents of AsiaPacific was more subdued. On an ultimate risk basis, reporting banks modestly raised their share of foreign claims on emerging market borrowers, especially those in Latin America. Cross-border flows into Korea and Thailand appeared to slow, although the share of these countries in total claims did not fall.
The term structure of interest rates can be an invaluable source of information for central banks. Proper reading of this information, however, requires separating expectations of future interest rates from the term premium in the bond market. After reviewing the concept of the term premium, Don Kim of the BIS and Athanasios Orphanides of the Central Bank of Cyprus examine alternative methods used to estimate it and discuss some of the challenges encountered in such efforts. The authors also point out how survey forecasts can be useful for providing an informal, model-free cross-check on simple regression-based forecasting models of term premia and for formal estimation of more complex ("no-arbitrage") models.
The BIS payment and settlement statistics are a unique centralised source of information on the use of payment instruments and payment systems, and of securities trading, clearing and settlement systems. The methodology and presentation of the statistics have recently been modified to enhance the comparability of data across countries. Tracing the historical development of the payment and settlement statistics, Elisabeth Ledrut of the BIS documents how they reflect the evolution of central bank interests and concerns. The statistics also show the impact of technological innovations on the use of payment instruments and on the processing of payments and securities settlements over the years. The author notes that the addition of data on the extension of central bank intraday credit to market articipants now allows for an analysis of liquidity needs in payment systems.
Consumer credit in Asia has grown significantly in recent years, particularly the credit card sector. There have also been several episodes of booms and busts, posing new risks to financial stability. Tae Soo Kang of the Bank of Korea and Guonan Ma of the BIS examine three recent episodes of credit card distress: Hong Kong SAR in 2002, Korea in 2003 and Taiwan, China in 2006. These episodes appear to share several common elements: intensified competition leading to reduced lending standards; a rapid build-up in household indebtedness; a disproportionate concentration of debt burdens among riskier cardholders; a sudden deterioration of asset quality; and a subsequent contraction in credit card receivables. Reflecting on these historical developments raises questions about the risks arising from this type of consumer lending as well as the appropriate policy response.
The Brazilian domestic government bond market has expanded rapidly since the mid-1990s and is now by far the largest in Latin America. In their review of the efforts made by the Brazilian authorities to develop the local currency government bond market since the beginning of the decade, André Amante and Márcio Araujo of the Central Bank of Brazil and Serge Jeanneau of the BIS show how they have helped markedly improve the structure of government debt and the overall liquidity of fixed income and related derivatives markets. Despite this progress, there is still room for improvement with respect to the liquidity of the cash market for government bonds.
1The period covered in the Overview is from 26 February until 1 June 2007.