Quarterly Review, December 2007
10 December 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 five special feature articles: the first on the use of network methods to identify international banking centres; another on international banking with the euro; a third on interpreting the growth in foreign exchange activity based on the BIS triennial survey; a fourth on the risk in carry trades with target currencies in the Asia-Pacific region; and a fifth on changing post-trading arrangements for OTC derivatives.
Overview: markets hit by renewed credit woes
Further deterioration in the US housing market and concerns about associated economic and financial risks continued to take centre stage during the period under review. Prices for risky assets had recovered into October, as earlier worries about systemic risk had eased, not least because of determined central bank action in the money markets. However, uncertainties about subprime and other credit market exposures remained, adding to more general concerns that US housing market woes would deepen and eventually contribute to broader economic weakness. With market participants refocusing on these risks and liquidity conditions in money markets remaining tense, sentiment worsened once again from mid-October.
Against this background, and with oil prices surging to new highs, share prices fell sharply in major equity markets. The financial sector was particularly badly hit, following a string of multibillion dollar credit-related writedowns by banks. Adding to this, third quarter year-on-year corporate earnings growth was negative in the United States for the first time in several years.
In this environment, government bond yields in major industrialised economies fell as investors again fled to safety, but also as the result of an anticipated weakening of economic activity. Heightened expectations of monetary policy easing, in particular in the United States, added to the decline in yields. Such expectations, in combination with the sharp rise in oil prices, may have contributed to rising break-even inflation rates in a number of markets.
While being drawn into more general market weakness later in the period, emerging market assets were supported by perceptions that downside risks to growth in many emerging markets would be more limited than for the major industrialised economies. Emerging market equities, in particular, outperformed their counterparts in the mature markets on assumptions of continued robust earnings growth.
Highlights of international banking and financial market activity
In the international debt securities market, issuance retreated sharply during the turmoil in financial markets in the third quarter of 2007. Borrowing in euro-denominated bonds and notes was hit hardest, while the dollar and sterling segments slowed as well, although less appreciably. The decline in euro borrowing reflected weak issuance from French and German residents. The slowdown in borrowing was also evident in the emerging markets as issuance fell dramatically in emerging Asia and Europe. This may have stemmed from a retreat in risk appetite, since issuance of lower-rated bonds and notes in developed countries plummeted as well.
The turbulence in financial markets led to the busiest trading on record on the international derivatives exchanges. Activity was particularly strong in derivatives on short-term interest rates, perhaps because traders shifted some trading from the spot market or the OTC derivatives market onto exchanges. Rapid growth was also recorded in contracts on stock indices and on foreign exchange. Combined turnover in listed interest rate, currency and stock index derivatives rose by 27% to $681 trillion between July and September, after remaining stable in the previous quarter.
The review also discusses the results of the latest Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, the most comprehensive source of data on OTC derivatives markets worldwide. It shows that positions in the OTC market have increased at a rapid pace since the last triennial survey was undertaken in 2004. Notional amounts outstanding of such instruments totalled $516 trillion at the end of June 2007, 135% higher than the level recorded in the 2004 survey. This corresponds to an annualised compound rate of growth of 33%, which is higher than the approximately 25% average annual rate of increase since the current format of the survey was established in 1998.
In the international banking market, activity returned to a more moderate pace during the second quarter of 2007 after a surge in the first quarter. Cross-border claims expanded by $1.3 trillion to stand at $30 trillion. The main destinations were entities in the United States, the euro area and emerging markets. Lending to private non-banks grew at 23% year-on-year. Bank credit to emerging markets hit a new record, with total claims expanding by $201 billion. Of net new claims on emerging markets ($104 billion), half were on emerging Europe, contributing to the continued rapid growth of credit in the region. The consolidated statistics show that much of the expansion overall was driven by German, French and US banks, and was accompanied by a strong rise in contingent facilities such as credit commitments and, especially, guarantees. They also show that the large flows to emerging markets have raised the emerging market share in BIS reporting banks' portfolios to some 12%.
International banking centres have attracted renewed interest recently, as established centres compete in an increasing variety of ways while new centres are also emerging. Comparative studies often focus on indicators of financial activity in a particular location, but the prominence of an international banking centre also reflects cross-border linkages with banks in other locations. Goetz von Peter of the BIS combines these cross-border linkages into a global network and identifies important banking centres using network methods. The author discusses a range of measures that capture the degree to which banking centres can be considered central to the international banking network.
The structure of the international banking market has evolved in important ways since the introduction of the euro in 1999. Drawing on the BIS international banking statistics, Patrick McGuire and Nikola Tarashev of the BIS show how, in comparison to legacy currencies, the use of the euro in cross-border banking transactions has grown on aggregate and how the bilateral linkages within the euro area became more dispersed in the years after its introduction. However, growth in the use of the euro globally has plateaued more recently. In addition, the authors note that measures of banks' presence in other European credit markets reveal rather mixed signs of greater integration of the euro area banking system since 1999.
The most recent BIS triennial survey shows that turnover in foreign exchange markets increased by more than 70% over the three years to April 2007. Examining the factors underlying the growth in FX activity, Alexandra Heath and Gabriele Galati of the BIS emphasise two specific findings. First, the growth in transactions between banks and other financial institutions was particularly strong, consistent with the increasing importance of hedge funds, portfolio diversification by institutional investors, such as pension funds, and an expansion in technical trading. Second, there has been a marked increase in turnover involving emerging market currencies.
Carry trades are often viewed as a highly speculative investment strategy. Nonetheless, they have become fairly common, as market participants have created tradable benchmarks for them as well as various forms of structured FX instruments that key off these indices. Jacob Gyntelberg and Eli Remolona of the BIS analyse carry trades involving the Australian dollar, Indonesian rupiah, Indian rupee, New Zealand dollar and Philippine peso as target currencies. While these carry trade strategies have tended to outperform major stock markets for the period under consideration, the returns of these strategies tend to be negatively skewed, reflecting a relatively high frequency of large negative returns. The authors propose ways of measuring this downside risk.
The post-trading infrastructure of OTC derivatives markets has not always kept up with the rapid growth in trading volumes. In their feature on changing post-trading arrangements for OTC derivatives, Elisabeth Ledrut of Euroclear and Christian Upper of the BIS document recent initiatives that seek to introduce multilateral elements such as central counterparties, data warehouses or multilateral terminations. These elements can facilitate flows of information between market participants while preserving the decentralised nature of the transactions. While central counterparties lead to the highest degree of mutualisation, services such as central information depositories or multilateral terminations could deliver similar benefits in terms of information management.