Latest BIS Quarterly Review discusses financial turbulence
14 June 2010
The BIS Quarterly Review for June 2010, released today, attributes the recent surge in volatility in global financial markets to a loss of investor confidence due to fiscal concerns and the risk of weaker growth. The European rescue package bought a temporary reprieve from contagion in euro sovereign debt markets, but market concerns about the economic outlook remain.
The June issue also provides highlights from the latest BIS data on international banking and financial activity.
In addition it features four articles. These focus on:
- The factors behind the sharp drop in cross-border bank lending to emerging market economies during the financial crisis. A reduction in the supply of credit by international banks outweighed lower demand for credit.
- The output costs of currency collapses. These appear to be related to the factors leading to the collapse, not the drop in the exchange rate itself. The depreciation actually raises trend output.
- Policy responses to dislocations in Korea's FX swap market. Drawing on the swap line with the Federal Reserve was effective, but providing funds from Korea's foreign reserves was not.
- European banks' US dollar funding pressures: banks in several European countries continue to rely on the FX swap market to fund their dollar positions.
An abstract of each of these articles is attached.
Global financial markets were highly volatile from mid-April to early June as fiscal concerns and the risk of weaker growth caused investor confidence to deteriorate rapidly. Investor worries about unsustainable fiscal positions crystallised around the problems of Greece and other euro area sovereigns. Faced with growing uncertainty, investors cut risk exposures and retreated to traditional safe haven assets. The announcement of a significant European rescue package bought a temporary reprieve from contagion in euro sovereign debt markets, but could not allay market concerns about the economic outlook. Instead, the flight from risky assets continued, resulting in additional increases in risk and liquidity premia.
A number of developments led investors to question the robustness of global growth. In advanced economies, investors and market commentators focused on the risk that the surge of public debt could derail the economic recovery. At the same time, rising Libor-OIS spreads reflected growing concerns that the financial system is more fragile than previously thought. Economic policy tightening in China, Brazil and India, among others, fuelled doubts that emerging economies could provide the necessary global growth momentum. Market confidence was further dented by rising geopolitical risk on the Korean peninsula and Spain's second downgrade, together with the difficulties of a number of Spanish savings banks, in late May.
BIS reporting banks' international balance sheets contracted for the fifth consecutive quarter in the final three months of 2009. International claims fell by $337 billion, bringing the cumulative decline for the past seven quarters to $5,024 billion, or 12% of the record level ($40,383 billion) reached at the end of March 2008.
Banks steered funds towards the faster-growing regions of the world, and away from the ones where the pace of economic recovery was sluggish. International claims on residents of emerging markets grew by $37 billion during the last quarter of 2009. Once again, the increase was mainly driven by higher claims on borrowers in the Asia-Pacific region, while claims on emerging Europe continued to decline. At the same time, reporting banks reduced their exposures to residents of all developed regions, with those to residents of the euro area contracting the most (-$311 billion).
Euro area banks were particularly exposed to the residents of Greece, Ireland, Portugal and Spain, accounting for almost two thirds of all BIS reporting banks' exposures to these countries. Within the euro area, French and German banks had the largest exposures ($493 billion and $465 billion, respectively). Banks headquartered in the United Kingdom had larger claims on Ireland ($230 billion) than banks based in any other country. Spanish banks were the ones with the highest level of exposure to the residents of Portugal ($110 billion).
Activity in the primary market for international debt securities recovered in the first quarter of 2010. Announced gross issuance went up by 27% quarter on quarter to $2,249 billion. With stable repayments, net issuance almost doubled to $595 billion, thus partly reversing the decline in the second half of last year.
Activity on the derivatives exchanges accelerated during the first quarter of 2010. Turnover measured by notional amounts of futures and options on interest rates, stock price indices and foreign exchange increased by 16% quarter-on-quarter to $514 trillion between January and March. Open interest, expressed in notional amounts outstanding, rose by 12% to $82 trillion.
Positions in over-the-counter (OTC) derivatives increased modestly in the second half of 2009. Notional amounts outstanding edged up by 2% to $615 trillion by the end of December. Exceptions to the upward trend were OTC derivatives on commodities and credit default swaps, whose volumes outstanding fell by 21% and 9%, respectively. Reporting banks' gross credit exposures, which provide a measure of counterparty risk, fell by 6%, after an 18% decline in the first half of 2009
During the financial crisis, Korea responded to dislocations in the FX swap market by both drawing on its swap line with the Federal Reserve and using its own international reserves to provide dollars to domestic banks. Naohiko Baba (Bank of Japan) and Ilhyock Shim (BIS) show that the Bank of Korea's use of the Fed swap line was very effective in alleviating dislocations in the won/dollar FX swap market, whereas the provision of funds using its own foreign reserves was not.
Currency collapses, defined as large nominal depreciations or devaluations, are associated with permanent output losses on the order of 6% of GDP on average. In this feature, Camilo Tovar (BIS) argues that the fact that these losses tend to materialise before a drop in the value of the currency indicates that it is not the large depreciation as such that is costly but the factors leading to the currency collapse. Taken on its own, the drop in the exchange rate actually has a positive effect on output.
Cross-border bank lending dropped sharply during the financial crisis. Elöd Takáts (BIS) uses a panel regression framework to analyse the key drivers of cross-border bank lending to 21 emerging market economies between 1995 and 2009. The analysis suggests that both demand and supply factors contributed to the fall, but the impact of supply was stronger. The two factors seem to have had more balanced effects before the crisis.
With major central banks having re-established temporary FX swap facilities to alleviate growing strains in short-term funding markets, European banks' US dollar funding patterns are back in the news. The feature by Ingo Fender and Patrick McGuire (BIS) documents the persistence of these banks' aggregate US dollar funding needs, pointing to an ongoing, large-scale reliance on sources of wholesale funds and, in particular, on the FX swap market.