Inflation and growth perceptions drove recent financial market developments argues the latest BIS Quarterly Review
6 June 2011
The BIS Quarterly Review for June 2011, released today, discusses how the reassessment of growth and inflation prospects in the advanced economies, as well as euro area sovereign debt concerns, drove asset prices.
The June issue also provides highlights from the latest BIS data on international banking and financial activity.
In addition, it features four articles (more detailed abstracts follow):
The global output gap may be gone: while structural estimates show some slack, these tend to overestimate the gap. Statistical estimates that are less subject to bias suggest that the gap has closed entirely over the past year.
- New methodologies lead to downgrades: in their ratings of financial institutions, credit rating agencies are putting more emphasis on systemic risk, the volatility of profits, and especially the potential for public support. As a consequence, the recent downgrading of the banking sector is likely to continue.
- The financial cycle can lead to output fluctuations: measures that condense several financial indicators into a single variable have some predictive power for near-term output fluctuations.
- Dealers can afford to move to central clearing: the major derivatives dealers already have sufficient unencumbered assets to meet initialmargin requirements of central counterparties. A few may need to increase their cash holdings to meet variation-margin calls.
Investors retreated to less risky assets after the devastating Japanese earthquake and tsunami in early March, but this reversed quickly as uncertainty about the economic impact of these events diminished. Since late March, investors have refocused on global growth and inflation prospects as well as possible monetary policy responses.
Bond yields in major developed economies declined on weaker prospects for both global growth and inflation. Prices of many commodities reached a plateau or even fell, lowering the near-term inflation outlook. Investors continued to expect strong growth in emerging markets as they cut back their growth forecasts for the United States. Central banks in emerging market economies tightened monetary policy further, reacting to inflationary pressures from strong growth and past increases in commodity prices.
Widening growth and interest rate differentials between emerging and developed economies resulted in a broad-based depreciation of the US dollar and capital inflows to emerging market bonds and equities.
In May, market participants became increasingly concerned about an eventual restructuring of Greek government debt. Spreads on Greek sovereign bonds widened to record highs. Fears about the wider impact of such an event also fed into higher spreads for other countries and into a marked depreciation of the euro.
The aggregate cross-border claims of BIS reporting banks declined during the fourth quarter of 2010, largely as a result of a significant fall in lending to residents of the euro area. By contrast, the cross-border claims of BIS reporting banks on residents of emerging market economies went up for the seventh quarter in a row. Most of the growth in the stock of international claims on residents of emerging market economies during the past couple of years has taken the form of shortterm lending.
Activity in the primary market for international debt securities increased in the first quarter of 2011. Completed gross issuance rose by 20% quarter-on-quarter to $2,127 billion, reflecting both a normal seasonal pickup and some increase in the underlying market activity. With somewhat higher repayments, net issuance picked up to $487 billion, from $299 billion in the previous quarter.
Notional amounts outstanding of over-the-counter (OTC) derivatives rose by 3% in the second half of 2010, reaching $601 trillion at end-December. Much of the increase was a direct consequence of the appreciation of major currencies against the US dollar rather than larger positions in the contract currencies. Gross market values of all OTC contracts fell by 14% and gross credit exposures dropped by 7% to $3.3 trillion.
Petra Gerlach (BIS) argues that the global output gap is still negative but closing. Structural estimates suggest that output in the advanced economies remains well below potential, but these measures probably underestimate how much the crisis lowered potential output. Purely statistical estimates do not suffer from that problem. They point to a global output gap that has already closed in both the advanced and the emerging market economies.
Frank Packer and Nikola Tarashev (BIS) review recent changes in the way the three major rating agencies assess banks' credit risk. So far, these changes have resulted in material downgrades, especially of European and US institutions. The agencies are, and will be, taking into account systemic risk and banks' dependence on external support to a much greater extent than in the past. They also intend to make ratings more transparent, conveying more explicit assessments of policy initiatives to restrict public support and to put in place effective resolution schemes.
Financial cycles are often marked by swings in credit growth, asset prices, loan conditions and other financial developments. Tim Ng (BIS) compares three measures that combine these indicators in a single measure and analyses how they predict output fluctuations up to two years ahead. He finds that financial cycle measures that include indicators of acute financial system stress can help predict output in the very near term but not further out.
By the end of 2012, all standardised over-the-counter (OTC) derivatives will have to be cleared through central counterparties (CCPs). Daniel Heller and Nicholas Vause (BIS) estimate that the major derivatives dealers already have sufficient assets to meet CCPs' initial margin requirements. But a few dealers may need to increase their cash holdings to meet variation margin calls.