June 2012 Quarterly Review: returning doubts drive up financial market volatility
4 June 2012
New BIS Quarterly Review for June 2012: returning doubts drive up financial market volatility
- The optimism that followed the ECB's second LTRO has given way to doubts about global growth and the financial health of some euro area countries and banks.
- In the fourth quarter of 2011, cross-border lending by internationally active banks fell by the largest amount since the end of 2008, with BIS reporting banks cutting claims on all regions.
- Over the past decade, countercyclical macroeconomic policies have helped to stabilise emerging market economies. This represents a significant change from earlier procyclical policies that stoked economic volatility.
- The history of the eurodollar market since the 1960s suggests that China's current account surplus need not hinder its currency's internationalisation.
- The growth of central bank balance sheets in emerging Asia over the past decade has coincided with stable inflation and stable financial systems. But balance sheets have now reached a size that distorts markets and increases the risks of inflation and financial instability.
This Quarterly Review features three articles (more detailed abstracts follow):
- Countercyclical policies in emerging markets
- Eurodollar banking and currency internationalisation
- The expansion of central bank balance sheets in emerging Asia: what are the risks?
Over the past three months, financial market participants have shifted their attention from hopes of global economic recovery to concerns about Europe. Sentiment improved substantially after the ECB's longer-term refinancing operations. And hopes of a steady economic recovery were raised by positive US economic news and resilient growth in emerging markets, lifting equity and commodity markets. Credit spreads tightened significantly for banks and selected euro area sovereigns, and capital inflows to emerging markets surged.
But by late May, optimism had given way to doubts about European economic growth, the financial health of euro area sovereigns and banks, the impact of fiscal consolidation on growth, and political stability inside the euro area. Together with signs of greater fragility in US and Chinese growth, all this unsettled investors and stoked global financial market volatility.
During the fourth quarter of 2011, BIS reporting banks recorded their largest fall in aggregate cross-border claims since the drop following the Lehman Brothers collapse three years earlier. The decline was worldwide, although it was driven by the deleveraging of banks headquartered in the euro area. Cross-border lending to non-banks also fell, but the drop in claims on banks was sharper.
Cross-border lending fell around the globe. BIS reporters' cross-border claims on both banks and non-banks in developed economies shrank by $630 billion. Euro area banks accounted for most of this decline. Cross-border claims on emerging market economies fell by $75 billion, or 2.4%. The decline was concentrated on Asia-Pacific in general and on banks in China in particular. For China, this was the first overall decrease since the opening quarter of 2009. Among all developing countries, only those in Latin America and the Caribbean saw an increase in cross-border claims.
The notional amount of outstanding over-the-counter (OTC) derivatives fell by 8% in the second half of 2011, while a rise in price volatility drove up the market value by 40%. Gross credit exposures rose 32%. After accounting for netting and posted collateral and adjusting for the double-counting of collateral in the industry data, the BIS estimates that credit exposures between counterparties in the bilateral OTC derivatives market increased slightly, to at least $2.1 trillion.
Emerging market economies (EMEs) have historically faced challenges in implementing countercyclical policies. Előd Takáts (BIS) argues that the policy environment has changed and shows that, over the past decade, EMEs have successfully conducted countercyclical monetary and fiscal policies. Both monetary and fiscal tools were used in the countries where the authorities leaned more heavily against the business cycle.
China's current account surplus need not jeopardise its currency's internationalisation, argue Dong He (Hong Kong Monetary Authority) and Robert McCauley (BIS). They analyse the rise of the eurodollar market since the late 1960s and find that it had little to do with the US current account balance. Looking at this market's evolution - principally as a means of intermediation among non- US residents - helps us understand how the offshore renminbi market might develop. Even if the latter now serves chiefly as a conduit of funds to mainland China from abroad, it may one day intermediate mainly between non-Chinese residents.
Surging foreign reserve assets have led to a rapid expansion of central bank balance sheets in emerging Asia. Andrew Filardo and James Yetman (BIS) argue that the resulting run-up in central bank liabilities has increased market distortions and the risks of inflation and financial instability. Lessons from the way that emerging market economies manage these risks will be valuable to central banks in advanced economies as they navigate the swings in their balance sheets in the years ahead.