September 2014 Quarterly Review: Volatility stirs, markets unshaken
14 September 2014
- Volatility has settled back to exceptional lows after spiking briefly in early August. Risk premia remain compressed, as worries over geopolitical tensions had only a brief impact on financial markets against the backdrop of unusually accommodative monetary conditions.
- International banking activity stopped contracting in the first quarter of 2014, when BIS reporting banks lifted their cross-border claims by $580 billion, the first significant uptick since 2011.
- Corporate borrowers from emerging markets have lengthened their debt maturities. This reduces their rollover risk but also makes bond prices more sensitive to yield changes, thus shifting risks from borrowers to bondholders.
- Global asset managers hold a significant share of emerging market stocks and bonds. Ken Miyajima and Ilhyock Shim (BIS) point to features of the asset management industry that could force funds to sell if prices fall, thus destabilising markets.
- Michael Chui, Ingo Fender and Vladyslav Sushko (BIS) argue that the large amount of international debt securities issued by emerging market corporations could make them vulnerable to any combination of a domestic slowdown, local currency depreciation and higher global interest rates.
- Bank lending to EMEs slowed in mid-2013 after the Fed's tapering announcements. Stefan Avdjiev and Előd Takáts (BIS) show that countries with large current account deficits and a large share of US dollar-denominated cross-border bank lending were particularly affected.
- Michela Scatigna, Robert Szemere and Kostas Tsatsaronis (BIS) present a database of house prices in 55 countries. For 18 countries, the series go back as far as the early 1970s.
Summaries of individual chapters
Following a prolonged period of unusual tranquillity, financial markets saw an uptick in volatility in early August. Risk appetite took a dent, as escalating geopolitical tensions added to renewed concerns about the recovery. Equity prices fell, especially in Europe, high-yield credit spreads widened significantly, and yields of safe haven assets such as short-maturity German bunds fell into negative territory. Markets, however, quickly rode out the turbulence. By early September, they had already recovered their losses, as worries over geopolitical tensions were surpassed by investors' anticipation of further monetary stimulus in the euro area.
After the spell of volatility in early August, the search for yield - a dominant theme in financial markets since mid-2012 - was again in full swing. Volatility fell back to exceptional lows across virtually all asset classes, and risk premia remained compressed. By fostering risk-taking and the search for yield, accommodative monetary policies thus continued to contribute to an environment of elevated asset price valuations and exceptionally subdued volatility.
The contraction in overall international banking activity which began in late 2011 went into reverse in the first quarter of 2014. The cross-border claims of BIS reporting banks rose by $580 billion between end-December 2013 and end-March 2014. While not enough to offset the preceding quarterly declines, the first quarter increase caused the year-on-year decline in cross-border claims to slow from 4.0% as of end-2013 to 2.0% as of end-March 2014.
BIS reporting banks increased their cross-border claims on both advanced and emerging market economies. Among the emerging market economies, claims on borrowers in China rose the most, to more than $1 trillion at end-March 2014. Claims on the rest of Asia, Latin America and Africa and the Middle East also grew, albeit at a more modest pace. By contrast, claims on emerging Europe fell for a fourth consecutive quarter.
EME corporate borrowers have lengthened the average maturity of their newly issued international debt securities. This lessens their rollover risk but increases the sensitivity of bond prices to yield changes. Although many institutional investors and other bond buyers operate with little if any leverage, they might potentially be induced to behave as if leveraged by widespread indexation, relative performance metrics or dynamic hedging to offset losses from option selling and other return-enhancing practices. The upshot is that they could be forced to sell into a falling market. This could impose significant costs on the economy through slower growth and tighter financial conditions.
The turbulence in emerging market economies following the Federal Reserve's tapering announcements in mid-2013 was a reminder that the activity of large asset managers can significantly affect small and illiquid asset markets in those economies. Data from EPFR Global show that the assets under management of dedicated emerging market funds have grown, from a pre-Lehman peak of $900 billion in October 2007 to $1.4 trillion in May 2014. Funds covered by the EPFR database now hold about 8.5% of total emerging market equities and bonds outstanding.
Ken Miyajima and Ilhyock Shim (BIS) argue that such markets could be destabilised by the increased influence of asset managers. Simultaneous purchases and redemptions by their ultimate investors may force funds to buy and sell simultaneously. Features of the asset management industry, such as the use of common benchmarks and relative performance measurement, could also lead to herd behaviour. This could create one-sided markets and amplify price fluctuations. Over the past two years, investor flows to asset managers and emerging market asset prices do, in fact, appear to have reinforced each other.
Corporates in many EMEs have taken advantage of unusually easy global financial conditions to ramp up their overseas borrowing and leverage. Issuance data based on issuer nationality (including issuance by the overseas subsidiaries of the corporations headquartered in a given country) indicate that private sector borrowers (other than banks) in major EMEs issued international debt securities worth almost $375 billion in 2009-12, more than double the amount issued in the four years before the crisis.
Michael Chui, Ingo Fender and Vladyslav Sushko (BIS) look at the financial stability risks from this increase in debt issuance. They present evidence that emerging market firms have increased their leverage. They also find that the share of debt denominated in foreign currency is very high, and there is reason to believe that many EME corporates are unhedged against this exposure. Together with their increase in leverage, this raises the vulnerability of EME corporates to the combined effects of a domestic slowdown, currency depreciation and a global rise in interest rates.
Cross-border bank lending to emerging markets slowed considerably during the taper tantrum in mid-2013. Stefan Avdjiev and Előd Takáts use newly available data to explain the drivers of the slowdown. They find that, although the initial tapering shock stemmed from advanced economies, EME-specific factors explain most of the variation in the deceleration across lender-borrower pairs. While factors connected with both the lender banking system and the borrower EMEs are statistically significant, the latter group is responsible for roughly 70% of the explained variation. In particular, the authors identify the current account balance and the share of cross-border bank lending denominated in US dollars as significant drivers. One lender banking system variable, the change in the average bank CDS spread during the taper tantrum, accounts for the remaining 30% of explained variation.
House prices are key indicators of financial stability, as property booms often lead to systemic crises. But, despite their importance, residential property data are not easily available in a format that makes them easily comparable across borders. To remedy this gap, the BIS collects data on house prices for 55 countries. For 18 of these countries, series are available that go back as far as the 1970s.
After introducing these data, Michela Scatigna, Robert Szemere and Kostas Tsatsaronis (BIS) show that house price developments have differed considerably across countries in recent years. In some of the advanced economies that recently went through a housing bust, real residential property prices have stopped falling and have even staged a comeback, although they continue to decline in other countries. In contrast, house prices are booming in most emerging market economies outside Europe.
* Signed articles reflect the views of the authors and not necessarily those of the BIS.