BIS Quarterly Review, September 2017 - media briefing

17 September 2017

Claudio Borio's remarks | Hyun Song Shin's remarks

Claudio Borio

If market participants had had just one wish, they would probably have wished for what they got in the past quarter. A simultaneous expansion in both advanced and emerging market economies (EMEs) had not been seen for a long time. In some of the largest advanced economies, labour markets became very tight - in Japan, even tighter than during the financial boom of the 1980s. And yet, wages remained remarkably subdued; and inflation, if anything, weakened. As a result, the concerns about a simultaneous monetary policy tightening that had jolted markets at the end of June quickly faded; bond yields retraced their steps. It looked like the Goldilocks economy had arrived.

The market's response was predictable. The constellation of factors boosted a "risk-on" phase that had begun earlier in the year. Share prices continued to climb towards new peaks, volatility plunged to new depths, and credit spreads tightened to levels not seen since the Great Financial Crisis (GFC). In the background, fuelling these developments, the US dollar depreciated and carry trade activity gained momentum. The dollar depreciated especially strongly against the euro, as the euro area economy's prospects looked increasingly bright. Portfolio flows to EMEs continued to recover, confirming the comparatively easy global liquidity conditions of the previous quarters signalled by the BIS international banking and securities statistics.

During the period under review, politics loosened its tight grip on financial markets. True, escalating geopolitical tensions in Northeast Asia shook markets in the second half of August. And part of the US dollar decline did reflect political uncertainties in the United States. But the imprint left on markets by these developments was rather short-lived. Similarly, concerns over political risk in Europe faded. As a result, central banks moved back to centre stage.

The low financial market volatility was remarkable. To be sure, equity market volatility has been comparatively low during monetary policy tightening phases since the early 1990s, probably also because share prices have tended to rise during such episodes. And, while quite low, the spread between implied volatility and realised volatility - an indicator of risk appetite - was broadly in line with past behaviour. But in a departure from the usual patterns, bond yield volatility too has fallen dramatically. The MOVE - a measure of implied bond yield volatility for the US Treasury market - reached its historical trough. We do not fully understand the factors at work. But surely the unprecedented gradual pace of monetary policy normalisation has played a role. Another factor could be market participants' belief that central banks will not remain on the sidelines should unwanted market tensions arise.

All this underlines just how much asset prices appear to depend on the very low bond yields that have prevailed for so long. Granted, earnings announcements have been solid of late. Yet, valuation indicators based on long-term cyclically adjusted price-to-earnings ratios, which do not incorporate information about bond yields, indicate that equity prices are quite stretched. Valuations seem to be aligned with historical benchmarks only after account is taken of the level of bond yields.

Indeed, a defining question for the global economy is how vulnerable balance sheets may be to higher interest rates. Post-GFC, global debt levels in relation to GDP have continued to rise. Deleveraging has not really occurred. Where private debt levels have adjusted, at least to some extent, public debt has taken over. As discussed in more detail in this year's Annual Report, and as updated in the Highlights section of this issue of the Quarterly Review, leading indicators of potential banking distress point to material risks in the years ahead in a number of economies less affected by the crisis, both emerging and advanced. A box in the Overview illustrates how, just as in the past, property developers have been playing a prominent role in some countries' financial booms, this time in emerging Asia. Admittedly, many steps have been taken to strengthen financial systems and macroeconomic frameworks: it would be a mistake to take the indicators at face value. Outcomes need not be the same as in the past. But the indicators do point to vulnerabilities. Debt service ratios, for instance, are only so low because interest rates have been falling so much. There is a certain circularity in all this that points to the risk of a debt trap: the protracted decline in interest rates to unusually low levels, regardless of the strength of the underlying economy, creates the conditions that complicate their subsequent return to more normal levels. Against this backdrop, the increase in the percentage of firms unable to cover their interest payments with their earnings - so-called "zombie" firms - does not bode well.

Tellingly, signs of credit market exuberance are also visible in some of the countries at the heart of the GFC. The Overview considers the case of companies in the United States. There, overall private sector debt in relation to GDP has actually declined post-crisis. But the adjustment has taken place only in households, whose overstretch was a key cause of the problems. Corporate debt is now considerably higher than it was pre-crisis. As a result, corporate leverage indicators have reached levels reminiscent of those that prevailed during previous corporate credit booms, such as the one in the late 1980s, although debt service burdens remain lower because of the historically low level of interest rates. Other signals point in a similar direction: strong high-yield debt issuance, the growing proportion of covenant-lite debt and narrowing credit spreads. Indeed, despite large cash holdings at many firms, the distribution of credit ratings has continued to deteriorate.

Naturally, very accommodative monetary policy has played a part in all this. This puts a premium on understanding the "missing inflation", because inflation is the lodestar for central banks. It feels like Waiting for Godot. Why has inflation remained so stubbornly low despite economies approaching or surpassing estimates of full employment and unprecedented central bank efforts to push it up? This is the trillion dollar question that will define the global economy's path in the years ahead and determine, in all probability, the future of current policy frameworks. Worryingly, no one really knows the answer.

Hyun Song Shin

Before the Great Financial Crisis (GFC), commentators pointed to the large US current account deficit and raised concerns about a depreciation of the US dollar, drawing parallels with the experience of emerging market economies (EMEs) that suffer a "sudden stop" in capital flows.

In the event, far from crashing, the dollar soared with the onset of the financial turmoil. This was because European banks had used short-term dollar funding to invest in long-term dollar assets in the United States. As asset prices fell and dollar debts came due, borrowers sought dollars to repay their maturing debts. Dollar appreciation fed on itself, as the stronger dollar piled further pressure onto these banks' balance sheets.

Some of the short-term dollar funding of the European banks had been raised from US money market funds, but a substantial amount came from the currency swap market, where European banks borrowed dollars by pledging other currencies (euros, for instance) as collateral. The special feature "FX swaps and forwards: missing global debt?" by Claudio Borio, Robert McCauley and Patrick McGuire sheds light on this important segment of the foreign exchange market.

An FX swap is similar to other collateralised borrowing arrangements in that the borrower posts collateral. However, the accounting convention deems FX swaps not to be debt, as the collateral is cash. How large is this "missing debt"? This research is the first to put a number on the amount of dollar debt missing from balance sheets and fills a gap in our understanding of the liquidity risk posed by financial firms operating across different currencies.

Outstanding swaps in the foreign exchange market turn out to be very large. Of the $58 trillion amount of FX swaps and related exposures, 90% is denominated in dollars and an estimated $13-14 trillion is owed by non-banks outside the US. For comparison, world GDP is about $75 trillion, and global trade $21 trillion.

What are the risks? Since cash is the collateral, credit risk is minimal. However, there is liquidity risk resulting from maturity mismatch, as we saw during the dollar funding squeeze for European banks in 2008. The study finds that most of the swaps are short-term. Around three quarters have maturities less than one year, and the typical transaction is much shorter.

Turning to the other special features in this issue of the Quarterly Review:

Bitcoin and other cryptocurrencies have become more prominent in market commentary of late. One strand of the discussion has been the role of central banks in a world where cryptocurrencies are more widely available, which is understandable given that these innovations raise fundamental issues on the nature of money and the structure of the financial system. The special feature "Central bank cryptocurrencies" by Morten Bech and Rod Garratt provides a taxonomy of digital currency to shed light on the issues. Money can be classified in different ways, depending on whether it is universally accessible, electronic or central bank-issued, and whether transfers are peer-to-peer (ie decentralised and not executed by a third party). Cash ticks all boxes except being electronic; bitcoin and its siblings tick all boxes other than being central bank-issued.

Central bank cryptocurrency (CBCC) ticks all four boxes. But it is far from clear that central banks have a natural role in facilitating cryptocurrencies. Some central banks have begun preliminary studies on how such currencies may operate alongside traditional forms of money. Most central banks currently accept only deposits from commercial banks. However, in principle, it may be possible for other users (households, for instance) to access retail versions of electronic money. Sweden is investigating retail CBCC, given the rapidly declining use of cash there. Wholesale CBCCs would fit better into the traditional central bank role of operating or supervising wholesale payment systems, and some jurisdictions (such as Canada and Singapore) are examining this possibility.

The special feature "What are the effects of macroprudential policies on macroeconomic performance?" by Codruta Boar, Leonardo Gambacorta, Giovanni Lombardo and Luiz Pereira da Silva studies the link between macroprudential policies (MaPs) and GDP growth and its volatility. MaPs are used more by EMEs than by advanced economies, and have been used more to tighten financial conditions than to loosen them. The authors of the piece show that growth was higher and less volatile among countries that were more active in using MaPs.

The authors look at how these effects change for economies that are more financially developed or more open to the global economy. They also measure "non-systematic" policy measures, meaning those that are not systematically tied to credit growth or capital inflows. These non-systematic measures seem to be associated with worse macroeconomic performance.

Finally, the special feature "Green bond finance and certification" by Torsten Ehlers and Frank Packer studies "green bonds", which are fixed income securities that finance investments with environmental or climate-related benefits. Issuance has grown rapidly since the first one in 2007, with more than $100 billion issued in 2016 and $60 billion through June this year. Issuance was initially dominated by advanced economy borrowers, but now EME borrowers, especially those from China, account for a large share.

Certification is an important issue. While a number of certification standards have emerged, they do not always agree on which bonds are green. Providers of green bond indices play a role, especially in ongoing monitoring of "greenness", but the criteria are not always consistent across indices. Credit rating agencies also play a role in providing external assessments.

The authors study 21 recent issues and find that yield spreads at issuance tend to be lower for green bonds than for similar conventional bonds. This suggests that primary market investors give some weight to whether a bond is green.

Green bonds do not hedge against environmental risks, such as climate change. This is because, even if they are earmarked for a specific project, their credit risk is related to the operations of the issuer as a whole. In fact, green bonds are more likely to be issued by firms in industries that are relatively more exposed to such risks.