BIS Quarterly Review December 2001 - International banking and financial market developments
10 December 2001
The terrorist attacks in the United States on 11 September brought uncertainty in global financial markets to a new level. During the summer, fading hopes for economic recovery had already weakened the major stock markets and problems in emerging markets had resurfaced. The attacks shook consumer and business confidence still further and reinforced prospects for a broad global slowdown. Nevertheless, once the initial shock had worn off, market participants again began to anticipate a recovery during the course of 2002, despite continued unfavourable macroeconomic data.
The immediate effect of the tragic events was to disrupt the functioning of some markets and to induce investors to shift into less risky assets. US equity markets closed for four days, while those of Europe and Asia, which remained open, saw stock prices retreat. When US stock exchanges reopened, prices there also dropped. The damage in New York to the operations of inter-dealer brokers, communications links and some clearing and settlement systems temporarily disrupted the functioning of segments of US fixed income markets, especially cash and repo markets for US Treasury securities.
Under the circumstances, the functioning of most markets and the confidence of participants proved remarkably resilient. Within a week of the attacks most fixed income markets were functioning again, albeit with reduced capacity. Towards the end of September issuance volumes in the corporate bond market rebounded, and by mid-October stock markets had returned to pre-attack price levels. While investors now expected the global slowdown to be more pronounced, they continued to exhibit confidence that a recovery would take place by mid-2002. These views were underpinned by the prompt easing of monetary policy in several countries and, in the United States, the added stimulus of a more expansionary fiscal policy.
This attitude of persistent medium-term optimism did not extend to emerging economies. Increased risk aversion and worries about the impact of the slowdown in industrial countries led to higher risk spreads and portfolio outflows from several emerging markets, though not all. The problems of specific borrowers, such as Argentina and Turkey, also weighed on market sentiment. Nevertheless, financial market contagion from these countries to other emerging markets appeared limited.
The international debt securities market
Reflecting the global weakness in fixed investment, demand for international financing slowed further in the third quarter of 2001. Net issuance in the international debt securities market fell by 40% from second quarter levels to $169 billion. The decline was broad-based, cutting across instruments, economic regions and business sectors. Net issuance by financial institutions fell particularly sharply, continuing the pattern established in the second quarter.
Gross issuance in international note and bond markets in the third quarter fell less than net issuance. High levels of repayments accounted for the difference, continuing the trend evident since the beginning of 2001. Credit spreads widened in the third quarter, especially for lower-rated borrowers. However, because of falling benchmark yields, corporate borrowing costs tended to remain stable or even decline. Despite the uncertain conditions prevailing after the terrorist attacks, investment grade borrowers generally maintained their access to bond markets.
Aggregate turnover of exchange-traded derivatives contracts reached a new record in the third quarter of 2001. The dollar notional value of contracts monitored by the BIS rose by 6% to $150.2 trillion. Overall activity was somewhat subdued in July and August, but the events of 11 September led to an upsurge of trading. Although trading was temporarily halted following the attacks, the major US derivatives exchanges functioned without significant difficulties owing mainly to the fact that they are located in Chicago.
The market turbulence in the second half of September failed to reverse some of the longer-term trends. Trading in US money market contracts, which had been exceptionally buoyant in the previous two quarters, remained robust. By contrast, business in other contracts, such as those on government bonds and equity indices, remained lacklustre.
The international banking market
Weak demand for bank financing restrained the growth of the international banking market in the second quarter of 2001. The locational banking statistics indicate that cross-border claims of BIS reporting banks contracted by $117 billion, partially reversing the first quarter's remarkably large increase in claims. Cross-border flows to corporations and other non-bank borrowers slowed considerably, driven by a fall-off in flows to the United States. International banks appeared to remain willing to extend credit to US borrowers in the second quarter, but the deterioration in economic conditions dampened demand for new bank financing. With no need to recycle either large repayments from non-bank borrowers or loans to such borrowers, bank unwound some of the large interbank positions they had built up in the previous quarter.
The picture in emerging economies was more mixed. The second quarter saw a $9 billion decline in cross-border claims on emerging economies, the largest in nearly two years. Demand for external bank finance remained weak in Asia and other regions with current account surpluses. Banks in the reporting area reduced their cross-border claims on countries perceived to be higher risks, most notably Turkey. They increased their claims on several other lower-grade borrowers, including Argentina and Russia, but at the same time limited their ultimate risk exposure through the use of collateral and third-party guarantees.
Why has global FX turnover declined?
The 2001 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity found that foreign exchange market turnover declined by 19% over three years. This decline contrasts with the findings of previous triennial surveys, which had recorded large increases in forex market activity. Among the different instruments, the decline was most pronounced in spot markets. In terms of activity between different counterparties, interbank trading and trading between banks and non-financial customers fell markedly, while transactions between banks and financial customers rose.
A special feature identifies four factors that may have contributed to the decline in forex market turnover. The first factor in order of importance appears to be consolidation in the banking industry, whose trend seems to have accelerated over the last three years. Second, the introduction of the euro led to a reduction in forex turnover by eliminating intra-EMS trading. Third, the growing role of electronic broking has caused a shrinkage of the spot interbank market by simplifying the price discovery process and reducing the incentives for leveraged trades. Finally, the decline in trading between banks and non-financial customers may reflect the growing concentration in the corporate sector across countries.
The emergence of new benchmark yield curves
As a result of changes triggered by the events of 1998, shifts in supply and the introduction of the euro, government securities are no longer the pre-eminent benchmark instrument that they were just a few years ago. Drawing extensively on a study undertaken by economists from six central banks plus the BIS on recent changes in the world's major fixed income markets, a second feature article examines the use of private sector debt instruments as benchmark yield curves. Government securities retain many advantages as hedging and positioning vehicles, not least of which is their better liquidity. But repo rates have already displaced government yields as benchmarks at the very short end of the yield curve. Further improvements in the liquidity and structure of collateralised obligations and interest rate swaps could enhance the attractiveness of these instruments as benchmarks at longer maturities, too.
The impact of M&A activity on the dollar/euro exchange rate
Over the last few years, expectations that the US economy would outperform that of the euro area led to a stream of M&A-related capital flows from the euro area to the United States. The huge size of a number of high-profile deals attracted much attention and kindled discussion on their possible impact on the dollar/euro exchange rate. A third article explores the extent to which transatlantic M&A deals are associated with movements in the dollar/euro rate between January 1999 and September 2001. The authors test whether this impact is due to a transactions effect, a portfolio effect or an announcement effect. They find evidence of a statistically significant impact of announcements of M&A deals on the dollar/euro rate. They also find that the size of this impact is independent of the financing of the deal, a finding that is inconsistent with the transactions effect. They conclude that the direction, timing and magnitude of transatlantic M&A activity is consistent with the strengthening of the dollar against the euro in 1999 and 2000.