BIS Quarterly Review, September 2002
9 September 2002
The BIS Quarterly Review released today is divided into two parts. The first part analyses recent developments in financial markets, financing flows and derivatives activity. The second part presents articles on topics of special interest. This issue offers four articles: three examining different aspects of the unusual strength of real estate markets and one analysing the rise of foreign currency deposits in China.
International banking and financial market developments
Loss of confidence deepens and spreads
In the second quarter of 2002 and early in the third, global financial markets were buffeted by a series of disconcerting events that undermined investor confidence. The most significant event was a financial restatement in late June by WorldCom, a large US telecommunications firm. The fear of more widespread corporate problems precipitated a slump in equity markets in both the United States and Europe. The negative sentiment even spilled over into the once resilient corporate bond market, where issuance slowed as credit spreads widened. In August, an absence of further bad news seemed to restore a degree of confidence. There were signs that investors were returning to the equity markets and corporate bond markets.
The financial sector did not fare as well in this latest bout of market weakness as in previous episodes. In July, share prices of European insurers fell below the levels reached in the wake of 11 September 2001. Banks in Europe and finance companies in the United States not only lost market value but also saw the spreads on their senior debt widen sharply. Even swap spreads began to reflect the concern of market participants over the counterparty risk of dealing with large money centre banks. These developments threatened to constrain financial intermediation, possibly adding to the difficulties of non-financial firms in raising money.
Several emerging market countries found their domestic economic and political problems exacerbated by the global rise in risk aversion. Investors punished most those countries for which questions about the sustainability of debt burdens coincided with political uncertainty. At the same time, sovereign debt spreads tended to widen with those on low-rated corporate bonds. Nonetheless, while bond issuance by emerging market borrowers slowed in July, the stronger credits among them maintained access to the market.
The international debt securities market
While net issuance in the international debt securities market rebounded modestly on average during the second quarter of 2002, there were indications of worsening financing conditions towards the quarter's end. For the quarter as a whole, net issuance amounted to $344 billion, 11% above that for the previous quarter. The private sector in Europe and Japan, in particular, accounted for the relatively strong demand for funds. In contrast, net issuance by US borrowers declined. Starting in June, however, wider corporate spreads began to take their toll as issuance of straight fixed rate securities weakened. Large finance companies were notably absent from the market in July.
The aggregate turnover of exchange-traded financial derivatives contracts monitored by the BIS remained buoyant in the second quarter of 2002. The notional value of transactions rose by 4% to $169 trillion. The increase in activity was spread across the major risk classes of interest rate, currency and equity. Unsettling events during the quarter provided numerous trading opportunities. For example, the revelations of corporate accounting irregularities heightened investors' perceptions of risk in equity markets and apparently boosted turnover in equity index contracts as many of these investors hedged their positions.
The international banking market
The slowdown in international banking activity evident throughout much of 2001 became more pronounced in the first quarter of 2002. Activity in virtually all segments of the international banking market was weak. Whereas a drop-off in credit to other banks had been largely responsible for the deceleration in cross-border banking activity during 2001, reductions in credit to banks' own foreign offices and non-bank borrowers exacerbated the slowdown in the first quarter of 2002. Subdued demand for bank credit appears to explain much of the slowdown, but a retrenchment of Japanese banks also made a significant contribution from the supply side.
With the exception of Latin America, lending to emerging markets was little affected by the global slowdown in credit growth. Banks broadly maintained their positions in Asia and Europe, even increasing them on selected countries. However, their claims on Latin America fell. In addition, residents of Latin America and the Middle East repatriated funds placed abroad, resulting in the second successive quarter of net flows into emerging markets from banks in the BIS reporting area.
Lessons from the US refinancing boom
This feature article identifies the recent US refinancing boom as an important reason for the unexpected strength of household spending during 2001. The resilience of consumer spending was particularly remarkable for the US economy, where falling equity prices might have been expected to dampen consumption. Akash Deep of Harvard University and Dietrich Domanski of the BIS argue that the US mortgage market provided US households with the liquidity that allowed them to spend part of their new wealth from higher housing prices. The authors discuss the unusual features of the wave of mortgage refinancing in 2001 and the factors behind it.
Explaining changes in house prices
Greg Sutton of the BIS explains the recent rise in house prices and explores the question of whether a continuation of the global economic slowdown and the fall in stock prices might eventually depress house prices. The author studies house price fluctuations in six economies - the United States, the United Kingdom, Canada, Ireland, the Netherlands and Australia - and asks to what extent these fluctuations can be attributed to movements in national incomes, interest rates and stock prices. He relies on vector autoregression, an empirical framework that permits him to identify the typical response of house prices to changes in and interactions among a small set of key determinants. Among his interesting results is that stock prices and interest rates influence house prices, but the size of the measured effect varies substantially across countries.
The case of the missing commercial real estate cycle
Pointing to the puzzling absence of a commercial real estate downturn in the recent global economic slowdown, Haibin Zhu of the BIS argues that the "missing" cycle is partly due to the rapid growth of real estate securitisation. In support of his argument, he explains that such securitisation has provided a substitute for traditional banking finance, improved information transparency and allowed risks to be spread across a wider array of investors. At the same time, the author warns that these developments do not imply that the commercial real estate cycle has been eliminated. Indeed, he suggests that commercial property markets might in future be subject to new sources of market volatility.
Rising foreign currency liquidity in China
Guonan Ma and Robert McCauley, both of the BIS, trace the recent rise of foreign currency liquidity in China's banking system. Understanding the factors influencing the demand for such liquidity provides insights into a significant source of financing for the US current account deficits in recent years. The authors specifically examine determinants of the demand for foreign currency deposits in Chinese banks. They find that interest rate differentials, exchange rate concerns and the one-off effect of the liberalisation of part of China's stock market jointly account for almost half of the movements in such deposits. They also analyse the recent declining trend of dollar loans booked by banks in China, and its implications for the strengthening foreign currency liquidity position of banks on the mainland.