BIS Quarterly Review March 2003 - International banking and financial market developments
10 March 2003
The BIS Quarterly Review released today is divided into two parts. The first part analyses recent developments in financial markets, financing flows in banking and debt securities markets, and activity on derivatives exchanges. The second part presents articles on topics of special interest. This issue offers three articles, with the following topics: instrument choice in managing official dollar reserves, the euro interest rate swap market, and the relationship between market volatility and activity in exchange-traded derivatives.
International banking and financial market developments
Uncertainty spoils the optimism
The continuing threat of war with Iraq has tended to overshadow news about the course of the global economy in recent months. A mood of investor optimism in October and November 2002 had buoyed equity and corporate bond markets and made yield curves steeper. Starting in December, however, uncertainty about the economic consequences of a war began to weigh more heavily on the markets. Once their optimism had dissipated, investors seemed to attach little significance to macroeconomic news. By mid-February, the war premium had taken back most of the late 2002 gains in equity markets. Yield curves had become somewhat flatter than in late November but continued to price in an economic recovery, albeit a more modest one.
The international corporate bond market offered more favourable borrowing terms but still failed to attract much in the way of net new issuance. This lacklustre demand for funds reflected a reluctance on the part of firms to increase their leverage in the face of uncertain economic prospects. The need to reduce debt was especially pressing for companies that had recently lost their investment grade credit ratings. Restructuring plans that favoured existing creditors over equity holders allowed the corporate bond market to stand apart from the equity markets in early 2003, with credit spreads remaining stable even as stock prices fell.
The hospitality of capital markets towards the close of the year also extended to borrowers from emerging markets. In the wake of the presidential elections, Brazil enjoyed a marked improvement in investor sentiment. Although sovereign spreads remained wide, Brazilian borrowers were quick to return to international markets to refinance maturing debt. Venezuela suffered the opposite fate as a nationwide strike against the government dragged on. Coupled with the prospect of war with Iraq, the strike led to a rise in oil prices, further undermining expectations about the strength of the global economic recovery.
The international debt securities market
The fourth quarter of 2002 witnessed a continuation of the slowdown in fund-raising through the international debt securities market. With global economic growth stalling, net issuance was an unusually subdued $185 billion. Not since the market turbulence in the second half of 1998 has there been such a slowdown in net borrowing. Net issuance by private financial institutions in particular remained tepid. Total gross issuance did rise to $501 billion, a 15% increase between the third and fourth quarters. The bulk of the proceeds, however, went to repayments, which reached a record level during the quarter.
The decline in corporate credit spreads during the quarter suggests that a reduced demand for funds by businesses was the primary cause for the weakness in net issuance. The slowdown in global economic activity and firms' reluctance to take on additional debt were probably the most significant factors behind the decline in demand. Nevertheless, credit conditions did remain tight for some borrowers, particularly issuers of lower-rated commercial paper.
The aggregate turnover of exchange-traded financial derivatives contracts monitored by the BIS declined in the fourth quarter of 2002. The value of trading dropped by 12% from the previous quarter to $170 trillion, following a 14% increase in the third quarter. Activity was weaker across all major market risk groups, namely fixed income, stock indices and foreign exchange, although turnover in stock index contracts slowed only slightly. Business reached an all-time record in October, with US and European equity markets beginning to rally in the second week of that month. Derivatives activity subsided gradually in the following two months. In the over-the-counter market, a new kind of contract - options on major US macroeconomic announcements - began to trade.
The international banking market
Activity in the international banking market in the third quarter of 2002 seemed to reflect the heightened sense of risk aversion evident among global investors during this period. Banks in the BIS reporting area invested substantial amounts in euro area and US government securities and other lower-risk assets. At the same time, cross-border lending to corporations and other banks remained subdued. Bank flows to emerging markets in the third quarter also showed a shift towards better quality assets. Latin America experienced the largest outflow of bank funds since the third quarter of 1999, while East Asia saw a record inflow of funds.
Choosing instruments in managing dollar foreign exchange reserves
Managers of official foreign exchange reserves no longer worry about a shrinking supply of US Treasury securities. Instead, they face the challenge of instrument choice in an environment of low interest rates. Robert McCauley and Ben Fung focus on US dollar reserves to analyse how central banks have responded to this challenge in recent years. They pose three questions: How is the official dollar portfolio invested? How has the choice of instrument evolved over time? And how have recent events - recession, US fiscal deficits, lower Treasury yields and corporate defaults - altered its evolution? They find that official dollar portfolios have continued to diversify away from Treasury securities and into agency and corporate debt. Recent events have slowed but not reversed this process.
The euro interest rate swap market
The euro interest rate swap market is one of the largest and most liquid financial markets in the world. It was among the first financial markets to become integrated following European monetary union and quickly gained benchmark status. Eli Remolona and Philip Wooldridge examine the development of this market, including its rise to benchmark status, the continued importance of counterparty risk, the growing concentration of dealers, and the robustness of liquidity. They attribute part of the growth of the market to continuing fragmentation in the government securities and repo markets in Europe. They also suggest that, while the euro swap market is a very liquid one, this liquidity might evaporate in times of volatility.
Volatility and derivatives turnover: a tenuous relationship
Does market volatility lead to increased activity in derivatives exchanges? Past empirical work based on daily or even higher frequency data suggests that the answer is yes. Serge Jeanneau and Marian Micu take a fresh look at this question by asking whether what holds at a daily or intraday frequency also holds at the monthly frequency. Before examining the issue empirically, they discuss the various trading motives that would lead to a relationship between volatility and turnover. They then look at two different markets, that for S&P 500 stock index contracts and that for 10-year US Treasury note contracts. They also consider two conceptually distinct measures of volatility, namely realised volatility from actual price movements and volatility implied by options prices. Surprisingly, they find no reliable relationship between volatility and turnover for the Treasury note contract and a negative relationship for the stock index contract. They also find no difference between the effects of the two forms of volatility.