BIS Quarterly Review, March 2004

The BIS Quarterly Review released today is divided into two parts. The first analyses recent developments in financial markets, financing flows in banking and debt securities markets, and activity on derivatives markets. The second part presents four articles on topics related to the housing market. The first sets the stage by discussing the relationship between household debt and the macroeconomy; the second examines the determinants of house price dynamics for a cross section of countries; the third analyses the common coincidence of peaks in equity and housing prices; and the final article presents a case study of the Danish mortgage market, a market that allows prepayment similar to that in the US market but seems to have escaped the associated volatility in long-term rates.

International banking and financial market developments

Appetite for risk lifts markets

Financial markets around the world rallied into the new year, adding to already impressive gains recorded in 2003. While improvements in global growth prospects and corporate finances would have justified some increase in the prices of equity, corporate bonds and sovereign debt, the size of the increases suggested further support from a robust appetite for risk. Not even further revelations of corporate malfeasance seemed to unsettle investors.

Even as equity and credit markets rallied, government and swap yields declined. Investors in fixed income markets appeared to focus less on global growth prospects and more on the lack of inflationary pressures and the likely stance of US and euro area monetary policy. Possibly illustrating the importance of the low level of interest rates for the buoyancy of other markets, a rise in yields in late January following a change in the US Federal Reserve's language on policy accommodation led to a temporary fall in credit and equity prices.

The international debt securities market

Net issuance of international debt securities hit an all-time high of $460 billion in the fourth quarter of 2003. The increase was primarily due to sharply increased issuance by euro area nationals, both in bonds and notes and in commercial paper. Net issuance by financial institutions and corporate issuers picked up, whereas issuance by governments declined. The fourth quarter capped a year in which euro-denominated securities issuance increased significantly, both in absolute terms and relative to other markets.

Net issuance of international debt remained high for emerging market borrowers, as high as for any fourth quarter since 1996. That these borrowers could raise funds so easily most likely stemmed from an ongoing search for yield by international investors amidst a continued narrowing of credit spreads. In Asia, there was substantial new net issuance by the Chinese government and financial institutions, while Russian financial institutions and the Polish government drove net borrowing in eastern Europe. Brazilian entities were prominent in Latin American issuance.

Derivatives markets

The aggregate turnover of exchange-traded financial derivatives contracts monitored by the BIS shrank further in the fourth quarter of 2003. The combined value of trading in interest rate, stock index and currency contracts amounted to $207 trillion, a 7% decline from the third quarter. Activity was uneven across the major market risk groups, with turnover in interest rate contracts falling substantially and that in stock index and currency contracts growing at a moderate pace. The overall decline in the turnover of fixed income instruments, the largest of the broad market risk categories, resulted from a drop in both money market and government bond contracts.

Nonetheless, for 2003 as a whole, the aggregate value of turnover in financial contracts rose. Turnover for the year reached $874 trillion, a 26% increase over the year before. Business was brisk in all of the broad market risk categories. Activity in the small market for currency contracts was particularly buoyant after a long period of decline.

The international banking market

Following a large build-up of funds over the three previous quarters, the international interbank market shrank in the third quarter of 2003. Roughly a third of the recent increase disappeared from banks' international balance sheets. Much of the contraction took the form of reduced interbank activity, which accommodated new lending to the non-bank private sector. The new lending reflected in part more demand for funds in offshore centres and possibly a pickup in corporate demand for loans.

Banks in the reporting area continued to move their emerging market portfolios into safer assets. This was evident in a rise in the share of claims on the emerging market public sector and a shift out of Latin America into somewhat higher-rated credits. In addition, a rise in net risk transfers from certain regions suggests that banks may increasingly be seeking third-party guarantees for their loans to emerging markets.

Special features

Household debt and the macroeconomy

The rise in household debt in a number of developed countries over the past two decades has raised concerns about the sustainability of such debt and the implications for the stability of the financial system if it is not sustainable. Guy Debelle, an economist visiting the BIS from the Reserve Bank of Australia, attributes the increase in household borrowing to two factors: the decrease in the prevalence of credit rationing that followed from the financial deregulation of the early 1980s; and the reduction in interest rates, in both real and nominal terms, as inflation has declined over the past two decades. These factors have contributed to a significant easing of liquidity constraints on households. The author suggests that the resulting growth in debt has made households more sensitive to unemployment shocks and increases in interest rates, especially in countries where variable rate mortgages are more widely used.

What drives housing price dynamics?

The behaviour of house prices influences business cycle dynamics through its effect on aggregate expenditure. These prices also affect the performance of the financial system through their impact on the profitability and soundness of financial institutions. Kostas Tsatsaronis and Haibin Zhu, both of the BIS, use a common empirical framework to analyse the main forces that drive aggregate house prices across a number of industrialised countries. Their most striking result is the dominance of inflation in the determination of real house prices despite marked differences in the structural aspects of national markets. Another important result is that the feedback from house prices to credit growth is stronger in the case of countries with more market-sensitive valuation methods for mortgage accounting. This suggests that prudential rules may have an impact on the co-movement between residential real estate prices and the performance of the financial system.

Twin peaks in equity and housing prices

Some three years after the global bust in equity markets, housing prices have continued to rise in many countries. This buoyancy seems rather unusual by past experience and raises questions about the sustainability of current trends. Could housing prices falter any time soon? And if they do, could large declines be in store? To cast light on these issues, Claudio Borio and Patrick McGuire of the BIS examine the evolution of housing prices in a sample of 13 industrial countries since the early 1970s, focusing squarely on the relationship between major peaks in housing and equity prices, the corresponding booms and busts and credit conditions.

They reach three main conclusions from this analysis of the historical record. First, over the period 1970-99, equity price peaks tended to be followed by housing price peaks, with an average lag of about two years. Second, movements in short-term nominal interest rates appear to have significant implications for housing price dynamics, underscoring the role of monetary policy. Finally, the subsequent decline in housing prices appears to have had a certain life of its own and to have been partly shaped by the characteristics of the previous expansion, notably by the size of the previous rise and the possible build-up of financial imbalances.

The Danish mortgage market

For such a small market, the Danish mortgage market is surprisingly sophisticated. With a standard Danish mortgage contract, it is possible to borrow long-term at fixed rates with an option to make penalty-free prepayments. This option is also embedded in the US contract. The main consequence of this option element in both the US and Danish contracts is that investors are exposed to prepayment and thus reinvestment risk. Yet the performance of the Danish market has not been much affected in periods with significant refinancing, while such periods tend to be characterised by higher volatility in US long-term interest rates.

Allen Frankel and Jacob Gyntelberg of the BIS, Kristian Kjeldsen of the National Bank of Denmark and Mattias Persson of Sveriges Riksbank offer a case study of this market. They identify two possible explanations for the observed differences between the Danish and US markets during periods of significant refinancing. First, the mortgage banks, the underwriters of Danish mortgages, are not permitted to manage prepayment risk in the same way as US mortgage underwriters. As a consequence, exposures to prepayment risk are primarily assumed by buy and hold investors. Second, the fixed exchange rate policy for the Danish krone vis-à-vis the euro may moderate volatility by giving investors in callable Danish mortgage bonds access to low-cost hedging of market risk in euro-based markets.