BIS Quarterly Review, September 2004
6 September 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: one on the common language provided by the new Basel II framework, one on the advantages of Asian local currency bonds in a diversified portfolio, one on a sectoral shift in the eurodollar market in London, and one on how macroeconomic announcements affect implied volatilities in swaption markets.
Reassessing the recovery
July and August 2004 saw a divergence in market views about the strength of the global economic recovery. Bond yields and equity prices fell, while corporate credit spreads remained little changed. Increases in US policy rates in June and August – the first since 2000 – were well anticipated by market participants, but surprisingly sluggish growth in US employment weighed on both bond and equity markets. Higher oil prices added to the negative sentiment. By contrast, investors in credit markets seemed unfazed by these developments.
In emerging debt markets, investors even turned bullish. Most of the widening in sovereign spreads seen in April and May had reversed by August, with a renewal of carry trades contributing to the rally. Owing to such favourable financing conditions, the pace of borrowing by emerging market debtors showed no signs of moderating, with Asian firms in particular stepping up their international issuance.
The international debt securities market
New issuance in the international debt securities market slowed somewhat in the second quarter of 2004, but remained at a strong pace overall. Issuance was supported by a recovering global economy and the easing of concerns about the implications of a tightening of monetary policy in the mature economies. New issuance exceeded repayments by $348 billion, although this was dwarfed by the $521 billion in net issuance seen in the first quarter. Low-rated and emerging market borrowers were especially active, as were Japanese borrowers. Net issuance by US entities declined sharply, resulting in a slowdown in global dollar issuance despite increased use of the dollar by non-US borrowers. Preliminary data indicate that most of these trends continued in July 2004.
Markets in the second quarter focused on the turn towards tightening of US monetary policy. Many borrowers, particularly lower-rated corporates and borrowers from European and Asian emerging economies, rushed to take advantage of market conditions that were still hospitable ahead of the phase of volatility that was feared might accompany the US policy shift. Other borrowers, notably higher-rated corporates from the United States, chose to reduce new issuance in view of the uncertain outlook. Latin American borrowers, in aggregate, repaid more international securities market debt than they issued. Worldwide, a rise in floating rate debt issuance signalled a willingness on the part of borrowers to accommodate investors’ uncertainty over the path of interest rates in the near future.
The aggregate turnover of exchange-traded financial derivatives contracts continued to expand strongly in the second quarter of 2004. The combined value of trading in interest rate, stock index and currency contracts amounted to $304 trillion, a 12% rise from the first quarter. The resulting 43% growth for the first half of the year represented a remarkable recovery from the sharp contraction in the second half of 2003, when activity had fallen by 16%.
However, the expansion was not shared by all risk categories. Indeed, activity fell for currency contracts and stagnated for stock index derivatives. Turnover in currency products contracted by 8%, a striking reversal of the 35% growth in the first quarter. Even among interest rate contracts, growth in activity for bond instruments was slow.
The international banking market
Cross-border activity surged in the first quarter of 2004 to a level twice as high as had ever been previously seen. The increase was driven by US dollar-denominated interbank claims, a large proportion of them involving repo transactions. Although overshadowed by interbank activity, new credit to non-bank borrowers was also robust. Rather than reflecting renewed corporate loan demand, this mainly resulted from a pickup in lending to offshore and other major financial centres as well as purchases of government and other international debt securities.
Emerging markets placed a record amount of new deposits with BIS reporting banks. The deposit flows outpaced a rise in lending to these economies, resulting in an overall net outflow. The deposits to some extent reflected the placement with BIS reporting banks of foreign exchange reserves held by monetary authorities. Among different regions, the deposits contributed to net outflows from both Asia and Latin America.
Basel II – towards a new common language
In June 2004, the banking supervisors and central bankers forming the Basel Committee on Banking Supervision released Basel II, the revised capital adequacy framework for banks. Ryozo Himino of the Basel Committee Secretariat argues that the framework provides a common language that improves communication among banks, supervisors and investors. Those concerned with the risk exposures of banks can now communicate with each other without having to confirm multitudes of assumptions and translate numbers based on one set of assumptions into those based on another. Himino illustrates this point by offering three examples related to the most recent changes to the Basel II framework arising from the consultative process, covering the issues of expected versus unexpected loss, securitisation exposures and credit card exposures.
Diversifying with Asian local currency bonds
Asian local currency bonds have in recent years provided attractive returns. Robert McCauley of the BIS and Guorong Jiang of the China International Capital Corporation address the question of how such bonds might fit into a global bond portfolio. They find that the returns on these bonds co-move only moderately with their US Treasury counterparts and thus offer scope for diversification. The gains from diversification are greater for bonds of lower credit standing and for less globalised domestic bond markets. However, the authors also find that diversification can falter when it is most needed. During the global sell-offs in mid-2003 and the second quarter of 2004, Asian local bonds offered less refuge than might have been expected.
A shift in London’s eurodollar market
Patrick McGuire of the BIS uncovers data showing that London's interbank market has undergone a sectoral shift in recent years. The proportion of dollar-denominated funds deposited in London's banks that are recycled back into the interbank market has declined sharply. While banks in London continue to receive large amounts of dollar deposits from banks abroad, they are channelling more and more of these funds to non-bank borrowers, particularly in the United States. This shift followed the introduction of the euro and the subsequent contraction in foreign exchange trading, and may in addition reflect the greater role of the London market in financing securities trading in New York.
Macroeconomic announcements and implied volatilities
It is well known that US macroeconomic announcements are among the most important information events in fixed income markets. However, not much is known about the impact of such announcements on market uncertainty. To measure this impact, Fabio Fornari of the BIS looks at the swap market and analyses the effect of announcements on implied volatility derived from swaption contracts. His analysis starts by confirming the dominant role of US announcements in both US and European markets. The releases of data lead to a pattern of volatility spikes on certain announcement days, with the size of a given spike depending on the type of announcement released that day and the magnitude of the surprise relative to the consensus forecast. As one would expect, the forward-looking volatilities implied by swaption prices tend to be elevated as an announcement approaches and to fall once the volatility spike induced by the announcement is over. The actual size of a given data surprise seems to have little effect on how much such volatilities decline after the announcement.