Quarterly Review, December 2005

The BIS Quarterly Review released today is divided into two parts. The first presents an overview of recent developments in financial markets, before turning in more detail to financing flows in banking and debt securities markets, and activity in derivatives markets. The second part presents five articles, each having a particular focus on newly developing financial markets: one on risk aversion and risk premia in the CDS market; another on financial sector direct investment in emerging market economies; a third on corporate bond markets in Asia; a fourth on the development of the domestic government bond market in Mexico; and a fifth on international government debt denominated in local currency in Latin America.

Inflation outlook unnerves investors

A deterioration in the outlook for inflation unnerved investors around the world in September and October. Upward pressure on consumer prices, resulting in part from high energy prices, prompted central bankers in the United States and the euro area to signal that monetary policy might need to be tightened to contain inflation expectations. Consequently, investors revised upwards their expectations regarding future policy rates. This led to higher bond yields in the major markets. Nevertheless, long-term yields remained low compared to their 2004 highs.

The prospect of a faster pace of monetary tightening contributed to volatile conditions in equity markets. Equity prices around the world dropped sharply in early October. They then rebounded in November, boosted by signs of still robust growth in the United States as well as announcements of mergers, share buybacks and dividend increases. Japan outperformed most other equity markets throughout this period. There, an incipient recovery in domestic demand heightened the prospect of an end to years of deflation.

While emerging market spreads moved in tandem with equity markets, corporate spreads remained stable. In contrast to equity and emerging markets, corporate bond markets never fully recovered from the sell-off earlier in 2005. This largely reflected concerns about the impact that the growing number of shareholder-friendly actions might have on corporate credit quality.

The international debt securities market

The pace of borrowing activity in the international debt securities market slowed in the third quarter of 2005, with gross issuance of bonds and notes down 19% from the second quarter. However, due to strong issuance earlier in the year, third quarter gross issuance was still up on a year-over-year basis by almost 10%. One region where issuance picked up markedly was the United States, whereas issuance by euro area nationals declined. High-yield entities once again stepped up their borrowing in the international market, shrugging off a weak second quarter that had seen turmoil in the US auto sector.

Borrowing by emerging market countries remained at a high level in the third quarter, as secondary market spreads on emerging market debt fell to a record low. Local currency issuance of international securities by emerging market entities continued to be particularly strong, and 2005 looks set to be a record year for this segment of the market. Latin American borrowers once again accounted for the vast bulk of local currency issuance, the government of Brazil being the main contributor with a $1.5 billion issue in September.

Derivatives markets

Trading on the international derivatives exchanges declined during the third quarter of 2005. Combined turnover in fixed income, equity index and currency contracts fell by 4% quarter-on-quarter to $357 trillion. However, this was mainly due to seasonal factors, which tend to depress activity in the interest rate segment in the third quarter. By contrast, the year-on-year rate of growth increased slightly to 23%, after 21% in the preceding quarter.

Growth was particularly strong in the market for futures and options on stock indices, which expanded by 22% to $34 trillion in the third quarter, after lacklustre activity in the first half of the year. Turnover in contracts on Korean indices surpassed that in US stock index derivatives for the first time. On the currency front, the growth of the domestic bond market in Mexico has spurred the development of an increasingly sophisticated OTC Mexican peso derivatives market.

Growth in the market for credit default swaps in the first half of 2005 weathered the spring sell-off in credit markets. Notional amounts expanded by 60% to $10 trillion, far outpacing growth in the underlying credit contracts, which increases the risk of squeezes. In addition, the assignment of trades without notifying counterparties has contributed to a backlog in trade confirmations. While market participants have promised to improve back office processes, it is still too early to assess the degree of progress.

The international banking market

Interbank activity drove strong growth in BIS reporting banks’ cross-border claims in the second quarter of 2005. Banks channelled funds to other banks in the United States, United Kingdom and offshore centres, with inter-office transactions accounting for roughly one third of the total. Credit to non-bank borrowers also continued to rise, as banks invested in debt securities, primarily issued in the euro area.

Emerging economies as a whole experienced a large net outflow of funds in the second quarter. The rise in oil prices over the past few years has meant that oil-exporting countries have had sharply increased revenues that must be either spent or invested. As a result, deposits placed in BIS reporting banks have been on the rise as these countries have channelled a portion of these outflows into banks abroad. In the second quarter, increased placements by residents in Russia, Saudi Arabia, Venezuela and other oil-exporting countries were behind the relatively large net outflow of funds from emerging economies.

The recycling of petrodollars back into the international financial system, in this most recent cycle, differs in several important respects from the pattern observed during previous periods of rising oil prices. While oil-exporting countries historically placed a significant portion of their petrodollars in bank deposits, they have increasingly channelled these funds elsewhere as of late. This has contributed to a rise in the proportion of petrodollars that cannot be accounted for on the basis of counterparty data. Furthermore, while petrodollar deposits are still significant, the importance of OPEC as a source of funds for BIS reporting banks has diminished over time.

Special features

Risk aversion and risk premia in the CDS market

Credit default swap (CDS) spreads compensate investors for expected loss, but they also contain risk premia because of investors’ aversion to default risk. Based on an analysis of CDS index spreads and default probabilities on the index constituents during 2002–05, Jeffery Amato of the BIS finds that estimated risk premia and risk aversion have undergone wide swings in recent years. Mr Amato presents statistical evidence that risk premia and aversion have been affected not only by fundamental macroeconomic factors, such as the stance of monetary policy, but also by technical market factors, such as the issuance of collateralised debt obligations.

Foreign banks in emerging market economies: changing players, changing issues

Financial sector foreign direct investment (FSFDI) in emerging market economies has surged over the past decade. Drawing extensively on a recent report of the Committee on the Global Financial System, Dietrich Domanski of the BIS analyses FSFDI patterns across different emerging market regions and institution types. While acknowledging the benefits of heightened financial sector efficiency, the author argues that foreign ownership of banks poses challenges for host countries, due to the migration of decision-making, and potential incompatibility of the organisational structures of foreign-owned banks with host country legal and regulatory systems. The author concludes that many of these challenges will be best met by global cooperation on the part of regulators and central banks.

Corporate bond markets in Asia

In recent years, policymakers in Asia have started to turn their attention to the development of corporate or non-government bond markets. Jacob Gyntelberg, Guonan Ma and Eli Remolona of the BIS document that Asia has large as well as small corporate bond markets, and that some primary markets have successfully opened up to foreign issuers while others have relied on quasi-government issuers. The authors argue that secondary markets in Asia may suffer from illiquidity due in varying degrees to narrow investor bases, inadequate microstructures and lack of timely information about issuers. The authors conclude that, in the longer run, diversifying the investor base and improving the flow of credit information could be the most important factors supporting corporate bond market development.

Reducing financial vulnerability: the development of the domestic government bond market in Mexico

Domestic government bond markets denominated in pesos have expanded rapidly in Mexico since the “tequila crisis” of the mid-1990s. Serge Jeanneau of the BIS and Carlos P¿rez Verdia of the Bank of Mexico argue that various initiatives undertaken by the Mexican government have helped to spur this development. The authors document the lengthening of the maturity structure of domestic government debt, the improvement of secondary market liquidity, and the growing efficiency of primary market auctions. Notwithstanding these significant advances, the authors caution that vulnerabilities remain.

International government debt denominated in local currency: recent developments in Latin America

Governments in Latin America have traditionally faced significant difficulties in issuing debt denominated in local currency in international markets. Camilo Tovar of the BIS discusses how three countries in the region – Brazil, Colombia and Uruguay – have recently issued this type of debt. The author argues that changes in both structural and cyclical factors have supported the issuance of these bonds. He also notes that the degree to which issuing international debt in local currency complements the development of domestic debt markets remains to be seen.