Quarterly Review, September 2006

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 highlights from the latest BIS data on international banking and financial activity. The second part presents five special feature articles: the first on the changing composition of official reserves; another on the domestic implications of foreign exchange reserve accumulation in emerging markets; a third on forward currency markets in Asia and lessons from the Australian experience; a fourth on derivatives activity and monetary policy; and a fifth on the past 150 years of financial market volatility.

Markets focus on monetary policy

The upward trend in government bond yields that had been evident in major bond markets for much of the year ended in June. This was largely due to investor perceptions of weakening economic growth, in particular in the United States, and markets reassessing the likelihood of further rate hikes by the Federal Reserve. Monetary policy decisions by other major central banks and expectations about their future actions also shaped developments in global bond markets.

In world equity markets, prices gradually recovered after the broad sell-off in May and early June, but volatility remained higher than before the turbulence. Implied volatilities also stayed above earlier levels, suggesting heightened uncertainty among investors about the near-term direction of equity prices. This may partly have been fuelled by concerns about the economic slowdown in the United States and questions about the outlook for corporate profits amidst higher oil prices and geopolitical tensions. However, equity prices were supported by falling bond yields and a generally favourable outlook for growth in the euro area and Japan, as well as positive second quarter earnings announcements.

In credit markets, while euro area markets largely recovered, spreads on highyield debt in the United States did not tighten much after the sell-off in May and June, being held up by higher energy prices related to rising geopolitical risks, as well as signs of increasing leverage. By contrast, on the back of a spate of sovereign rating upgrades, emerging markets regained much of the exuberance that had characterised the early part of the year, with sovereign spreads again approaching all-time lows for major indices. Credit markets in both developed and emerging market countries were supported by news seen as suggesting less tightening of monetary policy going forward.

Highlights of international banking and financial market activity

The latest BIS statistics on trading in exchange-traded derivatives markets, for the second quarter of 2006, indicate that the combined turnover of interest rate, equity index and currency contracts increased by 13% from the first quarter. The turnover of contracts on short-term yen interest rates soared several months ahead of the rate hike by the Bank of Japan. There was also heavy trading of equity index contracts in May and June, during the retreat from risky assets.

In the international debt securities market, issuance remained very strong in the second quarter of 2006. It was bolstered by securitisation activity as well as by corporate borrowing, with a number of firms tapping the international market to fund mergers and acquisitions. However, issuance by emerging market borrowers slowed sharply, owing mainly to the absence of sovereign issuers. The favourable financial position of many sovereigns allowed them to pay down their international debt in the second quarter.

In the international banking market, activity continued to expand at a very rapid pace in the first quarter of 2006. Banks in the BIS reporting area either maintained or increased their exposures to almost all countries, including many emerging markets and a number of countries where financial markets were unusually volatile. Interbank and inter-office flows accounted for much of the increase in cross-border claims, although they seemed in turn to be driven by a pickup in corporate borrowing. Despite a large increase in claims on emerging markets, these markets again saw net outflows as a result of an even larger increase in deposits placed with reporting banks.

Special features

The changing composition of official reserves

The way in which official reserves are managed is changing. Drawing on data compiled by the BIS on deposits placed by monetary authorities with commercial banks, Philip Wooldridge of the BIS finds that, although reserve managers approach diversification cautiously, the composition of reserves has changed in important ways over the past two decades. The author confirms that reserve managers have shifted steadily into higher-yielding, higher-risk instruments. He also finds that, while the currency composition of reserve holdings is still highly concentrated in US dollars and euros, the shares of some other currencies have changed significantly over time.

Foreign exchange reserve accumulation in emerging markets: what are the domestic implications?

The accumulation of foreign exchange reserves by emerging market economies has continued on an unprecedented scale for several years. In an analysis of the domestic implications of the large-scale use of foreign exchange intervention to resist currency appreciation, Madhusudan Mohanty and Philip Turner of the BIS document that, while many countries have adopted an accommodating monetary policy while intervening, various other forces have kept inflation under control and so eased one policy dilemma for central banks. Nevertheless, the authors note that large and prolonged reserve accumulation can still create risks other than near-term inflation. These include: high intervention costs; monetary imbalances; overheated credit and asset markets; and very liquid and perhaps distorted banking systems.

Forward currency markets in Asia: lessons from the Australian experience

In recent years, non-deliverable forward (NDF) markets have become increasingly important for a number of currencies in the Asia-Pacific region. Guy Debelle and Michael Plumb of the Reserve Bank of Australia, and Jacob Gyntelberg of the BIS, argue that the Australian experience in the 1970s and early 1980s – in which an NDF market evolved in the presence of currency restrictions – offers lessons to Asian authorities aiming to facilitate the transition from offshore to regular onshore or deliverable forward markets. The authors conclude that condoning rather than discouraging NDF markets may be desirable, because an NDF market may provide a "training ground" for both domestic and foreign market participants to improve analytical and trading skills. They also recommend that policymakers consider the potential benefits of having large global players commit to taking an active role in organising markets.

Derivatives activity and monetary policy

Trading in futures and options on short-term interest rates has grown rapidly in recent years. Relying in part on data on activity in exchange-traded derivatives, regularly published by the BIS, Christian Upper of the BIS presents econometric evidence on the relationship between turnover in exchange-traded money market derivatives and changes in monetary policy rates, both actual and expected. He finds that trading volumes respond much less to current rate changes than to changes in expectations of future interest rates. This is in line with evidence suggesting that monetary policy has become more transparent and predictable relative to the 1980s and early 1990s. The author also finds that higher turnover is associated with episodes of increased uncertainty about future central bank actions.

150 years of financial market volatility

Despite a rise in financial market volatility in the second quarter of this year, volatility in most markets remains below where it was at the turn of the millennium. Drawing on extremely long time series of monthly bond and stock returns in eight countries, Stefan Gerlach, Srichander Ramaswamy and Michela Scatigna of the BIS document the evolution of financial market volatility, and explore the linkages between volatility and macroeconomic conditions. The authors find that volatility varies considerably over time, and has risen across the world since about 1970. They conclude that the movements in volatility observed in recent years have been small from a historical perspective, and that a sharp increase in volatility from the levels observed over the last few years would not be unprecedented.