Quarterly Review, September 2007
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 evidence of carry trade activity; another on the covered bond market; a third on global and regional financial integration in emerging markets; a fourth on securitisation in Latin America; and a fifth on corporate financial restructuring in Asia.
Overview: credit retrenchment triggers liquidity squeeze
Concerns about exposures to US mortgages cast a dark shadow over global financial markets during the period from end-May to late August 2007, with deepening losses on mortgage-related products spilling over to markets for other risky assets.1 As uncertainty about the extent and distribution of these losses spread through the financial system, investors fled to safe havens and liquidity demand surged. This caused a pronounced squeeze across major financial markets, prompting central banks around the globe to inject large amounts of liquidity.
Triggered by declining confidence in the valuation of mortgage-related and structured credit products, spreads rose sharply across the credit universe, increasingly affecting higher-rated products and assets other than credit. The price of credit risk, a measure of investor appetite for credit market exposures, jumped upwards, suggesting that a large part of the ongoing repricing was due to changes in investor sentiment towards risk.
Government bond yields plunged as investors fled risky assets and turned to the relative safety of government securities. The downward pressure on bond yields also seemed to partially reflect a reassessment of risks to the growth outlook in the light of the deteriorating situation in the US housing market, and heightened fears of a credit crunch in the wake of the turmoil in credit markets. Apart from the impact on bond yields, the combination of flight to safety flows and surging liquidity demand was evident from a sizeable drop in Treasury bill rates that occurred while interbank money market rates rose considerably.
Equity markets sold off under the weight of mounting losses from the repricing of credit risk, with housing-related and financial sector stocks underperforming the wider market. In line with sharply reduced appetite for risk, estimates of implied equity market risk tolerance dropped significantly. Foreign exchange markets also saw sharp increases in volatility, as carry trades were rapidly unwound. Emerging market equities and bonds, however, proved relatively resilient through most of the period, reflecting broadly favourable economic conditions.
Highlights of international banking and financial market activity
The latest BIS statistics on activity in exchange-traded derivatives markets, for the second quarter of 2007 (which predates the most recent episode of market turbulence), indicate that the combined turnover of interest rate, equity index and currency contracts increased only marginally from the first quarter. While rising valuations lifted turnover in derivatives on stock indices, this barely offset slightly weaker activity in the much larger interest rate segment. A modest increase in turnover on foreign exchange contracts masked rapid growth in derivatives on the Brazilian real (34%) and Canadian dollar (26%).
In the international debt securities market, issuance expanded significantly in the second quarter of 2007, fuelled by advances in both dollar- and yen-denominated securities. Private non-bank financial institutions accounted for nearly one half of global net issuance. Net issuance from the emerging economies of Latin America, Asia and Europe was strong; however, consistent with the secular shift towards non-government debt in emerging markets, borrowing by sovereigns remained subdued. Throughout the emerging markets, there was a surge in borrowing in currencies other than the US dollar, euro, sterling and yen.
In the international banking market, total cross-border claims expanded by $2.2 trillion in the first quarter of 2007, driving the annual growth rate to over 20% for the first time since 1987. The volume of net flows through the international banking system was extraordinary, with the largest net transfer of funds during the quarter being from residents of the United Kingdom to those of the United States, largely offset for the United States by net outflows to Caribbean offshore centres, Switzerland and the euro area. In emerging markets, substantial net inflows were registered for the first time in four years.
The surge in claims in the first quarter of 2007 was also evident in the BIS consolidated banking statistics, which track international banking activity from the creditor's perspective. BIS reporting banks' total foreign claims on an ultimate risk (UR) basis reached $25 trillion in the first quarter, up from $17 trillion two years ago. Along with greater credit, banks continued to extend guarantees and credit commitments to borrowers in emerging Europe; by contrast, reporting banks' exposure to Latin America continued to decline on a relative basis.
Special features
Evidence of carry trade activity
Market attention has increasingly focused on currency carry trade activity as a driver of exchange rate developments, and on the possibility that a sudden unwinding of this activity might adversely affect financial stability. However, currency carry trades have proved difficult to track using publicly available data. After outlining the investor base and the strategies used in such trades, Gabriele Galati, Alexandra Heath and Patrick McGuire of the BIS examine various sources of data to gauge the importance of carry trade activity. Analysing the BIS international banking statistics as well as turnover figures in derivatives and foreign exchange markets, the authors conclude that the growth in carry trades funded in yen and Swiss francs may have contributed to increased activity in these currencies in the international banking markets. Moreover, turnover patterns in both target and funding currencies roughly correlate with measures of the attractiveness of these trades.
Over the past decade, covered bonds, or securities issued by financial institutions that are secured by dedicated collateral, have become one of the largest asset classes in the European bond market. Drawing on the BIS international debt securities statistics and other data sources, Frank Packer, Ryan Stever and Christian Upper of the BIS assess the recent evolution of the covered bond market and the pricing of these instruments. While they find some evidence of differences in the pricing of bonds by nationality of issuer, these appear to be only weakly related to differences in the respective legislative frameworks. At the same time, based on event study analysis of selected cases, the authors find that the valuation of covered bonds has been rather robust to shocks to both the creditworthiness of issuers and the value of the underlying collateral.
Global and regional financial integration: progress in emerging markets
In recent years, financial systems in emerging economies have become increasingly integrated with global financial markets, as well as with other markets within their individual regions. Alicia García-Herrero and Philip Wooldridge of the BIS review measures of financial integration and the progress of integration in emerging markets from both a global and a regional perspective. They find that the new members of the European Union achieve high levels of regional integration, as a result of their close ties to major EU financial centres, but relatively little integration with markets outside the region. The geographical reach of integration is broader in Latin American countries, but regional financial integration lags behind that of the new EU members. The situation in Asia is somewhere in between, with geographical links broader than among the new EU members, but with regional integration more developed than in Latin America. The authors conclude that regional financial integration should be viewed as a complement to, rather than as a substitute for, global integration.
Securitisation in Latin America
Securitisation can transform ordinarily illiquid or risky assets into more liquid or less risky ones. In their assessment of the development of this market in Latin America, Michela Scatigna and Camilo Tovar of the BIS document the rapid growth of securitisation over the last five years, notably in Brazil and Mexico. However, the small average size of issues and their lack of secondary market liquidity suggest that the Latin American market remains in its infancy. Because of its benefits, further encouragement should be given to promoting securitisation in the region. However, the authors caution that careful attention should also be paid to the associated risks, such as the difficulties in assessing the credit risk of structured products due to their complexity.
Corporate financial restructuring in Asia: implications for financial stability
Corporate financial fragility preceding the Asian financial crisis heightened vulnerabilities. Based on historical data from the financial statements of listed companies in emerging Asia, Michael Pomerleano of the BIS documents that many countries in the region undertook significant corporate financial restructuring after the crisis, though some countries bounced back much faster than others. Improvements in corporate balance sheets since the crisis appear to be related in part to the degree of progress made in the adoption of international standards and codes for sound financial systems. The author concludes that while such advances bode well for financial stability, further efforts to improve corporate financing practices, banking systems and financial infrastructure are essential to ensure that future increases in leverage take place on a sounder footing.
1The Overview covers events up to and including 24 August 2007.