December 2011 Quarterly Review discusses global market repercussions of euro area sovereign debt crisis
12 December 2011
The BIS Quarterly Review for December 2011, released today, shows how concerns about sovereign risk in the euro area affected financial markets across the globe.
The December issue also provides highlights from the latest BIS data on international banking and financial activity.
In addition, it features five articles (more detailed abstracts follow):
- FX trading strategies such as carry or momentum trades exhibit substantial downside risks to investors. One bad month can be sufficient to wipe out one to two years of excess returns.
- The Chinese policy of boosting the international role of the renminbi could undermine the effectiveness of capital controls while improving the allocation of capital.
- Policy frameworks need to take into account the liquidity cycle - liquidity and credit booms and their associated contributions to systemic risk as well as liquidity shortages or disruptions in the provision of credit.
- Federal Reserve and the Bank of England asset purchase programmes lowered government bond yields significantly.
- Large derivatives dealers have used some hard-to-value credit derivatives to transfer credit risk to non-bank financial institutions that could be considered shadow banks.
News on the euro area sovereign debt crisis drove most developments in global financial markets between early September and the beginning of December. Amid downgrades and political uncertainty, market participants demanded higher yields on Italian and Spanish government debt. Difficulties in meeting fiscal targets in a recessionary environment weighed on prices of Greek and Portuguese sovereign bonds.
Conditions stabilised somewhat in October on growing optimism that the end-month EU summit would propose comprehensive measures to tackle the crisis. But by November, investors were growing sceptical about the adequacy of some of these measures. Sovereign bond yields then rose across the euro area, including for higher-rated issuers.
Meanwhile, financial institutions with direct exposure to euro area sovereigns saw their costs and access to funding deteriorate. Affected banks took measures to further reduce leverage, selling assets and tightening credit terms. Financial institutions also sold certain types of assets to counter increases in the volatility of their portfolios. This included emerging market securities, whose prices plunged in September and fell again in November, while those of safe haven assets rose in a corresponding flight to quality.
BIS reporting banks reduced their cross-border claims on residents in developed economies in the second quarter of 2011 but increased cross-border lending to emerging markets for the ninth quarter in a row. In absolute terms, lending to residents of the United States shrank the most (by $155 billion or 2.8%). Claims on the United Kingdom and Japan also fell (by $52 billion or 1.1% and by $32 billion or 4.1%, respectively), whereas claims on residents of the euro area remained virtually unchanged, inching up by a mere $7.5 billion (0.1%).
Among the emerging market regions, increased cross-border lending to China ($68 billion or 16%) drove up claims on borrowers in Asia-Pacific (up $108 billion or 9%). Cross-border claims on residents of Latin America and the Caribbean and of emerging Europe also increased (by $33 billion or 5.9% and $10 billion or 1.2%, respectively), whereas claims on residents of Africa and the Middle East shrank by $6.3 billion or 1.2%.
High shares of cross-border claims and short-term international claims in their debt to BIS reporting banks could make Asia-Pacific economies more vulnerable to sudden capital flight through the banking system. That said, the risk of a withdrawal of lending triggered by a possible deleveraging by euro area banks is highest in emerging Europe.
Issuance of international debt securities dropped in the third quarter of 2011. Deteriorating market conditions compounded the usual summer slowdown in the northern hemisphere. This resulted in a 16% decline in completed global gross issuance. At $1,663 billion, this was the lowest since end-2005. Net issuance of international debt securities slid to $142 billion, the second lowest level since end-1998.
This article by Jacob Gyntelberg and Andreas Schrimpf (BIS) reviews several widely practised short-term multicurrency investment strategies designed to exploit perceived investment opportunities in FX markets. The most prominent example is the carry trade, in which an investor bets that exchange rate movements will not outweigh the interest rate differential (or carry). A second example is FX momentum strategies, where investors bet that appreciating currencies will continue to appreciate and depreciating currencies will continue to depreciate for a few months.
Gyntelberg and Schrimpf analyse the risk-return trade-offs of these strategies, paying special attention to how they fare in periods of financial market turmoil. They find that the strategies exhibit substantial short-term downside risks. One bad month can wipe out several years of excess returns.
Robert McCauley (BIS) argues that the managed internationalisation of the Chinese renminbi in the presence of significant restrictions on financial activity is a trip in uncharted waters. Continued capital controls continue to segment on- and offshore renminbi markets. The Chinese authorities regulate deposit and lending rates, give quantitative credit guidance and ration access to the bond market.
The expansion of offshore renminbi banking plays a dual role. On the one hand, viewed in isolation, it could undermine the effectiveness of these constraints. Renminbi credit will flow into China through the interbank and direct cross-border lending channels, complicating monetary and credit control. On the other hand, viewed as part of a broader strategy of gradual liberalisation, it produces a set of market prices that can guide the process. Prices in the offshore currency, money and bond markets could complement their domestic counterparts to inform policymakers' and market participants' decisions.
Global liquidity has become a buzzword in discussions about the international monetary system. The term "global liquidity", however, continues to be used in a variety of ways by a variety of people. The resulting ambiguity opens the door to undesirable policy responses. Drawing on recent work by the Committee on the Global Financial System, Dietrich Domanski, Ingo Fender and Patrick McGuire (BIS) present a conceptual framework for understanding and examining global liquidity, highlighting the analytical challenges involved in assessing the implications for financial stability. They argue that private sources of (outside) liquidity, generated by the credit creation by financial institutions, tend to dominate public (inside) sources of liquidity. This has two implications. First, policies need to take into account the full liquidity cycle - liquidity and credit booms and their impact on financial stability as well as liquidity shortages or disruptions in the provision of credit. Second, policy frameworks need to be sufficiently robust to account for global movements of both official liquidity (reserves) and private liquidity (credit).
Jack Meaning (University of Kent, United Kingdom) and Feng Zhu (BIS) estimate the impact of central bank bond purchases on asset prices. They find that both the Federal Reserve's large-scale asset purchase programmes and the Bank of England's asset purchase facility led to a significant reduction in government and corporate bond yields. Their estimates also suggest that the Federal Reserve's new maturity extension programme could have an effect on longer-term Treasury bond yields comparable to that of the outright asset purchases.
From June 2011, the BIS credit derivatives statistics provide more granular information on the types of risks transferred through credit default swaps by different groups of counterparties. The new data suggest that reporting dealers have used some hard-to-value credit derivatives to transfer credit risk to shadow banks, possibly exposing these counterparty groups to valuation risks. The data also show that some financial counterparties have sold protection against defaults in the same sector on a net basis.