BIS Quarterly Review, March 2017 - media briefing
6 March 2017
Politics tightened its grip on financial markets in the past quarter, reasserting its supremacy over economics. We left markets in December just as they had turned on a dime following the US presidential election, shrugging off previous long-standing concerns about a future of stagnant growth and stubbornly low inflation. All the talk was about a revival of "animal spirits" and "reflation". The mood hardly changed thereafter, supported by better economic data. But with market participants waiting with bated breath for concrete new evidence of policy measures, asset prices moved without a clear direction. It was as if, after an unexpectedly rich meal, investors had to take their time to digest it. As a result, central banks once more stepped back from the limelight.
Against this backdrop, the precipitous decline in correlations across asset classes, sectors and regions intensified.In line with the reflation trade, US equities surged and Treasury yields stayed high, while the dollar sustained its November gains. Even as the US stock market posted a strong performance relative to those elsewhere - to the point of reigniting familiar debates about possible overvaluation - there were clear winners and losers across sectors, reflecting expectations of the new administration's policy choices. The breakdown in correlations stands in stark contrast to most of the post-crisis experience, when successive waves of risk-on/risk-off behaviour tended to raise and lower all boats. This break with the past is yet another sign that the markets' close dependence - dare I say overdependence - on central banks' utterances and actions was at least temporarily weakened during the quarter.
Political events cast a shadow in the euro area too, influencing asset prices there and promoting divergence. Reflecting growing political uncertainty about future election outcomes, sovereign spreads widened, including the all-important spread between French and German government bonds. This also drew attention to the growing TARGET2 imbalances across the area. However, as explained in a box in the Overview, at least until recently the balances opened up not as a result of intraregional capital flight from countries perceived as less creditworthy - there is no such relationship with credit default swap spreads. Rather, they reflected the mechanical effect of central bank large-scale asset purchases in the absence of offsetting private portfolio adjustments. If the political tensions continue or intensify in future, no doubt this and other bellwether indicators will be scrutinised closely.
Political events in advanced economies have put the spotlight on vulnerabilities in emerging market economies (EMEs). These countries have been caught between a rock and a hard place, the rock being the prospect of a tightening of US monetary policy (even if gradual), an appreciating dollar and their FX currency debt, and the hard place the threat of rising protectionism. This sensitivity is evident from the relative performance of their exchange rates, which has been closely tied to their US trade exposure. Still, during the period under review, market sentiment improved, with exchange rates, equity prices and credit spreads recovering further from the losses incurred in November, on the back of renewed flows into EME funds. Moreover, while they are lagging indicators, the latest figures on global liquidity indicate that, to the end of September 2016, US dollar lending to EME non-banks began to grow again, after the pause and signs of decline in late 2015 - Hyun will say more about this in a minute.
During the quarter, we saw specific tensions in China's financial markets. As explained in the other box in the Overview, a liquidity squeeze contributed to a sharp increase in domestic bond yields, drawing attention once again to the latest reminder of the widespread vulnerabilities in the country's burgeoning shadow banking sector. And as the currency depreciated under pressure from capital flows, there were considerable swings in the wedge between the onshore (CNY) and offshore (CNH) renminbi. The tensions highlighted the policymakers' daunting task as they come to grips with the triple challenge of historically high domestic indebtedness, portions of the corporate sector still indebted in foreign currency and the growing internationalisation of the currency. Unlike similar episodes in the past, the tensions remained largely contained and did not spread internationally, not least because the short-term prospects of the economy remained positive.
Such tensions were just the latest reminder of a global economy that is struggling to find a safe passage towards a sustainable, financial stress-free expansion. In more ways than one, the long shadow of the Great Financial Crisis (GFC) is still hanging over us. All this underlines the importance of understanding developments in US dollar funding markets, given the dominance of the currency in the international monetary and financial system. As Hyun will explain, there are no signs as yet of a US dollar funding shortage. But were strains to emerge at some point, US dollar funding in general, and the FX swap market in particular, may well come under pressure again, as they have on previous occasions. This puts a premium on the ability to activate the safety net provided by central bank swaps - so instrumental in managing dollar funding strains during the GFC.
As Claudio mentioned, the role of the dollar in the global financial system is as important as ever. Total dollar-denominated debt of non-banks outside the United States stood at $10.5 trillion at end-September 2016, an increase of $420 billion from the previous reading six months earlier. Dollar credit to non-bank borrowers in emerging market economies (EMEs) stood at $3.6 trillion, a slight ($87 billion) increase over the same period. These totals now include statistics reported by China and Russia, which have joined the group of BIS reporting countries, resulting in a revision of the dollar credit series. The revision accounts for around $500 billion of the $10.5 trillion global total, and around $300 billion of the EME total of $3.6 trillion. The revised series reflect both the better measurement of dollar credit within these countries, as well as better measurement of cross-border lending from these countries.
Although the total amount of dollar debt continues to grow, there have been notable structural shifts in the pattern of dollar funding, especially for the global banking system. There are several elements to this structural shift.
One is the impact of US money market fund (MMF) reform on dollar funding for non-US banks (see box). The reforms, which took effect in October 2016, required prime MMFs to maintain a floating net asset value (NAV) and introduced other rule changes that affected investors. The impact of the reforms on dollar funding by MMFs to non-US banks has been significant. Prior to the reforms, non-US banks, in aggregate, raised over $1 trillion from US MMFs, but this total has decreased sharply. Between September 2015 and December 2016, non-US banks lost around $555 billion of funding from prime funds. Around $140 billion was made up by tapping government MMFs using repos but, overall, non-US banks have lost $415 billion of funding as a result of the MMF reforms.
On the surface, such a substantial loss of dollar funding may have been expected to curtail the total dollar funding of non-US banks. However, this has not happened. There has been a notable, likely structural, shift in funding towards greater use of dollar-denominated deposits. Such deposits rose by $537 billion between September 2015 and September 2016. This increase has more than offset the loss in dollar funding from US MMFs.
There remains the question of whether the greater deposit pool represents the diverted flow of dollars of US investors that previously kept their funds in US MMFs. But a closer look at the data shows that only around one third of the increase in offshore dollar deposits has come from US non-bank entities, such as US firms and households. The lion's share of the increased deposits has been sourced from elsewhere. These structural changes highlight the increasing role of offshore dollar funding in the global banking system.
These structural shifts raise several questions. Where have the dollar deposits come from? Which are the banks that have increased their dollar deposits most? How resilient is this new dollar funding? These questions deserve continued attention.
Let me now turn to the special features in this issue of the Quarterly Review.
Growth in the major advanced economies has finally picked up in the last few years. But in a number of countries (including the US, the UK, France and Italy), this recovery has been characterised by a relatively high contribution from consumption. Enisse Kharroubi and Emanuel Kohlscheen find that growth is lower than average when it is consumption-led, by some 0.5-0.7 percentage points. What's more, subsequent growth is weaker. This appears to be driven by a number of factors, but the authors focus on the role of housing wealth and credit growth. A period of growth driven by faster credit expansion or greater housing wealth (which often go hand in hand) appears to be less durable than when these factors are not present. One possible explanation is that when growth is driven by borrowing, households are burdened by higher debt service ratios, which acts as a drag on future demand.
The special feature by Benjamin Cohen and Gerald Edwards tackle another dimension of credit. They find that new accounting standards for banks' expected credit loss provisioning will help dampen the financial cycle by anticipating future losses. The major accounting standard setters (the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB)) have developed new provisioning standards that take a forward-looking approach to credit risk. The authors calculate that, for US banks, provisions in 2006 under a hypothetical scenario would have risen from 1.3% to 2.2% of gross loans - not a large increase, but possibly one that would have dampened somewhat the unsustainable pre-crisis boom. Provisions in 2009 would have fallen from 4.4% to 1.1% of gross loans, perhaps reducing the scale of the post-crisis credit crunch.
The special feature by Morten Bech, Yuuki Shimizu and Paul Wong finds that EMEs have been among the early adopters of "fast" retail payment systems, where small-value payments between individuals or businesses can be settled immediately, rather than after a few days. Network externalities are key, and these patterns may well be replicated in future years by other payment technologies, such as distributed ledger technology (DLT). The diffusion of retail payments presents new features compared with the spread of real-time gross settlement (RTGS) systems for wholesale payments, which started in the advanced economies.
The special feature by Lawrence Kreicher, Robert McCauley and Philip Wooldridge shows that interest rate swaps continue to gain at the expense of government bond futures as reference benchmarks for hedging and positioning at the long end of the yield curve. This shift is similar to how Libor displaced Treasury bills and other government rates as short-term benchmarks in the 1980s and 1990s. This shift has taken place despite the Libor scandal, the greater dispersion of banks' creditworthiness and the appearance of negative US dollar swap spreads in recent months.