BIS Quarterly Review, June 2003

The BIS Quarterly Review released today is divided into two parts. The first part analyses recent developments in financial markets, financing flows in banking and debt securities markets, and activity on derivatives exchanges. The second part presents articles on topics of special interest. This issue offers three articles, one on capital flows in East Asia since the 1997 crisis and two on measuring and explaining equity market investors' changing attitudes towards risk.

International banking and financial market developments

Buoyant markets in weak economies

April and May 2003 saw an unusual divergence in market views about global growth prospects. Equity and credit markets rallied during this period even as yield curves flattened. A series of disappointing macroeconomic announcements led investors in swap and government bond markets to revise downwards their expectations of economic growth. By contrast, investors in equity and credit markets discounted the weak macroeconomic data and instead focused on better than expected corporate earnings reports.

Spreads on higher-yielding debt, both corporate and sovereign, fell to levels last seen in the late 1990s, when global growth was significantly stronger than today. Faced with exceptionally low nominal yields, investors appeared willing to take on more credit risk in their search for higher returns. Despite a surge in corporate bond issuance in the first quarter and very weak equity issuance, investors' expectations of a further strengthening of balance sheets seemed to remain intact. Heavily indebted emerging markets such as Brazil and Turkey, which had found themselves shut out of international capital markets as recently as July last year, regained access on relatively favourable terms.

The international debt securities market

Fund-raising activity in international markets by euro area financial institutions surged in the first quarter of 2003. As a result, aggregate net issuance of international debt securities reached $352 billion, almost double the previous quarter's amount. Gross issuance rose by 58% to an all-time high of $774 billion, which explains why net issuance was so high despite a record amount of repayments.

The rebound in net issuance during the first quarter of 2003 was accompanied by a fall in long-term government yields in January and February. Net issuance of straight fixed rate bonds and notes surged, as financial institutions and corporate issuers moved to lock in low borrowing costs. Emerging market borrowers also took advantage of lower funding costs, brought about in part by the increased investor demand for higher-yielding assets, and stepped up their net issuance for the second quarter in a row.

Derivatives markets

The aggregate turnover of exchange-traded financial derivatives contracts rebounded in the first quarter of 2003. The combined value of trading in the various contracts increased by 16% to $197 trillion. Activity was uneven across the major market risk categories, with trading in fixed income contracts rising appreciably and business in stock index contracts declining marginally. Trading in European fixed income products was exceptionally buoyant. Exchanges continued to introduce a variety of new contracts, including futures on euro overnight index average (EONIA) rates.

In the over-the-counter (OTC) derivatives market, the latest BIS semiannual data on aggregate positions show a remarkable growth in global gross market values in the second half of 2002. During this period, these market values rose by 43% to stand at $6.4 trillion at end-December. Interest rate swaps accounted for the bulk of the expansion, which partly resulted from the sharp drop in swap yields from July to early October. Those paying fixed on swap contracts would have suffered losses, and they may have unwound their positions through the writing of new swaps. Such unwinding activity is suggested by the rapid growth in the notional amounts of swap contracts during the period. For the global OTC market as a whole, the aggregate notional amount rose by 11% to $142 trillion.

The international banking market

Banks sold debt securities and parked funds in the international interbank market in the fourth quarter of 2002. Cross-border lending to other banks was an unusually robust $430 billion, while that to corporations and other non-bank borrowers remained flat. Flows in the two previous quarters had been dominated by bank purchases of securities. The shift out of securities and into interbank deposits represented a move towards shorter maturities and may have reflected attempts to avoid losses from possible increases in interest rates.

During the same quarter, funds continued to flow out of emerging markets as a group and into banks in the BIS reporting area. The outflows from the Asia-Pacific region represented a turnaround from the inflows of the first quarter. These outflows were unusually large and partly took the form of the unwinding of repo transactions by a few countries. Latin America remained a source of heavy outflows, particularly from Argentina and Brazil, as they repaid bank debt. In an exception to the overall pattern, banks channelled further funds to emerging Europe, especially to those countries in accession negotiations with the European Union.

Special features

Capital flows in East Asia since the 1997 crisis

Not only is East Asia channelling capital on a net basis to the rest of the world, it is also engaged in an international exchange of risk that is rendering the region's economies more resilient. In buying high-quality US, European and Japanese government and agency securities and selling real assets, equities, and medium- and low-quality bonds, the region is building up relatively safe assets abroad while importing capital where the lender bears the risk. After documenting these patterns of capital flows, Robert McCauley of the BIS considers the criticisms that have been levelled against them and discusses policies to address associated problems. Such policies include completing the restructuring of banking and corporate sectors, developing both domestic non-bank financial institutions and bond markets, and relying less on exports to lead economic growth. He argues that such constructive policies would permit the global economy to move towards a more sustainable pattern of current account balances and capital flows.

Investors' attitude towards risk: what can we learn from options?

Observers of financial markets often attribute price swings to changes in investors' aversion to risk. Proxy measures of market participants' risk aversion can help individual institutions to manage market risk more effectively and enhance policymakers' monitoring, and interpretation, of market conditions. Nikola Tarashev, Kostas Tsatsaronis and Dimitrios Karampatos of the BIS estimate a broad indicator of such risk aversion in equity markets. Relying on modern finance theory, they construct their indicator by comparing the statistical likelihood of a sharp decline in equity prices, estimated with historical data, with the corresponding likelihood derived from forward-looking option prices. Based on their indicator, the authors find that periods of high risk aversion also tend to be periods of negative returns and high volatility in equity markets, and of reduced co-movement between equity and bond markets. They also find a significant co-movement of risk aversion in different equity markets, indicating an important cross-country component of investor sentiment.

What drives investor risk aversion?

Martin Scheicher of the Austrian National Bank focuses on explaining the day-to-day movements in investor risk aversion. He measures risk aversion in a similar way to Tarashev et al (see above), except that he measures it daily instead of monthly. He focuses on the Dax, the index that aggregates the stock prices of 30 major German companies, and examines the period from December 1995 to May 2002. To explain movements in risk aversion, he explores the effects of expectations about economic growth, market volatility, credit risk premia and negative news events. He finds that investors in the German equity market have become increasingly risk-averse since 1998. He also finds that movements in US stock prices have a strong impact on German risk aversion.