BIS Quarterly Review, June 2004

The BIS Quarterly Review released today is divided into two parts. The first analyses recent developments in financial markets, financing flows in banking and debt securities markets, and activity on derivatives markets. The second part presents three articles: one on the impact of credit rating announcements, one on the liquidity and performance of Asian local bond markets, and one on the markets for non-deliverable forwards in Asian currencies.

The prospect of rate hikes shakes markets

The prospect that US policy rates might start to rise sooner than expected triggered a broad sell-off in global financial markets in April and early May. Market participants around the world reacted unusually strongly to US macroeconomic releases and a Federal Reserve announcement perceived as indicating less patience with regard to raising rates, leading to losses in equity and government bond markets. In a reversal of the earlier search for yield, emerging market sovereign spreads widened sharply. Rising oil prices also weighed on the markets.

While most markets fell, some fell more than others. Moreover, markets that had previously tracked each other quite closely showed signs of diverging. US bond yields rose more sharply than those in other major markets, with euro yields in particular decoupling from dollar yields. Spreads on emerging market bonds widened by substantially more than those on high-yield corporate debt, owing in part to the importance of carry trades in the market for emerging market debt. Equity markets in Asia declined by more than equity markets elsewhere on concerns about a possible slowdown of the Chinese economy.

Despite the magnitude of the sell-off, market conditions remained orderly. There were few indications that the sharp movements in prices caused immediate financial difficulties for either issuers or investors, although those most exposed to higher interest rates could yet experience difficulties in the months to come.

The international debt securities market

Helped by a recovering global economy and easy financing conditions, fund-raising in the international debt securities market remained at record levels in the first quarter of 2004. Net issuance achieved a second consecutive quarterly all-time high of $518 billion. Government borrowers, particularly in Europe and Latin America, were among the most active, while issuance by financial institutions and lower-rated corporates stayed strong. Emerging market issuance continued its upward trend. Borrowing by investment grade non-financial corporations, by contrast, shifted somewhat from long-term securities markets to the commercial paper market.

The strength of issuance reflected the historically low level of credit spreads across virtually the entire credit spectrum. Even after widening somewhat in the course of the first quarter, spreads remained unusually narrow by the standards of the last five years. This in turn largely reflected the “search for yield” among investors who were willing to adopt somewhat riskier exposures in the face of the exceptionally low nominal yields on risk-free assets.

In April, issuance slowed in most sectors, amid widening credit spreads and increased uncertainty about the timing and implications of a shift to a less accommodative monetary stance in the United States. Issuance by emerging market borrowers in Asia and Latin America fell, but activity in emerging Europe remained strong in advance of the expansion of the European Union in May.

Derivatives markets

The aggregate turnover of exchange-traded financial derivatives contracts monitored regularly by the BIS returned to growth in the first quarter of 2004. The combined value of trading in interest rate, stock index and currency contracts amounted to $272 trillion, a 31% rise from the fourth quarter of 2003. Fixed income and currency contracts were notably buoyant, with turnover in both types of instruments growing by about 35%. Business in stock index contracts was comparatively subdued, with volumes rising by 9%.

Global turnover was boosted in the first quarter by a resurgence of activity in March, with many exchanges witnessing new daily trading records. Trading in options on short-term European interest rates and German government bond futures was unusually brisk as market participants became increasingly convinced that weak economic data would prompt a cut in ECB policy rates.

As published by the BIS, the most recent semiannual data on aggregate positions in the over-the-counter derivatives market show sustained activity in the second half of 2003. The notional amount of outstanding contracts rose to almost $200 trillion, an increase of 16%. Gross market values fell by 12%, marking the first decline since 2001.

The international banking market

Following a large contraction in the third quarter of 2003, activity in the international interbank market in the fourth quarter returned to levels seen earlier in the year. Claims in US dollars accounted for much of this recovery, as banks in offshore centres, the United Kingdom and the euro area lent to one another and to banks in the United States. Loans to non-bank customers, which had displayed signs of life in the third quarter, stagnated in the fourth; the modest increase in activity that did materialise largely took the form of lending from offshore centres to borrowers in the United States.

While less pronounced than in previous quarters, a discernible shift within banks’ exposures to emerging markets into somewhat safer credits continued in the fourth quarter. This shift was reflected in a fall in the share of claims on Latin America as well as a rise in the share of claims on the public sector in certain regions. These trends in bank flows accompanied an increased reliance on debt securities issuance by emerging market borrowers.

An expansion in deposits placed with BIS reporting banks outpaced a rise in lending, resulting in an overall net outflow from emerging market economies. Increased deposits contributed to net outflows from the Asia-Pacific region, Latin America and the Middle East and Africa, while growth in bank claims on emerging Europe led to a net inflow to that region.

Special features

The price impact of rating announcements

To assess the default risk of corporate bonds, investors rely on credit ratings as well as on other forms of information. Marian Micu, Eli Remolona and Philip Wooldridge of the BIS gauge the additional information contained in ratings by analysing the price impact of various types of rating announcements, including “reviews”, “credit watches”, “outlooks” and actual rating changes. Exploiting data from the relatively liquid credit default swap market, they conclude that credit ratings do convey additional information to market participants. Even announcements that are anticipated by earlier movements in spreads seem to provide relevant information.

Asian local currency bond markets

Guorong Jiang and Robert McCauley of the BIS analyse the liquidity and recent performance of local currency bond markets in Asia. They find that liquidity conditions vary substantially across economies. Market size and larger individual issues work for liquidity, while a concentration of holdings among buy-and-hold investors works against it. The authors argue that liquidity would improve with measures to consolidate different segments of the markets into fewer public issuers as well as into fewer but larger individual issues. Efforts to develop hedging markets and to broaden the investor base would also help. They also find that returns on higher-yielding instruments have enabled local currency bonds to outperform US Treasuries in aggregate. Such performance suggests that Asian local currency bonds might serve as a distinct asset class notwithstanding the close relationship of Asian currencies to the US dollar.

Non-deliverable forwards in Asia

Active non-deliverable forward (NDF) markets exist for six Asian currencies. Guonan Ma, Corrinne Ho and Robert McCauley of the BIS present an overview of these six markets. They find that aggregate turnover in Asian NDFs has risen, particularly in the renminbi, so that these contracts now represent the bulk of global NDF trading. The Asian NDF rates are typically more volatile than the corresponding spot rates. They also tend to correlate more positively with each other than do their spot counterparts, and respond similarly to movements in the forward rates of major currencies. The authors also find a tendency for wide interest rate differentials between onshore rates and the offshore rates implied by NDFs, suggesting effective segmentation between the onshore and offshore markets.