Quarterly Review, June 2006

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 financing flows in banking and debt securities markets, and activity in derivatives markets. The second part presents two special feature articles: one on securitisation in Asia and the Pacific, and another on the development of domestic bond markets in Latin America.

Retreat from risky assets

Yields on government bonds rose substantially up to the middle of May, reflecting expectations of robust growth as well as concerns about higher inflation. Initially, the rise in yields had little effect on the prices of risky assets or on investor risk appetite as strong fundamentals were thought to outweigh the impact of higher discount rates. Equity and commodity markets continued to rally into May, and spreads on lower-rated corporate and emerging market debt tightened further. The dollar depreciated significantly against other major currencies in late April and early May, with little apparent effect on other markets.

Concerns about the pace of recent gains in a broad range of markets culminated in an abrupt end to the rally in mid-May. Markets around the world fell. Emerging equity markets were the hardest hit, but losses were also recorded in other markets. Rather than a reassessment of fundamentals, the drop in the price of risky assets seems to have reflected primarily a higher risk aversion among market participants. This resulted in a reallocation of portfolios in favour of highly rated instruments such as government bonds.

The international debt securities market

Issuance of bonds and notes in international debt securities markets increased by 24% on a gross basis in the first quarter of 2006, to around $1.2 trillion, and by 9% on a net basis, to $622 billion. These levels represented historical peaks, suggesting ready access for borrowers to international credit markets and favourable financing conditions. Important contributors to the growth in gross issuance during the first quarter were, from a geographical point of view, US entities and, from a sectoral perspective, corporate issuers. US borrowers also significantly increased their funding in net terms, while euro area net borrowing grew at a more modest pace. Net issuance by Japanese entities increased markedly to a level that exceeded the total amount issued during the previous six quarters.

Last year's record-breaking issuance of international bonds and notes by emerging market borrowers was followed by continued robust activity in the first quarter of 2006, as borrowers took advantage of persistently narrowing spreads. Gross emerging market borrowing rose by 19% compared to the last quarter of 2005, reaching a new high of just below $60 billion, while net borrowing jumped by 33% to $42 billion – also a record level. While improving fundamentals have underpinned this strength for some time, the recent brisk pace seems also to have been fuelled to some extent by the search for yield among international investors.

Derivatives markets

The pace of trading on the international derivatives exchanges quickened in the first quarter of 2006. Combined turnover measured in notional amounts of interest rate, equity index and currency contracts increased by one quarter to $429 trillion between January and March 2006. The growth in turnover was particularly strong in interest rate products, as changing perceptions about the future course of monetary policy in the United States and Japan lifted activity in money market contracts in the US dollar and yen. Due to valuation effects from higher equity prices, turnover in derivatives on stock indices reached a record $43 trillion in the first quarter, up 11% from the previous three months. Volume increased sharply in derivatives on energy and non-precious metals, and was stable at a high level in contracts on precious metals.

Growth in the market for credit default swaps (CDSs) remained strong in the second half of 2005. The notional amount of CDSs outstanding increased by one third between end-June and end-December 2005 to $14 trillion. The rapid growth in these instruments has exposed several weaknesses in the market, such as occasional shortages of deliverable debt and backlogs in trade confirmations, though progress is being made in addressing these issues. A new and improved breakdown of the CDS statistics by counterparty indicates that the CDS market is largely an interbank market, and that purchases of CDSs by insurance companies to take on credit risk are limited.

The international banking market

BIS reporting banks' cross-border claims continued to expand in the fourth quarter of 2005. The bulk of this expansion was driven by greater intra-euro area lending, although new credit to borrowers in the United States and Japan also contributed. Yen-denominated claims rose noticeably in the fourth quarter, in line with the trend evident since mid-2004. Beginning at that time, residents of the United Kingdom and offshore centres stepped up their yen borrowing, suggesting an increased volume of yen-funded carry trades in 2005. Lending to emerging economies was quite strong in the fourth quarter, driving a net inflow of funds to emerging Europe and Latin America. International lending to emerging markets has picked up in recent years, and has flowed to borrowers with a lower average credit rating and on terms that are increasingly advantageous to fund-raisers.

In contrast to emerging Europe and Latin America, large deposit placements in BIS reporting banks were behind a record net outflow from Asia-Pacific. Such placements have become more common in recent years, as a portion of Asia's external surpluses is channelled through the international banking system. Asia's deposits are an important source of funds for BIS reporting banks, although only a small share of Asia's total funds invested abroad.

Special features

Securitisation in Asia and the Pacific: implications for liquidity and credit risks

Securitisation can turn ordinarily illiquid assets into reasonably liquid instruments, and create instruments of high credit quality out of debt of low credit quality. In their review of securitisation in Asia and the Pacific, Jacob Gyntelberg and Eli Remolona of the BIS document that Asian securitisation has been based largely on the repackaging of residential mortgages and consumer finance assets, and thus has been largely an activity for transforming liquidity. The authors note that a higher degree of credit risk transformation is often needed for corporate debt securitisation in Asia due to greater recovery risk as well as less diversified collateral pools than in the US and European markets. Even so, the authors suggest that there is great potential for the securitisation of corporate debt in Asia, and that this would be supported by the development of better accounting standards and disclosure rules.

Domestic bond markets in Latin America: achievements and challenges

In recent years, domestic bond markets have constituted a growing source of financing for Latin American economies. Drawing on statistics collected primarily from national sources, Serge Jeanneau and Camilo Tovar of the BIS argue that domestic bond markets have developed significantly, reflecting factors such as more stable macroeconomic policies, improved predictability and transparency of debt issuance, and the creation of liquid benchmark securities. Notwithstanding these advances, a number of vulnerabilities persist. In particular, the shift from external to domestic debt, which has helped reduce the risks arising from currency mismatches, may have contributed to maturity mismatches. Moreover, as the authors document, the investor base remains narrow, hampering the development of secondary market liquidity.