September 2011 Quarterly Review traces back recent turbulence in financial markets to weaker growth expectations

The BIS Quarterly Review  for September 2011, released today, shows how a weaker outlook for the global economy drove down the prices of risky assets and fuelled concerns about sovereign risk.

The September issue also provides highlights from the latest BIS data on international banking and financial activity.

In addition, it features three articles (more detailed abstracts follow):

1. Trade balance and real exchange rate: movements in real exchange rates have only limited effects on the trade account of some countries.
2. Global credit and domestic credit booms: rapidly growing foreign currency and/or cross-border credit could undermine the efforts of authorities to dampen credit growth.
3. The rise of sovereign credit risk has increased the vulnerability of banks to funding shocks.

This Press Release is also available in French, German, Italian and Spanish.

Global growth and sovereign debt concerns drive markets

Developments in financial markets during the review period largely reflect substantial downward reassessments of trajectories for economic growth. The prices of risky assets fell sharply in July and August as negative macroeconomic data cast a dark cloud over the strength of recovery in several major economies. Market participants' concerns about growth were amplified by perceptions that monetary and fiscal policies had only limited scope to stimulate the global economy.

In Europe, concerns about sovereign debt spread from Greece, Ireland and Portugal to Italy and Spain. This led to tighter funding conditions for European banks and even affected pricing in euro area core sovereign debt markets.

All these developments led to flows into safe haven assets, which appreciated in value. Yields on 10-year US Treasuries and German bunds fell to historic lows, while gold prices and the Swiss franc soared before the Swiss National Bank imposed a floor on the Swiss currency against the euro.

Highlights from the BIS international statistics

The aggregate cross-border claims of BIS reporting banks rose during the first quarter of 2011, mainly because of increased lending to US residents.

BIS reporting banks increased their cross-border claims on residents of emerging market economies by the largest amount since the global financial crisis. The $178 billion (6.3%) expansion was primarily due to a rise in interbank claims, which increased by $147 billion (10%). Cross-border claims on Asia-Pacific grew by an unprecedented $126 billion (12%) in the first quarter, largely reflecting a surge in claims on China ($80 billion or 24%). Cross-border claims on residents in the other emerging market regions also increased.

The political turmoil in North Africa and the Middle East led to outflows of funds from several countries in the region. Internationally active banks reported the largest single-quarter increase in liabilities to residents of Egypt ($6.4 billion or 26%). Liabilities to residents of Libya also increased considerably ($2.2 billion or 3.7%).

More bilateral netting and higher collateralisation have reduced counterparty credit exposures in the OTC derivatives market. BIS statistics show that the amount of bilateral netting in this market has gone up since late 2007, as has the degree of collateralisation.

Special features

The trade balance and the real exchange rate

The article by Enisse Kharroubi (BIS) finds that globalisation has affected the relationship between the trade balance and the real exchange rate in two ways. On the one hand, more trade takes place within industries, with countries importing and exporting very similar products. This makes the trade balance more sensitive to real exchange rate movements. On the other hand, countries trade more intermediate goods as firms specialise in particular stages of production and source globally. This reduces the sensitivity of the trade balance to movements in exchange rates.

The relative importance of these two effects varies across countries. Kharroubi estimates that changes in the real exchange rate could play a larger role in curbing the US trade deficit than in reducing the Chinese trade surplus. This confirms that real exchange rate adjustment is only part of the solution for global rebalancing, and needs to be accompanied by other policy actions.

Global credit and domestic credit booms

Claudio Borio, Robert McCauley and Patrick McGuire (BIS) point to the importance of cross-border and foreign currency credit in the world economy. US dollar credit is growing quickly outside the United States, especially in Asia, and in some economies it has outpaced overall credit growth. Cross-border sources of credit tend to outgrow other sources of credit in boom periods. Cross-border and foreign currency credit constrain the room for manoeuvre of the countries where such forms of financing play a significant role in the economy.

The rise of sovereign credit risk: implications for financial stability

In this article, Michael Davies and Tim Ng (BIS) review recent work by the Committee on the Global Financial System (CGFS) on the implications of sovereign risk for banks and for sovereign debt management. The increase in sovereign risk in the wake of the financial crisis and economic recession has increased the cost and reduced the stability of funding for banks. It has also meant that decisions about the maturity of government debt have become important to the dynamics of systemic financial distress.

Banks and governments can take a series of measures to reduce the impact of sovereign risk. Banks can improve their funding and asset risk management, and governments can lengthen debt maturities and impose sound banking regulation. Ultimately, however, public finances have to return to a sustainable path if current difficulties are to be managed.