March 2015 BIS Quarterly Review: A wave of further easing

• A growing share of sovereign debt and even some private bonds are now trading at negative yields as a wave of easier monetary policy feeds through into unprecedented bond market conditions.
• The revival in international bank lending since early 2014 has occurred alongside persistently strong bond issuance in emerging markets. Cross-border lending to most Asian emerging economies continued to grow rapidly, although lending to China showed signs of peaking.
• To view the potential costs of deflation solely through the lens of the Great Depression could be misleading, argue Claudio Borio, Magdalena Erdem, Andrew Filardo and Boris Hofmann (BIS). Their historical review finds little systematic connection between price deflation and growth.
• The heavy indebtedness of oil producers may have amplified the sharp drop in oil prices and related investment, find Dietrich Domanski, Jonathan Kearns, Marco Lombardi and Hyun Song Shin (BIS).
• Investment in the major advanced economies will only recover strongly once economic uncertainty recedes and firms regain confidence in their profit outlook, suggest estimates by Ryan Banerjee, Jonathan Kearns and Marco Lombardi (BIS).
• Greater financial inclusion boosts growth and reduces poverty. It also affects how central banks set monetary policy, argue Aaron Mehrotra and James Yetman (BIS). The financial system may become more stable, although that depends on how inclusion is achieved.

• Liquidity in core sovereign bond markets has recovered after the financial crisis but not so in corporate bond markets, argue Ingo Fender and Ulf Lewrick (BIS), drawing from a recent report by the Committee on the Global Financial System.

Summaries of individual chapters

A wave of further easing

Largely unexpected, a wave of monetary easing over the past few months has taken centre stage in global financial markets. Amid plunging oil prices and rising foreign exchange tensions, central banks in both advanced and emerging market economies provided further stimulus. The ECB announced an expanded asset purchase programme, which was both larger and longer-lasting than market participants had anticipated.

Volatility in most asset classes reverted to historical averages, closing out a period of unusually low market volatility. Commodity volatility spiked in January, marking an end to the oil price decline. Volatility in foreign exchange markets has been on the increase since mid-2014 in response to diverging monetary conditions and surged further in January as looser monetary policies added to the pressure on managed exchange rates. The Swiss National Bank unexpectedly abandoned the cap on the Swiss franc/euro rate, while other central banks adjusted policies in response to changed exchange rate configurations. The dollar continued to appreciate against the backdrop of diverging monetary policies and sagging commodity prices. 

Extraordinarily easy monetary policies fed through into unprecedented conditions in bond markets. A significant and growing share of sovereign debt and even a few highly rated corporate debt issues are now trading at negative yields. Historically low interest rates and compressed risk premia once again pushed investors into riskier assets in their search for yield, sending equity prices towards record highs.

Highlights of global financing

Global international banking activity continued to expand during the third quarter of 2014, after turning upwards in the first. International bank lending in the advanced economies revived as the growth outlook in some of these economies picked up and banking systems continued to recover. Bank lending to emerging market economies remained strong, particularly in Asia. The revival in international bank lending occurred in parallel with persistently strong bond issuance in emerging markets.

Cross-border lending to most Asian emerging economies continued to grow rapidly, although lending to China showed signs of peaking. Claims on China were 40% higher than a year earlier, but rose by only 3% on a quarterly basis in the third quarter of 2014, and international claims on Chinese banks fell. Burgeoning cross-border capital flows to some emerging economies, particularly in East Asia, could further stoke domestic credit booms. In other emerging economies and regions, cross-border lending continues to lag domestic credit growth.

Cross-border credit to Russian borrowers fell especially sharply in the third quarter of 2014, contributing to a year-on-year decline of 15%.

At end-September 2014, US dollar credit to non-bank borrowers outside the United States totalled $9.2 trillion. This represents an increase of 9% over a year earlier and of over 50% since end-2009. The total comprised $4.2 trillion of debt securities and $4.9 trillion of bank loans.

Special features

The costs of deflations: a historical perspective*

Concerns about deflation - falling prices of goods and services - are grounded on the view that it is very costly. Claudio Borio, Magdalena Erdem, Andrew Filardo and Boris Hofmann (all BIS) review the historical record for the link between output growth and deflation in a sample covering 140 years for up to 38 economies. They find that this link is weak and derives largely from the Great Depression. By contrast, protracted declines in equity and, especially, property prices - asset price deflations - tend to coincide with larger slowdowns. Indeed, output growth is little affected during price deflations if one takes into account the behaviour of asset prices.

The authors also test the hypothesis that high debt has made price deflations particularly costly - "debt deflations". They find little evidence for such a link. Instead, the most damaging interaction appears to be with property price deflations.

Oil and debt*

Oil prices fell sharply in the second half of 2014, although the fundamental supply and demand factors did not deviate much from initial projections. BIS economists Dietrich Domanski, Jonathan Kearns, Marco Lombardi and Hyun Song Shin explore whether the high debt burdens of oil firms could have affected adjustment in the oil sector and amplified price dynamics. The total debt of the oil and gas sector worldwide stands at roughly $2.5 trillion, two and a half times what it was at the end of 2006. The recent fall in the oil price represents a significant decline in the value of assets backing this debt. To remain liquid, highly leveraged oil producers may be forced to keep up their production levels, postponing the market-clearing effect of the price decline. Highly indebted firms may also come under greater pressure to hedge their exposure to further price declines, which will have the effect of further increasing supply.

Recent trends in capital spending, production and hedging developments appear to support this hypothesis. Oil production has remained strong in the United States, where many of the highly leveraged shale oil producers are located. Oil producers have also increased their hedging activity on US derivatives exchanges.

(Why) Is investment weak?*

In spite of very easy financing conditions worldwide, investment has faltered in the aftermath of the Great Recession. Ryan Banerjee, Jonathan Kearns and Marco Lombardi of the BIS find that the uncertainty about the economic outlook and expected profits play a key role in driving investment, while the effect of financing conditions is apparently small.

Given the meagre impact of financing terms, investment trends after the Great Recession seem broadly in line with past relationships. The authors' estimates suggest that lower economic uncertainty has stimulated investment in some G7 economies but not in the euro area. A stronger recovery in investment would depend on a reduction in economic uncertainty and stronger expectations for future growth. These conclusions are drawn from an econometric model linking investment in several advanced economies to a number of real and financial variables.

Financial inclusion: issues for central banks*

Access to appropriate financial instruments allows poor or otherwise disadvantaged people to invest in physical assets and education, reducing income inequality and contributing to growth. It is therefore a welcome development that more and more people around the globe are gaining access to financial services.

Financial inclusion also has important implications for monetary and financial stability policies, which are at the very core of central banking. Aaron Mehrotra and James Yetman (BIS) argue that financial inclusion may increase the effectiveness of interest rate tools and help central banks in their efforts to maintain price stability. There may also be implications for financial stability. On the one hand, a broader base of depositors and more diversified lending portfolios could buttress financial stability. On the other hand, greater financial access may increase financial risks if it proceeds from rapid credit growth or the expansion of relatively unregulated parts of the financial system.

Shifting tides: market liquidity and market-making in fixed income instruments*

Recent bouts of volatility are a reminder that liquidity in financial markets can evaporate quickly. The 2013 "taper tantrum" showed that liquidity strains can rapidly spread across market segments. In sovereign debt and, to an even greater degree, corporate bond markets, liquidity hinges largely on whether specialised dealers - market-makers - can respond to temporary supply and demand imbalances by stepping in as buyers or sellers. Post-crisis, several developments suggest that market-makers are changing their business models.

Drawing from a recent report by the Committee on the Global Financial System, Ingo Fender and Ulf Lewrick (BIS) spot signs of diverging liquidity conditions across different fixed income markets. They find that market-making is concentrating in the most liquid securities and fading in less liquid ones. This could make markets more sensitive to sudden changes in conditions, especially in the current low interest rate environment. The authors outline some policy options that could help to ensure that the pricing of market-making services is brought more into line with the costs and risks involved. For some markets, the narrow spreads seen in the past may have to give way to more realistic premia for providing liquidity to the market.

* Signed articles reflect the views of the authors and not necessarily those of the BIS.