BIS Quarterly Review March 2015 - media briefing

Please note that the Special Features present the views of the authors and not necessarily those of the BIS. When referring to the articles in your reports, please attribute them to the authors and not to the BIS.

On-the-record remarks by Mr Claudio Borio, Head of the Monetary & Economic Department, and Mr Hyun Shin, Economic Adviser & Head of Research, 16 March 2015

Claudio Borio

As bond markets show us day after day, the boundaries of the unthinkable are exceptionally elastic. At the end of February, around $2.4 trillion worth of global long-term sovereign debt was trading at negative yields. Of that total, more than $1.9 trillion had been issued by euro area sovereigns alone. And since then, the sinking trend has continued. The latest figures indicate that French, German and Swiss sovereign yields are negative up to four, six and 10 years, respectively.

In The Adventures of Tom Sawyer, Mark Twain tells us that the essence of good management is to have your friends paint the fence and pay you for the privilege. By that yardstick, some sovereigns have surpassed the master.

The proximate reason for this unprecedented situation is not hard to find. For some time now, central banks have been easing aggressively in their efforts not to fall short of their mandated objectives, not least in terms of inflation. It was the ECB that took the most aggressive measure recently, surprising markets with the size and open-endedness of its large-scale asset purchase programme. But since early December over 20 central banks have eased policy, often taking markets by surprise in their turn. Some, such as the People's Bank of China or the Reserve Bank of India, responded largely to domestic conditions; others, such as the Swiss National Bank or the Danish central bank, to external ones, as their exchange rates came, or threatened to come, under huge pressure. More generally, in highly integrated financial markets, even flexible exchange rates provide only limited insulation. Recall that the Special Drawing Right - the basket of the main reserve currencies - is now yielding less than 5 basis points at three months. In such a world, easing begets easing.

In the process, central banks have shown that the so-called zero lower bound on interest rates is quite porous. Negative policy rates at the short end, coupled in some cases with large-scale asset purchases at the longer end, have pushed both term premia and nominal yields firmly and farther into negative territory. If this unprecedented journey continues, technical, economic, legal and even political boundaries may well be tested. The consequences should be watched closely, as the repercussions are bound to be significant, on the financial system and beyond.

The combination of negative interest rates and large-scale asset purchases in the euro area lie partly behind another exceptional development - in recent months, euro area bond yields appear to have significantly influenced their US counterparts. Following the ECB announcement, 10-year German Bund yields fell by 13 basis points, and their equivalent US Treasuries by no fewer than nine.

Such low rates have both reflected and strengthened the other two major factors shaping the financial landscape. They have partly reflected the sharp drop in oil prices. The drop, along with smaller declines in other commodities prices, has intensified near-term disinflationary pressures. And they have strengthened the appreciation of the US dollar, in line with diverging current and prospective monetary settings as well as macroeconomic outlooks. The US dollar trade-weighted exchange rate has appreciated by no less than some 20% since mid-2014 - one of the sharpest appreciations on record within a similar window; in the meantime, the depreciation of the euro vis-à-vis the dollar has gathered momentum, with parity appearing within range.

What does all this mean for prevailing international financing conditions - or "global liquidity"? Can the euro and the yen take over from the US dollar as key drivers? Perhaps, but probably only to a limited extent. The US dollar remains the main currency of denomination for global trade, which results in a structural demand for dollar borrowing. And regardless of new flows, the outstanding stock has a major impact on financing conditions, as exchange rate and interest rate changes alter existing debt burdens. Here, the US dollar remains king, as more than $9 trillion in credit outstanding to non-banks outside the United States testifies; the euro is a distant second, at $2.3 trillion worth, mostly in the area's bordering region. If so, a further US dollar appreciation, especially if coupled with a US monetary policy tightening, will, on balance, tend to tighten international financing conditions.

In the meantime, vulnerabilities have been slowly growing, on the back of strong credit growth in several countries less affected by the crisis. In this issue, we bring together various indicators of global liquidity and put them in the broader context of domestic financial developments - something we intend to do on a regular basis.  The statistics highlight several developments: the post-crisis contraction in aggregate international bank credit following its pre-crisis boom, mainly because of shrinking intra-advanced country flows; its continued strong expansion in many EMEs, sometimes outpacing domestic credit growth; the surge in US dollar credit there; the shift from bank to capital market financing; and the, admittedly always fuzzy, signs of the build-up of domestic financial imbalances.

All told, global liquidity conditions have been reinforcing domestic ones. Of note, the latest figures indicate that financial booms in some EMEs have been faltering. Not least, the growth of claims on China by BIS reporting banks slowed down sharply, to a mere 3% on a quarterly basis in the third quarter of 2014. And interbank claims even contracted. The possible turn in domestic financial cycles as US dollar funding is set to tighten deserves close watching.

In the background, the search for yield has continued and so has the markets' dependence on central bank monetary accommodation. The latest market jitters in the wake of a strong US payroll figure, hinting at a policy rate hike sooner rather than later, is but the latest example. Volatility has been returning to historical averages, pointing to less aggressive risk-taking. But markets cannot remain liquid when the exit door has been narrowing for so long. There should be no illusion about this.

Let me now turn to my colleague Hyun Shin, who will also elaborate on some of these points.

Hyun Shin

Let me turn to the special features in this issue of the BIS Quarterly Review.

As usual, we have tried to assemble a set of articles that shed light on some topical questions.

In this issue, we address the economic costs of deflation, the evolution of investment after the financial crisis, the role of debt in the recent drop in oil prices, how financial inclusion affects central bank policy, and market liquidity.

Given the constraints on time, let me focus my remarks on three of them in particular.

The first is on the economic costs of deflation, written by Claudio Borio, Magdalena Erdem, Andrew Filardo and Boris Hofmann. It examines the historical evidence on the relationship between deflation and output growth.

The recent drop in the price of oil and other commodities has pushed down headline inflation rates around the world, in some cases into negative territory. In January, annual headline inflation was barely positive in the advanced economies and less than 3% in the emerging economies. 

The facts documented in the special feature give us pause for thought.

First, deflations - defined simply as declines in the price of goods and services - have been quite common in the sample period from 1870. The 38 economies examined in the study have spent roughly 18% of the time in deflation. That said, deflations became far less common and more short-lived after the Second World War.

Second, in the popular debate the term "deflation" conjures up images of the Great Depression, with large output drops and mass unemployment.  But the historical evidence suggests that the Great Depression was the exception rather than the rule. Average growth was indeed higher when prices go up than when they are falling, but this relationship is almost all driven by the period surrounding the Great Depression.

Third, delving further into the evidence, the authors find that episodes of falling property prices, in particular, are associated with much larger drops in output than goods price deflations.

And finally, there is not much evidence so far that deflation has been associated with debt deflation spirals, where lower prices increase the debt burden, which in turn depresses economic activity.

Let me now change tack and introduce the special feature on market liquidity and market making in fixed income markets.

Drawing on a recent report by a committee of central bankers on this topic, my colleagues Ingo Fender and Ulf Lewrick document how market liquidity conditions have changed in the aftermath of the global financial crisis.

While liquidity in the sovereign bond market is back to conditions seen before the crisis, this is not the case in other segments of the fixed income market. For instance, corporate bond markets seem to be less liquid than in the past. Bid-ask spreads have returned to something close to pre-crisis levels, but there are residual doubts on how well the market would cope with large transactions, particularly when many traders want to shed risky holdings at the same time.

We have seen examples of large price changes in markets that are normally very deep and liquid. One instance was in the US Treasuries market last October, and another recent example was the sharp movements in the Swiss franc in January. Fortunately, neither of these events had lasting repercussions for financial stability, but what happens in financial markets does not always stay in financial markets, and we would do well to be on the lookout for any potential economic impact from financial market disruptions.

The special feature on oil and debt illustrates some related lessons. I am an author of the piece, together with Dietrich Domanski, Jonathan Kearns and Marco Lombardi. We point out that the debt of the oil sector globally has increased two and a half times since 2006 to stand at $2.5 trillion at the end of 2014. 

As we learned from the housing market during the financial crisis, when a sector of the economy is highly indebted, the decline in the underlying value of assets can cause short-run disruptions that amplify any initial impact. 

The continued high rates of production and rapid accumulation of oil inventories may reflect in part the cash flow needs of producers to service their debt.

In particular, we show that hedging by producers displays a tell-tale downward-sloping supply response where declines in price are associated with increased sales of oil in the futures market.

The extent to which selling into a falling market sets off an amplifying price response depends on market liquidity and the capacity of dealers to absorb the sales.

A part of the rapid oil price decline in the recent episode could be attributed to the decreased capacity of swap dealers to absorb the sales. With this observation, we come full circle to the theme of the previous piece on market liquidity.