Quarterly Review, September 2005

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 in derivatives markets. The second part presents four articles: one on distinguishing global US dollar reserves from official holdings of assets in the United States; another on the structure, uses and recent enhancements of the BIS consolidated banking statistics; a third that analyses movements in interest rate volatility using data from swaptions markets; and a fourth that uses firm-level data to assess structural models of default.

Improving outlook lifts markets

An improving economic outlook underpinned a rebound in equity and credit markets between mid-May and mid-August. Equity markets rose on strong earnings reports, reaching their highest level in several years in Japan and Europe. Conditions in credit markets stabilised, helping corporate spreads to tighten from May highs generated by the rating downgrades of US auto makers. Emerging market spreads approached the lows seen earlier in the year.

A series of surprises did little to disrupt the momentum in markets. The terrorist attacks in London in July failed to dampen investor enthusiasm. Political uncertainty in Brazil and the Philippines had only a passing influence on emerging markets. The revaluation of the Chinese renminbi was also received calmly, with little lasting impact on either interest rates or the exchange rates of the major currencies. Eventually, however, concerns about high oil prices helped to erase some of the gains in equity and credit markets.

Investors’ appetite for riskier assets continued to be supported by the low level of nominal yields. Signs of robust growth and upward revisions to the expected path of policy rates did lead to increases in long-term yields between late September and mid-August, in the dollar and yen markets especially. However, yields failed to break out of the range in which they have been trading for the past year.

The international debt securities market

The appetite for international debt securities remained relatively robust in the second quarter of 2005 despite the turmoil in global credit markets. Overall gross issuance increased on a seasonally adjusted basis. Even before seasonal correction, gross issuance in the euro area expanded significantly when measured in euros. Global net issuance of bonds and notes declined by 4% during the period, even though, as with gross issuance, it was considerably higher than in the second quarter of 2004.

Conditions differed markedly between developed country high-yield markets and emerging markets. Borrowing by high-yield entities in developed economies fell sharply during April and May, reflecting heightened uncertainty following the ratings downgrades of US auto makers, although borrowing did rebound in September. By contrast, most emerging market borrowers were relatively unaffected by the spring dislocation in credit markets, with gross issuance rising further and sustaining the record-breaking pace of borrowing that began in early 2004. Issuance by emerging market borrowers of international securities denominated in local currencies continued to rise, as investors increasingly displayed a willingness to take on local currency risk.

Derivatives markets

Trading on the international derivatives exchanges continued to be buoyant during the second quarter of 2005. The combined turnover in fixed income, equity index and currency contracts increased by 11% to $372 trillion, after a 20% rise in the previous quarter.

The growth in activity was mainly due to market participants’ changing perceptions about the future path of policy rates. Consequently, the increase in turnover was greatest in short-term interest rate derivatives, both futures and options, whereas activity in long-term bond contracts declined slightly. The trading volume of equity index contracts rose for the third quarter in a row, albeit at a reduced pace, perhaps because traders were less inclined to take positions given increased uncertainty over equity returns.

Turnover in exchange-traded currency derivatives surged by 15% in the second quarter to $3 trillion, driven by the strength of the dollar. The increased trading volume also reflected rising speculative activity, as evident in the doubling of long dollar positions of non-commercial users. There was also solid growth in commodity derivatives, boosted by price volatility in oil markets.

The international banking market

The cross-border claims of BIS reporting banks surged in the first quarter of 2005, with new credit to non-banks rising sharply, particularly in the United States. Banks also continued to channel funds to non-banks in the United Kingdom and offshore centres, areas with considerable non-bank financial activity. There is some evidence that hedge funds and their use of leverage are contributing to this growth.

Meanwhile, emerging markets experienced a large inflow of funds. This was primarily the result of increased cross-border credit to banks in Asia-Pacific, despite the growing current account surpluses of many countries in the region. By contrast, funds flowed out of other emerging market regions, driven by increased deposits in BIS reporting banks. This was particularly the case with Russia, where there were large placements of overseas deposits by the banking sector, partially the result of the placement of official reserves.

Special features

Distinguishing global dollar reserves from official holdings of US assets

The extent to which global official dollar reserves exceed official holdings of assets in the United States has come under increasing scrutiny in recent years. Drawing on national and BIS data, Robert McCauley of the BIS finds that, while once crucial, yield differences have lost importance when explaining the growth in central bank holdings of dollar reserves offshore. Country risk and investment lags after heavy foreign exchange intervention, however, remain important. The author argues that, while offshore investments do not from an accounting perspective finance the US current account deficit, they do provide support for the value of the dollar. In conclusion, the author proposes that global official dollar purchases are best compared with the net US issuance of dollar liabilities when assessing the degree of dollar support such accumulation provides.

The BIS consolidated banking statistics: structure, uses and recent enhancements

The BIS consolidated banking statistics are the most comprehensive source of aggregate data on banks’ foreign assets, and provide internationally comparable measures of national banking systems’ exposures to country risk. The latest enhancements of the statistics include the provision of more detailed information about risk transfers, derivatives exposures and contingent claims. Patrick McGuire and Philip Wooldridge of the BIS outline the compilation and latest enhancements of the consolidated statistics, and discuss a few of their analytical uses. The authors show why the statistics are valuable, not only as a tool for monitoring banks’ country risk exposures, but also as a supplement to other external debt measures when assessing countries’ external vulnerabilities.

The rise and fall of US dollar interest rate volatility: evidence from swaptions

One noteworthy development in financial markets since 2001 was the sharp rise and subsequent fall in the implied volatility of US dollar interest rates. Using swaptions market data, Fabio Fornari, formerly of the BIS, documents that the swings in interest rate volatility were much greater for US dollar than euro rates and more sizeable for short-term rates and swaptions with short time-to-expiration. Comparing implied volatilities with forecasts of volatility derived from econometric simulations, the author uncovers evidence that the movements of US dollar implied volatility reflected changes not only in the expectations of rate volatility, but also in the compensation for volatility risk. Based on regression analysis, he concludes that the main determinants of compensation for dollar volatility risk have been the level of US interest rates, their volatility and the slope of the yield curve.

Structural models of default: lessons from firm-level data

Measures of default risk are of fundamental importance for the sound management of lender institutions and for the supervisory evaluation of their vulnerability. Calibrating well known theoretical models of default to firm-level data, Nikola Tarashev of the BIS compares the probabilities of default generated by these models to realised default rates. The author finds that using firm-level data substantially improves the ability of the models to account for the average level of default rates within rating categories. However, firm-specific information matters less when forecasting the path of default rates over time, since economic factors common to all firms strongly influence the evolution of predicted default rates.