March 2014 Quarterly Review: Emerging economies respond to market pressure

• The recent performance of emerging market currencies has reflected the success of central banks in defending exchange rates as well as the political uncertainty in a number of countries. External imbalances, inflation and domestic credit growth have played a much smaller role than during the depreciations in May and June last year.
• Cross-border interbank lending fell at an even faster rate in the third quarter of 2013. Banks headquartered in the euro area account for most of the decline after the financial crisis of 2007-09, and Swiss banks for much of the remainder.
• The stock of debt securities reached an estimated $100 trillion in mid-2013 on heavy post-crisis issuance by governments and non-financial corporations. Foreign investors hold a smaller share of debt securities than previously, suggesting that the globalisation of portfolios may have gone partially into reverse post-crisis. But the retreat could be temporary.
• Financial development is good for growth, but only up to a point. Leonardo Gambacorta, Jing Yang and Kostas Tsatsaronis (BIS) estimate that growth rates fall once this threshold is crossed. Economies with bank-based financial systems tend to have shallower recessions than those with market-based systems. But this reverses when a downturn coincides with a financial crisis.
• Forward guidance by major central banks has successfully lowered the volatility of expected future policy rates, conclude Andrew Filardo and Boris Hofmann (BIS). Less clear are the effects of forward guidance on the level of expected interest rates and on the responsiveness of financial markets to news.
• The gap between the credit-to-GDP ratio and its long-term trend is a valid indicator for the build-up of financial vulnerabilities, argue Mathias Drehmann and Kostas Tsatsaronis (BIS), and hence it should prove useful as a guide for setting countercyclical capital buffers.
• The markets for non-deliverable forwards (NDFs) tend to fade away when countries remove capital controls, find Robert McCauley, Chang Shu and Guonan Ma (BIS). In the case of the Chinese renminbi, deliverable forwards traded offshore are replacing established NDFs as the main hedging instrument against exchange rate volatility.
• Counterintuitively, large-scale bond buying by the Fed drew dollars into the United States from the eurodollar market. Robert McCauley and Patrick McGuire (BIS) document how non-US banks raised dollars abroad with the aim of holding them as reserves at the Fed.

Summaries of individual chapters

Emerging economies respond to market pressure

Investors resumed and accelerated their retreat from emerging market economies around the turn of the year as the subdued growth outlook continued to diverge from the generally upbeat sentiment in mature markets and as US policymakers reduced the flow of easy money. Signs of economic weakening and the growing financial risks in China also unsettled investors. The upshot was portfolio outflows and declining asset prices. In parallel, emerging market currencies continued to sag, prompting policy rate rises and foreign exchange interventions.

While the recent downturn in EME exchange rates bears a striking resemblance to the mid-2013 sell-off, the underlying drivers differ. In the earlier episode, the large depreciations tended to be by the currencies of emerging market economies with large external imbalances, high inflation or rapidly growing domestic credit. By contrast, the recent depreciations reflected political uncertainties and differences in growth prospects. Central banks also intervened much more forcefully this time round.

In advanced economies, the rally persisted. Investors pinned their hopes on policy commitments to support growth as well as on positive economic surprises, notably in the euro area and the United Kingdom. Thus, they took in their stride the prospect and actual start of US tapering. The tightening of credit spreads continued until mid-January, while steady inflows into equity funds kept upward pressure on stock prices. However, disappointing data on US job growth and headwinds from emerging market countries undercut market sentiment in late January. This led to a sharp, if temporary, reversal in valuations in all but the safest asset classes.

Highlights of the BIS international statistics

Cross-border claims by BIS reporting banks continued to fall in the third quarter of 2013. Interbank positions posted their largest drop since the second quarter of 2012, with inter-office positions accounting for most of this retreat. Cross-border credit to non-banks also declined, especially to borrowers in the United States and the euro area. Among the main reporting regions, only emerging market economies and Japan saw an increase in cross-border credit to their residents.

International interbank funding was heavily affected by the 2007-09 financial crisis and subsequent financial strains in the euro area. Cross-border interbank lending (including inter-office positions) fell from $22.7 trillion at end-March 2008 to
$17.0 trillion at end-September 2013. Banks headquartered in the euro area accounted for more than two thirds of the total contraction, and Swiss banks for most of the remainder.

Global debt markets burgeoned to an estimated $100 trillion in mid-2013, up from $70 trillion in mid-2007. Governments (defined broadly to include central, state and local governments) have been the largest debt issuers. The stock of public debt securities reached $43 trillion in June 2013, about 80% higher than in mid-2007. Debt issuance by non-financial corporates grew at a similar rate, albeit from a lower base. Issuance by financial institutions was more subdued.

Non-residents hold about one quarter of the stock of debt securities, compared to 29% in early 2007. This decline suggests that the process of international portfolio diversification may have gone partially into reverse since the crisis. But this could be temporary. Figures from the IMF-CPIS survey indicate that cross-border investments in debt securities recovered slightly in the second half of 2012, the most recent period for which data are available.

Special features

Financial structure and growth*

Banks and markets both foster economic growth, but only up to a point. Estimates by Leonardo Gambacorta, Jing Yang and Kostas Tsatsaronis (BIS) suggest that expanded bank lending or market-based financing reduces growth rates once the financial system grows beyond this threshold.

Banks and markets differ considerably in how they moderate business cycle fluctuations. In normal downturns, healthy banks help to cushion the shock but, when recessions have coincided with financial crises, the authors find that the impact on GDP has been three times more severe in bank-oriented economies than in market-oriented ones.

Forward guidance at the zero lower bound*

Four major central banks have adopted new approaches to policy rate forward guidance with the aim of increasing monetary policy effectiveness at the zero lower bound. In this special feature, Andrew Filardo and Boris Hofmann (BIS) find that the new approach to forward guidance seems to have lowered the volatility of the policy rates expected over the next few years, but that the effects are less clear on the level of interest rate expectations and on the responsiveness of financial prices to news. The future for forward guidance depends on how central banks deal with a number of significant challenges.

The credit-to-GDP gap and countercyclical capital buffers: questions and answers*

Basel III uses the gap between the credit-to-GDP ratio and its long-term trend as a guide for setting countercyclical capital buffers. In this article, Mathias Drehmann and Kostas Tsatsaronis (BIS) respond to criticism of this measure. They argue that, while many criticisms have merit, some misinterpret the indicator's purpose, which is to protect banks from losses rather than tame the business cycle. Historically, the credit-to-GDP gap has been a robust single indicator for the build-up of financial vulnerabilities in a wide range of countries and crisis episodes. As such, its role is to inform, not dictate, the thinking of supervisors on how and when countercyclical buffers should be imposed.

Non-deliverable forwards: 2013 and beyond*

Non-deliverable forwards (NDFs) let investors and borrowers take positions in currencies that are subject to official controls. Robert McCauley, Chang Shu and Guonan Ma (BIS) document that turnover in NDFs has risen in recent years as foreign investors use them to hedge growing investments in local currency bonds. The authors find that pricing in deliverable forward and NDF markets is segmented, with NDFs leading in times of strain.

A key question is what happens to NDF markets once the controls that give rise to their existence are lifted. The authors find that NDF markets tend to fade away after liberalisation. In the case of the Chinese renminbi, deliverable forwards traded offshore are gaining ground on the established NDF market.

Non-US banks' claims on the Federal Reserve*

Non-US banks' affiliates in the United States took up about half of the claims on the Fed that it created to pay for its large-scale bond purchases. They did so largely through uninsured branches unaffected by a new FDIC charge on wholesale funding payable by US-chartered banks. Robert McCauley and Patrick McGuire (BIS) find that these branches raised dollars from their affiliates abroad in order to deposit these funds at the Fed. On a consolidated basis, non-US banks raised dollars by swapping other currencies for dollars and increasing dollar liabilities. At the same time, they continued to increase their dollar claims outside the United States.

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