BIS Quarterly Review March 2014 - media briefing

On-the-record remarks by Mr Claudio Borio, Head of the Monetary and Economic Department, 7 March 2014

Investors resumed their retreat from emerging markets in mid-January. Dedicated emerging market bond and equity funds recorded sizeable outflows, and several emerging market currencies plummeted. This is the second episode of financial turbulence in emerging markets in just over six months, following the market tantrum in May.

The two episodes differ in important respects.

One concerns the trigger. It was the mere announcement that the Fed was considering tapering its large-scale asset purchases that set-off the jitters in May. By contrast, country-specific developments in emerging market economies were at work in January, notably political concerns - just as for the market jitters this week. In fact, markets took in their stride both the Fed's mid-December announcement that it would start to taper and the actual start of tapering in January.

A second aspect concerns the range of countries affected. Popular measures of external and internal vulnerabilities, such as current account deficits and inflation, go a long way towards explaining the movement in emerging market exchange rates in the first episode, but they matter little in the second. This is one reason why the fall in the currencies of the countries facing pressures in January was arrested thanks in part to more vigorous central bank responses through interest rate hikes and exchange rate intervention. Moreover, this general picture masks the fact that markets continued to reward good policies: least affected were countries that had taken long-standing steps to put their house in order, such as Mexico, or that had accelerated those steps in response to the May turbulence, such as India.

A third aspect concerns the relative performance of emerging market debt denominated in foreign and domestic currency. The yield on foreign currency debt was most affected back in May; that on domestic currency debt in January. In other words, exchange rate risk, as opposed to credit risk, became more prominent recently. Hence the salience of the central bank measures to calm currency markets. There is a sobering lesson in all this. The development of long-term local currency bond markets is very welcome, but cannot be expected to insulate countries from reversals in market sentiment. The soaring share of foreign investors' holdings of such securities adds to this potential vulnerability.

More generally, one should watch closely the vulnerabilities associated with the surge in issuance of debt securities, in both local and foreign currency, especially by corporates. Not least, borrowers have become much more sensitive to changes in risk premia, strongly influenced by global conditions. Risks mutate.

The recent market turbulence is just the latest reminder of how suddenly market sentiment can turn when background conditions shift. Those conditions have shifted substantially since May. The Fed has started tapering its large-scale asset purchases. And growth prospects in advanced economies have brightened even as those in emerging market economies have dimmed. Against this backdrop, it would be imprudent to rule out further tremors.

Looking further out, the character of the possible dislocations may also differ.

Influenced by extraordinarily easy monetary policy in advanced economies, policy rates in many emerging market economies - and not only there - have been unusually low for many years now. Indeed, the BIS has been arguing for some time that, for the world as a whole, interest rates have been too low for lasting monetary and financial stability. Such low rates have been reflected less in inflation than in strong financial booms in several countries: private sector credit and property prices have surged, in some cases at unsustainable rates.

Now, partly in response to external conditions, policy rates have been finally increasing in emerging market economies, although the dispersion is substantial. Where financial imbalances are still building up, higher policy rates could help to contain them. But large increases forced by external conditions could at some point precipitate the unwinding of the imbalances, even before they unwind spontaneously. This is so especially where financial cycles are in their late stages, so that credit growth has been slowing after a long boom. Higher debt servicing costs for overextended borrowers could trigger financial strains. Countries have already been taking macroprudential measures to fend off risks. But these may well be insufficient. It is critical to further strengthen the financial system, so that it can withstand losses should asset prices fall and loans go sour.

There is a disappointing element of déjà vu in all this.

Before turning to the Q&A part of this briefing, let me draw your attention to the special feature articles in this issue. Please note that they present the views of the authors and not necessarily those of the BIS. When referring to the articles please attribute them to the authors and not to the BIS. The articles focus on financial structure and growth, on forward guidance at the zero lower bound, on the credit-to-GDP gap as a guide for the Basel III countercyclical capital buffer, on the markets for non-deliverable forwards, and on the impact of recent regulatory changes on non-US banks' excess reserves at the Federal Reserve.

I would also like to let you know that we have decided to discontinue the June issue of the Quarterly Review in its current format, owing to its close proximity to the Annual Report. The relevant material about financial developments will be included in the Annual Report. The June issue will contain only information about the BIS statistics, notably the statistical annexes. The next full issue of the Quarterly Review will be published in September.

Let me now turn to the Q&A part of this briefing. Please note that all remarks made from this point on are strictly off the record. Before putting a question to the Quarterly Review authors, would you please identify yourself, giving your name and news organisation.