BIS Quarterly Review September 2014 - media briefing

On-the-record remarks by Mr Claudio Borio, Head of the Monetary and Economic Department, and Mr Hyun Shin, Economic Adviser & Head of Research, 12 September 2014

Claudio Borio

Financial market volatility has again been hovering around the exceptionally low levels of 2004 to 2006, although it has picked up somewhat in the last few days. In general, volatility has been exceptionally low across the whole spectrum of asset classes. To be sure, equity markets fell and volatility went up in late July and early August on the back of poor macroeconomic news in Europe and increasing concerns about the situation in Eastern Ukraine and the Middle East. Investors, particularly retail investors, withdrew from the market for high-yield bonds, pushing spreads up by some 70 basis points in the United States and 130 basis points in the euro area. But the sell-off ended as quickly as it had started. By late August, equity prices had mostly recovered their losses and volatility was back to the depths seen in early July. As I speak, credit spreads for lower rated corporates remain higher than in early July. But from a longer perspective the rise in the summer was a blip. The search for yield has resumed in force.

What explains this extraordinarily low volatility? One factor is muted uncertainty about the macroeconomic outlook. People may not necessarily like what they see, but they seem to think they see it more clearly. For instance, surveys indicate that the dispersion of analysts' forecasts, admittedly an imperfect measure of uncertainty, is among the lowest observed in the last 20 years. Ironically, the last time it was this low was in 2007, just before one of the largest forecast errors the economics profession has ever made.

A second factor is monetary policy. Monetary policy in the major advanced economies, and not only there, remains unusually accommodative. Market participants seem confident that it will either stay so or, where it won't, that it will be tightened only gradually. The divergent prospective monetary policy paths of the Federal Reserve and the Bank of England, on the one hand, and the ECB and Bank of Japan, on the other, have become increasingly apparent: the latest significant movements in the major exchange rates are testimony to this. And market participants also appear confident that, in case of need, central banks will be there to smooth things out. All this naturally dampens bond market volatility and term premia. In fact, term premia appear to be back well into negative territory: investors, it would seem, are actually paying for the privilege of incurring interest rate (duration) risk.

As the Quarterly Review explains, unusually low interest rates, low volatility and the search for yield go hand in hand. And a common mistake is to take unusually low volatility and risk spreads as a sign of low risk when, in fact, they are a sign of high risk-taking. This time is no different. This "financial instability" paradox is visible in the estimates of highly compressed risk premia, whether derived from spreads or volatility measures themselves. And it transpires from the willingness of market participants to sell options on volatility, absorbing the risk of a volatility spike as they strive to earn additional income (the option premium). This type of leverage is hardly visible but just as real. Unfortunately, one generally finds out how widespread it is only after the fact.

It all looks rather familiar. The dance continues until the music eventually stops. And the longer the music plays and the louder it gets, the more deafening is the silence that follows. Markets will not be liquid when that liquidity is needed most. And yet the illusion of permanent liquidity is just as prevalent now as in the past. Sometimes, though, its specific form evolves - the latest incarnation is the promise of daily liquidity in ETFs, which are especially popular among retail investors.

All this puts a premium on sound prudential policies, at the level of both individual institutions and markets. That said, the tools at the authorities' disposal are better suited to strengthening banks than non-bank players, precisely at a time when these players have become more prominent. My colleague, Hyun Shin, will be elaborating on this next. Beyond that, the prevailing environment also calls for extra prudence on the part of market participants themselves. Macroeconomic and geopolitical risks have not gone away. And central bank statements have made it clear that policy decisions are not predetermined and remain data-dependent. The market jitters in the last few days bear watching.

Hyun Shin

I would first draw your attention to the Highlights chapter on how cross-border bank lending has seen the first substantial increase for some time in the first quarter of 2014.

A longer-running theme has been issuance of debt securities by non-financial corporations, which has soared after the financial crisis. This is part of a broader shift in the pattern of financial intermediation from banks to the capital markets - a transition that we have called the "second phase of global liquidity".

The steepest increases in issuance have come from emerging market firms. At the BIS, we have a catch-all category of "developing countries" to denote both emerging and developing economies. And when I say "from emerging economies" I mean firms headquartered in those economies. A sizeable part of this debt has been issued through affiliates offshore, in places such as London, Hong Kong SAR or the Cayman Islands, and not directly by the parent. This means we have to look at nationality-based statistics, not at residence-based statistics, such as the balance of payments.

Is this second phase of global liquidity a good thing or a bad thing? On the one hand, developing countries have large capital needs, so mobilising the savings of the rich countries to harness these opportunities is clearly welcome. But there can be too much of a good thing. As Michael Chui, Ingo Fender and Vladyslav Sushko point out in one of the chapters, the leverage of emerging market non-financial firms appears to have increased significantly, although with some variation across countries.

Emerging market corporates have used benign global financing conditions not only to issue more debt but also to extend maturities. From one perspective, this is good news for the ability to roll over debt that is coming due. From another perspective, however, as I argue in a box in the Highlights chapter jointly authored with Branimir Gruić and Masazumi Hattori, this is not all good news. Yes, the share of debt to be refinanced every year has fallen, but longer maturities make fixed rate bonds more sensitive to interest rate movements, which makes them riskier for investors. In other words, duration risk for investors increases. If there is a rush for the exit by bond investors that shuts down the market as happened briefly during the "taper tantrum" last year, this could make it more difficult to refinance maturing debt, rather than less.

Let me return to the chapter by Michael, Ingo and Vlad. A second important finding in their chapter is that a large part of the debt securities issued by emerging market corporates is denominated in foreign currency. It is true that local currency bond markets have grown significantly in many emerging market economies in recent years, especially for government bonds. Corporates issue domestically, too, but they also issue abroad in foreign currency. The question is how well they are hedged against exchange rate changes. Unfortunately, data are sketchy. My colleagues find that many of the firms issuing abroad are from sectors that have some foreign currency revenue or have foreign assets. But many issuers are from domestically-oriented sectors such as property.

Rapid debt issuance has coincided with an increasing participation by asset managers in emerging market bond and equity markets. For many of these asset managers, emerging markets account for only a small part of their assets. But, because these holdings are so large, any significant reallocation of their portfolio could have a major impact on these markets, especially if there is herding among funds.

There is some evidence of herding. In another article, Ken Miyajima and Ilhyock Shim lay out two sets of reasons for why herding may occur. The first concerns the way the industry is managed. Widespread benchmarking and short-term performance assessments limit the degree to which individual portfolio managers can deviate from the industry average. The behaviour of the ultimate investors could introduce further correlation. Ken and Ilhyock provide some evidence that, during last year's taper tantrum, retail investors were prone to herding. And, they herded procyclically, which means that they withdrew from funds when prices were falling and re-entered when they were rising, thus forcing funds to sell when prices were falling and buy when prices were rising. Flows by institutional investors such as pension funds and insurance firms were more stable, but it remains to be seen whether they will remain so in more stressful periods.

The third article, by Stefan Avdjiev and Elöd Takáts, uses BIS international bank data to look at cross-border bank lending to emerging market economies during the taper tantrum. Some countries experienced large outflows after the Federal Reserve announced that it was considering a reduction in its asset purchases, while others only saw a slight slowing of inflows. Stefan and Elöd use new data on currency-adjusted bilateral lending flows to analyse this variation across countries. They find that countries with larger current account deficits and higher reliance on US dollar-denominated bank lending experienced larger drops in cross-border lending. The shock originated from the advanced economies, but the vulnerability to the shock depends in part on the individual countries.

The last article, by Michela Scatigna, Robert Szemere and Kostas Tsatsaronis, give an overview of the BIS data set on residential property prices which we have begun publishing on our website. I don't have to remind you of the importance of property prices for financial stability or economic activity. What is perhaps surprising is that there has been relatively little systematic data before now that allow us to analyse house price developments across countries or over longer periods of time. The BIS started working on house price data as far back as the late 1980s, in close collaboration with central banks. From June this year, we are publishing our data on our website. Michela, Robert and Kostas explain the characteristics of each of the three data sets and look at recent house price developments. So, if you are interested in our data series, their article is the best place to start. We are now giving our attention to commercial property prices. Unfortunately, many of the factors that make collecting data on residential property prices so difficult - the heterogeneous properties and infrequent transactions - are compounded in the case of commercial property prices, which have also been much more neglected by national statistical offices.