BIS Quarterly Review, December 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 Song Shin, Economic Adviser & Head of Research, 4 December 2015.

Claudio Borio

Calm has reigned over financial markets, but it has been an uneasy calm.

We left the markets in turbulence in the previous quarter. Then, just as suddenly as it had arrived, the turmoil gave way to calm. Markets roiled in August and September only to rebound in October. Stock markets recorded their strongest one-month rally in recent years. Commodity prices initially bounced back. Emerging market currencies stabilised alongside portfolio flows. Credit spreads narrowed. Volatilities declined. On the face of it, the turbulence turned out to be more like a brief summer storm than autumn thunder heralding the arrival of a long winter.

As events unfolded, the picture did not change much. By and large, financial markets took a brief pause. And they waited. They waited with bated breath for what they regarded as a highly likely lift-off by the Federal Reserve in December. The market-implied probability of a move by year-end, which had sunk to as low as 30% in September when the Fed chose not to raise rates, rose again to approach 80% in late November. The Federal Open Market Committee's communication, together with a surprisingly strong non-farm payroll number on 6 November, accounted for this shift. To be sure, in the days immediately following the employment data release, emerging market asset classes took a knock, not unlike that seen during the taper tantrum in May 2013. But they soon recovered. And at no time was there a sense that turmoil was about to break out.

Nonetheless, the calm has been uneasy. Very much in evidence, once more, has been the perennial contrast between the hectic rhythm of markets and the slow motion of the deeper economic forces that really matter.

The short-term outlook for emerging market economies (EMEs) hardly changed during the period under review. In general, the leading indicators of economic activity pointed to weakness ahead. Countries in the throes of a severe recession, such as Brazil and Russia, struggled on. Activity in China showed little signs of strengthening, while the BIS international banking statistics confirm preliminary evidence of a slowdown in capital flows earlier in the year. And, as the period wore on, commodity prices, including those for oil, copper and iron ore, plunged towards new depths.

Nor did the medium-term outlook change significantly - indeed, how could it be otherwise? In particular, the financial vulnerabilities in EMEs have not gone away. The stock of dollar-denominated debt, which has roughly doubled since early 2009 to over $3 trillion, is still there. In fact, its value in domestic currency terms has grown in line with the US dollar's appreciation, weighing on financial conditions and weakening balance sheets. And also still there is the large stock of domestic debt, especially corporate, but in some cases also household, that has surged post-crisis. If anything, as financial cycles mature and turn, credit and property price booms appear to have been losing steam, although at different speeds and from different starting points depending on the country.

Zoom in on the fixed income asset class and a number of anomalies suggest that not all is well in markets. Surprisingly, despite the higher credit risk involved, US swap rates have actually been lower than the corresponding Treasury rates. And even on a currency-hedged basis there has been a persistent premium for those wishing to borrow dollars - so much for economic textbooks' faith in covered interest parity. Thus, market-specific supply and demand imbalances are not being arbitraged away as would normally be the case. Financial institutions, notably banks, are not using their balance sheet capacity as they once did.

To be sure, to some extent this may reflect the fact that both funding and market liquidity were badly underpriced pre-crisis. We do not want to go back there. But it is also a symptom of deeper weaknesses. Remarkably, stand-alone bank ratings, which strip out official support, have deteriorated further since 2010 in major advanced economies. And in many jurisdictions, banks' equity still trades at a discount to book values - a clear sign of mistrust and scepticism. In the euro area, in particular, non-performing loans are far too high. Balance sheet repair should be pursued vigorously.

Finally, in the background, interest rates continued to remain exceptionally low. Even as the Federal Reserve appeared to be approaching lift-off, US 10-year Treasury yields were hovering around 2.2% in late November - a telltale sign of an unusually shallow expected path for the policy rate. Moreover, following clear signals of ECB accommodation, some 2 trillion, or fully one third, of euro area sovereign paper was trading at negative yields - a new peak. Market participants also kept wondering whether the Bank of Japan might ease further. Monetary policy divergence loomed ahead, with potentially significant implications for exchange rates and market adjustments. At the same time, interest rates, current and expected, continued to test the boundaries of the unthinkable day after day - and this despite the matter-of-fact tone of much of the running commentary. Familiarity breeds complacency.

Under such extraordinary conditions, it is not surprising that markets remain unusually sensitive to central banks' every word and deed. Just think of the market gyrations following yesterday's ECB decision to ease even further, but to an extent that fell short of market expectations. Hyun will say more about this shortly.

Against this backdrop, it is hard to imagine how the calm could be anything but uneasy. There is a clear tension between the markets' behaviour and underlying economic conditions. At some point, it will have to be resolved. Markets can remain calm for much longer than we think. Until they no longer can.

Hyun Song Shin

Let me provide some further perspective on the period covered in this issue of the BIS Quarterly Review.

The "uneasy calm" in global financial markets followed quite a choppy and confused period for global banking and financial flows. Global financial flows showed disparate patterns across regions and currencies, dancing to the tune of past and anticipated central bank actions.

• For emerging market economies (EMEs), cross-border bank lending in the second quarter was positive but generally subdued. Debt securities issuance in the third quarter slowed sharply, reflecting the market turbulence in Q3.
• For advanced economies, cross-border bank lending saw pronounced fluctuations. It was generally strong in the first quarter but weak in the second.
• A closer look suggests that the large swing in cross-border claims was due to fluctuations in the lending in euros. Cross-border lending in euros expanded strongly in the first quarter of the year but then fell back sharply in the second quarter (see Graph 1, centre panel, in the Highlights chapter).
• To understand what is happening, we need to place these fluctuations in the context of broader monetary policy developments.
• When an international currency depreciates, there is a tendency for foreign borrowers to borrow more in that currency. This is the so-called "risk-taking channel" of currency depreciation and has been well documented for the US dollar.
• What is perhaps new is that the euro seems to be taking on the attributes of an international funding currency, just like the dollar. Cross-border bank lending in euros to borrowers outside the euro area shows the telltale pattern where a depreciating euro goes hand in hand with greater euro-denominated lending to borrowers outside the euro area (see Graph 3 in the Highlights chapter).
• If the foreign borrowing in euros is associated with speculative short positions, then any short squeeze could result in sharp appreciations of the euro of the kind we saw yesterday.
• Foreign borrowing in euros also sheds light on the market anomalies that have become more pronounced recently. As Claudio has mentioned, the interest rates implied by cross-currency swap prices are out of line with interest rates that are available to market participants.
• One potential source of such anomalies is the hedging demand from long-term investors in advanced economies who need to hedge their pension and insurance liabilities against currency risk. If they hold a diversified portfolio of assets denominated in dollars or euros, but have pension liabilities in yen or Swiss francs that have not already been hedged for currency risk, they may have an incentive to borrow dollars or euros to hedge the currency risk. The imperative to hedge will be greater if currency moves are sharper or if those investors expect further depreciation of the dollar or euro. In this context, the QE policies of major central banks that lead to the depreciation of their currency will increase hedging demands from foreign long-term investors.
• This is yet another instance of the general lesson that global financial flows are sensitive to current and anticipated central bank actions.

Let me also mention the special features in this issue of the BIS Quarterly Review.

We have a piece on the US dollar-denominated debt of non-bank borrowers outside the United States, by Robert McCauley, Patrick McGuire and Vladyslav Sushko.

This reached $9.8 trillion in Q2, of which $3.3 trillion was to EMEs. For some countries, such as China and Turkey, the credit flows mostly through bank loans; for others, such as Korea and Mexico, bond issues play a greater role. And there are also important differences as to whether the credit goes through domestic banks or directly to non-bank borrowers.

We have a piece on calibrating the Basel III leverage ratio, by Ingo Fender and Ulf Lewrick.

This piece is the latest in a series of studies by BIS staff on the impact of regulation. The basic approach is straightforward: the authors look at the benefits of introducing the leverage ratio, which arise from reducing the likelihood of systemic banking crises. Then they compare the benefits with the costs in terms of potentially higher lending spreads for the real economy. These costs are based on very conservative assumptions. Here, "conservative" means likely overestimating the costs, if compared with the empirical results of many research studies. The authors find that, even using these very conservative assumptions, the benefits of the leverage ratio are expected to outweigh the costs, even at calibrations of 4-5%.

We have a piece on central clearing, by Dietrich Domanski, Leonardo Gambacorta and Cristina Picillo.

The use of central clearing for standardised derivative instruments has made substantial inroads in recent years. This is good news in that it reduces the bilateral exposures and complexity of the financial system. But it also introduces other kinds of risks. The authors highlight some of these, including how central clearing changes the propagation of shocks through the financial system, and how they affect the dynamics of deleveraging. These are issues that policy will need to focus on going forward.

Finally, we have a piece on sovereign credit ratings, by Marlene Amstad and Frank Packer.

Rating agencies have in recent years changed how they assign sovereign ratings. The authors find that factors such as growth potential, default history or whether a country has a floating exchange rate have become relatively more important. Moreover, the authors do not find evidence that large agencies systematically give lower ratings to EMEs once a key set of explanatory factors is taken into account, although they also acknowledge the difficulties in assessing this hypothesis in a fully satisfactory manner.