The Writing On The Wall via Bank of International Settlements
BIS Quarterly Review September 2015 - media briefing
On-the-record remarks by Mr Claudio Borio, Head of the Monetary & Economic Department, and Mr Hyun Song Shin, Economic Adviser & Head of Research, 11 September 2015.
We often look at the world as a set of still frames, rather than as a movie, as we should.
The still frame of the last quarter - the period under review in this issue - has one distinguishing feature: turbulence.
Initially - think of it as the left side of the frame - it was Greece that grabbed all the attention and headlines. But the Greek crisis, for all its drama and potential disruptive force, soon ended once some form of agreement was reached in early July. Its impact on global markets remained quite limited.
Market participants had hardly had the time to breathe a sigh of relief when Asia, in particular China, appeared in the centre of the frame.
First, the origin of the shock was the Chinese stock market, which on 8 July saw its largest one-day drop ever; then, on 12 August, it was the authorities', admittedly rather small, devaluation of the currency as they officially shifted towards a more market-oriented exchange rate regime.
Rather remarkably, the Chinese stock market had already fallen by over 30% from its June peak before its large one-day July move, but its impact on global markets had been quite contained; outside Asia, no one had taken much notice.
The shocks in July and August set off much bigger and far-reaching tremors.
Stock markets around the world weakened. More importantly, commodity prices plummeted - accelerating their previous longer-term decline - and volatility spiked.
The oil price gyrations were remarkable. The price sunk to a new trough below $40 on 24 August, undoing the whole of the partial recovery in the second quarter of the year, then soared some 30% in only one week before dropping back again. Even more importantly, the exchange rates of emerging market economies (EMEs), especially commodity exporters, were hit hard, and their credit spreads widened, although generally not dramatically.
By and large, market functioning outside the epicentre of the shocks has been smooth. That said, occasionally even FX markets have showed signs of gapping: sharp price moves with little trading. And there have been signs of minor dislocations in equity markets, with an increasing incidence of trade halts and wedges between the price of exchange-traded funds and the underlying equities.
Why such a big difference in the response to the initial sharp drop in Chinese equity prices in June and the subsequent shocks?
In part, this may reflect market participants' selective attention. More fundamentally, though, it mirrors their shifting perceptions of background economic conditions and of the power of policy. The initial equity drop was probably largely seen as a natural, to some extent intended, market-specific correction from blatantly overstretched valuations. Moreover, the authorities' measures to smooth the adjustment provided some comfort.
But the mood quickly changed as signs of economic weakness mounted and market participants began to question the effectiveness of the policy measures. The renminbi's devaluation, following persistent depreciation pressures, did nothing but fuel those concerns, prompting the authorities to lean against them as events unfolded.
If we shift our gaze to the right side of the frame, we see market participants pondering further about what the shifting global picture means for the monetary policy outlook in the large international-currency jurisdictions, first and foremost the United States - a key underlying theme.
Expectations of the timing of the Federal Reserve's lift-off have ebbed and flowed during the period, in synch with both domestic and global developments. The ECB is now seen as ready to ease further if conditions deteriorate, while the Bank of Japan is facing weaker output and inflation.
This follows easing measures by several other central banks, especially those whose currencies have been under pressure; only the Central Bank of Brazil tightened policy in the period under review as inflation rose despite a deepening recession. As we speak, core markets' bond yields have undone some of the increases of the previous quarter and remain extraordinarily low.
If we now settle back and look at events as a movie, their full meaning becomes clearer. In the big scheme of things, current events were already foreshadowed by the past evolution of the global economy.
The BIS statistics on international financing reveal that a slowdown in the credit flows to EMEs had already started in the last quarter of 2014 and strengthened thereafter, even as such flows had gathered pace among advanced economies. That is, the data reveal a certain bifurcation in global liquidity, with credit to China, Russia and, to a lesser extent, Brazil being especially weak.
Here, the role of credit denominated in US dollars plays a critical role. As highlighted in a number of BIS publications, the total amount of dollar credit to non-bank borrowers outside the United States had risen by over 50% since early 2009, to 9.6 trillion by end-March 2015, and almost doubled for EMEs, to over 3 trillion.
Much of it has found its way to corporates, raising serious questions about the financial vulnerabilities involved and the implications for self-reinforcing movements in exchange rates and credit spreads. Hyun will say more about this in a minute.
Even more important are shared vulnerabilities in domestic balance sheets, which have gradually emerged over the years as our movie has been playing. After all, when measured against GDP, while the size of foreign currency debt has indeed grown substantially, for most EMEs it remains below the levels reached ahead of previous financial crises. But since at least 2009, domestic vulnerabilities have developed in several EMEs, including some of the largest, and to a lesser extent even in some advanced economies, notably commodity exporters.
In particular, these countries have exhibited signs of a build-up of financial imbalances, in the form of outsize credit booms alongside strong increases in asset prices, especially property prices, supported by unusually easy global liquidity conditions. It is the coincidence of the reversal of these booms with external vulnerabilities that should be watched most closely.
A holistic view is critical. We are not seeing isolated tremors, but the release of pressure that has gradually accumulated over the years along major fault lines.
Taking an even longer-term perspective, as argued in detail in the latest BIS Annual Report, all this points to weaknesses in domestic and international policy arrangements - arrangements that have so far been unable to constrain sufficiently the build-up and unwinding of hugely damaging financial booms and busts across countries. Hence a world in which debt levels are too high, productivity growth too weak and financial risks too threatening.
This is also a world in which interest rates have been extraordinarily low for exceptionally long and in which financial markets have worryingly come to depend on central banks' every word and deed, in turn complicating the needed policy normalisation.
It is unrealistic and dangerous to expect that monetary policy can cure all the global economy's ills.
All this is reminiscent of the old joke about the stranded tourist who, having asked for directions, was told: "If I were you, I wouldn't start from here."
Hyun Song Shin
Let me provide some further perspective on global financial flows from the BIS international banking and financial statistics.
As Claudio has mentioned, one key theme in this issue of the Quarterly Review is the contrast between the continued revival of financial flows in advanced economies and the subdued financial flows in emerging market economies.
Especially noteworthy in the advanced economies has been the pickup in euro-denominated financing activity which has coincided with the asset purchase programme of the ECB.
One example of the increase in euro-denominated borrowing has been the growth of euro-denominated bonds issued by non-financial corporates from the United States - the so-called "reverse yankee bonds". Net issuance in the first half of 2015 was almost $40 billion, which is more than three times the pace of issuance in the same period last year.
It is true that euro-denominated borrowing from outside the euro area is still small compared with the equivalent US dollar amount, but it is now perhaps large enough to be associated with deleveraging episodes during periods of market turbulence. For instance, we saw during August that the euro strengthened when markets were in a "risk-off" mode. The flip side of this is that a weaker euro is associated with greater risk-taking, with associated cross-border spillover effects.
As Claudio has already mentioned, our latest estimate of the stock of US dollar-denominated debt of non-banks outside the United States stands at $9.6 trillion. For emerging economies, this overhang of US dollar-denominated debt has been weighing on macroeconomic conditions in recent weeks.
Nevertheless, there are a few mitigating factors here:
First, the international debt securities issued by emerging market corporates have long maturities, and the maturities have been getting longer. As we describe in the Highlights section, the emerging market debt securities issued so far in 2015 have had average maturity of 11 years.
Borrowers with long maturity debt are less vulnerable to runs.
Second, many emerging economies hold substantial foreign exchange reserves, in contrast to their situation in past crises.
And third, many of the emerging market issuers are global firms with revenues in foreign currency.
But even here, we need to bear in mind some important qualifications:
First, even if the bonds have long maturities, there are other repercussions on the economy if US dollar-denominated borrowing begins to unwind. Non-financial firms are deeply embedded in the economy, and their financial activities spill over into the rest of the economy.
A recent BIS working paper finds that dollar borrowing by emerging market corporates has had the attributes of a "carry trade" where, for every dollar raised through a bond issue, around a quarter ends up as cash on the firm's balance sheet. Here, cash could mean a domestic currency bank deposit or a claim on the shadow banking system, or indeed a financial instrument issued by another firm.
So, dollar borrowing will spill over into the rest of the economy in the form of easier credit conditions. When the dollar borrowing is reversed, these easier domestic financial conditions will be reversed. This issue of the Quarterly Review has a box by Bob McCauley on capital outflows from China that illustrates these themes.
Furthermore, even if a country has large foreign exchange reserves, the corporate sector itself may find itself short of financial resources and may cut investment and curtail operations, resulting in a slowdown of growth.
So, even a central bank that holds a large stock of foreign exchange reserves may find it difficult to head off a slowing real economy when global financial conditions tighten. Arguably, such a slowdown is part of what we are seeing right now in emerging market economies.
Let me now turn to the special features in the Quarterly Review. In this issue, we unveil a number of enhancements to the statistics produced and disseminated by the BIS.
Let me mention three, in particular:
First, we have enhanced our international banking statistics. Among other things, we now provide more detailed data on the domestic side of banks' balance sheets, as well as more detailed breakdowns of counterparties and currencies.
Second, we are publishing harmonised series on government debt. In compiling the new series, we have applied consistent definitions so as to allow better assessment of the evolution of government debt stocks over time and comparability across countries.
Third, we are publishing debt service ratios - that is, the ratio of principal and interest payments to income - for 32 countries. These are estimated from aggregate data, but they should give a good picture of how the indebtedness of the household or corporate sector of different countries has evolved over time and how it impinges on their real economic activity.
Let me also add that the BIS is revamping how it disseminates its data.
The tables previously published in the statistical annex to the Quarterly Review have been replaced with charts illustrating the latest developments.
The tables themselves have been redesigned and gathered in a new publication, the BIS Statistical Bulletin. These tables are made more accessible in a new dynamic web-based tool, the BIS Statistics Explorer. Please check them out.
The special feature on monetary policy spillovers by Boris Hofmann and Előd Takáts in this issue looks more closely at how short-term interest rates and long-term bond yields around the world are influenced by those in the United States - not just through financial market and macroeconomic linkages, but through US policy decisions. The authors find that the monetary policy decisions of the Federal Reserve have an impact on policy decisions elsewhere that goes beyond the normal linkages that take place through financial market prices.
Finally, a feature by Eli Remolona and Ilhyock Shim looks at the increasing integration of the banking system in Asia. The greater regional integration of banking in Asia is partly a reflection of local banks taking up the space left by the withdrawal of wholesale-funded European banks from Asia, but it also reflects the rapid growth of credit demand from borrowers in the region.
Deepening financial integration brings many benefits, but the authors also point to the need to address financial stability challenges, such as making sure the new regional banks do not rely excessively on short-term wholesale funding, denominated in foreign currency.
16 minute BIS Video of the 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.