BIS Quarterly Review
6 March 2016
Bank for International Settlements
Info of the BIS:
Markets have been roiled since the start of the year by concerns about growth in China and other emerging market economies, and about the health of large global banks. “The tension between the markets’ tranquillity and the underlying economic vulnerabilities had to be resolved at some point. In the recent quarter, we may have been witnessing the beginning of its resolution,” said Claudio Borio, Head of the Monetary and Economic Department.
The March 2016 issue, amongst others, recounts how financial market turmoil has emerged and spread since the beginning of 2016.
BIS Quarterly Review March 2016 – media briefing
BIS disclaimer: Please note that the special features present the views of the authors and not necessarily those of the BIS. When referring to the articles, please attribute them to the authors.
On-the-record remarks by Mr Claudio Borio, Head of the Monetary and Economic Department, 4 March 2016.
The uneasy calm has given way to turbulence.
In the previous Quarterly Review issue, we highlighted the uneasiness of the calm reigning over financial markets. The tension between the markets’ tranquillity and the underlying economic vulnerabilities had to be resolved at some point. In the recent quarter, we may have been witnessing the beginning of its resolution.
The new year greeted investors with one of the worst sell-offs on record. Investors had just breathed a sigh of relief following what had turned out to be an uneventful, if historic, 25 basis point increase in the federal funds target range in mid-December – the first hike since the overnight rate had been pushed to zero seven years earlier, marking the longest postwar phase of immobility. Just two weeks later, markets tumbled. As in the summer, the trigger was China, as signs of a slowdown there hinted at broader emerging market weakness. Equity prices took a dive worldwide, volatilities soared, credit spreads widened, emerging market currencies fell, especially vis-à-vis the US dollar, and the oil price sank to new lows, below the troughs reached during the Great Recession. In turn, these developments fed pessimism about other economies, notably the United States, thus spreading gloom further.
And this was only the first phase of the turbulence. A second, briefer but perhaps more worrying episode in the first half of February focused on the health of global banks. Their valuations, which had been under pressure for quite some time, plunged to new lows while their credit default swap (CDS) spreads rose. Price-to-book ratios hovered around levels not seen since the most acute phase of the crisis. Disappointing global growth prospects and earnings announcements added to jurisdiction-specific worries, such as stubbornly high nonperforming loans and regulatory-driven concerns about coupon suspensions for contingent convertible bonds (CoCos) in the euro area. Most likely, defensive dynamic hedging strategies made matters worse, as investors sold bank equities and CDS to cut losses on CoCos. But the main source of anxiety was the vision of a future with even lower interest rates, well beyond the horizon, that could cripple banks’ margins, profitability and resilience. Anxiety grew and spread following the Bank of Japan’s decision to adopt negative policy rates. At its peak, more than USD 6.5 trillion worth of sovereign paper was trading at negative yields – stretching once more the boundaries of the unthinkable.
Only more recently have markets regained a certain composure. But if we wish to look for clues to the deeper forces at work, we need to go beyond the markets’ all too familiar oscillation between hope and fear. Once we do so, the clues are not hard to find. Against the backdrop of a long-term, crisis-exacerbated decline in productivity growth, the stock of global debt has continued to rise and the room for policy manoeuvre has continued to narrow – a set of factors that might be termed the “ugly three”. Let me just say a few words about rising debt and the narrowing room for manoeuvre, in particular.
Debt was at the root of the financial crisis, and it has risen further globally in relation to GDP since then. In the advanced economies at the heart of the crisis, some private sector deleveraging has taken place, although public sector debt has grown steadily. But the most worrying development has been the steep rise in private sector debt elsewhere, especially in several emerging market economies (EMEs), including the largest – the main engines of global growth post-crisis. The increase has been strongest among corporates, whose profitability has been declining, and among commodity exporters. Often, as indicated by our latest statistical release, this has gone hand in hand with strong property price booms on the back of aggressive risk-taking – all eerily reminiscent of the financial booms seen precrisis in the economies subsequently hit by it.
Debt denominated in foreign currency has played a prominent role, with the US dollar portion for EMEs doubling since 2009 to some USD 3.3 trillion. Our global liquidity indicators now suggest that the growth in this component came to a halt in the third quarter of 2015. And the international debt securities statistics confirm that EME borrowers have been cutting back on issuance since then – in China, they have been paying back foreign currency debt, partly explaining the rapid fall of foreign exchange reserves. Alongside the changes in credit spreads and the depreciation of many currencies vis-à-vis the dollar, these are the telltale signs that external financial conditions have been tightening for EMEs. And this has been happening as domestic financial cycles have been maturing or turning. It is as if two waves with different frequencies came together to form a bigger and more destructive one.
Debt, therefore, is what helps understand apparently unrelated developments. It sheds light on the slowdown in EMEs. It provides clues about the worrying vicious cycle between US dollar appreciation and tightening financial conditions for firms or countries that have heavily borrowed in dollars. It gives a hint about the reason for the weakness in oil prices, as countries such as China demand less and highly indebted oil-producing firms come under pressure to keep the spigots open to meet their service burdens. And it may even illuminate the puzzling slowdown in productivity growth: recent BIS esearch finds evidence that credit booms sap productivity growth as they gather pace, largely by allocating resources to the wrong sectors. The impact of these misallocations lingers on and becomes more powerful if a financial crisis subsequently erupts. In turn, weaker productivity makes it harder to sustain debt burdens. Put differently, we may not be seeing isolated bolts from the blue, but the signs of a gathering storm that has been building for a long time.
And then we have the narrowing room for policy manoeuvre. The latest turbulence has hammered home the message that central banks have been overburdened for far too long post-crisis, even as fiscal space has been dwindling and structural measures lacking. Despite exceptionally easy monetary conditions, in key jurisdictions growth has been disappointing and inflation has remained stubbornly low. Market participants have taken notice. And their confidence in central banks’ healing powers has – probably for the first time – been faltering. Policymakers too would do well to take notice.