The BIS Quarterly Review for March 2011, released today, discusses how expectations of higher growth in the advanced economies and surging commodity prices pushed up short-term inflation expectations.
The March issue also provides highlights from the latest BIS data on international banking and financial activity.
In addition, it features four articles (more detailed abstracts follow):
- Systemic importance: bank size is a simple yet reliable indicator of systemic importance. A bank's total interbank lending and borrowing provide useful complementary information.
- Inflation expectations and the great recession: short-run inflation expectations have rebounded after dropping in the crisis. Measures of long-run inflation expectations suggest that investors continue to perceive central banks as credible for the time being, but their somewhat higher dispersion raises questions about how firmly expectations are anchored.
- The use of reserve requirements as a policy instrument in Latin America: changes in reserve requirements have helped several Latin American central banks to achieve their monetary policy and financial stability objectives in recent years, although not without costs.
- Foreign exchange trading in emerging market currencies: as income per capita rises, foreign exchange trading cuts loose from underlying current account transactions and takes place increasingly outside the home country.
Inflation pressures rise with commodity prices
Equity prices rose and credit spreads tightened in major advanced economies in the period from the beginning of December 2010 to the last week of February 2011. Investors priced in a strengthening of economic activity and an increasing likelihood that the recovery in those economies had finally reached escape velocity. Government bond yields also increased significantly, reflecting a combination of higher expected real yields due to anticipated monetary policy tightening and higher expected inflation. During the last week of February, however, investor sentiment changed dramatically as concerns mounted about the impact of the political unrest in North Africa and the Middle East.
The rise in inflation expectations, especially in the near term, was due not only to the stronger growth outlook, but also to rapid increases in agricultural and other commodity prices, in particular food prices. This prompted renewed concerns among investors and policymakers about the inflationary impact of higher commodity prices across the globe and possible second-round effects. Accelerating oil price increases in the wake of escalating political tensions in North Africa and the Middle East added to these concerns.
Equity and bond prices in a number of emerging market economies began to reflect increasing investor concerns about the impact of policy tightening in response to rising inflation. Moreover, the changing global outlook led investors to rebalance their portfolios geographically. This resulted in outflows from equity markets in Asia and Latin America and inflows into developed economy equity markets.
Highlights from the BIS international statistics
Cross-border lending by BIS reporting banks returned to positive growth in the third quarter of 2010. The aggregate cross-border claims of BIS reporting banks went up by 2.3%, bringing the stock to $31 trillion, still approximately $5 trillion below the peak reached at the end of March 2008.
Lending to emerging markets went up further in the third quarter of 2010. BIS reporting banks' cross-border claims on residents of emerging market economies increased by 6.3%, the sixth rise in a row and a larger one than any of the preceding five. More than half of the increase was directed towards the buoyant economies of the Asia-Pacific region ($84 billion) and well over a quarter ($44 billion) to Latin America-Caribbean. Lending to the emerging European economies rose by $22 billion, the first increase since the failure of Lehman Brothers. As of September 2010, the exposures of all major national banking systems to the Middle East and North Africa were fairly small relative to their aggregate foreign exposures.
Activity in the primary market for international debt securities slowed in the fourth quarter of 2010, reverting to the seasonal pattern observed before the financial crisis. Completed gross issuance fell by 9% quarter on quarter to $1,707 billion between October and December. With stable repayments, net issuance dropped to $293 billion, from $489 billion in the third quarter.
The volume of trade on international derivatives exchanges was higher in the fourth quarter of 2010 than in the previous one. Turnover, measured as the notional amount of traded derivatives contracts, rose by 9% in dollar terms. The bulk of this increase corresponds to a surge in the turnover of short-term dollar interest rate futures. This rose by 29%, reflecting particularly strong trading in November, when the Federal Reserve Board announced its second round of US Treasury bond purchases. A further notable portion of the increase is due to a 38% rise in trading of Korean equity index options. This was partly offset by lower trading of short-term euro interest rate options, which declined by 16%.
Systemic importance: some simple indicators?
In this article, Mathias Drehmann and Nikola Tarashev (BIS) search for simple, reliable and implementable indicators of banks' systemic importance. Such indicators can be used as substitutes for alternatives that are harder to compute and communicate. They are useful to regulators and banks alike, allowing systemic importance to be both measured and managed with limited system-level information. The authors find that bank size is closely related to three sophisticated measures of systemic importance. And, together with a bank's total interbank lending and borrowing, it can be used to construct a simple indicator.
Inflation expectations and the great recession
Petra Gerlach, Peter Hördahl and Richhild Moessner (BIS) find that measures of short-run inflation expectations dropped during the crisis, particularly in advanced economies, but rebounded by early 2011. Measures of long-run inflation expectations have in general fluctuated around a relatively stable level over the past two years, suggesting that recent events have left central bank credibility intact. At the same time, dispersion in inflation expectations is somewhat higher today than it was prior to the crisis, raising questions about how firmly expectations are anchored.
The use of reserve requirements as a policy instrument in Latin America
Reserve requirements are staging a comeback. Having long ago lost their role as instruments of monetary policy in advanced economies, they have recently been used by several central banks in Latin America and other regions as a tool in their effort to achieve monetary or financial stability goals. This article, by Carlos Montoro and Ramon Moreno (BIS), looks at the experience of Brazil, Colombia and Peru in an attempt to gain insights into the effectiveness of these instruments. The authors find that adjustments in reserve requirements have helped stabilise interbank rates, influenced market rates without necessarily attracting even higher capital flows, and helped smooth credit growth. However, these benefits did not come without costs: reserve requirements can generate distortions in the financial system that increase the cost of, and can reduce, financial intermediation.
Foreign exchange trading in emerging currencies: more financial, more offshore
The 2010 central bank survey of foreign exchange market activity showed rapid growth in turnover in emerging market currencies. In particular, global central banks reported that some up-and-coming currencies are now being traded outside their home market much more than market participants had estimated. This article, by Robert McCauley and Michela Scatigna (BIS), provides simple benchmarks for turnover and location of foreign exchange trading and highlights some important cases that deviate from those benchmarks. The authors find that, as income per capita rises, FX trading cuts loose from underlying current account transactions and a larger share takes place outside the home country. At given income levels, moreover, currencies with either high or very low yields attract more trading, consistent with their role as target and funding currencies in carry trades.