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International Monetary Fund. Monetary and Capital Markets Department

Abstract

Over the past six months, the global financial system, especially the health of financial intermediaries, has been further strengthened by the broadening economic recovery. The financial system has not looked as resilient as it does in the summer of 2004, in the three years since the bursting of the equity bubble. Financial intermediaries, banks and nonbanks alike, have strengthened their balance sheets to a point where they could, if necessary, absorb considerable shocks (see Chapter II, pages 64-73). While it is obviously feasible that one or the other financial institution, such as a hedge fund or even a bank, might succumb to serious mistakes in risk management or to outright fraud, such incidents should be isolated cases with limited, if any, contagion to the system as a whole. Short of a major and devastating geopolitical incident or a terrorist attack undermining, in a significant and lasting way, consumer confidence, and hence financial asset valuations, it is hard to see where systemic threats could come from in the short term. This positive assessment is focused on the financial sector, given its potential to create fast-moving knock-on effects through the wholesale markets. The household sector, in turn, could face certain financial problems going forward, despite its improved balance sheet position. However, from a systemic point of view, the household sector is the ultimate shock absorber.

International Monetary Fund. Monetary and Capital Markets Department

Abstract

During the period under review, a sharp erosion of investor confidence, heightened risk aversion, and growing concerns about the strength and durability of the global recovery and the pace and quality of corporate earnings had repercussions in all of the major equity, credit, and foreign exchange markets (see Chapter II). Market adjustments occurred against the background of the bursting of the telecom, media, and technology (TMT) bubble, which exposed a culture of irrational exuberance, and sometimes greed, among many buyers, sellers, and intermediaries, and most recently some senior executives who adopted business practices—some unethical and illegal—to boost their companies’ share prices at any cost. First, major equity market indices declined significantly and by early August were near or below levels not seen since the autumn of 1998, when global markets were unsettled by Russia’s default and the near-collapse of the global hedge fund, Long-Term Capital Management (Table 1.1). Second, as U.S. corporate bankruptcies hit records, institutional investors and banks discriminated more clearly between classes of borrowers and reduced lending to high-risk borrowers. As a result, corporate credit spreads widened, and speculative grade borrowers faced dramatically higher borrowing costs. The credit deterioration also created a record number of “fallen angels” whose outstanding bonds were downgraded from investment grade to junk status. Third, the dollar continued to depreciate against the other major currencies, reflecting reductions in foreign portfolio flows into U.S. equity markets and in foreign direct investment. The dollar’s decline, together with the continuous stream of accounting irregularities in the United States and the relative absence of them elsewhere so far, intensified concerns about how much further the major currencies would be realigned and doubts about the sustainability of capital flows needed to finance the U.S. current account deficit.

International Monetary Fund. Monetary and Capital Markets Department

Abstract

The deterioration in financial market conditions that has taken place since the release of the June 2002 Global Financial Stability Report appears to have been driven primarily by mutually reinforcing rounds of eroding investor confidence and heightened risk aversion. Against the background of the deflation in the TMT “bubble,” investor confidence was affected by growing uncertainties about the strength and durability of the global economic recovery, additional revelations of accounting irregularities, and downward revisions to corporate earnings forecasts. The attendant price adjustments in the mature equity, credit, and currency markets, and concerns about their implications for balance sheets, further weakened investor confidence and increased risk aversion. The sharp deterioration in market conditions through mid-July—when the major equity markets reached lows—also raised questions about the resilience of financial institutions, particularly in Europe. Meanwhile, financial institutions seemed to be reassessing their business strategies, particularly the relative profitability of wholesale versus retail banking.

International Monetary Fund. Monetary and Capital Markets Department

Abstract

Financial markets are adjusting with equanimity to the onset of the interest rate tightening cycle. The well-crafted communications strategy of the U.S. Federal Reserve Board prepared markets fully for the first measured rise in U.S. policy rates in June 2004. The backdrop of resurgent and broad-based economic growth, rising corporate earnings, and stronger corporate balance sheets have helped support equity and corporate bond prices, notwithstanding the prospect of further interest rate increases. Limited inflationary pressure to date has moderated expectations for the pace and degree of tightening in the United States and Europe. Market participants are now focused on the sustainability of the recovery, and its impact on interest rates and asset valuations.

International Monetary Fund. Monetary and Capital Markets Department

Abstract

The favorable climate for emerging market financing that characterized the first quarter of 2002 deteriorated in the second, as investors reassessed the pace and durability of the global economic recovery, the valuation of U.S. and European equities, as well as the scope for policy continuity in core emerging markets.

International Monetary Fund. Monetary and Capital Markets Department

Abstract

This is the third and final installment of a series of chapters in the Global Financial Stability Report (GFSR) discussing the transfer, reallocation, and management of financial risk. Throughout this series we have highlighted the flow and reallocation of risks throughout the financial system, and the ability of certain market participants to manage new types of risks. Traditional assessments of financial stability tend to concentrate on the condition or resiliency of systemically important institutions, most often banks. In this series, we have expanded the analysis and highlighted the changing flow of risks among market participants, often as a result of policies or standards intended to improve the ability to manage, monitor, or measure risks in a particular sector. However, such policies and standards frequently redirect the flow of risk to less-monitored or less-measured sectors, such as the household sector. As such, the question arises whether, as a result of these policies, the financial system as a whole has become or is becoming more stable, or whether new risks and sources of instability may be emerging.

International Monetary Fund. Monetary and Capital Markets Department

Abstract

As financial markets develop, a variety of nonbank institutions, such as insurers, pension funds, mutual funds, and hedge funds, have been increasing their exposure to market and credit risks. This chapter is the second in a series on the financial stability implications of this reallocation and transfer of risk, following the chapter, “Risk Transfer and the Insurance Industry,” in the April 2004 GFSR. This chapter focuses on pension funds, as significant institutional investors.

International Monetary Fund. Monetary and Capital Markets Department

Abstract

As financial markets develop, a variety of nonbank institutions, such as insurers, pension funds, mutual funds, and hedge funds, have been increasing their exposure to market and credit risks. This chapter is the second in a series on the financial stability implications of this reallocation and transfer of risk, following the chapter, “Risk Transfer and the Insurance Industry,” in the April 2004 GFSR. This chapter focuses on pension funds, as significant institutional investors.

International Monetary Fund. Monetary and Capital Markets Department

Abstract

Emerging markets have become net capital exporters since 2000.1 This development, which was highlighted in the September 2003 GFSR, has raised questions and concerns among market analysts and policymakers. Conventional wisdom suggests that capital should flow from capital-abundant mature markets to capital-scarce emerging markets. However, this general presumption does not hold for an individual country when it needs to adjust its international investment position as a result of a financial crisis, or when risk-adjusted returns shift global asset allocation away from emerging market assets. Moreover, when different types of risks and capital market imperfections are incorporated into the analysis, it is not unlikely that a particular emerging market country could become a net capital exporter—at least for a short period of time.

International Monetary Fund. Monetary and Capital Markets Department

Abstract

Akey policy prescription to prevent or ameliorate financial crises in emerging markets has been the development of local bond markets, and this strategy has been embraced by a number of policymakers and international organizations (see World Bank and IMF, 2001). From a macroeconomic perspective, local bond markets could soften the impact of lost access to international capital markets or bank credit by providing an alternative source of funding.1 From a microeconomic perspective, they could help create a wider menu of instruments to deal with inherent currency and maturity mismatches in emerging markets (see Eichengreen and Hausmann, 1999 and HKMA, 2001).