During the year ending May 2001, the global economic slowdown and greater synchronization between economic and financial cycles gave rise to reappraisals of financial risk, portfolio rebalancing, and asset repricing in a wide range of financial markets. As discussed in previous International Capital Markets reports, past financial market adjustments, such as that which occurred in 1998, often seemed to have originated in concerns that excessive leverage, market illiquidity, and other potential financial fragilities could engender real economic consequences such as a “credit crunch.” By contrast—and contrary to concerns expressed by market participants last year that the U.S. and global economies might experience overheating—the recent adjustment reflected perceptions, and then the reality, of deteriorating economic conditions and prospects. Concerns later arose that the attendant financial repercussions, including downward pressure on corporate earnings growth and rising default rates, would adversely affect prospects for real economic growth.

The financial effects of slowing economic growth and deteriorating prospects were clearly reflected in the repricing of risks in a wide range of equity and high-yield credit markets. Equity prices fell substantially during 2000, particularly for technology stocks, which registered virtually simultaneous sharp falls in markets around the globe. For a variety of borrowers, high-yield credit spreads surged to the highest levels since the 1991 recession as issuance dried up. The increased correlation between asset prices across countries probably reflected elements of the ongoing globalization of finance, including the greater tendency for global investors to manage portfolios from a sectoral rather than geographic perspective. A key exception was the Japanese fixed-income market, where spreads seemed compressed compared with those of other countries. Compressed spreads in Japan may have been due to the more important role of domestic investors relative to foreign investors and efforts by the authorities to promote corporate lending through loan guarantees. Global equity and fixed-income markets rebounded in early 2001 following monetary easing in the major economies.

Because economic and financial conditions and prospects deteriorated more or less simultaneously across a wide range of countries and markets, the pattern of global capital flows was broadly unchanged. The United States continued to absorb the bulk of international capital flows, including flows from Japan and the euro area. Accordingly, the dollar continued to strengthen on a multilateral basis, while the yen declined and the euro was broadly stable. The euro depreciated against the dollar, however, amid strong outflows of equity portfolio capital to the United States. Strong U.S. capital inflows might have reflected investor confidence that the U.S. downturn would be short-lived and that high productivity growth—which underpinned strong, risk-adjusted returns in U.S. asset markets during past years—would be sustained.

During the period under review, financing to emerging markets was significantly affected by the aforementioned economic and financial developments. Although total gross private financing to emerging markets rose by one-third in 2000, there were repeated episodes in which access to international markets by emerging market borrowers was limited. This “on-off” access of emerging markets to international capital markets reflected both structural and conjunctural factors. As a key structural factor, because dedicated emerging market investors are limited in number and size, “crossover” investors played a key role in determining capital flows to and from emerging markets.¹ The conjunctural factors included market turbulence in Argentina and Turkey—which affected the level of market access for many emerging markets—as well as periodic bouts of asset-price volatility in mature markets (particularly in equity markets) and concerns about the prospect of slowing global growth.

The on-off nature of emerging market access to international capital markets appears to have become a key characteristic of international financial markets. Emerging market borrowers have begun to adapt: when the market for U.S. dollar-denominated bonds has closed, these borrowers turn to the syndicated loan markets, attempt to issue in bonds denominated in euro or yen, or issue in local-currency bond markets. In addition, they employ staff with extensive experience in investment banking and securities trading, exploit “windows of opportunity” to prefund their yearly financing requirement, and engage in debt exchanges to extend the maturity of their debt and avoid a bunching of maturities.

This year’s International Capital Markets report explores these main themes, as it examines recent developments in the mature and emerging markets and analyzes key structural changes in global financial markets.

Chapter II provides a comprehensive description and assessment of developments in the mature markets. As the global economic outlook weakened during the second half of 2000 and concerns about overheating of the U.S. economy waned, monetary tightening gave way to easing or the expectation of easing in the major markets, and concerns arose about credit risk and slowing corporate earnings growth. Long-term interest rates declined, credit spreads rose, and equity prices fell sharply in all the major markets, particularly for technology stocks. The dollar continued to strengthen on a multilateral basis amid continued strong flows of capital into the United States, as the repricing in U.S. markets was broadly mirrored in other markets. In early 2001, monetary easing in the major economies renewed optimism about the economic outlook, and credit spreads narrowed and stock prices recovered. Deteriorating market conditions and credit quality weighed on bank earnings in the major economies but, except in Japan, no concerns arose about the stability of any major banking system.²

Chapter III reviews recent developments in emerging market financing over the past year, including trends in net and gross financing flows, and in primary and secondary markets for emerging market assets. Although net and gross capital flows were positively correlated throughout the 1990s, net capital flows declined substantially in 2000, whereas gross flows expanded sharply. This divergence primarily reflected the sharp rise in the current account surpluses of the oil-exporting emerging markets, which led to both an accumulation of foreign exchange reserves and increased claims (mainly deposits) on international banks. However, foreign direct investment flows also declined in 2000 for the first time since 1990. Emerging market equities issuance rose sharply in 2000, but issuance by Chinese entities accounted for the lion’s share. There was also a sharp contrast between the secondary market performance of emerging market bonds and equities. Despite the repeated episodes of limited bond market access, emerging market bonds were among the best performing asset classes, in part reflecting market perceptions of improving fundamentals for selected emerging markets. In contrast, emerging market equities were closely linked to developments in mature equity markets and experienced a 30 percent decline.

This year’s report also continues the analysis of key structural changes in global financial markets that has been undertaken in recent reports. Chapter IV discusses the financial implications of and policy issues surrounding the ongoing structural changes in the major government securities markets, which have been key building blocks of global finance. Major government securities and their markets have characteristics such as minimal credit risk and strong liquidity that distinguish them from other financial instruments and markets. Because of these characteristics, private market participants have come to rely on government securities and markets to play important roles in facilitating private finance. These roles, which include benchmarks, hedging vehicles, and safe haven assets during periods of stress, might not easily be filled by other financial instruments. The chapter analyzes the unique features of the major government securities and links them to their roles. The chapter then discusses recent structural changes in the major government securities markets, examines their financial implications, and identifies attendant public policy questions.

Chapter V provides a comprehensive assessment of financial sector consolidation in emerging markets, including both banking and securities trading and asset management. The last few years have witnessed accelerating consolidation among financial institutions in the mature markets and a similar trend is gathering momentum in emerging markets. The chapter discusses how the same forces driving consolidation in the mature markets are leading to different consolidation patterns in the emerging markets. In particular, consolidation in the latter is predominantly cross-border and the authorities have played a larger role in guiding the earlier stages of the process. Ownership structures, in particular family ownership, are seen as the main obstacle to faster, market-driven consolidation in emerging markets. The consolidation of financial institutions is driven by attempts to exploit economies of scale and scope, and technological advances such as the Internet and deregulation that facilitate universal banking activities are making it easier to reap such economies. Advances in technology are also transforming the securities trading industry. In response to the associated competitive pressures, stock and derivatives exchanges in emerging markets are consolidating, liberalizing access, and deregulating brokerage commissions. Barriers to entry of foreign brokerages and antiquated trading and governance structures have delayed the adaptation of some securities markets, however, with the result that liquidity and trading has migrated to offshore markets. Another feature of the consolidation process in emerging markets has been the rapid growth and consolidation of private pension funds, which sometimes contrasts with the stagnation of domestic securities markets. Finally, the trend of consolidation in emerging markets raises a number of policy issues, including the relevance of market discipline and adequate exit policies for institutions in distress, the importance of consolidated supervision and the architecture of supervisory agencies, the systemic risks derived from a more concentrated industry, and the rising importance of consumer protection and antitrust issues as a result of the potential of increased market power and privacy concerns.

Chapter VI provides a staff appraisal of the issues raised in the preceding chapters. It includes a discussion of the staffs views on the important risks and vulnerabilities present in global capital markets and the potential broader policy implications of changes in the structure of the major government securities markets and consolidation in emerging market financial systems.