CHAPTER II GLOBAL FINANCIAL MARKET DEVELOPMENTS
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International Monetary Fund. Monetary and Capital Markets Department
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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.

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.

This chapter analyzes key developments in mature and emerging financial markets, focusing on potential sources of risk, especially those arising from changing expectations on the degree and pace of monetary tightening in the United States. It considers developments in the external environment for new issuance by emerging markets and also assesses improvements in the soundness of major emerging market banking systems. It concludes with a review of structural issues in mature markets, focusing on hedge fund activities and the evolution of sectoral balance sheets in Europe, Japan, and the United States.

Overview

Throughout much of 2003, the combination of stimulative monetary policies and strengthening fundamentals contributed to a strong rally in asset prices and a compression of credit spreads on mature and emerging market bonds. In some cases, it appeared that in their quest for yield investors were motivated as much by the push of abundant liquidity as the pull of fundamental valuations. Abundant global liquidity and the steep yield curve for U.S. treasuries had created strong incentives for investors to borrow at low short-term rates to invest in higher-yielding assets. The April 2004 issue of the Global Financial Stability Report stressed that the unwinding of these carry trade positions had potential to trigger turbulence in a number of financial markets. It urged investors not to assume that extraordinarily low interest rates would continue indefinitely, and it called on the authorities to be vigilant for excessively leveraged or concentrated positions.

Early this year, as investors adjusted to the prospect of a less accommodative monetary stance, they became more cautious. In the process, some investments that had been encouraged by last year’s abundant global liquidity were partly unwound. The resulting adjustments, though pronounced in some emerging and higher-risk markets, resulted in fewer disruptions than had earlier been feared, with all markets so far remaining orderly.

The start of the tightening cycle in the United States was widely anticipated, and investors and intermediaries have had ample opportunity to adjust to a rising interest rate environment. However, some investors may find that the hedges they established are imperfect, and they may have to make adjustments. In addition, considerable uncertainty continues to surround the pace and path of tightening that will be needed to bring interest rates to a cyclically neutral level. Most notably, there is uncertainty about underlying inflationary pressures. Although core inflation remains low, oil and other commodity prices, especially base metals, have risen strongly.

Market expectations of longer-term inflation remain subdued, but the persistence of this view cannot be taken for granted, in particular if the output gap in the main industrialized countries continues to close. The financial authorities in several mature markets have appropriately stressed that they will respond if core inflation rises to levels that threaten price stability. In some cases, the authorities are also concerned about speculative bubbles developing in certain sectors, notably housing.

Emerging markets have weathered the transition in interest rate expectations relatively well. Borrowers had taken advantage of the strong appetite for emerging market assets around the turn of last year to raise the lion’s share of their financing needs of the current year. They could afford to be patient when conditions were less favorable in April and May of this year. In the event, appetite returned quickly with some investors, notably life insurers and pension funds, taking advantage of the lower prices of emerging market debt to enter the market, although with a noticeable preference for less risky assets.

Against this backdrop, policymakers can draw some comfort that tightening has commenced with such little disruption. They should also be encouraged that leveraged positions appear to have been reduced, and that financial institutions generally appear well positioned to withstand the move to a higher interest rate environment. At the same time, a number of important risks remain:

  • An unanticipated increase in inflation could transform the market’s assumptions about the likely pace of tightening and has potential to cause market turbulence. The perception that the U.S. Federal Reserve has fallen “behind the curve” and is chasing, rather than shaping, market expectations for interest rate increases could cause markets to assume interest rates will have to overshoot cyclically neutral levels in order to rein in inflation. Previous episodes have shown that such rapid changes to expectations can be unsettling. In such a scenario, risk management strategies would be severely tested. Investor assumptions about the ease with which they can exit from carry trades could prove optimistic. Yields and credit spreads could overshoot. For the moment, however, this risk appears remote.

  • Extraordinarily low interest rates have encouraged a variety of carry trades and increasing interest in alternative investments. These factors have contributed to an increase in leverage and a proliferation of hedge funds, whose assets under management are estimated to have doubled since 1998 to about $1 trillion. There is a risk of investor herding as particular speculative positions gain wide favor across a number of hedge funds and other leveraged investors. A reversal of such positions could result in a reduction of market liquidity and disproportionate price movements.

  • The orderly adjustment of global imbalances remains a challenge. The persistence of these imbalances and the magnitude of the flows involved remain a potential source of vulnerability in currency markets that could spill over to other asset classes.

  • Geopolitical concerns remain an imponderable risk factor. In recent months, security concerns have put pressure on oil prices. A further spike in oil prices would dampen economic activity and pressure the external accounts of oil importers. Geopolitical concerns have the potential to heighten risk aversion, leading to widening credit spreads and lower asset prices. Terrorist activity could disrupt the infrastructure supporting financial markets, although a significant amount of work has been undertaken in the major financial centers to assess potential vulnerabilities and put in place procedures and infrastructure in the event of disruptions.

  • Rising interest rates in the major financial centers have often resulted in a less hospitable financing environment for emerging markets. History suggests that abundant global liquidity is a major factor influencing the attractiveness of emerging market assets. Strong growth and the modest financing requirements of some emerging markets will probably mitigate the impact of higher mature market interest rates initially. However, as rates rise, emerging markets may find it increasingly difficult to attract the financing they need. In particular, investors may discriminate between those emerging markets that have made progress on their reform agendas, or are locked into a broader process that is likely to see them converge over time with more mature markets. Increased attention is also being given to debt structures and other balance sheet mismatches as potential sources of risk (Box 2.1, page 13). Although a number of countries have taken steps to improve the structure of their debt by extending maturities and reducing the share of debt indexed to foreign exchange or short-term interest rates, unstable debt structures and mismatched balance sheet positions remain potential sources of instability in a number of key emerging markets.

Developments and Vulnerabilities in Mature Markets

Markets Anticipate Higher Short-Term Interest Rates

Changing policy rate expectations have been the main driver of global financial markets this year. At the start of the year, markets were still anticipating that policy interest rates in the United States would remain, for most of the year, at or close to the exceptionally low levels to which they had been pushed to forestall deflation and stimulate growth.

However, the revised language in the January and March statements of the Federal Open Market Committee (FOMC), combined with strong economic data and signs of stronger employment growth, transformed market expectations for the degree and pace of tightening (Figure 2.1). By the end of July, markets were expecting the federal funds target rate to rise to 2 percent by the end of 2004, following the 25 basis point increase of the federal funds rate to 1.25 percent at the end of June.

Figure 2.1.
Figure 2.1.

One-Month Federal Funds Futures Rate

(In percent)

Source: Bloomberg L. P.

In the euro zone, expectations for a possible reduction in interest rates evaporated amid a recent uptick in inflation and as it became increasingly clear that U.S. interest rates were set to rise. Futures markets are now discounting an increase in euro short-term interest rates, although at a slower pace than in the United States (Figure 2.2). Interest rate expectations in Japan remained anchored by the authorities’ repeated commitment to the zero interest rate policy and their willingness to supply large amounts of liquidity to the financial system. However, as further evidence of the sustainability of the recovery emerged, and as the yen stopped strengthening even when intervention ceased, markets began to contemplate an exit from the zero interest rate policy. The authorities in Australia, New Zealand, Switzerland, and the United Kingdom had all initiated their tightening cycles before the United States made its first move (Figure 2.3).

Figure 2.2.
Figure 2.2.

Strip Curve Interest Rate Expectations

(Three-month LIBOR futures, in percent, as of July 30, 2004)

Source: Bloomberg L. P.
Figure 2.3.
Figure 2.3.

Selected Central Bank Policy Rates

(In percent)

Source: Bloomberg L.P.

Longer-term interest rates rebounded from their lows in mid-March, reflecting expectations of both stronger growth and higher inflation (Figure 2.4). The increase was sharpest in the United States, but was echoed in the euro area and later in Japan. Expectations for long-term inflation—calculated as the yield difference between inflation-indexed and non-inflation-indexed bonds—continued to increase early in the year, although there has been some moderation in recent months, and expected inflation rates remain low by historical standards (Figure 2.5). Until recently, longer-term inflationary expectations were well above actual inflation, but in the United States, actual inflation has now overtaken expectations derived from bond markets. This has yet to happen in Europe, however, as the increase in actual inflation has so far been less marked. In Japan, inflation-indexed bonds are new, and the market for those bonds does not have the depth of those in the United States or Europe. In any case, deflationary expectations have eased in Japan.

Figure 2.4.
Figure 2.4.

Ten-Year Government Bond Yields

(In percent)

Source: Bloomberg L.P.
Figure 2.5.
Figure 2.5.

Long-Term Inflation Expectations

(In percent)

Sources: Bloomberg L.P.; and IMF staff estimates.

As indicated in the April 2004 Global Financial Stability Report, low short-term interest rates and the steep yield curve created strong incentives to establish carry trades and other speculative positions. There was a risk that these positions were motivated largely by expectations that short-term interest rates would remain at extraordinarily low levels for an extended period. As interest rate expectations were adjusted in April and May, there is evidence that some of these positions were reduced (Box 2.2, page 15).

Market Volatility Remains Subdued

Nevertheless, options markets were not pricing in major market movements (Figure 2.6). The volatilities implied by the pricing of currency options remained generally low, and those for equity options rose only briefly before falling back to the low levels seen at the end of last year. The volatility priced into options to enter into swaps has also fallen. Low volatility in bond markets reflected in part more continuous and well-diversified hedging activity by holders of mortgage backed securities (MBS). As the pace of prepayments dropped amid rising interest and mortgage rates, and MBS durations increased, only a limited surge in bond option volatility was apparent this year compared to 2003.

Figure 2.6.
Figure 2.6.

Implied Volatilities

(In percent)

Source: Bloomberg L.P.

A number of factors have contributed to the relatively smooth adjustment of markets to the prospect of higher short-term interest rates. First, the large official purchases of U.S. dollar-denominated bonds, in particular, by Asian central banks, have provided a stabilizing influence in the bond and foreign exchange markets. Second, as already noted, the communications of the U.S. Federal Reserve gave abundant warning to investors and financial institutions to prepare themselves for the start of the tightening cycle. As a result, markets had widely anticipated the first interest rate hike in the United States, and the process of price discovery was short as markets swiftly found their new levels. Third, the message that the pace of interest rate increases will be measured is consistent with the market expectations that inflationary pressure is likely to remain subdued. Finally, higher economic growth is supporting the credit quality and earnings prospects of corporations in the mature markets.

Stocks, Flows, and Vulnerability Assessments

While aberrant flows characterize capital account crises, increasing attention is being given to the balance sheet exposures that can engender them. Balance sheet analysis focuses on shocks to stocks of assets and liabilities that can trigger large adjustments in capital account flows. The Asian crisis of 1997-98, in which private sector balance sheet mismatches rather than fiscal imbalances played a key role, gave impetus to research on the risks posed by potentially unstable positions. Such analysis can complement the traditional flow analysis that focuses on the gradual buildup of unsustainable fiscal and current account positions and may be insufficient in fully explaining the dynamics underlying modern day capital account crises.

Balance sheet analysis seeks to identify existing mismatches on the aggregated balance sheet of the corporate, financial, and public sectors. The analysis focuses largely on five sources of vulnerability:

  • currency mismatches that may leave a balance sheet vulnerable to a depreciation of the domestic currency;

  • maturity mismatches (e.g., long-term, potentially illiquid assets with short-term liabilities) that expose a balance sheet to risks related both to rollover and to interest rates;

  • rollover risk if liquid assets do not cover maturing debts;

  • interest rate risk, where a sharp increase in interest rates can lead to capital losses to investors and increase the cost to borrowers of rolling over short-term liabilities and cause a rapid increase in debt service; and

  • capital structure mismatches if debt-to-equity ratios become too high.

Shocks to interest rates, exchange rates, or market sentiment can bring about a deterioration in the value of a sector’s assets compared to its liabilities and lead to a reduction of its net worth. In the extreme case, net worth may turn negative and the sector may become insolvent.

Sectoral analysis is important since the liabilities of one sector are often the assets of another sector and risks can be transferred across balance sheets in severe crisis situations. If a shock causes the corporate sector or the government to be unable to satisfy upcoming liabilities, banking sector assets can be impaired. For example, balance sheet crises that originated in the corporate sector (as in several Asian countries during 1997-98) or the public sector (as in Russia 1998 and recently in Latin America) eventually caused a deterioration in the banking sector. By the same token, if banks restrict credit to prevent further deterioration in banking system assets, risks can feed back into the corporate and government sectors, which may be in need of new financing (as in Turkey in 2001).

The IMF has been using insights based on balance sheet analysis in its surveillance as well as its program work for some time.1 For example, there has been increased emphasis on adequate levels of official reserves in relation to short-term debt and money aggregates. Balance sheet techniques are also employed in debt sustainability analysis to measure the sensitivity of a country’s fiscal and external (private and public) debt to variations in the exchange rate, interest rate, and other variables. Finally, Financial Sector Assessment Programs (FSAP) often include stress testing of the sensitivity of the financial sector’s balance sheets to various shocks.

Balance sheet analysis also underpins modern risk management techniques, including credit risk and value-at-risk methodology. The accounting-based approach maps a reduced set of financial accounting variables—such as leverage, liquidity, and profitability—to a risk scale to discriminate between repayment and non-repayment at the corporate level.2

A variant of balance sheet analysis called the contingent claims approach (CCA), combines balance sheet information with current financial market prices to compute probability of default. CCA was developed from modern finance theory and has been widely applied by financial market participants, most notably Moody’s KMV, in assessing firm credit risk. CCA can also be applied to aggregated balance sheets to estimate similar risk indicators for the corporate, financial, and public sectors.3 Extending the contingent claims methodology to a multisector framework allows for examination of the linkages between the corporate, financial, and public sectors, where the potential feedback effects between sectors can be estimated and valued.

CCA uses standard option pricing techniques to derive a measure called the distance to distress. For a firm financed with debt and equity, this measure is defined as the difference between the implied market value of firm assets and the distress barrier based on the book value of debt—or the net worth of the firm—divided by the implied volatility of the market value of assets. The resulting measure yields the number of standard deviations the firm’s asset value is from the distress barrier, which can be translated into a default probability. The higher the net worth of the firm, or the lower the volatility of the firm’s assets and liabilities, the larger the distance to distress, and the lower the probability of default.

Since market prices represent the collective views and forecasts of many investors, CCA is forward looking unlike analysis based only on a review of past financial statements. Furthermore, CCA takes into account the volatility of assets when estimating default risk, and this incorporation of nonlinearity is crucial in increasing the predictive power of CCA over standard accounting-based measures. The ability to translate continuously adjusting financial market price information into current estimates of vulnerability is important given the speed with which economic conditions change relative to the time span between releases of consolidated accounting balance sheet information.

Gapen and others found the CCA approach to be useful in identifying vulnerabilities in the corporate sector and in estimating the potential for risk transfer between the corporate, financial, and public sectors. They used the Moody’s Macro Financial Risk (MfRisk) model—which is a practical application of the CCA methodology—to assess vulnerabilities retroactively in the corporate sector as well as in a multisector setting for Brazil and Thailand. Their results show the CCA approach holds promise as an early warning indicator of firm credit risk. Naturally, a useful extension of this work is to apply the CCA approach to a wider set of emerging market countries. Here, the analysis does not have to be limited only to assessing corporate sector vulnerabilities but can be usefully applied to estimate the potential for sovereign distress. The CCA approach provides an integrated framework within which policymakers can analyze policy mixes and evaluate which are best suited to countering vulnerabilities.

1 A recent example is Allen and others (2002). 2 A prominent accounting-based approach was developed by Altman (1968), who used a linear combination of five accounting and market variables to produce a credit score—the so-called “Z-score.” A subsequent seven factor “Zeta model” was later introduced by Altman, Haldeman, and Narayanan (1977) and another variant, the “O-score,” was introduced by Ohlson (1980). 3 Examples include Gapen and others (2004); Gray, Merton, and Bodie (2003); and Gray (2002).

Stronger Corporate Balance Sheets and Earnings Contribute to Stability

Corporate balance sheets have continued to improve, although the strength of the U.S. corporate sector tended to surpass the strength of the corporate sector in Europe. For many firms, sales picked up during the first half of 2004, but they were able to meet the higher demand with existing capacity, or with only limited fresh hiring and investment. As a result, cash flows were strong, and much of the higher revenues fed through to earnings. With interest rates still low, many firms were able to reduce the cost of servicing their debt, and lengthen the maturity of their liabilities. The balance sheets for many companies therefore looked considerably healthier by mid-year than was the case at the start of the year, and this was reflected in a preponderance of ratings agency upgrades. Even some companies that had looked severely strained last year came back from the brink as they have regained access to borrowing. The rate of corporate defaults dropped and credit spreads fell sharply last year as investors positioned themselves in anticipation of the balance sheet strengthening this year. Even as the tightening cycle started, and the cost of financing rose, corporate bond spreads in Europe and the United States have held on to most of last year’s gains (Figures 2.7 and 2.8).

Figure 2.7.
Figure 2.7.

High-Grade Corporate Bond Spreads

(In basis points)

Source: Merrill Lynch.
Figure 2.8.
Figure 2.8.

High-Yield Corporate Bond Spreads

(In basis points)

Source: Merrill Lynch.

Market Repositioning and Deleveraging

While the onset of the latest U.S. monetary tightening cycle was widely anticipated, the financial markets’ outlook remained overshadowed by concerns that rising interest rates might spark sudden sales of assets as leverage was unwound. These concerns were reminiscent of 1994, when the rate tightening cycle resulted in elevated financial market volatility and triggered a number of prominent financial failures.

There were at least three reasons to believe that leverage loomed large before interest rate expectations started to rise earlier this year.

First, U.S. policy rates were at a 45-year low and leveraged carry trades are a hallmark of low interest rate environments. Second, earnings derived from fixed-income activities of investment banks grew at a rapid pace in recent years. Third, assets under management by the hedge fund industry doubled to an estimated $1 trillion since 1998. Against this backdrop, this box attempts to shed some light on the extent of deleveraging that may have taken place in anticipation of monetary tightening.

Repositioning of U.S. Dealers

Global recoveries spell good and bad news for financial markets. The good news of rising economic returns tends to be accompanied by the bad news of increasing costs of capital. Responding to these forces, investors’ portfolio allocations change, thereby setting in motion far-reaching repositioning across financial markets. The nuts and bolts of such a repositioning include the hedging of risks associated with rising interest rates and the attempt to capitalize on potentially higher returns generated by the economic recovery.

Such repositioning appeared to be under way in U.S. fixed-income markets. Security holdings by primary dealers fell by $55 billion from their peak in March 2004 to $68 billion on a net basis at end-June (see the first Figure). This adjustment reflected to a large extent steppedup hedging activity. Primary dealers built larger short positions in U.S. treasury bonds in order to hedge their interest rate risk on higher-yielding bonds, including corporate and agency bonds. In doing so, primary dealers captured the yield spread offered by these bonds over U.S. treasuries, while containing duration risk.

uch02fig01

Primary Dealer Securities Positions

(In billions of U.S. dollars)

Source: Federal Reserve Bank of New York, Primary Dealers Transactions.

The repositioning appeared to have gone hand in hand with some deleveraging. U.S. primary dealers reduced their secured borrowing by $145 billion to $124 billion since the onset of the repositioning in mid-March to end-June (see the second Figure). Primary dealers, however, represent only one—albeit important and agile—segment of U.S. financial markets. Moreover, commercial banks built up large security portfolios, while risk and leverage can also exist in other less regulated parts of the financial system or through off-balance sheet positions and structured products.

Repositioning in Futures Markets

Leverage and speculation are often intertwined. Many institutional fund managers operate within investment policies that limit or prohibit leverage, while proprietary trading desks at investment banks and hedge funds often have mandates to build leveraged positions. Futures markets provide a useful barometer of overall speculative activity. Trades that take place at the Chicago Mercantile Exchange are distinguished according to their speculative or commercial character. Based on this distinction, the share of speculative positions taken in open futures contracts can be derived for contracts traded on this exchange.

uch02fig02

Secured Financing of Primary Dealers, Net

(In billions of U.S. dollars)

Source: Federal Reserve Bank of New York, Primary Dealers Transactions.

Share of Speculative Positions in Futures Markets1

(In percent)

article image
Source: Commodities Futures Trading Commission; Bloomberg, L.P.; and IMF staff estimates.

Plus (+) sign denotes a net long position, while a negative (-) sign denotes a net short position.

The repositioning and deleveraging observed by primary dealers coincided with a marked reduction of speculative positions in futures markets, although these only capture a small share of overall speculative activity. While high levels of speculative activity prevailed when the Federal Open Markets Committee (FOMC) meeting in January sparked a shift in interest rate expectations, speculative activity eased by mid-year across most major future contracts, especially currency and commodity futures. Speculative activity in interest rate and bond futures, however, heightened, reflecting the shift in interest rate expectations (see the Table). Hedge funds appear to have been particularly sensitive to the first signs of shifting interest rate expectations.

The improvements in cash flows and earnings also supported equity prices in mature markets (Figure 2.9). Coming into the year, expectations of impressive earnings growth buoyed equity markets. The technology sector, in particular, was bid up temporarily as it appeared that the long-awaited cycle of reinvestment in technology infrastructure was restarting. Earnings in the first half of 2004 lived up to those high expectations, rising by about 20 percent for the S&P 500 on year-ago levels.

Figure 2.9.
Figure 2.9.

Equity Indices

Source: Bloomberg L.P.

Nevertheless, equity markets have been largely range bound, resulting in modest losses or gains in most major markets during the first seven months of the year. Trading levels were low, and implied volatilities priced into options suggest market participants did not anticipate sharp moves in either direction. Even relatively strong second quarter earnings failed to arrest a general downward drift in major indices. Stronger earnings and lackluster price movements resulted in improved valuations. By mid-2004, forward earnings multiples fell back to levels below their 10-year average in most of the major markets (Figure 2.10). However, the valuation of global technology shares still appeared stretched.

Figure 2.10.
Figure 2.10.

Twelve-Month Forward Price/Earnings Ratios

Source: I/B/E/S International.

External Imbalances Remain a Potential Source of Volatility

Throughout much of 2003, the level of capital inflows needed to finance the U.S. external current account deficit weighed on the dollar (Figure 2.11). These concerns waned in early 2004 as strong U.S. growth and expectations for higher U.S. interest rates contributed to an appreciation of the dollar. In addition, as investors reduced leverage and unwound carry trades, they reduced long speculative positions in Asian currencies and equity markets and in commodity currencies, and contributed to dollar demand. As a result, currency market movements were subdued and implied volatility on currency options remained low. Nevertheless, the scale and structure of the financing flows to the United States represent potential sources of instability (Box 2.3, page 35).

Figure 2.11.
Figure 2.11.

Net Foreign Purchases of U.S. Financial Assets

(In billions of U.S. dollars)

Source: U.S. Department of the Treasury.

Developments and Vulnerabilities in Emerging Markets

The April 2004 GFSR warned of the risk that the transition to higher interest rates in the mature markets and deleveraging could unsettle emerging bond markets. Besides fundamentals and investor attitudes toward risk, the analysis found low policy rates in the major financial centers were a key determinant of the decline in emerging bond market spreads during the rally that began in October 2002 (Figure 2.12).

Figure 2.12.
Figure 2.12.

Emerging Market Debt Spreads

(In basis points)

Source: J.P. Morgan Chase & Co.

In the event, shifting interest rate expectations and a temporary heightening of risk aversion triggered an abrupt end to the rally this year that had led spreads to 10-year lows. In a matter of weeks, the results of almost one year of spread compression dissipated, with the spread of the EMBI Global rising to 549 basis points in May 2004. As a result, emerging market bonds experienced a loss in the second quarter this year for the first time since the third quarter of 2002.

Incidentally, the model presented in the April 2004 GFSR, subject to a minor modification, forecast the spread widening that occurred in April and May relatively well (Figure 2.13). In this context, Box 2.4 (page 39) discusses further research on the determinants of emerging bond market spreads.

Figure 2.13.
Figure 2.13.

Observed and Forecast EMBI+ Spreads

(In basis points)

Sources: J.P. Morgan Chase & Co.; and IMF staff estimates.

Changing interest rate expectations—as reflected by the slope of the eurodollar futures strip curve (Figure 2.14)—appear to have contributed to recent spread changes.1 A brief steepening of the eurodollar futures strip curve at end-January, following a change in language in a statement issued by the FOMC, coincided with an initial widening of emerging market spreads. Subsequently, interest rate expectations started to rise sharply with a further change in language by the FOMC in its statement issued in mid-March. This set the stage for the sell-off in emerging market debt in April and May. Once interest rate expectations stabilized in mid-May, emerging market spreads began to tighten again.

Figure 2.14.
Figure 2.14.

EMBI Global Spreads vs. Eurodollar Interest Rate Expectations

(In basis points)

Source: Bloomberg L.P.

Mounting expectations for higher interest rates affected spreads in part through the unwinding of carry trades. Although data on the extent of these leveraged investments are difficult to come by, investor surveys showed a sizable unwinding of positions by “trading accounts” during April when emerging debt markets suffered substantial declines (losing 5½ percent). These accounts include hedge funds and proprietary trading desks, which are prone to rely on leverage.

In addition to trading accounts, dedicated and crossover investors also reduced their risk during the sell-off by increasing cash levels, moving up in the credit quality spectrum, and reducing the duration of their portfolios. Market commentary and surveys suggest they did so primarily owing to fears over increases in global interest rates, rather than because of concerns about credit fundamentals. In fact, domestic country fundamentals have remained robust and in some cases strengthened for a variety of reasons, including:

  • a significant pickup in demand for emerging market exports as the global economy entered a broadly synchronized recovery, notwithstanding a more muted recovery in the euro area;

  • higher commodity prices fueled by the global economic recovery and particularly strong demand from China;

  • reduced external vulnerabilities stemming from the greater prevalence of floating exchange rates, more dependence on local financing, and higher international reserve levels; and

  • active debt management operations by a number of emerging market countries that reduced balance sheet vulnerabilities and/or led to savings on debt-servicing costs. To cite two prominent examples: Brazil has pursued a policy of reducing its dollar-linked liabilities, bringing them down to less than 15 percent of total net public debt from 30 percent at the end of 2002. Mexico implemented an innovative debt swap of global bonds to take advantage of inefficiencies in its global bond yield curve, generate savings, and provide greater liquidity to investors.2

The maintenance of overall good country fundamentals has helped the adjustment to higher interest rates remain orderly; there were no severe dislocations for either investors or issuers. However, the brunt of the sell-off was born by higher-yielding credits. Notwithstanding a subsequent recovery, by end-July the Dominican Republic, Brazil, Peru, and Turkey still showed losses year-to-date. (Figure 2.15). The shake up in Russia’s banking sector, however, also weighed on bond markets in Russia and the Ukraine.

Figure 2.15.
Figure 2.15.

Emerging Market Debt Returns

(In percent, year-to-date through July 30, 2004)

Source: J.P. Morgan Chase & Co.1From inception of the index.

Nevertheless, sub-investment grade credits outperformed in the rally that followed the sell-off and continued through July this year. The differential between average spreads on B-rated sovereigns compared to BB-rated or investment grade sovereigns began to narrow again following the sell-off in April and May (Figure 2.16).

Figure 2.16.
Figure 2.16.

Spread Differentials in Emerging Market Debt

(In basis points)

Sources: J.P. Morgan Chase & Co.; and IMF staff estimates.

Looking ahead, the main external risk for the asset class remains the possibility of another round of deleveraging. Expectations for a significantly faster pace of monetary tightening in the United States could lead to further risk aversion and higher spreads on emerging market bonds as speculative positions are reduced. Of less concern is a sharp slowdown in Chinese economic growth, which would most likely affect only selected emerging market countries with resource-intensive exports. Following the renewed spread tightening mid-year, emerging bond market valuations appeared once more stretched. By end-July, emerging bond market spreads relative to U.S. corporate bonds had fallen substantially from their peak in May 2004 (Figure 2.17), although they remained above their lows.

Figure 2.17.
Figure 2.17.

Differentials Between Corporate and Emerging Market Spreads

(In basis points)

Sources: J.P. Morgan Chase & Co.; Merrill Lynch; and IMF staff estimates.

Finally, while the supply and demand balance in primary markets appears largely favorable, excess supply represents a potential concern, in particular due to the still large remaining financing needs in parts of the emerging market corporate sector. There is also a possibility of further Paris Club-related issuance by bilateral creditors, akin to the ARIES deal that liquefied German Paris Club claims on Russia (Box 2.5, page 42). While this transaction allowed Germany to raise deficit financing without issuing debt, a strengthening of public finances would have been more prudent.

Despite these risks, a number of factors are likely to support a favorable external financing environment for emerging markets going forward:

  • Financing needs for the remainder of the year are moderate. An estimated 80 percent of planned 2004 issuance for emerging market sovereigns was completed in the first half of the year, despite the temporary lull in issuance by sub-investment grade sovereign borrowers during the second quarter of 2004.

  • The credit quality of emerging market sovereigns seems poised to improve. Credit ratings have remained broadly flat since 2002, despite a good deal of progress on fundamentals (Figure 2.18). Thus, there appears to be further scope for upgrades moving forward. Indeed, market participants are anticipating some key upgrades, an expectation buttressed by the results of credit ratings models.

Figure 2.18.
Figure 2.18.

Emerging Market Credit Quality

Sources: J.P. Morgan Chase & Co.; Moody’s; Standard & Poor’s; and IMF staff estimates.

To the extent that interest rates eventually reach cyclically neutral levels and yield curves flatten, the incentives for leveraged carry trades will diminish. Hence, the importance of domestic fundamentals as the dominant driver of emerging debt markets is likely to reassert itself. This underscores the need to persevere with efforts to reduce balance sheet vulnerabilities, remain vigilant about macroeconomic stability, and push forward with growth-enhancing structural reforms.

Shifting Interest Rate Expectations and Local Emerging Markets

The impetus to risk taking provided by low interest rates in the major financial centers was also reflected in local emerging markets. In an environment of abundant global liquidity, foreign flows into local emerging equity and bond markets appear to have been quite strong prior to April of this year. The main beneficiaries of such flows were Asian equity markets and, in the case of local bond markets, countries with the highest yields and deepest markets, including Brazil, Hungary, Indonesia, Mexico, Poland, South Africa, and Turkey.3 Equity markets experienced a significant reduction in foreign flows in the second quarter of this year, amid changing interest rate expectations in the United States. The effect on flows into local emerging bond markets, however, seemed smaller and largely concentrated on high-yielding markets, particularly Brazil and Turkey. Market feedback suggests that leverage was concentrated in these markets.

Local emerging equity markets sold off with mature markets in April and May in the wake of changing interest rate expectations and fears of a slowdown in China. Reflecting the concerns over China, the sell-off was particularly strong in Asia. While portfolio equity inflows to emerging Asia were buoyant in the first quarter of 2004, they slowed significantly in the second quarter. This is evident in the net flows into U.S.-based equity funds investing in Asia (excluding Japan), which reached a record of $1.1 billion in the first quarter but then experienced outflows of $410 million, the highest four-week outflow since July 1997, between April and May this year (IMF, 2004b).

The decline in emerging market equities was highly correlated with the decline in mature equity markets, suggesting that global factors, including shifting interest rate expectations, had ripple effects through mature and emerging markets (Figure 2.19). In fact, equity markets fell across emerging Europe, the Middle East, Africa, Latin America, and Asia.

Figure 2.19.
Figure 2.19.

Correlations of MSCI World and Emerging Market Indices

(Thirty-day rolling window)

Sources: Morgan Stanley Capital International; and IMF staff estimates.

Unlike emerging equity markets, the sell-off in local bond markets was more differentiated. Spreads of local currency bonds issued by Brazil and Turkey rose sharply in April and May (Table 2.1 and Figures 2.20 and 2.21), while their respective currencies experienced depreciation. Other local markets, however, were not materially affected. This differentiation reflected a combination of factors, including a shift out of the riskier sub-investment grade credits into the less volatile investment grade credits, the varying share of foreign ownership in local markets, and the concentration of leverage in high-yielding credits.

Table 2.1.

Selected Local Currency Bond Spreads

(In percentage points, monthly average over U.S. treasuries or German Bunds)

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Sources: Bloomberg L.P.; and IMF staff estimates.
Figure 2.20.
Figure 2.20.

Brazil: Local Market Spreads over U.S. Treasuries

(In percentage points)

Sources: Bloomberg, L.P.; and IMF staff estimates.
Figure 2.21.
Figure 2.21.

Turkey: Local Market Spreads over German Bunds

(In percentage points, one-year note)

Sources: Bloomberg L.P.; and IMF staff estimates.

Although offering the third highest yields among select local markets, Hungary’s local debt spreads fell during April and May 2004. This reflected its investment grade status and expectations of a continued easing of monetary policy even in the face of rising international interest rates. In South Africa and Poland, local spreads increased marginally in reaction to rising inflation expectations and, in the case of Poland, uncertainty about the fiscal outlook. Similarly, spreads of Mexican local instruments rose marginally due to an increased perception of inflation risk and an unexpected tightening of monetary policy by the central bank in April. In Indonesia, spreads fell over the period as monetary policy remained largely accommodative.

Portfolio outflows suggest that high-yielding local currency debt markets appear to have been subject to deleveraging in April and May this year. Nonresident purchases and holdings of local currency debt issued by Brazil increased sharply during the fourth quarter last year and the first quarter this year, before declining in the second quarter (Figure 2.22). Mirroring these developments, nonresident holdings of government debt peaked in April 2004, before declining in May and June (Figure 2.23).

Figure 2.22.
Figure 2.22.

Brazil: Portfolio Investment in Local Currency Debt Instruments

(In millions of U.S. dollars)

Sources: Central Bank of Brazil; and IMF staff estimates.
Figure 2.23.
Figure 2.23.

Brazil: Nonresident Holdings of Government Debt Instruments

(In billions of reais)

Source: Brazil Ministry of Finance.

Portfolio flows into Turkey exhibit a similar pattern. Portfolio flows rose sharply toward the end of last year and remained high in the first quarter of 2004 (Figure 2.24). A decline in April proved temporary, however, and inflows resumed in May. Foreign holdings of local currency bonds continued to increase in June and early July (Figure 2.25).

Figure 2.24.
Figure 2.24.

Turkey: Portfolio Investment in Local Currency Debt

(In millions of U.S. dollars)

Source: Central Bank of Turkey.
Figure 2.25.
Figure 2.25.

Turkey: Nonresident Holdings of Government Debt Instruments

(In quadrillions of Turkish lira)

Sources: Turkey Ministry of Finance; and IMF staff estimates.

The temporary reduction in foreign holdings of local debt securities issued by Brazil and Turkey suggests that deleveraging in high-yielding local debt markets was limited. Moreover, there is little evidence of substantial outflows from lower-yielding markets, including Hungary, Indonesia, Poland, and South Africa. Against this background, a renewed unwinding of leverage in mature markets may prove once more unsettling for local debt markets.

Emerging Market Financing

Gross issuance of bonds, equities, and loans by emerging market countries through June 2004 compares favorably with previous years, despite a lull in issuance in April and May as markets adjusted to the prospect of higher U.S. short-term interest rates (Table 2.2 and Figure 2.26). Bond issuance was particularly strong, although sub-investment grade borrowers encountered an unreceptive market in April and May. Equity issuance in the first two quarters of 2004 has also exceeded previous years, despite the lull in April and May. As usual, Asia dominated new equity issuance. Syndicated lending to emerging markets followed a similar pattern, and the level of such lending through June 2004 has been broadly in line with previous years.

Table 2.2.

Emerging Market Financing

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Sources: Bloomberg L.P.; Capital Data; J.P. Morgan Chase & Co.; Morgan Stanley Capital International; and IMF staff estimates.

Gross issuance data (net of U.S. trust facility issuance) are as of July 16, 2004 close-of-business London, and Secondary markets data are as of July 30, 2004 c.o.b. New York.

On April 14, 2000, the EMBI+ was adjusted for the London Club agreement for Russia. This resulted in a one-off (131 basis points) decline in average measured spreads.

Figure 2.26.
Figure 2.26.

Cumulative Gross Annual Issuance of Bonds, Loans, and Equity

(In billions of U.S. dollars)

Source: Capital Data.

On a net basis, emerging market issuance has also been strong, notwithstanding heavy redemptions. In the second quarter of 2004, however, net issuance in Latin America turned sharply negative as some sub-investment grade issuers remained temporarily out of the market and issuance in loan and equity markets was negligible (Figure 2.27). This was the third successive quarter of negative net issuance for Latin America.

Figure 2.27.
Figure 2.27.

Quarterly Net Issuance

(In billions of U.S. dollars)

Sources: Capital Data; and IMF staff estimates.

Bond Issuance

After gross bond issuance soared to a record $38.4 billion in the first quarter, issuance dipped sharply in the second quarter only to rebound strongly in late June. Gross bond issuance through June 2004 was well above levels of previous years and has further accelerated in July to start the third quarter at a record pace of some $19 billion (Figure 2.28). Early in the year, strong demand for emerging market assets, low global bond yields, and record low emerging market bond spreads created strong incentives for issuers to accelerate funding plans. Issuers were keen to lock in low financing costs as expectations of a turn in global interest rates became more pronounced. As a result, net bond issuance in the first quarter reached a multi-year high of $13.4 billion, despite record amortization payments. The inclusion of collective action clauses seems now to be widely accepted as industry standard (Box 2.6, page 44).

Figure 2.28.
Figure 2.28.

Cumulative Gross Annual Issuance of Bonds

(In billions of U.S. dollars)

Source: Capital Data.

Primary market access turned decidedly more difficult in late April, causing borrowing costs for many emerging markets to rise rapidly. Several issuers cancelled planned bond issues, and by mid-June, net bond issuance for the quarter had turned negative. Sovereign and corporate issuers in Latin America faced particular difficulties. During the month of May, not a single Latin American bond was launched. By late June, however, bond markets again appeared receptive to new issues from sub-investment grade borrowers as Brazil and Turkey launched bonds that were well received. Turkey came to the market with a $750 million seven-year fixed-rate bond that was heavily oversubscribed. Brazil launched a well-received $750 million five-year floating-rate note (FRN). The FRN capitalized on the growing appetite of investors for protection against rising interest rates. Sovereign and corporate issuers in Chile, Mexico, Russia, and Venezuela also issued FRNs.

The bond issues by Brazil and Turkey notwithstanding, issuance in the second quarter was dominated by higher-grade borrowers. In a high-profile transaction, Mexico successfully launched an innovative debt management operation involving the older, off-the-run global bonds for more liquid, on-the-run global bonds. The $3 billion transaction was well received by the markets, as it made the Mexican yield curve more efficient by replacing higher-yielding bonds with instruments that traded more in line with the sovereign yield curve. As suggested earlier, July was a bumper month for primary market issuance, with many sub-investment grade borrowers returning to the market.

In Europe, high-grade issuers successfully capitalized on positive market sentiment toward new EU members. The Czech Republic and Slovak Republic saw solid demand for their respective debut issues in the international bond market, while Poland (in May) and Hungary (in June) returned successfully to the Samurai bond market to issue ¥50 billion ($462 million) each in foreign bonds. The Samurai market saw a burst of activity as Japanese investor appetite for such bonds grew as a yield pickup over domestic yen interest rates. From the issuer’s perspective, yield spreads on yen-denominated Samurai bonds were comparatively low due to their limited supply.

Equity Issuance

Driven by robust new issuance in Asia, equity issuance has been on track to top the $41.8 billion in emerging market equity financing raised in 2000 (Figure 2.29). While increased market volatility in April and May triggered a brief pullback in new equity issuance, June saw a solid rebound in equity financing, mainly by Asian issuers. Chinese firms accounted for most of the region’s new share issues during the second quarter, led by China Telecom’s $1.7 billion share issue in May and the $1.9 billion initial public offering (IPO) by China’s Ping Ang Insurance. The two transactions were the largest share issues in the second quarter, boosting the region’s share in global emerging equity financing to some 80 percent. In June, firms in the Emerging Europe, Middle East, and Africa (EMEA) region also returned to primary equity markets, after having been largely absent for most of the second quarter. In sharp contrast, new equity issuance by Latin American firms remained quite low, following limited issuance in 2003. With only five of the region’s corporates having been able to raise funds during the entire first half of the year, Latin America’s share in total emerging market equity issues remained stuck at a mere 3 percent.

Figure 2.29.
Figure 2.29.

Cumulative Gross Annual Issuance of Equity

(In billions of U.S. dollars)

Source: Capital Data.

Syndicated Lending

After a strong first quarter, gross lending to emerging market borrowers slowed in May, but rebounded sharply in late June, in line with activity in primary equity and bond markets (Figure 2.30). On a net basis, lending to emerging markets contracted in May as lenders reduced market exposure in response to the global market sell-off. During the second quarter slowdown, lending to Asian corporates held up well. Loans to firms in the EMEA region declined markedly, however, and lending to Latin American borrowers slowed to a trickle.

Figure 2.30.
Figure 2.30.

Cumulative Gross Annual Issuance of Loans

(In billions of U.S. dollars)

Source: Capital Data.

Foreign Direct Investment

There are preliminary signs of a modest recovery in foreign direct investment (FDI) flows to emerging markets this year, following declines in 2002 and 2003. FDI flows to Latin America are estimated by the World Bank to have increased significantly in the first quarter of 2004 compared with the first quarter of 2003, led by flows to Chile and Mexico, and to a lesser extent Brazil (Figure 2.31). Asian FDI flows also increased over the same period, and continued to account for the bulk of global FDI flows to emerging economies. Within Asia, flows to China remained dominant. FDI flows to Eastern European countries and Turkey also show signs of increase. On the basis of these initial trends and the prospect of stronger global growth, FDI flows to emerging markets are forecast by the World Bank to recover moderately this year. This view is also supported by private sector surveys suggesting increased readiness to undertake cross-border acquisitions and investments.

Figure 2.31.
Figure 2.31.

Foreign Direct Investment to Emerging Markets

(In billions of U.S. dollars)

Source: World Bank.

Banking Sector Developments in Emerging Markets

Since the last GFSR, banking systems in the major emerging markets have continued to recover, with generally improving capital positions, asset quality, and earnings (Table 2.3). In most countries, domestic banks have expanded lending, funded by deposit growth and interbank credits from major international banks. Performance varies across regions, however. In Asia, the financial position of banks has generally strengthened further with the economic recovery, except in a few countries where underlying weaknesses have not been fully addressed. The stabilization of banking systems in Latin America is being sustained, but full normalization is contingent on a supportive global environment and fundamental restructuring to restore solvency of distressed institutions. Banks in emerging markets in Europe continue to perform well, with adequate capital, although rapid credit expansion is a source of risk in a number of countries. In the Middle East and Africa, there has been little change since the last GFSR, but there are encouraging indications of efforts to deal with structural weaknesses in state-owned banks in some countries.

Table 2.3.

Emerging Market Countries: Selected Financial Soundness Indicators

(In percent)

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Sources: National authorities: and IMF staff estimates.

Constructed according to a numerical scale assigned to Moody’s weighted average bank ratings by country. “0” indicates the lowest possible average rating and “100” indicates the highest possible average rating.

Excluding Japan.

Includes Central and Eastern Europe, Israel, Malta, and Turkey.

Emerging market banking systems face risks associated with a reversal of the low interest rate environment experienced in recent years. In many countries, low interest rates have allowed a strengthening of banks’ balance sheets through capital gains on their interest sensitive assets while the reduction in funding costs probably contributed to a widening of interest rate margins. To the extent that these gains have been distributed and on lent rather than added to capital or reserves, banks would need to adjust to opposite effects on their balance sheets as interest rates rise. Also, profits could be squeezed by a compression of interest margins to the extent that funding costs rise and banks are unable to fully pass this increase on to customers.

Supervisory authorities in emerging markets are also evaluating the implications for their banking systems of the revised Basel Accord (Basel II), which was endorsed by the Basel Committee on Banking Supervision in June 2004 for implementation in 2007. The precise impact of the new accord on banking systems in emerging markets is difficult to gauge. On the one hand, banks from these countries, which are likely to follow the standardized approach, may need to increase capital to allow for greater weighting of riskier credit exposures and to cover operational risk. On the other hand, they could adapt their portfolios to limit the need to provide additional capital. Supervisory authorities may need to ensure their banks have the capacity to meet the additional capital requirements. In addition, they may need to consider the impact of Basel II on the activities of international banks in their banking systems. International banks are more likely to operate under the internal ratings based (IRB) approach and will face higher risk weights on their emerging market exposures.

There are indications of a shift in the pattern of lending activities of major international banks in emerging markets toward interbank and government lending in foreign currency (Table 2.4). The rise in interbank lending is consistent with signs of recovery in many emerging market banking systems. Overall credit extended by these institutions to emerging markets rose on average but the share of foreign currency lending to the nonfinancial private sector declined noticeably in some regions. However, a significant portion of the increase in interbank lending may have funded part of the increase in lending to this sector by emerging market banks, possibly contributing to their currency and maturity mismatches.

Table 2.4.

Exposure of Foreign Banks to Emerging Markets1

(In percent)

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Sources: BIS, Consolidated Banking Statistics; IMF, International Financial Statistics.

These BIS bank data are cross-border consolidated and therefore capture both banks’ direct cross-border exposures and exposures incurred through the subsidiaries and branches located in the country (both in foreign and local currency). They include both loan and securities exposures.

Asia

Banking systems in emerging markets in Asia have continued to strengthen with the economic recovery. Earnings, asset quality, and capital adequacy show a steady improvement on average, helped by better interest margins and operational efficiency. These positive developments are also reflected in higher ratings of banks by private sector rating agencies and stronger relative market valuations of bank stocks, which have trended upwards after a slight correction early in the year (Figure 2.32).

Figure 2.32.
Figure 2.32.

Emerging Market Countries: Bank Market Valuations

(February 1999=100)

Sources: Datastream; and IMF staff estimates.

Authorities in a number of countries in the region are moving to address structural issues in their banking systems. In China, the authorities are making efforts to address weaknesses at state-owned banks and two of them have been recapitalized. In addition, they have been required to undertake external audits, tighten provisioning, and maintain higher capital ratios. Similarly, prospects for commercial banks in India have brightened with the steps taken by the authorities to address key vulnerabilities, including, in particular, the tightening of loan classification requirements. Following market reaction to a proposed securities transactions tax, the authorities have modified the proposal and taken steps to reassure markets.

In Thailand, while distressed assets still constrain banks’ balance sheets, profitability of private banks has improved and some banks have been able to raise capital. The Thai Asset Management Company’s (TAMC) executive committee has approved resolutions of 90 percent of the assets, but since not all agreements have been signed by debtors and several cases that are currently classified as foreclosure are likely to re-enter the debt negotiation phase, substantial work remains before all of TAMC’s nonperforming loans (NPLs) are resolved. Overall, indicators of bank soundness in Malaysia remain solid and systemic risks seem well contained. While the economic recovery there has helped lower the ratio of nonperforming to total loans, provisioning against such loans remains below 50 percent. In Korea, banks have weathered the credit card debt problem without systemic repercussions. In May, the government established a new “bad bank,” Hanmaeum Financial, to take over defaulted credit card debts and facilitate their resolution. The banking systems in Hong Kong and Singapore continue to perform well, with improved profitability supported by the ongoing economic recovery.

Bank profitability has improved in Indonesia, helped by reduced funding costs, but financial and governance problems persist in the large state banks. Bank Indonesia has moved to strengthen the banking system in preparation for the removal of the blanket deposit guarantee by intervening in several small banks. However, legislation for a deposit insurance scheme has been stalled due to elections. In the Philippines, scope for remedial action to address potential banking system vulnerabilities is hampered by weaknesses in the regulatory and supervisory framework, including the lack of an effective prompt corrective action framework and legal protection for supervisory intervention.

Latin America

Reflecting the return of stability in the troubled banking systems in the region, banks’ earnings, nonperforming loan ratios, and reported capital positions show improvement. Market indicators and ratings, however, suggest that concerns have not abated. Ratings of banks by private rating agencies weakened on average in 2003 before recovering in 2004, and relative market valuations have declined slightly since April 2003. Foreign bank penetration is generally high in Latin America, although there has been a pronounced decline in lending by international banks to the nonfinancial private sector and a shift toward interbank and government credit. Local banks’ interbank foreign currency exposures may therefore have increased and may need to be more carefully monitored.

Financing Flows and Global Imbalances

Amid heightening concerns over the sustainability of the financing of the U.S. current account deficit, the U.S. dollar has weakened from its 2002 high. Foreign exchange market intervention coincided in 2003 and early 2004 with pressure on many currencies to appreciate, especially in emerging Asia and Japan. Reminiscent of the late 1980s (see the first Figure at right), surging global foreign exchange reserves boosted official purchases of U.S. treasuries, notwithstanding the notable absence of concerted foreign exchange market interventions that were the hallmark of the 1987 Louvre Accord (see the second Figure below).

In a marked contrast from the late 1980s, concerns over deflation and financial market pressure have been major concerns for policymakers in recent years, most notably in Japan. On signs that a recovery was finally taking hold, global investors started to raise their portfolio weightings in Japan more closer to its weight in benchmark indices. Consequently, foreign purchases of Japanese equities surged in the second half of 2003 and early 2004. Expectations of exchange rate appreciation reportedly resulted in further speculative and leveraged position building, especially in the months following the September 2003 Group of Seven (G-7) Communiqué (see the third Figure).

uch02fig03

U.S. Current Account and Foreign Official Financing

Sources: IMF, International Financial Statistics; and U.S. Bureau of Economic Analysis.
uch02fig04

Group of Seven (excluding United States) Reserve Changes

(In percent of U.S. GDP)

Sources: International Monetary Fund, International Financial Statistics; and IMF staff estimates.
uch02fig05

Speculation and Intervention in Japan

(Three-month cumulative changes)

Sources: U.S. Commodity Futures Trading Commission; and Japan Ministry of Finance.
uch02fig06

Foreign Ownership of U.S. Securities

(In percent of total market)

Sources: Board of Governors of the Federal Reserve System, Flow of Funds; and IMF staff estimates.

Large-scale foreign currency market interventions by Japan in 2003 and early 2004 were undertaken with a view to smooth out undue currency fluctuations. Market participants tended to attribute these interventions also to the desire to overcome deflation and to minimize the risk that a premature tightening of monetary conditions resulting from currency appreciation could derail the nascent economic recovery. Interventions coincided with a rise in speculative long yen positions registered by the Chicago Mercantile Exchange from September 2003 through mid-February this year. While futures markets capture only a small share of speculative activity, this suggests surging speculative inflows may have contributed to the volatility of the yen.

The Financing of Global Imbalances

  • Foreign exchange reserves held by industrial countries and developing countries swelled during the interventions in 1986-88 and 2003-04.1 The accumulation of reserves, however, was more concentrated during the latter period, with the reserve increase experienced by Japan accounting for most of the increase in industrial country foreign exchange reserves (see the Table).

  • The rapid increase of foreign exchange reserves fuelled official purchases of U.S. securities on a large scale during both periods (see the fourth Figure). Nevertheless, official financing flows to the United States rose from 1.2 percent of U.S. GDP in 1986-88 to 2.9 percent of U.S. GDP in 2003-04. This increase outpaced the rise in global foreign exchange reserve holdings in relation to GDP over the past two decades.2

  • Reflecting the shift from concerted to unilateral interventions, the sources of official financing flows have become significantly more concentrated, with Japan’s share in official flows rising particularly strongly.

  • Private sector financing flows to the U.S. remained largely stable, averaging nearly 2 percent of GDP during 1987-88 and 2003-04. Nevertheless, foreign direct investment flows have turned negative on a net basis since the first quarter of 2003, as U.S. companies have stepped up their operations abroad. Mirroring these trends, U.S. equity investors have increasingly diversified their portfolios by increasing their foreign equity holdings. FDI and equity outflows on a net basis averaged 1.9 percent of GDP during 2003-04 compared with a 0.8 percent inflow in 1987-88.

Risks to an Orderly Resolution of Global Imbalances

The global imbalances, reflecting the U.S. current account deficit and large surpluses in other parts of the world, pose a continued risk. While the U.S. current account deficit is likely to adjust, the timing and nature of the adjustment are difficult to predict. Even though capital flows to the U.S. have remained buoyant, a slowdown cannot be ruled out, especially in light of the high share of foreign ownership of U.S. assets. Nevertheless, it is not easy to see why investors would engage in a wholesale shift away from U.S. dollar assets, in the absence of a compelling alternative to dollar assets in a high growth area, without undermining the rationale of their investment decisions.

  • The composition of inflows represents a further risk. Foreign direct investment flows turned negative, and the financing of the U.S. current account deficit increasingly relied on portfolio flows. In addition, there was a shift in the composition of portfolio financing flows from equity to fixed income related flows, which paralleled the growing structural U.S. fiscal deficit.

  • The high share of foreign ownership of U.S. assets, in particular U.S. bonds, raises the possibility that a lack of confidence in the U.S. dollar could result in higher yields. These could, in turn, call into question the discounted value of other assets and lead to price declines in other markets.

  • The unusually rapid growth of international reserves has facilitated the financing of the U.S. current account deficit. However, a shift in the currency composition, especially by those countries experiencing a continued large buildup or with large holdings of foreign exchange reserves, could undermine the strength of official financing flows to the United States.

U.S. Current Account Financing

(Annual rates)

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Sources: Bureau of Economic Analysis; and International Monetary Fund, International Financial Statistics.

Reported as “Other private investment in U.S. securities” during 1986:Q3-1988:Q2.

Including Agencies during 1986:Q3-1988:Q2.

Net short term, U.S. official non-reserve assets, and discrepancy.

German reserves 1986:Q3-1988:Q2; ECB reserves 2003:Q2-2004:Q1.