Chapter

II Recent Developments in International Capital Markets

Author(s):
International Monetary Fund
Published Date:
January 1988
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During 1987–88, international capital flows were closely related to large and persistent external imbalances among the major industrial countries, to a reduction in the current account deficit of developing countries from the levels of 1982–86, and to a continuing process of financial market liberalization. The environment within which these flows took place was characterized by considerable financial uncertainty associated with an upturn of interest rates in late 1987 and renewed concern about inflation, with increased exchange rate volatility and sizable official market interventions aimed at stabilizing the value of the U.S. dollar, and with the shock waves of the October 1987 stock market crisis. This section reviews the macro-economic environment internationally and within major industrial countries. It then traces the most salient developments in the banking, securities, and derivative products markets.

Macroeconomic Environment

Large external imbalances among the major industrial countries persisted during 1987–88, while the overall current account balance of developing countries, which registered a small surplus in 1987, moved sharply into deficit in 1988. The aggregate deficit of industrial countries, which increased from $168 billion in 1986 to $191 billion in 1987, is estimated to have risen slightly to $203 billion during 1988. The widening of this deficit in 1987 occurred despite a decline in the combined fiscal deficit of the seven major countries, which fell for the first time since 1984. Estimates for 1988 suggest a further marginal deterioration in aggregate fiscal deficits.

The current account deficit of the United States increased from $139 billion in 1986 to $154 billion in 1987, and represented 81 percent of the total deficit of the industrial world. In contrast, the current account surpluses of Japan and the Federal Republic of Germany continued to increase in 1987 and reached $87 billion and $45 billion, respectively (Table A7). These imbalances moderated somewhat in 1988. During 1988, for example, the current account deficit of the United States fell to $136 billion; the German current account surplus rose slightly to $49 billion; the Japanese current account surplus declined to $80 billion. Some observers have suggested that these large imbalances have persisted in part because of the existence of long and variable lags in the response of the current account imbalances to movements in exchange rates.

In contrast to their external imbalances in 1987 and 1988, the central government fiscal deficits of the United States and Japan declined. In the United States, the federal budget deficit fell sharply in fiscal year 1987/88 by 1.4 percentage points of gross national product (GNP). This outcome was partly the result of increased economic growth but was also influenced by a temporary increase in revenues arising from certain features of the 1987 tax reform. The budget outcome for 1988/89 resulted in a slight further decrease in the U.S. federal deficit in relation to GNP from 3.4 percent in 1987/88 to 3.3 percent in 1988/89. The Japanese central government deficit also declined in 1987 because the increase in revenues arising from strong output growth more than offset increased government expenditure. This increase in expenditure resulted from the implementation in May 1987 of a package designed to stimulate aggregate demand. In contrast to developments in the United States and Japan, the combined fiscal deficit in the Federal Republic of Germany increased from 1.2 percent of GNP in 1986/87 to 1.4 percent of GNP in 1987/88, partly reflecting a decrease in tax revenues arising from a slowdown in economic growth and a decline in the Bundesbank’s profits. Projections for 1988/89 point to a further increase in the deficit.

The overall current account balance of developing countries moved from a deficit of $42 billion in 1986 to a small surplus of $1.4 billion deficit in 1987 and back to an estimated $19 billion deficit in 1988. These totals, however, conceal the diverse performance of major country groups. While the current account position of capital importing countries registered a deficit of $11 billion in 1986, a surplus of $5 billion in 1987, and an estimated surplus of $1.3 billion in 1988, countries with recent debt-servicing problems recorded a combined deficit of $33 billion in 1986, $18 billion in 1987, and an estimated $21 billion in 1988. For the latter group, a slight deterioration in this performance was expected for 1989. Net debt-creating flows (e.g., foreign direct investment) and long-term flows from official creditors to these countries totaled $47 billion in 1987 and an estimated $33 billion in 1988. Their foreign reserves increased by $5 billion in 1987 and declined by $7 billion in 1988.

In addition to the influence of persistent external and fiscal imbalances in the major industrial countries, the financial environment in 1987–88 was affected by several other factors. Interest rates, which had been falling during much of the 1980s, began to rise in 1987. At the beginning of 1987, long-term interest rates in the United States, Japan, Canada, and Italy were at their lowest levels since the late 1970s. Interest rates began to rise, however, in most of the major industrial countries in late 1987, a trend which continued during 1988. For example, the LIBOR on six-month U.S. dollar deposits increased from 6.4 percent in the first quarter of 1987 to 9.4 percent in December 1988. In some of the major industrial countries, there was also an increase in the volatility of both short- and long-term interest rates in 1987, which was partly reversed in 1988 (Table 2).

Table 2.Major Industrial Countries: Interest Rate Volatility, 1983–Third Quarter 19881
198319841985198619871988
Long-term interest rate
United States0.0250.0340.0310.0460.0480.032
United Kingdom0.0290.0320.0210.0490.0450.019
Germany, Fed. Rep. of0.0250.0170.0300.0370.0370.033
France0.0160.0240.0130.0520.0350.026
Japan0.0270.0350.0640.0830.1430.100
Short-term interest rate
United States0.0350.0550.0440.0410.0570.048
United Kingdom0.0290.0700.0810.0610.0550.069
Germany, Fed. Rep. of0.0500.0290.0450.0220.0870.090
France0.0200.0200.0170.0400.0400.042
Japan0.0170.0140.0550.0630.0290.018
Source: International Monetary Fund, World Economic Outlook data base.

Volatility is defined as the standard proportionate deviation of the monthly changes in interest rates over the period indicated.

Source: International Monetary Fund, World Economic Outlook data base.

Volatility is defined as the standard proportionate deviation of the monthly changes in interest rates over the period indicated.

Some observers argued that the increased level and volatility of long-term interest rates, especially in the United States and Japan, reflected changing expectations regarding the stability of exchange rates among the major currencies. In particular, the depreciation of the dollar in the first half of 1987 was followed by an increase in the premium in dollar interest rates over interest rates on instruments denominated in Japanese yen or deutsche mark, and in a reduction in the discount on dollar interest rates over interest rates on instruments denominated in pound sterling and, for the first half of 1988, in French francs. These differentials persisted during 1988 (Table A8). The depreciation of the U.S. dollar against other major currencies and the increased volatility of exchange rates during most of 1987 occurred despite large-scale official exchange market intervention. At the beginning of 1988, the U.S. dollar started to recover against other major currencies and, in the second quarter of 1988, exchange rate movements among the three major currencies became less volatile. After weakening slightly later in the year, the dollar appreciated further, in part reflecting the strong performance of the U.S. economy.

Concern about inflation, stimulated in some countries by exchange rate movements, also affected the financial environment and has often been cited as one reason for the emergence of a more steeply sloping yield curve for the United States in the second half of 1987. Yield curves for most other industrial countries also became more steep, reflecting a generalized concern about future inflation. This concern moderated somewhat in the period immediately following the stock market break of October 1987 because of fears about a possible reduction in the level of economic activity. In the process, yield curves flattened somewhat. Nonetheless, as it became evident that the stock market break was not going to have such an effect, concern about inflation re-emerged, fostered by a growing perception that output was approaching capacity limits. In some countries, this later brought about inverted yield curves.9

Major Financial Trends in Industrial Countries

The financing of large current account imbalances among the major industrial countries in 1987–88 entailed large net capital flows among countries. At the same time, the continuing liberalization of major financial markets, as well as concerns about inflation, exchange rate, and interest rate developments, stimulated an expansion in the amount of gross international financial flows. Since 1985, the relative importance of official and private capital flows in the financing of the current account imbalances of the three largest industrial countries has varied considerably. Official capital flows, resulting principally from exchange market interventions, played a more important role in 1987–88 than in the preceding two years.

In the United States, net official liabilities to foreign monetary institutions, which increased by $50 billion in 1987, accounted for about one third of the current account deficit in 1987. In the first half of 1988, such flows represented 54 percent of a reduced current account deficit. Among net private capital flows, net short-term capital represented 70 percent of net inflows through the capital account in 1987. In the first half of 1988, however, long-term private capital inflows and official transactions were sufficient to finance the current account deficit since there was a net outflow of short-term capital. In Japan, net foreign exchange reserves increased by $39 billion in 1987, which corresponded to 45 percent of the current account surplus; in 1986, such reserve accumulation had accounted for only 18 percent of the current account surplus. During 1988, foreign exchange reserves expanded more slowly at a rate of $16 billion, or about 20 percent of the Japanese current account surplus. Moreover, inflows of short-term capital increased sharply in 1987, mainly reflecting an increase in foreign borrowing by Japanese banks. In 1987 and 1988, Japan therefore continued to be a net lender of long-term capital and a net borrower of short-term capital.

In the Federal Republic of Germany, the accumulation of net official foreign assets reached $18 billion in 1987 and represented 40 percent of the current account surplus, up from 3 percent in 1986. In 1988, Germany’s net official foreign exchange assets declined by $19 billion as net private capital outflows exceeded the current account surplus. Net outflows of private capital doubled in 1988 relative to 1987, partly reflecting a decline in foreign purchases of domestic securities. This development has been associated in part with changes in exchange rate expectations and in part with investors’ concerns about a new German withholding tax on interest income. Reflecting the shift in foreign investors’ preferences from long-term securities into more liquid assets that occurred after the stock market break of October 1987, net outflows of short-term capital by German residents (part of which had been used to finance purchases of long-term securities) decreased sharply from $52 billion in 1986 to $9 billion in 1987. Most of the yearly reduction in net outflows took place during the last two quarters of 1987 when there was a net inflow of short-term capital into Germany. In 1988, net outflows of short-term capital by German residents recovered to reach $21 billion.

The continuing liberalization of financial activities and the persistence of large external imbalances in major industrial countries also influenced both the scale and type of gross capital flows among industrial countries in 1987. In Japan, total gross long-term outflows of resident funds reached $133 billion in 1987 and grew to $149 billion in 1988.10 Long-term outflows mainly continued to reflect purchases of securities during 1987, but the relative share of securities purchases has declined from 77 percent of total long-term outflows in 1986 to 67 percent in 1987. An increase in the share of long-term loans made up the difference. Although long-term liabilities of Japanese residents to the rest of the world decreased by $4 billion in 1987, mainly as a result of reduced Japanese liabilities to residents of the United States, they increased substantially in the first half of 1988 (Table 3). The regional distribution of long-term capital flows has also shifted significantly in recent years, especially toward countries in the OECD area.11 The share of the OECD area in Japanese flows, which had been only 55 percent in 1982, rose to 89 percent in the first half of 1988. This trend was dominated by flows to the United States, which increased from 13 percent of long-term Japanese gross outflows in 1982 to 38 percent in 1987 and 51 percent in the first half of 1988.

Table 3.Japan: Geographic Distribution of Long-Term Capital Flows, 1983–First Half 19881(In billions of U.S. dollars)
19871988
19831984198519861987First half
Total assets
World-32.5-56.8-81.8-132.1-132.8-77.2-63.8
OECD2-19.8-40.4-65.3-115.1-109.8-65.2-56.8
United States-7.1-15.4-35.4-59.2-50.6-30.2-32.3
European Community-9.2-14.3-21.4-46.1-50.1-30.2-20.9
United Kingdom-2.6-4.6-7.0-14.9-11.7-6.8-6.4
International organizations-3.4-4.5-4.0-2.0-3.7-1.0-0.3
Loans
World-8.4-11.9-10.4-9.3-16.2-7.2-6.6
OECD-2.6-5.4-3.6-4.0-7.3-2.7-3.1
United States-0.3-0.4-0.7-0.6-1.5-0.3-1.6
European Community-1.5-1.6-0.7-1.1-2.2-0.9-0.5
United Kingdom-0.2-0.1-0.1-0.1-0.7-0.1-0.3
International organizations-1.1-1.3-0.90.7-2.0-0.4-0.3
Securities
World-16.0-30.8-59.8-102.0-87.8-58.3-37.8
OECD-14.0-27.8-55.2-96.7-83.1-55.1-36.7
United States-5.1-11.4-31.6-49.4-37.4-25.8-20.0
European Community-6.6-10.9-18.5-40.6-42.1-26.6-16.2
United Kingdom-2.2-3.8-6.2-12.8-8.7-5.8-3.5
International organizations-1.3-1.5-2.2-1.40.1-0.50.3
Total liabilities
World14.87.117.30.6-3.70.612.1
OECD13.56.517.65.63.51.813.0
United States1.50.62.2-6.5-10.5-5.0-0.8
European Community6.43.411.911.715.87.614.9
United Kingdom6.04.211.613.520.210.215.2
International organizations-0.1-0.1-0.1
Loans
World0.1-0.1-0.10.1-0.1
OECD-0.1-0.1-0.10.1-0.10.1
United States-0.1-0.2
European Community-0.10.10.10.1
United Kingdom-0.1-0.10.10.10.1
International organizations
Securities
World14.17.216.70.5-6.1-1.613.5
OECD7.46.617.05.43.11.214.1
United States1.20.71.7-6.5-10.8-5.6-0.1
European Community4.93.411.811.615.77.514.9
United Kingdom4.64.311.613.420.210.115.2
International organizations-0.1-0.1-0.1
Source: Bank of Japan, Balance of Payments Monthly.Note: Subsidiary categories show selected figures only. Component data, therefore, do not sum to world totals.

A negative value indicates an outflow of capital (an increase in assets or a decrease in liabilities). A positive value indicates an inflow of capital (a decrease in assets or an increase in liabilities).

Organization for Economic Cooperation and Development.

Source: Bank of Japan, Balance of Payments Monthly.Note: Subsidiary categories show selected figures only. Component data, therefore, do not sum to world totals.

A negative value indicates an outflow of capital (an increase in assets or a decrease in liabilities). A positive value indicates an inflow of capital (a decrease in assets or an increase in liabilities).

Organization for Economic Cooperation and Development.

In the United States, gross capital outflows decreased sharply from $98 billion in 1986 to $86 billion in 1987 (Table A9). This primarily reflected a reduction in the accumulation of U.S. banks’ claims abroad, which partly resulted from an increase in the supply of dollar-denominated assets by Japanese banks and by the Euromarket. In 1988, gross capital outflows increased moderately to $92 billion.12 Foreign acquisitions of long-term nonofficial claims on the United States decreased sharply from $186 billion in 1986 to $167 billion in 1987 and increased to $172 billion in 1988. Foreign purchases of U.S. securities fell from $75 billion in 1986 to $35 billion in 1987. This decline continued during the first quarter of 1988, following the stock market break of October 1987, and reflected investors’ concerns about future developments in U.S. equity prices and interest rates. Foreign purchases of U.S. securities recovered in the last three quarters of 1988 and, as a result, reached $47 billion by the end of the year.

The regional distribution of U.S. gross capital outflows has changed sharply during the period 1983–88. Outflows to Japan have increased significantly since 1983, from 8 percent of total flows to 44 percent. The proportion of flows going to countries within the EC increased from 14 percent in 1983 to 36 percent in 1987 and dropped to 30 percent in 1988. Disaggregated data by region are not available for the liability side of the capital account of the balance of payments in the United States. Data from international capital market flows indicate, however, that in recent years Japan has joined the United Kingdom as one of the major sources of external finance to the United States.

Developments in Banking Markets

International bank claims on industrial countries, which had expanded from $417 in 1986 to $550 billion in 1987, slowed down substantially to $392 billion during the first three quarters of 1988 compared with $405 billion in the first three quarters of 1987 (Chart 5). As in previous years, bank lending to industrial countries continued to be dominated by interbank activities. Interbank loans accounted for over 89 percent of bank lending to industrial countries in the first three quarters of 1988, while interbank deposits accounted for 93 percent of banks’ deposit-taking activities from industrial countries (Table A10). Banks with residence in the United Kingdom, Japan, and the United States maintained a 70 percent share in the total change in cross-border interbank claims on industrial countries, although they lost some ground in the change in interbank liabilities. Bank head offices’ net funding of the operations of their branches and subsidiaries located in major financial centers declined in absolute terms in the first half of 1988 (Table A11).

Chart 5.Growth Rate of International Bank Claims, 1976–Third Quarter 1988

(Twelve-month growth rates, in percent)

Sources: Bank for International Settlements, International Banking and Annual Report; International Monetary Fund, International Banking Statistics, and International Financial Statistics; and Fund staff estimates.

1 These data do not net out interbank redepositing.

The slowdown in activity in 1988 also extended to nonbanks. Bank claims on nonbank entities in industrial countries, which had more than doubled between 1986 and 1987 to reach $79 billion, amounted to only $42 billion in the first three quarters of 1988, one sixth less than a year earlier (Table A12). Nonbank entities in Japan and the United States, which accounted for over 70 percent of the change in bank claims on nonbanks in 1986–87, accounted for 64 percent in the first three quarters of 1988. The general slowdown in banking activity in 1988 occurred as investor interest in the international bond market was rekindled by somewhat reduced uncertainty regarding the behavior of exchange rates and bond yields. Such uncertainty in 1987 arguably benefited banking activities, not only because banks provided suitable instruments, but also because investors were led to borrow from banks in order to finance purchases of hedging instruments. Other major factors behind the decline in bank lending activity during 1988 were the reduced scale of foreign exchange market intervention by the major industrial countries and the fading impact that the opening in 1986 of the Tokyo offshore market has had on interbank flows.

As far as the country specific developments in banking markets are concerned, during 1987 and the first three quarters of 1988, residents of Japan remained the most important net borrowers in this market. Interbank activity reflected both a large volume of transactions between banks in Japan and in Hong Kong and the effects of the opening of the Tokyo offshore market at the end of 1986. The increase in total cross-border bank claims on Japan expanded by 45 percent ($223 billion) during 1987, 40 percent of the total change in international bank claims on industrial countries. At the same time, liabilities to Japanese residents grew by $146 billion. During the first three quarters of 1988, bank claims on Japan increased by $184 billion ($170 billion during the same period of 1987), while liabilities rose by $133 billion ($130 billion a year earlier). Despite large current account surpluses in 1987, Japan was a net user of funds from the international banking sector. In part, this inflow reflected the investment activities of the nonbank sector, which borrowed foreign currency in order to finance purchases of international securities or to hedge returns on those securities. As a result, cross-border bank claims on the Japanese nonbank sector increased by $31 billion in 1987 and by $14 billion during the first three quarters of 1988.

The United States was also a net user of funds from international banks in 1987. International bank claims on residents of the United States grew in 1987 by $106 billion. In contrast, bank liabilities to U.S. residents increased by $58 billion, $24 billion less than in 1986. Nonetheless, the nonbank sector in the United States still accounted for 42 percent of the total change in international banks’ liabilities to the nonbank sector of industrial countries. During the first three quarters of 1988, banks’ net claims on the United States increased by $49 billion, as compared with $76 billion in the first three quarters of 1987. Among other industrial countries, France reported one of the highest rates of expansion of international banking activity in 1987. Cross-border claims on domestic entities grew by $30 billion in 1987 and by $24 billion during the first three quarters of 1988, partly reflecting the removal of capital controls. International bank claims on the United Kingdom increased by $66 billion in 1987 and $59 billion in the first three quarters of 1988. Although bank liabilities to U.K. residents increased only slightly in 1987, this country was (after Switzerland) the second largest net supplier of funds to international banks. During the first three quarters of 1988, however, there was a net inflow of $20 billion from international banks into the United Kingdom.

Developments in Securities Markets

In contrast to trends in international bank claims during 1987–88, new issues of international bonds expanded by 24 percent to $225 billion in 1988 after a decline of 20 percent in 1987. The revival of bond activity in 1988 can be associated with relatively more stable exchange rates and long-term interest rates than in 1987 (although short-term interest rates rose significantly), and with the ability of borrowers and intermediaries to accommodate investors’ changing preferences in the presence of varying economic conditions. For example, issues of fixed interest rate bonds have expanded because borrowers have been able to offer products of shorter maturity and higher liquidity (Table A13). New issues of floating rate notes also expanded during 1988, concentrated mostly in issues of sterling floaters by U.K. institutions, but with some activity too in U.S. dollar-denominated issues. Moreover, equity-related bonds, which were adversely affected by the stock market break of October 1987, also recovered during 1988. This recovery, which was concentrated during the first three quarters of 1988, mainly reflected the increased issuance by Japanese borrowers taking advantage of rising share prices.

During 1987 and 1988, borrowers from industrial countries accounted for about 86 percent of total issues, while borrowers from developing countries, excluding offshore centers, accounted for only 4 percent of those issues, compared with a share of 6 percent in 1982 (Table A14 and Chart 6). Early repayments of bonds continued at a high rate during 1987 as low interest rates during 1986 and early 1987 encouraged borrowers to refinance debt contracted at higher interest rates during the early 1980s (Table A15). As a result, 63 percent of total early repayments were retirements of fixed interest rate bonds. In 1988, early repayments expanded slightly, despite higher interest rates. With rising scheduled amortization payments, the slowdown in the issuance of new bonds translated into a decline of 36 percent in net issues of international bonds (gross issues less early repayments and scheduled amortization payments) to $105 billion in 1987. During 1988, net issues of international bonds increased by $38 billion relative to the comparable period in the previous year. Bonds purchased by banks, which declined in 1987 to $53 billion, recovered somewhat in the first three quarters of 1988 to reach $50 billion, compared with $46 billion during the same period in 1987.

Chart 6.International Bond Issues by Groups of Borrowers, 1984–88

(In percent)

Source: Organization for Economic Cooperation and Development, Financial Statistics Monthly.

In 1987, new bond issues moved away from bonds denominated in U.S. dollars toward bonds denominated in Japanese yen, Swiss francs, and pound sterling. The share of U.S. dollar-denominated bonds declined sharply from 55 percent in 1986 to 36 percent in 1987 before recovering to 38 percent in 1988. Expectations of an appreciation of the yen led the share of bonds denominated in Japanese yen to increase from 10 percent in 1986 to 15 percent in 1987, but this was reversed in 1988. High interest rates in the United Kingdom and the appreciation of the pound sterling were key factors contributing to the increase in the share of bonds denominated in pounds sterling from 5 percent in 1986, to 8 percent in 1987 and to 10 percent in 1988. The partial recovery of U.S. dollar-denominated bonds in 1988 reflected increased confidence on the part of investors following a decrease in the U.S. trade deficit and an attendant appreciation of the dollar.

Significant changes in the types of instruments used for new bond issues occurred during the period 1984–88 (Chart 7). While the issuance of fixed interest rate bonds accounted for a growing share of total international bond issues during this period, the relative importance of floating rate notes and equity-related bonds varied sharply. Floating rate notes, which accounted for about 35 percent of total international bond issues in 1984–85, decreased sharply during 1986–87 to only 7 percent of total issues in 1987. At the same time, issuance of equity-related bonds, which accounted for about 9 percent of total international bond issues in 1984–85, rose sharply to reach 24 percent of total issues in 1987. The reduction in the use of floating rate notes reflected liquidity problems resulting from the collapse of the market for perpetual floating rate notes in December 1986. In contrast, the expansion of equity-related bonds occurred during the first nine months of 1987 when equity prices were rising sharply on a number of national markets. During 1988, despite increasing competition from Eurocommercial paper and fixed rate note swaps, the issuance of floating rate notes started to recover and accounted for 10 percent of total issues. This recovery was mainly associated with rising interest rates, which made floating rates more attractive for investors (Table A16). After several years of sustained growth, fixed interest rate bond issues declined by 14 percent in 1987 before recovering to $162 billion in 1988 (Table A17). The recovery occurred despite the continued interest rate increases and reflected notable improvements in the quality of the instruments in terms of liquidity and shorter maturities.

Chart 7.International Bond Issues by Major Instruments, 1984–88

(In percent)

Source: Organization for Economic Cooperation and Development, Financial Market Trends.

Despite the equity market break in October 1987, the issuance of equity-related bonds (convertibles and bonds with equity warrants attached) expanded sharply during 1987 to $43 billion, owing to a large issuance in the first three quarters of the year (Table A18). While new issues of equity-related bonds during the first three quarters of 1987 more than doubled those issued in the same period in 1986, little activity occurred during the weeks following the stock market break. During the course of 1988, the market recovered but new equity-related bond issues only totaled $39 billion for the year. Borrowers from Japan, who issued 65 percent of all international equity-related bonds in 1987, accounted for 90 percent of the total during 1988. Issuance by all other major industrial country borrowers declined in relation to the preceding year. This issuance activity encompassed both a sharp decline in the sales of convertible bonds (from $18 billion in 1987 to $10 billion in 1988) and an increase in the use of bonds with equity warrants (from $25 billion in 1987 to $29 billion in 1988). Although many industrial countries were active borrowers in the market for convertibles in 1987, only Japanese firms maintained their level of borrowing in this segment of the market during the first three quarters of 1988. Most other countries reduced their offerings during the period. During the fourth quarter, however, the market contracted sharply as a result of an oversupply of issues.

After a rapid expansion during 1983–86, newly arranged medium-term financing facilities contracted by 2 percent during 1987 and by 16 percent in 1988 (Table A19). The slower pace of activity in 1987 reflected developments in the market for non-underwritten facilities, particularly Eurocommercial paper programs, which declined slightly to $56 billion. By contrast, backup facilities, whose most important components include note issuance facilities, bankers’ acceptances, and commercial paper backups, increased by 6 percent to $31 billion in 1987. During 1988, arrangements of new Eurocommercial paper programs recovered, while the market for total backup facilities contracted sharply by 50 percent, primarily as a result of a significant drop in lending through multiple component facilities.

Despite the decline in overall activity in backup facilities in 1988, multiple component facilities have grown in relative terms, from 27 percent of new issues in 1984 to 51 percent in 1988. Multiple component facilities allow borrowers to select among various types of borrowing instruments so as to achieve the lowest cost of borrowing. In contrast, the use of more traditional backup facilities decreased during most of 1984–88. U.S. corporations accounted for 27 percent of the total use of backup facilities in 1987, but that proportion declined to 9 percent during 1988. Borrowers from the United Kingdom were also active in this market, arranging facilities totaling $7.5 billion in 1987 (24 percent of total usage); their share in the market continued at 23 percent during 1988.

The Eurocommercial paper market has grown substantially since it was established in 1985. From its peak of $59 billion in 1986, new program activity declined in 1987, to $56 billion, but rose marginally to $57 billion in 1988. Market participants expect wider use of Eurocommercial paper since commercial paper has the potential of raising short-term funds at a lower cost than that implied by traditional bank advances. The range of borrowers in this market has diversified since 1985. Borrowers from the United Kingdom, especially building societies, have increased their share from 6 percent in 1985 to 13 percent in 1988, while Sweden increased its share to 15 percent when the Government established a new program during 1988. Borrowers from the United States (which include major corporations as well as major financial institutions) have continued to make extensive use of Eurocommercial paper programs, but their participation has not been as dynamic as that of borrowers from other countries. Moreover, Japanese borrowers accounted for only 12 percent of new programs in 1988, compared with 20 percent in 1986. Most Eurocommercial programs are denominated in U.S. dollars, but there is a growing trend to use other currencies. Sovereign programs accounted for 17 percent of the total market in 1988, while bank programs comprised 35 percent.

Developments in Markets for Derivative Products

The increased volatility of interest rates and exchange rates experienced during the 1970s and 1980s stimulated the search for new instruments and techniques to transform and reallocate financial risks. The search was facilitated by continuing financial liberalization and innovation and the relaxation of capital controls in major industrial countries. As a result, the use of interest rate and currency hedging instruments has expanded sharply. A key development was the appearance of exchange-traded contracts as opposed to over-the-counter (OTC) contracts. In comparison with OTC instruments, exchange-traded contracts have the advantage that, by offering standardized terms, their associated secondary markets are quite liquid. In addition, since the exchange acts as counterparty in all contracts and since margin requirements must be maintained on a daily basis, exchange-traded instruments entail less credit risk than customized OTC instruments. Associated trading activity on exchanges around the world has expanded not only in terms of contract volume but also in the number and variety of instruments offered (Table A20).

Trading in Eurodollar interest rate future contracts, for example, has expanded rapidly since their introduction in 1981 on the Chicago Mercantile Exchange (CME). In 1987, the average monthly trading volume in Eurodollar interest rate futures at CME rose by 88 percent to 1.8 million contracts, representing a face value of $1.8 billion (Table A21). In addition, outstanding open interest13 at the end of 1987 totaled 292,326 contracts, over a third higher than in 1986. The expansion continued in the first three quarters of 1988, when average monthly trading volume grew by 5 percent relative to the corresponding period in 1987. The London International Financial Futures Exchange (LIFFE) and the Singapore Mercantile Exchange (SIMEX) also expanded their trading activities in Eurodollar interest rate future contracts in 1987, but the volumes traded on those exchanges were still modest in comparison with those on the CME.

Trading of Eurodollar options contracts, which started in 1985 at CME and LIFFE, also expanded sharply in 1987. On the CME, for example, these contracts increased by 46 percent to an average of 214,163 contracts a month.14 Average monthly trading volume of Eurodollar options on the CME decreased somewhat during the first three quarters of 1988. Similarly, trading activity in Eurodollar options at LIFFE expanded by 67 percent in 1987. In contrast to the growing use of the SIMEX Eurodollar futures contract, the SIMEX Eurodollar option has shown a limited activity in the first three quarters of 1988, when monthly trading volume reached an average of only 983 contracts. Some observers have attributed this performance to excessive premiums.

Interest rate futures and options contracts of public sector issues have also traded actively on the major exchanges. For example, the volume of futures contracts on U.S. Treasury bonds traded on LIFFE increased from a monthly average of 23,628 contracts in 1984 to 127,360 contracts in 1987, and expanded even further during the first three quarters of 1988 to a monthly average of over 172,735 contracts. Options contracts on this bond, which started trading on LIFFE in 1986, reached a monthly average of 6,241 contracts in the first three quarters of 1988, 47 percent higher than in a comparable period in 1987. LIFFE also started a futures contracts on Japanese Government bonds in August 1987. After a strong beginning, the market stabilized to a monthly average of about 11,000 contracts a month. Trading of futures contracts on 90-day U.S. Treasury bills has also been large at CME, but the average volume of activity declined during the period 1982–88, moving from an average monthly volume of 549,904 contracts in 1982 to an average of only 115,376 during the first three quarters of 1988. Options contracts on U.S. Treasury bills have followed the same pattern, declining from an average monthly volume of 5,314 contracts in 1986 to an average of only 527 contracts during the first three quarters of 1988.

Trading in currency futures has also increased during 1982–88. Most of this activity has been concentrated in the United States, especially on the CME. Trading in Japanese yen futures experienced the highest growth rate among currency futures in 1987–88.15 In 1987, trading volume in these futures on the CME grew by 35 percent to an average of 446,546 contracts a month. This expansion continued in the first three quarters of 1988 when the volume of trade in Japanese yen futures contracts rose to a monthly average of 526,407. Trading in currency options began in 1982 on the Philadelphia Stock Exchange (PHLX), which has remained the most active exchange for currency options. Monthly trading volumes in Japanese yen and deutsche mark experienced the highest rate of expansion in 1987, growing by 30 percent and 71 percent, respectively. While trading volumes in deutsche mark options declined somewhat during the first three quarters of 1988, the average monthly volume in Japanese yen option contracts traded at PHLX grew by 40 percent relative to the first three quarters of 1987.

An important over-the-counter hedging instrument, which emerged in significant volume in the early 1980s, has been the medium-term swap. Swap transactions have been used to arbitrage differences in borrowing costs across financial markets and to reallocate the interest rate and exchange risks contained in medium-term financial transactions.16 Interest rate and currency swaps have been among the fastest growing financial instruments of the 1980s; by the end of 1987, the total amount of outstanding swap transactions reached $1.1 trillion (Table 4). Interest rate swaps (which constitute agreements between two parties to exchange fixed against floating rate payments, both measured on the same notional principal amount and the same maturity) accounted for 80 percent of total outstanding swap transactions in 1987, and the bulk of these transactions (79 percent) was carried out in U.S. dollars. Currency swaps accounted for 20 percent of total outstanding swap transactions in 1987 and totaled $219 billion. Swaps involving the U.S. dollar and the Japanese yen accounted for 62 percent of total currency swap agreements. In a survey organized by the International Swap Dealers Association (ISDA), the swap market reported a very low incidence of losses. Of 71 major firms from the United States, the United Kingdom, Japan, the Federal Republic of Germany, France, Canada, Australia, the Netherlands, New Zealand, Sweden, and Switzerland, only 11 experienced any losses in 1987, a reflection of the general creditworthiness of counterparties engaged in swaps. Interest rate and currency swaps executed in the first half of 1988 totaled $311 billion, or 25 percent more than in the last half of 1987. This total included $251 billion of interest rate swaps and $60 billion of cross-currency swaps.

Table 4.Outstanding Swap Transactions by Currencies, December 31, 1987
CurrencyInterest Rate SwapsCurrency Swaps
(In millions of U.S. dollars)(Percentage)(In millions of U.S. dollars)(Percentage)
U.S. dollar703,15479.0598,01544.72
Japanese yen59,9886.7437,02516.89
Pound sterling40,1424.516,3272.89
Deutsche mark39,5834.4512,2815.60
Other46,6625.2565,54229.90
Total889,529100.00219,190100.00
Source: International Swap Dealers Association, New York.
Source: International Swap Dealers Association, New York.

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