II Recent Developments in International Capital Markets

International Monetary Fund
Published Date:
January 1991
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This section discusses developments in 1989–90 in gross and net international capital flows through banking and securities markets, devoting special attention to the initial effects of the outbreak of the Middle East crisis on financial markets. Developments in this period illustrated both the ability of international financial markets to transmit the effects of macroeconomic and political shocks rapidly across national borders and the key role these markets have continued to play in financing the large fiscal and current account imbalances in industrial countries.

Macroeconomic Environment

The global macroeconomic context in 1990 was characterized by an uneven pattern of economic activity across major industrial countries. Although economic growth remained strong in Japan and Germany, there was a marked slowdown in North America and the United Kingdom. In addition, there was renewed concern about inflation, with upward pressure on long-term interest rates in some major industrial countries. These concerns were intensified by the sharp rise in oil prices following the outbreak of the Middle East crisis in August 1990, although more recently interest rates have eased in a number of countries.

Short-term interest rates in the United States generally declined during 1989 and 1990, as the pace of economic activity slowed and, by late 1990, some easing of monetary policy was evident. U.S. long-term interest rates, however, after declining during 1989 increased during the first three quarters of 1990, reflecting renewed worries about inflation and the prospects for the U.S. fiscal deficit, then declined again in the fourth quarter. In contrast, German short- and long-term interest rates remained high as a result of concerns about the cost of financing unification, while long-term rates in Japan increased appreciably during the first three quarters of 1990, then declined in the fourth quarter. Taken together, these interest rate movements brought about a reversal of differentials between the United States and other major industrial countries, with U.S. interest rates, both short- and long-term, falling below the average interest rate of the other four major industrial countries—the differential being wider at the short end of the maturity spectrum (Table A1).

A major feature of exchange rate developments through the first three quarters of 1989 was the strength of the U.S. dollar against most other major currencies. Following a sharp decline in global equity prices in October 1989 and evidence of a widening U.S. trade deficit, the U.S. dollar weakened against major European currencies, depreciating by about 10 percent in nominal effective terms between the end of 1989 and the end of 1990. Equity prices, which in most major markets reached historic highs during 1989, registered an extended decline and, in a number of countries, an increased volatility throughout most of 1990 as fears associated with the onset of the Middle East crisis as well as negative expectations regarding inflation and recession came to the fore (Chart 5 and Table A2). The largest equity price decline among major industrial countries in 1990 occurred in Japan, where the Nikkei stock index fell by around 40 percent by year end. Following the start of military operations in the Middle East in mid-January 1991, equity prices rose sharply in all major markets; in North America and the United Kingdom, equity markets in early 1991 had recovered roughly to their levels prior to the invasion of Kuwait.

Chart 5.Major Industrial Countries: Stock Market Indices, January 1, 1989 to January 31, 1991

(Indices, August 2, 1990 = 100, logarithmic scale)

Source: Data Resources, Inc.

Impact of the Middle East Crisis

The response of global financial markets to the invasion of Kuwait on August 2, 1990, demonstrated the resilience of these markets and their capacity to transmit the effects of large real sector shocks rapidly across industrial and developing countries. An examination of asset price movements in spot, futures, and options markets provides an indication of the resulting adjustments in portfolios and changes in expectations concerning the future level and variability of asset prices. The initial adjustments in asset prices following the invasion suggest that the outbreak of the crisis had the following immediate effects: (1) it created the perception among market participants that the prospects for many economic fundamentals (e.g., growth and inflation) had deteriorated and that the range of potentially adverse outcomes for other parameters (e.g., interest rates) had increased; (2) it produced a flight toward more liquid, short-term, and safer assets, contributing to the rapid decline in equity prices and the tightening of market conditions for less creditworthy borrowers; (3) it implied a sharp increase in the anticipated near-term variability of asset prices as reflected in options prices; and (4) its effects on financial institutions were limited primarily to some banks located in the Middle East and to banks and securities houses in industrial countries that have traditionally incorporated unrealized capital gains on asset holdings into their capital positions, or whose assets were simultaneously being affected by adverse developments in equity or real estate markets. In contrast, the response of asset prices to the outbreak of armed conflict in January 1991 was in some respects less pronounced, apart from the substantial reduction in oil prices. Nevertheless, long-term interest rates fell on both spot and futures markets and the anticipated volatility of prices for oil, bonds, and equities declined. The difference in the adjustments of asset prices in August 1990 and in January 1991 appears to have reflected the fact that the latter event was anticipated by market participants to a comparatively larger extent.

Market Conditions at the Beginning of the Crisis

During the first seven months of 1990, prior to the invasion, asset price movements in global financial markets already reflected concerns about rising inflation and the prospect of slower economic growth in some major industrial countries. Pressure on interest rates was sustained by the continuing need to finance a number of large current account and fiscal imbalances and by the transformations underway in Germany and Eastern Europe. The period saw a general decline in equity prices (especially in Japan) from their peaks in late 1989 or early 1990. When combined with evidence of a slowdown of growth in Canada, the United Kingdom, and the United States, the weakness in equity prices and higher long-term interest rates stimulated concerns about the outlook for continued growth in world trade and output.

The emergence of the Middle East crisis intensified these concerns. Anticipated oil shortages and higher oil prices threatened to raise inflation rates and slow economic growth in many industrial and developing countries. In addition, the prospect of larger current account imbalances, which would increase the financing requirements of many countries, implied possible further upward pressure on interest rates. In attempting to gauge the future economic effects of the crisis, market participants were handicapped by deep uncertainty about its political and military aspects. Moreover, the near-term outlook for major country exchange rates and short-term interest rates was unclear, given uncertainties about the policy responses of monetary authorities in industrial countries.

Initial Asset Price Effects

Perceptions that, with the onset of the crisis, fundamental economic conditions were likely to deteriorate, but to an uncertain extent, affected a broad range of asset prices in spot, futures, and options markets. Spot and future prices for oil, equities, and long-term bonds reacted immediately. The Average Petroleum Spot Price (APSP) increased from $19.93 a barrel during the week ended August 3, 1990 to $25.97 for the week ended August 17, 1990.15 Futures prices rose correspondingly, with the price of West Texas crude to be delivered in September 1990, for instance, rising from $21.54 to $28.63 between August 1 and August 17, 1990. Equity prices, conversely, fell sharply in both industrial and developing countries. In industrial countries, the crisis accelerated the downturn in equity prices that had been evident throughout the first seven months of 1990. The decline in equity prices in the five largest industrial countries during August 1–17 was as large as that experienced during the break in equity prices on October 13, 1989 (Table A3). The decline in equity prices in many developing countries, particularly those heavily dependent on imported oil or located in the Middle East, was even more substantial than that in industrial countries (Chart 6). The secondary market prices for the external bank debt of many developing countries also declined during this period, reflecting the likely effects of higher oil prices on net oil importers as well as sales of developing country debt by banks in the Middle East with severe liquidity problems.

Chart 6.Impact of the Oil Price Rise on Developing Country Stock Markets

(Percentage change in price index)

Sources: International Finance Corporation (IFC); Emerging Markets Database.

1Percentage changes in IFC’s stock indices between August 3 and August 24, 1990. For Japan, the Nikkei 225 index is used; for the United States, Standard and Poor’s 500 index.

While short- and long-term interest rates in the major industrial countries rose during the first two weeks following the invasion, the term structure of interest rates in the spot and futures markets steepened or became less inverted. In the five largest industrial countries, for example, short-term money market rates increased by an average of 17 basis points while long-term government bond yields rose by an average of 46 basis points (Table A3 and Chart 7). In the futures markets for U.S. Treasury securities, the term structure of anticipated interest rates was steeper than in the spot market (Chart 8), which would be consistent with the expectation of a further rise of long-term interest rates relative to short-term rates.16 Moreover, a comparison of the term structure of interest rates for U.S. Treasury securities on the spot and futures markets indicated that the initial rise in short-term interest rates, at least in the United States, was expected to be reversed.17

Chart 7.Major Industrial Countries: Interest Rates, July 1, 1990–January 31, 1991

(In percent a year)

Sources: For short-term rates for United States, France, United Kingdom, and Germany, International Monetary Fund, Treasurer’s Department; for Japan, Nikkei Services, Inc. For long-term rates for the United States, the Federal Reserve Board; for Germany, France, and United Kingdom, Financial Times; for Japan, Nikkei Services, Inc.

1Three-month certificate of deposit rates for United States and Japan; three-month interbank deposit rates for other countries.

2Average of five countries shown, using 1989 GNP weights.

3Yields on government bonds with residual maturities of approximately ten years.

4That is, the differences between long-term rates and short-term rates.

Chart 8.Interest Rates Implied by Futures Contracts and Spot Rates for U.S. Treasury Bills, Notes, and Bonds

Source: Wall Street Journal.

In the foreign exchange markets, the decline of the U.S. dollar, which had been evident during much of 1990, was only momentarily interrupted by “safe haven” purchasing in the immediate wake of the crisis. During the period August 1–17, 1990, the U.S. dollar and the yen depreciated in nominal effective terms, while the deutsche mark and the pound sterling appreciated. Major exchange rates showed smaller percentage changes during this period than did equity or long-term government bond prices. The price of gold, another traditional safe haven asset, increased from an average of $375 an ounce during the week ended August 3, 1990 to $405 an ounce during the week ended August 17, 1990.

The behavior of prices for options on oil, foreign exchange, government bonds, and equities at the beginning of the crisis implied that market participants had sharply increased their estimates of the underlying volatility of asset markets (Chart 9).18 The implicit anticipated asset price volatility in U.S. equity markets more than doubled in the two weeks following the invasion of Kuwait. The implicit volatility in the markets for U.S. Treasury bonds and Eurodollar deposits also rose sharply. Not surprisingly, the sharpest increase was in the oil markets, where the implied volatility increased almost by a factor of three. In contrast, the implied volatility in foreign exchange options did not increase significantly but was more erratic following the invasion, in part reflecting uncertainties about the policy response of monetary authorities to the crisis and the change in oil prices. More generally, the Middle East crisis appears, to have stimulated the demand for derivative products that can be used to manage risk and uncertainty. Many futures and options exchanges reported record trading volumes after August 2. In August and September 1990, for example, the total number of derivative contracts traded on the International Petroleum Exchange in London was almost triple the volume in the same period of 1989.

Chart 9.Implied Volatility of Various Asset Prices, July 5, 1990–January 28, 1991

(In percent a year)

Sources: Reuters; and Salomon Brothers.

1Data cover the period July 5-September 7, 1990 and December 3, 1990–January 28, 1991. The implied volatility is derived from the movements in the price of a nearby call option on a Standard & Poor’s 500 stock index futures contract.

2Options on 90-day nearby futures contracts. Data cover the period July 5-Septembet 7, 1990. The implied volatility is derived from movements in the price of a nearby call option on a Eurodollar certificate-of-deposit futures contract.

3Data cover the period July 5-September 7, 1990 and December 3, 1990–January 28, 1991. The implied volatility is derived from the movements in the price of a nearby call option on a U.S. Treasury bond futures contract.

4Data cover the period July 5-September 7, 1990. The implied volatility is derived from the movements in the price of a foreign exchange option for a contract on the corresponding currency. The delivery date for the deutsche mark contract is June 1991.

5Data cover the period July 5-September 7, 1990 and December 3, 1990–January 28, 1991. The implied volatility for the first period is derived from movements in the price call option on a contract for New York light crude oil with a delivery date of December 1990 and a strike price of $24 a barrel; for the second period, it is derived from the movements in the price of a call option on a contract for New York crude oil with a delivery date of March 1991 and a strike price of $30 a barrel.

The sharp declines in equity prices and long-term government bonds and the much higher implicit anticipated asset price volatility reflected in options prices suggested that market participants were concerned not only with a deterioration in fundamental economic conditions, but also with the prospect of a much broader range of adverse medium-term outcomes for the global economy. This abrupt change in outlook appears to have been a key reason for the differences in market behavior between the equity market breaks of October 1987 and 1989 and the crisis of August 1990.19 Although the earlier market breaks occurred on a global scale, neither was a response to a single exogenous event that presaged a sharp change in economic fundamentals. The associated “flight to quality” involved a shift in portfolio holdings away from equities and toward government securities and short-term money market instruments, and the decline in equity prices was accompanied by a fall in interest rates, especially on government securities. In August 1990, by contrast, the deterioration in the outlook for inflation and other economic variables made holding long-term and medium-term financial claims less attractive. The resulting shift in portfolio preferences toward short-term, more liquid, and safer financial instruments contributed both to the more rapid decline in equity prices and to the rise in long-term interest rates (even on government securities) relative to short-term interest rates.

Effects on Institutions and Markets

The sharp adjustment in asset prices and the increased demand for liquidity following the invasion created both direct and indirect pressures on financial institutions. While the crisis itself forced some banks in the Middle East to deal with unanticipated liquidity strains, the declines in equity prices and higher long-term interest rates eroded bank capital and created new concern about the quality of bank assets in some industrial countries. The preference for safer financial instruments also resulted in increased spreads between corporate and government securities on national markets and between private sector Eurobonds and government securities denominated in the same currency on international markets. The most immediate institutional effects of the crisis were experienced by banks located in the Middle East. Many banks in the region faced large deposit withdrawals as well as reduced lines of credit from other correspondent banks, although the extent of initial outflows was limited by the fact that many wholesale time deposits could not be withdrawn before maturity.20 Increased demands for liquidity were satisfied by extending bank business hours, selling assets, including claims on developing countries, and receiving emergency assistance from domestic monetary authorities.

Activity in international bank and bond markets fell sharply immediately after the invasion of Kuwait. Although activity in both markets recovered in September, new bond issues and loans were increasingly focused on the most creditworthy borrowers. Thus, in the United States the average return on high-yield corporate bonds, already near historically high levels relative to yields on U.S. Treasury securities because of worries about the creditworthiness of highly leveraged corporations, rose from 619 to 628 basis points over U.S. Treasury securities of comparable maturity between August 2 and August 9. Yields on Eurobonds issued by less highly regarded borrowers rose by 40 to 50 basis points relative to comparable treasury issues in early August, although yield differentials between U.S. Treasury securities and U.S. dollar denominated Eurobonds issued by highly creditworthy sovereign and multilateral borrowers did not change significantly. Borrowers with relatively low credit ratings found it more difficult to raise funds in the Eurocommercial paper market during the third quarter of 1990. Moreover, the portfolio and income difficulties of some major banks led to a widening of spreads between bank and sovereign government securities. In addition, the trend toward shorter maturities in the Eurobond market continued. Although the declines in equity prices during August 1–17 were as large as those experienced on October 13, 1989, clearance and settlement systems operated smoothly. While this in part reflected lower trading volumes in some markets, it also provided an indication of improvements in telecommunications and enhanced automation of the clearance and settlement systems.

In Japan, the ongoing decline in equity prices that had been evident since late December 1989 accelerated in early August 1990, with the capital positions of both securities houses and commercial banks faltering. As discussed in Section III, Japanese banks have included unrealized capital gains on their securities holdings as part of tier-2 capital under internationally agreed capital adequacy standards. Prior to the downturn in the Japanese equity market, most large Japanese banks had capital positions that exceeded the interim capital adequacy target of 7.25 percent of risk-weighted assets (to be achieved by March 1991 in the case of Japanese banks) and many exceeded the 1993 final standard of 8 percent. The 31 percent decline in Japanese equity prices between the peak in December 1989 and mid-August eroded the size of the banks’ unrealized gains. In response, Japanese banks attempted to rebuild their capital adequacy ratios largely by reducing the growth of their lending activities and by raising new tier-2 capital through subordinated loans from domestic institutions, such as insurance companies, and the issuance of subordinated debt through offshore subsidiaries. Nevertheless, the average risk-weighted capital ratio of the major city banks declined from 8.1 percent at the end of March 1990 to 7.7 percent at the end of September 1990.

Although banks in the United Kingdom and those in the United States were not as directly affected by equity price declines as those in Japan, the prospect of higher interest rates and oil prices renewed concern about the quality of their corporate and real estate loan portfolios. During the period 1980–89, real estate loans as a percent of total commercial loans had risen from 29 percent to 37 percent for U.S. banks, and doubled to about 23 percent for U.K. banks. A downturn in real estate prices in both countries, especially for commercial property, led to an increase in nonperforming loans and a consequent rise in loan-loss provisions. In the United States, concern about bank portfolios and consequent credit downgradings led to a decline in banks’ equity prices and to sharply higher costs on new subordinated debt issues. Facing an increasing cost of capital, banks focused on reducing asset growth, through direct asset sales, asset securitization, and a curtailment of lending activity.

Impact of the Outbreak of Hostilities

While the invasion of Kuwait was unanticipated by most market participants, the outbreak of hostilities in January 1991 was preceded by the establishment of a United Nations deadline for the withdrawal of Iraqi forces from Kuwait (January 15, 1991), extensive military preparations, and a variety of diplomatic initiatives. Although uncertainty persisted, market participants had time to formulate investment and trading strategies that reflected their expectations concerning likely events. In addition, market organizations were able to prepare for the possibility of increased asset price volatility and higher trading volumes. For example, margins in a number of options and futures markets were raised in anticipation of higher asset price volatility. In addition, order transmission, clearance, and settlement systems on some major securities markets ran simulations on their computer networks to verify that they could effectively manage much heavier trading volumes. Thus, while the invasion and the subsequent outbreak of hostilities both constituted significant political shocks affecting the international economy, market participants had to respond to the August invasion more abruptly and with less information. In such a situation, asset price adjustments were, unsurprisingly, sharper and more extensive.

The outbreak of armed conflict in the Middle East on January 16, 1991 was accompanied by large declines in the prices of oil and traditional safe haven assets, a fall in long-term interest rates in most major industrial countries, a sharp increase in global equity prices, and a fall in anticipated asset price volatility across a broad range of markets. On January 17, the spot price of oil fell by over $10 a barrel, the largest one-day decline on record; and the price of gold fell by more than $20 an ounce. The U.S. dollar also weakened against all other major currencies. In part, these and subsequent asset price adjustments were attributed by market participants to the early success of the coalition forces and a reduction in uncertainty regarding the expiry of the United Nations deadline. While the onset of the Middle East crisis in August had resulted in a flight toward short-term, more liquid, and safer financial instruments, the beginning of hostilities in January saw a sharp rise in equity and long-term securities prices in most major industrial countries.

On January 17, equity prices rose by nearly 2.5 percent in London, about 4.5 percent in Japan and the United States, and by over 7 percent in France and Germany. In addition, the average level of interest rates on long-term government securities fell by 15 basis points. In the United States, movements in the prices of the March and June 1991 futures contracts for U.S. Treasury bills, notes, and bonds implied that the reduction in long-term U.S. interest rates was expected to be sustained during the first half of 1991. Sharp declines in the levels of anticipated asset price volatility implicit in options prices provided a further indication of reduced uncertainty. While the anticipated volatility of oil prices fell by about 20 percent on January 17, there were small declines in the United States in the anticipated volatility of equity prices (as reflected in the price of an option to purchase a futures contract on the Standard and Poor’s 500 stock index) and of interest rates on long-term U.S. Government bonds. Secondary market prices of the external bank debt of the most heavily indebted developing countries, which had declined in the week prior to the outbreak of hostilities, also recovered abruptly.

Net International Capital Flows

The sum of external current account deficits of the industrial countries, an indicator of the required net movement of capital through the system, increased by $10 billion in 1989 and by $5 billion in 1990, to a total of $216 billion.21 Current account imbalances in the three major industrial countries narrowed appreciably, however (Tables A4-A7). The current account deficit of the United States decreased steadily from a post-World War II peak of $162 billion in 1987 to $100 billion in 1990. Japan’s current account surplus also narrowed over the same period from a peak of $87 billion in 1987 to an estimated $36 billion in 1990. The current account surplus of Germany increased by $5 billion to $55 billion in 1989, but fell back in 1990 to about $45 billion. The net current account position (sum of surpluses and deficits) of developing countries registered a narrowing of the deficit by $1 billion to $15 billion during 1989, and by a further $5 billion in 1990, largely reflecting developments in the group of fuel exporting countries, whose current account shifted from a $6 billion deficit in 1989 to a surplus of over $6 billion in 1990. As in 1989, financing for the 1990 current account deficits of developing countries came principally from official creditors, while current account imbalances in the industrial countries were largely financed by private capital flows, particularly foreign direct investment and portfolio flows. This pattern of imbalances and financing suggests that, despite the rising financial needs of many Eastern European and developing countries, most net transfers of saving across borders continue to occur within the group of industrial countries.

Analysis of the recent evolution of net capital flows in major industrial countries is complicated by large “errors and omissions” in the balance of payments of a number of these countries. With this proviso, the remainder of this section provides a review of recent net capital flows in the three main industrial countries.

United States

During 1989, in sharp contrast to the three preceding years and reflecting substantial official intervention in currency markets, there was a large buildup ($25 billion) of net official reserves. Although net official reserves continued to increase during the first quarter of 1990, they declined during the second and, in particular, third quarter of 1990, mirroring an increase in the current account deficit. Net foreign direct investment into the United States, which had reached an average of $41 billion a year in 1988–89, largely owing to cross-border mergers and acquisitions activity, turned into a net outflow of over $17 billion during the first three quarters of 1990, owing both to a marked decline in inward flows and to the continued strength of U.S. direct investment abroad.

After taking into account the accumulation of net foreign reserves and net flows of direct foreign investment, the residual current account financing needs in 1989 (about $87 billion) were mostly met by portfolio inflows, mainly in the form of purchases of U.S. Government securities by nonresidents. In contrast, during the first three quarters of 1990, there was a net outflow of nearly $18 billion through the securities markets, reflecting worry about the weakening U.S. economy, problems in the domestic financial sector, and a significant reduction in interest rate differentials in favor of U.S. dollar-denominated assets. In particular, foreign purchases of U.S. Treasury bonds declined sharply from $30 billion in the first three quarters of 1989 to less than $2 billion in the first three quarters of 1990; over the same period $3 billion net purchases of U.S. corporate securities by foreigners gave way to net sales of $19 billion. As a result, residual current account financing needs in the first three quarters of 1990 (about $78 billion) were largely covered by unidentified flows (errors and omissions), possibly involving Eurodollar market transactions, and by an increase in short-term inflows through the banking system in the third quarter.


A decline of $13 billion in Japanese official reserves during 1989 seems to have been largely due to official intervention in support of the yen. As downward pressure on the yen continued during the earlier part of 1990, the authorities seem to have intervened further, and a decline in official reserves by $10 billion could be mainly attributed to these operations. During 1989–90, Japanese direct investment abroad continued to expand strongly, at an annual rate of $45–50 billion. Direct investment in the United States, however, which accounted for more than half of Japan’s total direct investment in the 1985–88 period, began slowing in 1989 as Japanese residents increased their activities in Europe. The rest of Japan’s direct investment abroad was directed mainly toward Asian countries.

Although net portfolio investments abroad declined sharply by $20 billion to $33 billion in 1989, both assets and liabilities expanded significantly during the year. The sustained two-way flow of portfolio capital reflected, inter alia, the continued strong interest of Japanese financial institutions in foreign securities, remaining rigidities in Japanese capital markets that encourage domestic firms to seek funding in international capital markets, and the fact that many bonds issued abroad by Japanese corporations are bought by Japanese investors. Such bond issues—most with equity warrants-declined sharply at the beginning of 1990, following the decline in prices on the Tokyo Stock Exchange. This was a key factor behind the net portfolio outflow of $17 billion during the first half of 1990.

Net inflows from the banking sector declined by $35 billion to $4 billion during 1989 and shifted to a net outflow in the first half of 1990. The fall was partly associated with a reduction in the proportion of foreign portfolio investments that were hedged by forward currency contracts with banks, which in turn may have reflected changes in exchange rate expectations. In addition, net long-term bank outflows declined because of increased borrowing by Japanese residents after restrictions on long-term Euro-yen lending were eased in May 1989.


The net external position of German monetary authorities fell by $11 billion during 1989 as the acquisition of German liabilities by foreign monetary authorities—particularly the United States-more than offset a rise in the foreign reserves of the Deutsche Bundesbank. Net official reserves increased, however, by about $4 billion in the first three quarters of 1990. An important feature of developments in 1989 was a sharp decline of net outflows through securities markets, which fell by $39 billion to $4 billion. This reflected a number of factors, including the announcement in April of the abolition of withholding taxes on interest earnings, the narrowing of international interest rate differentials, and favorable expectations concerning unification. During the first three quarters of 1990, however, partly reflecting unsettled equity markets and new concerns about the budgetary implications of unification, net portfolio outflows increased significantly, even as the current account surplus began to narrow. Largely offsetting these outflows was a simultaneous decline in outflows from the banking sector. At the same time, German direct investment abroad, mainly to countries in the EC, rose appreciably.

Gross International Financial Flows

While the level of net international capital flows remained relatively unchanged between 1989 and 1990, the deterioration in the macroeconomic environment and increased uncertainty about asset price developments led to a significant decline in the scale of gross capital flows and in activity in some major segments of international financial markets. After a sharp contraction in 1988, international banking activity recovered during 1989 (Chart 10). Gross flows continued to be concentrated in the industrial countries but, in contrast to previous years, the expansion reflected the growth of international banking activities in Western European countries, rather than in the United States and Japan. International bank lending to borrowers in industrial countries, which accounted for 69 percent of total cross-border lending in 1989, increased by $93 billion that year, while deposit-taking from entities in industrial countries expanded by $203 billion (Table 4). As in previous years, the bulk of international banking flows represented interbank activity (Table A8). In terms of growth rates, however, interbank lending to industrial countries increased by 10 percent in 1989, while lending to nonbank entities in industrial countries expanded by 75 percent (Table A9). Much of the growth in the latter category was associated with mergers and acquisitions, especially in the United States and the United Kingdom, and with increased activity in securities and derivative products markets.

Chart 10.Growth Rate of International Bank Claims, 1982-Third Quarter 1990

(Twelve-month growth rates; in percent)

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

1These data do not net out interbank redepositing.

Table 4.Change in Cross-Border Bank Claims and Liabilities, 1984-Third Quarter 19901(In billions of U.S. dollars)
198419851986198719881989First three quarters
Total change in claims2183276538803559820581432
Industrial countries132208413548471564413386
Of which:
United States365593106108936032
Developing countries3114222−6116−13
Offshore centers42928861648518111541
Other transactors5610−71963430−11
Unallocated (nonbanks)652643504291728
Memorandum items
Capital importing developing countries3,7135321−1065−8
Non-oil developing countries3,8143322−1176−8
Fifteen heavily indebted countries6−6−12−15−2−2−27
Total change in liabilities9186302584762541801565387
Industrial countries118194424494370573419330
Of which:
United States8228257846741−36
Developing countries32423−74737693950
Offshore centers4244613014510014888−11
Other transactors528−61861315−15
Unallocated (nonbanks)618314258282433
Memorandum items
Capital importing developing countries3,7252183625583454
Non-oil developing countries3,82316163625523150
Fifteen heavily indebted countries155−4105171316
Change in total net claims10−2−26−45411991545
Industrial countries1413−1155100−8−656
Of which:
United States2833124924261968
Developing countries3−12−199−25−43−58−32−62
Offshore centers45−17−4520−16332753
Other transactors552−1121144
Unallocated (nonbanks)−14−51−8−243112−5
Memorandum items
Capital importing developing countries3,7−13−16−5−15−36−51−28−62
Non-oil developing countries3,8−913−13−15−37−45−25−58
Fifteen heavily indebted countries−9−103−7−20−19−14−43
Sources: International Monetary Fund, International Financial Statistics (IFS); and Fund staff estimates.

In 1990, international banking flows declined abruptly during the first half of the year before registering a partial recovery in the third quarter. Overall, however, the growth of cross-border lending to industrial countries fell by $27 billion in the first three quarters of 1990 relative to the corresponding period of 1989, while the expansion of deposit-taking from industrial countries fell by $89 billion. Interbank business slowed substantially, most notably in the United States and Japan. Bank claims on developing countries, which increased by $11 billion in 1989, declined by $13 billion in the first three quarters of 1990 (Tables A10-A13). Reductions in banks’ claims on the 15 heavily indebted countries more than offset an increase in claims on other developing countries.22 Together with significant increases in deposit-taking, this meant that developing countries remained net providers of funds to the international banking sector, a pattern which began in 1987.

International bond markets continued to expand during 1989, albeit at a slower pace (Tables 5 and A14 and A15). New issues of international bonds reached $256 billion in 1989, a 13 percent increase over the previous year, mainly due to a $40 billion expansion in equity-related bonds issued by Japanese borrowers (Table A16). The growth in those types of bonds more than offset a decline in new issues in other sectors of the bond market, especially in the U.S. high-yield (“junk”) bond market. During 1990, in contrast, new issues declined by 11 percent to $229 billion, mainly due to the sharp contraction in equity-related bonds following weak-ness in the Tokyo stock market. While issues of fixed rate bonds remained practically unchanged (at around $155–160 billion) in 1989–90, interest rate uncertainties contributed to a doubling in the issuance of floating rate notes to $37 billion in 1990 (Tables A17 and A18). More generally, during the year, and particularly after the outbreak of the Middle East crisis, investors’ preferences shifted toward short-term instruments, including Eurocommercial paper, and toward high-quality issuers, especially sovereign or supranational entities.

Table 5.Developments in International Bond Markets, 1983–90
19831984198519861987198819891990First three

(In billions of U. S. dollars)
Total gross international bonds77110168227181227256229172
Net issues1599013216310514416611894
Bond purchases by banks1328557653676864
Net issues less bond purchases by banks4662778751779830
Of which:
Industrial countries3651637744678125
Developing countries23421221
By category of borrower
Industrial countries6091137200156198224189143
Developing countries3510546554
Other, including international organizations141321212123273525
(In percent)
By currency of denomination
U.S. dollar576461553637503437
Deutsche mark9678810689
Swiss franc1812910131271010
Japanese yen56810151091412
(In percent a year)
Interest rates
Eurodollar deposits310.
Dollar Eurobonds412.512.110.68.610.
Deutsche mark international bonds48.
Sources: Organization for Economic Cooperation and Development, Financial Statistics Monthly and Financial Market Trends; Bank for International Settlements, International Banking and Financial Market Developments; and Fund staff estimates.

As in previous years, borrowers from industrial countries dominated international bond markets (Chart 11). During 1989–90, about 85 percent of total issues were by industrial country borrowers, while the share of borrowers from developing countries declined from about 3 percent in 1988 to about 2 percent in 1989, before increasing slightly in 1990.23 In terms of the currency composition of new international bond issues, U.S. dollar-denominated bonds increased from 37 percent in 1988 to 50 percent in 1989 before falling back to 34 percent in 1990 (Chart 12). In part, this reflected a reversal of interest rate differentials between the United States and other major industrial countries. The composition of instruments traded in bond markets also shifted significantly during 1989–90. The share of fixed interest rate bonds, which had risen continuously between 1985–88, declined by a sharp 10 percent in 1989 before recovering in 1990 (Table A19). Issues of floating rate notes continued to decline during 1989 as well, as had been the case since the collapse of the market for perpetual floating rate notes in December 1986. In 1989, floating rate notes accounted for only 7 percent of total issues, compared with 35 percent in 1985. In 1990, however, that share rose to 16 percent. Correspondingly, the share of equity-related bonds, which had declined during 1988 as a consequence of the stock market break in October 1987, recovered sharply during 1989 on the strength of the Tokyo Stock Exchange, reaching a peak of 31 percent of total bond issues before reverse developments pushed it down to 13 percent in 1990.

Chart 11.International Bond Issues by Groups of Borrowers, 1985–90

(In percent)

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

Chart 12.Currency Composition of International Bond Issues, 1985–901

(In percent)

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

1 Based on rates prevailing at time of bond issue.

During 1989–90, international equity markets continued the strong expansion that had been evident since the early 1980s (Table A20). The value of international equity trading expanded by 26 percent during 1989 to $1.5 trillion while its volume rose by 10 percent (Table 6). The expansion was in part related to favorable expectations about the economic prospects associated with the changes in Eastern Europe and progress toward the creation of a single EC market. It also highlighted deepening financial interdependence, as increased arbitrage activities led to a narrowed spread of valuations across national and international equity markets.

Table 6.Equity Markets: Secondary Trading Values and Volumes, 1979–89(In billions of U.S. dollars)
Total World Trading ValueInternational Equity Markets
Trading valuePercentage changeVolume1Percentage change
Source: Michael Howell and Angela Cozzini, International Equity Flows—1990 Edition: New Investors, New Risks and New Products (London: Salomon Brothers, August 1990).

Primary issuance in international equity markets (excluding issues of bonds with equity warrants) rose by $7 billion in 1989, with the major share of growth occurring in ordinary, nonconvertible, shares (Table 7). Data for the first half of 1990 point to a further significant growth in the issuance of ordinary shares. As regards the composition of gross equity flows (purchases plus sales of equity), investors from the United Kingdom were, as in previous years, the most active traders in international equity markets in 1989 (20 percent of the total), although Japanese investors were the most active early in 1990. Of the total foreign equity trading by Japanese investors during 1989, over 30 percent involved U.S. securities, in sharp contrast to previous years, when the share had been in the range of 80 percent. Investors from the United States continued to concentrate their foreign equity trading on securities from the United Kingdom and Japan. Reflecting favorable expectations on German unification, trading in German equities increased sharply from $61 billion in 1988 to $109 billion in 1989, an expansion that continued during the first quarter of 1990, when the trading value in German shares tripled relative to the first quarter of 1989.

Table 7.International Equity Markets—Primary Issuance, 1986–89(In billions of U.S. dollars)
1986198719881989First half
Ordinary shares11.620.
Of which:
Memorandum item
Bonds with equity warrants15.223.528.567.1
Of which:
By Japanese borrowers41.46.3
Source: Michael Howell and Angela Cozzini, International Equity Flows—1990 Edition: New Investors, New Risks and New Products (London: Salomon Brothers, August 1990).

Net equity flows (purchases minus sales of equity) also expanded sharply during 1989 to $92 billion, a record high (Table A21). The sharpest increase (by $29 billion) was in net purchases by foreigners of European equities, particularly from Germany. Data for the first quarter of 1990 indicate further strong increases in net foreign purchases of European equities and substantial net sales of Japanese equities. International mergers and acquisitions activity continued to be an important source of net equity flows, although its rate of increase slowed substantially during 1989 (7 percent as compared with a compound annual average of 67 percent in the 1986–88 period (Table A22)). The United States, which had been the target country for about 70 percent of all international mergers and acquisitions in 1986–88, accounted for 50 percent of them in 1989 and for only 35 percent in the first half of 1990. By contrast, foreign funds into the United Kingdom and countries in continental Europe rose during 1989 and the first half of 1990, increasing their share in international mergers and acquisitions to over 50 percent.

Markets for Derivative Products

Trading activity in derivatives markets continued to expand in 1989–90, a trend that had been evident since the early 1980s, as volatility in asset prices, technological developments, and competition between exchanges continued to foster hedging and speculative activities. The Middle East crisis, as noted, contributed to a further sharp expansion in derivative products trading in 1990 (Table A23).

The range of derivative products publicly traded on organized exchanges also increased significantly during 1989–90. In April 1989, the London International Financial Futures Exchange (LIFFE) and the Marché à Terme d’Instruments Financiers (MATIF) introduced futures contracts on the three-month Euro-deutsche mark interest rate. In October 1990, the MATIF introduced an ECU bond futures contract, and LIFFE launched a similar contract in March 1991. The contract will complement the existing three-month ECU interest rate contract, which started trading on LIFFE in 1989, and will allow users to hedge both the long and short ends of the ECU yield curve. In late 1990, the Deutsche Terminborse (DTB) in Frankfurt began trading its first two financial futures contracts; a contract based on the real time index of 30 blue-chip stocks and a contract on ten-year German Government bonds, with the same characteristics as the contract traded on LIFFE since late 1988. A new Japanese exchange, the Tokyo International Financial Futures Exchange (TIFFE), opened on June 30, 1989 and offered trading in three contracts: a Euro-yen interest rate future, a Eurodollar interest rate future, and a yen/dollar currency future. Most of TIFFE’s activities, however, are concentrated on the Euro-yen interest rate contract, used mainly by banks and securities houses to hedge movements in short-term domestic interest rates. Stock index futures and options began trading in 1988–89 on the Tokyo and Osaka Stock Exchanges. The Singapore International Monetary Exchange (SIMEX) also started trading in a Euro-yen futures contract, as well as options on the Euro-yen contract. Other instruments introduced during 1989–90 include a Japanese Government bond futures contract offered by the Chicago Board of Trade (CBOT) and a U.S. Treasury bond futures contract offered on the Tokyo Stock Exchange.

While overall trading activity on organized exchanges for derivative products rose sharply during 1989–90, there were significant differences in trading volumes for some of the most important futures and options contracts. Futures and options on the German Government bond and on the deutsche mark expanded sharply during 1989–90, reflecting uncertainty over the effects of German unification. Futures on U.S. Government bonds also remained strong with a sharp expansion of activity on the CBOT. Trading in futures on yen government bonds on the Tokyo Stock Exchange fell during 1989 and 1990. Trading in gilt-edged contracts on LIFFE declined during 1988–89, reflecting the authorities’ buy-back program for long-dated gilts, but activity recovered in 1990.

The recent growth of derivatives exchanges around the world has resulted in a sharp decrease in the market shares of the Chicago Mercantile Exchange (CME) and the CBOT, whose joint activities fell from about 75 percent of world futures volume in the early 1980s to 50 percent in the last five years. As a response to increased competition, as well as to resulting pressures for longer trading hours, these exchanges directed their efforts toward the development of electronic trading systems in order to provide a global 24-hour trading network. Similar pressures have also led to some consolidation of organized exchanges. The MATIF, for example, bought a 28 percent stake in an electronic futures operation set up by the Stockholm Options Market, and a merger between LIFFE and the London Traded Options Market is envisaged. In the view of some market participants, tougher competition, greater demands for capital, and the process of globalization have reduced the profitability of several lines of business; as a result, a stronger move toward consolidation and specialization is expected.

Interest rate and currency swaps have been the most actively traded over-the-counter derivative products. Initiated in the early 1980s, trading in these products reached an estimated $2 trillion of notional principal amount outstanding by the end of 1989, a 54 percent increase over the previous year (Table A24). Swap transactions during 1989 remained concentrated in a few currencies. In particular, the U.S. dollar accounted for 66 percent of interest rate swaps and 79 percent of currency swaps at the end of the year while the yen accounted for 9 percent and 45 percent, respectively.24 The rapid expansion of swaps reflects the flexibility they offer in the design of risk-management programs as well as the arbitrage opportunities arising from market imperfections and limitations on the portfolio choices available to investors.

Note: This section was prepared by Liliana Rojas-Suarez, David Folkerts-Landau, Donald J. Mathieson, Augusto de la Torre, and Rosa Vera-Bunge.

The APSP is the simple average of U.K. Brent, Dubai, and Alaska North Slope crude, representing light, medium, and heavy crude oil, respectively, in the three different regions.

While futures contracts now exist for long-term government bonds issued by France, Germany, Japan, the United Kingdom, and the United States, the broadest range of short-, medium- and long-term futures contracts exists for U.S. Government securities. In addition to the futures contract on the long-term U.S. Treasury bond there are also contracts on 90-day treasury bills and medium-term treasury notes.

For example, the U.S. Treasury 90-day bill rate stood at 7.4 percent on August 17, 1990; whereas the December 1990 U.S. Treasury bills futures contract implied a yield for December of 7.15 percent.

An option gives its owner the right to buy (a call option) or sell (a put option) a financial instrument at a fixed price before or at a future date. A higher anticipated price variability of the security underlying the option will increase the price that the writer of an option will charge. The pricing models used by options writers are complex variants of the so-called Black-Scholes formula for the pricing of a European-style option (which can only be exercised at the end of the option contract). This formula implies that the price of a European call option (C) is given by

C = PN(X) – [e–Rt]S N (X– s T–½)

where P = the price of the underlying instrument, S the price at which the option can be exercised (the strike price), T the length of time until the option expires, s the anticipated standard deviation of the price of the underlying instrument, N(X) the standard cumulative normal probability distribution, and

X = ln (P/S[e–Rt])/sT½ + (½)sT½

Thus, the higher the anticipated volatility (s) of the instrument’s price, the higher the price of the option.

While this type of relationship is often used to price an option, given the option writer’s estimate of the anticipated volatility, the prevailing price of the option can be used to provide an estimate of the average volatility anticipated by market participants.

The events of October 1987 and the subsequent reform proposals are reviewed in Section V of International Monetary Fund, International Capital Markets (1989).

It was also reported that the average maturity of forward foreign exchange operations between Middle East banks and other banks declined from three to six months before the crisis to only one month in early August.

For a detailed discussion of recent macroeconomic developments, see International Monetary Fund, World Economic Outlook (1991).

A fuller discussion of developing country access to spontaneous bank lending is found in Section V of this paper, while bank debt restructurings are covered in Section VI.

A discussion of developing country access to bond markets is found in Section V.

Since each currency swap involves two currencies, the percentages of swaps denominated in all currencies total 200 percent.

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