This section discusses broad trends in international financial intermediation since the start of 1988. A feature of this period has been that current account imbalances in the large industrial countries were principally financed by private capital flows, rather than through large-scale central bank intermediation as in 1987. The shift in financing patterns was accompanied by a surge in intermediation through bond markets relative to 1987 when intervention had boosted banking flows, particularly in the interbank market. Flows related to direct investment and syndicated credits also increased significantly in this period, partly reflecting the continued high level of mergers and acquisitions. Portfolio investments in equity, however, remained below levels experienced before the October 1987 stock market break.

This section discusses broad trends in international financial intermediation since the start of 1988. A feature of this period has been that current account imbalances in the large industrial countries were principally financed by private capital flows, rather than through large-scale central bank intermediation as in 1987. The shift in financing patterns was accompanied by a surge in intermediation through bond markets relative to 1987 when intervention had boosted banking flows, particularly in the interbank market. Flows related to direct investment and syndicated credits also increased significantly in this period, partly reflecting the continued high level of mergers and acquisitions. Portfolio investments in equity, however, remained below levels experienced before the October 1987 stock market break.

Macroeconomic Environment

During 1988, activity in international financial markets continued to benefit from strong output growth in most industrial countries in an environment of moderate inflation (see Table 1). Real gross national product (GNP) in industrial countries grew by 4½ percent, which was the highest rate recorded since 1984, and mainly reflected an increase in the level of business investment and high growth of productivity. At the same time, the tightening of monetary policy in a number of major countries helped allay concerns about higher inflation, and the inflation rate in industrial countries increased only slightly to 3.2 percent in spite of the strength of economic activity. During 1989, output growth slowed to an estimated 3½ percent, in part reflecting the effect of increased interest rates on investment activity and consumer spending. While concerns about inflation re-emerged in the first half of the year—fueled by fear that output might be approaching capacity limits, by the introduction of indirect taxes in some countries, and by increases in food and energy prices related to special factors—they subsided in the latter part of 1989 as the slowdown in activity became more apparent. For the developing countries as a group, economic activity also expanded at quite a fast rate in 1988, before slowing in 1989. The growth in real GNP was concentrated in Asian countries, while the group of countries with recent debt-servicing problems experienced a sharp decline in growth accompanied by an acceleration of inflation.

The growth of activity in the industrial countries has been accompanied by a rise in the aggregate current account deficit of these countries, which increased by 9 percent in 1988 to $199 billion and is estimated to have reached $223 billion in 1989.6 Although large external imbalances in the major industrial countries persisted, the imbalances in the United States and Japan declined in 1988 and are estimated to have been reduced further in 1989. The current account deficit in the United States fell from $143 billion in 1987 to $126 billion in 1988 and further to $111 billion in 1989, which lowered its share in the total deficit of the industrial world from 78 percent in 1987 to 50 percent in 1989. Japan's current account surplus declined from $87 billion in 1987 to $80 billion in 1988, and is estimated to have declined further to $57 billion in 1989. In contrast the current account surplus of the Federal Republic of Germany widened from $45 billion in 1987 to $49 billion in 1988, and the surplus is estimated to have risen further to $53 billion in 1989. After registering a surplus of $4 billion in 1987, the total current account balance of developing countries moved to a deficit of $9 billion in 1988, and the deficit is estimated to have increased further during 1989 primarily reflecting a deterioration in the position of countries with recent debt-servicing difficulties.

In contrast to the increased aggregate current account deficit in industrial countries, the aggregate fiscal deficit was reduced slightly during 1988 and is estimated to have declined further during 1989. The total deficit of the governments of the seven major industrial countries fell from $367 billion in 1987 to $347 billion in 1988 and is estimated to have declined further to $317 billion in 1989. The fiscal position relative to GNP improved in the United States and Japan, more than offsetting an increase in the fiscal deficit in the Federal Republic Germany.

In addition to the influences of economic activity, external imbalances and fiscal developments, the behavior of exchange rates and interest rates played a major role in developments in international capital flows. Exchange rate volatility of the deutsche mark and the yen against the U.S. dollar declined in 1988 (Table Al), partly as a result of substantial official intervention in the foreign exchange markets and public statements by the Group of Seven to promote greater exchange rate stability; exchange markets were less stable in 1989, however, reflecting, inter alia, political developments in a number of countries. A key feature of exchange rate developments in the last two years has been the recovery in the nominal value of the U.S. dollar against most major currencies following three years of decline; this reflected a number of factors, including a relative tightening of U.S. monetary policy, the progress made in reducing the current account imbalance, and the continued strength of U.S. activity.

Another factor that affected international financial flows was the behavior of interest rates. Concerns about a potential re-emergence of inflationary pressures were an important consideration in the formulation of monetary policy during 1988, which was reflected in an increase in short-term interest rates in a number of major countries (Chart 2). In contrast, long-term interest rates remained stable, partly reflecting a recognition of the authorities' anti-inflation commitment and the expectations of more stable exchange rates. As a result, yield curves flattened in 1988 and even became inverted in the major countries in 1989 (Table A2). As interest rates adjusted, interest differentials widened gradually in favor of dollar-denominated assets through early 1989 (Table A3). This trend was reversed, however, from the second quarter of 1989 as U.S. interest rates came down as inflation concerns were reduced, while rates increased in major partner countries.

Chart 2.
Chart 2.

Five Major Industrial Countries' Nominal Interest Rates, January 1982–December 1989

(In percent)

Sources: Banque de France; Nikkei Data Service; Bank of England; Data Resources Incorporated (DRI); U.S. Federal Reserve; and International Monetary Fund, Treasurer's Department.1 Monthly averages of daily rates on money market instruments of about 90 days' maturity.2 France, the Federal Republic of Germany, Japan, the United Kingdom, and the United States; using three-year moving average, GNP-based weights.3 Monthly averages of daily or weekly yields on government bonds, with maturities ranging from 7 years for Japan to 20 years for the United Kingdom and the United States.

Capital Flows in Major Industrial Countries

This section employs balance of payments statistics on capital account flows to analyze how the macro-economic conditions just described have affected direct investment, banking flows, and transactions in bond and equity markets. In particular, it looks at how such flows were influenced by the need to finance current account imbalances, by changing perceptions in exchange markets, and by shifts in domestic monetary policies. This analysis provides the broader context for the discussion in subsequent sections of the various segments of the international capital markets on the basis of financial market statistics. The section focuses on developments in the United States, Japan, the Federal Republic of Germany, and the United Kingdom, countries which experienced particularly large imbalances and were especially affected by the revival of autonomous private capital flows.

In contrast to 1987, when large-scale intervention in foreign currency markets by central banks reconciled the external imbalances of the major industrial countries, 1988 and 1989 saw a substantial return to financing through autonomous private capital flows, although intervention remained important on some occasions. Instrumental in this regard was the more stable situation prevailing in international currency markets, which permitted private capital flows to respond much more strongly to interest rate differentials than in 1987. As a result, intermediation through securities markets, and in particular through the bond market, rose strongly relative to 1987 when large-scale official intervention had boosted banking flows. Net direct investment flows also increased significantly, partly reflecting the continued high level of mergers and acquisitions, although flows related to portfolio investments in corporate equities remained below the levels experienced before the October 1987 stock market break.

The main elements of international capital flows between the large industrial countries in 1988 and 1989 are summarized in Table 2. The United States—the major deficit country—saw a significant increase in inward capital flows in respect of direct investment as well as through bond markets. The converse of this increase were large incremental outflows of capital through bond markets from Japan, the Federal Republic of Germany, and the United Kingdom, and a surge in direct investment from Japan. These developments were offset in part by a turnaround in flows through equity markets, and, in Japan's case particularly in 1989, equity-related bonds. At the same time, there were significant short-term banking flows into the United Kingdom, supplemented particularly in 1989 by flows related to official intervention.

United States

The reduction in the current account deficit and the net increase in inward direct investment in 1988 and the first three quarters of 1989 significantly relieved the pressure on financial markets to generate large inflows into the United States and reduced the need for official intervention in support of the dollar. According to balance of payments statistics, reductions in official reserves and acquisitions of liabilities by foreign monetary authorities declined from $57 billion in 1987 to $36 billion in 1988, while in the first three quarters of 1989 there was an $8 billion build-up in official reserves (Table A4). It should be noted that balance of payments statistics fail to capture fully the role of official intervention by foreign monetary authorities in covering the U. S. current account deficit, which resulted in an understatement of the role of intervention in 1987, while exaggerating its role since then.7

Net capital inflows into the United States through portfolio investments in securities markets rose moderately in 1988 and the first three quarters of 1989 but experience varied markedly between different market segments. In particular, net purchases of public sector bonds by foreigners, mainly German and Japanese investors, increased substantially, reflecting in part the increased interest rate differential in favor of the United States and the relative strength of the U.S. dollar. The acquisition of corporate equity in the United States dwindled in 1988 following the October 1987 market break, despite the surge in inward direct investment. Net inflows through the banking sector fell sharply in 1988 and the first three quarters of 1989 as short-term borrowing by U.S. banks was reduced, owing in part to the withdrawal of dollar deposits from the Eurodollar market by foreign monetary authorities.


Japan's surplus on current account operations net of direct investment flows declined substantially in 1988 and the first half of 1989 (Table A5). At the same time, the rate of accumulation of official reserves was reduced in 1988 and gave way to a reserve decline in the first half of 1989, so that net financing to the rest of the world through financial markets was broadly unchanged in the period. There were, however, substantial changes in the composition of such financing, as a reduction of outflows through securities markets was balanced by a reversal in net flows through the banking system.

In 1988, net capital outflows through bond markets increased sharply, mainly in the form of purchases of U.S. Treasury bonds, reflecting an increased differential in favor of foreign securities and less exchange rate volatility. This recovery was more than offset, however, by a dramatic turnaround in net inflows through the stock market, corresponding mainly to a switch from substantial sales of Japanese stocks by foreigners in 1987 to purchases in 1988. The foreign interest in the Japanese stock market coincided with this market's quick recovery to pre-crash levels, fueled by considerable confidence in the medium-term outlook for the Japanese economy. In the first half of 1989, while purchases of foreign public sector securities continued at a high pace, sales of bonds (mainly equity warrants on the Euromarket) surged, and with flows through equity markets being little changed, net flows through securities markets were broadly balanced.

The banking sector in Japan traditionally experienced considerable net inflows, as Japanese residents covered a significant portion of their long-term foreign investments through short-term foreign borrowing; however, in reflection of the increase in short-term interest rate differentials, the relative stability in foreign exchange markets, and reform of the domestic money market, net recourse to short-term funds from the international banking system was sharply reduced in 1988, and Japan experienced capital outflows through this market in the first half of 1989.

Federal Republic of Germany

Germany witnessed a dramatic increase in long-term capital outflows though securities markets in 1988 and the first three quarters of 1989, reflecting mainly a sharp increase in the acquisition by German residents of foreign bonds and also reduced purchases of domestic securities by nonresidents (Table A6). These outflows were related to the above-mentioned widening of interest differentials in favor of the U.S. dollar, the generally bearish attitude toward the deutsche mark throughout most of the period, and the announcement in late 1987 that a withholding tax would be levied on domestic interest income. As a result of this capital outflow and despite the continuing large current account surplus, central banks had to intervene to support the deutsche mark.

With regard to the banking sector, there were net inflows of long-term capital in 1988 and the first three quarters of 1989 related to the issuance of foreign deutsche mark bonds. This occurred as foreign subsidiaries of German banks issued such bonds and placed the proceeds in long-term deposits in German banks, thereby taking advantage of the lower interest rates on foreign bonds related to the avoidance of the withholding tax as well as the exemption of long-term deposits from minimum reserve requirements. With respect to short-term capital flows, there was a small increase in net outflows, which stemmed mainly from an increase in the net interbank claims of German banks, in particular in deutsche mark claims on foreign banks, and was largely a result of purchases by the Bundesbank of deutsche mark in the exchange market.

United Kingdom

In the United Kingdom, large increases in the current account deficit in 1988 and the first three quarters of 1989 coincided with substantial capital outflows through securities markets (Table A7). The turnaround in portfolio investments in securities markets resulted for the most part from an increase in demand by British residents for foreign securities and was directed both toward foreign bonds and corporate equities. The renewed demand for foreign securities in this period largely reflected a reversal of the disinvestment in the final months of 1987 following the stock market break. Moreover, while short-term interest rates provided a significant premium on sterling assets, long-term interest differentials were substantially less favorable.

The current account deficit and net outflows through securities markets were mainly financed in 1988 through a large increase in the net inflow of funds through the banking system, which reflected the sharp increase in short-term interest differentials in favor of the United Kingdom. In the first three quarters of 1989, continued net inflows through the banking system were supported by substantial official intervention. It should be noted that the interpretation of the statistics is greatly complicated by the large and increasing entry for “errors and omissions.”

International Banking Activity

After rapid expansion in 1987, international bank lending slowed in 1988 and the first three quarters of 1989 (Chart 3). International bank lending to borrowers in industrial countries, which accounted for 86 percent of total cross-border bank lending in 1988, declined from $547 billion in 1987 to $475 billion in 1988, and such lending continued to fall in the first three quarters of 1989 (see Table 3). Deposit taking from industrial country entities also contracted in 1988 to $376 billion compared with $493 billion in 1987, but rebounded in the first three quarters of 1989. Most of the international banking activity within the industrial countries takes place in the interbank market; such activity declined sharply in 1988 and remained depressed in the first three quarters of 1989 (Table A8). By contrast, bank lending to nonbank entities in industrial countries was broadly unchanged in 1988, but rose sharply in the first three quarters of 1989 (Table A9).

Chart 3.
Chart 3.

Growth Rate of International Bank Claims, 1980–Third Quarter 1989

(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.1 These data do not net out interbank redepositing.

The slowdown in interbank lending in 1988 and the first three quarters of 1989 can be tentatively attributed to several factors. First, new international capital adequacy guidelines have acted as an incentive for banks to slow the expansion of their balance sheets, particularly in activities with low profit margins relative to their risk weighting. Second, interbank flows in 1987 were boosted temporarily by the opening of the Japan Offshore Market in December 1986 as banks placed funds into this market and by the impact of deposits related to official foreign exchange intervention. Third, relatively flat yield curves reduced the incentives for financing medium- and longer-term investment through short-term interbank borrowing.

Lending to residents in Japan accounted for a large proportion of cross-border bank lending to industrial countries in 1987–88, but such activity declined sharply in the last quarter of the year and in the first three quarters of 1989. This reduction partly reflected the deregulation in November 1988 of the Japanese short-term bill market, which increased banks' opportunities to obtain funds in the domestic money market. In spite of the continued large current account surplus, Japan remained a net borrower of funds from the international banking sector in 1988 and the first three quarters of 1989, albeit at a lower level than in 1987. Cross-border bank lending to residents of the United States was maintained in 1988 at about the level of 1987, while banks' deposit taking from residents of the United States increased sharply. As a result, the net use of funds by the United States declined steeply. In the first three quarters of 1989, lending to U.S. residents continued to decline, but deposit taking fell even more steeply, and the net use of funds rose relative to the same period of the previous year. Among other industrial countries, residents of the United Kingdom were also net users of funds in 1988 and the first three quarters of 1989, while net lenders included Belgium, Luxembourg, the Federal Republic of Germany, and Switzerland.

With regard to developing countries (excluding offshore centers), there was a significant turnaround in 1988 with bank claims on these countries declining by $9 billion after having risen by $21 billion in the previous year. Banks' increasing reluctance to participate in general purpose medium-term financing for heavily indebted countries and a relatively high rate of debt conversions were major factors behind the decline.8 Bank claims on developing countries rose $5 billion in the first three quarters of 1989 as debt conversions slowed while two major debtor countries accumulated substantial arrears. Deposit taking from developing countries continued in this period at a substantial rate so that net bank claims on developing countries fell by $44 billion in 1988 and an additional $23 billion in the first three quarters of 1989, following a $29 billion decline in 1987.

In contrast to the decline in interbank activity, the pace of long-term bank credit commitments rose sharply in 1988, as total international commitments rose to $143 billion, up from $116 billion in 1987 (Table A10). The surge in activity in 1988 was due in large part to $35 billion of merger-related lending, which was four times higher than in 1987 and represented over 30 percent of new syndicated Eurocredits. Corporate borrowing for debt consolidation was also heavy, often in connection with multiple option facilities and more traditional revolving stand-bys arranged to support commercial paper programs. By contrast, lending to sovereign borrowers remained subdued, reflecting reduced demand by creditworthy borrowers who were generally able to raise funds more cheaply through swap-related Eurobond issues. About one half of longterm bank credit commitments in 1988 were made to borrowers in the United Kingdom and the United States, related in part to corporate merger and acquisition activity.

In 1989, international syndicated lending activity subsided, with total long-term credit commitments dropping by 26 percent to $106 billion. The decline in activity was broadly spread, and affected merger-related transactions (which were increasingly financed on domestic markets), corporate borrowing in connection with multiple option facilities, and sovereign borrowing. The United States emerged as the largest borrower on the syndicated loan market as recourse by U.K. borrowers declined particularly sharply.

International Bond Markets

After the sharp contraction in activity in the international bond market in 1987, new issues of international bonds expanded by 25 percent to $227 billion in 1988, regaining the peak level of activity obtained in 1986 (Table 4). Increased bond issuance in 1988 was boosted by the more stable conditions in financial markets and was facilitated by the strong expansion of the swaps market. The recovery continued in 1989 when new issues of international bonds increased by 12 percent to $254 billion. The expansion in activity in 1989 was concentrated in equity warrant issues by Japanese borrowers, while other market segments were generally depressed. Factors adversely affecting the market included a flattening (and even an inversion in some cases) of the yield curves for several currencies, which started in late 1988 and continued through much of 1989. In addition, liquidity in the secondary markets for international bonds has increasingly been viewed as limited, while uncertainties regarding prospective economic and financial developments, and in particular the impact of merger and acquisition activities in the United States, have led investors to have a strong preference for the issues of top-quality and sovereign borrowers, where event risk is less. A related development has been the increased concentration of issues by borrowers from industrial countries; in 1988 and 1989 such issues accounted for 87 percent of total issues of international bonds (Table A11 and Chart 4). Borrowers from developing countries (excluding offshore centers), with a share of 6 percent in total issues in 1982, accounted for only 4 percent of those issues in 1988 and for only 2 percent in 1989.

Chart 4.
Chart 4.

International Bond Issues by Groups of Borrowers, 1984–89

(In percent)

Source: Organization for Economic Cooperation and Development, Financial Statistics Monthly.
Table 4.

Developments in International Bond Markets, 1982–89

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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.

Gross issues less scheduled repayments and early redemption.

Three-month deposits, at end of period.

Bonds with remaining maturity of 7–15 years, at end of period.

Early repayment of bonds, which had occurred at a very high rate during 1986–88, slowed during 1989, as rising interest rates discouraged many borrowers from refinancing existing debt (Table A12). Net issues of international bonds (gross issues less early repayments and scheduled amortizations) increased by 51 percent in 1988 and were 52 percent higher during the three quarters of 1989 than in that period of 1988.

With regard to the currency composition of bond issues, the share of U.S. dollar-denominated bonds, which had averaged 37 percent during 1987–88, recovered to 50 percent in 1989, boosted by the strength of the currency and declining long-term interest rates. In contrast, bonds denominated in Japanese yen, which accounted for 15 percent of total bond issues in 1987, fell to 10 percent of total issues in 1988 and 1989. This decline reflected investors' uncertainties about the exchange rate of the yen vis-à-vis the U.S. dollar, as well as movements in the differentials between Japanese and U.S. interest rates. Concerns about the depreciation of both the deutsche mark and the Swiss franc also resulted in reduced issuance of bonds denominated in those currencies during late 1988 and 1989.

The types of instruments used in international bond markets have experienced significant changes in recent years (Table A13 and Chart 5). New issues of fixed-rate bonds, increased by 32 percent in 1988 to $160 billion (Table A14), benefiting from increased credibility of the authorities' anti-inflation commitment and from the increasingly favorable terms available in the swap markets.9 Activity declined to $154 billion in 1989, however, as the flattening of the yield curve in many markets contributed to reduce investors' demand for medium-term as opposed to short-term instruments. Borrowers from the United States were the most important issuers of fixed rate bonds in 1988, but U.S. offerings increased only marginally during the year, and declined during 1989. In contrast, fixed rate bonds issued by borrowers from the United Kingdom more than doubled in 1988 and continued at a high level in 1989, while issues by borrowers in Japan rose sharply in 1989 to give these borrowers the largest share of the market. With respect to currency denomination, deutsche mark-denominated bond issues increased sharply in 1988 as the proposed introduction of the withholding tax on interest income in the Federal Republic of Germany induced investors to shift from domestic deutsche mark bonds to international deutsche mark issues. Issues denominated in deutsche mark fell back in 1989 following the announced elimination of this tax.

Chart 5.
Chart 5.

International Bond Issues by Major Instruments, 1984–89

(In percent)

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

New issues of floating rate instruments, which had fallen to a low in 1987, increased moderately in 1988, but activity in this market segment again fell back in 1989 (Table A15). The strength in 1988 owed in large part to issues by mortgage institutions and building societies from the United Kingdom, and as a result, issues denominated in pounds sterling accounted for 44 percent of floating rate bonds. In contrast, floating rate issues denominated in U.S. dollars, which had accounted for 80 percent of the market in 1986, represented only 38 percent of the market in 1988. The decline reflected rising U.S. short-term interest rates and the continuing impact of the collapse of the perpetual floating rate note sector.10 In 1989, however, U.S. dollar issues regained market share, as borrowing from the United Kingdom was cut back.

In spite of the adverse effects of the stock market break in October 1987, issues of equity-related bonds declined only moderately in 1988 to $41 billion, and activity in this segment of the market increased strongly in 1989 to $80 billion (Table A16). Offerings by Japanese borrowers accounted for 87 percent of new equity-related issues in 1988 and for 96 percent of the market in 1989, up from 65 percent in 1987. Most of these Japanese issues were bonds denominated in U.S. dollars with equity warrants, which were attractive to investors because of the profit opportunities provided by the strong performance of the Tokyo stock market. Moreover, the presence of the equity warrant and the use of currency and interest-rate swaps allowed Japanese borrowers to raise funds on very favorable terms, and without incurring the costs of flotation on the Tokyo stock market. In contrast, the market for convertibles was very sluggish, as issues by borrowers from the United States remained at depressed levels.

After a period of rapid growth, arrangements of international financing facilities contracted in 1988 and 1989 (Table A17). In 1988, the decline was particularly severe in the market for back-up facilities (whose most important components include note-issuance facilities, bankers' acceptances, and commercial paper backups) as many borrowers switched to Eurocommercial paper programs, which allowed borrowers to obtain funds at a lower cost. Arrangements of back-up facilities continued to decline in 1989, while arrangements of new Eurocommercial programs also slowed, owing in part to improvements in the borrowing terms offered by other international and domestic short-term markets and concerns with creditworthiness following well-publicized defaults by several borrowers. The recent weakness in facilities may also reflect the new capital adequacy guidelines, which raise the cost to banks of providing off-balance sheet guarantees. Borrowers from the United Kingdom (especially building societies) accounted for the largest share of the market in 1988, but their share in newly arranged programs declined sharply in 1989. Borrowers from the United States, the single largest group of users of the market in 1989, also reduced their use of facilities, while activity by borrowers from Australia increased. Although most Eurocommercial paper programs are denominated in U.S. dollars, there has been an increasing movement toward currency diversification. Moreover, currency swaps and forward contracts have recently been used to hedge many programs against exchange rate movements.

One important development in 1989 has been the successful issue by the World Bank of the first global bond, which was launched simultaneously in Europe and the United States. The elimination of capital controls in a number of markets has meant that the borders between the domestic and Euromarkets for instruments in those currencies are now blurred, with the continued market segmentation resulting mainly from divergent market traditions and practices. The World Bank global bond represented an experiment to see if these practices could be reconciled and the differences overcome, thus allowing the borrower simultaneous access to a large pool of investors and, by creating a much more liquid instrument, reducing its borrowing costs. As part of this effort, the Bank also hoped to tap the most liquid market segment in the United States by being classified along with U.S. Government agencies, thus giving it a similar status to that which it has always enjoyed on the Euromarket.11

Derivative Products

Markets for derivative products, including exchange-traded futures and options as well as other contingent claims traded over the counter (OTC), continued to increase in breadth and sophistication in 1988 and early 1989. International activity in these markets has expanded strongly for several years (Table A18); the high variability of interest rates, exchange rates, and stock prices has created a continuing need for hedging instruments, and firms' and investors' increasing familiarity with hedging techniques has permitted them to use these instruments more effectively. Although the October 1987 stock market break appears to have dampened interest in some derivative products, notably stock index futures and options, by demonstrating the settlement and other risks that strategies employing these products may entail under extreme market conditions, trading in many other products has continued to increase.

Increased market activity has resulted in, as well as being further stimulated by, an intensification of competition. The increasingly competitive international environment has been marked by the rapid expansion of trading in some market centers, as well as by the establishment of new centers. The Marché à Terme d'lnstruments Financiers (MATIF), which was established in 1986, has risen to third place worldwide in trading volume, although until April 1989 it confined itself to trading in domestic French franc-denominated financial instruments. There has also been a rapid expansion of futures and options trading in Japan, with the opening of trading in stock-index futures, beginning in 1988, on the Osaka Securities Exchange (OSE) and the Tokyo Stock Exchange (TSE), and in stock-index options beginning in 1989 on the OSE, the TSE, and the Nagoya Securities Exchange.

In contrast to these areas of rapid expansion, the volume of trading has declined in other areas: these include several stock-index products, such as the Chicago Board of Trade's (CBOT) Major Market Index futures, the Kansas City Board of Trade's Value Line futures, and the New York Futures Exchange's New York Stock Exchange Composite Stock Index futures and options. Another area of decline is that of futures and options on U.K. Government bonds (“gilts”), which had been among the most heavily traded contracts on the London International Financial Futures Exchange (LIFFE); the decline stems from a reduction in the outstanding stock of gilts as a result of the United Kingdom's financial policies.

An important development in January 1990 has been the establishment of the Deutsche TerminBörse (DTB) in Frankfurt. This is expected to facilitate trade in futures and options contracts on German Government bonds, which constitute the world's fourth largest government bond market. German interest-rate futures were already being traded on other markets: in September 1988, LIFFE introduced a futures contract on a ten-year government bond (the “Bund”), while in April 1989, both LIFFE and MATIF introduced three-month Euro-deutsche mark interest rate futures contracts.

Global competition among markets located in different time zones, combined with the worldwide scope of many prospective market users, has created pressure for a lengthening of trading hours. One response to this pressure has been to introduce longer hours on existing exchanges, for example on the CBOT in 1987 and on the Philadelphia Stock Exchange (PHLX) in January 1989. A second response has been the establishment of links among different exchanges: for instance, the Chicago Mercantile Exchange (CME) has maintained links with the Singapore Monetary Exchange (SIMEX) since that market opened in 1984; Eurodollar and currency futures and options contracts are cross-listed on the two exchanges, and positions opened on one exchange can be transferred to or closed out on the other. Although trading in cross-listed contracts on SIMEX is a small fraction of that on the CME (see Table A18), the fact that positions can be opened or closed on SIMEX while the CME is closed, and vice versa, adds to the attractiveness of trading on both exchanges. A third response to the desire for 24-hour trading has been the development of electronic trading systems, notably the CME-Reuters electronic order matching system called Globex, in which MATIF and the Sydney Futures Exchange have also agreed to participate. Globex has met with competitive responses from the CBOT and from LIFFE, which have both developed their own trading systems. In May 1989, the CME and the CBOT agreed to merge their systems; the features of the resulting system and the implications for the international linkage of futures markets have yet to be determined.

With regard to activity levels in different market segments, interest in three-month Eurodollar futures and options expanded strongly from the end of 1987 through October 1989 on all three relevant exchanges, the CME, LIFFE, and SIMEX; this occurred despite the introduction of a potentially competing product, the CBOT's 30-day interest rate futures contract. In U.S. Treasury bonds, the CBOT's contracts remained dominant, with 97 percent of the 1988 trading volume and a similar percentage of the end-of-1988 open interest. The CME's 90-day treasury bill contract has continued to be widely used, although somewhat more quietly traded. Activity in treasury bill futures options on the CME increased substantially over 1988 and the first ten months of 1989, but in October 1989 trading volume and open interest were still small relative to the corresponding futures contract. Trading volume and open interest in Yen government bonds on the TSE declined in 1988 but increased substantially in the year to October 1989. Another heavily traded contract is the MATIF's French Government bond contract: open interest in this contract increased in 1988 but by October 1989 had slid back to about its end-of-1987 level, while trading volume dipped in 1988 but increased strongly through October 1989.

The level of market activity in foreign exchange futures and options was mixed, and there were some changes in the market shares of different exchanges. The currency in which futures and options trading saw the most rapid expansion was the Australian dollar, which largely reflects the fact that these products have only recently become available—the CME futures and PHLX options in 1987 and the CME options in 1988. The recent popularity of these products may also reflect considerable market uncertainty and disagreement about the future course of the Australian dollar.

Activity in over-the-counter markets for derivative products also increased sharply during 1988. By year-end, the market for interest rate and currency swaps reached an estimated size of about $1.3 trillion dollars of notional principal amount outstanding, consisting of about $1 trillion of interest-rate swaps and $317 million of currency swaps (Table 5). The amounts of notional principal outstanding at year-end reflect a 48 percent increase in the amount of interest-rate swaps written and a 73 percent rise in the amount of currency swaps written in comparison with the end of 1987. Although the International Swap Dealers' Association's annual market survey reported swap transactions in 13 different currencies, transactions have tended to be concentrated in a few currencies. At the end of 1988, about 72 percent of interest-rate swaps were in U.S. dollars, and 8 percent in Japanese yen. For currency swaps, about 86 percent of the swaps involved U.S. dollars and 42 percent Japanese yen.12 Other OTC derivative products, including interest-rate caps, floors, collars, and “swaptions,” accounted for an additional $327 billion of notional principal at the end of 1988. Swaps and other OTC products offer features that can be tailored specifically to the user's risk-management requirements; OTC derivative products have had to become more flexible and sophisticated in order to remain competitive with an increasingly wide range of exchange-traded products.

Table 5.

Outstanding Swap Transactions by Currencies, 1987–88

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Each currency swap involves two currencies. To avoid double counting, the total is therefore half the sum of the individual currency amounts, and the percentages in each currency add up to 200 percent of this total.

International Equity Markets

The 1980s witnessed a rapid expansion of equity markets worldwide, which was accompanied by a particularly strong increase in international trading in equities—that is, transactions in domestic stock involving nonresidents.13 Despite a decline in 1988, the volume of transactions in international equity markets increased by an annual average of 18 percent from 1979 to 1988, while the average share price rose by 16 percent a year (Table 6). International equity trading amounted to over $1.2 trillion in 1988, and in one out of every nine equity trades, the buyer or the seller was a nonresident.

Table 6.

Equity Markets: Secondary Trading Values and Volumes, 1979–88

(In billions of U.S. dollars)

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Source: Michael Howell and Angela Cozzini, International Equity Flows—1989 Edition: Are International Equities Ex-Growth? (London: Salomon Brothers, August 1989).

Index 1979 = 100.

The exceptionally rapid growth in international equity trading over this period can be attributed, in part, to an attempt to reduce risk through international portfolio diversification and the pursuit of international arbitrage opportunities emerging in the context of changing macroeconomic, tax, and regulatory environments. The trend toward international portfolio diversification has also been facilitated by the reduction of barriers to both international capital movements and to the international provision of financial services. At present, about 10 percent of investment portfolios in the large industrial countries consists of foreign assets.

The expansion of international equities trading has been associated with a greater interdependence of national stock markets, as reflected, for instance, in an increased correlation between price movements in different centers. The correlation coefficient between stock price indices in the United States and in other countries increased, on average, from 0.35 in 1975–79 to 0.62 in 1985–88. Greater international interdependence of stock markets is associated with greater market efficiency: to the extent that funds can flow freely into markets in which assets are undervalued, and out of overvalued markets, prices tend to be based on more uniform risk-return criteria, enabling funds to be channeled into their most productive uses. On the other hand, increased interdependence also heightens the tendency of shocks to be transmitted rapidly from one market to another; the market break of October 1987 demonstrated the speed with which major adverse market developments can spread through equity markets worldwide.

The events of October 1987 interrupted the trend toward expansion of international equity trading. The value of trading dropped by almost 10 percent from 1987 to 1988, while the number of traded shares declined even more sharply, by 26 percent (see Table 6). However, international equity flows appear to be in the process of recovering. Gross international equity investment from the Federal Republic of Germany, Japan, the United Kingdom, and the United States reached an annualized flow of $584 billion in the first quarter of 1989, compared with an annualized flow of $485 billion a year earlier, and $546 billion in 1987.

Primary issues of equity securities on the international market have also increased rapidly in the 1980s, especially in the last five years.14 New international equity issues (excluding equity-linked bonds) rose from $300 million in 1984 to $18 billion in 1987 (Table A19). The interruption in the expansion of the international equity market was reflected in a sharp decrease in new international issues of equity to $7.7 billion in 1988. The drops in issues of Euro-equities (i.e., equities issued outside the issuing firm's home country) and issues related to privatization were particularly sharp.

U.K. investors have been the most active participants in international equity markets: the value of their purchases and sales of foreign equity during 1988 reached an estimated $224 billion or 18 percent of the total value of international equity trades (Table A20). U.S. and Japanese residents each accounted for about 12 percent of international equity transactions in 1988, while investors from Continental Europe accounted for 27 percent of gross international equity flows in 1988; among them, Swiss investors were the most active, as they initiated gross flows equivalent to 11 percent of global equity turnover. The value of international equity trades undertaken by U.K. residents in 1988 was fairly evenly distributed between equity securities from the United States, Japan, and Continental Europe. By contrast, 70 percent of the turnover generated by Japanese investors involved U.S. equity securities.

As regards the destination of equity flows, in recent years the United States has been the largest recipient of such investment, although these inflows moderated in 1988 and early 1989 as the dollar strengthened. Investment in Europe has been increasingly important, partly in reflection of the corporate restructuring that has taken place in connection with the planned establishment of a unified European market by 1992. A large portion of cross-border inflows came from Europeans themselves, particularly from U.K. residents. International interest in Japanese equity has also been strong, and it is estimated that foreign portfolio investors now own about 4 percent of Japanese equity securities.

In addition to international portfolio investment in equities, mergers and acquisitions constitute a major source of cross-border equity flows.15 In 1988, about 2,500 international transactions in mergers and acquisitions generated an estimated $125 billion in cross-border flows, that is, about one tenth of the gross equity flows associated with international portfolio investment (Table A21). Companies from the United Kingdom were the most active bidders in international mergers and acquisitions markets during 1988; they acquired foreign firms with total value of $44 billion, of which $32 billion (or 72 percent) was accounted for by the acquisition of 385 U.S. firms. The value of international acquisitions by companies from Continental Europe reached $37 billion, 40 percent of which involved acquisitions of U.S. firms. In all, the United States constituted the most important target market, attracting $67 billion, or over one half of the total international activity in mergers and acquisitions. Europe was also an important target of cross-border activity; it attracted $34 billion in such investment, of which $24 billion came from Europeans themselves.


Note that the aggregate current account deficit is defined in gross terms; that is, the current account balances of countries with surpluses are not netted out.


Foreign authorities' holdings of dollar reserves in the United States increased significantly less than the increase in total dollar reserves of foreign authorities in 1987, suggesting that intervention purchases of dollars during that year were partly deposited in the Eurodollar market. Such Eurodollar deposits prompted banks to cover their foreign exchange exposure by acquiring dollar assets—partly from the United States—and these flows were recorded in the U.S. balance of payments as private capital movements, although they were not of an autonomous nature but induced by intervention. This development was reversed in 1988 and the first half of 1989, when the increase in dollar reserves of monetary authorities held in the United States exceeded the total increase in dollar reserves reported by such authorities, reflecting the higher interest rates in the United States than in the Eurodollar market. See the Bank for International Settlements, 59th Annual Report, 1989, pp. 186–193, and International Monetary Fund, Annual Report of the Executive Board for the Financial Year Ended April 30, 1989 (Washington, 1989), pp. 53–57.


See Section III for a more detailed discussion of these developments.


Swaps allow investors effectively to change the currency of denomination of their bond investments through offsetting currency swaps at any point in time.


The market for perpetual floating rate notes had developed as a means for banks to raise secondary equity capital at costs that were closer to money-market instruments than to equity instruments. When rumors emerged in late 1986 that some regulatory authorities were considering applying to these notes capital costs that would avoid “double leverage” (i.e., banks holding each others' capital), prices of these instruments plummeted and liquidity vanished.


In the effort to tap the Eurobond and Yankee bond market simultaneously, many details had to be solved. One issue was whether the bond should be a registered security (the U.S. practice) or a bearer bond (normal for the Eurobond market). It was decided to make it the former, with the institutional demand for Euromarket paper considered to more than compensate for the loss of that portion of the individual investor market that shies away from registered bonds. The second major issue was to establish some form of link between the Euromarket's Euroclear and Cedel systems and the Fedwire to allow the bonds and associated payments to pass freely between Europe and the United States, without investors being subject to excessive delays on the transaction. Third, with different bond-marketing practices on the two markets, it was decided to emulate U.S. domestic sales practices by soliciting bids from an issuing group, as has recently been done for some other Eurobond issues, rather than distributing at par through a syndicate as is normal for Eurobonds. Finally, considerable work had to be done to create the legal documentation that accorded with the practices of the two markets and to ensure the bond's tax-free status.


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


For example, U.S. fund managers investing in Japanese stock, or British investment trusts selling Germany equity. However, the definition excludes transactions classified as direct investment in balance of payments accounts. This section on international equity markets draws on information from Michael Howell and Angela Cozzini, International Equity Flows1989 Edition: Are International Equities Ex-Growth? (London: Salomon Brothers, August 1989).


International equity issues comprise the underwriting and distribution of equity securities to investors in one or more markets outside the issuer's home country by international underwriting syndicates.


Flows related to merger and acquisition activity are generally classified as direct investment in balance of payments statistics.

International Capital Markets 1990
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    Five Major Industrial Countries' Nominal Interest Rates, January 1982–December 1989

    (In percent)

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    Growth Rate of International Bank Claims, 1980–Third Quarter 1989

    (Twelve-month growth rates in percent)

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    International Bond Issues by Groups of Borrowers, 1984–89

    (In percent)

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    International Bond Issues by Major Instruments, 1984–89

    (In percent)