Annex I Major Capital Markets: Trends and Recent Developments
Author: International Monetary Fund
Language:
English
Keywords:
WEFS; market; market participant; market infrastructure; settlement risk; market development; U.S. dollar; global bond; replacement value; pound sterling; plain vanilla; Yield curve; Stock markets; Securities; Securities markets; Loans; Global; Europe; North America
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Abstract

During most of the period under review, a favorable inflation outlook and reductions in official interest rates generally supported an environment of rising bond and equity prices and record levels of fund-raising. Against this background, the major currencies experienced a temporary misalignment beginning in March 1995 and lasting through the summer. The associated currency movements created substantial volatility in the major currency and related money and financial markets, but this volatility subsided as the major currencies became more aligned with economic fundamentals. Overall, the sharp currency movements had no discernible lasting effect on interest rates in the major industrial countries in 1995.

During most of the period under review, a favorable inflation outlook and reductions in official interest rates generally supported an environment of rising bond and equity prices and record levels of fund-raising. Against this background, the major currencies experienced a temporary misalignment beginning in March 1995 and lasting through the summer. The associated currency movements created substantial volatility in the major currency and related money and financial markets, but this volatility subsided as the major currencies became more aligned with economic fundamentals. Overall, the sharp currency movements had no discernible lasting effect on interest rates in the major industrial countries in 1995.

In early 1996, the strength of the U.S. economy raised concerns about the possibility of a global bond market correction similar to the market turbulence experienced in early 1994. Although U.S. long-term interest rates have risen in 1996. the other major industrial countries have experienced somewhat smaller increases, reflecting the significant differences in cyclical positions and the absence of the kind of speculative position-taking by hedge funds that had characterized the widespread turbulence in 1994. European interest rates experienced a considerable degree of convergence in the second half of 1995, and forward yield curves suggest that market participants expect to see further convergence over the next three to five years, even though spreads over German interest rates are implicitly expected to remain high in some countries.

Equity markets in most of Europe and Japan moved ahead more slowly in 1995 than they did in Canada, the United States, and the United Kingdom, but in early 1996, equity prices in all of the major markets have trended higher. The steady rise in U.S. equity markets has periodically raised concerns about the possibility of a sharp correction that could spill over into other markets. Although a correction cannot be ruled out, most objective market indicators suggest that equity prices are not necessarily out of line with underlying fundamentals.

The nonsynchronous nature of business cycles can also be seen in the performances of the major banking systems. Banks in Canada, the United States, and the United Kingdom have experienced record profit levels after having labored to resolve asset-quality problems that developed in the early 1990s. The resulting liquidity in these banking systems has driven margins on domestic and international syndicated loans to historically low levels and raised loan volumes. The performance of the banking systems in France and Japan continue to be affected by nonperforming loans.

Foreign Exchange Markets

The major currencies experienced a temporary misalignment in early 1995 (Chart 13). The dollar depreciated from ¥101 in early January to ¥80 in mid-April, and from DM 1.56 to DM 1.35 during the same period. The deutsche mark’s appreciation against the dollar was associated with currency movements within European currency markets, reflecting several factors including uncertainty about prospects for Economic and Monetary Union (EMU), the “flight to quality” associated with the Mexican financial crisis, and political uncertainty in several countries. During the early part of the year, the deutsche mark appreciated against the French franc, the Italian lira, and the pound sterling, and reached record highs against several other European currencies (Chart 14). In addition, the Spanish peseta and the Portuguese escudo were both devalued in March 1995—the first realignment within the European exchange rate mechanism (ERM) since the widening of bands in 1993.

The temporary misalignment of the major currencies generated a significant but temporary increase in transactions volume and price volatility in currency markets and in related securities and derivative markets. Average daily turnover increased markedly in global currency markets during this period, and reached as high as $2 trillion in April.1 Associated with this sharp increase in activity was a sharp rise in price volatility in foreign exchange markets (see Chart 8).2

Chart 13.
Chart 13.

Major Industrial Countries: Exchange Rates

(Local currency/U.S. dollar)

Source: Bloomberg Financial Markets.

Volatility tripled both in the yen-dollar market (in March and rose further in April) and in the deutsche mark-dollar market (between mid-February and the end of March 1995), and it increased for dollar rates against the other major currencies and for most of all the other cross-rates between the major currencies.

A combination of macroeconomic factors were widely cited by market participants as having contributed to the temporary misalignment of the major currencies in early 1995. These include the effects of the Mexican crisis; diminished expectations of further U.S. interest rate increases in response to signs of a slowdown in U.S. economic growth: the persistence of the U.S. current account deficit and the Japanese current account surplus; an intensification of U.S. Japan trade tensions: and a shift by Japanese investors away from dollar-denominated assets.

Despite these macroeconomic explanations, some market participants nevertheless did not believe that the dollar’s decline against the yen in March and April 1995 was entirely consistent with existing fundamentals. Instead, short-term trading conditions and the impact of the use of derivatives were frequently cited as factors contributing to the appreciation of the yen against the dollar. One factor that was widely cited at the time as having contributed to volatility in the dollar-yen exchange rate is the role of so-called knock-out options—options (in this case European-style options) that are used to hedge against moderate fluctuations in exchange rates but not extraordinarily large movements, and that are canceled when spot rates reach a specified knock-out level.3 Such options have gained in popularity because the knock-out feature makes them relatively inexpensive. It is thought that under market conditions similar to those present in early March 1995. these options contracts can exert a disproportionate influence on the underlying exchange rate. Market participants confirmed that large volumes of knockout options were purchased, largely by Japanese corporations, during the previous 12 months to partially hedge the yen value of expected dollar receivables against the possibility of a further modest appreciation of the yen. In such a scenario, a corporation would pay a fee up front for the right to sell dollars against yen, at say ¥90. and also specify that in the unlikely event the yen appreciates all the way to say ¥85, the option would be knocked out: the option would then become useless to the corporation, while the options dealer would earn the full premium.

Chart 14.
Chart 14.

Major European Countries: Local Currency vis-à-vis Deutsche Mark, January 3, 1994-May 31, 1996

Source: Bloomberg Financial Markets.

Market reports suggested that by late February 1995, the major dealers had accumulated on their books a substantial quantity of options with knock-out values somewhere between ¥90 and ¥80.4 To the extent that dealers can have an influence on the market, as the yen was appreciating in early March they had an incentive to push the value of the yen up through the knock-out levels and thereby eliminate their obligations under the options contract.5 Additional downward pressure on the dollar would also have come from those dealers who had dynamically hedged these contracts, and who then would have had positions requiring the sale of dollars after the knock-out level had been reached.6 Further downward pressure would have been created by the original customers who became exposed to an appreciating yen as the knock-out level was approached and their currency-risk protection removed. They, too. would be inclined to purchase more dollar put options or to sell dollars. It is believed by market participants that under the circumstances prevailing at the lime—a bunching of limit orders, spot prices approaching the knock-out levels, and momentum from technical analysis—trading by major dealers can influence the spot exchange rate for a short period around a specific knock-out value. This, perhaps, provided additional pressure on the exchange rate to move to the next lower knock-out value, and so on.

Although there seems to be a consensus that something like the scenario just described actually occurred, there still is considerable uncertainty among market participants and observers about the quantitative impact of these options on the dollar-yen spot rate in March and April 1995. Nevertheless, and despite the fact that there is no way of measuring the precise impact, market participants generally believe that these instruments had some influence on currency options markets. For example, prices of options, expressed in terms of the implied spot price volatility associated with them, doubled within the four trading days from March 2 to March 7. 1995. What appears to be clear is that short-term trading conditions and other technical market factors can have some influence, albeit this is difficult to measure, on underlying asset prices. Thus, along with other macroeconomic factors, trading conditions may have helped to raise the value of the yen against the dollar in early 1995.

In the event, the dollar depreciation was reversed in August and September 1995, reflecting coordinated exchange market intervention by the major central banks, the easing of interest rates in Japan and Germany, and the release of economic indicators that suggested to market participants that a higher value of the dollar against the yen and deutsche mark was appropriate (Chart 15).7 According to market participants, the recovery of the dollar since September 1995 owes much to the resolve of the major central banks, especially the Bank of Japan, to reverse the appreciation of the dollar. Many observers have credited the stability of the yen-dollar rate since late 1995 to the Bank of Japan’s foreign exchange intervention operations, which are considered to have effectively put a floor under the dollar of about ¥105. These views are reflected, for example, in the yen-dollar yield curve arbitrage positions that U.S. hedge funds built up in late 1995.

The dollar’s recovery in August and September 1995 removed much of the volatility that was present in financial markets early in the year. Lower volatility, in turn, eliminated some of the motivations for speculative trading and for hedging, and this led to a reduction in trading volumes in foreign-exchange-related derivatives markets. Worldwide turnover of exchange-traded currency futures and options rose by almost 27 million contracts in the first half of 1995 (an increase of more than 78 percent), which then eased back to an increase of only 3.6 million contracts (or 6 percent) in the second half of the year.8

Chart 15.
Chart 15.

Major Industrial Countries: Official Interest Rate, January 3, 1994-May 31, 1996

Source: Bloomberg Financial Markets.

Against this background of reduced uncertainty and lower volatility, a number of country-specific factors affected selected currencies: examples include the sharp volatility associated with the Quebec referendum in late October in Canada and the “speculative attack” on the French franc by U.S. hedge funds in early October.9

By the end of the 1995, the dollar had regained all of its losses against the yen, reaching ¥104, hut only part of the loss against the deutsche mark, ending the year at DM 1.44. In early 1996, concerns that the yen could again rise against the dollar led to a temporary increase in price and volume volatility in the yen-dollar market, and turnover on the derivative exchanges increased again. On the Tokyo International Financial Futures Exchange (TIFFE). turnover rose by 46 percent in January 1996 and 28 percent in February; on the London International Financial Futures Exchange (LIFFE) trading increased 89 percent in January and a further 22 percent in February; and turnover on the two big U.S. exchanges rose 32 percent (on the Chicago Board of Trade (CBOT)) and 8 percent (on the Chicago Mercantile Exchange (CME) in January and a further 8 percent and 13 percent, respectively, in February.

Three factors were cited by market participants as possibly influencing the yen-dollar rate in 1996. First, the repatriation of foreign investments by Japanese investors before the end of the fiscal year in March 1996 tended to strengthen the yen. Second, the record low (and near zero) short-term interest rates in Japan might have increased the probability of interest rate increases, which was perceived as possibly strengthening the value of the yen. Third, many market participants believed that an increase in short-term interest rates, or a strengthening of the yen, would spark a large sell-off in U.S. government bond markets and raise capital inflows to Japan, and attributed these possibilities to pressures associated with some large hedge funds covering their short yen positions.10 In part as a result of this increase in pressure and volatility in the yen-dollar market, the Bank of Japan intervened heavily in the foreign exchange markets, for the third time since the start of 1995 non-gold foreign exchange reserves of the Bank of Japan rose by $17 billion in February 1996 and by a further $4.3 billion by the end of April, pushing non-gold reserves from $125.8 billion at the end of 1994 to almost $205 billion.

Overall, the dollar’s recovery against the other major currencies and the associated marked reduction in market volatility since late 1995 has been sustained through the end of May 1996, even though there was some temporary uncertainty and volatility in the early part of the year. Between January and the end of May 1996. the dollar has appreciated by a further 5 percent against the yen and the deutsche mark, and most of the major European currencies, with the notable exception of the pound sterling, had fully recovered and appreciated slightly against the deutsche mark.

Although it is difficult to discern from market data how market participants view the future course of the major currencies, futures and forward market data provide some information about expectations. For most of the major currencies, there are no significant discounts or premiums over the next six months in futures and forward markets (Chart 16). At the end of May 1996, dollars could be bought against the yen and the deutsche mark for end-May 1997 delivery at about 5 percent and 2 percent, respectively, below the spot rate. For yen-dollar contracts two to five years forward, the forward discount on dollars is 10 percent for the end of May 1998 delivery, and this discount rises steadily to 20 percent five years forward. The forward price of dollars against deutsche mark reaches a maximum discount of about 6 percent four years forward. The discount on dollars observed in the forward yen market is consistent with the predictions of traditional interest rate parity conditions. Specifically, dollar interest rates are about 4 to 5 percentage points higher (per annum) than yen interest rates for instruments with maturities between one and five years. This suggests that over a five-year holding period, dollar-denominated instruments would yield about 20 percentage points more than yen-denominated instruments in the absence of any significant changes in the yen-dollar exchange rate.

Bond Markets

Bond markets rallied during the period from the end of 1994 through January 1996 after one of the largest bond market corrections in recent history (see Table 3 and Box 1). U.S. Treasury bonds recorded gains of 24 percent, and long-term bonds in most of the major industrial countries recorded gains in the range of 15-25 percent. In many cases, returns on bonds were well above returns on equities.

Interest Rates

Yield curves generally shifted downward in the major industrial countries throughout the period under review, reflecting reductions in official interest rates, indications of a “soft landing” of the U.S. economy, optimism about the prospects for U.S. budget deficit reductions, and disappointing economic growth in Europe and Japan (see Chart 3). During 1995, ten-year government bond yields fell by 225 basis points in the United States; 207 basis points in Canada; about 160 basis points in France, Germany, and Italy; 140 basis points in the United Kingdom; and 130 basis points in Japan (see Chart 4). At their low points in January 1996. long-term interest rates in the United States were at their lowest levels in more than a decade. Short-term interest rates also declined in 1995, but with greater variation across countries than was the case for long-term rates (Chart 17). Since the beginning of 1996, although short-term interest rates have continued to decline, long-term rates have risen. Consequently, yield curves have steepened in most countries since early 1996 (Chart 18; see also Chart 3).

The general optimism over inflation and cyclical factors that lifted bond prices in 1995 began to fade in early 1996, particularly in the United States, as concerns surfaced that inflationary pressures were rising in the United States. Market participants focused more intensely on these concerns when Federal Reserve Chairman Alan Greenspan observed in his remarks to the House Banking

Committee on February 20, 1996 that the U.S. economy had strengthened beyond earlier expectations. Shortly after these remarks, ten-year U.S. Treasury bond yields increased by 25 basis points on top of the 25-basis-point rise that had accumulated since yields bottomed out in January 1996. Bond market volatility more that doubled in the United States and Canada between mid-February and mid-March, and increased sharply in all of the other major countries (Chart 19). Market participants generally perceived the March 8, 1996 release of U.S. nonfarm payroll data and the March employment report released on April 5, 1996 as confirming that the U.S. growth had increased, and this together with a general feeling of disappointment about the inability to achieve a U.S. budget deficit reduction added further momentum to the downward pressures on bond prices. Between March 7 and April 8. 1996. the ten-year Treasury bond yield increased by 53 basis points, and the Dow Jones Industrial Average dropped 171 points (about 3 percent) on March 8, 1996 alone. Bond and stock markets around the world recorded smaller but significant declines. In the first four months of 1996. the ten-year Treasury yield rose by 125 basis points, reversing more than half of the interest rate decline that occurred in 1995.

Chart 16.
Chart 16.

Spot and Forward Rates for Currencies of Major Industrial Countries Against the U.S. dollar, May 31, 1996

Source: Bloomberg Financial Markets.Note: Data shown are bid rates. An increase means an appreciation of the U.S. dollar.
Chart 17.
Chart 17.

Major Industrial Countries: Short-Term Interest Rates 1

(In percent a year)

Sources: International Monetary Fund and Bloomberg Financial Markets.1 Three-month certificate of deposit rates for the United States and Japan; three-month treasury bill rate for Italy; rate on three-month prime corporate paper for Canada; and three-month interbank deposit rates for other countries. Weekly averages of daily observations are plotted for all countries other than Italy and Canada. For Italy, results of fortnightly treasury bill auctions are shown. For Canada weekly observations are plotted.2 1987 GDP weights.

The market conditions that led to the rise in interest rates in February 1996 raised concerns that global bond markets might experience another period of turbulence similar to that of early 1994.11

These concerns were related to perceptions that there were close parallels between the conditions in bond markets in 1993-94 and in 1995-96. First, market analysts noted that the rallies in U.S. bond markets (and other bond markets) in both periods were strong and that the rally was in fact greater in 1995 than in 1993: bond yields declined by more than 200 basis points in 1995, whereas they declined by about 150 basis points in 1993. Second, during both rallies, long-term interest rates declined below 6 percent. Third, the level of activity in derivatives markets rose sharply as the bond market rally in 1993 came to an end. in part because the demand for hedging instruments tends to be highly correlated with increased uncertainty, which often is associated with greater volatility. In the early months of 1996 there were near-record turnover volumes on the major derivatives exchanges, and swaps dealers reported near-record flows. These similarities led market observers to believe that the U.S. bond market was poised for a correction

Chart 18.
Chart 18.
Chart 18.

Major Industrial Countries: Differentials Between Long- and Short-Term Interest Rates 1

(In percent a year)

Sources: Financial Times, Nihon Keizai Shimbun, International Monetary Fund, and Bloomberg Financial Markets.1 The chart shows, for each country, the difference between the long-term rate shown in Chart 4 and the shortterm rate shown in Chart 17, except that for the United States three-month treasury bill rates are used as shortterm rates.
Chart 19.
Chart 19.

RiskMetrics Daily Price Volatility for Ten-Year Government Bonds, January 19, 1995-May 31, 1996

(In percent)

Source: J.P. Morgan.

Causes of Recent Swings in Bond Yields

Recent years have seen sharp swings in bond yields, with yields on U.S. ten-year government bonds tailing to 5.2 percent in October 1993, then rising to a peak of 8.0 percent in November 1994, falling back down to 5.5 percent in January 1996. before rising again in recent months. Similar swings have been experienced in many other countries. By historical standards, recent volatility in bond yields—measured by the standard deviation of daily changes in bond yields—has been substantial, but not extraordinary. The chart shows that volatility in long-term U.S. dollar rates during several past episodes, most recently in 1987, exceeded that of recent years, and that these were most volatile in 1979. German interest rate volatility peaked in 1986, and volatility for other currencies peaked in 1987. around the time of the stock market crash, which also led to a period of increased stock market volatility (see Borio and McCauley (1995)).

Insight into the causes of bond market volatility can be obtained by decomposing bond yields in two different ways. The first decomposition makes use of the Fisher equation, which expresses changes in nominal interest rates as the sum of changes in real interest rates and changes in expected inflation. In general, neither real interest rates nor market inflation expectations can be directly observed.

However, reported inflation forecasts do not appear to have varied substantially in most countries since the beginning of 1993. Revisions in intlation forecasts in the World Eco-nomic Outlook, for example, have been quite small for most of the major industrial countries (see Table A). Recent bond market swings would therefore appear to be due primarily to fluctuations in real long-term interest rates, not to changes in inflation expectations. Borio and McCauley (1995) present evidence that the volatility of month to month revisions in inflation forecasts does not seem correlated with changes in bond yield volatility.

bx01fig01

U.S. Long-Term Bond Yield Volatility

Source: IMF staff calculations from The WEFA Group data.Note: Annualized standard deviation of daily percentage changes during calendar months of the yield on the ten-year constant maturity Treasury bond.

The other useful decomposition of long-term interest rates employs the concept of forward interest rates, which are the hypothetical future short-term interest rates that make a series of short-term fixed income investments yield the same return as a long-term bond. These forward interest rates can provide an indication of expected future short-term interest rates, with the caveat that this abstracts from possible risk premiums in long-term rates. For U.S. rates over the last four years, current short-term interest rates and near-term forward rates have been substantially more volatile than more distant forward rates (see Table B). This indicates that fluctuations in current and near-term expected short-term interest rates have been more responsible for swings in bond yields than have expected short-term rates further in the future.

Table A.

World Economic Outlook Consumer Price Index Inflation Forecasts1

(Annual fourth quarter to fourth quarter percent change)

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Source: International Monetary Fund. World Economic Outlook, various issues

The period under each country indicates the corresponding World Economic Outlook publication.

Taken together, these decompositions indicate that fluctuations in real short-term interest rates have been responsible for much of the fluctuations in bond yields in recent years. One scenario consistent with this story is the possibility that central banks in major industrial countries aim for low, stable rates of inflation. When there are signs of incipient increased or decreased inflationary pressures, central banks adjust short-term interest rates before these pressures affect inflation. Long-term rates also change, as current and expected near-term short rates change, in order to preserve relative expected returns. A proximate cause of the bond market turbulence in February and March 1994, analyzed in International Monetary Fund (1994), was revisions in prospects for short-term interest rates in major industrial countries. This interacted with the highly leveraged positions taken by some market participants to produce high volatility. The message of the discussion above is that the biggest component of these swings in bond yields seems to be changes in short-term real interest rates rather than revisions of inflation expectations or of future expected short-term interest rates. Furthermore, while the ability of market participants to take highly leveraged bond market positions has increased over recent years, the concurrent bond market volatility is not without historical precedent, indicating that new financial techniques and instruments are not themselves responsible for the recent swings in bond yields.

Table B.

Changes in 12-Month Spot and Forward U.S. Dollar Interest Rates, 1993-95

(Average absolute value of annual interest rate changes)

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Source: IMF staff calculations based on data from Bloomberg Financial Markets.Note: Spot and forward interest rate data are based on swap yield curves. All data are based on three annual changes in percentage points (average absolute value of changes). Constant position on forward yield curve: year 2. for example, is the average of changes between 1994 forward at end-1992. 1995 forward at end-1993, 1996 forward at end-1994. and 1997 forward at end-1995. Constant calendar year uses forward for same calendar year (for example. 1996) for end-1992 through end-1995 yield curves.

Despite the close parallels between these two episodes, there were other factors counterbalancing the concerns about a correction that apparently made a repeal of the 1994 experience unlikely, even in the event of another increase in U.S. rates. One such factor was the gradual increase in the slope of the U.S. yield curve in December 1995 and again since February 1996. which relieved market pressures. This reduced pressure was reflected in current and implied forward yield curves as constructed from interest rate swap data (Chart 20).12 These yield curves suggest that long rates contain little immediate upward momentum, an implication that is consistent with futures market quotes for the future delivery of long-term bonds. They also imply that markets anticipate further increases in short-term interest rates in 1997.

Another counterbalancing factor was that market volatility began to subside in March 1996. as the level of activity in derivatives markets declined sharply. Market turnover declined by 26 percent on TIFFE. 22 percent on LIFFE, and 13 percent on the CBOT, and it rose only modestly by 8 percent on the CME. A third factor was that, despite the rise in bond yields, there was in early 1996 a considerably smaller volume of proprietary trading and a lower degree of leveraging than was observed during the bond market rally in 1993. Because of the relatively steep U.S. yield curve in 1993, it had been common for investors to finance long Treasury positions with short-term dollar borrowing. When the Federal Reserve began to tighten monetary policy in February 1994. investors covered their short positions, and this exacerbated selling pressures in the long-bond market and magnified the correction in bond markets. En contrast, since early 1995, the U.S. yield curve has been much flatter than it was in early 1994 (see Chart 18). At the same time, hedge funds—which experienced losses from leveraged yield curve plays in 1994—have reportedly turned their attention since then toward arbitrage plays rather than leveraged directional plays.

Another possible reason why a major bond market correction did not occur is that macroeconomic conditions in many industrial countries—notably in Europe—are generally perceived to be inconsistent with substantial increases in interest rates. This might explain why there has been a “decoupling” of the other major bond markets from the U.S. bond market. More specifically, while the ten-year Treasury yield increased by 128 basis points in the first four months of 1996, interest rates on comparable government securities in the other major industrial countries have increased by considerably less. U.K. ten-year interest rates have displayed the highest correlation with U.S. interest rates in 1996, increasing by about 57 percent of the increase in U.S. rates. Canadian rates increased about 50 percent of U.S. rates, German long rates increased by 37 percent of U.S. rates, Japanese rates rose only 5 percent of U.S. rates, and French and Italian rates actually fell quite sharply during this period—by more than 100 basis points in the case of Italy. It is likely that a root cause of this decoupling is the decoupling of the business cycles in the United Stales. Canada, and the United Kingdom on the one hand, and continental Europe and Japan on the other hand.

These differences in macroeconomic conditions are reflected in forward yield curves (see Chart 20). According to these yield curves, short-term interest rates are expected to rise sharply in all the major industrial countries during the second half of 1996 and through 1997, with the notable exception of Italy, where a decline is expected. At the long end of the yield curves, the expectation is that there is more room for rates to rise in Germany and Japan than in the United States. With the Japanese economy appearing to have begun to recover from the 1991-95 recession, the markets might he anticipating Inline interest rate increases in 1996 and 1997. The strength of the yen in late April and May 1996 might have reflected such expectations of higher interest rates. However, the Japanese yield curve has shown little sensitivity to these expectations or to the recent increase in yields in the United States. One often-cited interpretation of the Japanese yield curve is that market participants perceive the possibility that a major rebalancing of portfolios may result from a decision to raise interest rates in Japan.

The German yield curve has also attracted considerable attention. The steepness of the German yield curve compared to other Group of Seven countries (see Charts 3 and 18) has been explained by market participants and authorities in various countries as being due in part to a so-called EMU premium of about 50-100 basis points in long-term rates.13 If this reasoning is valid, then there should also be “EMU discounts” in long-term bonds issued by those European Union countries that generally have “weaker” currencies and that may participate in EMU.

There does appear to have been some degree of convergence in interest rates in Europe after the first quarter of 1995, although in many cases spreads are wider than they were in early 1994 (see Chart 5). Since their peaks in 1995, spreads on ten-year bonds have narrowed in France from 101 basis points to 2 basis points by the end of May 1996; Belgian spreads have narrowed from 91 to 25 basis points; Spanish spreads fell from 528 to 267 basis points; Swedish spreads have narrowed from 444 basis points to 203 basis points; and Italian spreads narrowed from 602 to 292. In contrast, U.K. spreads have widened from 140 basis points to about 165 basis points over the same period. Market participants and officials in many countries attribute this convergence to expectations of EMU, to a reversal of the “flight to quality” following the Mexican crisis, and to country-specific factors. The narrowing of Italian spreads, for example, is due largely to a reversal of the increase that followed the Mexican crisis as well as to the announcement that the withholding tax on Italian government securities would be eliminated for most foreign investors.

Yield curves are also substantially steeper in those European Union countries that are generally considered to be able to meet the criteria to participate in EMU than they are in countries for which there is more uncertainty about their eligibility to participate. Specifically, the one- to ten-year spread along swap yield curves at the end of May 1996 for the French franc was about 275 basis points; more than 355 basis points for the deutsche mark, the Belgian franc, and the Netherlands guilder; about 195 basis points for the pound sterling; 95 basis points for the Italian lira; 195 basis points for the Spanish peseta; and 285 basis points for the Swedish krona (see Chart 6). Some have concluded that the countries with the steeper yield curves contain an EMU premium, while the others contain an EMU discount, and this therefore might help explain the convergence in yields that was discussed above.

If the market believes the Maastricht criteria will be enforced strictly, then with the introduction of a common currency in participant countries, the yields on these countries’ government bonds should converge—the Maastricht criteria would effectively ensure that the differences in default risk would be minimal. At the end of May 1996, the actual swap curve produces the following five-year yield spreads over deutsche mark five-year swaps: -15 basis points for the Netherlands guilder, about 5 basis points for the Belgian and French francs, 225 basis points for the Italian lira, 210 basis points for the pound sterling, 290 basis points for the Spanish peseta, and 246 basis points for the Swedish krona (see Chart 6). In January 1999, the implied forward yield curve spreads are roughly unchanged for the French and Belgian francs and the

Netherlands guilder, and they narrow by 60-85 basis points for the pound sterling, the krona, and the peseta, and by 20 basis points for the lira. Looking out an additional two years to January 2001, these spreads narrow again, by about 20 basis points for the pound sterling, the lira, the krona, and the peseta.

In sum, the evidence suggests that there has been some narrowing in yield spreads over German interest rates since early 1995. It is difficult, however, to identify precisely the component that can be attributed to EMU. Forward yield curves suggest that, even for those countries that currently have high interest rates relative to deutsche mark rates, the market anticipates spreads to continue to converge over the next three—five years.

Volume of New Issues

The year 1995 set a record for annual issues in international bond markets. Net issues by public and private sector entities totaled $313.2 billion, pushing the stock of international bonds up by 15 percent to $2.8 trillion (Tables 6 and 7).14 About one quarter of the stock of international debt securities at the end of 1995 were issued by public sector entities, and new issues by the public sector in 1995 accounted for 23 percent of all new issues. At the same time, the industrial country share of total international bonds issued increased from 81 percent in 1994 to 84 percent in 1995. More than 90 percent of the increase in issuance activity occurred in the second half of 1995. In the first half of the year, the fallout of the Mexican crisis limited the access of many developing countries to international bond markets. Similarly, the temporary misalignment of the major currencies increased exchange rate volatility and reduced swap spreads in the U.S. dollar sector, and thereby slowed the pace of industrial country net issues.

At least three factors appear to have supported the overall rise in issuance in 1995. First, sharp declines in interest rates throughout 1995 provided borrowers with the incentive to bring forward their funding schedules in order to lock in low fixed rates. Second, spreads on interest rate swaps encouraged high volumes of activity throughout the year, particularly in the five-year deutsche mark sector (Box 2). Third, there was strong demand for international bonds from retail investors in Japan and, to a lesser degree, in Belgium, Germany, Luxembourg, and Switzerland.

Tranches of several bond issues in the international markets were marketed in Japan to retail investors. International bond purchases (on the primary market) by Japanese retail investors are estimated to have been in the neighborhood of ¥4.0 trillion in 1995.15 Low interest rates in Japan on yen-denominated bank deposits and Japanese government bonds appears to be an important motivation for this strong demand. Early in the year, Japanese retail investors favored yen-denominated issues, but subsequently increased their demand for higher-yielding currencies, including the Australian dollar, the U.S. dollar, and the deutsche mark. The retail sector has also been attractive to issuers because yields are typically substantially lower on retail issues than on professionally targeted issues. For example, highly rated issues can often be brought to the retail market at a negative spread to sovereign issues, and many developing countries have been able to reduce their funding costs by more than 100 basis points with retail issues.16

Chart 20.
Chart 20.

Major Industrial Countries: Spot and Implied Forward Yield Curves, May 31, 1996, January 2, 1997, and January 2, 1998

(In percent)

Source: Bloomberg Financial Markets.Note: Forward yield curves are calculated from the implied forward rates in the spot interest rate swap curves.1 Except for Japan (January 6, 1997).
Table 6.

Net Issues of International Debt Securities by Nationality

(in billions of U.S. dollars)

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Source: Bank For International Settlements

The Bahamas, Bahrain, Bermuda, the Cayman islands, Hong Kong, the Netherlands Antilles, and Singapore.

Table 7.

Outstanding Amounts of International Debt Securities

(In billions of U.S. dollars)

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Source: Bank For International Settlements

The Bahamas, Bahrain, Bermuda, the Cayman Islands, Hong Kong, the Netherlands Antilles, aad Singapore.

Table 8.

Outstanding Amounts and Net Issues of International Debt Securities by Currency of Issue

(in billions of U.S. dollars)

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Source: Bank For International Settlements.

In the first quarter of 1996, issuance activity increased 100 percent above the level of activity recorded in early 1995. This essentially confirms the views expressed in market commentaries that the continued strength of refunding programs (including funding associated with mergers and acquisitions) in tandem with low interest rates will work in 1996 to increase new issues to another record level.17 Issuance activity was particularly strong in January as interest rates in the major countries continued to ease. It then slowed somewhat in February owing to the increase in U.S. interest rates, and subsequently bounced back sharply in March as rises in interest rates in other industrial countries did not match the rise in U.S. interest rates.

A recent development in international bond and note markets is that banks and other financial institutions have accounted for an increasing share of new issues, totaling about 60 percent of new issues in 1995 and more than 70 percent in the first quarter of 1996. Even though these institutions are flush with capital, many large international banks have been shifting away from traditional sources of funding and toward debt securities.18 German financial institutions have been particularly active fund-raisers in international markets in the 1990s, accounting for about one fourth of all international debt securities issued by financial institutions. In contrast, nonfinancial issuers have continued to withdraw from the international markets. An example of this withdrawal is evident among Japanese corporations, which recently have been deleveraging.

In the dollar sector of international markets, narrow swap spreads and the temporary misalignment of the major currencies in the first half of 1995 resulted in a much smaller share of new dollar issues—only 10 percent. The reversal of these factors by midyear led the dollar sector to regain its historically dominant position as the year progressed. By the fourth quarter of the year, the dollar sector bad captured 31 percent of net issues. In the first quarter of 1996, the dollar sector’s share of new issues has increased further (Table 8).

Since the early 1990s, the dollar sector has experienced a gradual decline in market share, while the yen and deutsche mark sectors have increased market shares. In 1995, the deutsche mark sector roughly doubled its average share of new issues to about 18 percent, as the dollar sector share declined to an annual average of 25 percent. Much of the strength of the deutsche mark sector was in the five-year maturity range, owing in part to favorable swap rates. The market share of the yen sector declined from 37 percent in 1994 to 33 percent in 1995, reflecting a sharp decline in market share in the final quarter of 1995. The yen sector captured only 14 percent of the market in the first quarter of 1996. Unfavorable swap rates and strong demand by Japanese investors for foreign currency bonds are reported to be the key factors behind this drop in market share.

While the volume of new issuance on the international markets has been impressive, these markets are comparatively small next to domestic bond markets. The outstanding amount of debt securities in OECD countries is almost ten times as large, standing at just over $24 trillion at the end of 1995 (Table 9), and the level of new issues ($1.7 trillion) in 1995 was five times larger in the domestic markets than in the international markets. The United States accounted for about $10.7 trillion of the total outstanding amount, with Japan and Germany accounting for about $5 trillion and $1.9 trillion, respectively. The United States also accounted for more than 45 percent of new issues in domestic debt securities markets in 1995. Although the domestic debt markets are much larger than the international market, they have grown more slowly in recent years, reflecting fiscal consolidation efforts in the industrial countries, which has slowed the rate of public issues. Overall, outstanding amounts in domestic bond markets have grown at an average rate of 9 percent over the past five years, compared with 12 percent for the international markets.

Table 9.

Domestic Debt Securities by Type, Sector, and Country of Issuer1

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Source: Bank for International Settlements

Organization for Economic Cooperation and Development member countries only, excluding Iceland and Turkey.

Across all OECD countries, public sector issuers accounted for 64 percent of outstanding domestic debt securities at the end of 1995, although this proportion varies widely across countries. In 1995. public sector issues accounted for 90 percent of all domestic debt securities in Canada, around 70 percent in Japan and the United Kingdom, 77 percent in Italy. 63 percent in the United States. 53 percent in France, and 47 percent in Germany. Public sector issuers accounted for a much smaller share of the international debt securities markets—24 percent at the end of 1995—than in domestic markets. Conversely, financial institutions account for 37 percent of debt on the international markets, but only 25 percent in domestic markets.

Equity Markets

Developments in the Major Markets

The same factors that boosted bond markets in 1995 and in early 1996—low inflationary pressures and continued easing of official interest rates—were instrumental in raising equity prices. Equity markets increased earlier in Canada, the United Kingdom, and the United States than in the oilier major industrial countries (see Chart 9) and the upward momentum in 1996 allowed these markets to post the largest gains in the period January 1995-May 31. 1996 (see Table 3). Mirroring the decoupling in global bond markets, this upward momentum faded in interest rates rose in February 1996. Equity prices to most of the other major equity markets have moved higher since the beginning of 1996: in the first five months of 1996. the French, German, and Italian markets all rose more than 10 percent, and the Japanese market about half as much.

The magnitude of the rise in U.S. equity prices has attracted attention. At the end of 1994. the market capitalization of the three largest stock exchanges in the United States was $5.1 trillion.19 The roughly 40 percent rise in the broad market indices between the end of 1994 and the end of May 1996 translates into the creation of about $2 trillion in equity wealth. In contrast, most equity markets in continental Europe and Japan gathered momentum only later in 1995. In Japan, a more stable exchange rate and improved prospects for economic recovery led the Nikkei 225 index to be the top performer in the second half of 1995 among the Group of Seven countries, rising 37 percent in six months and recovering more than its losses from the first half of the year. This renewed interest in Japanese equities has been maintained in 1996: on April 22, the Nikkei 225 index broke through the psychologically important level of 22,000 for the first time in four years, rising 50 percent above its low point in 1995. French and Italian equity prices were held back for much of the year owing to political and fiscal concerns, but both markets have recovered in 1996 as these concerns have eased.

International Bond Issuance and the Swaps Market

A borrower that issues a bond assumes a particular currency and interest rate risk, which can be transformed into other currencies or interest rates through the use of interest rate and cross-currency swaps. A plain vanilla interest rate swap, in which the borrower agrees to pay a floating interest rate in return for receiving fixed interest payments, transforms a fixed-rate obligation into a floating-rate one. In a cross-currency swap, the original currency denomination can be redenominated into an exposure in another currency. Hence, swaps can be used to achieve a wide array of interest rate and currency exposures. Hence, a borrower with preference for a particular currency and interest rate risk can issue an obligation in almost any currency and interest rate market segment, and then use swaps to transform the risk according to these preferences. This allows borrowers to exploit markets that provide the lowest all-in cost of borrowing, factoring in the cash-flow on the swaps.

Consider, for example, a borrower faced with a choice between issuing floating-rate or fixed-rate obligations in the same currency, say dollars. Suppose this borrower prefers to end up with a floating-rate dollar liability. One option is to issue a floating-rate dollar liability paying a spread sL over the London interbank offered rate (LIBOR). Another option is to issue a fixed-rate bond paying rx and then enter into an interest rate swap in which the borrower receives a fixed-rate payment stream from, and pays a floating-rate payment stream to, a bank. Typically, the floating-rate side of the swap pays LIBOR, while the fixed-rate side is quoted at a spread, sx over the benchmark government bond yield, of the same currency and maturity, rG. The cost to the borrower of obtaining synthetic floating-rate financing is therefore the interest paid on the fixed-rate bond, minus the fixed-rate payment (sx + rG)received in the swap, plus LIBOR. If this is less than the rate the borrower can obtain directly on the floating rate market, that is, if rx-sx-rG<sL where the inequality compares spreads over LIBOR, then the borrower would prefer to issue the fixed-rate bond and swap into the floating-rate exposure. Alternatively stated, a borrower will issue fixed-rate bonds and swap into floating rates when the yield differential between its bonds and government bonds is less than the sum of the swap spread and the spread (over LIBOR) they would pay in the floating-rate market. In market parlance, this inequality indicates the existence of a “swap window.” The same inequality determines when a borrower who prefers a fixed-rate obligation will issue directly in the fixed-rate market rather than swap a floating-rate liability. Similar inequalities indicate when issuers would have a preference for issuing in different currencies and swapping into the preferred currency.

How do swap windows open? Rewriting the swap spread as the difference between the swap rate rs and the government bond rate rG and eliminating the government bond rate from the equation gives rx < rs + sL. While all three terms in this expression fluctuate, the term that probably varies the most is rx the interest rate on the fixed-rate bond issued by the borrower. This variation is due to simple supply and demand. As the supply of bonds in a particular currency and maturity range fluctuates, so does rx If the supply decreases, investors who have a preference for that currency and maturity bid up the price of the remaining bonds, driving down rx the yield on the bonds. The other terms in this equation, rs and sL tend to have more stable determinants. Since swaps can be hedged in the Eurocurrency futures market, at least imperfectly, and since swap dealers run swap books with many different contract maturities, the swap rate rs is more closely tied to swap rates for other maturities, and does not respond as much to fluctuations in the supply of bonds of a particular maturity. Instead the swap rate will likely be lied more closely to current and expected future short-term interest rates. The spread available to the borrower in the floating-rate market sL is a function primarily of the riskiness of that borrower’s credit, which also remains relatively stable over time.

A particular case illustrates the point. Chart A shows the deutsche mark swap and government bond yield curves on September i, 1995. The spread between the two rates widens discernibly at five years, creating a swap window at that maturity. This opportunity existed for most of 1995, and resulted in an increase in the issuance of deutsche mark bonds relative to bonds in other currencies. The swap window was created by a reduction in the issuance of five-year bonds from German issuers. In particular, the German federal agency Treuhandanstall went out of existence at the end of 1994: this agency had been a major issuer of five-year deutsche mark obligations.

Chart A.
Chart A.

Deutsche Mark Swap and German Government Bond Yield Curves, September 1, 1995

Source: Bloomberg Financial Markets.
Chart B.
Chart B.

Bond Issuance and Interest Rates

(Left scale in percent a year; right scale in billions of U.S. dollars)

Source: Bloomberg Financial Markets: International Monetary Fund, International Financial Statistics; Organization for Economic Cooperation and Development, International Capital Markets Statistics, 1950-1995; and The WEFA Group.

The foregoing describes a swap window opening in a particular segment of the international bond market. It is also sometimes asserted that swap conditions can be more favorable in the entire market than at other times, and that this drives issuance. In particular, when interest rates are expected to rise, swap rates tend to be driven up relative to other interest rates, perhaps because the for ward interest rates underlying swap rates reflect changes in expectations of future short-term interest rates. If bond yields are not tied as closely to short-term interest rate expectations as swap rates are, swap rates rise relative to other rates and it becomes more attractive to issue fixed rate bonds. This might he the case because changes in future short-term interest rates operate through changes in bank liquidity, and would be likely to show up most directly in interbank rates such as swap rates. On the other hand, as general market interest rates rise, the cost of borrowing (swapped or not) rises, and borrowers are likely to issue less debt. The time series of bond issuance and interest rate movements in Chart B suggests that this latter effect dominates. In years with rising interest rates (such as 1994), issuance volumes have tended to fall. The converse has also been true: between 1991 and 1993 interest rates fell, while bond issuance expanded. The swap spread has been relatively constant over this period. Furthermore, the growth of the swaps market since the mid 1980s has made it easier for borrowers to issue in currencies and interest rates different from their preferred habitat and then to use swaps to tailor their risk according to their preferences. This has allowed the range of currencies of denomination of international bonds to widen.

Low interest rates, low inflation, and improved earnings prospects have been the driving forces behind the recent buoyancy in industrial country equity markets. However, these factors alone probably do not explain the dramatic performance of the U.S. equity market. After the Mexican crisis, U.S. investors repatriated much of their foreign investments, and increased their focus on domestic markets.20 The associated increase in liquidity in U.S. markets appears to be an additional factor that pushed U.S. equity prices higher in 1995. Later in the year, and especially in early 1996. inflows into U.S. mutual funds helped to sustain this increased liquidity in U.S. equity markets. Over the past two and a half years, an average of $38 billion a month has been added to U.S. bond and equity mutual funds.21 Monthly inflows fell to below S30 billion by the end of 1994. but subsequently rose steadily. Inflows reached $42.5 billion in December 1995, and then increased to a record of more than $59 billion in January 1996, $52.9 billion in February, and $54.5 billion in Match. These inflows during December-March represent increases of 47, 86, 83, and 58 percent, respectively, over the same months a year earlier.22 More than half of the net inflows during this period have been directed toward equity mutual funds.

Inflows into U.S.-based mutual funds in late 1995 and early 1996 also boosted equity markets in other countries, particularly developing countries. Net sales of international equity mutual funds totaled about $11 billion in January-February 1996, well in excess of the total net inflows during all of 1995, and well on track to challenge the record-setting $27 billion in 1994. The magnitude of the portfolio flows from the United States to other equity and bond markets, in tandem with the infrastructure that has been assembled for exporting capital from the United Stales, has been shaping the behavior of bond and equity markets around the world.23

The concern most often expressed in market commentaries about global equity markets is that the U.S. market may be poised for a sharp correction. These concerns are predicated on several observations. First, the pessimism over inflation that has caused U.S. interest rates to rise has not had nearly the same impact on the equity market. The year-to-date value of transactions on the New York Stock Exchange (NYSE) reached $l trillion on March 26, 1996: in 1995 that volume of trading was not reached until May 12. Turnover has increased to 450 million shares a day in 1996, compared with 350 million shares a day in 1995 and 300 million shares a day in 1994. Second, the January-April period has in the past tended to see the greatest inflows into mutual funds, suggesting that the provision of liquidity from this source may decline in the rest of 1996. Third, equity price volatility in the United States has increased steadily since September 1995 (Chan 21). The unexpectedly high nonfarm payroll numbers released on March 8. for example, pushed the Dow Jones index to record its third largest one-day fall (3 percent) in its 67-year history, coming close to triggering the 250-point circuit breaker that would have shut down trading for the first time since the rule was implemented following the 1987 stock market crash.

Although most objective indicators of market direction and volatility suggest some mounting pressures on prices relative to fundamentals, these pressures do not appear to be unusually large. First, price-earnings ratios have increased from about 16 to 19 for the Standard and Poor’s 500 (S&P500) index since the end of 1994. In comparison, between January 1987 and October 1987, the price-earnings ratio for the S&.P 500 index increased from about 16 to 22—twice as large an increase as has occurred since the end of 1994. In addition, the level of the price-earnings ratio at the end of 1994 was a low point following its decline from about 26 in early 1992. Second, the earnings yield on U.S. stocks does not appear to have diverged from the yield on long-term bonds (see Chart 10 and Table 3).

The earnings yield has tracked the bond yield fairly closely over the past ten years, with abvious divergence occurring in mid-1987. The long-term bond yield in the United States has fallen sharply since the end of 1994. while earnings growth for U.S. equities has been strong. These two observations may be interpreted as suggesting that the dramatic stock market rally was necessary to align earnings yields with long-term bond yields in the United States. Third, implied volatility calculated from at-the-money futures call options indicate that volatility in the U.S. equity market may increase. However, when compared either to the other major countries or to historical levels, this increase is not particularly large (Chart 22).

Indicators of market sentiment also do not point to any significant departures between prices and fundamentals. In futures markets, December 1996 delivery Of the S&P 500 index was selling at the end of May for about 1 percent more than the current spot price. Furthermore, the ratio of put options to call options on the S&P 500 index—an indicator of short-to-long position taking—has shown little trend since the end of 1994. It has been widely reported that short interest in U.S. equities has risen to record levels in early 1996, which is often interpreted as an indicator of pessimism.24 These reports are difficult to interpret, however. First, the number of shares outstanding has a positive growth rate, and thus there is a natural tendency for short interest to rise. Indeed, the growth in short interest on the NYSE since the start of 1995—the start of the bull market—has been well below that in 1994, for example. Second, measured as a percentage of shares outstanding, the rise in short interest has not been dramatic, increasing to 1.4 percent in February 1996, from 1.3 percent during the previous three months.

Volume of New Issues

In sharp contrast to the international bond and syndicated credit markets, issuance activity in the international equity market declined by 9 percent in 1995, to $41 billion (Table 10). Privatizations historically have accounted for a significant portion of new issuance in the international equity market, in part because privatizations often are large issues relative to domestic equity markets, and the marketing and listing of these issues in more than one financial center can produce higher revenues and higher secondary market liquidity. The particularly weak investor sentiment for privatizations in 1995 and in early 1996 is the main reason for the sluggish primary market for international equities. For example, European countries’ privatizations in 1995, which have in recent years accounted for more than three quarters of all privatizations, amounted to only $24 billion, less than half of the estimated amount at the start of the year.25 Privatizations are reported to have slowed to a greater extent outside of Europe. For example, the $59 billion privatization of Indonesia’s PT Telkom was cut by half in the fall of 1995 because of weak demand from U.S. investors.

Chart 21.
Chart 21.

RiskMetrics Daily Volatility for Stock Price Indices, January 19, 1995-May 31, 1996

(In percent)

Source: J.P. Morgan.
Chart 22.
Chart 22.

Implied Volatility: S&P 500, Nikkei 225, and DAX Indices

Source: Bloomberg Financial Markets.Note: Implied volatility is a measure of the expected future volatility of the index based on market prices of the call options on futures on the index. The annualized percent rate of change plotted in the chart is a weighted average of the estimates of the implied volatility of call option futures.

Issuance activity in domestic equity markets in the major industrial countries has been mixed (Table 11). The sharp rise in U.S. equity prices helped to boost new issues in the U.S. markets by about 10 percent in 1995. but they remained below their levels in the early 1990s. Since early 1995, the most active segment of the U.S. market for new equity issues has been the market for initial public offerings from high-technology firms. More than 200 such firms went public in 1995. just under the record of 223 initial public offerings by high-technology companies in 1983.26 The sluggishness of the equity markets in the other major industrial countries is consistent with the less active new issue markets in these countries. In Japan, issuance activity by smaller companies on the over-the-counter (OTC) market—which is not included in the data in (see Chart 10 and Table 3).

Issuance activity in domestic equity markets in the major industrial countries has been mixed (Table 11—is reported to have been strong in 1995 and a substantial number of new issues in this market are expected in 1996. In Germany, equity issuance fell slightly in 1995, although 1994 was a strong year for new issues. The increased “equity habit” of investors and the shift by firms toward other sources of finance in Germany are important factors driving issuance activity. These same factors also figure prominently in explaining the high levels of new equity issues in Italy.

Table 10.

International Equity Placements1

(in millions of U.S. dollars)

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Source: Organization For Economic Cooperation and Development, Financial Market Trends, February 1996

Euro-equities plus other international share placements.

Regulatory and Structural Developments in Securities Markets

Perhaps the most noteworthy structural developments in securities markets in the past year have taken place in the United Kingdom. The Alternative Investment Market (AIM) was established on June 19. 1995 by the London Stock Exchange (LSE) to encourage initial public offerings by small and developing firms.27 This market has a lower level of regulation than the “first-tier” market and is targeted at professional investors. By the end of 1995, there were 121 companies listed on the AIM. over two thirds of which were simply transferred from the LSE’s so-called Rule 4.2 market, which has been a trading facility for unlisted shares.

Table 11.

Major Industrial Countries: Domestic Equity Issues1

(In millions of U.S. dollars)2

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Sources: Bank of Canada. Bank of Canada Review, various issues: International Monetary Fund. International Financial Statistics IIFS). and Organization for Economic Cooperation and Development. Financial Statistics Monthly, various issues.

Italy is not shown as consistent data for all years are not available

Local currency data are convened into U.S. dollars by using period average exchange rates from IFS (line rf).

First three quarters of data for 1995.

First two quarters of data for 1995

Contains both domestic and foreign equities.

The 1995 total is not comparable with totals for earlier years, since data are not available for the entire year for Canada, France, and Japan.

A second development in the United Kingdom is the implementation of the new trading service, Tradepoint, which began operations on September 21, 1995. Tradepoint is in direct competition with the LSE. but is itself not an exchange. The important difference, however, is that Tradepoint, unlike the LSE, is not a market-maker system, but rather is an automated, screen-based, order-matching trading system for 400 stocks—400 more are planned to be added in 199ft—that are listed on the LSE and is available to institutional investors to trade directly with each other. To date, trading on Tradepoint has been negligible.

There has also been much discussion recently of reforming the trading mechanism on the LSE. which appears to be related in part to competitive pressures associated with single market initiatives in the European Union (for example, the Investment Services Directive). The discussion has involved the trade-off between transparency and liquidity, the way in which private information is reflected in market prices, and whether the market-making trading system on the LSE is less efficient than an automated order-matching system, which has been adopted in virtually all competing European centers. It was announced in March 1996 that an order-driven electronic system will be introduced by May 1997 for a subset of equities listed on the LSE.

Developments in the U.K. government bond market—the “gills market”—have possibly been more substantial than in the equity market. The reform package for the gilts market has three elements. The first reform to be implemented was the introduction in 1995 of a preannounced auction calendar and maturity schedule. The second reform, implemented on January 2. 1996. is open gilt repo trading, referred to as the “most significant liberalisation in the gilt market since Big Bang.28 This liberalization means that “there will be no official restrictions on anyone repoing, lending or borrowing gills for any purpose, either directly or indirectly through an intermediary.”29 Previously, gilt repos were available only to Gilt Edged Market Makers (GEMMs), the authorized dealers of U.K. government bonds. The objective of this reform is to facilitate the financing of gilt holdings, thus increasing the liquidity and efficiency of the gilt market and lowering the government’s cost of funds. The third element of the gill market reform is that all returns on gilts will be taxable—formerly, only interest was taxed. This reform is designed to open the door to the introduction of a strips market in early 1997, which will further enhance the efficiency of the U.K. government bond market.30

The United Kingdom’s efforts at developing an equity market that smaller firms can tap for financing is a reflection of a Europe-wide initiative to develop equity markets similar to the NASDAQ market in the United States. In early 1996, the Nouveau Marche began operating in France as a subsidiary of the Paris Bourse and targeted at smaller firms throughout Europe.31 In Italy, preliminary approval from regulatory bodies has recently been granted for Metim, a stock exchange for smaller Italian firms.

In Japan, a number of important steps have been taken in recent months following up on the pledges contained in the financial services agreement reached with the United States in January 1995. First, The domestic bond market has been further deregulated, which has eased considerably issuance criteria for Japanese firms and for foreign entities (in the Samurai market). On January 1, 1996, the Japanese Ministry of Finance lifted the last important restrictions on the domestic bond market, removing the restrictions that the issuer had to have an investment grade rating and also removing stringent covenant requirements. Issuers now need not have ratings to issue in the domestic bond market. These liberalization measures are expected to lead to a flood of issuance in the domestic market by emerging market borrowers.

A second major development in Japan was the announcement in January 1996 of the introduction of an asset-backed securities (ABS) market before the end of the fiscal year (the end of March 1996). ABS markets have been particularly successful in the United States in transferring assets from balance sheets of financial institutions and corporations to securities markets. Some market participants in Japan believe that an ABS market may facilitate the resolution of the banks’ bad loan problems, by allowing banks to repackage non-performing loans as asset-backed issues.32

On August 2, 1995, the Ministry of Finance announced measures to encourage overseas investments and loans by institutional investors as part of its efforts to stabilize the value of the yen. First, insurance companies were permitted to make foreign-currency-denominated loans.33 Second, the so-called 50 percent rule limiting the share that insurance companies could hold in yen-denominated syndicated loans was abolished. Third, the 90-day “lock-up” period before Japanese residents could purchase Euroyen bonds issued by nonresidents was removed. Fourth, the valuation methods for foreign bonds held by institutional investors was revised. U.S. Treasury bonds, which previously had to be valued at cost, can now be valued at either market value or cost—the same treatment accorded to Japanese government bonds. In addition, the so-called 15 percent rule, which previously required companies to mark to market their foreign currency assets when exchange rates moved by over 15 percent, was lifted and can now be applied at the discretion of individual companies. Finally, the regulation on foreign exchange positions imposed on authorized foreign exchange banks was eased to promote their investment in foreign-currency-denominated bonds.

It is not clear to what extent these restrictions were binding and what impact their liberalization has had on capital flows. Press reports, however, suggest that Japanese banks and other investors have stepped up their investment in Eurobonds following the casing of restrictions on bond purchases, but this may also reflect declines in Japanese interest rates. The removal of the 15 percent rule will likely imply smaller capital inflows to japan prior to the end of the fiscal year than has been the case in other years in which the exchange rate has moved by more than 15 percent.

An over-the-counter equity market for special rule issues was established in July 1995 in Japan to ease firms’ ability to raise capital. Companies reduced their minimum trading lots to make their stocks more attractive to retail investors. The ban on issuing commercial paper with maturities of two weeks or less was lifted in October 1995 to help firms procure short-term funds. As of January 1996. foreign companies that are more than three years old were able to apply for listings on the foreign section of the Tokyo Stock Exchange (previously, companies had to have been established for at least five years). In addition, nonrated issuers were permitted to issue unsecured straight bonds, convertible bonds, and bonds with equity warrants from January 1996; the lifting of this restriction expands the range of potential Samurai issuers, allowing borrowers such as Argentina. Brazil, Mexico, and Turkey to tap the Tokyo bond market.

In Germany the asset-backed market has also recently captured considerable attention. The market for pfandbriefe—bonds collateralized by mortgages or public sector loans—attracted international attention in 1995-96, Traditionally, the market has been domestically focused, but the increased appetite for deutsche mark-denominated securities along with efforts by German financial institutions to improve and internationalize the pfandbriefe market have resulted in a considerable increase in issuance activity in the market, and significant marketing to foreign investors. Issuance of pfandbriefe in 1995 reached a record DM 240 billion. About 70 percent of outstanding issues are backed by public sector loans, and the remaining 30 percent by mortgages. In early 1996, the first global pfandbriefe issue came to the market, with much of the issue sold to Asian and American investors.34

In May 1996, the United States Treasury announced plans to offer in flat ion-indexed bonds for the first time. Although the amounts and structure were not announced, the bonds are expected to have maturities between 10 and 30 years and to offer real returns of about 3 percent. Currently, the main issuers of inflation-indexed bonds are the United Kingdom ($57 billion, outstanding) and Israel ($25 billion, outstanding). Canada, Sweden, and Australia also issue indexed bonds. The appeal of indexed bonds is their potential to lower government borrowing costs, as they reduce the incentive of the government to levy an inflation tax. Indexed bonds are particularly attractive to risk-averse investors, such as pension funds, that are committed to making inflation-indexed payments. Furthermore, a secondary market for indexed-Iinked bonds can provide a reliable indicator of market expectations for inflation.

Derivatives Markets

Between the end of 1986 and the end of 1994, the total notional principal of outstanding exchange-traded derivative contracts—including interest rate futures and options, currency futures and options, and stock market index futures and options—grew at an annual average rate of 40 percent, from $0.6 trillion to $8.9 trillion (Table 12). In the same period, annual turnover rose from 3 15 million contracts to 1,142 million contracts (Table 13),

In 1995, the growth in exchange-traded derivatives markets slowed considerably, and there was a shift in product types toward simpler plain vanilla structures and away from more exotic option-related structures. The notional principal outstanding rose by less than 4 percent in 1995, and total global contract turnover on exchanges increased by only 6 percent over 1994. Contract turnover overstates the slowing of the growth of these markets, because of the high volume of activity on a newly reporting Brazilian exchange in which the notional amounts of contracts is substantially smaller than in the developed markets: measured in dollars of notional principal, turnover actually fell by more than 4 percent in 1995.

The reasons for these changes in the growth rate and product types are related. First, several major losses associated with highly leveraged derivative products—including those of Orange County, Proctor and Gamble, and Barings—caused many participants to shy away from derivatives, particularly from exotic, highly leveraged structures. The structured note market in the United States, for example, virtually collapsed in 1995, with most of the activity in this market accounted for by “simple” step-up notes with short maturities.35 Second, declining interest rates in several major industrial countries reduced the demand for interest rate hedging products, by far the largest segment of the derivative markets. The small rise in turnover of exchange-traded derivative contracts in 1995 was held back by a sharp drop in trading in interest rate futures and options, with a 12 percent contraction in turnover in this market segment in the fourth quarter alone. In fact, activity in interest rate derivatives was buoyed in Europe by political and economic uncertainty, but the slackening demand in the United States and elsewhere offset this.

Turnover data for early 1996 indicate that volumes have rebounded considerably in the major markets due to increased uncertainty surrounding EMU and interest rates. For example, in London, volumes on LIFFE increased by 89 percent in January 1996, by 22 percent in February, and then dropped back in March to the levels seen in January, Peak volumes on most of the major exchanges approached levels in February seen at their high in March 1994, following the global bond market correction.

Table 12.

Markets for Selected Derivative Financial Instruments: Notional Principal Amounts Outstanding

(In billions of U.S. dollars, end-year data)

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Source: Bank for International Settlements

Traded on the Chicago Mercantile Exchange-International Monetary Market (CME-lMM; Singapore International Monetary Exchange (S1MFX). London International Financial Futures Exchange (LIFFE). Tokyo International Financial Futures Exchange (TIFFE). and Sydney Futures Exchange (SFE).

Traded on the TIFFE and S1MEX.

Traded on the Marche a Terme International de France (MATIF) and LIFFE.

Traded on the Chicago Board of Trade (CBOT). LIFFE, Mid-America Commodity Exchange (MIDAM), New York Futures Exchange (NYFF) and Tokyo Stock Exchange (TSE),

Traded on the MATIF.

Traded on the TSE, LIFFE, and CBOT.

Traded on the LIFFE and the Deutsche Terminborse (DTB).

Calls plus puts.

OTC derivative markets continued to expand at a brisk pace in 1995 in comparison to the exchanges (Tables 14 and 15). The members of the International Swaps and Derivatives Association (ISDA) report that the notional principal of outstanding interest rate and currency swaps increased from $1.0 trillion at the end of 1987 to $15.2 trillion by the end of 1995. In addition, the total notional principal of OTC interest rate options—caps, collars, floors, and swaptions—-increased from $0.6 trillion at the end of 1990 to $3.7 trillion by the end of 1995. In total, the notional principal of outstanding OTC derivatives (as measured by the reports of the members of ISDA) at the end of 1995 was $18,9 trillion.

Because OTC markets are highly decentralized, the available information on the size of the global OTC derivative markets is limited. The information reported by the members of ISDA, for example, does not include transactions by nonmembers of ISDA, and it includes only interest rate and currency swaps as well as interest rate options, and so only provides a limited picture of the global OTC derivatives market.

In April 1995. the BIS coordinated the first ever survey by central banks in 26 countries of OTC and exchange-traded derivatives markets. This survey provides the most comprehensive accounting of the markets to date, capturing about 90 percent of the intermediaries active in the derivatives markets.36 The survey includes swaps, forwards, and options for currencies, interest rates, equities, and commodities. Moreover, the BIS survey includes many derivative positions that are not recorded in the ISDA survey, not only because the BIS survey captures more market participants and instruments but also because it reports many arm’s-length derivative contracts that are netted out in the ISDA sur-vey.37 The motivation for including these contracts in the BIS survey is that the survey is intended to measure the market size in contrast to the ISDA survey, which is concerned primarily with net risk exposures. The BIS survey is, therefore, a much better indicator of market size.

Table 13.

Annual Turnover in Derivative Financial Instruments Traded on Organized Exchanges Worldwide

(In millions of contracts traded)

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Source: Bank for International Settlements

Traded on the Chicago Mercantile Exchange-International Monetary Market (CME-IMM) Singapore International Monetary Exchange (S1MFX). London International Financial Futures Exchange (LIFFE). Tokyo International Financial Futures Exchange (TIFFE). and Sydney Futures Exchange (SFE).

Traded on the TIFFE and S1MEX.

Traded on the Marche a Terme International de France (MATIF) and LIFFE.

Traded on the Chicago Board of Trade (CBOT). LIFFE, Mid-America Commodity Exchange (MIDAM), New York Futures Exchange (NYFF) and Tokyo Stock Exchange (TSE),

Traded on the MATIF.

Traded on the TSE, LIFFE, and CBOT.

Traded on the LIFFE and the Deutsche Terminborse (DTB).

Calls plus puts.

The findings of the survey are striking. The estimated notional value of outstanding OTC foreign exchange, interest rate, equity, and commodity derivative contracts totaled $47.5 trillion (after adjusting for double counting and including estimated gaps in reporting) at the end of March 1995 (Table 16). About 98 percent of this total is accounted for by interest rate ($28.85 trillion) and currency derivatives ($17.7 trillion). The outstanding interest rate and currency swaps and options reported by ISDA dealers was $13.9 trillion in mid-1995, which captures just over a quarter of the global OTC derivative market.38

Table 14.

Notional Principal Value of Outstanding Interest Rate and Currency Swaps1

(In billions of U.S. dollars)

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Sources: Bank for International Settlements and International Swaps and Derivatives Association, Inc. (ISDA)

As of end of December.

Including international institutions.

Including others.

Adjusted for double counting as each currency swap involves two currencies

The replacement value of the estimated $47.5 trillion in contracts was about $2.2 trillion, or 5 percent, which provides a better perspective of the actual credit exposure of dealers in these markets. The credit exposure is even lower than these numbers suggest because of netting arrangements between dealers and the value of collateral.39 For example, for ISDA members, at the end of 1994 netting reduced the replacement value by 55 percent, and collateral reduced it by about another 4 percent of the original replacement costs.

After eliminating double counting, the BIS estimates total average daily turnover of interest rate and currency contracts at $880 billion in April 1995. about three quarters of which was accounted for by foreign exchange forward and swap transactions. About two thirds of transactions involved counterparties in different countries, which points to the globalization of the derivative markets.

In addition to OTC derivatives, intermediaries that were involved in the survey coordinated by the BIS reported that they held a further $16.6 trillion in notional principal of exchange-traded derivatives. This suggests a large scale of involvement by intermediaries in both OTC and exchange-traded derivatives markets, related to the motives that dealers in OTC markets have to lay off their net risk in exchange-traded markets. In aggregate, therefore, respondents to this survey revealed that they were involved in transactions representing more than twice the world GDP.

Underlying this rapid growth in derivative markets has been the increasing trend toward the globalization of derivative activities. It has been found that 55 percent of all outstanding OTC interest rate and currency derivatives has involved counterparties in different countries.40 At the end of 1987, interest rate swaps denominated in currencies other than the U.S. dollar represented about 21 percent of all interest rate swaps; by mid-1992, this share had expanded to more than 60 percent, and has been above 50 percent since then (Table 17). Associated with the volatility in the yen-dollar market in early 1995, yen-denominated interest rate and currency swaps outstanding increased by almost 50 percent in the first half of 1995.

The globalization of derivative markets is reflected also in the increasing interconnection among derivatives markets around the world. The proliferation of after-hours trading and cross-listing of products has moved the markets closer to becoming a 24-hour, global derivatives market.41 Derivatives products listed in a variety of other industrial countries (for example, Italy and Germany) are becoming directly tradable from the United Stales. Similarly, the Investment Services Directive, which came into force on January I, 1996 in the 15 European Union member countries, increases the scope for cross-border securities trading by, for example, requiring regulators to allow trading screens for one member country’s market to be placed in any other European Union country. This legislation is likely to have profound effects on the trading of all securities in the European Union, possibly leading to a single electronic trading system for all products offered in the member states.

Table 15.

New Interest Rate and Currency Swaps1

(In billions of U.S. dollars)

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Sources: Bank for International Settlements and Internalional Swaps and Derivatives Association, inc. (ISDA)

During the respective half of the year.

Including international institutions.

Including others.

Adjusted for double counting as each currency swap involves two currencies.