This year’s capital markets report reviews developments and trends in the mature and emerging capital markets and banking systems and examines two important policy challenges—the implications of European Economic and Monetary Union (EMU) for financial markets and the management of external liabilities of emerging market countries, A key development in the mature markets was the continued appreciation of the dollar, owing mainly to large capital flows into the onshore and offshore dollar markets and to the relatively strong performance of the United States economy vis-à-vis Europe and Japan. Many of the mature equity markets also advanced further, reaching record highs. In an environment of low inflation and stable growth, investors entered into a broad spectrum of debt markets in search of higher yields, thus contributing to the compression of interest rate spreads that was a prominent feature of most markets. Against the backdrop of continuing globalization of financial markets, a record net inflow into the emerging markets reinforced the compression of borrowing spreads and contributed to surges of activity in domestic securities markets. But this generally favorable financial environment was not without problems, as markets challenged the ability of authorities in some emerging market countries to maintain currency stability in the presence of external imbalances.
The first of the two major international policy challenges discussed in the report concerns the European Union (EU). EU countries are entering into the most significant international financial arrangement since Bretton Woods, the establishment of EMU. It will create a stateless currency, the euro, and a multinational central bank to manage it. As a catalyst for change, the euro can provide impetus to existing initiatives for transforming the nationally segmented European financial markets into one of the largest single-currency financial markets in the world. Such an outcome would secure many of the benefits promised years ago by Europe’s single-market initiatives. The opportunities are far reaching, but so too are the remaining institutional and financial challenges (see Chapter III).
The second policy challenge is the need for emerging and transition countries to better manage the risks associated with their external liabilities. The immediate cost savings of borrowing in foreign currencies at historically low interest rates has not always been met with an appropriate effort to assess and manage the currency and maturity risk of such borrowing. As more emerging market countries become closely integrated into the international financial system the problem of external debt management becomes more pressing (see Chapter V).
The report is followed by two groups of self-contained annexes that provide background material. In Part I, the first annex reviews recent developments in emerging capital markets and also examines recent pressures in selected foreign exchange markets. Annex II provides a survey of recent developments and trends in the mature international capital markets, including foreign exchange, credit, and derivative markets. Annex III is a survey of selected banking systems, focusing on the ongoing process of restructuring and consolidation, supervisory and regulatory developments, and banking system performance in both the mature and emerging market country banking systems.
Part II focuses on three issues. Annex IV examines the implications of EMU for capital markets. It first discusses the size of EU capital markets compared with those of the United States and Japan, and the potential international role of the euro. The annex also describes the institutional framework for cross-border payments, monetary policy, and banking supervision and market surveillance, and the potential implications of EMU for international securities markets and banking systems. Annex V discusses the problem of risk management of external sovereign liabilities. It draws on the experience of countries that have reformed debt management policies and outlines some broad principles for managing the risks inherent in sovereign liabilities, including currency, interest rate, and credit risks. Finally, Annex VI provides some historical perspective on capital flows to the emerging markets. It compares the nature and scale of recent capital flows with those of the gold standard period (1870–1914) and the 1920s, and examines factors that have influenced the scale, composition, and geographic distribution of capital flows to the emerging markets since the 1970s. This annex also reviews recent attempts to identify the key structural and cyclical developments and changes in international financial markets that best explain the resurgence of flows in the 1990s.