II Developments, Trends, and Issues in the Mature Financial Markets
Author: International Monetary Fund
Language:
English
Keywords:
WEFS; market; market dynamics; emerging market; market participant; market discipline; commercial paper; return on equity; deutsche mark; stock market index; fixed income; Stocks; Emerging and frontier financial markets; Currencies; Global; North America
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Abstract

During the last twelve months, mature markets have experienced severe turbulence.1 Following the crisis in Russia and amid news of difficulties at a major hedge fund (LTCM), these markets experienced volatility of a magnitude rarely seen; credit and liquidity spreads rose sharply in U.S. money and credit markets, major equity markets declined significantly, and the yen underwent the sharpest one-day adjustment against the dollar since the collapse of the Bretton Woods system.2 Mature markets rebounded fairly quickly, though U.S. credit spreads remain somewhat above precrisis levels. As the turbulence subsided, mature markets came to be predominantly influenced by domestic and regional conditions, against the background of a variety of important structural and conjunctural developments. The onset of European Economic and Monetary Union (EMU), the economic and financial difficulties in Japan, low and declining inflation, and the divergence of economic conditions and policies among the major countries have also importantly influenced financial markets. On balance, by end-June 1999, short-term interest rates were generally lower, long-term rates were mixed, equity prices were higher, and the dollar was mixed against the other major currencies compared with a year earlier.

During the last twelve months, mature markets have experienced severe turbulence.1 Following the crisis in Russia and amid news of difficulties at a major hedge fund (LTCM), these markets experienced volatility of a magnitude rarely seen; credit and liquidity spreads rose sharply in U.S. money and credit markets, major equity markets declined significantly, and the yen underwent the sharpest one-day adjustment against the dollar since the collapse of the Bretton Woods system.2 Mature markets rebounded fairly quickly, though U.S. credit spreads remain somewhat above precrisis levels. As the turbulence subsided, mature markets came to be predominantly influenced by domestic and regional conditions, against the background of a variety of important structural and conjunctural developments. The onset of European Economic and Monetary Union (EMU), the economic and financial difficulties in Japan, low and declining inflation, and the divergence of economic conditions and policies among the major countries have also importantly influenced financial markets. On balance, by end-June 1999, short-term interest rates were generally lower, long-term rates were mixed, equity prices were higher, and the dollar was mixed against the other major currencies compared with a year earlier.

The Mature Market Turbulence and Its Aftermath3

Run-Up to the Mature Market Turbulence

Until July 1998, the mature financial markets in the United States and Europe were generally buoyant, extending a period of several years during which spreads on a wide range of instruments narrowed and the price of credit risk was increasingly compressed (a process that was little affected by the Asian crisis).4 Government bond yields continued to decline, while equity prices recorded further strong gains—especially in continental Europe, where markets surged in a number of countries by 45–65 percent over end-1997 levels. Contributing to this buoyancy were very subdued inflation, solid domestic demand growth in most countries, and increased confidence in a successful launch of EMU. In addition, the mature financial markets were bolstered by a “flight to quality” as investors shifted funds away from Asia and some other emerging markets. Despite these generally favorable developments, there were some signs of a weakening in sentiment in the months leading up to July 1998. Major stock market indices in the United States and the United Kingdom continued to advance, but the gains were increasingly narrowly based, and market indices for “small cap” stocks (which had underperformed “large cap” stocks for some time) began to weaken. Also, yield spreads on below-investment-grade bonds in the United States began to widen by about 90 basis points from their historic lows of about 240 basis points in mid-1997 prior to the Asian crisis, probably owing to concerns about the advanced state of the business cycle and rising risks of an economic slowdown, and the effects of the Asian crisis on corporate earnings.5 In other countries, the equity market weakened in Japan, where domestic economic conditions continued to worsen, and also came under downward pressure in countries with strong trade links to Asia or heavy reliance on commodity exports (notably, Australia, Canada, New Zealand, and Norway); exchange rates weakened in a number of these countries as well.

In June and July, credit spreads widened further, and the boom in U.S. and European equity markets stalled. Spreads on lower-quality U.S. corporate bonds, which averaged about 300 basis points during the early 1990s, crept up from a low of about 250 basis points around the end of April to about 320 basis points in July.6 Spreads on investment-grade bonds widened more modestly. Equity markets in the United States and Europe generally peaked in mid-July. While it is difficult to identify a particular event that triggered the subsequent correction, several factors may have led investors to reassess the sustainability of historically high equity market valuations and compressed credit spreads. First, the negative effects of the Asian crisis on output growth and corporate earnings were becoming more visible, particularly in the United States. In addition, it was increasingly apparent that the contraction in the Asian emerging market economies was much deeper than initially expected, and that prospects for early recovery in Japan had diminished. Signs that the situation was deteriorating in Russia also contributed to concerns that the emerging market crisis might spread beyond Asia. Bank stocks were hit particularly hard, in part unwinding earlier sharp gains but also reflecting concerns about bank exposures to emerging markets (Figure 2.1).

Figure 2.1.
Figure 2.1.

Major Industrial Countries: Stock Market Price Indices, January 1, 1997–June 25, 19991

(National currency; week ending January 2, 1997 = 100)

Source: Bloomberg Financial Markets L.P.1 For United States, Standard & Poor’s 500 index; for Japan, Price Index of Tokyo Stock Exchange; for Germany, DAX 100 Index; for France, Societe des Bourses Francaises 250 Index; for Italy, Milan Stock Exchange MIB Telematico Index; for United Kingdom, Financial Times Stock Exchange All-Share Index; and for Canada, Toronto Stock Exchange 300 Composite Index.

Mature Market Turbulence

The situation deteriorated sharply in the second half of August as the devaluation and unilateral debt restructuring by Russia sparked a period of turmoil in mature markets that is virtually without precedent in the absence of a major inflationary or economic shock. Neither Russia’s relative importance in the world economy nor the size of bank exposures to Russia can fully explain the magnitude of the market movements that followed.7 The crisis in Russia sparked a broad-based reassessment and repricing of risk, especially regarding emerging market investments, and a large-scale portfolio rebalancing across a range of global financial markets. In subsequent weeks, conditions in many of the mature financial markets deteriorated sharply, increasing the pressures on financial institutions, including LTCM. The equity market sell-off intensified, largely wiping out the gains recorded earlier in the year. In the United States, equity markets bottomed out in late August, roughly 20 percent below their highs, while European markets continued to decline through the first half of October, falling on average by about 35 percent. At the same time, the decline in government bond yields accelerated, taking yields to their lowest levels since at least the mid-1960s and in some cases since World War II, as investors increasingly sought to shift funds into the safest and most liquid assets (Figure 2.2). In the six-week period between mid-August and early October, for example, government bond yields fell by about 70 basis points in Germany, 110 basis points in the United Kingdom, and 120 basis points in the United States, implying price gains in the range of 6–11 percent (equivalent to about 50 to 100 percent at an annual rate) for the benchmark 7-to 10-year bonds. Elsewhere in Europe, yield spreads over German rates widened to their highest levels of the year within the euro area (among both core and peripheral countries), and even more dramatically outside the prospective euro area, with spreads for Denmark and Sweden widening by 30–40 basis points in less than a month.

Figure 2.2.
Figure 2.2.

Major Industrial Countries: Nominal Interest Rates, January 1, 1997–June 30, 1999

(in percent)

Sources: WEFA; and Bloomberg Financial Markets L.P.1 Yields on government bonds with residual maturities of 10 years or nearest.2 Three-month maturities: treasury bill rates for United States and United Kingdom; interbank rate for Germany, France, Italy, and Canada; and deposit rate for Japan.

Corporate bond spreads widened more sharply starting in the second half of August, and in some instances, new debt issuance dropped off markedly (Figure 2.3; Table 2.1). Comprehensive data are most readily available for the United States, where the corporate bond market is relatively large and well developed (Figure 2.4). Yield spreads over U.S. treasury bonds for below-investment-grade bonds widened from about 375 basis points immediately before the Russian debt restructuring to almost 600 basis points by mid-October, the highest level since the collapse of the U.S. junk bond market at the beginning of the 1990s. For the most part, the rise in spreads on higher-grade credits reflected the fall in treasury bond yields rather than a rise in actual borrowing costs. However, below investment grade, the spread widening was also associated with a sharp increase in nominal yields, and the spread of below-investment-grade bonds over investment-grade bonds widened substantially (a similar increase in credit differentiation was observed in the commercial paper market). The volume of U.S. high-yield bonds issued in October fell to about $2 billion, compared with a monthly average of roughly $15 billion in the second quarter (a substantial though less pronounced drop-off was observed in the issuance of U.S. investment-grade bonds). Corporate bond spreads also appear to have widened in some European markets, though time-series data on these spreads are much more limited. For example, spreads on AA euro sterling bonds over U.K. gilts widened from about 90 basis points to 130 basis points during the same period.8 There were also reports that high-yield corporate bond issuance slowed sharply in continental Europe.

Figure 2.3.
Figure 2.3.

United States: Corporate Bond Market, January 1998–May 1999

Sources: Board of Governors of the Federal Reserve System; and Bloomberg Financial Markets L.P.1 Spreads against yields on 30-year U.S. government bonds.
Table 2.1.

Major Industrial Countries: Outstanding Amounts of Private Sector Domestic Debt Securities1

(In billions of U.S. dollars)

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Source: Bank for International Settlements.

Debt securities issued in domestic currency by residents of the country indicated. Includes short-term paper (e.g., commercial paper).

Figure 2.4.
Figure 2.4.

United States: Yields on Corporate and Treasury Bonds, January 3, 1964–June 25, 19991

Sources: Board of Governors of the Federal Reserve System; Bloomberg Financial Markets L.P.; and Merrill Lynch.1 Weekly data; the Moody’s ratings of corporate bonds are as shown in the panels. Yields on 30-year treasury bonds of constant maturities are used for the U.S. treasury bond. The shaded regions indicate resession periods.

Starting in August, the deteriorating conditions in long-term fixed income markets gave rise to concerns that a widespread “credit crunch” might materialize in the United States. In the event, firms in large measure were able to avoid financing difficulties by substituting other sources of finance for corporate bonds during the disruption.9 In August and September, some firms issued commercial paper to delay issuance of corporate bonds. Others took out bank loans, or drew on credit lines, notwithstanding some tightening of credit standards by banks (some firms drew on credit lines that had been extended and priced during more tranquil periods).

In September and early October, indications of heightened concern about liquidity and counterparty risk emerged in some of the world’s deepest financial markets. A key development was the news of difficulties in, and ultimately the near-failure of, a U.S. hedge fund—LTCM—which had large highly leveraged and complex positions across a broad range of markets, including over-the-counter (OTC) derivatives markets, and substantial links with a range of U.S. and European financial institutions. Although a private rescue of LTCM, organized with the help of the New York Federal Reserve Bank, was announced on September 23, the market reverberations intensified in the ensuing weeks as previous positions were unwound and as concerns increased about the extent to which other financial institutions might be in trouble or face a need to unload assets into illiquid markets at distressed prices.

In response to these developments and the rapid deleveraging, market volatility increased sharply, and there were some significant departures from normal pricing relationships among different asset classes.10 In the U.S. treasury market, for example, the spread between the yield on “on-the-run” and “off-the-run” treasuries widened from less than 10 basis points to about 15 basis points in the wake of the Russian debt restructuring, and to a peak of over 35 basis points in mid-October, suggesting that investors were placing an unusually large premium on the liquidity of the “on-the-run” issue (Figure 2.5).11 Spreads between yields in the euro dollar market and on U.S. treasury bills for similar maturities also widened to historically high levels, as did spreads between commercial paper and treasury bills and those between the fixed leg of fixed-for-floating interest rate swaps and government bond yields, pointing to heightened concerns about counterparty risk. Interest rate swap spreads widened in currencies including the U.S. dollar, deutsche mark, and pound sterling. In the U.K. money markets, the spread of sterling interbank rates over generalized collateral repo rates rose sharply during the fourth quarter, partly owing to concerns about liquidity and counterparty risk (and also reflecting a desire for end-of-year liquidity).12

Figure 2.5.
Figure 2.5.

United States: Developments in Fixed-Income Securities Markets, January 1, 1998–June 30, 1999

(In basis points)

Sources: Bloomberg Financial Markets L.P.; and Merrill Lynch.Note: The vertical lines represent the following: Russia = Russian debt moratorium (August 17, 1998); F1 = Federal Reserve interest rate cut (September 29, 1998); and F2 = Federal Reserve interest rate cut (October 15, 1998).1 Spread between yields on 3-month U.S. treasury repos and on 3-month U.S. treasury bill.2 Spread between yields on 90-day investment grade commercial paper and on 3-month U.S. treasury bill.3 Spread between 3-month U.S. dollar LIBOR and yield on 3-month treasury bill.4 Spread of 25-year U.S. treasury bond over a 30-year on-the-run U.S. treasury bond.5 Spread of fixed-rate leg of 10-year U.S. dollar interest rate swaps over yield on 10-year U.S. treasury bond.6 Spread over 30-year U.S. treasury bond.

Foreign exchange markets also experienced a bout of severe turbulence. Notwithstanding the growing current account imbalances, the U.S. dollar had continued to strengthen on a multilateral basis through mid-August, remaining relatively stable against major European currencies but rising further against the Japanese yen and currencies of the major commodity-exporting countries (Figure 2.6). As the emerging market crisis took on global dimensions, however, the dollar began to weaken amid increased concerns about the downside risks to U.S. growth and a shift in market expectations about the direction of U.S. monetary policy from modest tightening to significant easing.13 These developments, combined with signs in Japan of greater progress with long-awaited bank reform (discussed in Annex II) and additional moves there toward fiscal and monetary stimulus, significantly altered the balance of risks perceived by investors with yen-denominated exposures. The initial weakening of the dollar was relatively orderly; it fell by less than 10 percent against both the yen and the deutsche mark between mid-August and early October. However, the situation changed in the week beginning October 5 when the dollar fell by about 15 percent against the yen in the space of three days. including the largest one-day movement in the yen-dollar rate since the collapse of the Bretton Woods system. This latter adjustment mainly reflected a sharp general appreciation of the yen: the dollar declined by less than 2 percent against the deutsche mark over the same period (Figure 2.7). It also coincided with an unusually abrupt steepening of mature market yield curves outside Japan, as bond yields rose from their historic lows while short rates continued to fall. Over the same week, for example, the gap between 3-month and 10-year rates widened by about 85 basis points in the United States, 50 basis points in Germany, and 60 basis points in the United Kingdom.

Figure 2.6.
Figure 2.6.

Major Industrial Countries: Effective Exchange Rates, January 1991–May 1999

(Logarithmic scale; 1990 = 100)

1 Defined in terms of relative normalized unit labor costs in manufacturing, as estimated by the IMF’s Competitiveness Indicators System, using 1989–91 trade weights.2 Constructed using 1989—91 trade weights.
Figure 2.7.
Figure 2.7.

Selected Countries: Bilateral U.S. Dollar Exchange Rates, January 1, 1998–June 30, 1999

(Local currency units per U.S. dollar; logarithmic scale)

Source: Bloomberg Financial Markets L.P.

These dramatic moves in the yen-dollar rate and in major credit markets are difficult to explain in terms of shifts in economic fundamentals alone. Instead, the large price movements in foreign exchange and credit markets were a particularly visible manifestation of a global move by investors (including a number of HLIs) to close out open positions and reduce leverage in the wake of the heightened market turmoil. For example, the sharp rise in the yen against the dollar appears to have reflected a large-scale unwinding of yen-denominated exposures—the “yen carry trade”—the effects of which were amplified by technical factors linked to stop-loss orders and dynamic hedging strategies.14 Also, as securities prices fell, market participants with leveraged securities positions sold those and other securities to meet margin calls on those positions, adding to the decline in prices. The decline in prices and rise in market volatility also led arbitrageurs and market makers in the securities markets to cut positions and inventories and withdraw from market making, reducing liquidity in securities markets and exacerbating the decline in prices. In this environment, signs that pressures were building on LTCM, an important market maker and provider of liquidity in securities markets, and considerable uncertainty about how much an unwinding of positions by LTCM and similar institutions might contribute to selling pressure-fed concerns that the cycle of price declines and deleveraging might accelerate.15

In response to these developments, the U.S. Federal Reserve Board began to cut interest rates starting in late September. An initial cut of ¼ of 1 percentage point in the target federal funds rate was announced following the Federal Open Market Committee (FOMC) meeting on September 29 but failed to have a significant effect in calming markets; spreads continued to widen, equity markets fell further, and volatility continued to increase. Against this background, the Federal Reserve followed up on October 15 with ¼ of 1 percentage point cuts in both the federal funds target and the discount rate, a move that proved to be the key policy action that stemmed and ultimately helped reverse the deteriorating trend in market sentiment. The easing—coming so soon after the first rate cut and outside a regular FOMC meeting (the first such move since April 1994)—sent a clear signal that the U.S. monetary authorities were prepared to move aggressively if needed to ensure the normal functioning of financial markets. Elsewhere, the Bank of Japan reduced the guideline for the uncollateralized call rate by about 25 basis points to ¼ percent on September 9, and official interest rates have been reduced since late September in Australia, Canada, and Europe. Furthermore, EMU central banks indicated that central bank rates might converge at the levels prevailing in core countries. While these moves were motivated primarily by domestic considerations, they have also played a helpful role from a global perspective by contributing to the broad easing of monetary conditions in the industrial countries.

Starting in mid-October after the Federal Reserve’s second cut in interest rates, some calm began to return to money and credit markets. Money market spreads declined quickly to precrisis levels, while credit spreads declined more slowly and remained somewhat above precrisis levels, probably reflecting the deleveraging (a return to the highly compressed credit spreads that prevailed before the Russian crisis was probably neither likely nor desirable).16 Except for low-grade credits, actual borrowing costs in mature markets did not appear to have increased significantly during the episode and may even have declined for many borrowers during the latter part of 1998. Issuance of long-term debt began to recover, though in November surveys suggested that banks were tightening lending conditions and there were signs of a renewed rise in short-term spreads. The Federal Reserve cut both the federal funds target and the discount rate by ¼ of 1 percentage point at the FOMC meeting on November 17, noting that although financial market conditions had settled down materially since mid-October, unusual strains remained. Short-term spreads subsequently declined. The calming effect of the rate cuts suggested that the turbulence stemmed primarily from a sudden and sharp increase in pressures on (broadly defined) liquidity, including securities market liquidity, triggered by a reassessment of risk.

Developments in Money and Credit Markets Since the Turbulence

From November 1998, as the turbulence waned, U.S., European, and Japanese money and credit markets were predominantly influenced again by domestic and regional conditions, including continued strong growth in the United States, the EMU process in Europe, and weak economic growth, financial system difficulties, and policy responses in Japan.

Toward the end of 1998, as the effects of the turbulence waned and the flight to quality reversed, U.S. fixed-income markets turned their attention to the mounting pressures on Brazil. Market participants hedged or unloaded exposures well in advance, and in the event, the realignment and floating of the real during January 13–15 had little effect on long-term credit spreads or short-term money market spreads.17

It became increasingly clear in early 1999 that although credit risk had been repriced and credit differentiation had increased as a result of the turbulence, access of most U.S. firms to credit had not been permanently reduced.18 Spreads of high-yield and Baa-rated bonds over Aaa-rated bonds remained wide, though tiering (differentiation of credit risks) in the commercial paper market decreased. U.S. corporate bond spreads against U.S. treasuries and dollar swap spreads remained above precrisis levels; risk also appeared to have been repriced in deutsche mark and sterling swaps and U.K. corporate bonds.19 Despite the repricing of risk in U.S. markets, issuance of commercial paper and corporate bonds resumed apace, and bank lending expanded at rates similar to early 1998 (though there were some indications that terms of bank lending remained tighter than before the turbulence, and highyield issuance was less buoyant than in the first half of 1998).20

At the same time, economic data pointed to continued strong growth in the United States, and fixed-income yields began to reflect concerns that monetary policy might need to be tightened to contain the risk of inflation, particularly in view of the easing that had taken place during the second half of 1998. Between end-December 1998 and mid-May 1999, long-term interest rates rose strongly; indicators of the expected stance of monetary policy, such as the slope of the yield curve and the federal funds futures rate, increased as well. The FOMC adopted a tightening bias at its May 18 meeting, and yields subsequently rose further in anticipation that the FOMC would tighten policy following its end-June meetings. By mid-June 1999, the yield on the 30-year treasury bond had risen by about 100 basis points from its end-1998 level to just above 6 percent, and the federal fund futures rate implied about 60 basis points of tightening over the second half of 1999. On June 30, as had been widely anticipated, the FOMC raised the target for the federal funds rate by 25 basis points to 5 percent, and also removed its bias toward tightening; long-term treasury yields declined, and stocks rallied.21

European money and credit markets continued to be influenced by the convergence in euro-area policies and the planned introduction of the euro. The convergence in euro-area interest rates was only temporarily interrupted during the turbulence. Following the turbulence, the trend decline in euro-area government bond yields resumed. Spreads of euro-area government bonds against comparable German bond yields narrowed, even briefly turning negative for Italy. Short-term interest rates converged as well, and were closely aligned within the euro area by the end of the year.

The introduction of the euro was successful and smoother than some had expected. In January 1999, some minor “teething troubles” were experienced in the Trans-European Automated Real-Time Gross Settlement Express Transfer System (TARGET) payments system, as banks adapted to the new system, but were quickly resolved. There was also some volatility in overnight interest rates in the first few months of 1999, and the euro overnight index average (EONIA) declined to below the ECB’s refinancing rate in March, as banks adapted to the new arrangements for monetary policy operations.22 Overall, by May 1999, European money markets were transferring funds across countries and institutions with reasonable efficiency, as financial systems and institutions that had excess liquidity were able to supply it to those that needed liquidity. However, some features of the euro financial infrastructure continued to limit recourse to cross-border transactions, including swaps and repos. These features, in some cases deriving from the EMU financial structure, included differences in market structure (such as the extent of bilateral interbank credit lines), national differences in infrastructure (such as payments and security settlement systems), and national differences in policies (tax, legal, and regulatory environments, including differences in the legal treatment of repo operations).

Following the launch of EMU, euro-area government bond spreads against Germany were broadly stable until the second quarter, when government bond rates rose amid rising U.S. bond rates. Spreads for Spain, Portugal, and Italy widened amid signs of divergent economic conditions within the euro area and concerns about the relaxation of Italy’s deficit target. Apart from such considerations, remaining spreads have reflected a variety of factors, including differences in liquidity, perceived credit risk, trading conventions, and market infrastructure (including clearing and settlement systems) among countries.23

The September 1998 International Capital Markets report identified a number of remaining challenges for EMU authorities in the areas of financial crisis prevention and management, especially in light of the ongoing integration of European money and financial markets and banking system consolidation and restructuring. Since the publication of that report, there has been important progress toward meeting those challenges, including intensified efforts to enhance coordination and cooperation among European Union (EU) supervisors and regulators. First, the Banking Supervision Committee of the European Central Bank (ECB) supports the Eurosystem decision-making bodies in their supervisory tasks, and serves as a forum for the exchange of views on supervisory policies and practices that are not directly related to the tasks of the Eurosystem. Second, a discussion is ongoing on a possible further strengthening of multilateral cooperation and information sharing among supervisors. Moreover, the Banking Supervision Committee is focusing on the issue of cooperation between the Eurosystem and supervisory authorities in payment systems oversight. Third, a Commission Communication on an Action Plan for Financial Services was endorsed by the European Council in Cologne in June 1999. A key element of this action plan concerns the need to ensure that the EU supervisory and regulatory framework is appropriate for a single financial market. Concrete actions and an indicative timetable for implementation have been identified, and the Commission will pursue the plan with input from a high level group of representatives of finance ministers. This group has already served as a forum for the exchange of views on, inter alia, the issue of consolidated versus sectoral supervision, the appropriate relationship between central banks and supervisory authorities, the need for intensified cooperation among supervisory organizations, and the possible future need for some form of European-level supervision. Fourth, in February 1999, members of the Forum of European Securities Commissions signed a multilateral European memorandum of understanding on surveillance of securities activities.

In the area of crisis management, there has been agreement within the Eurosystem on responsibilities for emergency liquidity assistance. In the event of a liquidity problem involving an otherwise solvent institution, the provision of emergency liquidity assistance would be the responsibility and decision of the relevant national central bank. If and when this liquidity assistance might be large enough to have a monetary policy impact, it would entail consultation with the ECB and might also require a decision by the ESCB about whether such liquidity assistance should be provided. In this context, emergency liquidity assistance is defined as liquidity provided to an illiquid but not insolvent institution to contain any potential systemic risk or contagion if this were perceived to be a possibility. Regarding cases of solvency problems, ministers of finance, the European Commission, and the ECB have jointly begun to assess whether the current instruments and responsibilities would need to be adjusted for the EMU environment.

Japanese money and credit markets have been influenced by important policy measures to address banking system weakness and continuing macroeconomic difficulties, and by the acceleration of corporate restructuring efforts. Against this background, money and credit markets in Japan have increasingly diverged from international markets during the period under review.

Concerted efforts by the Bank of Japan to maintain monetary and financial stability caused short-term interest rates to decline sharply; overnight rates declined to virtually zero. In the second half of 1998, the overnight call rate fell steeply to about 25 basis points as domestic economic activity slowed and the Bank of Japan eased monetary policy. (Some international banks were reportedly quoting negative yen-LIBOR (London interbank offered rate) rates in November 1998.) The Bank of Japan eased further in February 1999, and announced that it would “encourage the uncollateralized overnight call rate to move as low as possible.” The overnight call rate subsequently declined to 3 basis points, essentially zero net of brokerage fees. The low rate of remuneration on call money led to a shift of funds from call money to bank deposits, and the call money market contracted sharply.24 Liquidity pressures eased considerably, as onshore funding spreads declined and the Japan premium fell steeply to around zero.25

During the period under review, supply and demand shifts in the Japanese government bond (JGB) market gave rise to considerable volatility in JGB yields. A strong increase in demand drove yields on 10-year JGBs from about 160 basis points at end-June to about 80 basis points in mid-November, amid repatriation of funds and heightened concerns about the domestic economic situation and problems in the banking system. Subsequent concerns that expansionary fiscal policy would strongly boost the supply of JGBs and that support of the market by the Trust Fund Bureau might be cut back sharply contributed to a sharp rebound in JGB yields, which reached about 225 basis points in December. Later, suggestions (and in March 1999, official confirmation) that the Trust Fund Bureau would continue to buy JGBs, and injections of public capital into the major banks, contributed to a subsequent decline in yields and volatility, though both yields and volatility picked up again in the second quarter.26

International credit markets were dramatically influenced by developments in the major national markets.27 In the second half of 1998, lending to mature market borrowers in international credit markets appeared to have been hard hit by the turbulence in mature markets. Syndicated lending declined sharply and terms of lending tightened (Table 2.2; Figure 2.8).28 Net issuance of international bonds (gross issuance less repayments) also declined sharply, as scheduled repayments rose and completed issues declined (Table 2.3). Net issuance of international bonds rebounded strongly in the first quarter of 1999, and announced issuance hit a record high, but syndicated lending continued to fall and loan spreads widened, possibly reflecting a continued withdrawal of Japanese banks and a desire to hold liquid claims;29 also, there was considerable issuance of euro-denominated international bonds.30 More generally, the currency composition of international bond issuance reflected broader developments in the major financial markets during the period under review, as yen issuance declined and ECU issuance increased in 1998 (Table 2.4).

Table 2.2.

Announced International Syndicated Credit Facilities by Nationality of Borrowers

(In billions of U.S. dollars)

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Source: Bank for International Settlements.
Figure 2.8.
Figure 2.8.

Weighted Average Spreads for Announced Facilities in the International Syndicated Credit Market, First Quarter 1992-First Quarter 1999

(In percent)

Source: Bank for International Settlements.Note: Spreads over LIBOR on U.S. dollar credits.
Table 2.3.

Outstanding Amounts of International Debt Securities1

(In billions of U.S. dollars)

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Source: Bank for International Settlements.

Debt securities other than those issued by residents in domestic currency; this includes non-home-currency debt issued by residents and all debt issued by nonresidents.

The Bahamas, Bermuda, the Cayman Islands, Hong Kong SAR, the Netherlands Antilles, Singapore, and other offshore centers.

Table 2.4.

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, International Banking and Financial Market Developments, various issues.

Developments in the Major Foreign Exchange Markets Since the Turbulence

As the turbulence eased toward the end of 1998, developments in foreign exchange markets came to be dominated by the introduction of the euro, developments in the Japanese financial system, and the widening divergence in economic conditions between the United States and the other major currency regions (see Box 2.1 for additional perspective on developments in global foreign exchange markets).

Following the start of EMU on January 1, 1999, market participants initially displayed considerable enthusiasm about the new currency, reflecting the successful convergence process and launch of EMU, the promise of efficiency gains from pan-European financial markets, and enhanced policy discipline.31 Subsequent developments dampened some of this euphoria. In the first quarter of 1999, signs of continued strong growth in the United States indicated that U.S. monetary policy would probably not ease further, while weaker-than-expected growth of GDP in the euro area implied a possible easing in euro-area monetary policy (which materialized in April). Indications of divergent economic conditions among euro-area countries also contributed to concerns about economic tensions within the euro area and added to pressure on the currency. In this environment, the euro weakened by about 8 percent against the dollar during the first quarter of 1999 and another 4 percent during the second quarter. At mid-1999, the euro stood about 6 percent lower against the dollar compared with where the theoretical euro had stood a year earlier.32

The April 1998 BIS Survey of Foreign Exchange and OTC Derivatives Markets

The BIS’s triennial survey of foreign exchange and over-the-counter (OTC) derivatives market activity illustrates current trends in the types of instruments and currencies, turnover and amounts outstanding, trading locations, and market participants in these markets.1 This box reviews the main findings of the survey for the foreign exchange market (the derivatives market is reviewed in the main text of Chapter II).

Average daily turnover in terms of notional amounts in the global foreign exchange market, including spot, outright forward, and foreign exchange swap contracts, was estimated at $1.5 trillion in April 1998, compared with $1.03 trillion in 1995 (see table).2 This represents an annualized growth rate of 14 percent, compared with an annualized growth rate of 9 percent between the 1992 and 1995 surveys.

The U.S. dollar was the most actively traded currency, reflecting its liquidity, its use as a vehicle currency, and its predominance in trade-related transactions. The dollar was involved in 87 percent of all foreign exchange transactions.3 The second and third most traded currencies were the deutsche mark and Japanese yen, which contributed 30 percent and 21 percent to total turnover, respectively. While the share of the dollar increased by 4 percent, the share of the mark and yen decreased by 7 percent and 3 percent, respectively. The currency pairs formed by these three currencies together accounted for 40 percent of turnover in all currency pairs worldwide.4 Even the third most actively traded currency pair, the U.S. dollar-British pound, represented only 8 percent of total global foreign exchange activity. Emerging market currencies contributed less than 15 percent to total daily turnover.

Foreign Exchange and OTC Derivatives Market Turnover1

(Daily averages in billions of U.S. dollars)

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Source: Bank for International Settlements.Note: Reported monthly data were converted into daily averages on the assumption of 1 8.5 trading days in April 1995 and 20.5 trading days in April 1998.

Adjusted for local and cross-border double-counting.

Including estimates for gaps in reporting.

The global foreign exchange business is concentrated in four centers, which together account for 64 percent of total reported turnover: the United Kingdom (32 percent), the United States (18 percent), Japan (8 percent), and Singapore (7 percent). A larger share of U.S. dollar turnover (32 percent) and deutsche mark turnover (34 percent) is conducted in the United Kingdom than in either the United States (18 percent) or Germany (10 percent).

The share of outright forwards and foreign exchange swaps in total foreign exchange market turnover rose from 40 percent in 1989 to 60 percent in 1998. Nevertheless, among currency pairs not involving the U.S. dollar, spot transactions still dominate the business (70 percent of turnover).

The foreign exchange market is dominated by dealers, and is becoming increasingly automated and concentrated. Most trades (73 percent) take place among reporting dealers. Nonfinancial customers account for 20 to 30 percent of turnover in the smaller markets, and even less in larger markets.5 Business among dealers is mostly (59 percent) across borders, whereas transactions with nonfinancial customers are mostly (68 percent) domestic. The foreign exchange market is also increasingly automated. For example, in the United Kingdom, the share conducted over electronic broking systems increased from 5 percent in 1995 to 11 percent in 1998. In the United States, this share more than tripled from 10 percent to 33 percent during the same period. Consolidation in the financial industry contributed to growing market concentration in the foreign exchange business. The share of the top 10 dealers rose from 44 percent to 50 percent in the United Kingdom, and from 48 percent to 51 percent in the United States. Smaller markets tended to have higher levels of concentration.

1Bank for International Settlements (1999). This report aggregates and analyzes the surveys conducted by individual central banks.2 Direct comparisons of the results of the 1998 survey with results for previous years are potentially affected by three factors: (1) coverage of the survey was expanded from 26 to 43 countries; (2) the reporting date for amounts outstanding was shifted from end-March to end-June; and (3) the reporting basis was changed from location of reporters to worldwide consolidation. However, these distorting factors are believed to have only a small effect. For example, the additional countries included in the 1998 survey contributed only 2.6 percent to total turnover.These figures are adjusted for changes in the dollar value of nondollar transactions between 1995 and 1998.3 Since every foreign exchange transaction involves two currencies, the contributions of all currencies to total turnover sum to 200 percent. For example, suppose there are two spot currency transactions: an exchange of $15 for yen, and an exchange of $5 for euros. In this example, the dollar is involved on one side of all currency transactions, and the yen and euro are each involved on one side of half of all transactions. The dollar contributed 100 percent to turnover, the yen contributed 75 percent, and the euro contributed 25 percent.4 Currency pairs sum to 100 percent.5 A market is defined here as total foreign exchange turnover in a country.

The behavior of the yen after the turbulence seems difficult to reconcile with the broader environment and its trends prior to the turbulence. The yen traded around an appreciated level against the dollar compared with prior to the turbulence (in real and nominal effective terms, the yen was around 1997 levels), and there were few signs of a renewed trend weakening of the yen against the dollar, despite the widening cyclical divergence between the United States and Japan. Some market analysts suggested that this phenomenon might have reflected the deleveraging of speculative positions against the yen.33 Others have suggested that repatriation of funds (including in the run-up to the end of the fiscal year) and a scaling back of international activity by Japanese banks may have bolstered the yen. Another view is that market participants may have focused increased attention on the large current account surplus in Japan and the current account deficit in the United States, which are consistent with an appreciation in the yen against the dollar over the medium term. Most recently, some positive economic data released in June might have contributed to further upward pressure on the yen (which was followed by some official intervention).

Developments in the Major Equity Markets Since November 1998

Although the major equity markets staged impressive recoveries from the depths of the turbulence in October 1998, on balance, some markets performed much more strongly than others during the 12 months ending June 1999. In local currency terms, U.S. stocks have risen by about 20 percent since end-June 1998; broad indexes of European stocks have risen by about 5–10 percent (though some country indexes have fallen); Japanese stocks have risen by about 10 percent (and have been unusually volatile over the intervening 12 months). Gains during 1999 have been attributed to various factors, including in the United States, a surprisingly robust pace of economic growth, which has raised hopes for sustained growth in corporate earnings; in Europe, structural changes in equity markets and prospects that corporate consolidation and restructuring will boost corporate earnings; and in Japan, suggestions that recent measures improved the sentiment of foreign investors toward Japanese equities.

In March 1999, the long-running debate over the high valuation level of the U.S. equity market intensified as the Dow Jones Industrial Average (DJIA) crossed the 10000 mark (Figure 2.9).34 This strength is remarkable in view of the recent rise in long-term U.S. interest rates, which implies an associated rise in implied dividend growth or fall in the equity risk premium to justify current dividend yields (see Box 2.2). The mature phase of the business cycle suggests that growth in corporate earnings will slow, while a decline in the equity risk premium seems difficult to reconcile with the evident repricing of credit risk in fixed-income markets. Accordingly, concerns about the risk of a correction in equity markets have increased since mid-1998. Nevertheless, observers have suggested a variety of factors that might rationalize some of the recent rise in equity prices. These include broader household participation in the stock market through institutional investors; the increased number of funded pension plans; the strong performance of the U.S. economy, including low inflation and robust productivity growth; and (until 1999) the decline in long-term interest rates.35

Figure 2.9.
Figure 2.9.

United States: Equity Market Performance, 1926–March 1999

Sources: Board of Governors of the Federal Reserve System; Bloomberg Financial Markets L.P.; and Standard and Poor’s.

On balance, these considerations have given rise to concerns about a correction and its possible repercussions. A correction in the U.S. equity market could affect the risk appetite and financial condition of major financial institutions (particularly HLIs), which could adversely affect conditions in fixed-income markets in the United States and conditions in financial markets outside the United States (though reforms have bolstered the U.S. equity market infrastructure; see Box 2.3). It could also adversely affect economic activity in the United States, including through its effect on household wealth and corporate balance sheets, with knock-on effects to global trade and growth.36

In Europe, a trend decline in long-term interest rates has worked to support equity valuations over a period of increased uncertainty about the prospects for dividends. A simple calculation of expected dividend growth implied by the dividend yields for major European markets suggests that such expectations have become less optimistic or stayed the same since mid-1998 (see Box 2.2). Over the medium term, the performance of European equity markets might be supported by structural trends in European equity markets and in the European corporate sector. These include the privatization of major public enterprises; merger and acquisition activity; deeper and more unified European equity markets; an increasing number of defined-contribution pension plans; improved corporate control; and equity buybacks.37 In the near term, however, prospects are clouded by uncertainties about the pace of recovery in Europe.

The Japanese stock market has been affected mainly by developments in the domestic financial system and concerns about the burden of the corporate-debt overhang and weak economic performance. Between mid-November 1998 and end-February 1999, a period when U.S. and European stocks posted strong gains, the Nikkei was volatile but ended the period virtually unchanged. In the first two weeks of March, the Nikkei abruptly rose by about 12 percent, as the Japanese authorities’ efforts to stabilize the financial system and stem the economic decline contributed to an improvement in the sentiment of foreign institutional investors toward the Japanese stock market (which also coincided with a brief rise in the yen against the dollar).38 Overseas institutional investors reportedly raised benchmark weights on Japanese stocks (often from underweighted positions), bolstering foreign inflows. The pronounced rally in Japanese stock prices lost momentum in April, however, perhaps reflecting concerns that more fundamental measures were needed to put the Japanese economy and financial system on a path to recovery, and concerns that unloading of cross-shareholdings might depress stock prices. In June, stock prices rebounded following the release of favorable economic data.

Developments in Derivatives Markets

Developments in derivatives markets continued to reflect a number of ongoing trends (Tables 2.5–2.9).39 These trends, including rapid growth, the increasing dominance of the OTC segment compared with the exchange-traded segment, and the preponderance of “plain vanilla” derivatives, are clearly illustrated by the most recent Bank for International Settlements (BIS) triennial survey of foreign exchange and derivatives markets (see Box 2.1 for discussion of the foreign exchange segment of the survey). The survey covers traditional foreign exchange derivatives (outright forwards and swaps); more sophisticated foreign exchange derivatives (options, currency swaps, and others); and interest rate products.40 It conveys a sense of market size as measured by notional amounts and gross market value of derivatives outstanding, and activity as measured by average daily turnover of notional amounts.

Table 2.5.

Currency Composition of Notional Principal Value of Outstanding Interest Rate and Currency Swaps

(In billions of U.S. dollars)

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Sources: Bank for International Settlements, International Banking and Financial Market Developments, various issues; and International Swaps and Derivatives Association, Inc. (ISDA).

Adjusted for double-counting because each currency swap involves two currencies.

Table 2.6.

Markets for Selected Derivative Financial Instruments: Notional Principal Amounts Outstanding

(In billions of U.S. dollars)

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Source: Bank for International Settlements.

Calls and puts.

Table 2.7.

Notional Value of Outstanding Interest Rate und Currency Swaps of ISDA Members

(In billions of U.S. dollars)

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Sources: Bank for International Settlements, International Banking and Financial Market Developments, various issues; and International Swaps and Derivatives Association, Inc. (ISDA).

Including international institutions.

Including others.

Adjusted for double-counting because each currency swap involves two currencies.

Include caps, collars, floors, and swaptions.

Table 2.8.

New Interest Rate and Currency Swaps

(In billions of U.S. dollars)

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Sources: Bank for International Settlements, International Banking and Financial Market Developments, various issues; and International Swaps and Derivatives Association, Inc. (ISDA).

Including international institutions.

Including others.

Adjusted for double-counting because each currency swap involves two currencies.

Table 2.9.

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.

Calls plus puts.