Abstract

Exceptionally low short-term interest rates in the major financial centers contributed to resurgent economic growth and rising corporate earnings and to progress in strengthening corporate balance sheets, thus improving the fundamental economic outlook.1 Policies pursued to stimulate economic growth also created powerful incentives for investors to venture further out along the risk spectrum and contributed to a recovery of asset valuations.

Exceptionally low short-term interest rates in the major financial centers contributed to resurgent economic growth and rising corporate earnings and to progress in strengthening corporate balance sheets, thus improving the fundamental economic outlook.1 Policies pursued to stimulate economic growth also created powerful incentives for investors to venture further out along the risk spectrum and contributed to a recovery of asset valuations.

The combination of improved fundamentals and abundant liquidity buoyed global asset prices. Appetite for risk recovered and investor flows suggested an allocation away from relatively low-yielding assets in favor of riskier investments. Equity markets worldwide staged strong rallies in 2003, following three successive years of declines. In part reflecting the impact of this rally on investor sentiment, the level of volatility implied by options on European and U.S. equity markets fell. The complementary catalysts of improved credit quality and abundant liquidity also pushed credit spreads on mature and emerging market bonds to low levels, led by precipitous spread compression on high-yield bonds.

This combination created a very favorable external financing environment for emerging market borrowers in 2003 and early 2004. Gross and net issuance by emerging market countries recovered strongly in 2003. Bond issuance in January 2004 was exceptionally high. Many borrowers have appropriately taken advantage of the relatively low cost of capital and strong investor appetite to prefinance their borrowing needs and to undertake liability management operations aimed at improving the structure of their domestic and external debt.

These developments have helped to underpin a further improvement in the outlook for financial market stability since the last issue of the GFSR. Looking ahead, there are two sources of downside risk to the outlook.

  • In a low interest rate environment, asset valuations may be pushed beyond levels justified by tangible improvements in fundamentals. Stimulus aimed at recovery may also encourage overvaluation.

  • The large global external imbalances and the equally sizable flows they engender pose another potential source of market instability. Adverse developments in the currency markets could heighten investor risk aversion and spill over into other asset markets.

Low short-term interest rates and a steep yield curve provide powerful incentives to boost leverage, undertake carry trades, and seek yield by going out along the credit risk spectrum. There is a real risk of investor complacency in a low interest rate environment. An unanticipated spike in yields and volatility in the U.S. treasury market could also trigger a widening of credit spreads in mature and emerging markets and encourage an unwinding of carry trades and leveraged positions.

In this environment, policymakers and regulators must be vigilant for excessively leveraged or concentrated investor positions. Moreover, if asset valuations become based on excess liquidity rather than fundamentals, the withdrawal of monetary stimulus could trigger a widespread reassessment of asset valuations. To limit this risk, the transition to tightening needs to be carefully managed and clearly communicated to markets. In this context, the removal of the assurance that interest rates would remain low “for a considerable period” in the January 28 statement of the Federal Open Market Committee provided a salutary reminder to investors of the need to avoid being unduly influenced by low interest rates in making investment decisions. This reminder bears repeating.

Ensuring an orderly reduction in global external imbalances is another key challenge and a second potential source of risk to financial markets. The April 2004 World Economic Outlook highlights the need for cooperative international policy action to address the sources of these imbalances. From a financial market perspective, the magnitude of the capital flows needed to finance the large U.S. external current account deficit, the large share of official flows in this financing, and the heavy tilt toward fixed-income investments as a destination for such flows are attracting considerable attention.

The possibility that investors could demand an increased risk premium for U.S. dollar denominated assets in an environment of a rapid decline in the value of the dollar raises the risk of broad financial market turbulence. In this case, yields on U.S. treasury securities could be pushed significantly higher, undercutting the valuation of riskier assets. Although the dollar is widely expected to trend further downward in 2004, there are so far no signs of a lack of willingness to hold dollar assets. Indeed, data through the end of 2003 suggest continued strong official inflows related to currency intervention and renewed private investor interest in U.S. corporate bonds and equities. Moreover, the implied volatility on dollar/yen and dollar/euro currency options remains subdued.

Emerging markets face risks stemming from a potential deterioration in the favorable external financing environment. An unexpectedly sharp increase in underlying U.S. treasury yields would likely trigger a widening of credit spreads on emerging market bonds. Emerging market borrowers would face higher borrowing costs, and underlying vulnerabilities that had been masked by the very favorable external financing environment would be more starkly exposed. Countries with large levels of public debt and volatile debt structures would be most at risk. The risks to emerging markets are mitigated, however, by improved global growth prospects, higher commodity prices, the resilience afforded by increased exchange rate flexibility, increased foreign exchange reserves, and action taken to address potentially volatile debt structures.

This chapter analyzes key developments and risks in mature and emerging financial markets, focusing in particular on the factors underlying the strong rebound in global asset prices in 2003 and on whether that rebound has pushed asset valuations to levels that are not fully justified by fundamental improvements in earnings growth and credit quality.

  • The first section highlights developments and vulnerabilities in mature markets, including in particular the role of low short-term interest rates in influencing investor behavior, market expectations for short-term interest rates, developments in mature equity and corporate bond markets, and changing market sentiment toward the dollar. Given the potential for a more abrupt than anticipated increase in interest rates, the current yield curve environment is compared with that prevailing in 1994, the time of the last mature government bond market sell-off.

  • The second section analyzes spread developments in the emerging bond market, with particular attention to the degree to which low short-term interest rates rather than fundamentals alone have contributed to the steep decline in yield spreads on emerging market bonds. This section also provides an update on financial market developments in EU accession countries following the set-backs of 2003.

  • The third section reviews developments in gross and net portfolio and foreign direct investment flows to emerging market countries, placing them in the context of developments in mature and emerging secondary markets. Steps taken to use the currently favorable financing environment to undertake liability management operations to improve the structure of domestic and external debt are highlighted.

  • The fourth section applies financial soundness indicators to assess the vulnerabilities of selected emerging market banking systems.

  • Finally, the discussion of risks in the main financial centers provided in the fifth section focuses on improvements in sectoral balance sheets, developments in the U.S. mortgage market, the factors underlying the recent proliferation of hedge funds, progress (and setbacks) in improving corporate governance standards, and key recent regulatory developments.

  • Appendix I further explores the extent to which low short-term interest rates have compressed credit spreads on emerging market bonds to a point not fully justified by improvements in fundamental credit quality.

  • Appendix II assesses recent initiatives to develop a regional bond market in Asia.

Developments and Vulnerabilities in Mature Markets

Yields in Major Government Bond Markets Remain Exceptionally Low

Interest rates in the United States and other major markets are low and will eventually need to rise. Indeed, in some countries, notably Australia and the United Kingdom, the tightening cycle has already begun. Speculation over the timing and magnitude of the U.S. tightening cycle has increased, with the dissipation of deflation fears in mid-2003 and subsequent mounting signs of economic recovery. The transition to tightening could have broad implications since abundant liquidity—and not just improved fundamentals—has played a major role in boosting asset prices and the near homogeneous compression of spreads observed in the mature and emerging markets. When risk-free rates rise, valuations in many markets could be pressured, and investors’ appetite for risk tested.

With the Fed funds rate at a 45-year low of 1 percent, U.S. economic growth resurgent, and government bond issuance set to increase, the slope of the U.S. treasury yield curve has remained quite steep throughout 2003 and early 2004. The real Fed funds rate (deflated by the consumer price index) is negative. It is quite low by historical standards and given the stage in the economic cycle (Figure 2.1). Since short-term interest rates are a key building block for the valuation of other riskier assets, the maintenance of low short-term rates can have a pervasive effect on the price of other assets. As rates rise, asset valuations predicated on an unusually low level of risk-free rates could be called into question.

Figure 2.1.
Figure 2.1.

The Real Federal Funds Rate

(In percent)

Sources: Bloomberg L.P.; National Bureau of Economic Research (NBER); and IMF staff estimates.

In the major government bond markets, low short-term rates and limited inflationary pressure have helped keep nominal yields along the maturity spectrum low by historical standards in most major markets. Yields on U.S. treasury securities remained negative in real terms in January 2004 for maturities of up to two years, as were yields on German Bunds with a tenor of one year or less.

The yield on 10-year U.S. treasury securities has in the past tended to move with nominal GDP growth during non-recessionary periods. While nominal GDP growth has recovered from the recent recession, 10-year U.S. treasury yields remain bound in a low range (Figure 2.2).

Figure 2.2.
Figure 2.2.

U.S. Nominal GDP and 10-Year Treasury Rates

(In percent)

Sources: Bloomberg L.P.; National Bureau of Economic Research (NBER); and IMF staff estimates.

The real yields on inflation-indexed bonds in the euro area, the United Kingdom, and the United States have fallen to historically low levels (Figure 2.3). This decline largely reflects the influence of the low level of short-term rates on investor assessments of alternative investments. At the same time, market expectations for inflation in the euro area and the United States rose during 2003 (Figure 2.4).

Figure 2.3.
Figure 2.3.

Inflation-Indexed Bond Yields

(In percent)

Sources: Bloomberg L.P.; and IMF staff estimates.
Figure 2.4.
Figure 2.4.

Long-Term Inflation Expectations

(In percent, 10-year nominal yields less inflation-indexed yields)

Sources: Bloomberg L.P.; and IMF staff estimates.

Throughout much of 2003, while deflation fears weighed on bond yields, the break-even inflation rates2 in the euro area and the United States were below the actual inflation rate, suggesting that the market expected inflation to fall further (Figure 2.5). Since October 2003 however, the break-even inflation rate has risen and is now slightly above the actual inflation rate, suggesting markets now expect actual inflation to rise. While market-based measures of inflationary expectations can be distorted by market segmentation and by the smaller size and lower liquidity of the markets for inflation-protected securities compared with securities offering nominal yields, some market participants viewed these developments as a harbinger of upward pressure on yields.

Figure 2.5.
Figure 2.5.

Inflation Expectations Less Current Inflation

(In percent)

Sources: Bloomberg L.P.; and IMF staff estimates.

Reflecting the steep slope of the U.S. treasury yield curve, short-term interest rate futures contracts are discounting an increase in U.S. dollar interest rates (Figure 2.6). Markets in the euro zone and the United Kingdom are also pricing in an increase in short-term rates, although not as rapid as that anticipated in the case of the United States. U.S. short-term interest rates are priced to exceed those in the euro area from 2005.

Figure 2.6.
Figure 2.6.

Three-Month LIBOR Futures Strip Curves

(In percent, as of March 2, 2004)

Sources: Bloomberg L.P.; and IMF staff estimates.

While global short-term interest rates are widely anticipated to increase from exceptionally low levels, this increase is presently not expected to be disruptive. Nevertheless, bond market volatility has remained high and investors could quickly revise their interest rate outlook, as they did during the 1994 sell-off of global fixed-income markets (Box 2.1). In 1994, policy rates in the United States rose much more rapidly than anticipated, resulting in a global government bond market sell-off. In that episode, volatility and the correlation of global government bond markets rose sharply.

The Shift to Tightening: Parallels Between 1994 and 2004

Forward markets have priced in a gradual rise in U.S. short-term interest rates over the next years. Bond market volatility has remained elevated, however, reflecting uncertainty over the timing and extent of policy tightening. Investors could quickly revise their benign interest rate outlook, as they did prior to the sell-off in global fixed-income markets of 1994.

The Global Bond Market Rout of 1994

Prior to the sell-off in 1994, U.S. investors had built up sizable positions in Europe’s bond markets, attempting to capture capital gains expected from the unwinding of financial market strain that followed the breakup of the European Exchange Rate Mechanism in 1992.1 Entering 1994, financial markets anticipated monetary easing in Europe, driven by the uncertain recovery in Germany, subdued inflationary pressures, and high and rising unemployment. In the case of the United States, financial markets expected that a cyclical rebound would result in a gradual but steady increase in U.S. interest rates.

In the event, monetary easing in Europe fell short of expectations and markets were surprised by the pace of monetary tightening in the United States that began in February 1994. During the following 12 months, the Fed funds rate was doubled to 6 percent in the course of seven successive rate increases. The ensuing sell-off in the U.S. treasury bond market was exacerbated by attempts by leveraged U.S. investors to hedge their exposure to European bond markets. Bond market volatility and correlation rose, and 10-year U.S. treasury yields shot up by almost 250 basis points, peaking at 8 percent in November 1994. Short-term rates rose by more, triggering a marked flattening of the U.S. treasury yield curve. In the process, investors curtailed their borrowing at short-term rates and their exposure to longer-dated, higher-yielding assets. This de-leveraging was broad-based and resulted in a marked widening of emerging bond market yield spreads from 405 basis points at end-1993 to 800 basis points in mid-December, 1994, before the onset of the Tequila crisis.

uch02fig01

U.S. Treasury Market Yield Curve

(In percent)

Sources: Bloomberg L.P.; and IMF staff estimates.

Parallels with 1994

Just as in 1994, the outlook for interest rates in the United States was benign at the beginning of 2004. While inflation and nominal yields were substantially below those prevailing a decade ago, the shape of the yield curve at the beginning of 2004 was similar to that prevailing in 1994 (see the first Figure).

  • The increase in short-term interest rates priced into futures markets at the beginning of 2004 was broadly comparable to the increase priced in a decade ago for shorter-dated contracts. However, for longer-dated contracts, the magnitudes of the interest rate increases expected at the beginning of 2004 exceeded those of 1994 (see second Figure).

  • The U.S. treasury yield curve in 1994 and at the beginning of 2004 was extraordinarily steep (see the third Figure).

  • The yield curve’s unusual steepness provided strong incentives to seek leverage and build “carry trade” positions during both episodes. Such carry trades involve borrowing at low short-term interest rates to build positions in higher-yielding, longer-dated bonds. Abstracting from bond price movements, such positions yielded 3 percentage points on average during 2003, estimated as the differential between the yield on 10-year U.S. treasury bonds and three-month LIBOR (see the fourth Figure). This differential reached a 10-year high last year, underscoring the potential for volatility from an unwinding of carry trades in response to rising short-term rates and a flattening of the yield curve. In addition to carry trades, low short-term interest rates encourage investors to reach for yield in other ways, a factor that contributed to the marked compression in corporate credit spreads observed last year and a decade ago.

uch02fig02

Implied Changes in Eurodollar Forwards Rate

(In basis points)

Sources: Bloomberg L.P.; and IMF staff estimates.
uch02fig03

Excess 10-Year U.S. Treasury Yield Over Three-Month LIBOR

Sources: Bloomberg L.P.; and IMF staff estimates.
uch02fig04

U.S. Interest Rate Indicators

Sources: Bloomberg L.P.; and IMF staff estimates.

Divergences from 1994

While the phrase “it is different this time” is notorious for being a dangerous formulation in finance, no two market situations are ever identical. The similarities just described suggest that there is considerable scope for interest rate volatility and spillover to other markets, especially if market expectations shift from the gradual increase in rates currently discounted to a more abrupt pace of tightening and yield curve flattening. Current circumstances exhibit a number of major differences from those prevailing in 1994. However, some of these differences may as easily exacerbate as dampen volatility.

  • Foreign holding of U.S. treasury securities reached an historic high at end-2003, accounting for 43 percent of the stock of marketable debt outstanding. Rising issuance was increasingly absorbed by demand from the foreign official sector, largely fueled by the proceeds of foreign exchange market intervention.

  • Consequently, foreign official purchases had a discernible impact on yield developments. The stock of marketable debt securities rose by $370 billion during 2003. Private holdings—both foreign and domestic—increased by $209 billion, with the slack taken up by official purchases. While the Federal Reserve Bank increased its holdings by $37 billion, foreign official holdings increased by $130 billion. The latter absorbed about one-third of the net increase of the stock of marketable securities during this period. Consequently, foreign official holdings rose to an estimated 24 percent of the stock of marketable U.S. treasury securities outstanding.

  • Real interest rates remained low by any standard in January 2004, much lower than real rates in 1994. Real interest rates, however, could come under pressure to rise, if demand for capital by the private or public sector were to exceed expectations.

  • The macroeconomic backdrop for financial markets was substantially different at the beginning of 2004 from a decade ago. While the current recovery has been more forceful, inflationary pressures are more subdued than in 1994, in part reflecting high productivity, softness in the labor market, and low capacity utilization. Consequently, pressure on yields to rise was limited in early 2004, notwithstanding the widening fiscal deficit and the need to boost issuance (see the Table).

Selected U.S. Economic and Financial Indicators

article image
Sources: Bloomberg L.P.; and IMF, World Economic Outlook.

Annualized second-half 1993 and 2003, respectively.

FY1994 and FY2004, respectively.

End-1993 and end-2003, respectively.

End-1993 estimate using yield-to-worst convention.

End-1993 EMBI, end-2003 EMBI+.

1 See, for example, Goldstein and Folkerts-Landau (1994).

Bond and Equity Prices Surge

Corporate bond and equity market investment returns reflected an unusually vigorous credit cycle. With the first sign of global economic recovery, the value of claims on business in mature markets surged. A self-reinforcing improvement in valuations emerged as new high-yield credit and convertible financing for marginal borrowers again became available, sharply reducing the risk of business failure. Measures taken by corporations to cut costs, defer investment, and strengthen balance sheets amplified the positive impact of resurgent economic growth on earnings, cash flow, and credit quality. The cyclical rebound in asset prices was further accentuated by the low interest rate environment and a starting point of high risk aversion that had developed in 2002.

Credit spreads on corporate bonds narrowed sharply in 2003, led in particular by high-yield bonds (Figure 2.7). The return on high-yield bonds in Europe and the United States in 2003—of nearly 30 percent—exceeded equity returns in mature markets and were comparable to the return on emerging market bonds. These returns were fueled by improved credit quality and strong investor inflows into corporate bonds in a quest for yield.

Figure 2.7.
Figure 2.7.

United States and European Corporate Bond Spreads

(In basis points)

Sources: Merrill Lynch; and IMF staff estimates.1The average credit quality for the U.S. investment grade index is lower than that of the European index.

Corporate bond markets were boosted by expectations of a continued decline in corporate default rates (Figure 2.8). Bond rating downgrades of companies to below investment grade—which exclude them from some portfolios and cause significant loss in value for important investor groups—were also sharply lower. Reduced default risk and strong investor demand for high-yielding assets permitted a rebound in high-yield bond issuance by European and U.S. corporations in 2003.

Figure 2.8.
Figure 2.8.

Corporate Default Rates

(In percent)

Source: Moody’s.

Corporate bond valuations, for both investment grade and high-yield bonds, are high but not too far out of line compared with previous credit recoveries. Across a range of credit classes, spreads remain above those that prevailed during the last credit expansion of 1992–97 (Figure 2.9). Moreover, adjusting for the unusually low level of current risk-free rates, riskier yields appear attractive when measured as a proportion of the risk-free rate. This comparison is, of course, vulnerable to rising rates.

Figure 2.9.
Figure 2.9.

U.S. Corporate Bond Spreads by Rating

Sources: Lehman Brothers; and IMF staff estimates.

Global equity markets also staged a strong, broad-based rally in 2003, reversing three years of decline (Figure 2.10). As with the corporate bond market, the rebound in global share prices was largely in response to an improved outlook for corporate earnings and economic growth, progress in strengthening corporate balance sheets in the mature markets, and record low short-term interest rates in the major financial centers that helped to whet investor appetite for risk. Since the start of 2004, most major equity indices have experienced a period of consolidation as investors have shown renewed caution. Technology shares, in particular, have stabilized as investors have appropriately paused to await further signs of improving fundamentals. However, stocks in Japan have continued to rise.

Figure 2.10.
Figure 2.10.

Selected Equity Market Performance

(January 1, 2000 = 100)

Sources: Bloomberg L.P.; and IMF staff estimates.

Business earnings, a critical factor in equity valuations, have recovered. In the United States, for example, the operating earnings of firms in the S&P 500 index rose by 17 percent in 2003 from a year earlier. Earnings of U.S. firms in 2003 exceeded their previous peak in 2000, fully recovering from the recession. Earnings in Europe and Japan are recovering with a delay and remain below prior cyclical peaks.

In U.S. markets, aggregate analyst expectations of earnings drifted higher during the course of 2003, in contrast to sharp downward revisions in previous years. In Europe and Japan, earnings forecasts were also revised up strongly in 2003. The improving earnings outlook and strong rally in stock prices contributed to relatively subdued volatility expectations. The implied volatility of options on major equity markets fell over the course of the year (Figure 2.11). Earnings growth is expected to remain robust in 2004 in Europe, Japan, and the United States.

Figure 2.11.
Figure 2.11.

Implied Equity Market Option Volatility Indices

(In percent)

Sources: Bloomberg L.P.; and IMF staff estimates.

U.S. Dollar Depreciates as Deficits Rise

Markets see the U.S. dollar as facing pressure toward depreciation from a variety of sources. These include the need to sustain an unprecedented level of capital inflows to finance the external current account deficit and the high proportion of official inflows related to currency intervention. Markets do not appear overly concerned that the dollar’s decline will either accelerate or have a disruptive impact on other asset markets. Should the expectations underpinning this outlook—notably continued strong foreign official inflows and a rebound in private flows—prove unfounded, the pressure on the dollar will intensify. A decline in demand for U.S. dollar assets could trigger an increase in bond yields.

The nominal depreciation of the U.S. dollar versus the other major currencies has been orderly, and options markets suggest that investors are not expecting sharp currency movements. The call for flexibility in last September’s Group of Seven (G-7) communique caused the volatility implied by option contracts on the yen to rise temporarily (Figures 2.12 and 2.13). The February 2004 G-7 communique highlighting the undesirability of excess volatility helped to dampen volatility expectations. Nevertheless, the dollar has continued to decline and the volatility implied on euro option contracts, while well within historical ranges, has risen (Figure 2.14). However, there is no strong directional tilt in the pricing of currency option contracts. The premium that investors are willing to pay for the right to sell dollars, over the equivalent right to buy dollars, has reverted to normal levels for both the euro and the yen.

Figure 2.12.
Figure 2.12.

Yen Probability Density Function

Sources: Bloomberg L.P.; Reuters, PLC; and IMF staff estimates.
Figure 2.13.
Figure 2.13.

Euro Probability Density Function

Sources: Bloomberg L.P.; Reuters, PLC; and IMF staff estimates.
Figure 2.14.
Figure 2.14.

Currency Volatilities

(In percent versus the U.S. dollar, 3 month)

Source: Bloomberg L.P.

While most market indicators now suggest a generally sanguine view of future currency movements, a few anomalies have emerged. These reflect market speculation of an eventual revaluation of Asian currencies. A marked rise in forward premiums on the yuan and the Hong Kong dollar in the second half of last year suggested that markets did not rule out a revaluation. Speculative inflows pushed the Hong Kong SAR interbank offered rate (HIBOR) well below LIBOR (Figure 2.15).

Figure 2.15.
Figure 2.15.

Hong Kong SAR: HIBOR Versus LIBOR

(In percent)

Sources: Bloomberg L.P.; and IMF staff estimates.

Official intervention by Asian central banks has remained strong. Japanese authorities intervened in increasing amounts in 2003 to prevent the yen from strengthening more rapidly. Foreign exchange reserves of the 11 major Asian central banks now approach $2 trillion, with no sign of a slowing in the trend (Figure 2.16).

Figure 2.16.
Figure 2.16.

Foreign Exchange Reserves of Selected Asian Central Banks

(In billions of U.S. dollars)

Sources: Bloomberg L.P.; and IMF staff estimates.

Much of the reserves accumulated on account of currency market intervention has been invested in U.S. treasury and agency securities. These investments have helped underpin strong foreign portfolio flows into the United States and contributed to the substantial increase in the share of U.S. treasury and agency bonds held by foreigners (Figure 2.17). Private international investor flows into the U.S. equity and corporate bond markets rebounded with the recovery in U.S. corporate earnings and credit quality. So far, however, a substantial recovery of foreign direct investment into the United States, the dominant source of external financing during 1999–2000, appears unlikely. European corporations—major players in the past U.S. merger and acquisition boom—are not expected to have the interest or wherewithal to invest heavily in U.S. firms, notwithstanding the recent strengthening of the financial position of European firms.

Figure 2.17.
Figure 2.17.

Foreign Ownership of U.S. Securities

(In percent of total)

Sources: U.S. Federal Reserve Flow of Funds Accounts; and IMF staff estimates.

Markets are not expecting a disorderly change in the value of the dollar versus the other G-3 currencies. Asian central banks are expected by the market to continue to intervene to stem the pace of appreciation. However, the effectiveness on market expectations of intervention could decline over time as the sustainability of high levels of intervention is questioned.

The importance of bonds as a destination for foreign inflows has so far been one of the factors helping to anchor longer-term U.S. treasury yields, notwithstanding the strong rebound in U.S. economic growth and the prospect of a substantial increase in U.S. treasury issuance. But the heavy tilt toward bonds in the composition of net foreign inflows carries risks. A spike in bond yields in the United States arising from an increased risk premium on U.S. dollar assets would be problematic given the role of low yields in supporting household consumption and in boosting the valuation of riskier assets. Turbulence in the U.S. treasury market could in particular also spill over to other fixed income markets, widening credit spreads from their current low levels. A rapid decline of the dollar in the context of slowing inflows would undermine the valuation of other assets and potentially contribute to broader market volatility.

Improved Fundamentals and the Quest for Yield Buoy Emerging Market Bonds

As in the case of mature corporate bond markets, emerging market credit spreads fell precipitously in 2003, with bonds at the low end of the credit risk spectrum leading the charge. The same factors that contributed to the compression of corporate bond spreads—improved fundamentals and the impact of abundant liquidity on investor behavior—underpinned a similarly impressive compression of spreads on emerging market bonds. However, valuations on emerging market bonds, especially sub-investment grade bonds, appear vulnerable to an increase in underlying U.S. treasury yields.

Emerging market bonds posted impressive returns in 2003 (Figure 2.18). The highly accommodative monetary stance in the main industrialized countries contributed to a search for yield among investors that encouraged sizable new inflows into the secondary market for emerging market bonds. The inducement of low risk-free rates was complemented by expectations for strengthening fundamentals as a result of improved prospects for global growth, surging commodity prices, fiscal consolidation in some key countries, low inflation, increased foreign reserve holdings, and the earlier shift to floating exchange rates. This combination especially benefited high-yielding credits, whose spreads had been pushed to high levels in the environment of acute risk aversion of 2002. However, in early 2004, following a surge of new issuance, the prospect of a transition to tightening in the United States triggered a moderate correction. Emerging market bond spreads widened significantly in February as investors were reminded of the risk of being over-influenced by low short-term interest rates—instead of fundamentals—when making investment decisions. Moreover, investor discrimination seems to have increased during this period as the spreads on high-yielding Latin American credits widened more than those on lower-yielding Asian bonds.

Figure 2.18.
Figure 2.18.

Returns During 2003 of the EMBI+ and Select Sub-Indices

(In percent)

Sources: J.P. Morgan Chase & Co.; and IMF staff estimates.

The compression in emerging market bond spreads was mirrored by declines in implied default probabilities in the credit default swaps market (Figure 2.19).3 The implied default probabilities peaked in mid-2002, at the height of the Brazilian crisis. However, there were regional differences, with greater volatility in Latin America than elsewhere. Asian default probabilities remained low and stable.

Figure 2.19.
Figure 2.19.

Default Probabilities Implied by Five-Year Credit Default Swap Spreads

(In percent, calculated as an average of 16 emerging market credit default swaps on senior debt and a 40% recovery rate)

Sources: Bloomberg L.P.; and IMF staff estimates.

Foreign investor interest in local emerging market investments has also risen. Foreign inflows are motivated in part by the high valuations on external emerging market bonds. In addition, the prospect that emerging equity markets will strongly benefit from resurgent global growth has attracted foreign flows into a number of emerging equity markets and helped underpin the strong rise in emerging market equity prices in 2003. Local bond markets attracted sizable inflows amid improving fundamentals, falling policy rates, and expectations for further currency appreciation in many of the larger markets, including Brazil, South Africa, and Turkey. Indeed, in some countries with debt denominated in or linked to foreign currencies, exchange rate appreciation has contributed at least temporarily to improved debt dynamics. However, financial market volatility increased in Hungary and Poland amid concerns that widening fiscal deficits would overburden monetary and exchange rate policy and potentially delay the adoption of the euro (Box 2.2).

There has been a noticeable improvement in credit quality among emerging market countries over the past several years. In 2003, there were a number of credit rating upgrades, notably Indonesia, Russia, South Africa, and Turkey. Moody’s upgrade of Russia to Baa3 in 2003 resulted in over 50 percent of the asset class being investment grade. The credit quality of the EMBI Global—as calculated by the weighted average rating of its constituents—is now well anchored at double B compared with single B+ just two years ago (Figure 2.20).

Figure 2.20.
Figure 2.20.

Emerging Market Average Credit Quality

Sources: J.P. Morgan Chase & Co.; Moody’s; Standard & Poor’s; and IMF staff estimates.

While improved credit quality has undoubtedly contributed to the spread compression observed in 2003, favorable external financing conditions also played a significant role. The broad-based nature of the rally, reduced discrimination among investors (as measured by the low dispersion of returns among credits), and the increase in cross-correlations among credits for most of last year point to a market being driven more by common factors including liquidity and market technicals, rather than individual country fundamentals (Figures 2.21 and 2.22). Likewise, the strong correlation between global risk indicators and emerging bond market spreads throughout most of 2003 suggests that performance of the latter was closely tied to increased global liquidity and risk appetite. Indeed, research suggests that low short-term interest rates have been a key determinant of emerging bond spreads since 2001 (Appendix I).

Figure 2.21.
Figure 2.21.

Dispersion of Returns Within the EMBI+

(In percent)

Sources: J.P. Morgan Chase & Co.; and IMF staff estimates.

The strong emerging market performance of last year—three quarters of which was driven by spread compression with the balance accounted for by coupon payments—is unlikely to be repeated in 2004. The scope for further spread compression from already historically low levels is limited, and an increase in underlying U.S. treasury yields is widely anticipated. As a result, most analysts forecast low single-digit returns for the EMBI+.4

The prospect of lower returns in an environment of rising interest rates could deter new inflows, and even prompt a reallocation of assets away from emerging markets. In particular, an unexpected spike in U.S. treasury yields could lead to wider emerging market bond spreads and to a more pronounced reallocation by crossover investors from the asset class. Moreover, a disorderly adjustment in the major currency markets, particularly if accompanied by a spike in yields and volatility in mature debt markets, could raise investor risk aversion and contribute to a widening of spreads on emerging market bonds. Spreads on emerging market bonds at historically low levels leave little buffer to absorb adverse developments.

The risks stemming from higher U.S. treasury yields were demonstrated in the summer of 2003 and again in January 2004. During June-August 2003, 10-year U.S. treasury yields rose by almost 150 basis points, triggering a sell-off in emerging bond markets. Spreads, however, were relatively stable. Analysts attributed this stability to the view that valuations remained relatively attractive at that point, and that the sell-off in the U.S. treasury market was largely due to technical considerations—convexity hedging by mortgage agencies—and an easing of deflationary fears, rather than a signal of tightening liquidity conditions. The situation was different in January 2004 when the change in language of the Federal Open Market Committee (FOMC) statement triggered an increase in emerging bond spreads. This spread widening was attributed by some to the partial unwinding of leveraged carry trades. To others, the abrupt widening of emerging market spreads was a reflection of stretched valuations that would be increasingly called into question in a rising interest rate environment. In addition, the record pace of new bond issuance in the first three weeks of January 2004 also temporarily weighed on the market.

For the present, however, a number of factors mitigate these risks. The global recovery has strengthened and broadened, and global commodity prices have risen strongly. The favorable external financing environment has enabled many countries to prefinance a significant part of their planned issuance. Many countries have also taken advantage of the favorable market conditions to improve their debt profiles by lowering borrowing costs, extending maturities, and reducing the share of debt indexed to short-term interest rates and foreign currencies. While many countries have used the inevitably temporary favorable external financing conditions prudently, others have loosened their fiscal stance and slackened the pace of adjustment. When the external financing environment becomes less favorable, underlying vulnerabilities veiled by the earlier ready access to financing are likely to become more apparent.

Figure 2.22.
Figure 2.22.

Emerging Market Debt: Average Cross-Correlations

Sources: J.P. Morgan Chase & Co.; and IMF staff estimates.Note: Thirty-day moving simple average across all pair-wise return correlations of 20 constituents included in the EMBI Global.

Bond Market Convergence of EU Accession Countries: Recent Setbacks and Prospects

The September 2003 Global Financial Stability Report (GFSR) underscored the need for fiscal consolidation in Central Europe to mitigate the risks of exchange rate and interest rate volatility. While prospects of EU accession in May 2004 had spurred a secular broadening of the investor base, the dependence on portfolio inflows to finance large fiscal deficits had risen to unprecedented levels, most notably in Hungary and, to a lesser extent, in Poland. Fiscal laxity overburdened monetary and exchange rate policies in these countries. The June 2003 devaluation in Hungary reinforced concerns over an apparent subordination of inflation targeting to exchange rate considerations. Investor concerns that the timetable for euro adoption might slip—in part on account of warning signals that the Maastricht ceiling on general government debt could be breached in Hungary and Poland—were also emphasized in the September 2003 GFSR. Market developments in late 2003 have highlighted the risks associated with fiscal policy slippages and heavy reliance on foreign investor financing.

Recent Market Setbacks

In Hungary interest rate and exchange rate volatility surged in late 2003. Amid concerns over Hungary’s widening twin deficits, foreign investors reduced their holdings of government securities—by an estimated €574 million—during the three-month period ending in November 2003. Faced with heightening pressure on the forint, the National Bank of Hungary raised its policy rate by 300 basis points to 12.5 percent in late November, following a 300 basis point rate hike in June. As a result, the yield of the five-year benchmark bond spiraled up to 11 percent in early December, widening its yield spread over Bunds to more than 700 basis points (see first and second Figures).

At the same time, investor concerns over the sustainability of fiscal policies in Poland rose. The widening of the general government deficit envisaged under the 2004 budget draft was widely seen as an indication that substantial fiscal reforms were unlikely ahead of Poland’s parliamentary elections scheduled for 2005. Against this background, the yield spread of five-year benchmark bonds over Bunds widened substantially, temporarily reaching 400 basis points at the end of November 2003. Continuing the slide that began in mid-2001, the zloty depreciated to a new low of 4.80 zlotys per euro at the end of January 2004. Besides uncertainties about fiscal policy, investors attributed zloty weakness in part to the perceived uncertainties over the course of monetary policy, following the appointment of a new monetary policy council in January.

uch02fig05

Five-Year Sovereign Benchmark Yields

(In percent)

Sources: Bloomberg L.P.; and IMF staff estimates.
uch02fig06

Five-Year Sovereign Spreads Over Benchmarks

(In basis points)

Sources: Bloomberg L.P.; and IMF staff estimates.
uch02fig07

Foreign Ownership of Government Securities

(In percent)

Sources: National authorities; and IMF staff estimates.
uch02fig08

Forward Spreads

(In basis points, 5x5 year over euro rates)

Sources: Commerzbank; and IMF staff estimates.

The deteriorating investor sentiment toward Hungary and Poland, however, had only negligible repercussions for local markets in the Czech Republic and Slovak Republic. Fiscal reform measures aimed at almost halving their respective consolidated budget deficits by 2006—to 4 percent of GDP in the Czech Republic and 3 percent of GDP in the Slovak Republic—helped shelter these markets from the pressure experienced in the larger markets in Central Europe. The risk of a spillover was further mitigated by the relatively small foreign ownership of securities issued by the government of these countries (see the third Figure). Consequently, yield spreads over Bunds widened only marginally during 2003.

Policy Responses

Following substantial budget overruns in 2003, Hungary introduced further measures to reduce its fiscal deficit in January 2004. Earlier budget cuts—announced in June and December 2003—had proven insufficient to restore investor confidence. At the same time, the National Bank of Hungary abandoned its focus on a narrow exchange rate fluctuation band and avoided any mention of explicit exchange rate targets. This was widely seen as an attempt to assuage investor concerns that inflation targeting had been subordinated to exchange rate considerations.

Measures to curtail Poland’s widening budget deficit were adopted by the government in January 2004. As part of a medium-term fiscal strategy, the government agreed on expenditure cuts equivalent to almost 3 percent of GDP (29.4 billion zlotys) over the period of 2004–07. The minority government still needs to secure parliamentary approval of the necessary legislation. Recognizing the policy challenges lying ahead, the government extended its target for meeting the Maastricht criteria by two years to 2008–09, implying euro adoption in 2010 at the earliest.

Vulnerabilities and Market Outlook

Notwithstanding these initiatives, domestic government financing costs remained elevated in both Hungary and Poland in early 2004. Hungary’s yield spread over Bunds was near a four-year high at the end of January, while that in Poland was near a two-year high. Investors emphasized that meeting the tightened fiscal targets was essential to mitigating the risk that foreign holdings of local securities could once more become a catalyst for interest rate and exchange rate volatility.

Forward markets underscored the risks of further slippages, while differentiating Hungary and Poland from the Czech Republic and the Slovak Republic. Five-year forward interest rates for Hungary and Poland have risen steadily, reaching about 200 basis points over comparable forward rates for the euro area by end-January, 2004 (see the fourth Figure). The elevated spread over forward rates in the euro area was widely seen as an indication that euro membership was expected to be delayed beyond 2009 in the case of Hungary and Poland. In contrast, forward markets implied a high probability of euro area entry by the Czech Republic and Slovak Republic in five years’ time.1

1Assuming a spread of 20 basis points over euro area rates upon euro area entry, forward rates at the end of January 2004 implied a probability of euro area entry by January 2009 of 88 percent for the Czech Republic; 30 percent for Hungary; 41 percent for Poland; and 92 percent for the Slovak Republic.

Surge in Issuance by Emerging Markets Meets Strong Investor Demand

Emerging market borrowers are benefiting from a very favorable external financing environment. Notwithstanding a marked increase in issuance levels, investor appetite still appears strong and the terms for new financing remain relatively attractive to borrowers. Gross financing raised by emerging markets in international capital markets rose in 2003 (Table 2.1 and Figure 2.23). Equity placements, which were facilitated by the strong rally in emerging stock markets, exceeded the levels of the previous two years by a wide margin. Bond issuance was also robust. Following the rebound in issuance in 2003 and the flurry of issues in January 2004, it is estimated that about 40 percent of emerging market sovereign bond issuance plans for 2004 had already been fulfilled. Syndicated loan commitments have been buoyed by a spate of deals in Europe, the Middle East, and Africa (EMEA), reflecting an uptick in corporate borrowing in Russia and lending in the Gulf.

Table 2.1.

Emerging Market Financing

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Sources: Bloomberg L.P.; Capital Data; J.P. Morgan Chase & Co.; Morgan Stanley Capital International; Salomon Smith Barney; and IMF staff estimates.

Issuance data (net of U.S. trust facility issuance) are as of February 17, 2004 close-of-business London and secondary markets data are as of March 8, 2004, c.o.b. New York.

On April 14, 2000 the EMBI+ was adjusted for the London Club agreement for Russia. This resulted in a one-off (131 basis point) decline in average measured spreads.

Figure 2.23.
Figure 2.23.

Cumulative Gross Annual Issuance of Bonds, Loans, and Equity

(In billions of U.S. dollars)

Source: Capital Data.Note: 2004 data as of February 17.

Despite sizable amortizations in the bond and loan markets, net issuance levels recovered in 2003 (Figure 2.24). Net bond issuance, which was negligible in 2002, rebounded. Net flows associated with syndicated loans, which were negative in 2001 and 2002, also turned positive. In early 2004, issuance in the emerging bond and equity markets remained buoyant, and the near-term pipelines looked promising.

Figure 2.24.
Figure 2.24.

Quarterly Net Issuance

(In billions of U.S. dollars)

Sources: Capital Data; and IMF staff estimates.

Bond Issuance

Bond issuance in 2003 exceeded levels witnessed over the last six years. After a slowdown in issuance during the summer owing to the spike in U.S. treasury yields, issuance was particularly heavy toward the end of the year and in early 2004 (Figure 2.25). Issuance was spurred by low yields and strong investor demand as borrowers sought to lock in low rates and extend maturities. Net issuance in 2003 ($35.3 billion), although significantly higher than 2002, was moderated by sizable amortization payments, however.

Figure 2.25.
Figure 2.25.

Cumulative Gross Annual Issuance of Bonds

(In billions of U.S. dollars)

Source: Capital Data.Note: 2004 data as of February 17.

Among sovereigns, the increase in subinvestment grade issuance was noteworthy as it reflected the quest for yield that dominated yield spread developments in the secondary market. Sub-investment grade offerings were heavily oversubscribed and many were upsized, indicating strong investor demand. The market was also supported by strong cash flows of coupon and amortization payments, which increased the supply of funds available for reinvestment. By October, sovereigns, including Mexico, Brazil, and Poland, started to prefinance some of their 2004 funding needs.

Liability management was also an important feature in 2003. Many countries took advantage of the favorable external financing environment to improve the maturity profile of their debt and to release collateral. Mexico retired all its Brady bonds in an exchange. Panama, Poland, the Philippines, and Venezuela bought back some of their Brady bonds. On the domestic front, liability management activities included measures to address potentially volatile debt structures arising from short maturities and indexation to short-term interest rates and foreign currencies (Box 2.3).

Investor appetite also accommodated the issuance on a small scale of international bonds denominated in local currency. Uruguay issued 5.6 billion pesos of three-year inflation-linked bonds under New York law in October, its first foray into international bond markets since its 2002 debt exchange. While the issue was noteworthy given its currency denomination, the size of the issue was small, and secondary market liquidity quite limited as most investors appear to plan to hold the issue to maturity. Most investors were attracted to the deal by the prospect of a real appreciation of the peso. Others saw the opportunity to lock in relatively high real yields while the indexation to inflation would hedge out at least part of the accompanying currency risk. There appears to be some scope to increase the issuance of local currency debt internationally, and some large institutional investors have expressed a willingness to invest in such paper.

Corporate bond issuance rebounded in 2003, supported by an increase in global risk appetite and a search for yield as bond yields declined and spreads compressed across credit products (Figure 2.26). Latin American corporate issues were up nearly 150 percent from 2002, amid a plethora of deals from Mexico and Brazil. In Brazil, banks were the first to tap international markets, arbitraging between onshore and offshore rates, while nonfinancial corporates soon followed as investor sentiment turned unambiguously positive. Corporate issuance in EMEA was strong in early 2003, with Russian issuers particularly prominent, but supply tailed off in the latter part of the year in the aftermath of the corporate investigations starting in the summer. Issuance by Asian corporates gathered pace through the year as SARS-related concerns dissipated.

Figure 2.26.
Figure 2.26.

Share of Bond Issues

(In percent)

Source: Capital Data.

Dollar-denominated issuance picked up during the course of 2003. In the first half of 2003, over 25 percent of total issuance was euro-denominated, as the European investor base made its comeback after an 18-month absence following the Argentine default. However, amid an easing in access, cost considerations dominated funding decisions, so that the share of dollar-denominated issuance rose from to 87 percent in the second half of the year from roughly 70 percent in the first half.

Another salient development in 2003 was confirmation that the inclusion of collective action clauses (CACs) has developed into an industry standard for bonds issued under New York law. Investment grade credits blazed the trail at the outset of the year, followed by the sub-investment grade credits (Box 2.4). An exception, however, was the $1 billion global bond issued in October by China.

January 2004 witnessed a burst of activity in the primary debt market, following December’s lull. Issuers rushed to market to take advantage of low borrowing costs and strong investor appetite. Inflows into the asset class by both institutional and retail investors were also supportive. The total volume of debt, the total number of issuers, and the weighted average maturity of issuance in January were all significantly higher than in previous years. On the sovereign side, Brazil, Turkey, and Venezuela came to market with 30-year deals. The long average maturities are particularly impressive given the number of corporate deals. Notably, two Brazilian corporates successfully sold 10-year paper, while one-third issued into the 30-year sector. More recently, however, the market has showed some signs of indigestion, exacerbated by the January 28 FOMC statement that temporarily reduced investor demand. Issuance slowed in February. However, almost 40 percent of expected sovereign issuance for 2004 had been completed by the end of January.

Emerging Market Borrowers Improve Debt Structures: Case Studies

Past issues of the Global Financial Stability Report (GFSR) have highlighted the importance for emerging market borrowers of taking advantage of a favorable financing environment to improve the structure of their domestic and external obligations and to deepen local bond markets. Such measures are particularly important in countries with potentially volatile debt structures. Debt structures with short average maturities or a high share of outstanding debt linked to short-term interest rates or foreign currencies can be particularly problematic. Even countries with relatively stable debt structures have taken steps to deepen domestic financial markets and achieve a better debt profile. To illustrate these benefits, this box reviews the liability management operations of two large emerging market borrowers—Mexico and Brazil. Mexico, an investment grade credit, and Brazil, whose credit rating is sub-investment grade, have each taken steps to improve the profile of both their domestic and external debt while deepening their domestic bond markets.

Mexico: Recent Liability Management Operations

In an effort to reduce debt-service costs and to improve the financial conditions of future borrowing, Mexico undertook several liability management operations in 2003. These efforts have focused on prepaying debt obtained under less favorable market conditions, broadening its investor base, and diversifying its external financing sources. Since February 2003, the authorities have included collective action clauses in all dollar-denominated bonds issued under New York law.

In April 2003, Mexico prepaid $3.8 billion of outstanding dollar-denominated Brady Par Bonds, with maturity in December 2019. The bonds contained a call provision that gave Mexico the right to retire the bonds, and were guaranteed with principal and interest collateral. The resources to finance the operation were obtained from the federal government’s liquidity position and from a one-year credit facility of $2 billion. Official estimates indicate the prepayment resulted in an external debt reduction of $1.8 billion, generated an estimated net present savings of $327 million, and led to the release of collateral of $1.9 billion.

In June 2003, Mexico prepaid its remaining Brady Par Bonds denominated in Dutch guilders, German marks, Italian lira, and Swiss francs, which amounted to $1.3 billion. The bonds contained a call provision that gave Mexico the right to retire the bonds, and had an original expiration date of December 2019. The resources to finance the prepayment were obtained from the federal government’s liquidity position. Official estimates suggest that the operation led to an external debt reduction of $1.3 billion, generated net present savings of $283 million, and led to the release of collateral of approximately $694 million.

After the buyback of the Brady Bonds, Mexico took steps to extend its investor base. On January 6, 2004, Mexico issued a $1 billion Global Floating Rate Note (FRN) with a five-year maturity, Mexico’s first ever FRN. The bond has a floating interest rate in dollars of the three-month LIBOR rate plus 70 basis points. At the current level of LIBOR rates, the annualized financing cost of Mexico is 1.85 percent. The transaction put Mexico in touch with a new buyer base at a competitive cost, as 25 percent of the FRN was purchased by high-grade pension and bank funds and others that were not previously part of Mexico’s traditional investor base.

Domestic debt management has aimed at increasing the average maturity of government debt, reducing refinancing risks for the federal government, and promoting the development of capital markets. During 2003, the stock of long-term fixed rate bonds with maturities between three and ten years increased significantly to around 50 percent of the outstanding stock in December 2003, while the stock of inflation-linked bonds decreased to around 10 percent (see first Figure). The amount auctioned of the 28-day Cetes was reduced, offset by increases in 91- and 182-day Cetes.

Favorable market conditions and increased investor confidence allowed Mexico to introduce a new 20-year fixed-rate bond in October 2003. The bond should provide a long-dated government benchmark that facilitates the extension of corporate bond maturities in the local market. The increase in the auctioned amounts of long-term bonds and reduction in the amounts of shorter-term bonds should help increase liquidity in the secondary market and complement other recent efforts in this regard, including measures to improve the market-maker program, change the auction schedule, and reopen outstanding issues in primary auctions.

uch02fig09

Mexico: Government Securities by Type

(In percent, outstanding at end of period)

Source: Secretaria de Hacienday Credito Publico.

Brazil: Recent Liability Management Operations

After a 12-month hiatus, Brazil returned to international debt markets with a five-year $1 billion global bond in late April 2003 followed by a ten-year $1.25 billion global bond in June. The new bonds contained CACs, with a 85 percent threshold in the majority restructuring provision. All subsequent external issuance has contained similar provisions.

Brazil raised over $600 million through a debt swap augmented with new issuance at the end of July. The Republic offered bondholders to swap existing Par and Discount Bradies and the benchmark C-bond, for new sovereign debt maturing in 2011 and 2024. Nearly $1.3 billion of principal was exchanged, releasing approximately $490 million in collateral. Furthermore, $123 million was subsequently added in new issuance to the Global’11 for improved liquidity and additional financing, bringing the total issue size to $500 million. However, Brazil did not accept any offers for the C-bond as bondholders were unwilling to exchange out of the liquid benchmark bond for a longer-dated maturity during a period when U.S. treasury rates were under pressure. The exchange was essentially market-value neutral for bondholders.

Brazil completed external issuance for October 2003 and began pre-financing for 2004 with a $1.5 billion global bond with maturity in 2010. This brought total external issuance to $4.4 billion for the year or $3.9 billion, excluding the principal unlocked from the Brady swap. The favorable external environment continued into 2004 as Brazil was able to tap external debt markets in January with a 30-year $1.5 billion global bond at only 377 basis points above comparable U.S. treasuries.

In domestic markets, Brazil has made significant strides in reducing the amount of U.S. dollar-linked domestic debt while gradually improving the maturity profile. After rolling over 100 percent of principal on foreign exchange-linked debt during the first half of 2003, Brazil announced a policy to reduce the rollover rate beginning in June. The rollover rate fell quickly to 60 percent in July and has remained below 10 percent since October, allowing the withdrawal of some $6 billion in maturing principal as of end-January 2004 (see second Figure). As a result of the policy, and the steady appreciation of the currency throughout the year, the share of foreign exchange-linked debt (including foreign exchange swaps) in total domestic public sector debt has fallen from 37 percent in December 2002 to 22 percent at the end of 2003. The withdrawal of foreign exchange-linked domestic debt has been primarily replaced by fixed-rate nominal coupon debt and inflation-indexed debt.

uch02fig10

Rollover Rate of U.S. Dollar-Indexed Federal Domestic Debt, Including Swaps

(In percent of total principal coming due)

Source: Central Bank of Brazil.

The maturity profile of domestic debt improved as Brazil sought to gradually lengthen the maturity of newly issued debt while simultaneously increasing average size and addressing gaps in the domestic yield curve. The average maturity of newly issued debt increased from a low of one year during the peak of market uncertainty in September of 2002 to three years in December 2003. As a result, the share of domestic debt maturing in the ensuing 12 months fell from 41 to 33 percent.

Brazil has also sought to strengthen domestic liability management practices by implementing new arrangements for primary and secondary dealers and expanding the domestic investor base. The aim of the new primary and secondary arrangements is to increase both liquidity and competition in domestic debt markets. The new arrangements will be bolstered by a new electronic trading platform on the Brazilian Mercantile and Futures Exchange in early 2004. The domestic investor base was expanded in late 2003 through the introduction of a Treasury Direct system, which allows direct access by individual accounts to Treasury auctions of domestic debt. Investor participation through this program has increased nearly fourfold since its introduction.

Equity Issuance

The surge in emerging market equity prices since April has triggered a sharp pickup in primary market activity, with the fourth quarter of 2003 far surpassing levels recorded prior to the bursting of the high-tech bubble (Figure 2.27). The distribution of issuance across regions differed starkly. After lying dormant for the better part of the year, Asia’s equity market erupted with new stock issues from a wide array of companies in the final months of the year. Firms in China and Hong Kong SAR were particularly active, issuing $8 billion in the fourth quarter. The China Life IPO was noteworthy. At $3.46 billion, it was the largest IPO worldwide for 2003 and was 25 times oversubscribed. In Southeast Asia, Indonesian issuers were active, with stakes sold in Bank Mandiri, Bank Rakyat Indonesia, and PGN. Thailand’s government successfully divested stakes in Krung Thai Bank and Thai Airways. By contrast, issuance in Latin America remained low, notwithstanding $540 million in issuance by Mexico’s Cemex. New equity issuance was also limited in EMEA, where activity was dominated by the Central European telecom sector and a $300 million American Depository Receipt (ADR) issue by Russia’s Norilsk Nickel. Amid ongoing inflows by international equity investors, there is no sign of the deal flow drying up. In particular, issuance by Asian companies continued at a fast pace in the first few weeks of the year, and several large deals are in the pipeline for the remainder of the year.

Figure 2.27.
Figure 2.27.

Cumulative Gross Annual Issuance of Equity

(In billions of U.S. dollars)

Source: Capital Data.Note: 2004 data as of February 17.

Syndicated Lending

Gross bank lending to emerging markets in 2003 exceeded levels of the previous two years. Net syndicated lending to the emerging markets was positive in 2003, marking a turnaround from the net contraction of the last two years (Figure 2.28). Amid ample global liquidity, borrowers eagerly refinanced, while international banks’ appeared especially prepared to lend to Central and Eastern European borrowers and to the Middle East. Russian corporates were prominent borrowers in the fourth quarter, with a wide array of corporate facilities arranged on attractive terms prior to the unfolding of developments at Yukos. Market participants, however, reported that the extremely fine margins on some of the Central European credits, largely reflecting the abundance of liquidity in local markets, drove some of the international banks further afield. Gulf states benefited from increased risk appetite by international banks, manifested in a rise in both project financing and lending to financial institutions. Latin America witnessed a pickup in loan volumes, primarily due to Mexican corporates.

Figure 2.28.
Figure 2.28.

Cumulative Gross Annual Issuance of Loans

(In billions of U.S. dollars)

Source: Capital Data.Note: 2004 data as of February 17.

Foreign Direct Investment

The declining trend in total private external financing for emerging market countries that had been in place since 1997 was reversed in 2003 (Figure 2.29). Foreign direct investment (FDI) to emerging market countries has been more resilient but has also declined in recent years, owing in large part to a sharp reduction in flows to Latin America and reduced privatizations of state-owned assets in the service sector. Nevertheless, FDI has remained the most important net source of private external capital for all regions.

Figure 2.29.
Figure 2.29.

Private Flows to Emerging Market Economies

(In billions of U.S. dollars)

Source: World Bank, Global Development Finance, 2004.

Preliminary information indicates that FDI flows to emerging market countries continued to fall in 2003. However, the decline was smaller than in the previous year and largely reflected reduced FDI in Brazil and the EU accession countries. The outlook for FDI is expected to improve in 2004 with the strengthening growth prospects of the global economy.

In Latin America, FDI flows fell in 2003 by less than in the previous year with declines in Brazil (43 percent) and Mexico (15 percent) largely accounting for the regional drop (Figure 2.30). The decline in Brazil reflects, in part, the winding down of large-scale privatization in the telecommunication and energy sectors. FDI to Chile increased by over $1 billion reflecting the country’s ongoing economic recovery and strong institutional base. FDI in Argentina appears to have stabilized at very low levels.

Figure 2.30.
Figure 2.30.

Geographic Distribution of FDI Flows

(In percent of total)

Source: World Bank, Global Development Finance, 2004.

Asia increased its dominance as the main recipient of FDI to emerging market countries, with aggregate inflows increasing for the third year in a row. FDI to China continued to increase and now represents 86 percent of total FDI to emerging market countries in Asia. Elsewhere in Asia, FDI also increased in India (reflecting the easing of foreign investment restrictions in the automobile, private banking, and telecommunications sectors) and Thailand.

FDI flows to emerging Europe declined in 2003 reflecting a 50 percent decline to the EU accession countries (Czech Republic, Hungary, Poland, and Slovak Republic). FDI rose in Russia by almost 100 percent, mainly to the oil sector.

Results from a recently completed survey conducted by a working group of the Capital Markets Consultative Group (see CMCG, 2003) emphasized the importance of regional economic, structural, and institutional factors in influencing FDI prospects. The direct investors participating in that working group reported that there was no large-scale withdrawal from Latin America and that the effect on FDI from the Argentina crisis was concentrated in the banking and utilities sectors.

Collective Action Clauses: Update on Market Practice

An increasing number of emerging market countries have included collective action clauses (CACs) in their international sovereign bonds issued under New York law, where these clauses had not previously been the market standard. During the latter part of 2003 and early 2004, sovereign issues containing CACs grew to represent more than 70 percent of total volumes issued (see the Table).

In September 2003, Turkey included CACs in its bonds governed by New York law, followed shortly by Peru. These were the first two subinvestment grade countries that issued New York law bonds with CACs that included a voting threshold of 75 percent of outstanding principal for majority restructuring clauses. This represented a change in market practice with respect to previous non-investment grade issuers that had included higher voting thresholds (e.g., 85 percent in the case of Belize, Brazil, and Guatemala). Both issues were priced very tightly along the yield curve and there was no evidence of a yield premium as a result of the lower voting threshold.

In the latter part of 2003 and early 2004, Chile, Colombia, Costa Rica, Panama, the Philippines, Poland, and Venezuela also issued global bonds governed by New York law that included CACs. All issues were heavily oversubscribed and priced broadly along the yield curve.1 With respect to majority restructuring provisions, recent New York law bonds differ on the voting threshold for amending key terms. Chile, Colombia, Italy, Mexico, Panama, Peru, Poland, and Turkey used a 75 percent voting threshold while the issuances of Brazil and Venezuela relied upon a 85 percent voting threshold. Regarding majority enforcement provisions, all of the recent bond issues governed by New York law except Poland used a 25 percent threshold for acceleration.2 However, they differ on the threshold for deacceleration: in the case of Chile, Colombia, Mexico, Peru, and Venezuela, the threshold is set at more than 50 percent of outstanding principal while the issuances by Brazil, Italy, Panama, and Turkey included a 66 ⅔ percent threshold for de-acceleration. All recent bond issues used a fiscal agency structure. In general, there was no evidence that the issue prices included a premium for CACs, an opinion generally shared by private market participants who have lately been disregarding the inclusion of CACs in market reports on sovereign issues.

Emerging Market Sovereign Bond Issuance by Jurisdiction1

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Source: Capital Data.

Number of issuance is in number. Volume of issuance is in billions of U.S. dollars.

Data for 2004: Q1 are as of February 17, 2004.

Includes issues of restructured bonds by Uruguay.

English and Japanese laws, and New York law where relevant.

German and New York laws.

A number of international sovereign bonds were issued under English and Japanese law including CACs, as has been the practice in these markets. The emerging market issuers included Hungary, Poland, Slovak Republic, and Ukraine and mature market issuers included Austria and Sweden. Bond issues under German law continued to lack CACs, although legislative work aiming at the elimination of perceived legal risk in the usage of CACs under German law is underway. International bond issues under German law have been rare in the last three years, however, which may partly be due to lost or reduced market access of important traditional issuers.

1In the sole case of Colombia, prices were somewhat above the existing sovereign yield curve. However, market participants reported this was the result of high volumes of emerging market debt placed in the same week.2The Polish bond allows each bondholder to accelerate its claim upon a payment default or declaration of moratorium by the sovereign issuer and does not provide for de-acceleration with respect to these events of default.

The CMCG report also notes that FDI in emerging market countries is increasingly being undertaken to service domestic demand in the host country, which highlights the importance of large markets and promising growth prospects. Consequently, emerging market countries with good governance practices and improving infrastructure and institutions are likely to secure greater amounts of FDI.

Banking Sector Developments in Emerging Markets

The improved economic climate is supporting the recovery of banking systems in the major emerging market countries despite slow progress in fundamental restructuring. For the most part, banking systems in Asia continue to recover, although growing credit risk exposure to certain sectors, in conjunction with persistent balance sheet weaknesses, deserves close attention by the supervisors in a few countries. In Latin America, severe liquidity pressures on distressed banking systems are receding, but less-than-robust economic growth and political factors are exacerbating financial distress in some countries. Banking systems in emerging Europe have coped well with weak macroeconomic conditions and now stand to benefit from improved economic prospects. Nonetheless, fast credit growth in some countries needs to be closely monitored. The authorities are making efforts to address long-standing structural problems in the banking systems in some countries in Africa and the Middle East.

Capacity in emerging markets to absorb shocks from mismatches in the external assetliability positions of banks has improved. Banks in emerging market countries now have on average a more balanced external position vis-à-vis BIS reporting banks than in 1997–98. Official reserves coverage of the banking systems’ net liability positions has generally increased (Table 2.2). And supervisory and regulatory efforts have intensified, although significant improvement in effectiveness in this area will take time. The focus of regulations in several countries is shifting toward requirements for improved risk management by individual institutions. Regulatory authorities are also seeking to harness market discipline through greater disclosure and provision of accurate financial information to markets.

Table 2.2.

Individual Countries’ Bank Net Asset/Liability Position vis-à-vis BIS Banks as a Ratio of Official Reserves1

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Sources: Bank for International Settlements; IMF, International Financial Statistics; and IMF staff estimates.

A negative ratio indicates a net liability position (liabilities exceed assets).

Asia

The financial systems of the major emerging market countries in Asia are being bolstered by the economic recovery. Soundness indicators on average point to solid rates of return on assets and sustained improvement in capital adequacy and asset quality (Table 2.3). Bank ratings by private analysts and market valuation of bank stocks relative to overall stock indices also continue to improve (Figures 2.31 and 2.32).

Table 2.3.

Selected Financial Soundness Indicators for Emerging Markets

(In percent)

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Sources: National authorities; EDSS; and IMF staff estimates.Note (*): Data for 2003 is for various quarters and for a more limited sample.

Constructed according to a numerical scale assigned to Moody’s weighted average bank ratings by country. Zero indicates the lowest possible average rating and 100 indicates the highest possible average rating.

Includes Central and Eastern Europe, Israel, Malta, and Turkey.

Excluding Japan.

Figure 2.31.
Figure 2.31.

Moody’s Financial Strength Index

Sources: Moody’s; and IMF staff estimates.
Figure 2.32.
Figure 2.32.

Emerging Market Countries: Banking Sector Market Valuation1

(February 1999 = 100)

Sources: Datastream; and IMF staff estimates.1 Ratio of banking sector stock prices to total market stock prices, simple average.

In India, low interest rates have further boosted bank soundness and performance indicators as the authorities have adopted measures to contain credit risk, including legal and regulatory changes. The banking systems in Thailand and Malaysia are benefiting from restructuring and reforms. In Korea, the financial system has had to absorb the effects of the bankruptcy of the chaebol SKGlobal, an affiliate of SK, Korea’s third largest chaebol, and substantial losses at some credit card companies—the latter prompting the authorities to announce steps to strengthen prudential supervision of credit card companies. While the banking system has remained stable, the urgency of enhancing reform of the insolvency regime and instituting tighter oversight of nonbank institutions has been brought into focus. The financial systems of Hong Kong SAR and Singapore have weathered the effects of SARS and are well positioned to take advantage of the region’s economic recovery.

The process of bank restructuring in Indonesia has been completed and overall indicators of bank soundness continue to improve. Some concerns remain related to state-owned banks’ lending growth, notwithstanding measures to strengthen the banking system, including careful monitoring. In the Philippines, banks’ reported capital adequacy exceeds regulatory requirements and profitability is improving somewhat. Asset quality, however, remains a problem and strategies are being devised to reinforce the capacity of the banking system to cope with shocks. In China, the recent capital injection into two large state-owned banks may represent an important step toward strengthening the banking system, provided restructuring plans, improved governance, and oversight of the two banks are promptly implemented (see Box 2.5).

Latin America

Although some aggregate indicators of banks’ financial soundness for the region as a whole deteriorated further in 2003, the situation in countries recently in financial crisis has begun to stabilize. Moreover, banking soundness indicators have continued to slowly improve in the other countries in the region.

Financial conditions in Argentina’s banking system stabilized during 2003, but credit growth remains marginal, while past policy-related losses have not been fully compensated and bank assets are concentrated in low-yielding government assets. Progress in restructuring the banking system in Uruguay has been limited.

Macroeconomic uncertainty, often coupled with political uncertainties, cloud the prospects for the banking system in several countries, including Bolivia, Ecuador, and Paraguay, where the ratio of nonperforming to total loans has continued to edge up without an offsetting increase in provisions. In the Dominican Republic, questions about the solvency of individual institutions have had a marked impact on market confidence.

By contrast, despite slow economic growth, banking sector performance has improved in Brazil, Chile, Colombia, and Mexico. Returns on assets have firmed and compare favorably with international norms, while excess provisioning and comfortable capitalization levels continue to provide a buffer against potential deterioration in credit quality.

Emerging Europe

Banking systems are enjoying improved rates of return and asset quality, and strong capital positions. This good performance is also reflected in private analysts’ ratings of banks, which were on average raised in 2003 (Figure 2.31). After strengthening sharply in mid-2002, relative market valuations of bank stocks have receded somewhat, although they still stand above the average levels in the previous two years (Figure 2.32).

In Turkey, while the banking system has successfully coped with the effects of the Imar Bank scandal, the episode has again raised questions about the supervisory framework. In addition, a variety of structural issues—resolution of Pamukbank, sale of assets of other distressed banks, and privatization of state banks—are yet to be addressed adequately. Elsewhere in the region, risks have generally receded and banking systems maintain confidence and stability. Several countries, however, have experienced fairly rapid credit expansion, which warrants rigorous credit evaluations and close monitoring of credit quality.

State Bank Recapitalization in China

On the basis of a decision by China’s State Council, $45 billion (about 4 percent of GDP) of China’s international reserves were used on December 30, 2003 to recapitalize two of China’s four major state-owned commercial banks—the Bank of China and China Construction Bank. The capital injection was split equally between the two banks. The recapitalization was executed by the central bank (the People’s Bank of China—PBC) transferring the funds from its international reserves holdings to a newly created holding company, owned by the State Administration of Foreign Exchange (SAFE), which was established to facilitate the recapitalization. The holding company exchanged the foreign currency assets (mostly in the form of U.S. treasury securities) that it received for equity positions in the two banks. The banks will retain these foreign currency assets in their original form.

The authorities have stated that the recapitalization is part of a broader overall reform strategy for these banks. As part of this strategy, they have suggested that additional steps will be taken, including (1) adopting stricter auditing requirements; (2) requiring the banks to move more quickly to fully meet provisioning requirements; and (3) boosting capital adequacy ratios to 8 percent, in line with international standards. If these steps are taken, the recapitalization may significantly improve the health of these two banks and that of the banking system as a whole, since these banks constitute about one-third of the assets of the banking system. However, to maximize the chances of a successful outcome, of immediate importance is the need to develop and begin implementing concrete restructuring plans for the two banks. In particular, substantial improvements in the internal operations and governance of the banks are required, accompanied by efforts to further improve oversight by the supervisory authorities.

Middle East and Africa

Banking systems in these regions are characterized by highly divergent financial performance and balance sheets.

Banks in the wealthy oil producing countries of the Middle East are generally strong and their positions strengthened further in 2003. In particular, the banking system in Saudi Arabia remains highly liquid, profitable, and well capitalized. The main risks stem from an economic slowdown and geopolitical uncertainties.

Elsewhere in the region banks continue to suffer from structural weaknesses that are being addressed. In Egypt, large public sector banks received a capital injection in early 2003 and efforts are under way to improve performance through changes in management. In Morocco, growing weaknesses in state-owned specialized banks are being addressed, while commercial banks generally have a strong capital base and prudent provisioning policies. Financial conditions in Lebanon have eased considerably, but asset quality and bank exposure to the sovereign, whose debt is very high, remain important issues. Bank restructuring and privatization efforts have also progressed in Pakistan, and banks’ balance sheets have strengthened.

The financial system in South Africa has stabilized and undergone consolidation, following serious difficulties at some banks in 2001. The authorities are now turning to measures to broaden access to financial services for the population.

Structural Issues Should Be the Focus in Mature Markets

The relatively benign conditions in both mature and emerging markets described earlier have allowed further progress in reducing balance sheet vulnerabilities in mature markets. In large part, this represents the continuation of the trend reported in the September 2003 GFSR and earlier issues:

  • Corporate and household sectors have continued to build up liquidity. In the United States in particular, strong corporate cash flow has reduced borrowing needs, while in Europe household savings continued to be directed into money market instruments.

  • Rising asset values have strengthened net worth across a wide range of sectors. This is true not only for the corporate and household sectors but also for banks and for institutional investors such as insurance companies (discussed in detail in Chapter III).

  • Over the last six months, hedging activity in the U.S. mortgage market has become somewhat less of an influence on interest rate volatility. As most borrowers who could refinance their mortgages have done so, refinancing levels are unlikely to rise to the peaks of 2003. However, the market has given increased attention recently to the possibility that, if 10-year yields fall much further, mortgage hedging activity could grow and thus accentuate the decline in yields.

  • Nevertheless, debt levels remain high in many sectors and remain a vulnerability if interest rates rise. The stock of debt in Europe in particular continues to rise for both households and corporates. Although the debt service requirements are currently modest and many corporates and households (especially in the United States) have locked in low interest rates, rising interest rates would still increase the debt service burden.

During recovery points in a cycle it may be appropriate to focus on some of the longer-term topics of interest for financial stability:

  • The hedge fund industry has been growing rapidly and institutional investor participation has substantially increased. Although leverage and counterparty exposures are better monitored (due in part to greater oversight by institutions), it would be helpful to have more consistent disclosure standards.

  • Corporate governance initiatives need to be pursued. Although progress has been made in particular countries and multilaterally, the cases of Parmalat and of late trading and market timing in the U.S. mutual fund industry serve as a reminder that more can and should be done.

  • The Basel II Accord is due to be finalized by mid-2004. It is likely to improve financial stability. However, some questions remain, particularly concerning its implementation. This section discusses these issues in more detail.

Sectoral Balance Sheets

As the global economic recovery took hold and interest rates remained low, the balance sheets of household, corporate, and bank sectors strengthened over the course of 2003, extending the trend identified in the September 2003 GFSR. However, some fragilities and sources of potential vulnerabilities remain.

In most European countries and in the United States, buoyant housing and equity markets have contributed to the improvement in household balance sheets and increased net worth. Together with the low interest rate environment, this has led at the same time to a continuing growth in mortgage debt. Household balance sheets could thus prove sensitive to a turnaround in house prices, which could be triggered by a larger-than-expected rise in interest rates or disappointing income or employment growth. Consumer credit growth has been less strong and, in contrast to the United States, European consumer credit growth has slowed, perhaps reflecting the lag in continental Europe’s economic recovery.

Corporate balance sheet restructuring in the major mature markets progressed in 2003 as the economic recovery significantly strengthened cash flow. This factor, together with low interest rates, allowed corporates to lengthen debt maturities and reduce debt servicing costs. The degree of balance sheet improvement, however, differs between countries, largely reflecting the uneven pace of the global economic recovery. European nonfinancial corporations, for example, are still burdened by very high levels of debt and could be vulnerable to a rise in interest rates or a disappointing pace of recovery. In the United States, on the other hand, cash flow has been particularly strong. In Japan, rising profits have allowed corporates to reduce leverage.

Banks overall have benefited from improvements in the economic and financial background and in their own risk management. Strong mortga