Abstract

Throughout most of the 12-month period ending in June 2000, developments in international capital markets continued to be strongly influenced by the perception that the U.S. economy offered the highest risk-adjusted asset returns in the major currency areas. Favorable perceptions reflected the continued strong performance of the U.S. economy, uncertainty about growth prospects in Europe, and the halting economic and financial recovery in Japan. While this combination of factors might not explain all of the international reallocations of capital and risks, or all asset-price movements, it was an important part of the background against which these adjustments occurred. Beginning with the April–June 2000 period, this favorable sentiment about U.S. returns may have changed.

Throughout most of the 12-month period ending in June 2000, developments in international capital markets continued to be strongly influenced by the perception that the U.S. economy offered the highest risk-adjusted asset returns in the major currency areas. Favorable perceptions reflected the continued strong performance of the U.S. economy, uncertainty about growth prospects in Europe, and the halting economic and financial recovery in Japan. While this combination of factors might not explain all of the international reallocations of capital and risks, or all asset-price movements, it was an important part of the background against which these adjustments occurred. Beginning with the April–June 2000 period, this favorable sentiment about U.S. returns may have changed.

Throughout most of the period under review, and despite uncertainty about the sustainability of U.S. productivity growth, U.S. markets continued to receive considerable attention from international investors, as reflected in U.S. financial flows and asset price dynamics. Even when U.S. equity markets declined sharply, investors temporarily shifted capital into U.S. fixed-income markets and reentered equity markets when they thought equity valuations had fallen to sufficiently attractive levels. From time to time, investors’ faith in the sustainability of U.S. asset returns faltered, and there were occasional periods of high volatility, most notably in U.S. equity markets and in the value of the dollar, which most likely reflected a rebalancing of risks in portfolios. Overall, however, the value of the dollar first appreciated, then depreciated, and on balance held its ground (on a nominal weighted-average basis), despite the growing current account deficit and mounting uncertainty about whether U.S. productivity gains would continue to support high growth with low inflation.

Strongly reflecting investors’ sentiments, U.S. investment themes increasingly resonated internationally. Most notable was the worldwide and concentrated allocation of funds into the equity and debt instruments of companies in the technology, telecommunications, and media sectors. Market developments also reflected the rebalancing of portfolios away from government bonds and toward private markets as fiscal positions consolidated in many countries. Reflecting these tendencies, although a continued net capital flow out of Europe weighed heavily on the euro, European equity and corporate bond markets appreciated sharply as capital flowed into them. Some of Japan’s markets benefited as well from improved investor sentiment. In late summer and early fall 1999, signs of an economic recovery in Japan persuaded some international portfolio managers—others soon followed—to raise their Japanese equity and, to a lesser extent, bond holdings from underweighted positions relative to Japan’s share of global asset markets and the size of the real economy. This rebalancing was associated with a sharp rise in the yen and a rally in Japan’s equity market that was sustained until recently.

Toward the end of the period under review, investors increasingly focused on the uncertainties in the U.S. economic outlook, especially on the possibility that monetary policy would tighten when there emerged evidence of persistent rising wage and price pressures and an overheating U.S. economy. At the same time, the Japanese yen showed signs of strengthening further against the dollar, and the euro began to recover from record lows—both indications that investor sentiment might be changing to reflect uncertainties about the sustainability of dollar asset returns. At end-June 2000, considerable uncertainties remained. The key risks reflect these and related uncertainties summarized in the following questions. Is inflation on the rise in the United States, and what would this mean for U.S. and international portfolio adjustments and asset markets? How far will the euro appreciate, and what impact might it have on the process of financial and corporate restructuring that is now under way and making demands on European finance and financial markets? Will Japan’s asset markets adjust smoothly if and when the recovery begins in earnest, and has financial and corporate restructuring established the basis for an enduring expansion in the world’s third largest economy? Finally, have risk management practices and financial markets infrastructures improved sufficiently since the Asian, Russian, and Long-Term Capital Management (LTCM) crises to reprice and reallocate capital in the presence of the risks just described, especially if some of the adjustments occur in a less orderly than desirable fashion?

Foreign Exchange Markets

During the period (mid-1999–mid-2000) under review, the main developments among the major exchange rates were a weakening of the euro against the dollar and a strengthening of the yen. Over the year to June 2000, despite record current account deficits, the U.S. dollar strengthened by about 1 percent in nominal effective terms and ranged around the strongest levels since the late 1980s, appreciating steadily against the euro by 10 percent, but depreciating by 12 percent against the Japanese yen (Figure 2.1). Support for the dollar was underpinned by capital inflows to dollar markets, driven partly by confidence that U.S. productivity gains would sustain further improvements in corporate profitability and thereby bolster equities and corporate bond valuations (Table 2.1 and Box 2.1).1

Figure 2.1.
Figure 2.1.

Selected Major Industrial Countries: Exchange Rates, January 1, 1998–June 30, 2000

(Weekly average)

Sources: Bloomberg Financial Markets L.P.; and IMF.Note: In each panel, the effective and bilateral exchange rates are scaled so that an upward movement implies an appreciation of the respective local currency.1Local currency units per U.S. dollar except for euro area and United Kingdom for which data are shown as U.S. dollars per local currency.21990 = 100; constructed using 1989–91 trade weights.3Prior to 1999, data refer to synthetic rate.
Table 2.1.

Net Foreign Purchases of U.S. Long-Term Securities, 1995–99

(In millions of U.S. dollars)

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Source: United States, Department of Treasury, Treasury Bulletin (various issues).

Movements in the major currencies also reflected capital flows out of European markets and toward the United States and Japan.2 Much of the foreign interest in U.S. corporate securities came from European investors. Net capital outflows from Europe (amounting to about $70 billion in the financial account, and including about $180 billion in net direct investment and portfolio outflows) contributed to the weakening in the euro from $1.184 at the start of European Monetary Union (EMU) to a low of $0.885—a depreciation of 25 percent, although the euro rebounded somewhat to $0.95 by the end of June 2000, a net depreciation of 20 percent. The view that the spread between dollar and euro interest rates was likely to increase further, and the rapidly increasing supplies of both domestic and international euro-denominated securities (Table 2.2)—reportedly including issuance by sovereign and international borrowers who used the proceeds to pay down dollar-denominated debt—also likely contributed to the weakening of the euro against the dollar. As the euro slipped in value, the volatility of the euro-dollar rate increased (Figure 2.2), partly reflecting a withdrawal of capital devoted to market-making amid financial restructuring. However, this decrease in market-making does not appear to have had a lasting impact on liquidity in the euro markets—spreads on currency trades involving the euro have generally narrowed to levels previously associated with the deutsche mark.

Table 2.2.

Outstanding Amounts and Net Issues at International Debt Securities by Currency of Issue, 1993–First Quarter 2000

(In billions of U.S. dollars)

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Source: BIS, International Banking and Financial Market Developments, various issues.
Figure 2.2.
Figure 2.2.

Implied Volatility: Japanese Yen, Deutsche Mark, and Pound Sterling, January 3, 1997–June 30, 2000

Source: Bloomberg Financial Markets L.P.Note: Implied volatility is a measure of the price variability of an underlying security based on the market prices of the call options on futures on that security. Volatilities are expressed in percent rate of change, and are measured using three-month options on the indicated currencies against the U.S. dollar.

The strength of the yen seems to have reflected three main factors: the large and growing Japanese current account surplus; strongly improved investor sentiment and associated capital inflows; and capital repatriation by Japanese investors, who reportedly reduced foreign currency exposures ahead of the end-September 1999 fiscal half-year (during July–September, the yen appreciated by 15 percent against the dollar). Volatility in the yen-dollar market displayed no clear trend during the period under review, although at various points in time it did spike up. Market participants have suggested that interventions by the Japanese authorities were aimed not only at limiting appreciation of the yen but also at offsetting increases in yen-dollar volatility. Variations in yen-dollar volatility over the period under review also appear to be related to technical factors, including hedging of dollar exposures by Japanese institutional investors. Specifically, Japanese institutions typically hedge about 40 percent to 60 percent of their dollar exposures (totaling $400–$500 billion), often with barrier options (see Box 4.1). These hedge ratios depend on the level and volatility of the exchange rate. A change in hedge ratios of, say, 10 percentage points, which is reportedly not uncommon, can generate considerable rebalancing activity—especially if the yen-dollar rate approaches knockout prices on barrier options, triggering volatile market dynamics. This is consistent with the marked increase in actual and implied yen-dollar volatility from about 10 percent in the first part of 1999 to as high as 22 percent in September 1999.

Credit Markets

Developments in the mature credit markets were driven primarily by the rising trend of interest rates in Europe and the United States and little change in the supportive monetary and fiscal policies in Japan (Figure 2.3). The main sources of higher interest rates were continued strong growth in North America and a firming of the European recovery that, in turn, encouraged central banks in these regions to tighten monetary conditions.

Figure 2.3.
Figure 2.3.

Short- and Long-Term Interest Rates, January 1, 1994–June 30, 20001

(In percent)

Sources: Bloomberg Financial Markets L.P.; and European Central Bank.1Weekly data for United States, Japan, and United Kingdom; and monthly data for euro area.2For United States, Japan, and United Kingdom, three-month LIBOR; and for euro area, three-month EURIBOR.3Spread between yield on 10-year government bonds and three-month LIBOR.4Spread between yield on 10-year government bonds and yield on equivalent U.S. government bond.

A variety of other temporary factors influenced yield curves. In Japan, expansive fiscal policy created concerns about the prospective increase in the supply of long-term Japanese government bonds (JGBs). By contrast, in Europe and the United States, yield curves and spreads of corporate bonds (relative to government bonds) were influenced by strong corporate financing requirements in tandem with reduced public-sector financing requirements. In the United States, the stock of government debt dropped from 48 percent to 39 percent of GDP during 1995–99, while the stock of nonfinancial corporate debt increased from 17 percent to 22 percent of GDP. In Europe, euro-denominated international debt issues reached a record in 1999, exceeding U.S. dollar issuance in that year as well as issuance in the euro’s legacy currencies in earlier years.

United States

In U.S. money markets, liquidity remained ample in 1999 despite the Federal Reserve’s reversal of the interest rate reductions made during the autumn of 1998. Nonetheless, the demand for liquidity occasionally pushed up liquidity-sensitive money market spreads, as in late 1999 when spreads relative to treasury bills widened on year 2000 (Y2K) concerns (Figure 2.4). During the last week of 1999 the Federal Reserve injected liquidity into the banking system, and the federal funds rate fell from 5.5 percent to below 4 percent—the widest deviation from its target rate in over nine years. Subsequently, the federal funds target rate was raised in a sequence of six steps to 6½ percent, with tightened liquidity and wider money market spreads in 2000.

Figure 2.4.
Figure 2.4.

Selected Spreads, January 5, 1990–June 30, 2000

(In basis points)

Sources: Bloomberg Financial Markets L.P.; and Merrill Lynch.1Spread over 30-year U.S. treasury bond; weekly data.2Spread between yields on three-month U.S. treasury repos and on three-month U.S. treasury bill.3Spread between yields on 90-day investment grade commercial paper and on three-month U.S. treasury bill.4Spread between three-month U.S. dollar LIBOR and yield on three-month treasury bill.5Spread between yields on a 30-year off-the-run treasury bond and yield on a 30-year on-the-run treasury bond.6Spread of fixed-rate leg of 10-year U.S. dollar interest rate swaps over yield on 10-year U.S. treasury bond.7Spread over main refinancing operations rate.

Foreign Capital and the U.S. Boom

Alongside the strong performance of the U.S. economy since the mid-1990s, foreign investors have looked increasingly favorably on the U.S. from a global asset allocation perspective. As a result, U.S. securities, and in the past few years particularly U.S. corporate bonds and stocks, have been receiving a large and increasing weight in international investors’ portfolios. This can be illustrated with a variety of indicators, but is most easily seen from standard balance of payments figures. Although the U.S. economy presently accounts for about 30 percent of global output, from the perspective of international investors making asset allocation decisions, U.S. capital markets have been receiving a disproportionate share of global capital. In the past year, two-thirds of all capital exported from countries running current account surpluses has been directed toward U.S. capital markets (see first figure).

uch02fig01

United States: Current Account as Share of Global Surpluses, 1992–99

(In percent)

Source: IMF, World Economic Outlook database.

Capital inflows to U.S. securities markets have been impressive since the mid-1990s. As discussed in the 1997 International Capital Markets report, however, recently there has been a fundamental change in the type of U.S. securities toward which foreigners have steered much of their funds. Prior to 1998, the major U.S. beneficiary of the substantial increases in foreign capital inflows had been the U.S. Treasury. For example, from 1995 to 1997, the U.S. treasury market was attracting two-thirds of all capital inflows to U.S. securities markets (see Table 2.1). Two recent developments have fundamentally changed this picture. First, the U.S. Treasury has not had any new financing requirement. Specifically, while the U.S. government’s fiscal position has steadily improved since the deficit peaked at nearly 300 billion in 1992, the fiscal deficit that existed through 1997 has turned into an estimated surplus of close to $200 billion in the current year. Second, there has been a largely uninterrupted improvement in U.S. corporate profitability during the past decade that has led to a near doubling in corporate profits as share of national income (see IMF, 2000b).

The above factors have resulted in two main shifts in the past two to three years in foreign portfolio allocations within the United States. The first is that foreigners now strongly favor U.S. private securities over U.S. treasury securities and the second is that these investors have shifted significantly away from their historical bias toward U.S. fixed income securities and toward U.S. equities (though the net contribution of bonds to financing the U.S. current account still outweighs the net contribution of equities). In particular, foreign purchases of U.S. equities were more than 25 percent greater than foreign purchases of U.S. treasuries during 1999, and foreign purchases of U.S. corporate bonds were almost 100 percent greater. Placed in historical context, the influence of the above factors is even more apparent: foreign purchases of U.S. corporate bonds have nearly tripled since 1995 and foreign purchases of U.S. corporate stocks have risen tenfold.

Another way to view the recent significance of foreign capital in the United States is by examining foreign investment positions rather than foreign investment flows.1 Non-U.S.-based investors currently have financial claims on the United States totaling $6.5 trillion (see second figure). Foreign ownership of U.S. treasury and corporate bonds and stocks totals $4 trillion, and accounts for about 35 percent of the treasury market, almost 20 percent of the corporate bond market, and 7 percent of the equity market. To put these numbers in context, note that the U.S. economy accounts for about 30 percent of global GDP, the U.S. equity market accounts for about 40 percent of the global equity market, and U.S. fixed income markets account for around half of global fixed income markets. In light of the well-known fact that investors hold most of their portfolios in domestic securities, the magnitudes of current foreign positions in U.S. markets are substantial.

uch02fig02

Foreign Ownership of U.S. Assets, 1993–20001

(In percent)

Source: United States, Board of Governors of the Federal Reserve System (2000).1Data for 2000 refer to the first quarter of 2000.
1

Aggregating portfolios of all investors in the world is, by definition, the “market portfolio”—the weights on individual assets and markets exactly correspond to the relative values of the assets and markets. Estimates of investment positions in the United States of non-U.S. investors would be more useful. Unfortunately, it is not possible with the available data to construct portfolios of investors by country of residence.

Upward pressure on long-term treasury yields from tightening monetary conditions was offset by actual and expected reductions in supplies of U.S. treasuries. In the first quarter of 2000, investors began to hoard liquid long-term treasury securities, particularly after the U.S. Treasury announced that it would repurchase $30 billion in bonds. Between January and April, 30-year treasury yields dropped by more than 100 basis points, and the yield curve inverted at the long end (see Figure 2.4). These supply-induced dynamics in the U.S. treasury market in turn had three important effects. First, investors unwound speculative short positions. As a result, volatility in the term spread reached historical highs, and during the week following the February 2 announcement of the treasury buyback, the spread between 30-year and 1-year treasury securities experienced the largest swing since the stock market crash in 1987. Second, investors sought alternative pricing benchmarks and hedging vehicles, including a shift away from 30-year treasury bonds toward 10-year treasuries and long-dated U.S. agency obligations such as those of the Federal National Mortgage Association (Fannie Mae).3 Third, the decrease in long-maturity treasury securities, in tandem with a heavy supply of corporate securities, contributed to large increases in long-term swap and corporate bond spreads over treasury rates. Spreads of U.S. dollar swap rates over treasury rates, for example, peaked in May 2000 at 140 basis points, a record high (see Figure 2.4). The increase of corporate spreads over treasury securities has also been significant, though it is well below the level of the early 1990s. Overall, the sharp rise in dollar credit and swap spreads seems to mainly reflect the decline in U.S. treasury yields, rather than an increase in credit risk.

Europe

In the second half of 1999, long- and short-term euro-area interest rates increased, but lagged behind increases in U.S. and U.K. interest rates. On balance, euro-area monetary conditions remained accommodative throughout 1999, as reflected in strong money and credit growth. These conditions may have encouraged the authorities to raise interest rates during the first half of 2000, leading to subsequent sharp increases in short- and long-term bond yields.

A year and a half after the introduction of the euro, financial market integration has progressed markedly. The general narrowing of money market spreads across borders as well as bid-ask spreads, the sizable level of cross-border turnover, and the decreased reliance on ECB backup facilities by euro-area financial institutions all point to a high degree of integration and improved liquidity management in the unsecured money market. The euro-area money market appears to be developing into a two-tiered structure. The first tier includes the large banks in each national market, which compete for ECB funds at auction and trade liquidity among themselves, effectively distributing liquidity throughout the euro area. These large banks act as hubs for distributing liquidity to a second tier of smaller institutions in national markets.

Overbidding remained a prominent feature of ECB auctions during the period under review. The fixed-rate, fixed-quantity structure of the ECB main refinancing operation (MRO) has apparently given euro-area banks incentives to bid very aggressively for liquidity at auctions. At auctions during the March 24–April 23, 2000 reserve maintenance period, banks bid for between 35 and 70 times more liquidity than was offered by the ECB.4 On June 8, 2000, the ECB announced that, starting with the operation settled on June 28, it would switch to variable-rate tenders for its MRO, to address the overbidding problem. The new format employs a minimum bid rate, initially set at 4.25 percent—the MRO rate in effect following the 50-basis-point increase on June 8. At the first variable-rate operation on June 27, the ECB auctioned €99 billion at a weighted-average rate of 4.32 percent. Market participants noted that the operation went smoothly and ECB Chief Economist Issing noted that the new procedure had solved the overbidding problem.

Euro-area bond markets have grown rapidly since the start of EMU (Figure 2.5). In 1999, debt issuance by private nonfinancial corporations increased by nearly 300 percent as robust merger and acquisition activity stimulated direct access to credit markets.5 Going forward, prospective changes in corporate capital gains taxation in Germany (discussed later) are also expected to increase capital market issuance, as corporations and financial institutions may need additional financing to unwind their complex cross-holdings. Despite the rapid growth of European private bond markets, the outstanding stock remains small in absolute terms and in comparison with markets in the United States. Bank loans are equivalent to 100 percent of GDP in the euro area, compared with 50 percent in the United States; by contrast, corporate bonds are equivalent to 3.3 percent of GDP in the euro area, compared with 30 percent in the United States.

Figure 2.5.
Figure 2.5.

International Bond Issuance by Currency, First Quarter 1996–Second Quarter 2000

(In billions of U.S. dollars)

Source: Capital DATA Bondware.1Prior to 1999, data refer to legacy currencies of the euro.

Lack of an integrated repo market has hindered the development of a euro-area-wide bond market, as noted in the 1999 International Capital Markets report. A recent ECB study suggests that the continued lack of integration of private repo markets reflects (1) the differing liquidity of underlying bonds; (2) the lack of harmonization of legal documentation used for repo agreements; (3) practical difficulties in the cross-border management and settlement of collateral (notably the existence of 29 national securities settlement systems); (4) differential tax treatment of bonds across countries; and (5) an uneven availability of collateral across the euro area.6

Japan

In contrast to other mature markets, Japanese interest rates did not rise (from their very low levels) during the period under review. Because of concerns with the weak recovery in real activity as well as the lingering concern about the financial system, in February 1999, the Bank of Japan lowered the uncollateralized overnight call rate from ¼ percentage point to effectively zero. In April, the Bank of Japan signaled that it would maintain the zero interest rate policy until deflationary concerns were dispelled. The Bank of Japan has indicated since late 1999 that a pickup in private domestic demand would be sufficient to dispel deflationary concerns. The call rate fell to as low as 0.02 percent, engendering a concomitant decline in other money market rates to record lows as well as causing a rapid buildup of banks’ excess reserves. However, lending on the overnight market contracted sharply because lenders could not earn sufficient returns to cover the commissions charged by money market brokers (it was more profitable to deposit funds in liquid bank accounts), and because of the decreased demand for excess reserves reflecting the Bank of Japan’s policy of providing ample liquidity. Outstanding claims in the call money market declined from about ¥36 trillion to below ¥20 trillion during 1999 as major lenders such as trust banks, insurance companies, and agricultural cooperatives exited the market. Funds have flowed to other instruments, notably expanding the 13-week Financing Bill market. which has taken over from the certificate of deposit market as the benchmark for short-term interest rates.

Japanese long-term bond rates dipped after the announcement of the zero interest rate policy, but rebounded shortly thereafter and, overall, have exhibited little direction over the past year—remaining in the 1½–2 percent range. According to market participants, the main factors that have helped to maintain long rates at this low level include large capital inflows, domestic price deflation, a strong yen, and strong demand for JGBs by Japanese banks (whose holdings were estimated at ¥44 trillion in 1999, compared with ¥31 trillion in 1998). Some observers have expressed concerns that if banks reduce their purchases of JGBs, bond prices could drop sharply, which could in turn cause valuation losses at banks and reduce bank profitability.

Japanese financial institutions reportedly expect that JGB market supply and demand will remain balanced at roughly current prices, even as the stance of monetary and fiscal policies becomes less accommodative. Nevertheless, it has been cited as presenting risks that the Trust Fund Bureau will likely have to reduce its purchases as its funding (postal savings deposits) declines. Although some market participants believe that such tensions will be deftly negotiated without upsetting market expectations, risks remain. The experience in December 1998—when a relatively minor and anticipated change in the Trust Fund Bureau’s purchases of JGBs led long-term yields to rise sharply—suggests that it might be difficult to maintain the balance of supply and demand at current prices.

In Japanese corporate bond markets, credit spreads narrowed from their early-1999 highs, in part owing to increased liquidity from the Bank of Japan’s zero interest rate policy, and in part owing to anticipated corporate restructuring.7 In May 2000, five-year A-rated Japanese corporate bonds traded at spreads of around 40 basis points over government bonds, compared with spreads of about 120 basis points for A-rated U.S. corporate bonds of comparable maturity (yen swap spreads were similarly compressed). The number of announced restructuring plans and the value of takeovers and mergers have both risen sharply in the recent period, and a number of new measures have encouraged restructuring. Nonetheless, some market participants continued to express concerns about the slow pace and limited efficacy of financial and corporate restructuring (see Annex I).

International Securities and Syndicated Loan Markets

The start of Stage III of EMU and the introduction of the euro were accompanied by increased net issuance of euro-denominated international securities compared with U.S. dollar-denominated securities, which accounted for 48 percent and 43 percent of overall net issuance respectively (see Table 2.2). European financial institutions dominated issues in euros, while U.S. agencies dominated issues in U.S. dollars. The shares of both euro- and dollar-denominated securities in the outstanding stock of international securities rose modestly to 29 percent and 47 percent respectively, while the share of yen-denominated securities shrank.

Merger and acquisition activity boosted syndicated lending, as announced transactions increased by 6 percent to about $960 billion in 1999, and remained strong in the first quarter of 2000 (Table 2.3). Market analysts suggest that despite the growing access to the private bond markets in Europe, many corporations still prefer the speed, flexibility, and discretion of the syndicated loan market, especially for merger and acquisition finance. They also note that as the banking industry consolidates further, increasing numbers of regional banks will likely be involved in pan-European syndicated loans.

Table 2.3.

Announced International Syndicated Credit Facilities by Nationality of Borrowers, 1992-First Quarter 2000

(In billions of U.S. dollars)

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Source: BIS.

Equity Markets

There were two main developments in the major equity markets (Figure 2.6). First, technology shares globally increased sharply through March 2000, and then fell back during the subsequent two months. Second, in broader markets, only euro-area equity prices have managed to sustain gains during the period under review.

Figure 2.6.
Figure 2.6.

Major Industrial Countries: Stock Market Price Indices, December 31, 1998–June 30, 2000

(National currency)

Source: Bloomberg Financial Markets L.P.1For United States, Standard & Poor’s 500 Index; for Japan, Nikkei 225 Index; for euro area, Financial Times Stock Exchange Eurotop 100 Index; 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.2For United States, NASDAQ Composite Index; for Japan, JASDAQ Index; for euro area, EASDAQ Index; for Germany, Neuer Markt Index; for France, Nouveau Marche Index; for Italy, Nouvo Mercato Index; and for United Kingdom, Financial Times Stock Exchange SmallCap Index.

Broad Market Indices

Despite the absence of sustained significant gains in U.S. equity prices generally, the relatively high level of U.S. equity prices (as measured by traditional valuation indicators) has been maintained by confidence in continued buoyant economic conditions, productivity gains, and ongoing corporate share purchases through buy-back programs and mergers. On the other hand, the broader U.S. equity market was negatively affected by portfolio shifts toward high-technology shares.

As broad market indexes advanced sharply in the euro area, the equity market became a more important vehicle to raise capital, partly reflecting the rising pace of merger and acquisition activity. Among the reasons for this, German tax reform signaled new avenues for restructuring domestically and through cross-border merger and acquisition. In December, the government’s announced income tax reforms included a surprise proposal to eliminate capital gains taxes (currently 50 percent) on corporate and industrial shareholdings. The DAX index rose by 4.5 percent on the day of the announcement (December 23) and subsequently outpaced the U.S. market.

A major step in consolidation among European stock exchanges came in March 2000 with the creation of Euronext, which merged the stock exchanges of Amsterdam, Brussels, Madrid, Paris, and Zurich. This was followed in May by plans to create the International Exchange (iX), which combines the London Stock Exchange and the Deutsche Börse. The plans for iX also include the creation of a pan-European market for technology stocks (operated out of Frankfurt in place of the Neuer Markt) in a joint venture with Nasdaq.

Through March 2000, the Japanese equity market outperformed other major international stock markets, though these gains quickly proved to be short lived. The stock market recovery was aided by improved sentiment about economic prospects, which induced strong net inflows of foreign portfolio capital as investors raised their country allocations to Japan from long-standing underweight positions. However, during April-June 2000, share prices dropped to mid-1999 levels on increasing concern about the need for further corporate restructuring, the strengthening of the yen, and cyclical uncertainty.8 The short-term performance of stocks may also have been dampened by speculation about corporate liabilities from the prospective implementation of tighter pension and mark-to-market accounting standards during FY2000—FY2002. Nonetheless, in the medium term, the expected improvements to transparency and accountability could stimulate corporate restructuring and an unwinding of cross-shareholdings and make companies in traditional sectors more attractive. In addition, prospective pension reform (which implies a shift to defined-contribution-like plans) and the potential real-location of maturing postal saving deposits into equities are expected to stimulate the Japanese equity market. Specifically, during 2000–2001, ¥106 trillion (21 percent of GDP) in postal saving deposits are expected to mature. While the general expectation in early 2000 was that withdrawals of postal savings could be substantial, evidence to date suggests that most of the funds have been redeposited into the postal saving system.

Technology Stocks

In the United States, Europe, and Japan, technology-focused indexes outperformed broader indexes by considerable margins, especially up to March 2000 (Figure 2.7). In the United States, the Nasdaq index strongly outpaced the broader U.S. index by 86 percentage points. The high average price-earnings ratio for the Nasdaq 200 in April implied that investors expected future earnings to grow at an exceptionally rapid rate, notwithstanding the fact that Nasdaq earnings declined by 18 percent during the 12-month period ending in April 2000.

Figure 2.7.
Figure 2.7.

Sectoral Stock Market Indices and Price-Earnings Ratios, December 31, 1998–June 30, 2000

Source: Datastream.1Price indices; December 31, 1998 = 100.2Price-earnings ratios; price-earnings ratios are systematically higher in Japan than in the United States, partly reflecting differences in accounting practices (see Bildersee, Cheh and Lee, 1990).

In Europe and Japan between June 1999 and March 2000, the technology-laden Easdaq and Jasdaq indexes outpaced their corresponding broader stock market indexes by 104 and 89 percentage points, respectively. European technology sectors benefited from a surge in investment funds allocated toward technology shares. In Japan, the sharp rise in technology share prices was also aided by new specialized stock exchanges and investment funds that eased access for investors. In December 1999, the Tokyo Stock Exchange launched a specialized stock market for high-tech firms, which was followed in June 2000 by the launch of Nasdaq-Japan, a joint venture by Nasdaq and Softbank. Several firms plan to introduce new high-tech and startup investment funds.

The strong rise in technology stocks globally through March 2000 fed an increasing sense of unease in the major equity markets. During the first four months of 2000, volatility in technology stocks rose about fourfold in the United States and Europe, and rose as much as sevenfold in Japan. Unease was also boosted by sharp increases in margined stock purchases. Between end-1996 and end-April 2000, margin credit in the United States grew at an average annual rate of 33 percent. At the market peak in March 2000, margin credit accelerated to a record level of $279 billion, rising by 78 percent from levels 12 months earlier (margin credit declined by about 14 percent during April–May, however). In February 2000, the Jasdaq began to register declines and, on March 10, 2000, the Nasdaq index peaked at 24 percent above its end-1999 level (and 130 percent above its end-1998 level). The ensuing market correction in the United States (more than 30 percent during the March-May period) and Japan spread to Europe.

Major Banking Systems

Major banks in the mature markets generally recorded improved results in 1999, as the effects of the 1998 crisis waned in an environment of broadly supportive economic activity and rising stock prices. Trading income rebounded for many internationally active banks following weak performance in the second half of 1998. Nonetheless, in a number of countries, bank stocks trailed broad indexes, perhaps reflecting market skepticism that trading gains could be sustained, concerns that the credit cycle might have peaked, or the threat of competition from Internet-based financial intermediaries. Banking consolidation continued apace, against the background of a number of important developments including, in the United States, the repeal of Glass-Steagall restrictions on combining investment and commercial banking; in continental Europe, the first year of the single currency, and the ongoing search for “national champions”; and in Japan, efforts to cut costs and raise core profitability in a more stable financial environment.

In 1999, U.S. banks earned record net revenues for the eighth year running, owing in large measure to a rebound in trading income. Earnings from venture capital activities, including capital gains, accounted for as much as 25 percent of earnings at some institutions. Strong core earnings have also helped to sustain bank profitability in recent years, as net interest margins have remained around 4 percent in an environment of vigorous economic activity. Against this background, average return on equity for top banks climbed by about 2 percentage points to about 19 percent in 1999, and return on assets also edged higher. Nonperforming loans were broadly stable as a share of assets, as unusual strength in the U.S. economy offset a shift to more risky types of consumer lending. Top U.S. banks maintained a healthy level of capital, with an average Tier 1 ratio of about 8 percent. Thus far in 2000, many banks have indicated a strong showing in the first quarter, including a 55 percent rise in trading revenue to record levels at U.S. commercial banks. However, some banks and analysts have also warned that earnings growth may have fallen off in the second quarter.

Looking ahead, many analysts foresee a pickup in consolidation among small U.S. financial institutions following the passage of financial modernization legislation (the Gramm-Leach-Bliley Act that repealed certain sections of Glass-Steagall walls between investment and commercial banking; see Box 2.2). Financial institutions may seek to add franchise value by spanning a broad array of business lines to make use of synergies between trading activity and other business lines. At the same time, trading income has become more volatile and may be vulnerable to a deterioration in economic and financial conditions. The Federal Reserve and the Treasury Department have proposed to require banks to set aside capital equivalent to 50 percent of their venture capital exposures, compared with the current 8 percent requirement for merchant-banking investments.9

Canadian banks enjoyed another year of strong profits reflecting robust economic growth. Net income for the top six banks rose by 25 percent, and average return on equity rose 3 percentage points to about 18 percent. Asset quality remained favorable, and charge-offs as a percentage of loans eased. The average Tier 1 capital ratio rose by about 1 percentage point to slightly more than 8 percent, and analysts generally consider that Canada’s banking system can easily withstand a slowing in economic activity. The banking system underwent further consolidation, as one of the six major banks acquired the seventh-largest bank. In May 2000, the government introduced a formal process for official approval of bank mergers. The top banks that were denied permission to merge several years ago may soon seek official approval for mergers under this process.

U.K. banks also reaped strong profits, owing to healthy margins and a favorable economic environment. Net income rose at double-digit rates for most top banks, some of which registered returns on equity of 20 percent to 30 percent. As in past years, profits were especially strong in domestic retail businesses, which has prompted some official scrutiny.10 As on the European continent, the U.K. banking sector saw consolidation during 1999, including the domestic acquisition of a major London bank and the acquisition of a French bank by a major international bank headquartered in the United Kingdom. Asset quality remains strong for U.K. banks, and Tier 1 capital is robust, at about 8–10 percent for the top banks. Nonetheless, in the period ahead, U.K. banks may face challenges from increased competition in retail markets if strong profitability attracts new entrants.

Major continental European banks enjoyed robust trading income and faced increased pressure to consolidate in the environment of the new single currency. The introduction of the euro has catalyzed financial and corporate restructuring (including cross-border mergers and acquisitions) and increased financial sector competition. Euro-area regulatory, supervisory, and market surveillance are being viewed in Europe as requiring greater harmonization, cooperation, and coordination (Box 2.3). The three major German banks all registered strong results for the first six months of 1999. Gains in trading income ranged as high as 75 percent for one bank, and some banks earned record levels of commission income. French banks also enjoyed robust growth in revenues from capital markets activities, and in the first half of 1999, year-on-year pre-provision income grew at double-digit rates for three of the largest four banks. Italian banks appear to have sustained strong trading profits, though they likely did not improve upon the previous year’s results. Despite continental banks’ positive results, their returns on equity generally remained relatively low by international standards—no more than about 10 percent for most banks—and net interest margins generally remained weak, partly reflecting fragmentation and limited market shares in retail banking and (particularly in Germany) reflecting competition from public-law banks. Capital ratios are mixed, with reasonably strong Tier 1 capital ratios for major French and Italian banks (about 7–9 percent) contrasting with weaker levels for major German banks (generally closer to 5 percent). Central banks in France and Spain have asked their banks to increase provisioning so as to reflect risks over the full economic cycle.

Financial Sector Reform in the United States: The Gramm-Leach-Bliley Act

After failed past attempts to modernize financial legislation, the Gramm-Leach-Bliley Act was enacted in November 1999. This Act repeals Section 20 of the Glass-Steagall Act of 1933, which restricted affiliations between banks, securities firms, insurance companies, and other financial service providers. It also modifies the Bank Holding Company Act of 1956 by allowing holding companies that own commercial banks to engage in any type of financial activity. The Gramm-Leach-Bliley Act also allows securities firms to buy banks. Rather than serving as a sea change, the Act modernizes U.S. financial regulations to reflect the current state of the financial services industry.

One element of the Act is the creation of a new “financial holding company” structure that allows a banking organization to engage in any type of financial activity or to affiliate with any type of financial company (see the table). A financial holding company is a special type of bank holding company, except approval from the Federal Reserve is not required before engaging in nonbanking financial activities. Bank holding companies may also conduct certain nonfinancial activities, if the Federal Reserve sees the activity as complementary to financial activity, and if the activity does not pose a substantial risk to the safety and soundness of depository institutions. Activities could include real estate management, commodity trading, leasing, and accounting and auditing services. Through a financial holding company structure, a securities firm can acquire a bank, but the securities firm would have to face greater regulatory constraints. The Gramm-Leach-Bliley Act also allows financial holding companies to acquire insurance firms, and in effect eliminates the long-standing barriers to foreign insurance companies operating in the United States. In addition, national banks are allowed to own directly a new type of “financial subsidiary” that can participate in the newly authorized financial activities, except for insurance underwriting, real estate development and investment, merchant banking, or other complementary activities.1 National banks may still underwrite credit-related insurance and engage in complementary activities such as leasing, accounting, and auditing through the provisions of existing operating subsidiary regulations, however.

A sharp increase in the pace of consolidation is unlikely. Banks already have purchased securities firms, and the passage of the Gramm-Leach-Bliley Act does not create new acquisition opportunities. The impact of the Act may, however, be felt in smaller mergers and acquisitions that allow banks and nonbanks to integrate vertically. For example, mortgage lending companies would be free to add real estate services.

The Gramm-Leach-Bliley Act also empowers the Federal Reserve Board as the “umbrella supervisor” for financial holding companies—on the grounds that large financial services companies manage risk on a consolidated basis and it is important to understand the risks that the holding company faces. At the same time, the Act limits the Federal Reserve’s authority over financial companies regulated by functional regulators—the so-called Fedlite provision. For example, a financial holding company that is regulated and supervised by the Federal Reserve may own a bank regulated by the Office of the Comptroller of the Currency, a broker-dealer supervised by the Securities and Exchange Commission, and an insurance company regulated by a state insurance regulator. As a result, the Federal Reserve faces an inherent tension of protecting banking entities from undue risk, while avoiding supervising the nonbank affiliates.

While providing broad guidelines, the Act does not specify how umbrella and functional supervision should be implemented in practice. The Federal Reserve is expected to rely as much as possible on the examinations and reports prepared by the functional regulators. At the same time, the Federal Reserve has the authority, under certain circumstances, to examine any affiliate of a financial holding company. The Federal Reserve Board can examine functionally regulated entities only if (1) there is reason to believe that the entity is engaged in activities that could pose risk to an affiliated depository institution; (2) it is necessary to inform the Board about the risk management system of the company; and (3) the Board has reasonable cause to believe that the entity is not in compliance with the banking laws. To work effectively, the combination of umbrella and functional regulation will require open communication, and close cooperation and coordination among the various regulatory bodies. One shortcoming of the legislation might be that the Federal Reserve does not have immediate access to detailed information about the exposure of insurance and securities subsidiaries even during times of market stress. Instead, it must rely on information from the functional regulators, who, unlike the Federal Reserve, do not operate under a mandate to ensure financial stability. Work on this issue is current under way at the Federal Reserve and the Securities and Exchange Commission.

Key Provisions of the Gramm-Leach-Bliley Act

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Although Section 20 of the Glass-Steagall Act prohibited banks from being affiliated with firms that are principally engaged in the underwriting of securities, the Federal Reserve had interpreted this regulation to allow banks to affiliate with firms that underwrite bank impermissible securities as long as this was not a substantial part of the affiliate’s business.

1

In general terms, state-chartered banks can engage in the same activities as national banks, as long as state law permits. In addition, state banks that are not members of the Federal Reserve System can apply to the Federal Deposit Insurance Corporation to engage in any any activity, including those that a new financial holding company may engage in, and which are prohibited for the new financial subsidiaries of national banks.

Recently, considerable domestic consolidation has been seen in continental European banking systems, but (except in a few instances in Nordic and Baltic countries) relatively little cross-border consolidation. In Germany, the banking system remains highly fragmented, despite considerable consolidation among savings and cooperative banks. In the first half of 2000, a high-profile merger attempt between two major German banks was called off amid a disagreement over how to (or whether to) merge investment banking operations. In France, merger discussions among three major domestic banks culminated in a two-way merger that created Europe’s second-largest bank in terms of assets. The Italian banking system has likewise seen a number of mergers in recent years at both the regional and national levels. Significant cross-border mergers seem to have been held back by the structure of cross-shareholdings of European bank shares, the limited economies of scale in cross-border retail mergers, the increased risk of failure compared with domestic mergers, and continued efforts to build “national champions” that can compete in cross-border investment banking.

Japanese major banks reported modest net profits in the year to March 2000, as operating profits and realized gains on equities more than offset substantial loan-loss charges. Equity market gains accounted for about half of aggregate adjusted pre-provision profits, while gains from fixed-income trading declined. Overall profitability remained relatively low by international standards, with annualized returns on equity at about 8 percent. Problem loans (as measured by the Financial Revitalization Law definition) declined by about 9 percent, largely reflecting the writing down of claims.

Analysts suggest that uncovered losses remain substantial, owing in part to a deterioration in the value of collateral. In addition, corporate restructuring may put further pressure on loan quality in the period ahead. Tier 1 capital averages about 6½ percent for top banks, at the lower end of the range for top banks worldwide. Analysts have raised concerns about the quality of Tier 1 capital, which consists mainly of tax receivables (about 25 percent of aggregate Tier 1 capital, compared with a regulatory maximum of 10 percent in the United States) and government-subscribed preferred stock (about 25 percent of capital). Some have also raised concerns that subordinated debt and other limited-life liabilities will need to be refinanced within two years. In addition, banks’ heavy investments in JGBs have significantly exposed them to a rise in long-term interest rates. By one estimate, a 100-basis-point rise in long-term interest rates costs the major banks ¥1.1 trillion, equivalent to about one-third of operating profits or 5 percent of Tier 1 capital.

Japan’s financial landscape has changed considerably in the recent period, but banks face many of the same long-term challenges (see Annex I). One of the two nationalized major banks has been reprivatized, and the other is expected to be reprivatized soon. Since mid-1999, 4 major bank mergers involving a total of 11 banks have been announced. With these mergers, the 10 city banks that existed in September 1997 will be reduced to 5 (1 of the original 10 is no longer a city bank). Analysts see these mergers as a defensive response to the entry of nonfinancial companies into banking. In part, they are seen as a strategic response to Big Bang reforms, as only the strongest and best managed institutions will be able to compete effectively for capital markets business and postal savings outflows. It is less clear, however, whether they are an effective response to the challenge of raising core profitability, a challenge that will prove difficult to surmount in view of the limited scope for cost cutting given their already low costs by international standards, competition from public financial intermediaries in retail banking, and intense competition from foreign financial institutions in capital markets.

Financial Stability Challenges Arising from the Introduction of the Euro

The introduction of the euro in January 1999 has created new financial stability challenges for European authorities. To assess them, a working group was set up by the European Union’s Economic and Financial Committee and chaired by Henk Brouwer of the Netherlands Bank.1 This box summarizes the main conclusions of the report, and explores some of the issues that could arise with implementation.

The Brouwer Report reviews the framework for coordinating the activities of supervisors and central banks in light of the recent separation of the domains of supervision, which remains national, and central banking, which is conducted for the euro area as a whole by the European System of Central Banks (ESCB). It characterizes this framework as operating on several levels: the regulatory level based on the mutual recognition of national regulations and harmonization through EU directives; the supervisory level, based on the principle of home country consolidated supervision supported by a network of bilateral Memorandums of Understanding specifying the modalities of cross-border cooperation; and through multilateral forums for the exchange of information, such as the Banking Supervision Committee and the Group de Contact. The report concludes that in principle this framework is adequate but that it could be strengthened at the level of its practical functioning in two areas: through a convergence of supervisory practices to improve the monitoring of cross-border institutions and better coordination between banking, securities, and insurance supervisors in the supervision of financial conglomerates; and by strengthening the exchange of information between supervisors and between them and the ESCB, with emphasis on information about financial problems with potential contagion effects.

The recommendations relating to cooperation between supervisors are likely to prove un-controversial as they are consistent with those advocated by banking, securities, and insurance supervisors. Those concerning the exchange of information, however, leave open important questions relating to the type of information, its frequency, and its timeliness. The chance of achieving consensus on these issues is likely to be less for crisis prevention than for crisis ma agement. In the latter case, cooperation should be relatively easy to achieve since infomation is typically only needed when a crisis situation develops and can be identified based on its features. For crisis prevention, ho ever, supervisors and central banks must reach a consensus on both the factors contributing to the risk of a crisis and the information that needs to be monitored. Given the highly confidential nature of supervisory information and the costs involved, some supervisors may be reluctant to provide it unless they are convinced it is necessary. Two considerations in particular may make consensus hard to achieve. First, supervisors and central banks may have different perspectives. While supervisors are concerned about individual institutions, the ESCB focuses on systemic risk and risks to market functioning in the euro area as a whole. Second, there is an ongoing, rapid transformation of the European financial landscape, spurred in part by the introduction of the euro, the removal of barriers to competition and consolidation, the impact of new technology, and the development of much larger and more liquid financial markets. This has exposed financial institutions to new and possibly unfamiliar risks and may have contributed to changes in the nature of systemic risk. In areas where these considerations prevent (or delay) supervisors and the ESCB from reaching a consensus, the ESCB may lack the information to engage in effective crisis prevention, limiting its role largely to crisis management. Given these potential impediments to effective crisis prevention, it may be prudent to ensure that the ESCB has timely access to relevant supervisory information even when consensus has not been achieved. Work on this issue is under way within the ESCB.

The exposure of mature-market banks to emerging markets continued to decline during 1999, though at a slower pace than in 1998 (Table 2.4). Total exposure of mature-market banks to emerging markets declined by about 8 percent to just under $1 trillion at end-December 1999. Since mid-1997, bank exposures to emerging markets have decreased by about $300 billion, a decline of about 25 percent. Exposures to Asian emerging markets, and particularly the countries affected by the 1997 crisis, have been strongly reduced; exposures to Africa, Latin America, and the Middle East have risen moderately.

Table 2.4.

Claims of Banks in BIS-Reporting Countries on Selected Emerging Markets as of December 19991

(In billions of U.S. dollars)

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Sources: BIS, International Banking and Financial Market Developments (Basel, various issues); and IMF staff calculations.

On-balance-sheet claims, excluding claims on offshore centers (with the exception of Hong Kong SAR and Singapore, which are included in Asia).

Because data are not reported for Greece, Luxembourg, and Portugal, data are for Austria, Belgium, Finland, France, Germany, Ireland, Italy, the Netherlands, and Spain.

Developments in Derivatives Markets

During the period under review, activity in global derivatives markets was mixed (Tables 2.52.8). Between June 1998 and December 1999, notional principal (the reference amount for payments in a derivatives contract) in global OTC derivatives markets rose from $72 trillion to $88 trillion, while notional principal in organized exchange markets declined modestly from about $15 trillion to about $14 trillion (see also Chapter IV). Between April 1995 and April 1998 (the most recent period for which global OTC turnover data are available), average daily turnover in global OTC derivatives markets rose by about 50 percent to $1.3 trillion, while turnover on derivatives exchanges rose by about 16 percent to $1.4 trillion. During 1999, amid the introduction of the euro, the waning of the effects of the autumn 1998 turbulence, and a reduction in leverage in the financial system, the pace of growth in OTC derivatives activities slowed (including an outright fall in OTC foreign exchange derivatives), though growth in interest rate derivatives picked up sharply in the second half of the year. In addition, fluctuations in the demand for and supply of underlying cash instruments (particularly government securities) had a particularly pronounced effect on fixed-income markets (as noted above). Activity continued to decline at some of the major exchanges owing to the decreasing competitiveness of pit trading, though electronic exchanges gained increasing market share.

Table 2.5.

Exchange-Traded Derivative Financial Instruments: National Principal Amounts Outstanding, 1986–First Quarter 2000

(in billions at U.S. dollars)

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Source: BIS.
Table 2.6.

Annual Turnover in Derivative Financial Instruments Traded on Organized Exchanges Worldwide, 1986–First Quarter 2000

(In millions of contracts traded)

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Source: BIS.
Table 2.7.

Global Over-the-Counter (OTC) Derivatives Markets: Notional Amounts and Gross Market Values of Outstanding Contracts, 1998–991

(In billions of U.S. dollars)

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Source: BIS (2000b).

All figures are adjusted for double-counting. Notional amounts outstanding have been adjusted by halving positions vis-à-vis other reporting dealers. Gross market values have been calculated as the sum of the total gross positive market value of contracts and the absolute value of the gross negative market value of contracts with nonreporting counterparties.

Single-currency contracts only.

Adjustments for double-counting are estimated.

For end-June 1998: positions reported by institutions that only participated in the 1998 Triennial Survey of Foreign Exchange and Derivatives Market Activity; for subsequent periods: estimated positions of those institutions.

Gross market values after taking into account legally enforceable bilateral netting agreements.

Table 2.8.

Global Over-the-Counter (OTC) Derivatives Markets: Notional Amounts and Gross Market Values of Outstanding Contracts by Counterparty, Remaining Maturity and Currency Composition, 1998–991

(In billions of U.S. dollars)

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Sources: BIS (2000a, 2000b).

All figures are adjusted for double-counting. Notional amounts outstanding have been adjusted by halving positions vis-à-vis other reporting dealers. Gross market values have been calculated as the sum of the total gross positive market value of contracts and the absolute value of the gross negative market value of contracts with non reporting counterparties.

Residual maturity.

Counting both currency sides of each foreign exchange transaction means that the currency breakdown sums to twice the aggregate.

Data before end-June 1999 refer to legacy currencies of the euro.

Single-currency contracts only.

Adjustments for double-counting are estimated.

For end-June 1998: positions reported by institutions that only participated in the 1998 Triennial Survey of Foreign Exchange and Derivatives Market Activity; for subsequent periods: estimated positions of those institutions.