Financial Stability 2/2004

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1 International developments and Norwegian securities markets

1.1 International developments
1.2 International banking industry
1.3 International securities markets
1.4 Securities market in Norway

Boxes:
- Derivatives markets are expanding
- Use of a central counterparty in the settlement of financial instruments

1.1 International developments

Global financial stability has strengthened since Financial Stability 1/2004. Growth in the world economy in 2004 is expected to be the highest for several decades. Households and enterprises are benefiting from higher income and low interest rates. The international banking industry is posting solid results and can strengthen its financial position.

It is uncertain how long the strong pace of economic growth will continue. High prices for oil and other commodities and falling investment and growth in China could have a dampening impact on growth. A further depreciation of the US dollar may have an impact on capital flows and the geographical distribution of economic growth, and lead to considerable price movements in securities markets.

The sharp rise in house prices and household debt in many countries constitutes a risk to economic developments in the longer term. Household demand was high through the entire cyclical trough in 2001-2002. Business investment fell in the same period, and has shown signs of picking up in some countries only in recent months. This is reflected in the persistently high credit growth rates for households and lower rates for enterprises (see Chart 1.1). The fairly high household debt burden in many countries could mean that future growth is more dependent on a pick-up in business investment.

Chart 1.1

1.2 International banking industry

Low loan losses and solid bank earnings

Strong economic growth, solid corporate earnings and low interest rates contributed to a fall in banks’ loan losses in many countries in 2003 and the first six months of 2004. Banks’ return on equity has also increased markedly in many countries.

Banks’ loan losses normally fluctuate with the business cycle. However, the global downturn around 2001-2002 only had limited impact on loan losses (see Chart 1.2). Improved risk management at banks, low exposure to highly loss-exposed sectors and low interest rates are probably the main reasons. Prospects of relatively solid economic growth and continued low interest rates would suggest that banks’ loan losses will remain low for a period ahead.

Chart 1.2

Among foreign banks, the banks in other Nordic countries are of particular importance for the financial sector in Norway.¹ The largest Nordic banks have very low loan losses and solid earnings (see Section 3).

High growth in mortgage lending

House prices have been rising at a fast pace in many countries for a long time. Low mortgage rates and expectations of rising house values have probably been important driving forces.² Higher house prices have increased homebuyers’ borrowing needs. At the same time, existing mortgage customers have increased their loans on the basis of higher values for their dwellings. This means that higher house prices have not necessarily increased banks’ collateral margins, i.e. the difference between the mortgage value and the loan amount. As a share of GDP, outstanding mortgages have increased sharply in several countries (see Chart 1.3). Moreover, surveys in the euro area and the US show that a steadily rising share of banks are softening their lending criteria vis-à-vis households.³ This may increase the vulnerability of banks to a fall in house prices and a weakening of households’ financial situation. There have recently been signs of moderating house price inflation in several countries, and in the UK and Australia, among other countries, house prices have declined in recent months.

Chart 1.3

Banks more active in commodity derivatives

The turnover in energy derivatives has increased over the past year. Increased price volatility for many commodities and low returns on financial assets have been the main driving forces, but high commodity prices may also have contributed. In addition, energy market deregulation has led to strong growth in energy derivatives markets. According to the IMF, energy-related contracts, including contracts based on energy sources such oil and gas, now constitute the largest derivatives market after financial instruments such as interest rate and foreign exchange derivatives⁴. Banks have recently become more active in energy derivatives markets (see Chart 1.4). Developments in these markets have thus become more important for stability in the financial sector.

Chart 1.4

1.3 International securities markets

Small price changes in the largest equity markets

Equity prices in the largest markets are now at about the same level as six months earlier when the previous report was published (see Chart 1.5). In the US and Europe, prices declined somewhat through the summer. The rise in oil prices and warnings from companies of weaker profits in the second half of 2004 have contributed to this. Equity prices have risen again this autumn. In the US, 62% of the companies in the S&P 500 Index reported higher third-quarter profits than analysts had expected. The relationship between equity prices and expected earnings (P/E ratio) in the US has fallen somewhat since Financial Stability 1/2004 and is lower than the 10-year historical average (see Chart 1.6). In the US market, uncertainty surrounding price developments, as measured by implied volatility using options, has fallen further since the previous report.

Chart 1.5     Chart 1.6

Lower long-term interest rates

Central banks in the US, the UK and a number of other countries have increased their key rates somewhat this year. Long-term interest rates are still generally lower now than six months earlier (see Chart 1.7).

Chart 1.7

Lower long-term interest rates may indicate that bond investors have reduced their growth expectations for the current period, both as regards the duration and intensity of growth. The implications of the depreciation of the dollar and a persistently high oil price for global economic growth are especially uncertain.

More positive credit assessments of enterprises

The yield differential between corporate bonds and government bonds in the US and Europe has narrowed over the past year. Solid earnings and lower debt ratios have contributed to this. The international credit rating agencies are more positive about companies’ financial situation. The number of companies whose ratings are revised upwards now exceeds the number whose ratings are revised downwards. The ratio was 1.13 in the third quarter, compared with 0.85 in the second quarter and 0.52 one year earlier.⁵ Improved creditworthiness and low interest rates have increased companies’ possibilities for extending debt maturity.

1.4 Securities market in Norway

Large price gains in the Norwegian stock market

At the end of October, the Oslo Stock Exchange benchmark index set a new historical record. The index has advanced by more than 19% since end-May this year and 34% since the beginning of 2004 (see Chart 1.8). Options prices indicate that uncertainty surrounding future price developments on the Oslo Stock Exchange is considered to be relatively low (see Chart 1.9). The banking index has shown even larger gains than the benchmark index over the past six months. As a result of higher bank share prices and low price volatility, the probability that banks will default on their commitments, as estimated by Moody’s KMV, is lower now than when Financial Stability 1/2004 was published (see Chart 1.10).6

Chart 1.8     Chart 1.9     Chart 1.10

Since the previous report, equity prices have advanced considerably more in the Norwegian market than in the large international markets. The high proportion of oil companies on the Oslo Stock Exchange is one reason behind the stronger gains in Norway relative to other countries. At the end of September, the market value of the companies in the energy index, which includes oil companies, accounted for almost 50% of the total market value on the Oslo Stock Exchange. Since the beginning of 2004, the rise in oil prices has coincided with a sharp advance in the energy index both globally and in Norway (see Chart 1.11).

Chart 1.11

Equity prices for companies in the other sub-indices on the Oslo Stock Exchange have also increased since Financial Stability 1/2004. In the last quarters, companies in several sectors have posted solid profits, higher than analysts had expected. The solid profits are due to a number of factors (see section 2.3). Companies outside the energy sector are probably also benefiting from high oil prices through higher domestic demand. In addition, the increase in freight rates and other commodity prices have had a favourable impact on share prices for many companies listed on the Oslo Stock Exchange. In other countries, the rise in oil prices has led to lower demand and higher costs for most companies. An analysis of companies in the S&P 500 Index shows that over the past 20 years only returns on companies in the energy sector have shown a positive correlation with oil prices.⁷

High expected earnings

Analysts increased their profit forecasts for 2005 by more than 10% in the period from May to November 2004 for companies on the Oslo Stock Exchange benchmark index. This is in line with price developments so that the P/E ratio in the Norwegian market has shown little change in the same period (see Chart 1.6).

Pricing in the Norwegian stock market may be influenced by changes in interest rate or in uncertainty as measured by the risk premium on shares. Table 1.1 shows the results of calculations of expected future dividends using a model for equity prices based on discounting. The model is applied to a selection of companies on the Oslo Stock Exchange. With an assumed risk premium of 3%, equity prices and the interest rate and dividend level in October 2004 imply an expected annual real increase in dividends of 2%.

Table 1.1

Changes in the risk premium have a substantial impact in this model. If the risk premium is assumed to increase from 3% to 5%, the expected real increase in dividends must be 3.9% to justify today’s price level. These conclusions are contingent on the model assumptions and should therefore be interpreted with caution.

The same model shows that market participants are pricing in a lower expected dividend increase now than the last time equity prices were at the same level, in September 2000. This is because the dividend level was lower and interest rates were higher at that time. Future growth in dividends will depend on companies’ future earnings, which also vary with growth in the overall economy.