Financial Stability 1/2004

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1 International developments and Norwegian securities markets

1.1 International banking industry
1.2 International securities markets
1.3 Securities markets in Norway

Box:
- How Norwegian is the Oslo Stock Exchange?

International developments have an impact on the financial system in Norway through several channels. First, global economic developments have an impact on economic growth, inflation and the interest rate level in Norway. This influences the financial situation in the enterprise and household sectors in Norway and thereby the risk linked to bank lending. Second, developments in international securities markets have an impact on Norwegian markets, which in turn influence banks’ income from securities trading for own account or on behalf of customers. Third, developments in securities markets and the international banking industry can influence Norwegian banks’ funding costs. In addition, developments in large Nordic banks are important because Nordic banking markets have become more integrated.

The global financial system is less vulnerable than in November when Financial Stability 2/2003 was published. Global economic growth has picked up, and listed companies have seen an increase in earnings. Equity prices have edged up. The balance sheets of financial institutions, enterprises and households have strengthened, even though the value of both equity and bondholdings has declined somewhat recently. There is a risk that low interest rates in many countries may have contributed to inflating assets prices to a level higher than that implied by fundamentals. Low short-term interest rates may have stimulated borrowing in order to invest in instruments with a higher expected return. This may have augmented the risk of a sharp price fall when interest rates rise.

1.1 International banking industry

Improvement in bank performance in 2003

In spite of weaker economic developments and low interest rates in recent years, banks in many western countries have recorded solid results (see Chart 1.1). There are also signs of improvement in Germany and Japan, where the banking industry has been struggling for some time.

Chart 1.1

An important factor behind low earnings in German banks has been a very low level of net interest income, partly as a result of excess capacity and intense competition. In 2003, the weak return on assets was related to large extraordinary loss provisions. Excluding this factor, the largest banks recorded a marked improvement in operating results from 2002 to 2003.

The largest Japanese banks also improved their situation in 2003, and posted a profit for the first time in several years. This is primarily ascribable to lower recorded loan losses and price gains on securities. However, substantial efforts are still required to address the problem of bad loans, particularly in regional banks. At the end of the first quarter of 2004, non-performing loans accounted for 5.2% of total loans in the 11 largest banks, compared with 7.2% one year earlier.

Both large US and European banks strengthened their earnings in 2003 owing to higher securities income and lower loan losses. European banks have also improved earnings as a result of cost cuts. Danish and Swedish banks improved their performance somewhat in 2003 compared with 2002, primarily reflecting lower operating expenses and higher securities income (see comparison with Norwegian banks in Chapter 3.1). Nordic banks’ loan losses have been relatively low. In Denmark, the bankruptcy rate for the enterprise sector has remained constant, even though company results have weakened in recent years. In Sweden, the bankruptcy rate has fallen over the past year. Household debt growth has increased in Denmark, Sweden and Finland. At end-March, debt growth stood at an annualised 8%, 10% and 14%, respectively.

Stable net interest income in spite of low interest rates

Net interest income has a considerable impact on banks’ results (see Chart 1.2). Net interest income is partly influenced by changes in central banks’ key interest rates. When key interest rates are cut to low levels, banks’ deposit rates approach a floor at zero and cannot fall further. This means that a fall in lending rates can weaken banks’ interest margins and thereby their net interest income.

Chart 1.2

However, a comparison of accounting figures for a selection of the largest US banks and European banks shows that net interest income has only declined marginally in recent years, measured as a percentage of total assets (see Chart 1.3). Net interest income has been particularly stable in countries that already had low net interest income. This applies to several countries such a Germany. The Scandinavian countries have seen a somewhat larger decline in net interest income.

Chart 1.3

Developments in net interest income partly reflect the stock of fixed-interest loans (see box in Chapter 2). Many banks have also used derivatives to hedge against interest rate changes. Balance-sheet structure has also influenced the impact of interest changes on net interest income. For example, Norwegian banks have a relatively large volume of loans outstanding and a low share of fixed-interest loans. As result, the fall in interest rates has had an impact on their net interest income. US banks have a relatively large share of consumer loans. Interest rates for these loans are fairly stable, which contributed to a more steady level of net interest income. At the same time, very low short-term interest rates have reduced banks’ funding costs. Many banks have also profited from the relatively wide difference between short and long rates by taking positions in derivatives.

1.2 International securities markets

Equity prices have advanced by 5-20% on the largest stock markets since Financial Stability 2/2003, in spite of a considerable decline in recent months (see Chart 1.4). Equity prices are now 40-50% higher than at bottom in March 2003. A pick-up in economic growth and improved corporate earnings have contributed to the stock market recovery. Annual earnings for listed companies in the US and Europe increased by 20% and 50%, respectively, from 2002 to 2003. Analysts project that the increase will be somewhat lower this year. Stronger economic growth and somewhat higher inflation have also led to an increase in long-term interest rates in recent months (see Chart 1.5). Expectations of an interest rate increase and high oil prices have contributed to the recent decline in equity prices.

Chart 1.4     Chart 1.5

Search for yields

Relatively low returns on government bonds have induced investors to seek higher returns in equity markets, corporate bond markets and emerging economies. Growing confidence in stronger economic growth may have reduced the expected risk associated with such investments. In the US, the yield differential between bonds issued by corporations and government bonds has narrowed further since last autumn (see Chart 1.6). However, the yield differential for low-grade debt instruments has increased somewhat this year.

Chart 1.6

The rebound in equity prices has been stronger than expected growth in earnings. As a result, the P/E ratio has increased since the beginning of 2003 (see Chart 1.7).

Chart 1.7

The increase in the P/E ratio and the fall in risk premiums on corporate bonds may indicate that investors have been willing to take more risk. This is supported by the fall in implied volatility using options on the S&P 500 Index through 2003, down to its lowest level since 1996. Investors’ willingness to take risk, as measured by global investors’ purchases and sales of risky assets in relation to their total holdings in the countries where they invest, increased through 2003. Willingness to take risk has fallen again this year, however (see Chart 1.8).

Chart 1.8

A more active search for returns increases the risk of herd behaviour, where investors may take positions in less liquid and less transparent markets. Risk perceptions may change rapidly and trigger a steep fall in prices.

Direct investment in China accounted for close to 90% of total direct investment in emerging economies in Asia in 2003. This has contributed to a sharp increase in fixed investment, which now exceeds 40% of GDP. The Chinese central bank’s purchases of foreign exchange to maintain the value of the national currency against the US dollar have increased liquidity in the banking system. High liquidity has led to higher credit growth, high lending growth for banks and an increased risk of overinvestment. The Chinese authorities have attempted to restrain credit growth by tightening reserve requirements and temporarily prohibiting lending by some banks. A capital injection into two large state-owned banks has also been undertaken with a view to strengthening the banking sector.

Imbalances in the US remain an important source of uncertainty

The main uncertainty as to developments in international securities markets is whether it is possible to maintain a reasonable balance between the historically high current account deficit in the US and demand for US securities. Reduced demand for US securities can lead to a further depreciation of the US dollar (see Chart 1.9) and/or a fall in US equity and bond prices, with spillover effects on other markets. A sharp decline in securities prices will weaken financial institutions’ balance sheets.

Chart 1.9

In addition to the US, Japan, China and the UK are the main international investors in the US government securities market (see Chart 1.10). While the high figures for the UK partly reflect many other countries’ trading via banks in London, Japanese purchases primarily reflect the Japanese authorities’ exchange rate policy and low returns on Japanese securities.

Chart 1.10

1.3 Securities markets in Norway

Sharp advances in the stock market

The Norwegian stock market has recorded stronger advances than the largest international stock markets since Financial Stability 2/2003 (see Chart 1.1). The P/E ratio for the Norwegian stock market has risen since spring 2003 (see Chart 1.7). Rationalisation, lower interest rates, high oil prices and the depreciation of the krone in 2003 (see Chart 1.9) have contributed to improving performance among listed companies. Analysts’ estimates for companies’ results in 2004 have been revised upwards considerably since Financial Stability 2/2003.

The upswing in the Norwegian stock market has been broad-based (see Chart 1.11). Since the end of 2003, high oil prices have contributed to a steep increase in the energy index. The bank index has shown a somewhat weaker rise than the other sub-indices.

Chart 1.11

Growing uncertainty

The uncertainty in the Norwegian stock market can be measured by implied volatility using options on the OBX index. Uncertainty declined through 2003, but has risen again since the bottom reached at year-end (see Chart 1.12). Option prices also indicate that investors have recently perceived the risk of a price fall as higher than in December.

Chart 1.12

As has been the case in international securities markets, low interest rates in Norway seem to have induced investors to seek alternative returns in other markets such as the stock market. The recent rise in the implied volatility index may indicate that investors have reassessed the risk associated with such investments.

High equity turnover

The equity turnover on the Oslo Stock Exchange has increased considerably, in tandem with the upswing in the stock market. In 2004, the previous record turnover level in 2000 was passed (see Chart 1.13). However, bond turnover remained unchanged in the same period.

Chart 1.13

Higher equity prices have boosted issue activity (Chart 1.13). The value of shares and primary capital certificates on the Oslo Stock Exchange increased by 18% from 2002 to 2003. Bonds issued by private enterprises rose by 12% in the year to mid-2003. However, issuance by Norwegian private non-financial enterprises in the Norwegian bond market is relatively limited (see Chart 1.14 and Table 1 in Annex 1).

Chart 1.14

Risk in the banking sector is assessed as low

The risk premium on bonds issued by Norwegian banks, as measured by the yield differential against government bonds, is low and has narrowed since Financial Stability 2/2003. The probability of default¹ by Norwegian banks fell up to November 2003, but has since edged up (see Chart 1.15). A higher default probability probably reflects increased volatility in prices for bank shares and primary capital certificates.

Chart 1.15

Box:

How Norwegian is the Oslo Stock Exchange?

National markets for goods, services and capital are becoming ever more closely integrated. This has a bearing on which factors will have an influence on developments in national financial markets. In this box, we look more closely at how globalisation is affecting price developments on the Oslo Stock Exchange.

One of the most commonly used indicators of globalisation of the Oslo Stock Exchange is developments in foreign ownership. The share of foreign ownership has remained fairly stable in recent years at around 30%. Less is known about the extent of international activity in listed companies. This influences how global economic conditions affect price developments in the Norwegian market. It may influence investors’ choice of where to invest, which in turn may affect the supply of capital for companies that choose to be listed on the Oslo Stock Exchange.

How international a company is can be measured in several ways. The geographical distribution of employees is one possible indicator. At end-2003, about 35% of the employees in the companies that make up the Oslo Stock Exchange Benchmark Index¹ worked in Norway. The geographical distribution of the companies’ operating income indicates how dependent they are on markets outside Norway. Foreign customers accounted for almost three quarters of listed companies’ operating income in 2003. Of this, about 60% came from customers in other European countries (see Chart 1).

Chart 1

A distinguishing feature of the Oslo Stock Exchange is that large groups of companies are either very national or very international. Most of the largest companies are also among the most international (see Chart 2). There is a positive correlation between market value and foreign sales in all industries. This may be due to the relatively small customer base in Norway, which limits enterprises’ potential for achieving a high turnover and market value.

Chart 2

UNCTAD² has developed a measure of companies’ multinationality – the Transnationality Index (TNI). The TNI is the average of the ratio of foreign to total for sales, assets, and employment. Of the companies in the OBX Index³, technology and shipping companies score highest in the TNI. Financial conglomerates are at the other end of the scale.

Regression analysis can shed light on the extent to which price developments in companies on the Oslo Stock Exchange can be explained by global developments.⁴ Sensitivity to international price movements increases in pace with the portion of operating income that comes from abroad. This indicates that the extent of companies’ international activities is reflected in equity prices. Investors that seek exposure to developments in the Norwegian economy must therefore select equities with this in mind. On the other hand, considerable international diversification can be achieved through a portfolio of equities listed on the Oslo Stock Exchange. If geographical exposure is to be given weight when investing in equities, investment choices should be made on the basis of company activities rather than the stock exchange on which the company is listed.