Financial Stability 1/2003

Print

2 International developments and securities markets

2.1 The international environment
2.2 Securities markets in Norway

Rammer:
- The effect of the fall in share prices on pension schemes
- The P/E ratio for the Norwegian stock market

2.1 The international environment

International financial markets are still marked by the downturn in the global economy and by the stock value corrections which began three years ago. The projections for growth in the world economy in the near future have been revised downwards. The revival in the stock markets in the last few months and declining risk premiums on US corporate debt may, however, be an indication of increased optimism among many market participants.

Servicing debt has been an increasing problem in many countries. Nevertheless, the burden on banks has generally been limited, to a large extent because capital adequacy has been high and probably also because risk management has improved. Interest rate risk has increased for both banks and insurance companies. A continuation of recent developments, with relatively high loan losses and falling asset prices, will increase the risk of more serious problems in financial institutions.

Inflation is very low or falling in a number of large countries. Until now, few countries have had a sustained period of deflation. A substantial, sustained fall in the general price level may have an unfavourable impact on financial stabil-ity because debt to the general public increases in relation to wages and prices, and because it may be impossible to lower real interest rates. The value of collateral for loans also falls.

Private consumption has sustained economic activity in many countries, partly on the basis of a rise in house prices. A recovery in the global economy will therefore probably depend on a rebound in investment. The outlook for corporate earnings is deteriorating, however, because many companies must use future earnings to safeguard pension obligations, as the fall in equity prices has resulted in large shortfalls in relation to commitments under defined benefit pension schemes.

International stock markets continue to fall

The stock market continued to fall early this year after a brief lull in October and November 2002 (see Chart 2.1). There have been few clear macroeconomic signals of a recovery in the global economy. Nevertheless, stock markets have risen since mid-March, in part because the war in Iraq has been concluded. In a number of countries, equity prices have passed the level prevailing at the beginning of 2003.

Chart 2.1

Annual returns on equity investments have been low for several years. Nevertheless, over a 10-year horizon, returns including dividends have been approximately 9-10% in Europe and the US (see Table 2.1). Returns have been very low in the Japanese market, where share prices have now returned to the level prevailing more than 20 years ago.

Table 2.1

The price fall has generally been sharper than the decline in expected earnings in listed companies. This has contributed to a fall in the price-earnings ratio (P/E), especially in the US (see Chart 2.2). Nevertheless, P/E ratios are still higher than the average in the period 1988-1998. The P/E ratio across all shares listed on the Oslo Stock Exchange has been analysed in a separate box.

Chart 2.2

The interest rate level has been falling for a long time and is now very low in many countries. This is also the case for securities with long maturities (see Chart 2.3). High demand for fixed-income securities may have contributed to high bond values. If long-term interest rates increase again, both insurance companies and banks may incur considerable losses on their bond portfolios. This is discussed in greater detail below.

Chart 2.3

Increased saving in liquid assets

The accumulation of liquid assets in the household and corporate sectors has been particularly marked in the US, but the same tendency is also evident in Europe and Japan. Combined with the fall in equity values, this has, for example, resulted in US household bank deposits approaching the value of shareholdings for the first time since 1994 (see Chart 2.4). Developments in the corporate sector have been similar, and in the US, liquid assets are now larger than short-term debt. This development does not simply imply financial consolidation. It also means that large reserves may be transferred quickly to equity markets or to fixed investment if perceptions about future earnings change.

Chart 2.4

An easing of monetary policy, particularly in the US, has made it comparatively more profitable to invest in long-term fixed income securities, even though long-term interest rates have also fallen. This has allowed banks to convert large deposits from the private sector to investments in long-term fixed income securities with a solid interest margin. As a result, banks’ interest rate risk has increased. Stronger economic growth ahead may result in the movement of capital from bank deposits to the stock market, as long-term interest rates rise and the market value of these securities falls. The consequence may be that banks have to cover immediate needs for liquidity by selling their holdings in a falling bond market.

Increasing bank losses, but solid financial strength in most countries

US banking operations were positive in 2002. Results for the banking industry as a whole were the best since 1998. Net losses written off increased considerably less than the year before and the default rate fell. On the other hand, the default rate in the bond market was very high in 2002 (see Chart 2.5). To a greater degree than before, banks’ results seem to be robust with regard to developments in the corporate sector. This is probably due to some extent to better risk management, where the use of financial instruments in particular has made it possible to move credit risk out of the banks. Nevertheless, the occurrence of bankruptcies in the banking sector increased markedly last year, measured in terms of both the number of banks and total assets in these banks (see Chart 2.6).

Chart 2.5     Chart 2.6

German banks' earnings have been relatively low for a long time. This is due to overcapacity, high costs and competition from institutions with public sector affiliations. They have also recorded substantial losses on equity holdings in German companies. A number of the largest banks have tried to boost earnings by increasing activities in the area of securities trading, underwriting and advisory services. Results in these areas have also been weak, however, due to market developments. In addition, a low level of economic activity in Germany has contributed to increasing loan losses. This has led to a proposal to establish special institutions which can relieve banks of their loan portfolios and free up capital which may be used for new loans. Table 6.2 shows that German banks have had considerably higher losses and lower returns on equity than banks in many other European countries.

Table 6.2

Banks in Japan are plagued by large unrealised losses on loans and share portfolios. This is reflected in the fall in prices for Japanese bank shares (see Chart 2.7). In a number of large banks, capital increases designed to improve the balance sheet before closing the accounts on 31 March resulted in an increasing degree of cross-ownership between banks and their customers as well as the rest of the financial sector. Therefore, the capital increases have scarcely reduced systemic risk in Japan.

Chart 2.7

At the end of the third quarter of 2002, Norwegian banks had claims on foreign banks equivalent to NOK 38.7bn. Therefore, problems in foreign banks will only have a modest direct spillover effect on Norwegian banks but may affect Norwegian banks’ access to financing (see Chapter 4).

Who has the credit risk?

Investors may purchase insurance against different forms of credit loss through credit derivatives. Globally, banks have been net buyers of such insurance. Credit risk has thus been moved out of the banks, which may have contributed to their relatively positive developments despite an increasing number of bankruptcies and defaults in the corporate sector. Insurance companies are the largest sellers of insurance against credit risk. Therefore, ultimately, the risk may be concentrated in a few large reinsurance companies. Although banks as a whole have been relieved of credit risk through these markets, individual banks have issued credit derivatives to a large extent to take on credit risk. Studies from the rating agency Fitch suggest that small German banks in particular have been active.

Developments in emerging economies

Uncertainty in the global economy has made it more expensive for many borrowers in emerging economies to obtain funding in the international bond market. However, investors have demonstrated the ability to distinguish between different borrowers. Positive signals concerning economic policy in Brazil have resulted in a significant reduction in the yield differential on Brazilian government debt (see Chart 2.8). However, new international borrowing by Latin American countries was considerably lower in 2002 than in 2001.

Chart 2.8

2.2 Securities markets in Norway

The Oslo Stock Exchange’s all-share index fell from December 2002 until the end of February. Since then, it has recovered substantially (see Chart 2.9). During this period, developments in the sub-index for industrials and in a weighted average of the IT and telecoms index were somewhat weaker than developments in the all-share index. The energy index has avoided a similar fall due in part to high oil prices. The financial index has fluctuated widely but has also climbed because of a price increase in connection with the merger negotiations between DnB and Union Bank of Norway.

Chart 2.9

New share issues on the Oslo Stock Exchange totalled only NOK 5.6bn in 2002, down from NOK 28.5bn in 2001. New issue activity during the first four months of 2003 has been somewhat lower than in the same period last year. The few new issues that have been completed so far this year were mainly rescue operations for companies in crisis.

Activity in the bond market is high. In 2002, new issues and increases of existing issues amounted to NOK 107.6bn, 63% higher than in 2001. The Government and government-owned enterprises accounted for 38% of this. In the first four months of 2003, new issues and increases were 23% higher than in the same period last year. Banks and insurance companies have accounted for approximately 31% of the new issues so far this year, which is a reduction from slightly more than 40% in the two previous calendar years.

Turnover in the stock market, including primary capital certificates, fell more than 20% from 2001 to 2002. This, combined with the low volume of new issues, has resulted in a marked decline in operating profits for securities firms. Lower operating income has been somewhat offset by cost reductions in the form of job cuts and lower bonus payments. In March, one securities firm terminated its operations, and further consolidation in this business sector cannot be ruled out unless income picks up.