Financial Stability 2/2002
2 International developments and securities markets
2.1 The international environment
2.2 Securities markets in Norway
Box:
- Some spillover effects in the financial sector of the fall
in equity prices
2.1 The international environment
General picture
The fall in prices in equity markets worldwide during the past six months must
be viewed in the light of deterioration in the outlook for the global economy
and increased uncertainty concerning the information in listed companies’
accounts. Overall wealth has been substantially reduced. Higher bond values
and a continued rise in house prices in many countries have curbed the decline
in wealth somewhat. During the third quarter of 2002 alone, the market value
of listed shares in industrial countries dropped from 92% to 75% of their combined
GDP.
In the financial sector, insurance companies and pension funds in particular
have had large shareholdings. Unwinding of positions and attempts to increase
future payment capacity by raising new equity have contributed to pushing down
equity prices. As a result of the upturn in the equity market through the 1990s,
allocations for companies’ future pension obligations could be covered
largely by the increase in value of existing assets. In the future, pension
saving will probably have to lay claim to a larger share of current value added.
The problem is exacerbated by the low interest rate level, because the net present
value of future obligations is increasing. A larger amount must be allocated
today to provide for a given expected disbursement in the future.
On the whole, Norwegian and other Nordic banks have low exposure to developments
in equity markets, whereas the exposure of Japanese and German banks, for example,
is far more extensive.
In recent years, the international financial system has absorbed various shocks
effectively, aided by risk diversification, for example through syndication
of bank loans, securitisation and increased lending through the securities market.
Recently, investors have also demonstrated an improved ability to distinguish
between degrees of risk, even in turbulent situations, so that risk premiums
reflect actual risk to a greater extent than previously. New financial instruments
have allowed for better risk management, so that loan losses are less concentrated
in the banking sector.
A robust financial sector is dependent on adequate buffers against losses.
The recent decline in the equity market has to varying degrees weakened the
ability of financial institutions, households and enterprises to withstand further
shocks. Since the economic outlook has deteriorated as well, we now view the
outlook for international financial stability as less favourable than in the
spring of 2002.
Sharp fall in equity markets
US equity markets have fallen appreciably since the spring, despite the recent
upturn (Chart 2.1). Heightened uncertainty regarding companies’ actual
earnings contributed to a fall in equity prices in the wake of the WorldCom
scandal in June and investigations of a number of other enterprises and associated
financial institutions. There has been great uncertainty in the equity market
for an unusually long period (Chart 2.2).
Chart 2.1 Chart
2.2
At the same time, the economic outlook has deteriorated. Up to end-September,
analysts lowered their estimates for reported earnings in 2003 for companies
in the S&P 500 index. During October, the estimates were nevertheless raised
by 10%, chiefly as a result of an upward revision of estimates for the second
half of 2003. The price bubble in the US equity market has so far paralleled
events in Japan ten years earlier (Chart 2.3). The crash in the US in 1929 was
far more severe, however, even though the upturn that preceded the crash was
not much more pronounced.
Chart 2.3
Since this spring, European equity markets have fallen somewhat more than US
markets. The weak position of telecom companies has contributed strongly. Telecom
companies are struggling, partly because of very high investment in the next
generation mobile network. European insurance companies are also in a generally
weak position. To a greater degree than US companies, they bear the risk associated
with returns on life and pension insurances. Since the beginning of 2002, telecom
and insurance company shares have fallen 33% and 46% respectively. The impact
on the Swedish equity market has been particularly severe, and the shares of
large companies such as Ericsson and Skandia have fallen sharply (Chart 2.4).
Banks contributed largely with intermediate financing of the telecom sector’s
high investments up to 2000. A large portion of these loans have subsequently
been refinanced in the bond market, thereby reducing banks’ exposure to
the telecom sector.
Chart 2.4
The Japanese equity market has performed appreciably better than the US and
European markets so far this year. Since the peak at the end of 1989, it has
nevertheless fallen by a full 78%, and equity prices are now at the same level
as they were in 1983. The situation of banks remains weak. Non-performing loans
account for 9% of the total volume of loans at the end of the first quarter
of 2002. The authorities have proposed a number of measures to accelerate restructuring.
Among the proposals are stricter rules for calculating losses and equity capital.
If banks must reduce lending in order to meet the minimum capital adequacy requirements,
the result will probably be closures and major restructuring in enterprises.
Japanese banks have large shareholdings and have been ordered to reduce their
exposure from the current level of 140% to 100% of core capital by September
2004. However, a large-scale unwinding of positions by banks in the open market
could push prices down further. This is part of the reason that the Japanese
central bank has announced that it intends to buy shares for up to USD 16 billion
from banks in the period up to end-March 2003. This purchase period may also
be extended by a year.
Weak developments in German banks
German banks have also traditionally had a high proportion of equities in their
portfolios (Table 2.1). It is common for banks to own shares in the companies
to which they extend loans. As a result, there is a higher correlation between
German banks’ loan losses and their losses on shares than is the case
in many other countries. German banks also appear to have a relatively low return
on equity, and their loan losses have increased. At the same time, many banks
face higher financing costs as German state guarantees for bank loans are gradually
abolished by mid-2005 in compliance with a EU decision. These factors have contributed
to substantially weaker developments in German bank shares than in the US and
in Europe as a whole (Chart 2.5).
Table 2.1 Chart
2.5
Downgradings and higher risk premiums in the bond market
The low level of economic activity has led to a sharp rise in defaults on bond
loans in the US, Europe and the world in general (Chart 2.6). Global developments
up to mid-2002 point to defaults for 2002 as a whole amounting to 3.8% of all
bond debt, well over the previous high of 3.1% in 1991. The recent increase
in Europe is closely linked to the problems in the telecom sector. In the US,
credit quality, as measured by the credit rating companies, has fallen across
the board. In the low quality segment, speculative grade, there were 1.28 upgrades
of credit quality for every downgrade in the period 1993 to 1997. This ratio
was 0.38 from 1998 to June 2002. The corresponding figures for the high quality
segment, investment grade, were 1.1 and 0.58. At the same time, markets demand
higher risk premiums for a given rating, even for the highest quality segments
(Chart 2.7). This may indicate that markets are characterised by higher risk
aversion. At the same time, a clear distinction is made between segments of
different qualities, so that risk premiums increase most for the least safe
bond loans. For the most reliable borrowers, the fall in the risk-free interest
rate level has resulted in more or less unchanged loan costs. For other enterprises,
the costs associated with new long-term financing have increased appreciably.
Chart 2.6 Chart
2.7
Developments in the enterprise sector also influence the banking sector. US
banks have already seen a sharp increase in realised losses, which have exceeded
the previous high in 1991 (Chart 2.8). Measured in relation to gross lending,
losses are still somewhat lower than in 1991, but have nevertheless shown a
marked increase. The situation may gradually deteriorate further as many enterprises
must pay high interest rates on new loans. A large share of the loan losses
in the US have occurred in the bond market, and this has contributed to shielding
banks against the downturn.
Chart 2.8
Will US households save more?
How US enterprises and households, which have record high debt, will adapt
to the lower equity prices, is uncertain. A sharp rise in house prices and falling
interest rates have led to extensive refinancing of housing loans. Housing loans
have risen by 19% in the past two years. However, this increase may have contributed
to curbing growth in various types of consumer loans. Household gross debt has
increased from 96% to 107% of disposable income since end-1996. The decline
in value since 1999 in households’ shareholdings and various funds, including
life insurance funds, has amounted to a full 113% of disposable income. However,
the decline in total wealth was countered by a steady rise in housing wealth
(Chart 2.9). The rise in house prices has so far been of great importance to
developments in household wealth. A fall in this market as well could lead to
substantially reduced net wealth, so that households would want to save more.
Chart 2.9
Developments in emerging economies
The deteriorated outlook for the global economy has also had an impact on emerging
economies. However, investors appear to be distinguishing between countries,
and a general unwinding of positions has been avoided. Russia and many Asian
countries have managed relatively well compared with the developed economies.
Russian equity markets have climbed through the year, and the market’s
perception is that credit risk on loans to the Russian state and Russian enterprises
has decreased considerably. As a result of the political and financial crisis
in Argentina, real GDP is now expected to fall 16% this year, and there are
no immediate prospects of a solution to the crisis. Brazil now appears to be
the most vulnerable of the larger countries.
Brazil's debt has increased sharply in recent years as a result of the fall
in the country’s exchange rate. A very large share of government domestic
debt, over 40%, is denominated in foreign currency. Interest and instalments
on foreign debt and transfers of dividends from foreign direct investment in
Brazil account for over 90% of export revenues. The market’s assessment
of the probability of the government defaulting on its loans has increased sharply
(Chart 2.10). A good 40% of bond debt falls due in the next 12 months. If this
must be refinanced at the current interest rate level, the burden is likely
to become unsustainable.
Chart 2.10
Loans from foreign banks, including Brazilian branches and subsidiaries, account
for over half of Brazil’s external debt. Almost half of this, in turn,
has a term to maturity of less than one year. The country is therefore very
vulnerable to a sudden loss of external bank loans. The fact that the lenders
are concentrated in a few countries increases the risk. A total of 72% of foreign
bank debt is from banks or local subsidiaries of banks located in the US, Spain,
the UK, the Netherlands and Germany (Chart 2.11). Viewed in relation to the
size of these countries, the Spanish banking sector, in particular, is vulnerable
to spillover effects from Brazil. Half the foreign lending of Spanish banks
and their subsidiaries is associated with Latin America. These loans correspond
to about one-fourth of domestic credit in Spain. However, the loans extended
through subsidiaries do not expose Spanish banks to risk over and above their
equity capital.
Chart 2.11
2.2 Securities markets in Norway
General fall in equity prices on the Oslo Stock Exchange
Since the end of April, the all-share index on the Oslo Stock Exchange has
fallen by 33% (Chart 2.12). This is somewhat more than the fall in the large
international indices. The sub-indices have not differed appreciably. The energy
index, the financial index, the manufacturing index and an ICT index, which
is calculated as the average of the telecom index and the IT index, have fallen
by a good 30%. Through the year as a whole, however, the ICT index has declined
more than the other indices. At end-October, the market value of the companies
listed on the Oslo Stock Exchange was NOK 502bn. Companies in the energy and
financial indices accounted for 44% and 13% respectively.
Chart 2.12
Since the end of April, life insurance company holdings have dropped from 3.4%
to 2.1% because these companies have unwound positions in order to reduce the
risk in their securities portfolios. Foreign owners have added somewhat to their
ownership interests. The volume of new issues in the equity market has been
low compared with 2001. By end-October, new issues totalled NOK 4.5bn, compared
with NOK 23.7bn at the same time last year. The Statoil issue accounted for
NOK 13bn in 2001. However, there was a surge of new issues in the bond market.
Private debt securities for about NOK 65bn had been issued by the end of October.
In July, the volume issued this year already surpassed the total for the whole
of 2001. Developments in the bond market are discussed in more detail in a separate
box.
Some spillover effects in the financial sector of the
fall in equity prices
Banks in most countries do not have large shareholdings. Important exceptions
to this rule are Japan and Germany, where, as a result of a network of cross-ownership
between banks and the business sector, a large proportion of banks’
assets consist of equities. Norwegian banks have small equity portfolios and
are not directly affected to any major degree.
Life insurance companies and pension funds are major participants in securities
markets, both internationally and in Norway. Defined benefit schemes account
for much of pension saving in Europe. This means that future pension benefits
do not depend on returns on savings, and the companies therefore bear the
market risk. In addition, many companies have guaranteed their customers a
certain minimum return. When equity markets fall and companies’ shareholdings
are considerable, it may be difficult to fulfil these guarantees. The authorities
have introduced various requirements for ensuring that companies are in a
position to meet their obligations in relation to customers. Requirements
with respect to equity capital and solvency have induced many life insurance
companies and pension funds to unwind positions in the equity market. Companies
in a number of countries have also announced substantial increases in share
capital in order to meet these requirements. Both these factors have contributed
to pushing down equity prices.
Because yields are low, it is difficult for life insurance companies in other
countries to fulfil guarantees of a minimum return through alternative investment
in the bond market. This situation may also compel companies to issue new
share capital. In Norway, the guaranteed minimum return cannot be more than
3.75%. The relatively high yield on krone-denominated bonds enables Norwegian
companies to fulfil the return guarantee through investments in bonds in their
own currency. Therefore, resources that have been freed up from equity investments
appear to have been reinvested largely in the bond market (see Chart 1). This
may have contributed to the price rise in this market in recent months.
Chart 1
The bond market in Norway is relatively weakly developed, and there are few
large borrowers. Life insurance companies wishing to invest more in bonds
from Norwegian issuers are therefore restricted by the rules concerning maximum
exposure to a single counterparty. Foreign enterprises have taken the opportunity
to borrow money from these Norwegian life insurance companies through the
market for so-called Eurokrone bonds. These are bonds with a face value and
return in NOK which are offered for sale outside Norway. From January to September
this year, Eurokrone bonds for more than NOK 30bn were offered for sale, triple
the value for the same period in 2001. The majority of issuers of Eurokrone
bonds are sound foreign financial institutions. They have little interest
in krone financing, and therefore wish to exchange their exposure in NOK to
another currency. In currency swap transactions, Norwegian banks with financing
in foreign currency are natural counterparties. Therefore, interest in Eurokrone
bonds among Norwegian institutional investors has the spinoff effect of making
currency-hedged foreign financing cheaper for Norwegian banks because of increased
liquidity in this market.
Financial institutions and large manufacturing companies have also met the
increased demand by issuing new bonds. In the first three quarters of 2002,
Norwegian private issuers raised NOK [10]bn more through the bond market than
in the whole of 2001. By contrast, the volume of equity issues so far this
year has been very low. A shift toward a more liquid bond market provides
a number of alternatives to domestic bank financing. This strengthens financial
stability because the credit risk in the enterprise sector is spread across
more lenders.
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