Financial Stability 2/2000
3 International developments and securities markets
Norges Bank: Financial stability 2/2000
3.1 The international environment
3.2 Stock markets
3.3 Fixed income markets
3.4 Market risk in Norwegian financial institutions
3.1 The international environment
Soaring oil prices in recent months have fuelled uncertainty about international
inflation developments. This does not appear to have affected long bond yields
(see Chart 3.1). On the other hand, stock markets seem to be very sensitive to news
of relevance to future interest rate movements. The greatest elements of uncertainty
internationally continue to be high valuations in stock markets - even though share
prices have fallen since the peak level in March - and developments in current
account balances and exchange rates in the three main currency areas. In addition,
private sector debt continues to rise sharply in the US and the euro area.
A new element of uncertainty is the telecommunication sector's increased debt
in connection with the auctioning of mobile telephone licenses, infrastructure
investment and company acquisitions. Companies are financing their operations
by means of bank loans and bond issues. In the first nine months of the year,
the telecommunications sector accounted for one-third of new bond issues for
private enterprises in Europe. This is a fairly concentrated accumulation of
debt in a single sector.
Chart 3.1
The US current account deficit - continued high capital inflows?
The US current account deficit rose from 3¾% of GDP in 1999 to 4¼%
in the second quarter of 2000. Expectations of high returns on investments in
the US have fuelled high capital inflows. The dollar has been strong. During the
last few years, foreign investors have shifted their portfolios of US securities
from government bonds to private sector securities. Those who invest in private
securities are exposed to credit risk and are presumably fairly active in
managing their portfolios. This may increase the probability of an extensive
sale of US securities if the market revises its perception of return prospects
in the US. The result may be falling share prices and currency unrest.
Increase in European property prices
Share prices have increased sharply in both the US and Europe in the last
few years. This is discussed in more detail in Section 3.2. Prices for another
important asset, property, have also risen sharply (see Chart 3.2). In Europe,
property price increases have been especially marked in Ireland, Spain and the
Netherlands.
Chart 3.2
Vulnerable Japanese financial sector
Owing to very low interest rates on short-term instruments, investment in
long-term paper has been profitable in Japan. If long rates rise, there
is a risk of a considerable reduction in the value of banks' large
government bond holdings. Banks are also vulnerable to a decline in
share prices. Measures such as capital infusions and structural changes
have been initiated to make the banking sector more robust. Banks'
earnings on core activities are low, however. A number of major
bankruptcies and weak results in both financial and non-financial
sectors indicate that the quality of banks' portfolios remains an
open question. As a result of low interest rates, life insurance
companies have experienced problems in meeting their return
guarantees to customers. Four life insurance companies have become
insolvent this year.
Uncertainty regarding some emerging economies
There is uncertainty regarding developments in some emerging economies.
This includes South Korea, where one of the largest enterprises has
become insolvent, and Argentina, which needs to refinance major
loans in the near future. In recent months investors have become
more sceptical about future prospects in Argentina, and this has
resulted in higher borrowing costs. Many emerging economies are
experiencing more difficult financing terms and instability in
domestic financial markets.
Changes in capital flows to countries in South-East Asia
The composition of capital flows to previously crisis-hit countries in
South-East Asia has changed dramatically since before the crisis broke
out in 1997 (see Chart 3.3). Net direct investment (long-term strategic
investment) has shown a stable trend, but other financing, especially
loans from international banks, has declined sharply. Funding
requirements in the beleaguered countries have been reduced in the
last few years as a result of their current account surpluses.
Experience from the crisis showed that international bank loans
are an unstable form of financing. A shift towards increased emphasis
on long-term financing has reduced the liquidity risk of funding
recipients. At the same time, the currency mix has moved in the
direction of more debt in the domestic currency, thus reducing
exchange rate risk. Both factors make the economies more robust
to financial unrest.
Chart 3.3
Reduced liquidity in financial markets
The IMF and others have pointed out that liquidity has declined in
many financial markets in the last few years. This reduces the markets'
ability to absorb sizeable portfolio movements, including large
cross-border capital flows. External shocks or herd behaviour may,
therefore, generate greater price fluctuations than would otherwise
be the case. On the other hand, reduced liquidity may be due to
less speculative activity and greater risk awareness as a result
of the market unrest in 1997-1998. The need for considerable
absorption capacity may therefore be less than it was a few
years ago.
3.2 Stock markets
Technology shares - high prices and major fluctuations
The increase in international share prices through 1999 and
up to March this year was largely driven by the rise in market
prices for technology shares. In March, fears of increased inflation
and higher interest rates in the US triggered a sharp decline in
share prices internationally, primarily for technology companies.
Record-high share prices fuelled nervousness among investors.
Indices picked up during the summer, but fell further this autumn,
and volatility increased (see Charts 3.4 and 3.9).
Developments since 1999 have been characterised by a split in the
market (see Chart 3.5). After rising sharply, technology share
prices have fallen substantially since the second quarter of 2000,
while prices for other types of shares have remained fairly flat.
Seen in relation to current earnings, technology shares have been
priced several times higher than other types of shares. The difference
has narrowed since March 2000 (see Chart 3.6), but is still large.
Rapid technological advances make it difficult to assess companies'
future prospects.
The composition of the technology sector varies in different markets
(see Chart 3.7). Measured in terms of market capitalisation,
telecommunication companies dominate in Europe, while in North
America and Asia, computer and Internet companies predominate.
This means that movements in technology indices in different parts
of the world may be driven by somewhat different factors. Despite
structural differences, the correlation between technology indices
in different parts of the world is high and has increased considerably
since the beginning of 1999.
Chart 3.4 Chart
3.5 Chart 3.6 Chart
3.7
Wide fluctuations in the Norwegian stock market as well
Since the decline at the beginning of the second quarter of this year,
the Norwegian stock market has shown somewhat stronger growth than important
foreign markets (see Chart 3.4), due primarily to high oil prices and good
freight rates in the shipping sector.
From mid-April to the last half of August this year, the all-share index
and all the sub-indices on the Oslo Stock Exchange have shown a rising trend
(see Chart 3.8). Thereafter, the value of shares in a number of sectors
dropped, in some cases substantially, up to the last half of September.
Since the sharp decline in share prices this spring, the IT index has
fluctuated widely. The financial index has been the most stable in recent
months.
During the first half of 2000, the Norwegian stock market was generally
marked by fairly high volatility, followed by a calmer period in July and
August (see Chart 3.9). Volatility increased again towards the end
of the third quarter.
The volume of shares traded on the Oslo Stock Exchange fell somewhat
in the period from April to July this year, after rising steadily since
the end of 1998 (see Chart 3.10). Since August, turnover has moved up
again, particularly in August when share turnover was a record NOK 82.7
billion. The high turnover may be partly due to acquisition interest in
some major companies.
Chart 3.8 Chart
3.9 Chart 3.10
Increased investment in securities funds
Investment in securities funds is rising, with a marked shift towards
foreign unit trusts (see Chart 3.11). Net subscriptions to the end of the
third quarter this year totalled NOK 14.7 billion. The Norwegian Mutual
Funds Association expects net subscriptions for the year to reach about
NOK 20 billion. This is the same level as in 1997, before the "mini-crash"
in autumn 1998. In 1997, new subscriptions were primarily in funds that
invested in Norwegian shares. At present, there is a net redemption of
shares in this type of fund. Unit trusts that invest in foreign shares
dominate new subscriptions. There have been net redemptions in bond funds
during the entire period, while new subscriptions in money market funds
have fluctuated considerably. Enterprises often invest surplus liquidity
in money market funds. Despite growth in new subscriptions in securities
funds, Norway lags appreciably behind Denmark, Finland and Sweden in
new subscriptions.
At end-June this year, the Norwegian fund market managed about NOK 136
billion, of which 57% was related to the household sector. As a result
of growth in the fund market and the shift towards international shares,
fluctuations in international foreign exchange markets and stock markets
have a greater impact on household wealth. Household wealth is also more
diversified than previously, however.
Chart 3.11
3.3 Fixed income markets
The net issue of international bonds, notes and short-term paper was
lower in the first half of 2000 than in the same period last year (see
Chart 3.12). Although non-financial enterprises increased the net issue
of debt instruments from the first to the second quarter of 2000, issue
volumes were lower than in the second quarter of 1999. The volume of
issues was unusually large in 1999, and euro issues in particular
increased sharply. Issues in euros have declined this year.
At the same time, activity in the international banking market was
extraordinarily high in the first quarter of 2000. Activity was driven
by interbank transactions resulting from the channelling of funds to
non-financial borrowers in Europe. Telecommunications companies and
companies that have carried out acquisitions have been major borrowers,
both in banks and in the bond market.
The BIS and others have pointed out that the pricing of credit risk
in debt markets this past year has been influenced more than usual by
share price changes and stock market volatility. This may be due to an
increased use of methods for estimating credit risk whereby shares are
regarded as an option on a company's assets. Market information is thus
used to assess the quality of borrowers. This may contribute to a
better assessment of credit risk, but may also mean that stock market
unrest can more easily spill over into debt markets.
The spread between corporate and government bond yields in the US has
widened recently, especially for the most uncertain enterprises. The
junk bond market has practically dried up.
Since April 2000, there has been little change in the yield spread
between 10-year swaps and government bonds in the US, Germany and Norway
(see Chart 3.13). The difference between swap and government bond yields
provides an indication of credit risk associated with banks. It is
uncertain, however, whether this development is due to expectations
of increased credit risk or is the result of a reduced supply of
government bonds. While government debt has been reduced in the US
and Norway in recent years, it has remained unchanged in Germany.
Sharp reductions in government debt have led to fewer investment
opportunities in risk-free securities.
After a prolonged decline, turnover in bonds has picked up on the
Oslo Stock Exchange since May 2000. Increased turnover may indicate
somewhat improved liquidity in the bond market. Government paper
accounts for the bulk of turnover in fixed-income instruments.
Chart 3.12 Chart
3.13
3.4 Market risk in Norwegian financial institutions
Norwegian financial institutions' exposure to market risk varies. Banks have
very small shareholdings (see Table 3.1), and share price changes will therefore
have little direct effect on these institutions. At end-June 2000, commercial
and savings banks' holdings of bonds, notes and short-term paper accounted for
8.7% and 5.4% respectively of their combined total assets. Estimated sensitivity
to interest rate changes for bond holdings (calculated as the percentage fall
in value of a portfolio in the event of a 1 percentage point increase in
interest rates) indicates that interest rate risk for banks' trading portfolios
is low. The use of hedging instruments further reduces this risk. Therefore,
the greatest effect of unrest in securities markets for Norwegian banks will
probably be its impact on developments in the real economy.
Insurance companies have considerably larger holdings of shares and fixed-income
instruments than banks and their direct exposure in these markets has increased
in recent years. This exposure must be seen in the light of insurance companies'
long-term commitments. At the end of the first half of 2000, shareholdings accounted
for 32% and 24% respectively of life and non-life insurance companies' total assets.
Since the start of the year, life insurance companies have increased the share of
long-term bonds, and the interest rate sensitivity on their bond holdings has
risen by 1.5 percentage points. The interest rate sensitivity of non-life companies
has dropped somewhat. During the first half of 2000, life insurance companies'
total assets rose by NOK 9 billion to about NOK 370 billion at end-June. During
the same period, buffer capital fell by NOK 7 billion to NOK 38 billion. On the
whole, insurance companies' market risk appears to have risen somewhat since the
beginning of the year.
Table 3.1
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