Financial Stability 1/2000

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3 International developments and market risk

Norges Bank: Financial stability 1/2000

3.1 Developments in international financial markets
3.2 Developments in the Norwegian securities market
3.3 Market risk in the financial industry

Box - The importance of securities markets to financial stability

3.1 Developments in international financial markets

Exceptionally high share prices in many markets - despite the recent fall - combined with a levelling-off in the rise in long market rates, reflect widespread expectations of continued economic growth and stable inflation (see Charts 3.1 and 3.2). As in the last report, one international impulse which may weaken stability in the financial system is linked to the risk of a sharp fall in prices in stock markets. The rising current account deficit in the US, accompanied by possible financing problems, also constitutes an element of uncertainty. Generally, growth in private sector debt is rising at a rate that is not sustainable in the long term, in both the US and Europe.

Chart 3.1      Chart 3.2

Nervous stock markets

In recent months, international stock markets have been influenced first and foremost by the sharp rise in prices, followed by a marked fall in IT shares. Prices for traditional shares have also edged down recently. The short-term fluctuations in share prices have been substantial, with a somewhat negative correlation between changes in IT shares and traditional shares. This may indicate that investors have shifted investments between different types of shares rather than reduce the equity share of their portfolios. Share prices are generally higher than when the last report was published six months ago.
   Traditional methods for credit rating are less suitable for a large number of the new companies, many of which have substantial current losses and are expected to record profits only in the longer term. As they have little to offer in the way of security, they are often financed through a larger share of equity capital, for example in the form of venture capital. Financial institutions therefore have little direct exposure, but may be indirectly exposed through participation in venture funds.
   It is argued that interest rates are of less importance to the new economy, due to the low debt-equity ratio. On the other hand, the fact that expected profits lie in the future indicates that the discount factor, ie interest rate, should be of considerable importance to valuation.
    Several other factors confirm the impression of speculative behaviour in the stock market. There has been a clear tendency towards increased debt-financing of shares in the US. Loans negotiated by brokers on the New York Stock Exchange with security in equities rose by 78% from March 1999 to March this year. In addition, lower transaction costs due to new technology led to considerable activity among smaller investors, or so-called day traders. Such investors may be more inclined to display herd mentality, and are less resilient in the face of unexpected events.
   The most recent major correction in international stock markets occurred in 1987. A comparison of interest rates and share prices in the US in the two periods 1987-1988 and 1998-2000 is presented in Charts 3.4a and 3.4b. The charts show some important differences:
   The upswing in 1987 was broad-based and the dual-track stock market observed in recent months did not exist. Disregarding the strong growth in technology share prices, the current rise in interest rates in the US has helped to restrain the rise in share prices. Prior to the fall in share prices in 1987, the entire stock market showed advances despite higher interest rates.
   Although share prices have edged down recently, they remain at a very high level. This level is based on a number of optimistic assumptions regarding future profit performance in business and industry. New information, which implies less favourable assumptions, may result in a considerable correction in share prices.

Chart 3.3      Chart 3.4a      Chart 3.4b

International debt trends and capital flows

In both the US and Europe, credit to the private sector has continued to rise sharply. In the past year, the twelve-month rise in countries in the euro area was over 10%. In the US, growth was 6.5% in 1999, a good 1% stronger than growth in nominal GDP. Household saving as a share of disposable income has fallen by 4.5 percentage points in the US in the past five years. In the same period, wealth has risen at a stronger pace than income, with an attendant reduction in public sector debt growth. Developments in Japan have been the opposite, and the private sector is currently reluctant to raise new loans.
   Thus far, the US has had no problems in financing its current account deficit, which rose from 2.5% of GDP in 1998 to 3.7% in 1999 (see Chart 3.5). On the contrary, the dollar exchange rate has strengthened. With a government budget surplus, capital inflows have come in the form of foreign purchases of private securities, particularly bonds issued by enterprises and various mortgage companies. The shift towards private securities may also indicate that investors are more willing to take risks following the turbulence in 1997 and 1998.
   International bank lending rose sharply in the third quarter of 1999, primarily as a result of increased lending in the interbank market among industrial countries. A further decline was recorded in lending from banks in industrial countries to emerging markets, in part reflecting the choice by some of these countries to fund operations through the issue of securities, following an improvement in their credit ratings in line with a more favourable growth outlook. Investors therefore consider that the risk associated with developments in these markets has been reduced.
   The euro's first year has been characterised by a far weaker exchange rate than expected. The most marked trend in the financial sector was the sharp growth in issues of private securities. Issues of new bonds by private, non-financial enterprises in the euro area increased by 285% from 1998 to 1999, albeit from a low level. An increasing number of small, higher risk companies could also make use of this market. One particular factor that contributed to the strong growth was the considerable number of business takeovers and mergers in 1999. Such a consolidation was expected as a result of the introduction of the euro. Securities are a common form of financing for such operations.
   In countries in the euro area, credit has traditionally been channelled through banks. Greater use of the securities market provides more financing alternatives for companies and investment alternatives for savers. This trend will also reduce the risk of financial instability (see separate box).

Chart 3.5

3.2 Developments in the Norwegian securities market

Price trends in the Norwegian securities market have largely shadowed international trends. Prices on the Oslo Stock Exchange rose by 45% in 1999 (see Chart 3.6). A new peak was recorded in the all-share index in early March. However, this was followed by a falling trend and substantial fluctuations.
   Turnover in shares on the Oslo Stock Exchange was record high in 1999, with a 43% increase on 1998. The strong growth in turnover has continued in 2000. In the period to end-April, turnover was 103% higher than in the same period last year, indicating a steady rise in the number of new investor groups in the stock market, in part due to the increase in securities trading on the Internet.
   Many companies have taken advantage of the favourable price trend on the Oslo Stock Exchange and risk willingness on the part of investors to raise new equity capital. Equity issues rose by 26% to NOK 14.4bn in 1999. The IT sector was the largest issuer, accounting for 36.6% of new share capital subscribed. This trend has continued in 2000, with new issues of shares amounting to nearly NOK 11bn in the first four months. Issues in the IT sector accounted for 48%.
   Developments in the Norwegian stock market regarding the "old" and "new" economy, as represented by the industrial and IT indices respectively, are very similar to those in the US stock market. The IT index on the Oslo Stock Exchange rose by 57% from the beginning of October 1999 to the end of the first week in May 2000, whereas the industrial index advanced by 14% in the same period (see Chart 3.7). The industrial index shows strong covariation with the all-share index of the Oslo Stock Exchange. Contrary to developments in the US, interest rates in Norway moved on a downward trend up to the interest rate increase on 13 April. Share price trends have therefore been consistent with interest rate changes.
   Price volatility in the Norwegian stock market, measured by the trend rise¹, shows a clear upward trend (see Chart 3.8). Volatility is still considerably lower than during the turbulence in autumn 1998. Volatility on the Oslo Stock Exchange closely shadows movements in both the DAX and S&P 500 indices.
   The correlation between the Oslo Stock Exchange and US and German markets indicates that the Norwegian stock market is affected by the turbulence in international stock markets.² In recent months, however, the correlation between the Oslo Stock Exchange and the US stock market has gradually weakened and is now below the historical average (see Chart 3.9). This may in part be explained by the fact that the S&P 500 index includes large companies, whereas the all-share index of the Oslo Stock Exchange covers all companies, including the smaller, IT-related companies.
   Turnover in certificates and bonds on the Oslo Stock Exchange has moved on a downward trend since 1998 (see Chart 3.10). The decline in turnover in bonds and certificates, combined with relatively large spreads in the market, indicates a fall in liquidity in the bond market.
   Share price trends in Norway have been weaker than in many other countries in the past couple of years, and the all-share index did not exceed the last recorded peak in 1998 until March this year. Historically, however, there has been a high degree of covariation between price trends on the Norwegian and foreign stock markets, indicating that an international downturn will probably also affect developments in Norway.

Chart 3.6      Chart 3.7      Chart 3.8      Chart 3.9      Chart 3.10

¹Volatility is measured as the trend rise (90-day moving average) in a weighted average (last observation is given greatest weighting) of the standard deviation in the return on the relevant stock market index over a 20-day period.
²The correlation is measured as the trend rise (90-day moving average) over an average of 60-days' correlation.

3.3 Market risk in the financial industry

Financial institutions' exposure in the stock market in particular and the securities market in general is of importance to market risk. Banks have very small shareholdings (see Table 3.1). Bank lending with securities as collateral accounted for 1.5% of gross lending in September 1999, a slight decrease from one year earlier. Banks are therefore only directly affected by price changes to a small extent. However, the indirect effects may be considerable.
   Insurance companies are considerably more exposed, and this exposure has increased substantially in recent years. However, exposure must be viewed in the light of their long-term commitments, and they are therefore less vulnerable to short-term fluctuations in the securities market. Furthermore, market risk for life insurance companies - which is not the case for banks - is automatically shared with the customer through supplementary provisions and profit sharing.
   According to the Banking, Insurance and Securities Commission, life insurance companies' total assets, shareholdings and supplementary provisions amounted to NOK 361, 112 and 45bn respectively at end-1999. From the start of the year to 10 May, prices on world stock markets, measured by Morgan Stanley's World Index, fell by 7%. Share prices on the Oslo Stock Exchange rose by 2% in the same period. Assuming that life insurance companies' foreign shareholdings (64%) move in line with the world index and Norwegian holdings (36%) in line with the all-share index of the Oslo Stock Exchange, this represents a reduction of less than NOK 5bn in life insurance companies' supplementary provisions over the period.
   Estimated sensitivity to interest rate changes for bond holdings (calculated as the fall in value of a portfolio for all maturities in the event of a 1 percentage point increase in interest rates) varied from 0.8 to 2.7% at end-1999 (see Table 3.1). The interest rate sensitivity of bond holdings is reduced if banks use different hedging instruments (eg interest rate derivatives). The interest rate risk in banks' trading portfolios therefore appears to be low.

Table 3.1