International Capital Markets

In 1997 the foreign-exchange markets were characterized by the strengthening of the dollar against the D-mark and the yen and by the strengthening of the pound sterling. Falling bond yields generally prevailed on the international bond markets.

The severe crisis in Southeast Asia began as a foreign-exchange crisis, but spread to the capital markets and economies of the countries affected. At the end of the year the crisis triggered a price drop on international share markets. However, this was of a temporary nature and the share markets showed considerable increases for the year as a whole.

Exchange-Rate Conditions

Exchange-rate and interest-rate conditions in the ERM countries are described in the section on the European Monetary system.

In 1997 the dollar strengthened against the other principal currencies, by 15 per cent against the D-mark and by 12 per cent against the yen, cf. Chart 20. The rising trend from 1996 thus continued. The background to

the dollar's strengthening is the ongoing cyclical upswing in the USA.

The yen strengthened temporarily in the spring of 1997 on the basis of expectations of a forthcoming raising of Japanese interest rates, which did not take place, however. The weakening of the yen continued at the end of the year against the background of the weak growth in the economy, the crisis in Southeast Asia and the difficulties faced by the Japanese banking system.

The pound sterling generally followed the dollar. In 1997 sterling strengthened by 12 per cent against the D-mark, cf. Chart 21, and has rallied by 33 per cent in total since the beginning of 1996.

The Swedish krona was relatively stable in 1997. The Norwegian krone strengthened considerably at the end of 1996 and beginning of 1997. Norges Bank reacted with large foreign-exchange purchases, but in connection with a lowering of interest rates on January 10, 1997 Norges Bank declared that for a period it would not intervene in the foreign-exchange market to any significant extent. The Norwegian krone subsequently stabilized and the exchange rate at the end of the year was almost at the level at end-1996.

Development in Interest Rates

On March 25, 1997 the Federal Reserve signalled a raising of the key official interest rate - the fed funds rate - by 0.25 per cent to 5.5 per cent in order to offset inflationary trends as a consequence of persistent high growth. Long-term interest rates rose concurrently, cf. Chart 22. Despite favourable development in employment and a drop in unemployment inflation declined throughout the year to a relatively low level. This contributed to the drop in bond yields in the second half-year. The crisis in Southeast Asia also contributed to the falling interest rates in the last months of the year. The crisis has generally dampened expectations of global growth in 1998, thereby contributing to reducing fears of inflation. At the same time the greater volatility of the share markets caused some investors to prefer to shift funds to the bond market. For the year as a whole the long-term bond yields fell by 0.7 per cent.

In Japan long-term interest rates continued the receding trend from the second half of 1996, interrupted only by a temporary increase in the spring. This temporary rise was due to widespread market expectations that the central bank would raise interest rates. However, these expectations were not fulfilled since the discount rate remained at 0.5 per cent while long-term interest rates fell by 0.9 per cent for the year as a whole. The record-low level of interest rates of below 2 per cent can be attributed to the weak

economy. Growth prospects deteriorated further as a consequence of Japan's close links with the crisis-torn countries of Southeast Asia.

In Germany long-term interest rates declined by 0.5 per cent during the year as a whole. The Bundesbank's raising of the repo rate in October had no permanent impact on long-term interest rates. At the close of the year the 10-year bond yield had fallen to a historically low level of 5.30 per cent. The drop in German interest rates reflected the declining interest rates in the USA and Germany's weak cyclical position. The differential between 10-year bond yields in the USA and Germany widened at the beginning of 1997, but narrowed again at the end of the year.

After rising temporarily during February and March long-term interest rates in the UK fell by 1.3 per cent in 1997, cf. Chart 23. At the same time the differential between 10-year bond yields in the UK and Germany narrowed by 0.8 per cent to 1.1 per cent at year-end. The Bank of England raised the repo rate from 6 per cent to 7.25 per cent in five stages during 1997 in order to counter the inflationary pressure. The Bank of England's repeated raising of interest rates contributed to the considerable decline in long-term bond yields. At the end of the year the term structure of interest rates was inverse, indicating market confidence in the Bank of England's ability to meet the inflation target of 2.5 per cent. At the beginning of May the government transferred the authority to fix the official interest rates to the Bank of England. The greater independence of the central bank may also have contributed to the drop in interest rates.

Long-term interest rates also fell in Sweden and the 10-year yield differential to Germany narrowed to 0.65 per cent at the end of 1997. In December Sveriges Riksbank raised the repo rate by 0.25 per cent to offset expected inflationary pressure.

In Norway the 10-year yield differential to Germany also narrowed and was 0.2 per cent at the end of the year.

The Share Markets

The share markets have been subject to considerable price increases for several years. Prices continued to rise in the USA and Europe in 1997, but towards the end of the year share prices became subject to considerable uncertainty due to the development in Southeast Asia.

In the USA the Dow Jones index rose by 23 per cent in 1997, but the index also showed some volatility, cf. Chart 24. US share prices appear to be high in relation to the current level of earnings and the favourable share market may reflect market expectations of sustained high growth and low inflation in the USA.

In October a sudden drop in share prices in Hong Kong caused prices to plummet all over the world. Share markets in the USA and Europe soon rallied, however, and came out of the year at a level close to the situation immediately before prices fell in October.

In Japan the benchmark Nikkei index fell by 21 per cent in 1997. The decline can be attributed to the stagnating Japanese economy, difficulties in the banking sector and the crisis in Southeast Asia. The latter has had a strong impact on Japan due to its considerable economic ties to the countries affected by the crisis.

For several years Japanese banks have held large portfolios of non-performing loans and at the end of 1997 several financial institutions were forced into liquidation. Since their share portfolios are considerable the banks' capital was also undermined by the price drops on the share market. In the course of the autumn of 1997 the Japanese government introduced measures to stimulate the ailing economy and to curtail the adverse impacts of the crisis in the financial institutions. One element of the assistance package is the transfer of public funds to Japan's deposit insurance corporation.

(to be continued)