International Capital Markets

In 1998 the international capital markets were affected by the turbulence which began in Southeast Asia in 1997. From August, the situation was further aggravated when Russia suspended payments on its debt and abandoned its pegging of the rouble to the dollar. The crisis in Russia affected the capital markets in many other countries, especially in Latin America. The demand for safe, liquid government bonds from the industrialised countries increased at the expense of other bonds and shares. From the end of October the turbulence subsided and to some extent the capital markets returned to normal.

On the foreign-exchange markets the dollar depreciated against the D-mark and the yen. Prices generally rose on the international stock markets of the industrialised countries, although interrupted by strong price drops in connection with the Russian crisis.

Interest rates

Development in interest rates
Long-term yields in the USA declined during 1998, cf. Chart 19. During the first half of the year the weak Asian economies and low commodity prices helped to keep inflation down, despite high growth and high capacity utilisation. Against the background of the turbulence on the international financial markets in August and September, the Federal Reserve in September, October and November lowered the official short-term US interest rate - the federal funds rate - by a total of 0.75 per cent to 4.75 per cent. The interest rates were also lowered to ward off credit-tightening as a consequence of losses in the US banking sector in connection with the financial-market turbulence. The turbulence released strong demand for "safe" government bonds, which resulted in a significant drop in US long-term yields. From October the financial markets stabilised as a consequence of the lowering of interest rates (including in the other industrialised countries), the approval of an IMF-coordinated loan package for Brazil, and important political measures in Japan directed at the banking sector and the economy. The drop in long-term yields in the USA subsided. Yields fell by 1.1 percent over the year.

In Japan long-term yields continued the receding trend from 1997, cf. Chart 19. The drop in interest rates was supported by the Bank of Japan via low official interest rates and the provision of ample liquidity. The discount rate was unchanged at 0.5 per cent, although in September a leading interest rate was lowered by 0.2 per cent to 0.25 per cent.

Chart 19 Yields on 10-year bonds in the USA, Japan, Germany,
the UK, Sweden and Norway

Note: Weekly observations.

The drop in long-term yields was interrupted by a strong increase by more than 1.0 per cent in November and December, when fears arose that the deterioration in government finances would significantly increase the supply of government bonds. At the same time it was clear that bond purchases by public institutions would be significantly lower than expected. In 1998 Japan's growth diminished further after the collapse of many Southeast Asian economies. The crisis in the banking sector also worsened, cf. Box 2.

In Germany the official short-term interest rate - the repo rate - was unchanged at 3.30 per cent until December when the Bundesbank lowered the rate by 0.30 per cent as part of a coordinated action by the coming euro area member states. Low inflationary pressure and the falling US interest rates contributed to a decline in Germany's long-term yields by 1.4 per cent over the year, cf. Chart 19. As in the other major industrialised countries the drop in interest rates was particularly pronounced from August 1998.

In the UK the Bank of England raised the repo rate in June by 0.25 per cent to 7.5 per cent in order to counter the inflationary pressure resulting from a tight labour market, rising wage pressure and the weakening of the pound sterling which began in April, cf. Chart 23.

Box 2 THE CRISIS IN THE JAPANESE BANKING SECTOR

Since the collapse of the Japanese real estate and stock market at the beginning of the 1990s the Japanese banks have suffered a profound crisis. The crisis was aggravated in 1998 as a consequence of weak domestic demand and the collapse of the Southeast Asian economies. This led to an increase in the proportion of defaulted loans. The banks also suffered high unrealised capital losses on their share portfolios as a consequence of the drop in equity prices. More stringent and more appropriate requirements of financial statements and identification of bad loans increased the pressure on the Japanese banks to strengthen their capital base and financial soundness. In their efforts to achieve this, the Japanese banks have scaled down e.g. their lending activities. This created financing problems for business enterprises and exacerbated the state of the domestic economy. The banking crisis and the economic crisis developed into a vicious circle. In October the Japanese government therefore approved comprehensive measures to revive the weak Japanese banking system. The plan was based on a framework of 60 trillion yen (approximately kr. 3,400 billion, or 12 per cent of Japan's GDP) distributed as 18 trillion yen for the nationalisation of banks, 25 trillion yen for recapitalisation of banks, and 17 trillion yen for depositor insurance. The plan also entailed the establishment of new institutions, which e.g. in connection with bank crises will take over a significant proportion of the responsibilities of the Ministry of Finance.

The less favourable global growth prospects as a consequence of the financial turbulence in August and September, and ever clearer signs of a dampening of domestic growth, led to a lowering of interest rates in October, November and December by 1.25 per cent in total. Long-term yields were relatively stable in the 1st half-year, but fell strongly in the 2nd half-year, cf. Chart 19. Over the year they declined by 2.0 per cent.

Falling oil prices and a danger of overheating of the economy led to pressure against the Norwegian krone. The short-term official Norwegian interest rate - the current-account interest rate - was raised in seven stages by a total of 4.5 per cent to 8.0 per cent. Long-term yields remained by and large unchanged over the year, but rose in connection with the Norwegian currency unrest, cf. Chart 19.

In Sweden the Riksbank lowered the repo rate in June, since lower inflation than expected made it possible to relax monetary policy within the framework of the inflation target. In 1998 long-term yields fell by 1.8 per cent, cf. Chart 19.

Chart 20 The 10-year yield differentials of Russia and Brazil to the USA

Note: Weekly observations. Yield differential: difference in yields between Russian/Brazilian 10-year government bonds denominated in dollars, and US 10-year government bond.

Effects of the crisis in Russia: increased risk aversion and widening of yield differentials
In August Russia suspended payments on its debt and abandoned the pegging of the rouble to the dollar. The resulting turbulence significantly increased investors' risk aversion. The demand for government bonds issued by the industrialised countries rose and as stated led to a strong international drop in interest rates. The falling interest rates were accompanied by significant widenings of the yield differentials between the benchmark government bonds of the major industrialised countries and bonds entailing a higher credit or liquidity risk. There were also substantial price drops on stock markets, cf. p. 57.

The widening of the yield differentials was particularly pronounced for bond issues from emerging markets, cf. Chart 20, but was also significant for bonds issued by the smaller industrialised countries. The 10-year yield differentials of most EU member states vis-à-vis Germany thus widened. Investors' increased risk aversion also widened the differentials in individual countries between yields on mortgage-credit/corporate bonds and government bonds, cf. Chart 21.

In view of their low credit and liquidity risk the benchmark bonds of the major industrialised countries were particularly favoured by the flight to safety. Moreover, market participants expected that the financial crisis would lead to lower growth and inflation, and thereby monetary-policy relaxations, in these countries. In the course of the 3rd quarter US, Japanese, German and UK 10-year yields fell by between 0.75 per cent and 1.0 per cent.

Chart 21 Yield differential between mortgage-credit and corporate bonds
and government bonds in the USA

The general widening of differentials caused difficulties for a major US hedge fund, Long Term Capital Management (LTCM), cf. Box 3. For borrowed funds LTCM had speculated extensively in a general narrowing of yield differentials, e.g. a lower yield differential between new and existing issues of government bonds, corporate and government bonds, mortgage-credit and government bonds, etc. When the problems faced by LTCM became known in September, the yield differentials widened. The background was fear that LTCM and other hedge funds with a similar investment strategy would reverse their positions.

In order to cover losses ensuing from the crisis in Russia, at the beginning of October hedge funds and other investors took advantage of the high price levels for the benchmark long-term government bonds to close out their positions in those bonds. Some of the positions in the benchmark government bonds and the unprofitable placements in emerging markets were financed by yen loans. The appreciation of the yen at the beginning of October, cf. Chart 22, therefore strengthened the incentive to close out positions in benchmark bonds. The result was a brief reversal at the beginning of October of the drop in long-term yields, cf. Chart 19.

Box 3 HEDGE FUNDS

A hedge fund is a mutual fund with an investment strategy which often entails a considerable element of speculation and high gearing of equity capital. Investment strategies - and thereby positions in relation to the financial markets - can vary considerably among hedge funds. Some mainly take positions in relation to macroeconomic variables, e.g. based on expectations of exchange-rate fluctuations, while others take positions in relation to special events which might e.g. affect the development in a certain share price or a stock index. A third group is based on market-neutral strategies: buying assets ("being long") which are found to be undervalued in relation to the market, and selling or borrowing assets ("being short") which are found to be overvalued. LTCM belongs to the last-mentioned group.

The course taken by financial markets in 1998 shows how financial unrest in one country can quickly spread to another. It has also shown that the growing complexity of the financial markets makes it difficult to manage risk. These two factors have contributed to new discussion of the future design of the global financial markets, including how their structural and institutional framework can be improved, so as to avoid a financial crisis from developing at the pace and on the scale seen in 1998. In these discussions, it was among other things recognised that improvements must be made to market transparency and the supervisory role played by the authorities (particularly in emerging markets).

In February 1999 the group of major industrialised countries, G7, resolved to appoint a secretariat under the Bank for International Settlements, BIS, to coordinate and strengthen international supervisory cooperation.

Foreign-exchange markets

In 1998 the dollar depreciated by 7 per cent against the D-mark, cf. Chart 22. Greater "eurooptimism" after the selection of the 11 euro area member states in May and signs of an increase in economic activity in Germany weakened the dollar in early summer. The dollar came under pressure again in late summer, when fears arose that the crisis in Russia would spread to Latin America, and thereby affect the US economy more severely. It was also a widespread belief that falling equity prices, cf. Chart 26, would more significantly affect the US economy, because US households' share portfolios are larger than those of households in other industrialised countries, so that the potential consumption-dampening effect of decreases in equity prices is greater. In the last quarter of the year and at the beginning of 1999 the dollar regained some of the lost ground. The dollar's rise was to a high degree a result of prospects of continued stronger economic growth in the USA than in Germany, and receding expectations of a further lowering of the US interest rate.

Chart 22 Dollar vis-à-vis yen and D-mark

Note: Weekly observations.

The dollar weakened by 15 per cent against the yen in 1998 after substantial fluctuations during the year. Continued deterioration in the Japanese economy, concern about the financial sector's stability and uncertainty regarding future fiscal-policy measures caused the yen to weaken strongly against the dollar up to August, despite joint Japanese/US intervention to support the yen in the foreign-exchange market on 17 June 1998. From August the yen strengthened considerably, among other reasons because hedge funds and other borrowers closed out yen loans. This was supported by a restoration plan for the Japanese banking sector, a record-high package of measures to stimulate the economy, and a narrowing of the US/Japanese yield differential.

Chart 23 Pound sterling, Swedish krona and Norwegian krone
vis-à-vis the D-mark

Note: Weekly observations.

The pound sterling generally followed the dollar and weakened by 6 per cent against the D-mark in 1998, cf. Chart 23.

Chart 24 Exchange rates of South Korea, Thailand
and Mexico vis-à-vis the Dollar

Note: Weekly observations.

Chart 25 Exchange rates of Indonesia, Russia and Brazil vis-à-vis the Dollar

Note: Weekly observations.

Both the Norwegian krone and the Swedish krona depreciated by approximately 9 per cent against the D-mark, cf. Chart 23. In Norway growth has been high for several years. As a consequence of falling oil prices and uncertainty concerning economic policy the Norwegian krone came under pressure in March. Norges Bank raised its interest rates in several stages and intervened in the foreign-exchange market to support the krone, but in August abandoned its defence of the exchange rate. The unrest concerning the Norwegian krone also affected the Swedish krona. As a consequence of this unrest the Danish krone also came under pressure in August and September, cf. p. 39ff., but strengthened again in the 4th quarter. At the beginning of 1999 the Norwegian krone and Swedish krona also appreciated.

The exchange rates of emerging economies fluctuated considerably in 1998, cf. Charts 24 and 25. With the exception of the Indonesian rupiah, the Southeast Asian currencies rose against the dollar in 1998. The Korean won and the Thai baht thus appreciated by respectively 33 per cent and 28 per cent against the dollar. The Indonesian rupiah depreciated by 32 per cent during the year, but in mid-year had weakened by 68 per cent from the beginning of the year as a consequence of social unrest, etc. The restructuring of private-sector foreign debt and the implementation of reforms are part of the explanation for the strengthening of most of these currencies. The yen's appreciation against the dollar in the second half-year also contributed.

During the last 5 months of the year the Russian rouble fell dramatically after Russia abandoned the pegging of the rouble to the dollar. The rouble depreciated by 71 per cent over the year, cf. Chart 25.

The crisis in Russia led to increased pressure on the Latin American currencies and weakened e.g. the Mexican peso, cf. Chart 24. The Brazilian real likewise came under serious pressure, but as a consequence of e.g. the adoption of a relatively tight budget and an IMF-coordinated loan, cf. p. 91, it was kept within the exchange-rate corridor against the dollar. However, defence of the exchange rate was abandoned in January 1999 and in the course of a few weeks the real depreciated by 41 per cent, cf. Chart 25.

Stock markets

In the first half of the year equity prices rose, cf. Chart 26. Up to mid-July the US Dow Jones index and the German Dax index rose by respectively 18 per cent and 45 per cent. The positive development on the stock markets was attributable to very low interest-rate levels and to expectations that restructuring measures and cost savings would maintain earnings levels. The development on the stock markets in the USA and Europe contrasted sharply with the situation in Japan where equity prices fell as a consequence of the continued deterioration in the economy and the severe situation in the financial sector.

Chart 26 Share indices in major industrialised countries

Note: Weekly observations.

Chart 27 Share indices in selected emerging markets

Note: Weekly observations.

In August and September global stock markets saw strong price drops in reaction to the financial unrest following on the Russian crisis. In the USA and Germany shares fell to a level respectively 5 per cent and 8 per cent below the year's starting level. The drop in equity prices was especially pronounced for emerging markets, cf. Chart 27. In the 4th quarter of the year the falling equity prices reversed to increases. US and German shares closed the year respectively 16 and 18 per cent higher. The turnaround in the final quarter of the year can be attributed to a reduced risk of a serious global dampening of growth as well as a number of major corporate acquisitions and mergers which led to expectations of further acquisitions at prices above current market values.