Global financial conditions generally improved during 1999 and the first half of 2000, along with the strong rebound in the world economy as a whole, according to the IMF staff’s latest International Capital Markets released on September 11. Following the severe market turbulence of 1997-98, the report observes, credit concerns have eased, and global investors have become more willing to engage in risk taking, particularly by investing in the technology-related companies of the “new economy.”
As markets recovered, mature market credit spreads remained appropriately above precrisis levels, the report finds. What it terms the remarkable, continued rapid growth of U.S. productivity—largely related to the new economy—helped to contain the slow expansion of inflation and spur both U.S. and worldwide investment. Despite the rise in global interest rates, equity markets rose to record highs in many countries, while the deepening and broadening of credit markets in the euro area helped to boost global debt issuance.
Risks in mature markets
The staff report notes, however, that a key risk for international financial markets lies in a sharper-than-expected rise in U.S. inflation. Mounting evidence of increased inflation in early 2000 heightened investor uncertainty about both the size and the timing of interest rate increases and the sustainability of strong non-inflationary growth. The report states that it is unusually difficult at this time to gauge whether markets fully appreciate, and properly price, the risk of an unexpectedly sharp rise in U.S. inflation and an abrupt policy tightening. If not, it warns, there could be a further correction in U.S. equity and corporate bond markets, a repricing of financial risks, and widespread portfolio rebalancing. If portfolios are rebalanced internationally, there could be a shift in the patterns of international capital flows and exchange rate adjustments.
Even if the risk of inflation does not materialize, the report cautions that there are more medium-term risks, related both to the high level of U.S. external imbalances and shifting cyclical positions in the major industrial countries and to changing expectations about asset returns. In this environment, it observes, markets may reassess whether the record U.S. external imbalances can be sustained at prevailing exchange rates and perhaps trigger a realignment among the euro, the U.S. dollar, and the Japanese yen. The risks are particularly evident for Japan, the report notes, where more private efforts are needed to put the financial and corporate sectors of the economy more securely on the path to a sustainable recovery. More generally, an increase in market volatility has led to a greater recognition of the risks in global financial markets, including those associated with the rapid integration of national financial markets into the global arena, a lack of transparency, and increased competitive pressures on financial institutions.
Overall, there have been favorable developments in emerging market financing during the past year, according to the report, and financial flows to these markets have recovered to an encouraging extent. Moreover, although further structural reforms are still needed in many countries, macroeconomic policies are generally stronger than a few years ago, and several key emerging markets have introduced notable fiscal reforms.
The weakness in emerging market asset prices in March-May 2000, coinciding with the weakness in the mature markets, came as a sharp reminder that such assets are among the riskier asset classes, the report states. These assets were hit hard when global stock markets fell and the tightening of monetary policy in mature markets threatened to be more extensive than earlier expected.
Short and long-term interest rates
1Weekly data for United States, Japan, and United Kingdom; and monthly data for euro area.
2For United States, Japan, and United Kingdom, three-month LIBOR; and for euro area, three-month EURIBOR.
Data: Bloomberg Financial Markets L.P. and European Central Bank
However, the correlations between emerging and mature market returns are far from perfect, and the report notes that the performance of emerging market assets will still depend substantially on the economic policies that these countries follow and the financial health of borrowers.
Derivatives markets are central to the functioning of global financial markets and both exchange-traded and over-the-counter derivatives have significantly improved the pricing and allocation of financial risks. The rapid growth of these transactions has accompanied, and in many ways driven, the international integration of national financial markets and the globalization of finance. Recent market turbulence has demonstrated the risks to market stability arising from certain features of over-the-counter derivatives and markets.
The report identifies those features that are a risk to market stability, as well as imperfections in the underlying infrastructure. Progress in ameliorating some of these risks has been limited, and further efforts are needed to reduce or avoid future instability. In particular, it notes, the private sector can reduce the potential for instability through more effective market discipline, risk management, and disclosure. Public efforts are needed to strengthen the incentives for market discipline, remove legal and regulatory uncertainties, and improve the effectiveness of surveillance over over-the-counter derivatives markets.
Private sector involvement
Recent public sector initiatives to strengthen private sector involvement in crisis prevention and resolution, and the extent to which they are interpreted as setting a precedent, have profound implications for the workings of the international financial system and the nature and structure of capital flows. The IMF staff found a considerable lack of awareness among national officials and market participants of recent work on standards, codes, and transparency. Those aware of the work, however, strongly supported the IMF’s efforts to develop the Special Data Dissemination Standard and codes of transparency.
In general, private sector involvement in resolving financial crises is accepted as a “fact of life,” the report states. It is also appreciated that no circumscribed set of rules can apply to all potential future crises. Moreover, market participants are confused about the official sector’s policies on private sector involvement and would welcome a “framework” that would define when such involvement would be invoked, what would determine its scale, and whether it would be voluntary or involuntary.
The report concludes that the public sector should take into account that as particular lending instruments, such as bonds and interbank loans, are involved in a restructuring, the private sector will seek out new instruments that increase the probability of repayment and are insulated from future restructurings.
Role of foreign banks
Since the mid-1990s, there has been a sharp increase in foreign bank participation in many emerging markets, especially in Central Europe and Latin America. The report finds that competitive pressures created by foreign bank entry have improved banking system efficiency. It also notes that foreign banks could potentially add to the stability of the banking system. Foreign banks will be more likely to “cut and run” during a crisis, however, if their parent banks are in a weak financial condition.
The main policy issues involved in foreign bank participation, according to the report, are the need to coordinate and upgrade prudential supervisory and regulatory policies across borders, concentration issues arising out of large international bank mergers, and associated systemic issues.
International Capital Markets is prepared in the IMF Research Department and coordinated by Donald J. Mathieson, Chief of the Emerging Markets Division, and Garry J. Schinasi, Chief of the Capital Markets and Financial Studies Division. Copies of International Capital Markets: Developments, Prospects, and Key Policy Issues are available for $42.00 ($35.00 academic rate) each from IMF Publication Services. The text is also available on the IMF’s website: www.imf.org. See page 292 for ordering information.