Summary by Ramana Ramaswamy
The Global Financial Stability Report (GFSR) is a new quarterly publication, produced by the International Capital Markets Department, which replaces the IMF’s International Capital Markets Report and Emerging Market Financing publications. The GFSR provides regular assessments of developments in global financial markets and seeks to identify potential systemic weaknesses that could lead to crises. The focus of the June 2002 issue is on the impact of corporate profitability on financial markets, developments in emerging bond and equity markets, financial market activities of insurance companies, and the performance of emerging equity markets over the past decade. A summary of the analyses in the GFSR’s thematic chapters follows.
The report argues that an important source of uncertainty in financial markets currently is the level and quality of corporate profits in mature markets. In the aftermath of Enron’s failure, questions surrounding the quality of reported corporate profits continue to have an adverse impact on international equity and corporate bond markets—with weak corporate profitability negatively affecting the quality of some banks’ and insurance companies’ balance sheets. The report identifies the risk of an equity price correction, owing to disappointing corporate earnings, as the main danger for mature markets.
The GFSR notes that the spread compression in emerging bond markets, in the first quarter of this year, reached levels not seen since the Russian crisis, but argues that they remain vulnerable to corrections. The growing involvement of crossover investors in emerging bond markets creates the risk of rapid funds withdrawal should event risk appetites decline or other asset classes become relatively more attractive. Political factors also weigh on emerging bond markets.
Insurance and reinsurance companies are now an important and growing class of financial market participants. An analysis of this sector is provided in the report along with issues identified as likely to have medium-term implications for financial stability and efficiency.
Reaping strong investment returns has been particularly important for life insurance companies, which were able to offer high guaranteed returns on insurance policies in the 1980s and early 1990s. As nominal bond yields sank during the 1990s, insurers responded to an environment of lower real premium growth by managing asset portfolios more actively and shifting the asset mix into potentially more volatile investments. The GSFR makes the case that while the systemic risks associated with the financial market activities of insurance companies are relatively limited compared with that of internationally active banks, there remain uncertainties about insurers and whether they hold sufficient capital against financial risks, whether their management of market risk is adequate, the extent of their off-balance-sheet activities, and the potential migration of financial risks from the banking to the insurance sector.
After languishing for a protracted period, equity prices in emerging markets have witnessed a sharp rebound during the last nine months. Despite this strong recent performance, emerging equity returns have been relatively poor—in both absolute and relative terms during the past decade. The GFSR provides a detailed empirical analysis of the return-volatility performance of emerging stock markets and analyzes the reasons for the poor performance of emerging equity markets.
Valuations do not appear to be the key factor for explaining the longer-term performance of emerging equity markets. The price-earnings ratio for the IFCI Composite has been, on the whole, significantly lower than that of the S&P 500 for much of 1990–2002. Other indicators such as the price-to-book ratio and dividend yields also do not indicate structurally overvalued emerging equity markets. Rather, a string of financial crises in major emerging market countries culminated in prominent currency depreciations and severe contractions of economic activity, which in turn weakened the income and balance sheet position of corporates. The poor corporate performance along with the sizable currency depreciations resulted in poor returns in dollar terms from investing in emerging market equities. The report also identifies the reduction in liquidity associated with the migration of the listings of top-quality emerging market corporates to mature market stock exchanges, and issues of transparency and corporate governance as also having had a dampening effect on emerging equity markets.