Introduction

Asset price developments

The uncertainty that pervaded financial markets in the early months of 2000 shifted to cautious optimism towards mid-year. Market participants around the world continued to focus on the US economy and what the Federal Reserve might do to keep inflation in check. In April and May, fears of a prolonged period of monetary tightening and a possible hard landing contributed to equity market declines in the United States and Europe, a further widening of swap and credit spreads and a general aversion to risk. In June, US stock markets led a rally in global equity and fixed income markets on signs that were interpreted as weakening the case for further tightening in the United States. The swing in sentiment turned on a few data releases that suggested US economic growth was slowing to a more sustainable pace.

Shifts and uncertainties in macroeconomic expectations in recent months seemingly exerted more pronounced effects on stock markets than before, most notably in the United States. In contrast to historical experience, on several occasions changes in expectations about the near-term course of US interest rates had a significant impact on equity markets but a muted impact on fixed income markets. Moreover, price declines and increases in volatility in equity markets appeared to have a greater influence on credit spreads than in the past. This latter link between credit and equity markets seemed to arise in part from a growing use of an approach to estimating credit risk based on treating equity as an option on a firm's assets. Widespread use of such an approach could potentially increase the sensitivity of credit spreads to a sharp correction in equity prices, if such an adjustment were to occur.

While equity valuations have recently been the focus of much attention, property prices have also registered significant gains over the last few years in many countries. The strength of the economy has tended to be the driving factor in real estate price gains. Indeed, among industrial countries, Ireland had the strongest property market between 1995 and 1999, and Japan the weakest. At the same time, rapid credit growth has added fuel to price gains in some markets. The commercial property booms in Dublin, Madrid and major US cities, for example, have been accompanied by private credit growth that has far outpaced that of the underlying national economies. Experience indicates that, at least in those countries where property prices have risen sharply and approached previous peaks, developments warrant close monitoring.

The international banking market

The most recent data reported to the BIS show a resurgence in the international banking market in the first quarter of 2000, driven by cross-border interbank transactions. A strong demand for financing mergers, acquisitions and bids for third-generation mobile phone licences in the European telecommunications sector appears to have set in train a movement of funds from various banking centres around the world to Europe, especially London. This process of rechannelling funds caused lending flows between banks in developed countries to rise to $321 billion during the first quarter, the highest level of activity seen in the interbank market since the fourth quarter of 1997. A portion of these funds was onlent to non-bank borrowers, resulting in a near tripling of new loans to non-bank borrowers in developed countries to $65 billion.

The resurgence of the international banking market did not, however, extend to developing country borrowers, for whom securities markets continued to be by far the most important source of debt finance. In the first quarter of 2000, international banks further reduced their overall exposure to developing countries, albeit at a slower pace than in 1998-99. Their investment in securities - at $7 billion, the largest flows since mid-1997 - was more than offset by a $9 billion reduction in loans. Much of this reduction was due to a decline in lending by US banks to Middle East borrowers. In Latin America new lending roughly offset repayments, while in Asia bank lending turned slightly positive after 10 consecutive quarters of repayments.

The international debt securities market

In the international debt securities market, net issuance amounted to $265 billion in the second quarter of 2000, a slight increase over the previous quarter but substantially below net issuance in the same quarter a year earlier. Issuance by US housing agencies and financial institutions slowed between the first and second quarters, affected by relatively high and volatile credit spreads. Among financial institutions, much of the decline in net issuance was accounted for by German banks, which reduced their issuance of Pfandbriefe after several quarters of very rapid growth. Developing countries also cut their issuance, despite a downward trend in spreads.

The subdued borrowing activity in the public and financial sectors was more than offset by strong issuance by corporations. Non-financial corporations more than doubled their net debt issuance in the second quarter, to $78 billion. European telecommunications firms involved in mergers and takeovers were especially active, notably firms in Germany and France. Corporate activity and unsettled conditions in US and European credit markets helped to drive net issuance of yen-denominated bonds to its highest level since the mid-1990s.

Derivatives markets

Turnover in exchange-traded derivatives products expanded further in the second quarter of 2000, reaching its highest level since the third quarter of 1998. In the United States, activity in Treasury-based instruments continued to shift from the long bond (30-year) contract to the 10-year note contract, owing to the reduced issuance of longer-maturity bonds. In Europe, the MATIF enjoyed a further recovery of futures trading on French government bonds, not least because of the establishment of a market-making scheme by French banks.

Reviewing longer-term developments in derivatives markets, 1999 witnessed the first decline in exchange-traded activity since 1996. By contrast, the notional amounts of over-the-counter (OTC) contracts outstanding rose to record levels last year. The introduction of the euro made intra-European currency products redundant, and at the same time resulted in a substantial increase in the use of OTC euro-denominated interest rate contracts. Concerns about the Y2K changeover were also a factor in the lower turnover of exchange-traded instruments.

The relationship between US stock markets and the dollar

A featured article analyses the co-movement of returns on US stock markets and changes in the value of the dollar over the last two decades. The article shows that there is little evidence of a robust significant correlation between stock market indices and the major exchange rates. This result is consistent with the fact that, over a long horizon, international portfolio equity flows have not been correlated with exchange rate movements. At the same time, as evidenced by higher correlations in 1999 and during some historical episodes, a contemporaneous sharp movement in US equity markets and the dollar cannot be ruled out.

Foreign currency deposits in China

A second special feature analyses foreign currency deposits in China's banking system. Foreign currency deposits in China have grown rapidly since the Asian crisis, and amounted to over 7% of M2 at the end of 1999. The article suggests that their growth reflects the disappearance of the yield premium on renminbi deposits relative to foreign currency deposits in China during 1998, and the subsequent rise in the yield premium on US dollar deposits. The scale of foreign currency deposits means that the Chinese banking system is, by this measure, more open than has generally been recognised. This option to hold foreign currency deposits in China has in effect helped to domesticate capital flight.