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-- Developments during the Second Half of 2007 --
March 26, 2008
Bank of Japan
Financial Markets Department
Global financial markets in the second half of 2007 experienced large swings due to the turmoil triggered by the U.S. subprime mortgage problem. In securitization markets, which had been rapidly expanding, investors began to reassess risks, and credit spreads widened reflecting downgrades of securitized products caused by the increase in delinquency rates on subprime mortgages. In addition, stock prices in global markets dropped in summer 2007, largely due to position adjustments accompanying investors' risk reduction. In September, when concerns about a deterioration in the U.S. economic conditions faded in response to the Federal Reserve's policy rate cut, stock prices rebounded temporarily, but then followed a downward trend against the background of uncertainty about the financial conditions of major U.S. and European financial institutions and renewed concerns about a slowdown in the U.S. economy. Reflecting expectations of the slowdown in economic growth and a flight to quality during the market turmoil, long-term government bond yields declined with fluctuations. In foreign exchange markets, volatility increased sharply, leading to a large-scale unwinding of carry trades which used leverage to exploit interest rate differentials in an environment of low financial market volatility. As a result, high-yielding currencies depreciated and low-yielding currencies, including the yen, appreciated. The U.S. dollar was on a depreciating trend reflecting the increasing uncertainty about the financial and economic developments in the U.S. In money markets, funding needs mounted and short-term interbank rates came under upward pressure because of heightened concerns about counterparty credit and liquidity risks.
Financial markets in Japan experienced swings caused by developments in global financial markets, but the extent of the swings varied depending on the market concerned. In Japan's stock market, stock prices trended downward, and the extent of the decline was even greater than that in U.S. and European stock prices, which were directly hit by subprime woes. The sharp decline was mainly due to the fact that market participants became cautious about the Japanese economy against the background of the yen appreciation and the decrease in housing investment caused by the enforcement of the revised Building Standard Law. Japanese long-term government bond yields declined reflecting the fall in the U.S. and European long-term yields and the cautious outlook for the Japanese economy. On the other hand, in Japan's credit markets, spreads widened from the summer, but on the whole the extent of the widening was limited compared with that in the U.S. and European credit markets. This was mainly because Japanese financial institutions, whose risk exposure to U.S. and European securitization markets was relatively small, maintained accommodative lending attitudes as firms' creditworthiness and financial fundamentals continued to be favorable. In Japan's money markets, the effects of the tightening of credit conditions in the U.S. and Europe became evident and rates on term instruments with maturities beyond the year-end, for example, came under upward pressure, but fluctuations in these short-term rates were small compared with those in U.S. and European markets.
There are several reasons why the rise in delinquency rates on U.S. subprime mortgages, which comprise merely a small portion of underlying assets of various securitized products, affected global financial markets substantially. First, unexpected losses on subprime-related securitized products raised strong concerns about the most important functioning of financial markets, i.e., about whether risks had been properly priced under the originate-and-distribute model of financial intermediation. Since the credit risks of various underlying assets were spread among a wide group of investors in the originate-and-distribute model, investors started to reassess risks of securitized products overall. Second, the increase in mark-to-market losses on securitized products caused many investors to want to sell but few to buy, leading to a mutually reinforcing deterioration in market and funding liquidity. The deterioration in liquidity decreased the risk appetite of investors further and affected credit markets overall as well as stock markets. Third, the disruption in securitization markets forced banks to face a reintermediation of risks which they had seemingly transferred off their balance sheets. U.S. and European banks experiencing an involuntary expansion of balance sheets were then confronted with a rise in funding costs, reflecting heightened concerns about counterparty risk in money markets. Finally, concerns mounted that the tightening of bank lending might adversely affect the macroeconomy, raising uncertainty about the outlook for the U.S. economy and leading to an increase in the volatility of asset prices and a further deterioration in market liquidity.
The significant deterioration in market liquidity has made it difficult for investors to reevaluate financial assets adequately. Adjustments in securitization markets and credit markets overall have intensified further. Therefore, developments in global financial markets and their effect on the global economy warrant careful attention.
With a view to supporting the improvement in both the functioning and the efficiency of financial markets in Japan, the Bank addressed the following two major issues concerning the market infrastructure in 2007: (1) the facilitation of active trading in money markets; and (2) the enhancement of business continuity planning (BCP) in financial markets.
As for the first issue, the functioning of money markets has recovered steadily following the termination of the quantitative easing policy in March 2006. From February 2007 to July 2007, the Bank took a series of actions, mainly focusing on practical matters, to support and promote the autonomous improvement of the functioning of money markets. Market participants also took various actions that contributed to the improvement. Through these efforts, money market transactions increased steadily in 2007.
With regard to the second issue, ensuring that necessary transactions can be conducted even in emergency situations, such as earthquakes or terrorist attacks, is in the interest not only of each individual market participant but also contributes to maintaining the stability of the financial markets and the economy as a whole. Moreover, for an international financial center, resilience of the financial markets to disasters is a key requirement. In 2007, significant progress was made in the BCP for money markets (call markets), securities markets, and Tokyo foreign exchange markets.
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Financial Markets Department, Bank of Japan
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