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-- Recovery in Risk Appetite in Global Financial Markets and Vulnerability of the Global Economy
-- Developments in Domestic Financial Markets in the First Half of 2009: Improvements in the Financial Environment and Nervousness in Financial Markets
-- Outlook for the Financial Markets
August 31, 2009
Bank of Japan
As the global economy was suffering through the financial crisis after autumn 2008, economic conditions significantly deteriorated, instigating a rapid increase in uncertainty about the economic outlook and financial asset valuations. Under these circumstances, governments and central banks utilized all their policy tools to break the vicious cycle between the financial system and the real economy. Around March 2009, however, uncertainties over the economic and financial environment started to decrease, and some economic agents which had been extremely pessimistic started to change their behavior. As excessive concern over financial system soundness began to abate and expectations began to grow that the real economy would bottom out, investors' risk appetite recovered somewhat and their purchases of risk assets such as equities and credit assets increased gradually.
Such risk-taking activities have yet to be seen in all economic agents. Economic agents have yet to shrink their balance sheets, which grew excessively during the global credit boom that continued until 2007. Accordingly, the global economy remains fragile. Judging from Japan's experience after the bursting of the bubble, balance-sheet adjustments are likely to continue and exert downward pressures on the economy until excess debt declines to a sustainable level. For example, real estate buyers such as households in the United States and the United Kingdom are likely to continue curtailing their spending until their degree of leverage returns to an appropriate level. Subsequently, the supply and demand conditions in real estate markets are likely to continue deteriorating. If the prices of real estate continued to fall as a result of the above, the balance sheets of real estate buyers would be devastated, and their spending would be further constrained.
Although the financial system is regaining market confidence, banks in the United States and Europe still have problems with their balance sheets. They have sought to improve their capital base, but the level of leverage is still high. If asset prices become volatile again due to an economic downturn, U.S. and European banks would have incentives to reduce leverage to avoid bankruptcy -- deleveraging pressures -- because higher leverage means higher bankruptcy risk. During the past few years, U.S. and European banks became increasingly dependent on short-term funding in the interbank markets and increased their long-term loans funded by this short-term money. Following the financial turmoil, however, banks were exposed to higher liquidity risk due to maturity mismatches. While funding constraints were alleviated as central banks provided substantial liquidity, U.S. and European banks, in order to reduce the risk, would grow less dependent on short-term funding in the interbank markets, which would also exert deleveraging pressures.
Adjustment in the balance sheet of the private sector consists of downward pressure on the economy. Therefore, the public sector should instead underpin aggregate demand for the time being. However, global financial markets seem to be aware of the potential risk that expansion of the public-sector balance sheet due to the increasing fiscal deficit will destabilize long-term interest rates.
After autumn 2008, domestic markets were strongly impacted by the turmoil in global financial markets and the market functioning deteriorated. Domestic markets remained very nervous for some time after the turn of the year, but upward pressure on interest rates moderated gradually in money markets, reflecting the active implementation of policy measures by the Bank of Japan. In the CP market where the issuing conditions had continued worsening toward the end of 2008, the issuance rate declined thanks to the policy measures taken by the government and the Bank, such as those to facilitate corporate financing. The CP market improved, and many firms with high ratings were able to issue CP without constraints in terms of lots and terms. As investors' risk appetite recovered, investors started to shift the weight in the investment portfolios from safe assets such as government bonds to risk assets such as stocks and corporate bonds. As a result, the increase in the government bond yields, the rise in stock prices, and the decline in credit spreads on corporate bonds were seen.
In the financial markets as a whole, although the intermediary functioning was on an improving trend, the market functioning had yet to fully recover. In money markets, the volume of transactions, particularly longer-term ones, remained low. In the credit market, investors remained highly selective about the issues they purchased. While investment demand for issues with high ratings was firm, that for issues with low ratings was weak on the whole. In Japanese government bond markets, there was some nervousness, affected by concerns about the increasing fiscal deficit.
In 2009, foreign exchange (FX) rates continued to show unstable movements, greatly influenced by market participants' views on global economic conditions and the financial system. Buybacks of the U.S. dollar and the yen, which were observed toward the end of 2008, came to a halt. After March 2009, some investors shifted their investment from the U.S. dollar and the yen to currencies of resource-rich countries and high-yielding currencies as their risk appetite recovered. However, volatility in FX markets remained high, and investors' risk-taking activities were limited. Short positions in the U.S. dollar and the yen expanded only slightly.
Projections regarding the financial and capital markets need to take into account how the recovery of global final demand and the improvement in financial conditions, particularly of the U.S. and European financial institutions, proceed. When there exists a sector with excessive debt such as U.S. households, the spending of such a sector is curtailed and the demand stimulus effect of additional credit supply may decrease. In such a situation, the pace of economic recovery is likely to be moderate. If adjustments in balance sheets of nonbank sectors continue, there is a risk that nonperforming loans (NPLs) in the banking sector may increase. If the economy deteriorates and the performance of financial institutions worsens again, there is a possibility that concerns over the capital adequacy of financial institutions will reemerge. Markets are still cautious about such a risk. Given these circumstances, markets are likely to remain volatile and sensitive to shocks.
If concerns reemerge over the conditions of the financial sector in the United States and Europe, the downward pressure on the economy will strengthen through a negative feedback loop between financial markets and economic activity. This will lead to an increase in fiscal expenditure and to heightened uncertainty over its financing. If this results in a divergence of long-term government bond yields from fundamentals and an increase in the government's funding costs, there will be a chain reaction in which the funding costs of the private sector supported by the government increase as well. As a result, there is a possibility that global financial markets' instability would negatively affect domestic financial markets. Considering these potential impacts, the key to financial stability is whether the U.S. and European financial institutions can maintain their disposal of NPLs with due speed.
Meanwhile, in the long run, it is necessary to bear in mind that in the past aggressive policy measures to restore stability in response to financial crisis triggered financial imbalances that developed subsequently, even though the measures' original objectives were achieved. If the financial markets unnecessarily seek the stability, the risk of a new financial imbalance would be heightened. Therefore, maintaining market functioning in a sustainable manner so that appropriate risk assessment is carried out is necessary for financial market stability in the long run. It is vital for each market participant to recognize this, and to work to restore the self-sustaining functioning inherent in the financial markets and strengthen the robustness of the financial and capital markets.
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Financial Markets Department, Bank of Japan
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