FINANCIAL SECTOR OUTLOOK.

1 SUMMARY

Last year's interest rate increases and financial turbulence contributed to reversing a trend with sharply rising debt and growing imbalances in the financial system. Credit growth has tapered off over the past year, and banks have managed to reverse the tendency of deteriorating financial strength. However, competition in the financial industry remains strong. This situation, combined with prospects for a turnaround in the Norwegian economy, with increased credit risk and expectations of higher loan losses, therefore represents a major challenge to banks.

Continued uncertainty regarding developments in securities markets

The turbulence in international financial markets has gradually diminished in recent months. The robustness of the financial system has probably increased as a result of a reduction in the scale of large debt-financed "speculative" positions. In addition, international work to prevent financial crises and establish better routines has intensified.

However, there is still considerably uncertainty associated with developments in the securities markets. For example, both the OECD and the IMF have pointed out that equity prices in the US may be overvalued in relation to fundamentals (Chart 1.1). A sharp correction in the US equity market could have substantial contagion effects on international markets, including the Norwegian financial market.

[Chart 1.1 OMITTED]

Norwegian financial institutions have limited direct exposure in countries where the uncertainty is greatest. Therefore, the possible effects on developments in Norway's real economy or in Norwegian securities markets as a result of turbulence in international financial markets will be of major importance to developments in Norwegian financial institutions.

Strong competition puts pressure on banks' earnings

The competitive situation in the financial sector has intensified in recent years, and banks' earnings have come under pressure. This trend continued in 1998. Interest margins increased sharply in 1998. Even though interest margins declined in the last two quarters up to the end of the first quarter of 1999, banks' margins so far this year are somewhat higher than at the beginning of 1998. This may indicate that banks are giving higher priority to earnings than to maintaining or increasing market shares. However, there are many indications that the increase in margins is primarily related to changes in interest rates. In that case, margins are expected to fall back to the levels seen in 1997 as interest rates stabilise.

Pricing loans so that they reflect expectations of increased credit risk and losses will be a considerable challenge for banks in the period ahead. A number of factors indicate that competition from foreign financial institutions will increase further. Prospects for lower demand for credit from households and enterprises also suggest that competition for loans will intensify. However, slower credit growth will contribute to more balanced developments in the financial sector, entailing that banks can maintain their financial strength even if profits are reduced.

So far no increase in non-performing loans ...

The rise in interest rates through 1998 led to a sharp increase in the interest burden of borrowers. So far, this has not been reflected in an increase in non-performing loans in the Norwegian market.

However, the increase in interest rates has contributed to a change in private and municipal sector credit growth. Credit from domestic sources has declined, while credit from foreign sources increased markedly in the fourth quarter of 1998. It is primarily the enterprise sector, particularly petroleum-related activities, that have increased borrowing from foreign sources. The accumulation of debt in some enterprises therefore appears to be continuing.

... but increased credit risk and the prospect of higher loan losses, ...

Defaults and losses on loans to households are expected to remain low in the years ahead even though unemployment is expected to edge up. The strong growth in income and employment in recent years has led to a substantial improvement in households' financial position. A falling real interest rate up to the beginning of 1998 contributed further to improving debt-servicing capacity. The result is that the financial exposure of households is relatively low, and the credit risk associated with financial institutions' loans to households is generally limited.

There is, however, reason to expect an increase in defaults and losses on loans to the enterprise sector, although there is considerable uncertainty in this respect. A sharp rise in debt in recent years has resulted in a marked increase in the debt burden of enterprises. At the same time, a number of industries are experiencing growing pressures on profit margins as a result of increased labour costs and low product prices. Intensified international competition and prospects for weaker economic growth among our trading partners and in Norway will reinforce the negative profit trend for enterprises, particularly in some exposed industries. However, household consumption will make a positive contribution to parts of the enterprise sector, particularly in sheltered industries. For the financial sector, this means that losses will be most pronounced for commitments to the internationally exposed sector.

... and continued high liquidity risk associated with short-term foreign financing

Since 1995, banks' foreign debt has increased substantially. Short-term debt accounts for a large share of this, and has partly contributed to funding domestic credit growth. The growth in foreign debt thus implies a marked increase in banks' liquidity risk. Growth in foreign debt was slightly lower in 1998 than in the two previous years, and at the same time there was a shift from short-term to more long-term foreign financing. However, the magnitude of short-term foreign financing is still considerable, and developments in the first quarter of 1999 indicate a further increase.

Need for measures to improve earnings

Increased credit risk and prospects for higher losses suggest that a number of institutions will have to take steps to improve earnings and maintain financial strength, possibly at the expense of market share. Analyses of possible developments in bank earnings illustrate that this may be a considerable challenge. Estimates indicate that banks may achieve satisfactory results in 1999. From 2000, however, pressures on earnings and rising loan losses could lead to a fall in operating results, with a weaker return on equity in relation to the banks' stated objectives. As a result of expectations of lower lending growth, however, it will still be possible to maintain financial strength. If lending growth should be higher than the estimated figure, financial strength will deteriorate, as core capital will rise at a slower pace than lending.

[Charts 1.2-1.5 OMITTED]

2 INTERNATIONAL AND NORWEGIAN SECURITIES MARKETS

2.1 Developments in international financial markets

The crises in Asia and Russia in 1998 demonstrated that because of the increased globalisation of financial markets a shock in one country or market rapidly spreads to other parts of the world. Norwegian financial markets are no exception. International shocks tend to be associated with sharp changes in commodity prices, and since the Norwegian economy is relatively vulnerable to changes in commodity prices, the effect of international shocks on Norwegian financial markets may in some cases be stronger than in other countries. Monitoring factors that may cause turbulence in international financial markets is therefore important.

Gradual stabilising of international financial markets

The situation in international financial markets has gradually stabilised so far this year. Several countries, Brazil in particular, did experience problems in the wake of the Asian and Russian crises, but contagion to other countries and markets proved far less extensive than feared. In general, the financial system should have become more robust as a result of a decrease in the size of large, debt-financed "speculative" positions. The intensified international work to prevent financial crises also helps to increase the robustness of the financial system.

The continued advances on stock exchanges, and slightly higher long-term interest rates, may indicate greater international optimism regarding growth. This also applies to Japan, where both banks and the authorities are now showing increased determination to tackle bank losses. However, current indicators still show a very weak trend. Both the OECD and the IMF have pointed out that equity prices in the US may now be overvalued in relation to fundamentals. A sharp correction must be expected to have substantial international contagion effects. The increasing US current account deficit is also an imbalance that may give rise to a sudden change in mood with wide-ranging implications for financial markets.

Brazil abandoned its fixed exchange rate (crawling peg) policy in January. The Brazilian real depreciated thereafter by about 40 per cent against the USD, but has since strengthened slightly. The interest rate has also been reduced in a number of steps over the past months, as the unrest has subsided. However, there is still some fear that the country will be unable to service its general government debt, which is very short-term and partly denominated in foreign currency.

Although several countries with a fixed exchange rate experienced pressure on their currencies, and responded by raising interest rates, the contagion from Brazil to other countries via the financial markets has been less than feared. There may be several reasons for this. First, the crisis in Brazil was expected to a greater extent than the crises in Asia and Russia. As a result, the investors with the most speculative positions, who normally react fastest and on a larger scale...