Financial Stability

Financial Stability ² 05

D e c e m b e r

Reports from the Central Bank of Norway

No. 5/2005

Financial Stability is published twice a year and this report and the Inflation Report together comprise Norges Bank’s report series.� �he report is also a�ailable on Norges Bank’s website� �he report is also a�ailable on Norges Bank’s website��he report is also a�ailable on Norges Bank’s website�

http�//www.�norges-bank.�no.�

�he series of reports is included in the subscription for Economic Bulletin, which costs N��� ���� per year �incl.� ����.�costs N��� ���� per year �incl.� ����.�

Subscriptions may be ordered o�er the Internet� www.�norges-bank.�no under�

“Publications”, or by paying to bankgiro ��6�9.�96.��68��� or by writing to�

Norges Bank, Subscription Ser�ice P.��.� Box 1179 Sentrum

��1��7 �SL� N�RW�Y

�elephone� +47 �� 31 63 83

�elefax� +47 �� 31 64 16

E-mail� central.�bank@norges-bank.�no Editor� S�ein Gjedrem

Design� Grid Stategisk Design �S

Setting and printing� Reclamo grafisk senter as

�he text is set in 11½ point �imes

ISSN 1����-�749 �printed�, 1���3-88�8 �online�

Norges Bank’s reports on financial stability

Financial stability means that the financial system is robust to disturbances in the economy and is able to mediate financing, carry out payments and redistribute risk in a satisfactory manner.�

Experience shows that the foundation for financial instability is laid during periods of strong growth in debt and asset prices.� Banks play a central part in extending credit and mediating payments and are therefore important to financial stability.�

Pursuant to the Norges Bank �ct and the Payment Systems �ct, Norges Bank shall contribute to a robust and efficient financial system. Norges Bank therefore monitors financial institutions, securi- ties markets and payments systems in order to detect any trends that may weaken the stability of the financial system.� Should a situation arise in which financial stability is threatened, Norges Bank and other authorities will, if necessary, implement measures to strengthen the financial system.�

�he Financial Stability report discusses the risks facing the financial system, particularly credit, liquidity and market risk.� We use the designations low, relati�ely low, moderate, relati�ely high and high risk in a qualitati�e assessment of the degree of risk.� Changes in the risk situation since the pre�ious report are also e�aluated.� �he risk assessment may be different for the short and for the long term.�

�he report is published twice a year.� �he main conclusions of the report are summarised in a submis- sion to the Ministry of Finance.� �he submission is discussed at a meeting of Norges Bank’s Executi�e Board.� Norges Bank’s annual Report on Payment Systems pro�ides a broader o�er�iew of de�elop- ments in the Norwegian payment system.�

Financial Stability 2/2005

Editorial ... 7 Summary ... 8 1. International developments and securities markets ... 1��

1.�1 International de�elopments .�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�1��

1.�� Main trends and risk factors .�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�1��

1.�3 Securities markets in Norway .�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�1�

Box:

�re equity prices more �olatile in Norway

than in other countries? .�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�1�

2. Macroeconomic developments, households and enterprises ... 17 �.�1 De�elopments in the Norwegian economy .�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�17 �.�� Households .�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�18 �.�3 Enterprises .�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.��6 Boxes:

De�elopments in house prices .�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.���

Distribution of household debt,

income and financial assets.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.��4 Macroeconomic gap indicators .�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�3��

. Financial institutions ... 3�

3.�1 Solid results and financial strength .�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�3�

3.�� Risk outlook for banks .�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�34 3.�3 Scenarios for banks .�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�36 3.�4 �ther financial institutions.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�38 3.�� �utlook ahead .�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�38 Boxes�

Foreign banks in Norway .�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�4��

Security for loans from Norges Bank�

new guidelines .�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�4�

Annex 1: Earlier boxes 2001-2005 .�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�43 Annex 2: Other published material on financial stability at Norges Bank .�.�.�.�.�.�44 Annex 3: Statistics .�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�.�4�

�he cut-off date for this report was 3�� No�ember ������

Considerable demands on banks’

credit risk assessment

With low interest rates and fa�ourable economic conditions, banks’ loan losses ha�e been �ery low o�er the past couple of years.� Combined with lower costs, this has resulted in solid results in the banking sector.�

Looking ahead, it appears that household real income will continue to rise and unemployment will decline.�

High prices for our exports, solid global growth and high domestic demand point to continued high corpo- rate profitability for a period.� �he risk of a substantial increase in banks’ loan losses in the near term seems to be fairly low.� �he outlook for financial stability in the short term is therefore positi�e.�

Solid growth in household income and low interest rates ha�e continued to dri�e up house prices, although house prices seem to ha�e increased more than implied by these factors alone.� Experience shows that high house prices ha�e a relati�ely long-lasting effect on debt.� �he sharp rise in house prices that we ha�e obser�ed may thus contribute to an increase in the household debt burden from an already high le�el in the years ahead, e�en if the rise in house prices should slow in the period ahead.� �his would entail a risk of less stable economic de�elopments and higher loan losses for banks in the longer term.� When the interest rate is gradually brought up to a more normal le�el, howe�er, the rise in house prices and debt is expected to edge down.� �his will reduce the risk of wide fluctuations in acti�ity in the Norwegian economy and in banks’ losses and results.�

�he relationship between de�elopments in house prices and debt is amplified by financial institutions com- peting for market shares by offering new loan products that facilitate mortgage equity withdrawal.� �his increases the liquidity of housing wealth.� �hese loan products pro�ide greater opportunities for borrowers to spread consumption o�er a lifetime.� Howe�er, the new loan products place considerable demands on banks’

credit risk assessment and ad�isory ser�ices.� When the interest rate is unusually low, it can be particularly challenging for borrowers to assess their debt-ser�icing capacity o�er time.�

Svein Gjedrem

Summary

Chart 1Household debt burden¹⁾in selected countries. Annual figures. 1990 – 2004

1)Debt as percentage of disposable income. Loan debt as percentage of liquid disposable income for Norway.

Sources: OECD, Bank of England, Sveriges Riksbank, Danmarks Nationalbank, Sedlabanki Island and Norges Bank

50 100 150 200 250

1990 1992 1994 1996 1998 2000 2002 2004 50 100 150 200 250

Denmark

Norway

Sweden UK

US

Iceland

Chart 2 Banks’ Tier 1 capital ratio and pre-tax profit as a percentage of average total assets¹⁾.

Annual figures.1998 – 2005

1)Excluding branches of Norwegian banks abroad Source: Norges Bank

2)As of September 2005

0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6

1998 1999 2000 2001 2002 2003 2004 2005 01 2 34 5 67 8 910

Profit before loan losses (left-hand

scale) Profit after loan losses (left-hand scale) Tier 1 capital ratio (right-hand scale)

2)

Chart 3 Banks’¹⁾lending margins on loans to households and non-financial enterprises. Per cent. Quarterly figures. 02 Q1 – 05 Q3

0 1 2 3 4

Mar 02 Sep 02 Mar 03 Sep 03 Mar 04 Sep 04 Mar 05 Sep 050 1 2 3 4

Non-financial enterprises

Households

1)All banks in Norway Source: Norges Bank

Favourable outlook for global financial stability in the near term

�he near-term risks to the stability of the global financial system are low and somewhat lower than in May ������

when the pre�ious Financial Stability report was published. Global economic growth remains strong.� Both enterprises and banks are posting substantial profits.� Share prices ha�e ad�anced in the largest markets.�

Howe�er, the medium and long-term risks are somewhat more pronounced.� First, house prices and household debt ha�e increased substantially in many countries.� �ny cor- rection in the housing market may result in increased sa�ing, lower economic acti�ity and higher loan losses in banks.�

Second, high oil prices may contribute to lower growth in the global economy.� Moreo�er, oil prices may contribute to higher inflation expectations and higher interest rates than implied by de�elopments in capacity utilisation.� �hird, a long period of low long-term interest rates has increasingly induced in�estors to search for yield in markets associated with higher risks than the go�ernment bond market.� �his has pushed up prices in these markets so that the risk of losses may ha�e increased.� Finally, imbalances in global trade and cross-border capital flows ha�e increased.�

Norwegian banks have achieved solid results

De�elopments in �ariables that influence financial stability in the near term ha�e also been satisfactory in Norway.� Banks achie�ed solid results in the first three quarters of ������, primarily as a result of �ery low loan losses and lower costs.�

Low losses reflect low interest rates and solid income growth in both the enterprise and household sectors.� Pre-loss profits in relation to total assets ha�e been fairly stable o�er the past couple of years.� High lending growth has contributed to dampening the fall in net interest income in relation to total assets and has countered lower interest margins.� Banks’

return on equity has impro�ed from �����4 to the first three quarters of ������.� Capital adequacy has declined somewhat in the past year, but financial strength is ne�ertheless solid.�

�he macroeconomic outlook points to continued low losses and robust results in banks in the near term.�

In the longer term, a normalisation of interest rates or weaker cyclical de�elopments could lead to higher loan losses.�

With solid financial strength and earnings, banks seem well poised to deal with such de�elopments for a period.� Interest margins will probably continue to narrow, exerting pressure on banks’ earnings.� Banks must then increase other income or further reduce costs to maintain profitability.�

Households continue to accumulate debt

In the near term, households’ financial position is fa�ourable

-4

0 4 8 12 16 20 24 28

1997 1998 1999 2000 2001 2002 2003 2004 2005 -4 0 4 8 12 16 20 24 28

Non-financial enterprises¹⁾ Households²⁾

Chart 4Credit to mainland Norway. Per cent. Twelve- month growth. Jan 97 –Sep 05

Source: Norges Bank

1)All foreign credit to mainland Norway assumed given to enterprises

2)Household domestic debt

Total credit (C3)

Chart 5 Equity-to-assets ratio and pre-tax return on equity for companies listed on Oslo Stock Exchange.¹⁾Per cent. Quarterly figures. 04 Q1 – 05 Q2

1)Companies registered in Norway with the exception of banks, insurance companies, Statoil and Hydro

Sources: Statistics Norway, Statoil, Hydro and Norges Bank -20

-10 0 10 20 30 40 50

2002 2003 2004 2005 -20

-10 0 10 20 30 40 50

Equity-to-assets ratio

Return on equity

Chart 6 Growth in household credit. Estimate with fan chart.¹⁾Quarterly figures. Per cent. 03 Q1 – 08 Q4

30% 50% 70% 90%

1)The bands in the fan chart indicate different probabilities for credit growth. The probabilities are among other factors computed based on deviations between estimated and actual credit development during the period 94 Q3 – 05 Q2 Source: Norges Bank

0 5 10 15

2003 2004 2005 2006 2007 2008 0 5 10 15

debt has increased, households ha�e also set aside capital in recent years.� Housing in�estment is high.� Households’ net financial wealth to income ratio has been relati�ely stable in recent years.� � large portion of their financial assets consists of group insurance claims.� Most insurance claims are funds which households cannot draw on when their financial situ- ation weakens.� Excluding insurance claims, the net financial wealth to income ratio has fallen in recent years.� Moreo�er, only a small portion of financial assets are held by house- holds with high debt burdens.�

Household debt accumulation is still �ery high and the debt to income ratio is higher than at the end of the 198��s.� Low- and middle-income households show the highest increase in debt in relation to income in this period.� House prices ha�e risen substantially in recent years and the price le�el may now seem to be somewhat high in relation to de�elopments in income, interest rates, unemployment and residential construction.� Experience shows that de�elopments in the housing market ha�e considerable influence on lending and that the effects are long-lasting.� Growth in household debt may therefore remain high for se�eral years, e�en if the rise in house prices should taper off.� If so, the debt burden will increase to a �ery high le�el.� �ariable-rate loans account for the bulk of household borrowing.� Due to unusually low interest rates, the interest burden is low, but will increase as the interest rate gradually normalises.

Solid corporate profitability

Enterprises’ financial position is fa�ourable.� Profitability impro�ed from �����3 to �����4 in most industries.� Listed com- panies’ profitability has been high in ������.� �he number of bankruptcies is continuing to fall.� �hese de�elopments ha�e been dri�en by high oil prices, increased demand, moderate wage growth and low interest rates.� Corporate debt growth has risen, but is still moderate.� High earnings ha�e pro�ided enterprises with an ample supply of internal funds to finance their in�estments and ha�e curbed growth in borrowing.� In the longer term, factors such as a deterioration in competiti-

�eness may reduce enterprises’ profitability and their capa- city to ser�ice debt.� In addition, lower prices for oil and other export goods may weaken earnings in many industries.�

Satisfactory financial stability outlook

With a high equity ratio and continued solid profitability in the corporate sector, the credit risk associated with loans to the corporate market is assessed as relati�ely low, and some- what lower than in May.� �he risk of a substantial increase in losses on loans to households is regarded as relati�ely low and unchanged since the pre�ious report.� Banks’ liquidity and market risk are still considered to be relati�ely low.� Banks’

performance has impro�ed.� �n balance, the short-term out- look for financial stability is therefore regarded as satisfac- tory and somewhat better than half a year ago.� �he sharp rise in house prices and debt, howe�er, entail a risk of less stable economic de�elopments in the longer term.�

10

1 International developments and securities markets

0 1 2 3 4 5 6 7 8 9 10 China

Japan North America Western Europe

World 2006 October

2006 May 2005 October 2005 May Chart 1.1Forecasts for real GDP growth in 2005 and 2006 as of May and October 2005. Per cent

Source: Consensus Forecasts

Source: EcoWin

Chart 1.2 International equity indices. Index 2005 = 100. Daily figures. 1 Jan 01 – 29 Nov 05

30 50 70 90 110 130 150

2001 2002 2003 2004 2005

30 50 70 90 110 130 150

Japan Topix Europe Stoxx

Norway OSEBX US S&P 500

Source: EcoWin

Chart 1.3 GDP and stock prices (price indices) in the US. Logarithmic scale. Index 1 Jan 1947 = 100.

Monthly figures. Jan 45 – Oct 05

10 100 1000 10000 100000

1945 1955 1965 1975 1985 1995 2005 10 100 1000 10000 100000

S&P 500

GNP

1.1 International developments

�he near-term risks to the stability of the global financial system are low and somewhat lower than in May when the pre�ious Financial Stability report was published.� �his is attributable to solid earnings in the enterprise and banking sectors.� Enterprises and banks ha�e therefore been able to strengthen their capital buffers.�

Growth in the global economy is expected to remain strong.�

�he projections for global GDP growth in ������ ha�e been re�ised upwards somewhat since May ������ �see Chart 1.�1�.�

�he growth outlook has been re�ised upwards considerably for Japan and re�ised downwards somewhat for Western Europe.� In China, growth is still high but is expected to slow somewhat in �����6.�

In the US, Europe and Japan, equity prices ha�e ad�anced by 6%, 1�% and 36% respecti�ely since the pre�ious Financial Stability report �see Chart 1.���.� US go�ernment bond yields ha�e edged up in the past few months.� Howe�er, interna- tional long-term interest rates and real interest rates are still low compared with historical le�els.�

Low real interest rates and a rise in equity prices appear to be gi�ing mixed signals concerning economic de�elopments.�

Real interest rates may, howe�er, be affected by factors other than growth prospects.� High demand for go�ernment bonds, for example, has contributed to keeping interest rates at a low le�el.� Moreo�er, there is often little correlation between economic growth and equity prices in the short term.� �he correlation is higher in the long term �see Chart 1.�3�.�

1.2 Main trends and risk factors

E�en though the outlook for financial stability is positi�e in the short term, long-term �ulnerability may ha�e increased.�

Some of the main trends and risk factors for global financial stability are discussed below.�

Sharp rise in house prices and household debt growth

House prices are rising rapidly in many countries, although the pace has slowed somewhat during the past year.� �ne important exception is the US, where the rise in house prices is still strong and is an important dri�ing force behind housing in�estment and pri�ate consumption and thereby economic growth.� �t the same time, the rise in house prices has contributed to increasing household debt.� �he share of disposable income that is used to ser�ice debt has increased moderately and is at a historically high le�el in spite of �ery

11 Source: EcoWin

Chart 1.4 US: Mortgage rate in per cent. Interest and instalments on mortgages as percentage of disposable income. Monthly figures.

Jan 80 – Oct 05

45 67 89 1011 1213 14

1980 1984 1988 1992 1996 2000 2004 45 67 89 1011 1213 14

30-year fixed mortgage rate Debt servicing ratio

Floating mortgage rate

-15 -10 -5 0 5 10 15

-30 0 30 60 90

Rise in house prices

Saving ratio

Chart 1.5Household saving ratio in 2004 in per cent. Total rise in house prices in percentage of disposable income. 99 Q4 – 04 Q4

1) Estimated reinvested dividend payments since 2001 excluded from the saving ratio

2) Saving ratio during the financial year March 2003 – March 2004 New Zealand²⁾

Australia Norway¹⁾ US

Japan

Germany

Sweden

Canada

Sources: OECD, EcoWin, Statistics New Zealand and Norges Bank

Sources: CFTC and EcoWin 0

400 800 1200 1600 2000

1995 1997 1999 2001 2003 2005 0 20 40 60 80 100

Share of non- commercial actors (right-hand scale)

Number of open contracts (1000, left-hand scale)

Chart 1.6The market for crude oil derivates (NYMEX). Open contracts and non-commercial actors` share. Oil price indices. 95 Q1 = 20. Weekly figures. Week 13 1995 – week 46 2005

Oil price, spot (right-hand scale)

1Both house prices and sa�ing are also affected by other factors, including interest rates.�

low interest rates on debt �see Chart 1.�4�.� Both the share of floating-rate mortgages and the share of interest-only loans ha�e increased sharply.� �he extensi�e use of such loans makes it easier to ser�ice debt today, but increases house- hold �ulnerability to higher interest rates or a reduction in income.�

�he accumulation of assets through the rise in house prices has contributed to low household sa�ing in the US. In a number of other countries, there also seems to be a negati�e relationship between the rise in house prices and the house- hold sa�ing ratio �see Chart 1.���.�¹ � low sa�ing ratio may increase the probability and scale of future financial consoli- dation among households.� If the combination of a high rise in house prices, high debt growth and low sa�ing persists o�er a prolonged period, a turnaround in the housing market and pri�ate demand may be pronounced.� �his would weaken economic growth and increase banks’ loan losses.�

The US current account deficit

�he large differences in household sa�ing ratios across coun- tries are also reflected in de�elopments in countries’ current account balances.� �he US, �ustralia and New Zealand ha�e large current account deficits, whereas Japan and Germany ha�e a current account surplus.� �he US current account deficit is currently record high.� �t the same time, strong economic growth and a positi�e interest rate differential against other regions ha�e contributed to high capital inflows to the US and thus to financing the deficit.� � weakening of in�estor confidence in the US economy could, howe�er, engender considerable unrest in securities and foreign exchange mar- kets.�

High oil prices

�he price of crude oil �both spot prices and futures� has fallen in the past few months, but is still higher than in May ������.�

Persistently high oil prices may ha�e a negati�e impact on global economic growth and thereby on de�elopments in the equity and corporate bond markets.� In isolation, high oil prices may also contribute to higher inflation and rising infla- tion expectations, which may push up interest rates.�

�he rise in oil prices in the past few years has contributed to a sharp increase in crude oil deri�ati�es trading �futures and options� �see Chart 1.�6�.� �he share of contracts entered into by non-commercial operators �financial in�estors� has risen sharply since 199�.� �his share has climbed in periods of rising oil prices.� It may appear therefore that speculating has been concentrated on rising oil prices.� Howe�er, there has also been an increasing interest in speculating in falling oil prices during the past year.� E�en though in�estors are positioned

12

97 100 103 106 109 112

-40 -30 -20 -10 0 10 20 30 97 100 103 106 109 112 S&P 500, stock index

Bond index, low credit-worthiness Hedge fund index

Bond index, high credit-worthinessGovernment bond index

Chart 1.7 Developments in some asset classes during substantial falls in share prices 1998 - 2005.¹⁾Indexed, low point = 100. Days before/after low point

Sources: EcoWin and Norges Bank

1)Average of 22 periods with more than a 5 per cent fall in S&P 500.

Indices for the US, except the global hedge fund index

0 75 150 225 300 375

Consum. Energy Finance Health Ind./mat. ICT 0 75 150 225 300 8 Oct 1998-14 Sept 375

26 Feb 2003-18 Nov 2005

Chart 1.8Sub-indices on the Oslo Stock Exchange during 1998-2000 and 2003-2005. Daily figures

Source: EcoWin

0 200 400 600 800 1000 1200 1400

30 Sept 2000 31 Oct 2005

Other IT and telecom.

Finance Consumer goods Industry and material Energy

Sources: Oslo Stock Exchange and Norges Bank Chart 1.9 Market value by sector on the Oslo Stock Exchange. Billions NOK

in net terms for rising oil prices, the net position as of 1�

No�ember only accounted for 1-�% of the number of con- tracts, compared with about 1�% in the second half of �����4.�

�his may indicate that in�estors are more uncertain about oil price de�elopments in the period ahead.�

The search for yield

In�estors ha�e traditionally searched for yield by in�esting in go�ernment bonds or other low-risk assets.� Yield from low-risk instruments allows in�estors to hold assets with higher risk and higher expected returns, such as equities.�

With low long-term interest rates o�er the past few years, in�estors ha�e increasingly searched for yield in more risky assets such as corporate bonds, real estate projects, funds with absolute return targets �including hedge funds� and structured credit in�estments.� If the risk associated with such in�estments has been underestimated, prices may be higher than implied by fundamentals.� �his would increase the probability of substantial market fluctuations.�

In�estors’ shift towards more risky assets in order to secure their return le�els may also contribute to wider fluctuations in in�estors’ portfolios.� In periods of financial unrest, there is a negati�e correlation between go�ernment bond prices and equity prices �see Chart 1.�7�.� Some of the asset classes that are replacing go�ernment bonds in the search for yield ha�e a positi�e correlation with equities in such periods.�

�his may amplify any decline in the �alue of the portfolio.�

Bank earnings

Banks in the US and Europe ha�e traditionally had considerable short-term borrowing and assets with long- term returns.� �hey ha�e thereby profited from the wide difference between long and short rates.� Since spring �����4, the difference between long and short rates has narrowed appreciably, especially in the US.� �his may imply that net interest income will fall.� �t the same time, loan losses ha�e been �ery low.� It may, therefore, be a challenge for banks to maintain a high le�el of earnings.� Banks’ financial strength, howe�er, is solid.�

1.3 Securities markets in Norway

Prolonged rise in prices in the Norwegian equity market

In spite of a fall in prices in �ctober, the �slo Stock Exchange benchmark index has ad�anced by more than

���% since the last Financial Stability report in May, reaching record le�els on a number of occasions in this period �see Chart 1.���.� �s of �9 No�ember, the benchmark index was 37% higher than the peak in �������.� Howe�er, both market

1 Chart 1.10Foreign owners’ share on the Oslo

Stock Exchange and developments on the Oslo Stock Exchange. Index 31 Dec 95 = 100. Monthly figures. Des 94 – Oct 05

Source: EcoWin

0 50 100 150 200 250 300 350

1995 1997 1999 2001 2003 2005 22 24 26 28 30 32 34 36 38

Foreign owners’ share (right-hand scale)

Oslo Stock Exchange (left-hand scale)

-5 0 5 10 15 20 25 30

jan.97 jan.99 jan.01 jan.03 jan.05 -5 0 5 10 15 20 25 30 Chart 1.11 Selected valuation indicators for the Norwegian stock market. Monthly figures.

Jan.97 – Oct. 05

Sources: EcoWin, Thomson Financials and Norges Bank P/E forward looking

P/E historical

E/P-10 year government bond rate

0 10 20 30 40 50

1984 1989 1994 1999 2004-3

3 9 15 21

Repurchase 27

Dividend payments

Sources: EcoWin and Norges Bank Stock indices

(left-hand scale) Return on equity (right-hand scale)

Chart 1.12Dividend payments and repurchase of shares on the Oslo Stock Exchange in billions of NOK (left-hand scale). Return on equity in per cent.

Stock indices, 1984 = 5. Yearly figures. 1984 – 2004

�See Financial Stability 1/���.�

3Energy companies account for approximately 3�% of the market �alue of unrestricted equities.�

4 �he increase in go�ernment equity holdings reflects the listing of Statoil and �elenor, which are companies where the go�ernment ownership interest is high.�

structure and the economic situation were different in �������

compared with ������.�

Oil prices are an important driving force

�il price de�elopments ha�e been an important dri�ing force behind price de�elopments on the �slo Stock Exchange for a long period.� Empirical analyses show a positi�e correlation between oil prices and the majority of sub-indices on the

�slo Stock Exchange.� �he correlation is clearly strongest between the price of oil and the energy index.�^� �he period from 1998 to ������� was marked by a sharp rise in prices for IC� shares �see Chart 1.�8�.� E�en though the upswing on the

�slo Stock Exchange from �����3 to ������ has been somewhat broader than before the peak in �������, oil prices ha�e probably become an e�en more important dri�ing force for price de�el- opments.� Energy companies currently account for more than half of the total market �alue on the �slo Stock Exchange, compared with 13% at the end of �������³ �see Chart 1.�9�.� By comparison, IC� companies accounted for more than 18% of total market �alue at the end of September �������.�

Foreign ownership share increases

Foreign in�estors’ ownership share of equity holdings on the

�slo Stock Exchange has increased since ������� �see Chart 1.�1���.� Combined with an increase in go�ernment equity holdings,⁴ this means that foreign in�estors currently own a substantially larger portion of the unrestricted equities on the �slo Stock Exchange.� Foreign in�estors’ equity holdings ha�e fluctuated somewhat in recent years and the fluctua- tions follow equity prices to some degree.� Foreign in�estors’

beha�iour may therefore ha�e contributed to amplifying price mo�ements.�

Valuation measures

Measured against the bond market, the equity market was priced higher in ������� than in ������ �see Chart 1.�11�.� Current bond yields are considerably lower than in �������.� �his has contributed to widening the return gap between bonds and equities.� In relation to company earnings, equities on the

�slo Stock Exchange were priced higher in ������� than they are today.� �n the basis of reported earnings for the pre�ious 1� months, the P/E ratio of the �slo Stock Exchange was historically high at the end of �������, whereas on the basis of expected earnings for the next 1� months, the P/E ratio was more than 1.�6 times higher in September ������� than today.�

1

Increase in dividend payments and share buy-backs

High earnings in Norwegian listed companies in the past few years ha�e resulted in the accumulation of large cash holdings.� �his has led to an increase in di�idend payments and companies’ share buy-backs^� �see Chart 1.�1��.� �he increase in di�idend payments has also been moti�ated by the planned introduction of tax on di�idends recei�ed as from �����6.�

Many new listed companies and high issue activity

�he number of new companies on the �slo Stock Exchange has increased steadily o�er the past three years.� �wenty- eight new companies ha�e been listed so far this year, which is the highest figure since 1997.� Nearly 4��% of the new listings are energy companies.�

�o end-�ctober ������, the companies on the �slo Stock Exchange increased their share capital by nearly N��� ��bn through share offerings.� If this acti�ity le�el persists until year-end, the �alue of share issues in ������ will be the highest since �������.� Pri�ate bond issues are also at their highest le�el since �������.�

�Share buy-backs were permitted in Norway when the new Limited Liability Companies �ct entered into force in 1999.� Buy-backs of own shares is a flexible supplement to di�idends and fluctuates considerably with profits.�

1

Fluctuations in equity prices o�er a gi�en period are often referred to as stock market �olatility.� � com- mon assumption is that equity prices express the present �alue of future cash flows associated with the equity.� �he �olatility of equity prices will thus be influenced by both in�estors’ risk preferences and expectations concerning fundamentals such as company earnings and the interest rate le�el.�

�olatility is often measured as the standard de�ia- tion of daily equity price changes o�er a historical time period.� Howe�er, stock market �olatility �aries according to the time horizon applied when measur- ing price changes.� Chart 1 shows annualised stock market �olatility in the period 1989-������ based on different time horizons.� �olatility is higher on the

�slo Stock Exchange than on other exchanges in Europe and the US for all the time horizons.� �he differences are small for daily price changes, but

�olatility on the �slo Stock Exchange increases relati�e to other exchanges in Europe and the US as the time horizon increases.�

Are equity prices more volatile in Norway than in other countries?

Chart 1Volatility in the US, European and Norwegian equity markets during 1989-2005.

Measured over different time horizons, annualised

0 0.1 0.2 0.3 0.4

Day Month Quarter Year

Norway (OSEAX) US (S&P 500) Europe (Stoxx 600)

Sources: EcoWin and Norges Bank

Se�eral factors may explain the higher le�el of

�olatility on the Norwegian stock market compared with other markets.� �he Norwegian stock market is relati�ely small.� Small markets tend to be less liquid and less di�ersified than larger markets, and this may contribute to higher �olatility.� Moreo�er, high

�olatility may be self-reinforcing.� Fluctuations in in�estors’ risk preference may lead to wider swings in in�estors’ required rate of return, and hence equity prices, the higher market �olatility is.�

�he size of the listed companies may also ha�e an impact on �olatility.� Small companies tend to ha�e a narrower range of income sources than large com- panies.� �his may result in higher �olatility in small companies’ share prices.� Most companies on the

�slo Stock Exchange are small in an international context.� �olatility on the �slo Stock Exchange is still lower when all the companies are gi�en the same weight than when the companies are weighted on the basis of market �alue �see Chart ��.� �his may indicate that price de�elopments on the �slo Stock Exchange are dominated by a few large companies, and that the index is more di�ersified when the companies are gi�en the same weight.� It seems that this factor is of greater importance to �olatility on the �slo Stock Exchange than the fact that small companies’ share prices tend to show wide fluctua- tions.�

It is not ob�ious why �olatility increases more in Norway than in Europe and the US when the time horizon increases.� �ne explanation may be that cyclical shares account for a larger portion of the Norwegian stock market than stock markets in Europe and the US.�¹ Cyclical shares are hea�ily dependent on general economic de�elopments so that the price de�elopments �ary according to busi- ness cycle fluctuations.� Since a business cycle tends to span a long period, cyclical shares often feature high �olatility when measured o�er long time hori- zons.�

Sources: Bernt Arne Ødegaard (2005): ”Asset Pricing at the Oslo Stock Exchange. ASource Book” and Norges Bank

Chart 2Volatility in the Norwegian equity market based on market value-weighted and equal-weighted indices¹⁾. Daily figures. 1989-2004

Market value-weighted indices

1)Moving average over 100 days, non-weighted observations Equal-weighted indices

0.0 0.1 0.2 0.3 0.4

1989 1991 1993 1995 1997 1999 2001 2003

0.0 0.1 0.2 0.3 0.4

1

�he difference between the �slo Stock Exchange and the large stock exchanges has narrowed.� While daily price �olatility was higher in Norway than internationally in 1989-96, it has been somewhat lower on a�erage in Norway in the period 1997-������

�see Chart 3�.� �here may be se�eral reasons for this.� �he �slo Stock Exchange is now part of a common trading platform together with the other Nordic stock markets through the N�REX coop- eration.�^� �his may ha�e contributed to enhancing the transparency of the market and thereby reduced in�estor uncertainty.� �t the same time, the listing of large companies such as Statoil and �elenor has probably increased the attracti�eness of the �slo Stock Exchange for foreign in�estors.� �his is also reflected in the increase in the number of foreign members.� �n increase in the number of in�es- tors has probably impro�ed liquidity and thereby reduced �olatility.�

3IC� companies’ portion of the market �alue of the S&P �����

index a�eraged �3% in the period 1996-������, but was close to 4��% at the price peak in �������.� �n the �slo Stock Exchange the portion was 18% and 13% respecti�ely, at the peak in ������� and in

�ctober ������ �see Chart 1.�9�.�

� N�REX is an alliance between the stock exchanges in Stockholm, Helsinki, Copenhagen, Reykja�ik and �slo.� �he �slo Stock Exchange was integrated into a common index classification with the other N�REX exchanges in ������� and a common trading system in ������.�

1 �his is partly because non-cyclical companies such as water works, sanitation companies and the like are listed on the stock exchange to a further extent in the US and Europe.�

Chart 4Daily volatility in selected sub-indices in Norway and US. 1996-2005. Annualised. Per cent

0 5 10 15 20 25 30 35 40 45 Total index

Utilities Finance Industry/materials Cons. goods Energy ICT

OSEAX S&P 500

Sources: EcoWin and Norges Bank

1)

1)Utilities excluded for Norway, because of the low number of enterpises

� relati�ely low portion of IC� companies on the

�slo Stock Exchange may also ha�e contributed to reducing the difference in �olatility across exchanges.�³

��er the past 1�� years, equity price �olatility for IC� companies has on a�erage been higher than for other types of companies �see Chart 4�, which partly reflects the build-up and deflation of the IC�

bubble around �������.�

Sources: EcoWin and Norges Bank

Chart 3Daily volatility in the US, European and Norwegian equity markets. Daily figures.

1989-2005.¹⁾Annualised.

US (S&P 500) Norway (OSEAX)

Europe (Stoxx 600)

1)Moving average over 100 days, non-weighted observations Differential against Norway²⁾

2)Yearly average of differentials against US and Europe -0.1

0 0.1 0.2 0.3 0.4 0.5

1989 1991 1993 1995 1997 1999 2001 2003 2005 -0.1 0 0.1 0.2 0.3 0.4 0.5

1

2005 2006 2007 2008

Private consumption 3¾ 3½ 2¾ 2

Public consumption 1¾ 2 1¾ 3

Mainland gross investment 7¾ 6 3¼ 2½

Traditional exports 3½ 3¼ 3½ 3¼

Imports 7¼ 4¼ 2¼ 1¾

Mainland GDP 3¾ 3¼ 2½ 2¼

GDP, trading partners¹⁾ 2¼ 2½ 2½ 2½

Registered unemployment rate 3½ 3¼ 3¼ 3¼

CPI-ATE²⁾ 1 1¾ 2 2½

2)CPI-ATE: CPI adjusted for tax changes and excl. energy products

Table 2.1 Macroeconomic aggregates. Percentage change on previous year unless otherwise stated

1) Weighted total with Norwegian exports used as weighting factor Sources: Statistics Norway, Directorate of Labour and Norges Bank

Projections Inflation Report 3/2005

0 2 4 6 8 10 12

1987 1990 1993 1996 1999 2002 2005 2008 0 10 20 30 40 50 60 70 Chart 2.1 Mainland GDP growth, real interest rate¹⁾ and oil price ²⁾. Yearly figures. 1987-2008.³⁾Per cent

1)3-month money market rate deflated by inflation measured by the CPI-ATE

2)USD per (Brent Blend) crude oil. Spot price

3)Projections for 2005 - 2008

4)2005-figures are based on monthly observations until november. Figures for 2006 – 2008 are forward prices per 28 November 2005

Sources: Statistics Norway and Norges Bank Real interest rate

GDP growth

Oil price⁴⁾(right-hand scale)

Chart 2.2 Credit as a percentage of GDP.

Quarterly figures. 87 Q1 – 05 Q3

110 120 130 140 150 160 170 180

1987 1990 1993 1996 1999 2002 2005110 120 130 140 150 160 170 180

1)Percentage of GDP

2)Percentage of mainland GDP Source: Norges Bank

Total credit to mainland Norway²

Credit from domestic

sources (C2)²⁾ Total credit

(C3)¹⁾

2 Macroeconomic

developments, households and enterprises

2.1 Developments in the Norwegian economy

�he Norwegian economy is in an upturn and is now expand- ing at a brisk pace.� Low interest rates, high oil prices, strong growth in petroleum in�estment and high prices for Norwegian exports ha�e been the dri�ing forces.� In Inflation Report 3/���, mainland GDP growth is projected to increase further in ������ and then abate somewhat in �����6 and further ahead �see �able �.�1�.� �he growth outlook has been re�ised upwards slightly since Financial Stability 1/���.� Capacity utilisation has picked up in the past two years and gradually mo�ed to somewhat abo�e its normal le�el.� Howe�er, sub- stantial labour shortages ha�e not emerged in the economy as a whole.� �he number of registered unemployed has declined in the course of ������ and was 3.�4% in �ctober.� �he unem- ployment rate is expected to fall further to 3¼% in �����8.�

Norges Bank’s key rate has been raised by ½ percentage point to �.���% since the pre�ious report.� �he interest rate le�el is still unusually low.� Underlying inflation in the Norwegian economy has edged up since the pre�ious report but is still low.� �he effecti�e krone exchange rate ��WI� has appreciated by 1½% in the same period.�

Monetary policy easing in �����3 and low inflation ha�e resulted in strong growth in household real disposable income, fuelling growth in pri�ate consumption and housing in�estment.� House prices ha�e continued to rise, albeit at a gentler pace.� Households are still optimistic with regard to their financial situation.� �heir expectations regarding the domestic economy remain high, but declined somewhat from the third to the fourth quarter.�

�il prices ha�e risen since the pre�ious report and were approximately USD �� per barrel for North Sea oil at the end of No�ember.� Petroleum in�estment will increase sub- stantially in ������ as a result of large, ongoing de�elopment projects both offshore and onshore.� In�estment in the petro- leum sector is expected to fall o�er the next few years as a result of the completion of projects, but will still remain at a high le�el.�

Mainland fixed in�estment has risen sharply.� Strong growth in fixed in�estment has gradually become an important dri�ing force behind the expansion.� Moderate wage growth, low interest rates and rising demand ha�e impro�ed profitability.�

�otal credit to mainland Norway as a percentage of mainland GDP is at a historically high le�el �see Chart �.���.� Household debt growth remains �ery high and considerably higher than corporate debt growth.� �wel�e-month growth in total domestic debt has picked up since the pre�ious report, while growth in credit from foreign sources is still negati�e.�

1

Chart 2.5 Housing turnover and housing starts in thousands. 12-month growth in house prices in per cent. The time it takes to sell a dwelling measured in number of days. Monthly figures. Jan 99 – Oct 05

Sources: Statistics Norway, ECON, FINN.no, Association of Norwegian Real Estate Agents (NEF), Association of Real Estate Agency Firms (EFF) and Norges Bank

-5 5 15 25 35 45 55

1999 2000 2001 2002 2003 2004 2005 -5 5 15 25 35 45 55

Housing turnover

House prices Housing starts The time it takes to sell a dwelling

Chart 2.4 Household debt as a percentage of disposable income divided into deciles by after- tax income. 1987 – 2003

50 100 150 200 250

1987 1991 1995 1999 2003

50 100 150 200

Decile 10 250

Total

Decile 1-6 Decile 7-9

Sources: Statistics Norway and Norges Bank -5

0 5 10 15 20

1997 1998 1999 2000 2001 2002 2003 2004 2005 -5 0 5 10 15 20 Chart 2.3 Growth in household debt.¹⁾Per cent.

Jan 97 – Oct 05

1)Twelve-month growth in domestic credit. Four-quarter growth in mortgage loans and other loans

Source: Norges Bank

Mortgage loans Domestic credit to households

Other loans

2.2 Households High debt growth

Household debt has increased rapidly since �������.� In the year to �ctober, debt increased by 13% �see Chart �.�3�.� Growth in non-mortgage loans �other loans� has also increased.�

�ther loans may be secured on other types of assets such as cars, boats or securities, or may be unsecured.� �ther loans constitute about ��% of household borrowing.� �bout one- third of other loans are loans to unincorporated enterprises, self-employed and non-profit organisations.� Some of these loans are used for business acti�ities.�

Each quarter, ��redittilsynet �the Norwegian Financial Super�isory �uthority� conducts a sur�ey of selected finan- cial institutions that mainly offer unsecured consumer loans.�

�t the end of the first half of ������, the 1�� companies in the sur�ey had outstanding loans totalling N��� �4bn, an increase of 13% o�er the past year.�

Debt as a percentage of disposable income has increased for low- and middle-income households �deciles 1-6� �see Chart �.�4�.� Younger households in particular ha�e a high and growing debt burden.� �t the same time, debt as a share of income has decreased sharply o�er the past 1� years for the highest income class �decile 1���.� �his partly reflects changes in the tax system.� Prior to 199�, it was ad�anta- geous for high-income households to borrow extensi�ely.�

�he high rate of debt accumulation in recent years must be

�iewed in the light of de�elopments in house prices, which ha�e a strong and prolonged effect on debt accumulation.�

Continued rise in house prices

�he rise in resale home prices has been high since �����3

�see Chart �.���.� Solid growth in household income and low and falling interest rates up to summer ������ ha�e been the main dri�ing forces �see box on page ���.� House sales ha�e been high and increasing for the past six months.� �he time it takes to sell a house is short.� Following a sharp rise through

�����4, housing starts ha�e fallen somewhat this autumn.�

� sur�ey by Econ �nalyse �S shows that it takes longer to sell new housing projects in Østlandet �south-east Norway�

than six months ago.� Howe�er, some de�elopers are still reporting satisfactory sales.� �ccording to figures from Prognosesenteret �S �a forecasting centre�, the number of households planning to mo�e this autumn fell by 1�% from the le�el one year earlier.� �his is one of the lowest figures recorded in this sur�ey in the past six years.� In isolation, this implies a somewhat lower turno�er in the housing market in the near term.�