The international capital market

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By Sir Siegmund Warburg, S G Warburg & Co

The history of the Eurobond market and its rapid development since its inception in the early 1960s is well documented. In its short life the market has been subjected to many different and sometimes conflicting influences; throughout it has exhibited extraordinary flexibility. It is this flexibility which has enabled it to survive and mature into a truly international capital market.

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Euromoney
October 1970

Though by natural evolution it will inevitably undergo various changes in form, it is, I believe, here to stay as an important part of the financial scene.

The period 1969-70 has so far been probably the most critical and, at the same time, the most instructive of the market's adolescent years. This period has been characterised by currency uncertainties, by the unusual spectacle of continued inflation side by side with recession in many industrialised countries and by the eclipse — at any rate for the time being — of the 'equity cult'.

In this article I propose to examine the evolution of the international market in the most recent past and, perhaps rashly, to draw some tentative conclusions as to its likely development in the immediate future. Finally, and at the risk of exposing myself to the charge of repetition, I shall stress once more what I have pointed out on several previous occasions, namely the need for some form of regulation of the new issue side of the market.

The past one to two years

In August 1969 the pressure on the French franc was relieved by its devaluation, but the parity of sterling continued to be suspect until some real evidence of a change in our trading position began to emerge towards the end of the year. In the meantime, as a result of the advantage in the rate of inflation enjoyed by Germany as compared with her major trading partners, speculative purchases of the Deutschemark built up until the German authorities were compelled, first, to allow their currency to float in relation to the dollar, and subsequently, to adopt a new parity resulting in an effective revaluation of just under 10 per cent.

These events had two main effects on the international market. In the first place, the rapid growth of the German foreign exchange reserves in the early months of 1969 was a source of some embarrassment to a German Government reluctant both by temperament and for domestic political reasons to revalue the German currency unilaterally.

The German authorities therefore evolved a policy to encourage the export of capital through the issue on behalf of foreign borrowers of bonds denominated in Deutschemarks; in 1969 such issues accounted for 40 per cent of all international issuing activity in Europe as against 23 per cent in the previous year and 10 per cent in 1967.

This surge of activity, which brought the major German banks into the market as leading managers of international issues, was encouraged by a propensity on the part of many investors to seek securities denominated in a 'hard' currency, particularly in one which might give rise to a speculative gain. In the aftermath of the revaluation of the Deutschemark in November 1969 selling pressure on internationally-syndicated Deutschemark bonds built up rapidly. It was therefore apparent that these bonds had become the repository for 'hot money' which — were it not for the stringent reserve requirements placed on deposits with German banks by non-residents — might have more naturally been held in liquid form.

The second principal effect of the 1969 currency scares was to keep interest rates in the short-term Eurodollar market at extremely high levels. This reflected the operations not only of currency speculators but also of commercial concerns who wished either to speculate on a revaluation of the hard currencies — particularly the Deutschemark and the Swiss franc — or, quite legitimately, to cover liabilities incurred in such hard currencies. The persistence of high interest rates — at one point in July the inter-bank rate for six-months Eurodollars was over 12 per cent — and investor preference for issues denominated in hard currencies aggravated conditions in an already over-burdened market for long-term issues denominated in dollars and with no equity content as a potentially redeeming feature. It again became apparent that the pool of funds available for such issues is limited.

On more than one occasion the new issue market broke down completely as several issues were thrown on to it with little regard for its capacity to absorb them. Long-term interest rates spiralled and activity in the secondary market fell sharply as dealers became increasingly reluctant to take large positions and suffer the resulting losses.

Meanwhile the 'equity cult' had become rather accentuated and continued late into 1969. Consequently investors absorbed large quantities of bonds with an equity feature, often without due regard for the quality of the underlying earnings or the reasonableness of the price/earnings multiple or the soundness of the asset and liquidity positions. Out of the 60 per cent of total issues denominated in dollars in the year 1969, over 65 per cent had some equity feature.

After the revaluation of the Deutschemark it was widely hoped that we could look forward to a period of relative calm on the currency front. This hope was furthermore encouraged by the adoption of the Special Drawing Rights scheme by the International Monetary Fund early in 1970 and the first allocation of SDRs. In recent months, however, currency fears have once more come to the fore.

While sharp increases have taken place in the foreign exchange reserves of such countries as Germany, Holland and Japan, where the rate of inflation is, relatively speaking, in balance with productivity gains so that these countries are increasingly competitive in international trade, the balance-of-payments deficit of the United States has persisted and has been exacerbated by that country's overseas military commitments. As the terms of trade continue to turn against the United States, plagued as it is by the conflicting influences of recession and high unemployment on the one hand, and seemingly incurable inflation on the other, currency uncertainties are likely to intensify. Already the Canadian authorities, embarrassed by the size of their foreign exchange reserves, have felt themselves obliged to float their currency and, as a result, an effective revaluation of about 5 per cent has taken place.

The German Central Bank is believed recently to have been a heavy buyer of dollars against Deutschemarks in an effort to contain the upward pressure on the Deutschemark, and the German authori- ties have also taken certain measures to reduce domestic interest rates with a view to stemming the flow of 'hot money' into Germany.

Perhaps the most significant feature of the international financial scene so far this year has been the heavy fall of equity prices in every major stock market. This has had a direct effect upon the international capital market. It has become virtually impossible to raise funds by tempting the investor with an equity interest; prices in the market for convertible bonds have fallen sharply and trading activity is at a low level.

The petitions filed by Penn Central and Four Seasons Incorporated (the American nursing home chain), the widely publicised difficulties of the Investors Overseas Services group, and the failure of Commonwealth United to pay the interest on its convertible Eurobonds issued in February 1969, have done nothing to raise the level of confidence in the international capital market. Banks and investors alike are now taking a closer look than ever before at the underlying quality of the earnings and assets of the companies which have floated equity-linked Eurobonds. In the long run this must be salutary.

The effect which the currency uncertainties and the fall in prices on world stock markets has had on the international capital market in the first seven months of 1970 is not diffcult to demonstrate. During this period a total of $1,432 million was raised compared with $1,574 million for the corresponding period of 1969, the breakdown being as follows:

1969
$ million 
1970
$ million
Straight Dollars 205659.5
Equity-linked Dollars672147.5
Straight Deutschemarks655131
Units of Account4224
Variable Rate Dollars-225
Dutch Guilder Notes-245

The Dutch Guilder Note — which is unquoted and sold exclusively to non-Dutch residents — has been a rather significant development under the close and well-managed supervision of the Dutch Central Bank. The timing of these Guilder issues has been carefully controlled, as has been the quality of borrowers allowed to use the new instrument.

The capital demands of governments and industry do not necessarily diminish just because market conditions are difficult, hence the search for new financing vehicles to satisfy these demands goes on. The latest of these, which appeared early in 1970, was the Floating Rate Bond — an investment which, in effect, bridges the gap between the short-term Eurodollar pool and the long-term investor whose prime concern is to protect his capital and earn a reasonable rate of return. Indications are that, if used with moderation and restricted to borrowers of top quality, this type of financing will be a permanent and useful feature of the international capital market.

Another source of funds to which potential long-term borrowers have increasingly turned is the short-term Eurodollar pool, which is estimated to have grown over the past years to approximately $37.5 billion. This market has been tapped by means of short-term bank credits and medium-term floating rate credit facilities.

In recent months the amount raised by way of such medium-term facilities has increased substantially as against a fall in all other sectors of the market. Such facilities normally have a life of up to five years (but occasionally up to seven years) with interest payable at a margin over the offered rate in the London inter-bank Eurodollar market.

I should refer here to a further new feature in the market, also born out of the difficulty of raising long-term funds, namely the development of commercial paper issued by commercial borrowers under the cover of bank lines of credit. The so-called 'Eurocommercial paper' market is modelled on a similar market which has existed in New York for some vears and which has grown to an estimated $40 billion in the past year in consequence of the tight rein on bank lending maintained by the Federal Reserve Bank. However, its European cousin is as yet unproved; there has only been one issue of commercial paper for an amount of $5 million. It will be interesting to see if a truly viable market in this paper can be developed in Europe in the coming months.

The outlook

The résumé of developments in the international market in the past year set out above will serve to demonstrate the flexibility which is necessary to ensure survival in a climate of constant change. I am sure that the next 12 months will prove no exception to this rule.

The future, particularly at this juncture, is full of uncertainties: incipient recessions in many industrialised countries; the monetary policy which the Nixon Administration is pursuing but which may change once the Congressional elections are out of the way; the growth of the German and Japanese exchange reserves; the political uncertainties in many parts of the world — the list is endless. Against this background it would be a reckless man who would make any but the most general forecasts.

It would seem logical, however, to anticipate a continued flow of international issues denominated in Deutschemarks and of small Euroguilder note issues. While there has been some easing in short-term Eurodollar rates in recent weeks, in line with a similar movement in the United States, there seems little likelihood of a sharp fall in short-term rates in the immediate future.

This, coupled with a certain amount of investor scepticism about the dollar, would suggest that there will be only a modest number of straight debt dollar issues and only at high yields to the investor. I do not believe that until there is firm evidence of a return to favour of equities any significant amount of money will be raised by equity-linked issues; though in due course I would expect equities to play a more important part in the market.

In every important European domestic capital market way or another and it is rarely suggested that this regulation is anything other than beneficial for all concerned. [Editor's note: this is the misprinted section to which Christopher Fildes refers.]

In the case of issues sold internationally, regulation is exercised in all cases except for dollar-denominated issues — which, of course, have historically been the most important. In Germany a committee formed from the principal issuing houses operates extremely effectively an informal queue system for international Deutschemark issues; the Swiss queue system for foreign loans is well known and respected; the Dutch Central Bank, as mentioned above, controls the flow of Euroguilder issues.

On three separate occasions in the past year we have seen the market for new dollar-denominated issues evaporate under extreme pressure as borrowers rushed in to raise funds which they and their financial advisers mistakenly believed were available. In each case turmoil has resulted — issues have had to be reduced or withdrawn and secondary markets have deteriorated to the point of non-existence.

In believe that there is a very strong case to be made out for a form of regulation of dollar-denominated issues by an impartial body to be constituted by representatives of the principal issuing houses. In order to succeed, such a system would require the co-operation not only of the issuing houses but also of regulatory bodies in various countries, such as Central Banks and Stock Exchanges, and of the principal secondary market dealers.

I feel that it is in the interest of all concerned with the successful functioning of the international capital market that such co-operation should be forthcoming and that definite action should now be taken to put it into practice.