European Economic Perspectives 28

Border Crossing

The advent of the euro is a significant event for investment managers. A new CEPR Policy Paper explores its impact on portfolio allocation and the structure of European securities markets.

Europe’s financial markets are facing pressures for change from a number of sources, including new technologies, securitization, demand for pension reform and changing regulations. Economic and monetary union (EMU) is providing a further stimulus. The elimination of currency risk potentially creates a level playing field in that funding costs are becoming more transparent. This enhances competition within the financial industry and encourages the introduction of new investment strategies.

The latest CEPR Policy Paper examines the impact of the euro on the processes of security issuance and portfolio adjustment in Europe. The greatest changes are predicted to take place in the corporate bond market. The search for higher yields by investors, greater expertise in analysing credit risks by institutional investors, and reduced issuance by European governments is spurring growth in this market. Indeed, in the first nine months of 1999, the European corporate bond market outpaced the US and UK markets; and the average credit rating of European issuances fell, reflecting the increasing depth of the market.

But despite this strong growth, corporate bonds grew unevenly across sectors and countries. Growth came primarily from large companies in the telecoms sector and from the larger EMU countries: France, Germany, Italy and Spain. Given this sectoral concentration, investors are exposed to risks that cannot be diversified away within the corporate bond market alone.

Will the euro entail significant portfolio readjustments? The Paper’s analysis of optimal portfolio allocation strategies before and after EMU – taking account of the possibility of investing within and outside Europe in several broad asset classes – suggests the disappearance of currency risk in itself is probably not a major event for investors. But at the same time, post-EMU changes in the correlation of equity returns are significant. EMU is associated with increased correlation between countries and, though less pronounced, between sectors.

The practical implications of this finding are that sectoral risk dominates country risk and no European country offers enough sectoral breadth to make it unnecessary to invest in another EMU country. More than ever before, this brings into question the common investment industry practice of allocating portfolios along geographical lines. The much-discussed impulse that the euro might give to portfolio allocations along sectoral lines thus appears warranted – provided that the benefits of geographical diversification are not forgotten in the process. The Paper confirms the superiority of a diversification approach that follows both countries and sectors.

The euro has undoubtedly made an important contribution to reducing the effective and psychological obstacles to international diversification. Yet obstacles to cross-border investment are still substantial, hindering the emergence of truly European capital markets and thus generating further barriers to international diversification in the form of underdeveloped and less liquid markets. The costs of cross-border investment and the related issue of the size and depth of European capital markets can have a major impact on the cost of capital for European firms and the opportunities for the average European portfolio investor.

These are legitimate sources of concern for policy-makers. As the Paper notes, the euro was meant to launch a new era of cross-border financial trading and to end the maze of trading technologies that characterize Europe’s financial markets. Yet Europe still has 15 stock exchanges, more than 20 derivatives markets and no national centre for bond trading.

Fragmented markets are costly to investors seeking pan-European assets. Consolidation would bring benefits to consumers in the form of better and more diverse financial services, more liquid markets and lower transactions costs. But the prospects for pan-European securities markets with centralized settlement remain uncertain. Although the structure of European markets is changing rapidly following widespread demutualization, mergers of exchanges within countries and various links between national exchanges, it appears unlikely that pan-European markets will evolve quickly. There are several obstacles that impede the transition.

The first barrier is the lack of any centralized settlement systems. This is primarily a technical problem of incompatible domestic systems or differences in trading platforms across exchanges. In many cases, they can be resolved through linkages and mergers. In others, where linked systems are constrained by weak or obsolete technology, new investment will be required.

If a centralized settlement system is agreed to be an important part of integrating securities markets, a tougher attitude by a European authority is essential. At the national level, this function is performed by the central bank, which can offer guidance and moral suasion in deriving a market-based solution or participate directly in forging the desired outcome. But at the European level, there is a vacuum since the European Central Bank does not currently have a legal mandate to address this issue.

The second barrier relates to policy and includes differences in tax regimes, accounting standards and regulatory frameworks, all of which heighten legal uncertainties about cross-border transactions. In several European countries, legal restrictions hinder pension funds from taking on a more diversified portfolio. And although there have been some efforts to foster harmonization, progress is slow. The reluctance of domestic authorities to create a level playing field in part reflects political motivations: these obstacles protect domestic institutions and markets from outside competition.

One contribution policy-makers could make to more integrated markets would be harmonizing the issuance of government bonds. A policy of stable and predictable issuances would improve liquidity and potentially generate interest rate savings, at least for issues that are perceived as perfect substitutes. It could also help reduce the liquidity premium that smaller EMU member countries are currently paying. As the correlation increases among European government bonds, the rationale for having different futures contracts corresponding to different national issuers would disappear. The emergence of a single futures contract would be an important step towards an integrated European government bond market.

The structural changes in securities markets also have implications for regulators. The Paper argues that the regulatory framework needs to encompass innovations in cross-border transactions, foster competition between all types of standards and enhance cooperation between national regulators.

On the one hand, European regulators should pursue a hands-off policy by allowing markets to evolve quickly in response to new technological advances. On the other hand, they need to establish a new harmonized code on norms, rules and procedures to ensure stable competitive markets for the profit-oriented exchanges. Until now, most exchanges have been self-regulated in that via club membership or shares, the listed companies held a vested interest in maintaining a well functioning exchange. Such a self-regulatory mechanism will not necessarily operate under demutualized exchanges.

This article summarizes ‘EMU and Portfolio Adjustment’, CEPR Policy Paper No. 5 by Kpate Adjaouté, Laura Bottazzi, Jean-Pierre Danthine, Andreas Fischer, Rony Hamaui, Richard Portes and Mike Wickens

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