|
European
Economic Perspectives 26
Capital
Gains
One
of the hopes for the single currency is that it will eventually lead to
pan-European capital markets. New CEPR research assesses the initial
evidence on the impact of the euro on Europe’s financial landscape.
Europe’s
economic and monetary union (EMU) offers the possibility of creating a
domestic financial market to rival that of the United States. In 1995,
for example, the combined value of outstanding equities, bonds and bank
assets in the 11 countries in the euro zone was $21,084 billion,
compared to $22,865 billion in the US market. The key question is to
what extent this arithmetic is likely to translate into economic
reality. While a single currency is a necessary condition for the
emergence of pan-European capital markets, it is by no means a
sufficient one.
In
a recent CEPR Discussion Paper, Jean-Pierre Danthine, Francesco Giavazzi
and Ernst-Ludwig von Thadden review progress so far. Their assessment of
the initial evidence on the impact of the euro on European capital
markets is very favourable. They conclude that, on almost all counts,
EMU has either already drastically changed the financial landscape of
Europe or has the potential to do so in the future. This success is all
the more surprising given the euro’s current weakness against the
dollar.
The
researchers point out that Europe’s capital markets have undergone a
remarkable transformation since the euro was launched. A
euro-denominated corporate bond market has emerged with issuing activity
in 1999 in excess of that in the dollar market. Primary issues in
European equity have reached record highs. Europe-wide indices have been
established and portfolios have begun to be allocated along pan-European
sectoral lines rather than on a country basis. Eurex, the German-Swiss
exchange founded in 1998, has overtaken the Chicago Board of Trade to
become the world’s largest derivative exchange. Banks all over Europe
have merged or formed alliances on an unprecedented scale, dramatically
changing national banking environments and beginning to create
international firms and networks. And cross-border mergers in all
industries have increased strongly, giving rise to record volumes in
Europe’s mergers and acquisitions (M&A) industry.
Danthine
and his colleagues argue that some of these developments could have been
expected as consequences of the ‘direct effects’ of the euro. These
effects comprise standardization and transparency in pricing; shrinking
of the foreign exchange market; elimination of currency risk;
elimination of currency-related investment regulations; and
homogenization of the public bond market and bank refinancing
procedures. But the euro also has indirect effects, which fall into four
categories:
-
the
cost of cross-country transactions within the euro zone;
-
the
liquidity of European financial markets;
-
the
diversification opportunities available to European investors;
-
and
the institutional changes stimulated by EMU.
Transactions
costs: Up to now, EMU has had little direct effect on transaction costs,
but it has clearly made the existing obstacles and inefficiencies more
visible. Within Europe, cross-border payments and securities settlements
are more expensive, lengthier, riskier and less standardized than
equivalent domestic transactions. What is more, the euro zone has 18
large-value systems (compared to two in the United States), 23
securities settlement systems (compared to three in the United States)
and 13 retail payments systems (again, compared to three in the United
States). Differences in taxation, legislation and standards create
further obstacles.
EMU
has prompted a renewed urgency among policy-makers to address these
problems. The establishment of TARGET and EURO1 – the settlement
systems for large transactions for the European System of Central Banks
and the European Banking Association, respectively – and the
implementation of the European Commission’s Directive on cross-border
credit transfers are the most visible steps taken in this direction.
Liquidity risk: Despite
the problem of transaction costs, by eliminating currency risk, EMU has
put traders in foreign euro-denominated assets on an equal risk base
with domestic traders. Together with the increase in transparency
resulting from the single currency, this has greatly reduced the
barriers to trading such assets. In this sense, EMU has increased the
demand side of the market for every asset traded in the euro zone. And
to the extent that expanded markets give rise to increased trading, this
should reduce liquidity risk.
Nevertheless,
as Danthine et al note, economic theory suggests that markets with
transaction costs and liquidity risk may experience ‘multiple
equilibria’. In other words, the possibility of good equilibria –
‘virtuous circles’ of high trading activity and low liquidity risk
– sits alongside the threat of bad equilibria – ‘vicious
circles’ of low trading and high liquidity risk.
When
assessing the euro’s impact on liquidity, it is therefore important
not only to add up the different pre-euro domestic markets, but also to
evaluate the relationships between market prices, trading volume, the
number and size of participants and transaction costs in the market
after EMU. These researchers’ analysis of public and private bond and
equity markets indicates that markets have indeed deepened considerably,
though there is still scope for further integration of the public bond
market. Private bond and primary equity markets have expanded at a speed
where it is possible to speak of an ‘equilibrium switch’, with
secondary equity markets somewhere in between.
Diversification: A
second potential benefit of increased market size is the opportunity for
greater diversification. In theory, the reduction in the costs and risks
of cross-border transactions allows investors to improve the spread of
risk of their holdings and to rebalance portfolios towards assets that
were previously too costly in terms of the risk-return trade-off of
standard portfolio theory. The problem with this theoretical argument is
that it is counterfactual. As documented repeatedly in the 1980s and
early 1990s, the share of international equity in total equity holdings
by domestic investors has traditionally been too small to be compatible
with the standard portfolio model – the so-called home-bias puzzle.
Danthine
and his colleagues argue that the home bias for equity may be better
explained by information problems that domestic investors face when
valuing foreign securities. In this view, both the weakly developed
equity culture of European investors and the lack of transparency and
trading opportunities in European firms explain the paucity of equity
flows in and out of Europe prior to 1990. And the change in both these
features during the 1990s explains the observed increases in equity
flows. Thus, EMU fosters market integration not by eliminating foreign
exchange risk, but by improving information flows and by reorienting
traditional international asset allocation methods from a country basis
to a pan-European industry basis. The extent to which the record
turnover on European primary and secondary equity markets in 1999 can be
attributed to this effect is still, however, unclear.
Institutional change:
In assessing how EMU has affected financial market institutions, the
researchers note some surprising success stories, such as the rise of
Eurex and the increased competition between stock exchanges. But the
banks, the main players in the European capital markets, have been
affected by the euro in different ways. In particular, while the changes
in capital market activity tend to hurt the traditional deposit and
lending business of commercial banks – by producing a ‘shift from
banks to markets’ – they benefit the more market-based asset
management and investment activities.
Danthine
et al conclude that banks, especially in Europe, continue to be
important in an environment of deepening and broadening capital markets.
But they have had to adjust significantly in the past few years and the
evidence suggests that this adjustment has not always been successful.
Several indicators, such as the evolution of M&A activity, suggest
that EMU has had a major effect on bank restructuring in Europe.
This
article discusses research reported in ‘European Financial Markets
After EMU: A First Assessment’, CEPR
Discussion Paper No. 2413
(March 2000) by Jean-Pierre Danthine, Francesco Giavazzi and
Ernst-Ludwig von Thadden. Danthine and von Thadden are at the Université
de Lausanne; Giavazzi is at the Università Bocconi, Milan; and all are
CEPR Research Fellows.
|