The Effects of EMU on European Capital Markets

Table of Content

Introduction

1. European Capital Market Integration
1.1 1987 and the Single European Act
1.2 Maastricht and Beyond

2. The Effects of EMU on Capital Markets
2.1 The Direct Effects of EMU
2.1.1 Standardisation and Price Transparency
2.1.2 Shrinking of Foreign Exchange Markets
2.1.3 Elimination of Currency Risk
2.1.4 Homogenisation of Refinancing Procedures
2.2 The Indirect Effects of EMU
2.2.1 Market-Depth and Liquidity
2.2.1a The Public Bond Market
2.2.1b The Private Bond Market
2.2.2 Market-Breadth and Diversification
2.2.3 Banking and Financial Market Institutions

3. One Market?
3.1 The Cost of Intra-European Investing
3.2 Banking Structure
3.3 Economic Barriers
3.4 Home Bias

Conclusion

Bibliography

Introduction

Within the last three years, the European financial landscape has undergone a rapid transformation that continues to astonish observers and market participants alike: Corporate and public euro bond markets have emerged whose issuing activities rival those of respective US dollar markets. Europe-wide indices have been firmly established. Institutional portfolios are being traded along pan-European sectoral rather than national lines. Cross-border mergers of banks and financial institutions on an unprecedented scale are drastically changing national banking landscapes as well as international financial structures and underlying all of this is the revolutionary emergence of a genuine European equity culture.

Quite naturally, not all of these developments can be attributed to the eventual arrival of European Economic and Monetary Union (EMU). Many trends have had their precursors in the continuing liberalisation and de-regulation processes of the 1990s, as manifested in the 1992 Maastricht Treaty. However, historical data makes it difficult not to account for EMU as one major factor behind many of the most recent changes.

In this paper, I will therefore argue that at least some of the above changes can best be explained by the effects of EMU. In several ways, the advent of the single currency has triggered an equilibrium shift in more than one field that would otherwise not have occurred. In order to do so, I shall first put EMU into perspective by briefly sketching its position within the wider framework of the process of European capital market integration by means of liberalisation. Second, I shall illustrate whether and to what extent the intended direct effects of EMU did in fact materialise, but also how further indirect effects go beyond these and contribute to explaining some seemingly less related developments. Last, I shall evaluate how integrated European capital markets in fact are compared to national markets, using the U.S. as a benchmark, and close with a brief discussion of potential normative implications.

1. European Capital Market Integration

The movement of the production factor capital can be considered ‘free’ if entrepreneurs are able to satisfy their needs for investment funding, and investors can offer their disposable capital, in the place or the country where conditions are most favourable to them.^[1]

The integration of capital markets can be defined as the complete merging into one of the segmental, here European, markets, through a variety of measures. First of all, this would include the removal of all constraints on foreign exchange as well as of discriminatory tax regimes and other obstacles. This is the so-called “negative integration”. Since capital is highly mobile and apt to go where the returns are highest, “positive integration” will also be a necessity; that is, the integration of capital markets by means of harmonising the rules which govern their organisation and functioning: banking regulation, payment systems and similar components of the functional framework. Inherently, a substantial degree of monetary policy integration would also be implied.^[2]

The European Union (EU) has aspired to this goal over a period of several decades. However, in the original Rome Treaty, the free movement of capital took only an instrumental role, to “the extent necessary to ensure the proper functioning of the Common Market”.^[3] Member states did not wish to give up their rights to restrict flows of capital since they understood this to be a vital requirement for the effectiveness of internal macro-economic policy. The Treaty did thus in no way enjoin upon the Community the creation of a European capital market. Further efforts in this direction were made ever since but, until 1987, did not result in any substantial agreements beyond the above stipulations. The main reason for this can be assumed to have been the conviction of member states that the ability to control capital movements is a vital instrument of monetary policy.

1.1 1987 and the Single European Act

In the 1980s, this conviction began slowly to shift in favour of deregulation of capital flows. There are several factors that most likely contributed to this paradigm change, the most important ones being:^[4]

- External Position

The improvement of member states’ balances of payment situations made it less and less necessary for them to employ capital controls.

- Poor Efficiency

Used methods of capital controls were increasingly being bypassed by means of so-called ‘off-shore’ markets, most notably the (misleadingly termed) ‘euro markets’, which used loop-holes in regulation and the fast-developing telecommunication and information technologies to increase the volume of intra-European bond and currency transactions by about 10,000% (!) during the period 1970-1985.^[5]

- General Tendency & Favourable Environment

In line with academic opinion in the field of monetary economics and reassured by experiences that illustrated the negative distortions of capital controls as well as the fact that structural economic reforms could only be delayed (rather than prevented) by movement restrictions, many governments were already beginning to unilaterally liberalise their regulatory frameworks.

After rather tentative steps during the 1970s^[6], a major advance towards closing the gaps was made with the Commission’s Second Banking Directive, passed in 1977 and implying, amongst others, the principles of mutual recognition of licenses, minimum harmonisation and home country control.^[7] Further alignment of capital markets with the more advanced framework of goods market integration was finally achieved in the 1987 Single European Act and constitutionalised in the 1992 Maastricht Treaty.^[8]

1.2 Maastricht and Beyond

The Maastricht Treaty codified the establishment of a fully liberalised European market for capital. At the same time, capital flows between the EU and third countries were gradually opened. All restrictions on the movement of capital between member states and between member states and third countries were now legally prohibited. However, some exceptions remained, mainly regarding the institutional structures of the EU members, including taxes, company laws and financial intermediaries.^[9] Full positive integration was thus not achieved. After 1992, the common European capital market remained incomplete.

Major steps towards capital market integration end here. Full negative liberalisation has been achieved and, throughout the 1990s, a host of EU directives and regulations aimed at positive integration have been passed.^[10] On 1 January 1999, the exchanges rates between the (then) eleven countries of the Eurozone were irrevocably fixed, monetary policy responsibility passed into the hands of the European Central Bank (ECB) and EMU became operational. This unprecedented milestone in economic history was aimed at further integration of its members’ economies and a general increase in microeconomic efficiency by means of eliminating transaction costs and reducing exchange rate uncertainty.^[11]

[...]

^[1] For reasons of brevity, the theoretical argument for the free movement of capital between economies will not be explained here in detail

^[2] W. Molle, The Economics of European Integration, Dartmouth, 2001, p.174

^[3] Molle, p175

^[4] see Molle, pp.177

^[5] Molle, 204

^[6] 1973 freedom of establishment for banks, 1977 First Banking Directive

^[7] for a more detailed discussion of the directive see C.M. Buch (2001), Financial Market Integration in a Monetary Union, KIWE Working Paper 1062, Kiel, 2001, pp.4

^[8] C.M. Buch (2000), Financial Market Integration in the U.S: Lessons for Europe?, KIWE Working Paper 1004, Kiel, 2000, pp.5

^[9] Molle, p.179

^[10] for a more detailed discussion, see Buch (2001)

^[11] P. DeGrauwe, Economics of Monetary Union, 4th Edition, Oxford, 2000, pp.59