Select Committee on European Union Eighteenth Report


PART 4: HOW IS THE EURO WORKING FOR ITS MEMBER STATES?

HAVE CAPITAL MARKETS BENEFITED AS MUCH AS WAS EXPECTED?

94. In the area of financial institutions and capital markets, even in advance of the introduction of euro notes and coins the euro has had significant effects, both direct and indirect[78]. The direct effects include the virtual elimination of the foreign exchange market among former euro-zone currencies, the elimination of currency risk, and the relaxation of investment regulations based on currency denomination of assets. The indirect effects include those resulting from reducing the costs of transactions across national boundaries in the euro zone, from the increased liquidity of euro financial markets, from greater opportunities for diversification, and from changes in the structure of financial markets. The Governor of the Bank of England said that the removal of transaction costs resulting from a single currency was obviously healthy, but he did not see it as "a big issue". The integration of equity markets could make much more substantial cuts in transaction costs, especially if the trading platform were separated from the netting and settlement systems (Q 288).

95. The foreign exchange market has been affected directly by the introduction of the euro. Although most private persons will continue to encounter significant costs of switching money between different euro-zone currencies until euro notes and coins are introduced, the situation is different for large transactions. Between 1995 and 1998, intra-EMU currency transactions had already fallen from $201 billion to $125 billion, probably because of the diminishing desire to speculate or hedge as the introduction of the euro approached. Since 1998, these transactions have almost disappeared. A fraction of the fall in transactions activity represents the loss of revenue to the banking industry and other currency traders. One estimate puts the total direct loss of all foreign exchange fee revenue caused by the euro at approximately $25 billion per year[79]. For Irish banks, Mr Power quantified the cost of the loss of revenue from foreign exchange transactions at around IR£100 million in 1999[80] (Q 174).

96. The introduction of the euro has also reduced arbitrage profits from trading bonds and other securities. Participants in financial markets are reported to have estimated that they have lost up to 60 per cent of their European bond business and up to 30 per cent of their swap business due to the elimination of the 10 different local currencies[81].

97. The introduction of the euro has in principle allowed pension funds and life insurance companies in most euro-zone countries to diversify their portfolios[82]. In most Member States they were previously required to keep at least 80 per cent of their assets in the same currency as their liabilities; now they can diversify across the euro-zone. However, it appears that in many cases the previous restriction was not a real constraint, in that institutions held more than the required 80 per cent of assets in their own currency by choice; in such cases it is not clear that the introduction of the euro will have had a significant impact on their behaviour.

98. A direct effect of the removal of exchange rate fluctuations inside the euro zone has been the removal of exchange rate risk from international transactions. The risk had been diminishing already in the run-up to 1999, as currency fluctuations became smaller, and the effects of its removal are difficult to quantify. However, the Belgian government considered that it was of significant importance to domestic businesses (p 114); the Italian government considered that the disappearance of the exchange rate risk seemed to have increased the flow of international non-banking portfolio investment from Italy (p 116); and the Federation of German Industries noted that for some internationally-oriented enterprises the abolition of hedging had brought about considerable cost savings (p 120).

99. Further direct effects of the introduction of the euro and the money market operations that go along with it have been the introduction of a market in euro floating rate instruments and the associated interest rate (Euribor), and the introduction of the cross-border payments system (TARGET). Although these are important institutional changes, their economic benefits are difficult to quantify.

100. It was anticipated that the introduction of the single currency would create in Europe an integrated capital market on the scale of that of the United States. In 1995, in the 11 countries which now form the euro-zone, the value of assets on stock markets, banks' assets and public and private bonds taken together was $21,000 billion, as compared with $23,000 billion in the United States. However, in the euro-zone bank assets ($12,000 billion) were relatively important, and stock market capitalisation ($2,000 billion) and bonds ($7,000 billion) less so. The comparable figures for the United States were: bank assets $5,000 billion, stock market $7,000 billion, and bonds $11,000 billion. The differences reflect the relative importance of bank finance in the euro-zone. It had been anticipated that the replacement of capital markets in the ten separate currencies of the euro-zone with a capital market in euro-denominated assets would make stock and bond markets much more liquid and increase the opportunities for diversification of risks. Both these changes would, it was hoped, increase the attractiveness to investors of using euro-zone capital markets.

101. There is evidence of striking growth in the market in euro-denominated private sector bonds[83]. As Table 5 shows, in 1999 the global net issuance of international debt securities (bonds, notes and money market instruments) denominated in euros was put by the Bank for International Settlements (BIS) at $575 billion (having grown from almost nothing before 1999), while the issuance of US dollar bonds was $545 billion. Net issues in euros have continued to match those in dollars in the first half of 2000—$220 billion in euros as against $231 billion in dollars.

Table 5: Net issuance of international debt securities by currency and region (billion US dollars)

  
1998
1999
1999
2000
  
Year
Year
Q2
Q3
Q4
Q1
Q2
Europe US dollar
77.6
55.3
25.3
11.8
0.3
32.9
35.6
  Euro
170.7
491.7
132.3
142.3
102.2
99.9
92.6
  Yen
-9.1
6.2
2.2
7.9
2.5
3.4
32.2
  Other currencies
42.0
77.7
24.2
20.5
12.0
19.5
14.6
North AmericaUS dollar
262.1
435.4
124.0
117.8
72.9
68.6
63.3
  Euro
32.6
45.6
12.1
14.2
7.4
9.1
8.6
  Yen
- 4.1
- 1.3
- 0.5
0.7
0.3
5.1
4.6
  Other currencies
14.6
15.1
11.2
1.8
2.5
2.3
0.8
Others US dollar
71.0
54.5
22.3
12.2
2.1
21.3
9.4
  Euro
20.6
37.3
8.1
8.3
9.3
4.7
5.0
  Yen
- 13.7
- 12.1
- 3.5
- 0.5
- 4.3
- 10.6
- 3.8
  Other currencies
17.0
13.6
4.3
4.6
1.4
2.6
2.5
Total US dollar
410.7
545.2
171.6
141.8
75.4
122.8
108.4
  Euro
223.8
574.6
152.5
164.8
118.9
113.7
106.2
  Yen
- 26.8
- 7.2
- 1.8
8.1
- 1.6
- 2.0
33.0
  Other currencies
73.7
106.4
39.7
26.9
15.9
24.5
17.9

Source: BIS Quarterly Review August 2000, p 22
Note: Region is based on the nationality of the borrower. For the euro, before 1999, total of predecessor currencies.


102. At the same time, there is evidence of new issues of corporate bonds being taken up by investors across the euro zone[84]. This is a reflection of investors in the euro-zone diversifying their portfolios to include euro-denominated assets from firms located not only in their own country. The Governor of the Bank of England expected the market in euro-denominated bonds to continue to grow, as well as that in European equity insurance[85] (because of ageing populations and the need to fund pensions) (Q 287)[86].

103. Further evidence of the integration of private bond markets is provided by the establishment of a euro-zone yield curve for corporate bonds. McCauley and White show the convergence of private interest rates for Belgium, France, Germany, and the Netherlands by early 1997, and the collapse of the yield curves of each participating Member State to a single euro-zone yield curve from May 1998 onwards[87]. The ECB also publishes euro-zone yield curves[88]. The single yield curve indicates that market participants regard corporate bonds (of a given rating) as being perfect substitutes and forming a single market.

104. The market for government debt in the euro-zone does not appear to have become unified in the same way. There remain differences in the yields on bonds issued by euro-zone governments. The difference between the highest and lowest benchmark yield across the euro-zone (excluding Finland and Portugal) on 2-year bonds was 0.256 percentage points on 1 April 2000 (or 0.243 percentage points for AAA-rated countries). For 10-year bonds the difference was 0.262 percentage points in both cases. These gaps have fluctuated over time, but these figures indicate the order of magnitude, revealing variations in yields between euro-zone Member States of the same order of magnitude as those between the component states of the United States. It is possible that the government bond market at present has multiple equilibria[89]. If so, there could be a sudden change in the behaviour of people who invest in government bond markets as a result of which the market suddenly becomes integrated. There is arguably nothing fundamental about the nationally segmented public bond market, and a change in the market's beliefs about it could shift it to a different equilibrium. If investors no longer looked at countries when they invested, but weighted their portfolios by industry when making investment decisions, Dr Walter argued that the result would be a more efficient allocation of capital and faster economic growth (p 124). Several of our witnesses commented on the benefits of having an integrated euro-zone market in government bonds.

105. Greater competition in the financial sector might be expected to lead to changes in the structure of the industry through mergers and acquisitions, rationalisation, firms opening up operations across the euro-zone, and so on. There is some evidence of a recent growth of merger activity in euro-zone banking. The value of M and A[90] transactions in the euro-zone was $17.5 billion in 1991-2, $14.6 billion in 1993-4, $19.1 billion in 1995-6, and $100.4 billion in 1997-8[91]. Mr Power confirmed that significant changes in the banking industry globally had already been underway before EMU (the consolidation which had started in the United States ten years ago had begun to spread into Europe), but he thought that the single currency had served to accelerate the process (Q 173); the regulatory changes which had already taken place earlier in 1990s may also have had an effect.

106. Bank mergers in the euro-zone have largely been within countries, creating larger banks[92], but there is now a trend towards a bigger proportion of mergers being across borders within the euro-zone, and some covering wider areas. The profitability of major banks in European countries has been low compared with United States banks, and (except in Spain) there is no evidence of increasing rates of return on bank assets, despite their efforts to cut costs and restructure themselves.

107. The Belgian government (p 115) welcomed the integration of the Belgian stock market into the broader European entity, Euronext, the exchange formed by the merging of the French, Belgian and Netherlands exchanges. The Governor of the Bank of England also reflected on the future of stock exchanges (Q 288), but interestingly the issue was not mentioned by other witnesses.


78   For HM Treasury, Mr Woods suggested that the main impact of the euro so far had probably been on capital markets (QQ 41-43). See also HM Treasury's supplementary note at pp 18-19. Back

79   Estimate by McKinsey, reported by Jean-Pierre Danthine, Francesco Giavazzi, and Ernst-Ludwig von Thadden, "European Financial Markets after EMU: A First Assessment", CEPR Discussion Paper 2413, 2000, revised 15 May 2000. Back

80   In addition to the costs to them of transition to the euro, estimated at around IR£70 million (Q 175). Back

81   Hannah Scobie, The cost and timescale for the switchover to the European single currency for the international securities market, London: European Economics and Financial Centre, 1997; reported by Danthine et al, op citBack

82   There ought to have been a single European market in financial services by the end of the 1990s as a consequence of the implementation of the EC's Second Banking and Investment Services Directive. However, several restrictions had survived., including the one described in the text following this footnote.  Back

83   The ECB becomes quite lyrical in its appreciation of the growth of the private bond market: "The start of Stage Three of EMU has acted as a catalyst for the development and integration of the euro area capital markets towards a pan-European capital market. With regard to the euro-denominated bond market, the most significant development in 1999 was undoubtedly the rapid growth of the private or corporate bond market, which surpassed the expectations of many observers prior to the launch of the euro. This market gained momentum with the launch of large debt securities issues, which were related to a number of sizeable mergers and acquisitions in the first half of 1999" (ECB Annual Report 1999, pp 15-16).  Back

84   Danthine et al (op cit) comment on two examples. In 1999, the French firm Alcatel issued bonds worth 1 billion euro, of which 28 per cent were sold to Italian investors and more than 20 per cent to German investors. ore than 30 per cent of a bond issue by a US insurance company, Principal Life, was sold in France. Back

85   Mr Power noted that in 1999 euro corporate bond insurance was for the first time greater than in the US (Q 176). Back

86   Although he reassured us that he did not see this as a threat to the City of London, which was already active in the field. Back

87   Robert McCauley and William White, "The Euro and European Financial Markets", in P R Masson, T H Kreuger, and B G Turtleboom (eds), EMU and the International Monetary System, IMF, Washington DC, 1997. Reported in Danthine et al, op cit. Back

88   ECB Monthly Bulletin, January 1999 and subsequent issues. Back

89   If investors believe that the market is segmented by country, then the market in each country's debt has different liquidity risk and thus different equilibrium yields. But if investors believe that the market is integrated and all bonds have identical liquidity risk, then they treat all countries' bonds the same, and the market has a common equilibrium yield curve for bonds of all countries. Thus there can be two equilibria, each supported by a set of self-fulfilling beliefs. It is not possible to say why the market should find itself in one configuration rather than the other; it may be historical accident. Precedent co-ordinates the beliefs of different market participants. Back

90   Merger and acquisition. Back

91   Data from BIS. Back

92   ECB Annual Report 1999, p 15. Back


 
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