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 In 1997 there was a raging debate as to whether the European Currency Union would get started and whether it would include Italy, which many in Germany thought was a bad idea.  They may yet be proved right.  I was asked for my view, not as to whether it was a good idea, but as to whether it would happen.  I said yes, because of the specifics of the negotiation.  Here was my analysis.

 WHAT THE EURO MEANS

TO A GLOBAL INVESTOR

DRAFT #2

6/26/97

by

Jarrod W. Wilcox

The promised advent in 1999 of the Euro, a common European currency, is a significant event for the global investor.  Its impact will be felt not only by commercial banks, brokers, investment bankers, mutual funds and investment advisors but also by corporate and government financial professionals dealing with pension funds or charged with raising money.

Abolishing multiple European currencies will cause far-reaching simplification beyond leaving fewer currencies in which to deal.  The lower transaction costs and reduced risks of cross-border investment will create a unified European capital market similar to the United States.   Frictional costs, and therefore opportunities for financial intermediary revenue, will shrink.  Many ways to add value through skillful cross-border arbitrage will also dwindle.  Even the scope for cleverly picking the right country in which to invest will diminish.

Some financial experts argue there are grave difficulties in the way of the Euro which have now been accentuated by the changed political climate in France.  This is natural because the financial industry has something to lose in the short run from a common currency.  However, a major reversal is unlikely.  While some politicians may be intimidated by voters and while there could be setbacks, the key leaders of Europe will likely push ahead with a common currency for a very simple reason.  It is part of a policy of dismantling barriers to economic progress that dates back 45 years to the founding of the European Coal and Steel Community in 1952.  To bet against the Euro is to bet against history. 

Further, it probably will be here on time, in January 1999.  Since not even Germany truly meets the convergence targets set by the Maastricht Treaty, the issue is not when standards are met.  It is simply how long it takes to complete the inevitable horsetrading.  And that can be done on schedule.

The implications of creative destruction

 At the heart of the Euro lies financial deregulation or, expressed another way, creative destruction.  The first consequences are likely to be felt in the markets themselves but soon after there will be a major impact on many market participant organizations.  It seems likely that a single European capital market will emerge for each of three broad classes of securities – bonds, stocks and futures.  For the global investor the implications are as follows:

• In the bond market, many of the fixed income arbitrage opportunities that have led to trading profits and active management value added in prior years will disappear.  However, the pattern of lower government deficits for most countries should encourage more savings to go into corporate and mortgage bonds, leading to the development of additional tradeable fixed income securities in the European private sector.  This should create new diversification and active management opportunities.

• In the stock market, the deregulatory nature of the Euro should assist in improving productivity, leading to higher expected stock returns as productivity growth accelerates.  The disappearance of individual currency fluctuations will lower the risk of investing in an individual country but for a global investor this will be offset by a loss of currency diversification.  Since expected return is a bit higher, and risk largely unaffected, allocations to Europe within global investors’ portfolios should be increased.

• In the currency market the implications at a portfolio level are less certain.  Since the Euro in some sense represents a portfolio of its component national policies and business situations, diversification will tend to make it more stable than its typical predecessor components.  However, if currencies such as sterling, the Italian lira and the Swedish krona fail to join the Euro, there will be substantial loss of diversification potential.

The benefits of integration

 Before analyzing these implications in more detail, it is worth pointing out that the policy of European economic integration has been linked with increasing European economic promise.  The latter appears clearly in the world’s stock markets.  Figure 1 estimates the fraction of the world’s stock market value represented by developed Europe.  It plots the European part against the whole of the Morgan Stanley Capital International (MSCI) World Index plus the International Finance Corporation Composite Index of Emerging Markets.  The MSCI portions have been scaled up to account for MSCI estimates of total market size.  Even in the face of competition from the US, Japan and the emerging markets, Europe is rapidly increasing in relative stature on this measure.  It has risen from about 17% in 1983 to about 26% of the world of market equity in 1996.  As the countries of Eastern Europe catch fire with free market expansion, this trend is likely to persist.

As for the next stage of integration, if Germany does not meet the Maastricht convergence targets, then the negotiations as to which countries will be invited to join the initial monetary union becomes one of bargaining rather than of treaty-bound convergence criteria.  There will be convergence, but it will be to European and not necessarily German standards.

It is worth noting that the bargaining will be done within the European Council of Ministers, and that Spain, Portugal and Italy have a voting bloc sufficient to veto changes.  They will likely all stick together rather than exclude Italy.  Only Greece will be left out, and its time may come sooner than most people think.

That leaves some Nordic countries and Britain as the countries who seem headed for self-inflicted exclusion.  However, the recent British election of a Labor government with more flexibility toward Europe bodes well for early British participation even though the new government still pronounces it unlikely.

A silver lining for US firms  

The big losers from the appearance of the Euro are likely to be banks, particularly European banks.  They will lose an important source of profit, as well as employment, in currency exchange bid-ask spreads for the middle market.  They will lose most of the profit in the swap market.  Their ability to profit in a more unified bond market will decline. As national governments grudgingly abandon their favorite banks to the vagaries of competition, fees for security custody will be driven down toward US levels.  There will be more bank mergers and reduction of employment in these activities, reinforcing the trend already underway.

As European banks lose the ability to cross-subsidize their investment management activities, it is likely that we will see an acceleration of the trend toward fee unbundling that took place years ago in the US.  The combined impact of these moves  will also strengthen the ability of specialist firms to cherry-pick bank customers in areas such as mutual funds.  Because of the unified market, which does not require subsidiaries in each country, and because of a more unbundled fee structure US-style, it will be much easier for outsiders.  The Euro is a cloud with a silver lining for US financial service firms competing in Europe.

 When markets consolidate, it is typically a process of the big fish eating the little fish.  This argues for the coming greater dominance of the London exchanges in Europe, resulting in parity with large US markets.  The Euro is a threat to the employment of many financial intermediaries, and is thus widely feared in London.  Ironically, its arrival could lead to eventual greater prosperity through the overall growth of the London markets but if Britain does choose to stay out of the currency union, the door will be left open for Paris.  Because its markets were initially less sophisticated and less successful, Paris has had more nearly a clean slate on which to construct computer-age trading, and it has gone about this with vigor.

One caveat is the growing trend toward electronic trading.  Physical exchange marketplaces are no longer strictly necessary.  As geography becomes less relevant the issue may well become, not London or Paris or Frankfurt, but London, Paris, Frankfurt or Cyberspace.

New opportunities in the bond market

The impending arrival of the Euro and the European Central Bank has diminished and will further diminish both short-term money market yield differences and long-term bond return differentials.  Not only will the staple currency plays be eliminated but there will be continuing and greater levels of business cycle convergence.  Existing skills in arbitrage will have to adapt or be abandoned.

The European bond markets have become more stable and their yields have moved closer together during the process of convergence to qualify for the currency union.  The generally lower inflation rates, and, except for the UK, the growing simultaneity in business cycles, have brought even longer term bond yields into a high degree of alignment.  After the currency union begins, however, it may be longer than the market expects before the inter-European system reaches the kind of cohesion seen in, for example, the provinces of Canada.

Governments have always used currency depreciation as a tool, sometimes the tool of last resort, for escaping from a variety of pressures.  Businesses want protection from competitors.  There is generally an excess of people wanting government help over taxpayers willing to support them.  This causes fiscal budget deficits that create burdensome debt that can be financed temporarily by devaluing that debt.  Wage rigidities in the face of productivity improvement differentials cause changes in real exchange rates that are eventually reflected in changes in currency exchange rates.  The Euro closes all these escape hatches.  Until the ground rules change, these continuing social pressures will have no outlet left but fiscal deficits and government borrowing.

The Stability Pact signed in 1996 provides for fines as a percentage of GDP if a participating government exceeds government deficit targets.  This strict Teutonic idea has been compromised by  a loose political mechanism for deciding when fines will be enforced.  In any case, while member countries are still sovereign it is hard to imagine them submitting voluntarily to significant fines for responding to local social pressures.  Consequently, the Stability Pact looks unworkable.  It is likely that weaker governments will experience periodic credit crises as they overspend and then are forced to be extra prudent to recover.  The result for some years will be continued volatility in intra-European yield spreads and continued substantial average spreads between the best and worst credits.  The Canadian model of spreads of only 35 basis points between sound and imprudent provincial governments appears too optimistic.

Yet on the whole lower government deficits should draw more savings into private sector bonds.  This very important consequence will lead to enhanced growth for financial service firms involved in debt issuance and packaging and in trading in the secondary markets involving sophisticated credit and derivatives analysis.  The increase in opportunity for these new skills may well offset the probable trauma to traditional currency and monetary analysis skills.  We may even see the eventual emergence of an important European junk bond market which would benefit some firms but possibly represent another blow to bank profits.

In government issues, the reduction in opportunities for active management will be at least partly offset by increased simplicity and liquidity for passive investing.  Though progress is likely to be gradual, a more unified European bond market may eventually rival the US bond market in appeal as a store of liquidity.

A boost for indexation in equities

Just as in the bond markets, there will be changes within Europe’s stock markets. The new demand will be for skill in assessing and arbitraging different industry sectors within a broad geographical region.  For example, analysts will define their beat as a European electric utility sector, a European banking sector, and so on, rather than in Italian or French or German specialties.

The creation of Europe-wide stock indices and the apparent reduction of many country arbitrage opportunities will lead to an increase in the relative attraction of index funds as opposed to active management.  It seems likely that passive funds will grow to 25% of the market or more, as in the US.  Structured investment processes, which the market for pension and mutual fund management sees as intermediate between active and passive investment styles, may therefore become of greater importance.  This is likely to further open the door to the marketing of financial services by quantitatively oriented US investment management firms, as well as to European firms that see the same opportunity.

Short-term local stock market movements in response to inter-European currency exchange rate movements will disappear, leading to reduced volatility.  However, if changes in real relative profitability can no longer be ameliorated through currency depreciation, there will be greater long-term stock market return disparities.  The sorting out of the resulting complicated effects should give ample employment to stock analysts during the next five years or so.  For example, what will happen to local auto production in Italy if the lira cannot depreciate?  What will happen to the business of a German car manufacturer if the threat of DM appreciation is removed?

A strong or weak Euro?

Diversification will tend to make the Euro more stable but what will be its portfolio effect on a US or Japanese investor?  On one hand, the generally conservative nature of the currency union convergence criteria makes more countries more fiscally prudent.  This in itself diminishes the dangers of sudden, large devaluations.  However, the increased cohesion of monetary policy will reduce the risk reduction possible through diversification.  The Euro might be as stable as the D-mark.  However, it may be less stable than a portfolio of European currencies with diversifiable risks.  This concern is obviously a function of how many countries join.  If only those already closely tied to the D-Mark, there will be little change.  If sterling and others are lost, there will be much less diversification potential.  To summarize, the Euro is likely to be stable, but at a portfolio level the net benefit is uncertain.

It is not possible at this time to judge the policy that will be employed when the new European Central Bank is in place.  The plan has been that such an institution should be relatively independent of its political masters and should be modeled closely on the Bundesbank.  However, already there is talk of expanding its goal list from monetary stability to promoting growth.  Political pressure from less prudent countries and more populist political parties will tend toward greater tolerance of inflation in good times and lower short-term interest rates in bad times.

The demand and supply for currency on a short-term basis today seems to be largely a matter of hot money chasing short-term interest rates.  However, financing trade and holding foreign monetary reserves against a rainy day should not be ignored.  Part of the reason the US dollar is still strong despite 15 years of huge government deficits is that it remains the premier reserve currency for foreign nations.  The same thing was once true of the UK.  The prestige and respect enjoyed by the dollar is eroding, as it did for the UK, but only very slowly.  What will be the impact of the Euro on that process?

There is a mathematical argument for reduced demand by European countries for the dollar as a reserve currency.  As the boundaries of the currency union expand, less and less commerce will be with foreign currencies.  Therefore there is less need for currency reserves to finance fluctuations in trade balances.  Since the dollar is used as a general purpose reserve, the demand for dollars will fall.  This is a sound argument but any effect is likely to be slow and may be offset by increasing trade among other countries outside Europe.  However, the dollar’s market share of reserve usage may well decline at an accelerating rate as Europe re-emerges in economic growth and political presence.

Remember the Reagan Revolution?

The European Currency Union is social engineering on a large scale.  We can foresee only the general outline of its aftermath as governments, businesses and wage-earners cope with change. Governments, in particular, are giving up control over their money  before they submit themselves to checks and balances on spending and taxation.  During a transition period on their way to greater coordination, it seems likely that one or more governments will run the risk of credit default while others may tire of financing profligate neighbors.

Something on a similar scale may have happened in the US not too long ago.  Remember the Reagan revolution that began in the presidential campaign of 1980?  The thought process was very simple.  It said that the government was too big and that high taxes were sapping economic growth.  The premise was that if we cut taxes, not only would supply-side economics ensure more industrial growth through entrepreneurial activity but also, somehow, the government would stop growing.

The outcome could not have been imagined by most.  There was a big tax cut, but not much initial change in spending.  This caused a huge government deficit.  Because US government credit was superb, foreigners rushed to finance it.  The resulting strong dollar allowed a flood of imports that created a rust belt of abandoned inefficient plants in the older industrial sections of the country.  Eventual increases in productivity, encouraged not only by the imagined entrepreneurial benefit of cutting the top marginal tax rate, but by very tangible layoffs and plant closings, led to renewed commercial vitality.  After prolonged resistance by politicians and beneficiaries of government spending and income transfers, the budget deficit is beginning to close.  The growth of government has slowed.  Twenty years later, the Reagan Revolution has turned out well.

Just as tax cuts and deregulation led to renewed economic growth in the US, so, too, will breaking down currency barriers lead to radical improvements in the financial services industry in Europe.  As before, the full consequences will include not only competitive pressures but profitable new opportunities.  The D-mark is dead.  Long live the Euro!