European Monetary Union and International Capital Markets: Structural Implications and RisksWP/97/62-EA.European Monetary Union and International Capital Markets: Structural Implications and Risks. by Alessandro Prati and Gary J. Schinasi The introduction of the euro provides incentives for greater reliance on direct financing in European capital market by directly reducing transactions costs and removing the volatile currency-risk component of intra-EMU cross-border financing costs. These changes will focus markets on the remaining, much less volatile, components of risk and asset pricing, including credit, liquidity, settlement, legal, and event risks. If fiscal reforms are undertaken, a large pool of investable funds will flow out of the public sectors into European and international capital markets, all denominated in euro and seeking various tradeoffs between risk and return. All these structural changes point in the direction of less segmented securities markets and open up possibilities for increased market integration, more uniform market practices, and more transparency in pricing. How far these processes will evolve depends on the degree of cross-border competition and the institutional structure for policymaking in EMU. In European banking, there is room for significant further consolidation at the retail banking level, where unlike at the wholesale level, competitive pressures have been resisted. There are private mechanisms through which consolidation can occur, but important barriers might prevent the necessary adjustments and create the need for public support of inefficient retail banking systems. The euro is likely to surpass existing EU currencies combined as both a reserve currency and a currency of denomination for international financial transactions. A rebalancing of official and private portfolios and shifts in the pattern of international capital flows are likely to noticeably affect foreign exchange markets and the major domestic financial markets worldwide. Whether this implies a weak or a strong euro will depend on perceptions about the European authorities. ability to achieve fiscal consolidation and structural reforms (including in capital markets and retail banking systems), and the effectiveness and credibility of EMU monetary and exchange rate policies. |