European Monetary Union and International Capital Markets: Structural Implications and Risks

WP/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