Introduction of EMU and Euro Holds Important Implications for Capital Markets

• Pages: 221-223

Page 221

In recent months, discussions of the European economic and monetary union (EMU) have been largely preoccupied with entry issues, with relatively little attention given to the enormous potential structural implications for international capital markets. A European monetary union of any size will present significant challenges, opportunities, and risks for the European and world capital markets, explain Alessandro Prati and Garry J. Schinasi of the IMF's Research Department in their IMF Working Paper entitled European Monetary Union and International Capital Markets: Structural Implications and Risks.

Some things will change unalterably in European markets: transaction costs will drop, currency risk will disappear, and direct financing in European capital markets should increase. Less volatile aspects of asset pricing will supplant currency risk in importance. The volume of investable funds should swell in the wake of necessary pension, social security, and health insurance reforms. Possible efficiency and other gains in the financial sector, however, will be reaped in proportion to EMU's ability to promote the completion of financial integration, create more uniform market practices, and achieve greater transparency in pricing. Also important will be the extent to which EMU members pursue related structural reforms and the quality and effectiveness of EMU policymaking. EMU's implications for banking and the international monetary system are equally profound, but here, too, full realization of its benefits will depend heavily upon complementary actions.

Implications for European and World Capital Markets

Financial deregulation, new investment opportunities, and bank disintermediation have in recent years made European capital markets more integrated and liquid. The creation of EMU and the introduction of the euro are expected to accelerate this process and spur greater securitization-that is, an even greater number of publicly tradable forms of credit, ownership, or derivatives whose price is determined, at frequent intervals, in an open market. A single currency should also, observe Prati and Schinasi, induce greater uniformity in market practices, more transparent pricing, and increased market integration. These changes will derive from:

* the elimination of national currencies-which will lower transaction costs-and of foreign exchange rate risk;

* the growing importance of other risk components, notably credit risk;

* fewer barriers to cross-border investment and the removal of some restrictions on currency exposures for pools of capital, such as pension funds; and

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* possible alterations in portfolio diversification. "Whether or not these incentives lead to the development of deep and liquid...