In most European countries, the financial markets have, traditionally, been rather shallow, with few participants and a narrow range of financial instruments on offer. A high degree of segmentation and a lack of cross-border competition have implied relatively low trading volumes, high transaction costs and a reluctance to implement innovative financial instruments. This segmentation has been a function of exchange rate borders, tradition, differing practices and, of course, national regulations and tax regimes.
Following the elimination of the barriers implied by different currencies, it is now up to the European Commission and the relevant national authorities to further the integration process in the areas of regulation and taxation. Meanwhile, it is up to market participants to take advantage of the business opportunities implied by the increased scope for market integration.
The introduction of the euro brought about an almost immediate integration of the national money markets into a euro area-wide money market. This was made possible thanks to the establishment of pan-European payment systems, such as the TARGET system set up by the Eurosystem, which enables banks to access liquidity throughout the euro area in real time.
The cross-border integration of bond markets in the euro area is progressing at a slower pace, as is also true of equities and derivatives markets. This notwithstanding, we are also experiencing important developments in these segments of the financial markets. These developments are partly due to the general trends towards globalisation and technological refinement and partly related to the introduction of the euro. As a result of the introduction of the euro, market participants increasingly perceive similar instruments traded in the different national markets to be close substitutes. This holds true, in particular, for bonds issued by the euro area governments, where the establishment of common benchmarks, the narrowing of yield spreads and increased market liquidity seem to indicate that a high degree of cross-border substitutability has already been achieved.
The fact that euro area financial instruments are increasingly considered to be close substitutes increases the competitive pressures on national markets to attract issuers and investors wishing to benefit from increased cross-border competition and lower transaction costs. In this context, we have recently experienced several initiatives aimed at creating capital markets across national borders, such as the plans to establish common trading platforms linking the European stock exchanges. Similar initiatives have also been taken to establish links between national securities settlement systems, which would facilitate the cross-border mobilisation of securities. In the longer run, such developments will make it possible for investors to manage their investment portfolios more efficiently.
The Eurosystem welcomes such initiatives aimed at improving the cross-
border integration of financial markets in the euro area, and globally,
since they may result in a wider range of financial instruments on offer,
and at a lower cost, than is currently the case in the national markets.
This could lead to a virtuous circle in which the increased issuance of
instruments denominated in euro will draw the attention of international
investors to the euro area capital markets, in turn making the euro an
increasingly attractive currency for private as well as public issuers.
In fact, the experience of the first few months of the life of the
euro seems to indicate that such a positive development may already be
under way. In the first quarter of 1999, bonds denominated in euro
accounted for around 50% of the bonds issued internationally. This share is
considerably higher than the traditional aggregate share for bonds
denominated in the constituent currencies, which had been in the range of
20% to 30% in recent years. We have also seen a considerable increase in
the average size of bond issues denominated in euro, as compared with those
of bonds denominated in the former currencies, which may indicate that the
trade in euro-denominated issues is likely to become increasingly liquid.
Despite the recent developments in the euro area capital markets,
euro area companies are still mainly dependent on financing through the
banking system. Hence, there is still plenty of scope for further
development in the area of corporate financing. For example, the amount of
private bonds traded in the euro area is still very low compared with the
United States. The market capitalisation of equities is considerably lower
in most euro area countries as compared with the United States and the
United Kingdom. Likewise, the venture capital business in the euro area is
still in its infancy compared with the relatively mature venture capital
markets in the United States and the United Kingdom. Personally, I am
convinced that the introduction of the euro will also be helpful to the
development of these segments of the financial markets.
In this context, I should like to say a few words on how the
introduction of the euro may underpin the reshaping of the European banking
sector. The increased scope for securitisation will put pressure on the
European banking sector to move away from traditional retail banking
activities in favour of more advanced financial services. The European
banking industry is still segmented into relatively small national markets.
The introduction of the euro is likely to add momentum to cross-border
integration in the European banking sector. Although a considerable
consolidation of the European banking sector has taken place over the last
decade, this consolidation has so far been almost exclusively based on
mergers and acquisitions within national borders. It is only recently that
we have also started to see such deals taking place across national
borders.
I welcome this trend towards an expansion beyond national borders
with open arms, since the establishment of truly pan-European - and global
- banking groups will be instrumental in efforts to enhance competition in
the provision of financial services.
5. The Eurosystem and the equity markets
I should like to conclude my presentation today by briefly discussing
about the euro area equity markets as seen from the perspective of the
Eurosystem. It is clear that the Eurosystem has no direct control or
influence over the development of equity markets. However, the Eurosystem
acknowledges the importance of well-functioning and efficient equity
markets for the economy as a means of mobilising savings into productive
investment. Hence, efficient equity markets with transparent price
formation, high market liquidity and low transaction costs are of great
value in the capital formation process.
The existence of efficient equity markets should also reduce the risk of the emergence of asset price bubbles, which is desirable from a monetary policy perspective. Prior to the emergence of asset price bubbles in some industrialised countries in the early 1990s, few central banks paid much attention to the development of prices of equities or other assets in their monetary policy formulation.
However, the effects of the bubble economies in the early 1990s,
notably in Japan, the United Kingdom and Scandinavia, led to an intense
debate among economists on how monetary policy could have responded better
to the situation. Some research was carried out in order to establish price
indexes that would incorporate asset prices and which could be used as
target variables or indicators within the monetary policy framework.
However, no central bank is explicitly making use of such asset price-
weighted indexes in monetary policy formulation. Nevertheless, this
development in the early 1990s made most central banks aware of the fact
that large swings in asset prices can have important effects the price
formation in the economy through its implications on real economic
developments and, in particular, financial market stability.
However, in practice it is not easy to let monetary policy actions respond to asset price developments. Central banks have only one tool for the implementation of monetary policy - the short-term interest rate. They can therefore not effectively try to achieve several objectives at the same time. It is also difficult to judge how developments in asset prices actually feed into consumer prices, thereby making it tricky to assess the need for the appropriate monetary policy response to their changes. This difficulty is exacerbated by the rather high volatility of certain asset prices, such as equities, which could result in frequent changes in policy interest rates if the central bank were to incorporate them mechanistically into its reaction function.
In this respect, the present situation in the United States, as well as in several European countries, is interesting: equity prices have risen rapidly for an extended period but consumer prices remain very subdued and there are, so far, no signs that there is going to be a spill-over from asset price developments into consumer price inflation.
Against the background of the rather unclear relationship between
asset price developments and consumer price inflation, the development of
equity prices does not have a prominent role in the formulation of the
Eurosystem's monetary policy. This notwithstanding, the Eurosystem closely
monitors the prices of equities and other assets within its broadly based
assessment of economic developments in the euro area, which forms the
second pillar of its monetary policy strategy. The Eurosystem will
therefore remain vigilant in order to detect any influence from asset
prices, through their impact on real economic developments and financial
market stability, on the formation of consumer prices.
***
THE MONETARY POLICY OF THE EUROPEAN CENTRAL BANK
Speech by Eugenio Domingo Solans
Member of the Executive Board of the European Central Bank during the "Working Breakfast" at the Permanent Seminar on 4 December 1998 in Madrid
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