FOR all that it has clearly had profound effects already, and will have even deeper ones after January 1st, the euro by itself can only do so much. It is best seen as one, albeit central, element of a bigger project: to create a true single market in Europe. This view is supported by plenty of academic research on the effects of single currencies on economies and businesses. One useful strand of research led by Andrew Rose, an economist at the University of California at Berkeley, suggests that thanks to the single currency, intra-European trade should fairly quickly double or even treble in volume. If that turns out to be correct, then Europe will greatly surprise the numerous pessimists who have bemoaned its inability to pick up where America's decade of extraordinary economic growth has left off.
However, another important strain of research explains why one-factor changes, such as the introduction of a single currency, have less of an impact than might at first be expected. Subramanian Rangan, an economist at Insead, France's leading business school, has studied globalisation and its effect on large multinational companies' pricing policies and sourcing of goods. He argues that in a large region such as Europe that is moving towards economic integration, it is vital to understand the role played by national borders. “The moment you talk in terms of integration, you presuppose that there are things to integrate,” he says. “But national borders engender discontinuities so profound that they cannot be overcome by removing a single factor among many.”
This argument is important because it explains why the euro cannot be viewed in isolation from other economic forces. Among the discontinuities caused by borders, Mr Rangan includes the following:
• administrative rules and standards;
• social and religious phenomena;
• capabilities, including geography and natural resources;
• economic development and infrastructure; and
• information differences, including language.
The environment in which businesses operate is influenced by all of these. Thus, whereas the single currency will have the important effect of removing the barrier that is currently being imposed by different currencies, by itself it does not change much else. These currencies are simply administrative characteristics defining national economies. Although in future they will no longer exist, nothing else in this particular category of differences will disappear in their wake.
This analysis even puts a different perspective on the euro's impact on price transparency. True, the single currency will make it easier for consumers to compare prices. But the starting point for this change is that Europe currently has heterogeneous customers who largely buy heterogeneous products with different ingredients, labels and packages. Much else will need to converge before prices do.
Indeed, Mr Rangan predicts that although prices in the euro zone will indeed converge, they will do so more slowly than many people think, and mainly in areas where the cost to consumers of making a mistake are relatively low. “No one, if they have a choice, hires the cheapest lawyer,” he says. Mistakes with big-ticket items, such as cars and houses, are not easy to reverse. Mistakes with health care and drugs can incur irreversible costs.
To see Mr Rangan's point, consider the euro itself. It is Europe's money, but is there as yet a single market in money? A quick look at the banking system or at the broader financial-services industry suggests that this remains a distant goal. The euro has prompted some notable achievements, but there have also been glaring failures, and plenty of gaps remain.
Among the achievements is the euro-denominated capital market. Starting from nothing three years ago, this has become one of the world's main wholesale markets (see chart 2). The euro has removed exchange-rate risk and done away with the segmentation by currency that had previously characterised Europe's money and bond markets.
The interbank unsecured-money market, for instance, is in effect pan-European, with large banks successfully feeding liquidity to smaller, national banks. The secured market has been less successful, largely because its very existence has exposed problems in the underlying infrastructure that can make it difficult to transfer collateral. In time, however, as these problems are tackled, it should become bigger than the unsecured market.
The eurobond market has also been an overall success, thanks in part to the integrated clearing and settlement infrastructure that predated it. In the corporate market, well-known companies such as Philips have launched big benchmark issues, and even a few small, unrated companies such as Ducati have issued bonds successfully. Jan Hommen, chief financial officer at Philips, says the market is becoming deeper and better segmented, pointing to the ease with which he raised euro4.25 billion in two separate deals this year.
Observers say that fewer medium-sized companies have raised money by issuing bonds than was hoped at the outset. Until more do so, the bank-driven alternative system of funding will continue to misallocate capital. This is a fair criticism. But the market has shown that it can fulfil its function as a viable long-term alternative to the bank debt that has always dominated European financial intermediation. In the early part of this year it provided a flood of liquidity to telecoms issuers as equity investors' enthusiasm for that industry dried up. The issuance has since also dried up, but it represented progress.
These successes are tempered by the relative failure so far to integrate Europe's equity markets. Although more and more shares are quoted in euros, and there have been some mergers among stock exchanges, the underlying markets remain fragmented. One reason is that equities are more complex instruments than bonds. A more powerful one, however, is that vested interests at local level have blocked efforts to integrate securities markets.
Consider Europe's rival clearing and settlement systems. Ideally, Europe should have a central counterparty for all securities trading, because that would be most efficient for settlement and for minimising movements of collateral. At present, this seems unlikely to happen. In principle, however, it should be possible for several securities markets to co-exist in the euro zone, each with its own trading exchange, clearing mechanism, settlement system and depository.
For there to be a single market, each individual market would have to allow seamless trading between itself and the other euro-zone markets. At a trivial level, that would require the exchanges and systems to have the same operating hours and to run the same clearing and settlement cycles. At present they are a long way from this, with exchanges opening and closing at different times and relying on a variety of clearing deadlines that require constant vigilance from investors.
Observers say reforms that at first sight appear to be relatively simple have turned out to be a nightmare because individual countries are so reluctant to remove any barrier that might reduce their importance in the overall financial system. The European Commission issued a Financial Services Action plan in 1999 and has since pushed steadily for implementation of its 42 measures by the end of 2005. A report published in February this year by a committee chaired by Alexandre Lamfalussy, a former central banker, was endorsed at a summit held in Stockholm in March as a sensible basis for further efforts to integrate the capital markets, but for a variety of reasons has made little progress since. And even simple reforms require each country to enact new laws, so there is ample scope for political interference. The bigger the country, the higher the barrier.
More fundamentally, the euro has shone a harsh light on basic differences in the legal concepts that define securities. In America and Britain, the law allows two forms of ownership rights. The first, shared by continental Europe, is full legal ownership. The second, not shared in Europe, is beneficial ownership. This concept allows the creation of depositories in which securities are “dematerialised”. If you buy shares in America, you buy a traceable claim on designated securities, not the securities themselves. By contrast, in Europe you buy the securities direct, and they are held in your name. In America, individual holdings in, say, shares of General Electric can be bundled by money managers into so-called “pooled accounts”, which allows for more efficient administration and trading. In Europe, each account has to be segregated.
Underlying these legal niceties is a hard-nosed business issue: who owns what, and in which order, in the event of a bankruptcy? In a world of segregated accounts, direct ownership is easy to establish. In the Anglo-Saxon model, however, and in fluid financial markets where collateral is constantly exchanged between counterparties, the issue can be moot. It is particularly moot where the two legal systems overlap, as they do every time a money manager in London trades with one in Frankfurt. Suppose that you pledge shares as collateral for a loan, and later want to reverse the trade. If your counterparty goes bankrupt before your shares have been returned, who owns them? Such problems present serious barriers to an integrated cross-border securities market and will not easily be overcome. And even if Britain joins the euro, these legal issues will still need to be resolved.
The problems of integrating capital markets can all too easily appear unconnected to the daily needs of European businesses. In fact, the lack of a single market in money is a serious blockage in the economy that can have a direct effect on companies. Nothing better symbolises the difficulties of achieving a single market than a recent argument between the European Commission and Parliament on the one hand and Europe's banking industry on the other over the cost of sending a small credit across a national border.
In March the commission conducted a secret study by sending 1,500 cross-border payments of euro100 each all over the EU's 15 member states. Seven of the transfers never arrived, of which only five were returned to the sender. But the commission's ire was raised not so much by the lack of efficiency as by the outrageous cost of the transfers. The average charge was euro24 and the highest, for a transfer from Greece to Denmark, was nearly euro61. Moreover, more than 15% of the payments were unlawfully double-charged, so that both the recipient and the sender had to pay.
At first the issue looks almost academic, because such cross-border payments currently account for only 1% of all payments sent by banks within the euro zone. But on closer examination it becomes clear that this affects businesses as well as individuals. A small business wanting to refund a customer in another euro-zone country might find that the bank charges not only eat up the refund but cost the poor customer money on top. Consumers wanting to buy goods by mail order may be unable to pay by cheque because the seller will be unwilling to accept a payment that carries a levy of nearly 25%.
If a regulation now before the European Parliament is passed in the coming months, it will stop banks from discriminating against cross-border payments, making them charge the same for these as for local ones. At a recent conference, Romano Prodi, the president of the commission, asked: “What use is a single currency if citizens and companies can use it only on paper or in electronic form in their home country?” Frits Bolkestein, Europe's internal-market commissioner, berated banks for a decade of inaction and blamed them for bringing the regulation on themselves. He also warned them against equalising charges upwards by raising the price of local transfers.
The European Parliament is strongly in favour of regulating, but is under pressure to give banks a chance to compromise. One possibility is that the proposed deadline for regulation to begin, January 2003, will be extended to give banks more time to solve the problem. The European Central Bank is in favour of such an extension. But it does not want cheques to be included in the regulation, arguing that these are an inefficient payment mechanism that should be discouraged even at local, let alone cross-border, level.
Europe's governments, including those that for the moment remain outside the euro, must choose whether they really want to pursue a single financial market. If they do, they will have to generate considerable political will across a number of areas, particularly retail financial services, which currently suffers from a serious lack of pan-European spirit. Otherwise the euro will deliver only a small fraction of its potential economic benefits. But it is not just financial markets that have so far failed to integrate. Two other important examples are cars and drugs, which are the subjects of the next two articles.
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