Creating an European “Capital Markets Union”
An ambitious initiative - poorly conceived!
That well functioning capital markets are a key driver for growth, employment and implementing economic policies in general, who could deny it? That the EU suffers currently from sluggish economic activity, high unemployment and still largely uncoordinated economic policies, who would contest it? The Commission’s ambitious initiative to create a Capital Markets Union (“CMU”) seems therefore fully justified.
However, the chosen approach as outlined in the Green Paper (“GP”) and the related questions listed in the Consultation Document demonstrate a poor understanding of the role and functioning of capital markets. This could lead to disappointing - if not marginal - outcomes, delaying significantly the implementation and effectiveness of desirable reforms.
The main problem relates to the geographical scope of the proposed Union. The choice of extending its applicability to the EU 28 seems to have been taken on purely political/ideological grounds. Addressing deficiencies in 28 separate markets whose characteristics differ widely will necessarily lead to compromises that will prevent optimisation of features that should underpin the development of capital markets. One suspects, in addition, that there was an overarching and understandable desire to ensure participation of the United Kingdom both to benefit from its clear leadership and experience and to bind it further to the EU.
Indeed, size in a key element of smooth functioning markets, a feature which the GP recognises in basing its analyses - if not its ultimate objectives - on a comparison with the capital markets of the Unites States. This is particularly true when it addresses features such as liquidity, multiple sources of funding, diversity of available alternatives (both for investors and borrowers), or when considering the lack of harmonisation of tax or insolvency regimes, (not to mention the use of languages) where the size of accessible markets will feature importantly in cross border investment decisions.
An increase in the overall size of capital markets - as opposed to changing the balance between its different segments (for instance replacing bank loans by securities issuance) – can originate from three main sources: the growth of the economy as a whole, an increase in the leverage factor applied to various investment products (bank loans, mortgages, collateralised instruments, derivatives, etc.), or from attracting “foreign” investments.
Under current conditions, even if growth rates returned to historical averages, no significant increase in the overall size of markets should be expected from this source.
An increase in leverage is also unlikely to occur in light of the steps taken to reinforce financial stability by the G20 since the crisis. These include an objective of significant “deleveraging” of both private and sovereign indebtedness which is still far from completed.
As far as encouraging “foreign” investments, one should consider two aspects:
The first is a requirement to ensure “reciprocity”, meaning that encouraging foreign investment should be a two way process. “Free” movement of capital across borders must be organised in such a way that the regulatory framework within which investors, borrowers and intermediaries operate, provide “equivalent” levels of obligations and protections to all participants. While regulatory “harmonisation” (as within the United States) is also necessary within the EU and is a key objective of CMU, “equivalence” between the two systems is also desirable to attract a two way flow of capital. It is noteworthy that the depth and breadth of US markets and their “federal” regulatory framework has been a powerful magnet for attracting “foreign investments”, contributing to the size and liquidity of domestic markets and offering attractive risk diversification opportunities to investors and borrowers alike.
A second factor - and probably the most important one - is totally ignored in the GP: it concerns “currency risk”. It is a key factor in evaluating cross border investment opportunities and consequently an important consideration in creating a performing CMU. Attempting to bring into a single coherent “Union” the capital markets of entities as different as the Eurozone, the United Kingdom and Lithuania, each of which boasts independent “monetary sovereignty”, is doomed to inefficiency at best and failure at worse.
While cross border investments are motivated primarily by the expectations of capital appreciation and/or superior cash returns, the potential for appreciation (or depreciation) of the underlying currency is also an important element of investment decisions. The value of fixed income securities are more directly affected by foreign exchange (“FX”) movements; currency diversification through bond markets can therefore constitute an objective in itself either as a “hedge” mechanism or as an outright speculative play. Equity, commodity and real estate investments have a greater inbuilt degree of adjustment, making them less vulnerable to currency fluctuations over time.
The liquidity of markets in underlying FX “pairs” of currencies - together with their related forward/option markets - will play an important role in attracting large foreign “fixed income” investors to a given market. Within the EU, only € and £ denominated “fixed income markets” have the potential to compete with their US, Japanese or Chinese rivals.
Despite the avowed aim of CMU to reduce market “fragmentation” within the EU through regulatory and operational harmonisation, the problem remains, nevertheless, heavily correlated to FX risk exposures. ECB President Draghi has expressed comfort in the recent reduction of the Eurozone banking market fragmentation. There remain, however, significant impediments to bank cross-border lending because of a strong domestic market bias and the desire to achieve a reasonable balance between asset/liability exposures to the economies of other EMU Members. As long as doubts remain concerning the long term survival of the €, fragmentation is likely to impede the cross border development of both banking and capital markets within the EU, affecting significantly the decisions of EU as well as foreign operators .
A first conclusion is that the CMU initiative, presented as a pillar of the Juncker Commission’s program, needs to be reassessed. In particular, its structure should follow the lines of the “Banking Union” by being made compulsory for EMU members and open to participation by other Member States on a voluntary basis.
Such an approach is justified by the relative importance and potential of a “Eurozone” capital market relative to that of all other non Member States with the notable exception of the UK. The participation of the UK in the initiative should therefore be strongly advocated in order to benefit from its market leadership position (including in FX), its technical/regulatory expertise, its developed financial infrastructure and its broad based human resources; in exchange one should acknowledge the legitimate interests of the City and strengthen its position as the main centre for financial market activities within the European time zone. CMU should bind the UK more closely to the EU more successfully than would a looser arrangement aiming at satisfying (protecting) the diverging interests of 28 Member States.
This procedure would be totally compatible with the Treaty which obligates Member States to converge their economies in order to join EMU. The two countries – UK and Denmark – benefitting from derogations should adhere “voluntarily”, the first because its stands unquestionably to be a prime beneficiary, the second because it’s “currency peg” aligns it largely on the Eurozone.
A second important conclusion, which is already partially recognised in the GP, concerns the need to initiate new - or amend existing – legislation/regulation in related areas in parallel to the implementation of the CMU. This explains the launching of the simultaneous consultations on the “Prospectus Directive” and on “Securitisation” as well as identifying the need for a greater level of harmonisation in areas such as EU fiscal and bankruptcy law.
However, the most important area where progress must be achieved to reap the expected benefits from a deep liquid and diversified European Capital Markets Union is the completion of EMU. Moving away from an intergovernmental “rule based” EMU towards the establishment of a “federal” Authority, endowed with supranational budgetary, fiscal and borrowing powers, is a sine qua non prerequisite for success.
Going forward, as now envisaged, in an attempt to find the necessary compromises to satisfy all 28 Member States, is – maybe - “politically correct” but it would also send a strong signal that extending and completing EMU is no longer a priority. This is bound to increase doubts over the single currency’s long term survival; its implosion would necessarily nullify all the carefully crafted objectives of the CMU.
Finalising the “Banking Union” (single deposit guarantee scheme) and establishing the proposed “Capital Markets Union” should be seen as essential structural elements in the process of EMU integration. After the completion of EMU, the EU could deploy its full capacity of influence on global markets as well as in the international political arena.
Brussels, 9th March 2015
Paul N. Goldschmidt
Director, European Commission (ret.); Member of the Steering Committee of the Thomas More Institute.
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