Development in financial markets is an ongoing process. In European financial markets the pressures arise from several sources: new technologies (telecommunications and computing), repackaging assets (securitization), the demand for pension reform (demographic change) and changing regulations. The euro represents just one further shock to which investors have to respond. The elimination of currency risk potentially creates a level playing field in that funding costs are becoming more transparent. This enhances competition within the financial industry and introduces new investment strategies.

The fifth CEPR Policy Paper examines the factors influencing the portfolio reallocation process following the introduction of the euro and identifies the remaining barriers to cross-border transactions. The Policy Paper thus offers a progress report on the integration of European securities markets. Aside from currency risk, a range of factors – such as expected future inflation and default risk – affect portfolio allocation and the authors recognise the difficulties in identifying these risks. Their empirical analysis focuses on three broad categories of possible portfolio allocation: domestic versus international investment, debt versus equity investment, and public- versus private-debt investment.

European Security Markets

The 'home bias' effect (i.e. the observed lack of international diversification of actual portfolios relative to the portfolio which the standard theory would suggest as optimal) is central to any analysis of the impact of EMU on portfolio structure. The percentage of total financial wealth invested in foreign assets has increased over the last ten years, but the level of diversification remains quite low – e.g. UK (24%), the Netherlands, Germany and Italy (17%), France (12%), and Spain and the US (5%). Although the home bias is pervasive throughout Europe, the Report notes that its extent varies according to investor types. In addition, the benefit of international diversification depends heavily on the kinds of assets agents hold: it is higher for equities, less so for bonds and subject to significant practical difficulties in the case of other assets such as real estate.

The Report reviews the current composition of financial wealth for five European countries: France, Italy, the Netherlands, Spain and the UK. Households are found to play a major role as they hold between 40% (in the UK) and more than 54% (in Italy) of financial assets. Banks are the second biggest agent, holding between 31% (in Italy) and 59% (in the Netherlands). However, in the last decade the role of households and banks has declined in favour of institutional investors, who hold far more of their wealth in foreign assets. In the case of equities, if banks and households are excluded, the level of diversification is close to what portfolio theory would have predicted for some types of institutional investor in Italy, the Netherlands and the UK. The results also show that investors who own a higher share of equities tend to invest more in foreign assets. This analysis leads the authors to conjecture that the increasing importance of institutional investors and the growing equity culture will lead to the erosion of the home bias effect.

The transaction costs associated with investing across national borders also provide a barrier to international diversification. For example, cross-border payments and securities settlements are still substantially more expensive than domestic ones. Broadly speaking, cross-border transactions seem to cost 10 to 20 times more than domestic transactions: a domestic transaction costs from $1 to $5; a transaction between two European markets costs $10 to $50. Since Europe has a fragmented banking system and the ECB has only limited authority in this area, the authors envisage some difficulties in achieving a satisfactory payments system without public intervention.

The authors predict the greatest changes will take place in the corporate bond market. Since the launch of the euro, European pension, insurance and mutual funds have joined banks as significant buyers of corporate bonds. This in part reflects the historically low yields available on European government bonds and the need of investors to find higher-yielding alternatives. Yet the market for private-sector debt is still relatively small compared with the volume of the public-sector market. This reflects the extensive use of bank loans, as opposed to capital markets, by European firms. The authors argue, however, that the traditionally close relationship between European companies and their principal banks is not likely to disappear quickly. Nevertheless, the average credit rating of companies issuing bonds has fallen sharply since the launch of the euro, reflecting the increasing depth of the European market: in 1998 22% of European corporate bonds had a credit rating of A, by 1999 this had risen to 46%. Previously AAA and AA-rated quasi-sovereign and financial bonds dominated Europe's debt markets.

Although the market is still in its infancy, several features have emerged. First, the market is sector specific: half of the high-yield bonds issued in 1999 stem from the cable and telecommunications sector. As a result, investors seeking high-yield returns in the European market are unable to fully diversify. Second, spreads between junk (BB rated) bonds and a risk-free (AAA) bond are higher in Europe than in the US. In many cases, the difference is more than 100 basis points. And third, growth in the European corporate bond market has been uneven: the corporate bond market for Germany, France, Spain and Italy grew 78.4% over the first three quarters of 1999, compared with only 9.2% for the remaining seven EMU countries.

The emergence of globalization and virtual exchanges means that stock exchanges are now less about having a physical presence, buildings, traders, history or a culture, and more about providing attractive services to a footloose clientele. Electronic communications networks (ECNs) represent the most serious challenge to traditional exchanges; they can settle transactions more efficiently in terms of cost and time and tailor themselves more readily to the demands of the individual investors. Currently, ECNs handle between 25% and 30% of the volume on the Nasdaq and 4% of the NYSE. Their future success depends on the liquidity generated from online trading, which settles a large share of trades with ECNs.

Portfolio theory states that diversification is valuable precisely because there is imperfect correlation between the returns on different assets. In the context of the euro zone, international diversification is performance improving to the extent that national stock markets are imperfectly correlated. The euro has at least two possible implications in this respect. First, it is necessarily equivalent to the disappearance of currency risk, and second, it is part of a broader set of structural changes likely to alter the traditional forces underlying asset returns and thus the relevant correlations between stock indices. To shed light on these issues and their implications for portfolio allocation decisions, the Report focuses on how the euro has affected the characteristics of the variance-covariance matrix of asset returns within the euro area.

The Report uses data on national stock market indices as well as specific sector indices for the 11 countries in the euro area for the period 1990-99. The data is split into two periods: a pre-convergence period, defined as preceding the Maastricht Treaty of January 1995, and a convergence period after it. The authors then calculate both correlation and variance-covariance matrices for all possible country pairs in the euro area. The above graph illustrates the pre-convergence and convergence correlations. Aside from a few exceptions, every convergence period correlation is higher than its pre-convergence counterpart. The formal Jenrich tests confirm these differences as statistically significant.

Of course, this pattern of increasing return correlations is not necessarily caused by or even associated with the process of EMU; it could merely be a reflection of a broader worldwide trend, possibly as a consequence of increasingly mobile international capital flows. Evidence on this question is provided in the Report, with the evolution of the return correlations between stock indices representing the major regions of the world. The results show that while there is some increase in the level of correlation across the world, the increase in the correlations was much more pronounced in the case of euro area countries. The global average for region pair correlations was 0.454 during the pre-convergence period and 0.585 during the convergence period; whereas the average country pair correlation for the euro area was 0.333 for the pre-convergence period and 0.585 for the convergence period. The result of increasing country-to-country correlations is robust to both changes in the date for splitting the pre-convergence and convergence periods and for neutralizing the currency fluctuations.

In the euro area, the rise in the correlation of countries' stock market returns were accompanied by an increase in the standard deviations of returns. It is not clear whether this increase in the level of risk has any causal relationship with EMU, but it is interesting to note that there is some presumption that return correlations increase during periods of high volatility – e.g. see the contagion literature. The increase in the standard deviations in returns may in this sense explain part of the common increase in correlations both in the euro area and elsewhere in the developed world.

The authors conclude from this analysis that the conditions under which portfolio investors diversify across the euro area equity markets have changed in the 1990s. With an increased degree of correlation between national stock indices, diversification opportunities have been significantly reduced. It seems difficult not to attribute this to the process of economic and monetary integration. Within this process the disappearance of currency risk seems to have been less important to investors than the convergence of economic structures or the homogenization of economic shocks across the EU. A similar but less pronounced process of increasing correlations among country or regional indices seems to be at work elsewhere in the world, suggesting that EMU is not the only factor at work.

In order to gain further insights into the process, the authors repeat the above analyses using sector indices for the euro area economies – i.e. they examine in each euro area member equity returns for certain types of industry. Two levels of disaggregation are considered: four sectors and ten sectors per country. Although not as pronounced as the country analyses, the sectoral analyses exhibit the same pattern: the sectoral indices in individual countries are more correlated with the same sectors in other countries. What implications does this have for the portfolio manager? The results suggest that the advent of the euro means the end of pure country allocation strategies within Europe: the increased correlation of stock returns across countries implies that international diversification across the euro area on the basis of a pure country allocation model has increasingly smaller benefits.

These results also have implications for the 'home bias', the propensity of most investors to invest disproportionately in their home market. They suggest that the changing economic structures within Europe and the disappearance of currency risks may have actually lowered the cost of the home bias within the euro area. This intuition is confirmed if the alternative to staying at home is to diversify using a pure country allocation model. In some cases, the cost of the home bias (measured in this way) has decreased to zero. Further analysis by the authors, however, shows that diversification across both countries and sectors remains a far superior investment strategy and that, measured against this alternative strategy, the cost of the home bias continues to be significant in Europe.

In sum, this study shows that for asset returns, the importance of EMU may come from the evolving economic structures that affect return correlations rather than the mechanical effect associated with the disappearance of currency risk. This conclusion would confirm the prognosis of those who have proclaimed that the euro would be only a minor event for investors while also asserting that currency risk is not the explanation for the home bias. In spite of the theoretical debate, the report's analyses suggest that the cost of the home bias effect will remain high and may even increase, and that the traditional country allocation model should be scrapped with appropriate diversification proceeding along sectoral as well as geographic lines. These are non-trivial consequences for European investors.

CEPR Policy Paper No. 5 'EMU and Portfolio Adjustment' by Kpate Adjaouté (Université de Lausanne), Laura Bottazzi (IGIER, Università Bocconi, Milano, and CEPR), Jean-Pierre Danthine (Université de Lausanne and CEPR), Andreas Fischer (Swiss National Bank and CEPR), Rony Hamaui (Banca Commerciale Italiana), Richard Portes (London Business School and CEPR) and Mike Wickens (University of York and CEPR).