January 1, 1999 begins the third stage of the Economic and Monetary Union with the participation of eleven of the fifteen member states of the European Union (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain). The adoption of the euro as a single currency will mark the beginning of a monetary area of first magnitude in the world economy and an historic milestone in the process of the construction of Europe. Financial markets represent one of the fields to show the biggest changes and for this reason ”la Caixa” Research Department has devoted number 14 in its Studies and Reports Series to an examination of the effects on these markets by means of eight articles by prestigious professionals.

Economic and institutional environment

Meeting of the convergence criteria – although with some qualifications, some of which were substantial – provides a stable environment in which the various financial markets are carrying out changes. This is recognized in reports by the European Commission, the European Monetary Institute and the Bundesbank, Germany’s central bank, whose opinion has given a strong boost to market confidence.

According to Carmen Alcaide, director of the Research Department of the Official Credit Institute, present concerns lie in the rate of convergence of official interest rates and in the level of rates which will be set by the European Central Bank (ECB). Once the euro has been adopted, attention will be focussed on consolidation of the stability reached on inflation and the government deficit and there will be discussion of the process of harmonization of the tax systems of the member countries. Over the longer term, the main challenges will be the credibility of the single monetary policy and the euro exchange rate in terms of other countries, such as the dollar, yen, pound sterling and Swiss franc.

Single monetary policy

Monetary policy will become managed through the European System of Central Banks (ESCB) made up of the ECB and the central banks of member states. The two big questions which arise are: what will be the orientation of the new monetary policy and how will the European System of Central Banks function?

According to the analysis by Javier Aríztegui, deputy general manager of the Bank of Spain, the basic objective of the new monetary policy will be the control of inflation which measured by the consumer price index must stand somewhere between 1%-2%. The short-term interest rate is the operative variable chosen as the intermediate objective. Using suitable instruments it will try to ensure that the interest rate takes on a specific value in the euro interbank deposit market. The instruments will be permanent facilities, open market operations, structural operations and the cash ratio. The resultant interest rate will be the central hub around which other financial markets in the EU will revolve.

The ECB will make the policy decisions on monetary objectives, interest rates, calling of liquidity auctions, management criteria, etc. The national central banks will put these decisions into practice and operate with the various banks in financial markets. Putting the new monetary policy into effect will require an infrastructure which must serve the trading of operations, provision of guarantees, international mobilization of securities and liquidation of cash. To establish this has involved a complex process of negotiation.

It may be hoped that the transition to the new monetary policy will take place without major hurdles. On the one hand, implementation of monetary policy in many aspects maintains a line of continuity with that followed by the Bank of Spain. On the other hand, this institution has systematically introduced the more relevant changes related to markets over the past three years – payment systems compatible with the TARGET system and criteria for reform of settlement houses, has established permanent credit and deposit facilities and is accepting private securities in its loan operations, etc. These measures will provide Spain’s financial system with a simpler link with the operational practices of the ESCB.

Bond market

A fully integrated bond market will require a process of legislative changes and changes in practices of market operators which will be long and complex. The costs of the transition may exceed 110,000 ECU per operator and cause job losses of 15%-20% although various studies show major differences.

According to Robert McCauley, of the Bank for International Payments, Basle, Switzerland, the effects will be positive to the extent that the bond market advances along the path of real integration. Adoption of the euro will stimulate growth and liquidity of the market in Europe. The single currency will immediately form a single yield curve and could also lead to a greater integration of the national public debt market. Liquidity of private bonds in euros will rival those in dollars. It may however be debated whether this statement may be extended to the public bond market due to the differences in the amount of debt and how its convergence may be managed.

A bond market in euros which is broader, more liquid and more competitive will stimulate changes in financial policy of European corporations which will shift their sources for obtaining funds from the banks toward the bond market. European institutions which buy bonds will be deprived of the high yields of bonds expressed in lira or pesetas and will be obliged to accept lower interest rates. In addition, the increase in competition will attract international investment and increase the role of the euro in the international financial system.

Stock market

Technological innovation in data-processing and telecommunications have been a key factor in the integration of European stock markets so that it is likely that monetary integration will not bring about the formation of a single share market but rather that it will strengthen the interconnection of existing exchanges. This is the opinion of Blas Calzada, director of the Research Department of Madrid Stock Exchange. As a result, European stock markets, especially the Spanish stock market, have great growth potential both in terms of trading and capitalization.

The key strong points of the Spanish stock market are its technical structure which allows easy trading, settlement and provision of information. The process of privatizations and incorporation of new companies which have broadened the shareholder base providing the market with liquidity at low cost; and the existence of a good market for bonds and derivatives, among others. To this should be added the growth of household savings and the trend to a concentration of savings in pension funds and investment funds.

Private bond market

In recent decades, government bonds have been the big leader in bond markets. But adoption of the euro will stimulate the development of markets for private financing, according to the article by Francisco de Oña, chairman of the Board of Directors of the Association of Intermediaries of Financial Assets (AIAF) Bonds. The reduction or stabilization of the role of the public sector will give way to this market as a major source of funds for economic development. This implies the adoption of decisions in the taxation field, simplification of the issue process and making the listing process easier along with changes in the provision of securities.

The private bond market in Spain is relatively recent. In 1991 the AIAF bond market was recognized as an unofficial secondary securities market. From then on the trading volume has shown major increases. In 1995 the market was given a new legal status in order for it to be recognized as a regulated securities market in keeping with the European Union directive on investment services. It was thus set up as AIAF Mercado de Renta Fija, S.A.

As well as its recent formation we should mention its loose structure. Basically six bond markets are maintained with five systems of compensation and settlement. There are also various trading systems. In view of the adoption of the euro it is worth mentioning three aspects – its limitation to public sector paper; concentration of savings in group investment formulas; and the growing role of the private sector as the engine of development and subsequently its financing needs.

Government bond market

The convergence process and the EMU have imposed certain restraints on the issue policies for government bonds arising from the fact that they must be carried out under competitive conditions such as those of any other issuer. At the same time, it has fostered financial orthodoxy by separating monetary policy from government borrowing policy. A significant step in this direction, according to Ignacio Ezquiaga, deputy general manager of Analistas Financieros Internacionales, is the fact that the Bank of Spain is prohibited from directly acquiring bonds from the issuer, a criterion set out in the Law for Autonomy of the Bank of Spain and in the statutes of the ESCB.

One important consequence of this separation is the change in the nature of country risk which was considered of top quality because countries enjoyed monetary sovereignty. The system of shared sovereignty implied by the EMU has meant that rating agencies have reconsidered their classifications in euros making them equivalent to those they award in foreign currency. In addition, the sovereign rating may not now be used as a maximum for other national ratings so that some issuers, such as the autonomous governments, may obtain a better classification.

The EMU will begin with bond markets carrying out their activities in euros but following the national dynamic in which they operate as there do not yet exist agreements for harmonization and linking of settlement systems. Thus the major impact of the EMU on this market will be seen in the choice of procedure for redenomination of bonds, the process of price formation in the market, and the struggle of regional markets to survive. Once the exchange rates are fixed, domestic yield differences on the government bonds of the various issuers will depend on three factors – the credit rating of the issuer, the flow structure of securities (coupons, coupon period, residual term) and market conditions.

Derivatives market

The EMU will speed up the process of concentration of liquidity in the organized derivatives market (futures and options based on bonds or shares). According to Enrique Vidal-Ribas, markets director of MEFF and editor of this monograph, strategy for the new situation should take into consideration from an overall point of view the interdependence existing between the spot market, the organized derivatives market and the nonregulated derivatives market (OTC). In order to strengthen the various markets it is important to consider that an organized market is a service company, that the homogeneity of its products is compatible with a segmentation which opens up new opportunities and that technological innovation provides solid bases for a competitive strategy. In this context, strategic alliances take on a key role.

Companies: main consequences

Companies will benefit from greater economic stability and a significant reduction in transaction costs – elimination of exchange rate risk, more liquidity and a greater degree of disclosure in the market. According to León Benelbas, partner and director for Spain of Price Waterhouse Corporate Finance, companies will operate in a climate of greater internationalization and competitiveness. Naturally, they must handle the costs of the transition to the euro – adaptation of accounting, legal, data-processing, etc. The effects will not be the same for all sectors. In tourism, for example, which represents 5.5% of Spain’s GDP and in which 75% of tourists come from the EU, will be among those most affected in a positive way. In general terms, the EMI will have a direct effect on policy relating to mergers, acquisitions and leveraged operations.

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