Does economic and monetary union (EMU) reduce the cost of capital and hence
stimulate corporate investment? New research by Professor Enrique Sentana on the
impact of the European Monetary System (EMS) on capital markets suggests that
reductions in exchange rate volatility do tend to reduce the required rates of return on
stocks and bonds. His study, which is published in the latest issue of the Economic
Journal, also indicates potentially strong beneficial effects on the cost of capital from
increasing integration of European stock markets arising from monetary union and the
development of the single market for financial services.
In 1990, in the famous ‘One Market One Money’ special issue of European Economy,
the European Commission argued that ‘potentially the most important source of gains
from European Monetary Union comes from the reduction in overall uncertainty EMU
might provide’. The Commission went on to contend that a reduction in exchange rate
risk would reduce the risk premium, and that this reduction in the cost of capital would
stimulate corporate investment.
Nevertheless, it is not a priori obvious that intra-European exchange rate risk should
affect the cost of capital. For example, firms might be able to hedge their exchange rate
exposure through a variety of financial instruments. Similarly, those who diversify their
investments globally may not be affected by idiosyncratic variations in a country’s
exchange rate.
Therefore, a relevant empirical question is whether country-specific exchange rate risks
are rewarded in financial markets. For although those risks should not be rewarded in a
world with complete market integration, the existence of capital controls or other legal
impediments to cross-border investment (such as limitations on the holdings of foreign
securities by pension funds and insurance companies), informational asymmetries,
illiquid markets, behavioural biases, etc. suggest that idiosyncratic exchange rate risk is
likely to be priced.
In principle, if country-specific exchange rate volatility is associated with higher stock
returns, then systems that attempt to reduce nominal exchange rate variability, such as
the Exchange Rate Mechanism (ERM) of the EMS may well reduce capital costs for
firms that raise funds by issuing equity. Nevertheless, it should also be noted that a
credible target zone system may increase interest rate volatility if the monetary
authorities are forced to defend the currency. If interest rate volatility is also positively
associated with risk premia on equity markets, and if ERM membership raised interest
rate volatility, then the EMS might even have increased the cost of capital.
In any case, since the stock market is not the primary source of finance in many
continental European countries, Germany being the prime example, it is also necessary
to look at bond returns. Further, since the risk free rate is a fundamental component of
the cost of capital, the effect of the EMS on the riskless interest rate is also very
important.
Sentana’s empirical findings indicate that a target zone system such as the EMS does
reduce exchange rate volatility as long as it remains credible, and that average interest
rate volatility was in fact smaller on average in ERM countries than in non-ERM ones.
At the same time, the results confirm that during turbulent periods in the foreign
exchange market, reductions in idiosyncratic exchange rate volatility were achieved a t
the expense of increases in local interest rate volatility.
Importantly, the evidence also suggests that a system that reduces both the expected
level and the volatility of idiosyncratic exchange rate movements is likely to reduce the
riskless component of the cost of capital.
The evidence for bond and stock markets is less clear-cut, although periods in which
local exchange rate volatility has risen have tended to be associated with increases in
the required rate of return on bonds and equities. Nevertheless, the effects that
Sentana uncovers are small.
The research also examines the question of whether European capital markets are
integrated. In this respect, it is worth noting that an important indirect effect of EMU, in
conjunction with the development of the single market for financial services, should be
the elimination of many of the remaining barriers to cross-border investments in the
European Union.
In order to gauge the potential gains from increased market integration, Sentana
compares stock market risk premia under full integration with the risk premia that would
prevail in the context of completely segmented markets. The empirical results suggest
that such an upper bound on the potential gains from stock market integration could be
rather large.
In practice, of course, markets are neither fully segmented nor fully integrated, and
moreover, the transition from one state to the other is a gradual process, which
accelerated after 1995, when forward interest rates differentials vis-à-vis Germany
began to narrow in anticipation of EMU membership.
ENDS
Notes for Editors: 'Did the EMS Reduce the Cost of Capital?’ by Enrique Sentana is
published in the October 2002 issue of the Economic Journal. Sentana is Professor of
Economics at CEMFI, Casado del Alisal 5, E-28014 Madrid, Spain.
For Further Information: contact Enrique Sentana on +34-91-429-0551 (fax: +34-91-
429-1056; email: sentana@cemfi.es; website: http://www.cemfi.es/~sentana/); or RES
Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email:
romesh@compuserve.com).