ࡱ> #` %bjbjmm -($$$$$$$8...8..8zT"x/x/(///{0{0{0SSSSSSS$UhXT!$@{0{0@@T$$//4TWKWKWK@$/$/SWK@SWKWKnPp$$QR/l/ V.ER qR|JT0zT1R X#JX@QRX$QR {0b5WK9<{0{0{0TTJX{0{0{0zT@@@@888d(.888.888$$$$$$  EURO - Its Impact on National Money and Capital Markets by Vinko Kand~ija, Ph.D.* Zdenko Prohaska, Ph.D.** Abstract In this paper the implications of EMU and especially the introduction of EURO and it s impact on national money and capital markets will be discussed. It is expected that after January 1, 1999 the introduction of the Euro will lead to a greater integration of Europes financial markets because there will be strong incentives for participating countries to drop the barriers between their domestic financial markets and work together toward greater financial integration. If integration and efficiency gains are achieved, Europes financial markets could represent the biggest financial market in the whole world. Therefore an analysis is done on the structural implications of Euro on European financial markets, including the possible evolution of EMU markets for repos (repurchase agreements), interbank funds, bonds, shares, derivatives as well as on the institutional framework. The analysis is based on data concerning the potential size of EMU financial markets calculated in terms of market value (capitalisation) of short-term securities, bonds, shares and bank-assets issued in EU countries. One sample consists of all EU member countries (EU-15), and the other sample is calculated taking into account only the first eleven countries participating in EMU. That means EU member countries without Great Britain, Sweden, Denmark and Greece. Expected results of the research are based on the effects of the introduction of the Euro and its influence on financial markets in Europe. Euro will lead to a more liquid and integrated financial markets in Europe, where a greater level of capital mobility, competition among financial institutions and market transparency will be achieved. Currency risk will disappear between EU-11 countries and will be replaced by credit risk; a greater supply and demand for short-term and long-term funds will lead to more breadth and depth of all segments of European financial markets which will cut transaction costs and will make this market more competitive in comparison to U.S. or Japanese financial markets. * * * Prepared for the II International Conference Economic System of the EU and Adjustment of the Republic of Croatia, April 22-23, 1999, Rijeka * Full Professor, University of Rijeka, Faculty of Economics **Associate Professor, University of Rijeka, Faculty of Economics 1. Introduction In this paper the implications of European Monetary Union (EMU) and especially the introduction of EURO and its impact on national money and capital markets will be discussed. It is expected that after January 1, 1999 the introduction of the Euro will lead to a greater integration of Europes financial markets because there will be strong incentives for participating countries to drop the barriers between their domestic financial markets and work together toward greater financial integration. If integration and efficiency gains are achieved, Europes financial markets could represent the biggest financial market in the whole world. Therefore an analysis is done on the structural implications of Euro on the development European financial markets, including the possible evolution of EMU markets for repos (repurchase agreements), interbank funds, bonds, shares, derivatives as well as on the institutional framework. 2. Evolution of financial markets in European Union The European securities markets are passing through an important and deep transitional phase or evolution. This change can be said to have started in the mid-1980s when Great Britain introduced the so-called Big Bang, when important changes were introduced altering the regulatory and the basic institutional structure of the markets and spread later to other European and overseas countries. Three basic features characterise the changes now under way. They are: A) an increase in size and scope and changes in the character; B) continuing adjustment of stock exchanges and firms to the new and continually altering external environment; C) changes in the regulatory framework governing the functioning of the markets, both on the European Union and domestic levels. (Ravell and Rybczynski, 1994, pp. ) Ad A) The European capital markets are expanding in size and scope and are changing in character The increase now under way of the activities of the domestic markets of the fifteen members of the European Union (EU), as well as of the markets in the countries if the European Free Trade Association (EFTA) now being integrated into the European Economic Area, which will be subject to EU rules and regulations. It is reflected in the increase in the number of listed companies and public bodies securities listed in stock exchanges (indicative of a continuing rise in the reliance of private sector companies on external funds raised through capital markets rather than from banks and other saving collection institutions), a steadily growing advance in the activities of the secondary markets. The main factors propelling this increase in size and geographical scope and a growing variety of financial instruments, now extending to derivatives, are the strong trend towards securitisation of the financial system, thr privatization policies being pursued by governments in Europe and overseas, and a rising resource to capital markets by European and other public sector bodies. The trend towards securitisation has involved a greater reliance of non-financial corporations on external funds raised through capital markets and a greater use of them by the public sector, as compared with funds raised through banks by way of bills and similar instruments and by direct appeal for direct savings to the household sector using various government savings instruments and publicly-owned savings banks. The trend towards securitisation can be explained first by reference to the lower cost and flexibility of funds raised using capital markets rather than banks, and indeed directly from other financial intermediaries such as insurance companies and so on. Sizable corporations can now raise additional funds more easily and cheaply, relying on domestic, foreign and international capital marktes. One of the important factors working in favor of the lower cost of capital market finance is the new capital requirements on banks required by the regulators in accordance with Basle Accord, which imposes high risk coefficients on loans and holdings of equity in business enterprises. Not only is the cost of capital funds lower, but also capital market instruments can be combined flexibly, with rich variety of instruments offering opportunities to reduce interest rates and exchange risk by way of swaps, futures and options. Accompanying the attraction of capital markets for sizable companies has been a change in preferences of households to hold a larger share of their financial wealth in the form of stock exchange securities. The second main factor responsible for the increase in the size of the European capital market has been the now rapidly developing trend towards privatization. One lasting legacy of the new economic philosophy and policies developed in the 1980s has been the acceptance of the need to privatize as large a proportion of publicly-owned and controlled assets as possible, as well as to shift a great proportion of welfare spending undertaken by government, particularly as regards pensions, health and education, to privately-funded shemes. Privatization of state-owned assets has now become a part of economic policy in Europe as well as other developed and developing countries. (Prohaska and Miljan, 1997, pp. 151-153) Ad B) The character of the markets changes also It involves mainly internationalization and segmentation into two sectors. Internationalization covers a rising volume of cross-border transactions in primary and secondary markets, associated with freedom of movement of capital and diversification by investors and companies seeking lowest-cost finance. Internationalization of European capital markets has involved: a rise in the relative share of new issues made in European domestic markets and euro-markets by non-EU and non-European entities; growth in the number of EU and othe European and non-European securities listed in the EU (and EFTA) capital markets; a rise in the number and value of EU (and EFTA) securities held by non-residents; an increase in the relative importance of cross-border business in the EU secondary markets involving intra-EU, intra-European and non-European business. Segmentation covers the division into wholesale and retail markets, each with different characteristics. This is due to the spread of institutional investors to the countries on the continent Europe and overseas. Institutional investors are diversifying their holdings to include foreign secururities and are trying to trade in large blocks continually, to take advantage of changes in their perception of markets, currencies and different securities. The emphasis of institutional investors is on cost and speed of execution as compared with emphasis on protection required by individual investors. The main factors behind the rapid growth of institutional investors are demographic trends and governmental policies to transfer part of of the burden of welfare provision, and pensions to the private sector by encouraging funded pension and helath schemes. In addition, institutional investors, which also comprise collective savings institutions such as unit and investment trusts, are gaining in importance because of special tax privilege accorded to them to spread the habit of holding shares by individuals. Increase in size and scope, and changes in the character of the domestic capital markets in Europe, together with the rapid advances in technology, are having profound impact on the structure of teh industry. All stock exchanges are now in the process of modernization and streamlining involving: the adoption of technologically advanced methods of price dissemination, information, trading, and clearing and settlement; the restructuring in the number of agency broking, broking/dealing and market-making firms; linking of regional exchanges with central national and foreign exchanges. To a large extent the changes in the strucrure of the European capital market industry affecting market-makers, broking/dealing, agency brokers and exchanges are a reflection of the pressures put on them by companies using them for the purpose of rising funds, by investing institutions, and by competition by themselves to gain a proper place in the newly emerging Single European Financial Market and especially competition among London, Frankfurt and also Paris to become a leading European financial center. Closely linked to the modernization and automation of the national stock exchanges has been the restructuring of the intermediares. The main feature of the development now under way is: the acceptance of the system of dual capacity in the countries where the functions of market making and acting as agent had been separated; concentration of market-making and broking/dealing in the hands of universal banks, either directly or indirectly through special subsidiaries, accompanied by rationalization; interpretation of various domestic market intermediaries and markets by other European and non-European firms through purchasing previously independent firms and setting up subsidiaries and branches. As a consequence, capital market intermediary activities tend to be dominated by a relatively small number of institutions surrounded by a relative small and decreasing number of independent agency brokers whose business tends to be limited to special areas. Modernization of exchanges is accompanied also by the trend towards disintermediation among participants in the capital markets consisting in investors trying, with the help of new technology, to develop methods of dealing directly with other investors as regards their secondary market business. On the European level, the proposal to create an EU-regulated price and company news information service, Euro-quote, has been abandoned. In its place it is planned to introduce Euro-list, a new service covering 150 large European companies. The inclusion on Euro-list will automatically list companies in all EU and EFTA exchanges which are members of the Federation of European Stock Exchanges. Ad C) Changes in the regulatory framework Partly in response to rapid technological advance, partly as a means of helping their capital markets to gain a leading position or to prevent to much business drifting away, and partly as a move to create a Single European Financial Market, the regulatory framework continues to be changed, both on national and European (now Pan-European) levels. As regards the Pan-European level, teh EFTA countries will now be adopting all EU directives relating to financial matters. The EU regulatory framework includes the Investment Services Directive, which involves a single passport for investment banking activities (issues in primary markets, trading in secondary markets by firms offering such services), and allied directives concerned with the functioning of the markets, as for example insider trading. The EU regulation of investment firms is essentially concerned with their capital adequacy. This matter is also being dealt with by the Bank for International Settlements (BIS), G-10 Committee on Banking Supervision and the International Orgazation of Securities Commissions (IOSCO), a body bringing together national securities regulators. The Capital Adequacy Directive, and the Investment Services Directive now being discussed in Brussels, try to reach a compromise between the approach to and the demands of the universal banks which are involved in securities business, pure investment banking houses and, above all, the UK and US firms, which do not engage in deposit banking. The size of European markets (including their liquidity) and their scope are likely to continue to increase for various reasons: growing internationalization; further growth in size of companies, and lower cost and flexibility of capital market funds; a more rapid privatization, partly due to the endeavor of governments to contain the growing burden of welfare provision, mainly pensions and health; continuing rise in the relative importance of the institutional investors, trading wholesale and linked to the advance in funded pension and also health schemes, as well as the spread of collective savings institutions, often with special tax privileges. This development, already leading to two tiered structure of the industry and dividing it into large multinational investment/securities houses and small and medium-size specialized firms, can be expected to gain momentum. After the presentation and discussion of the evolution of domestic capital markets in Europe generally, the most developed secondary capital markets in Europe will be examined. 3. Size of European financial markets European Monetary Union (EMU) has occurred on January 1, 1999, when a number of 12 member countries of the European Union (EU) has adopted a single currency the Euro. EMU will create strong incentives for countries to dismantle the barriers between their domestic markets and work toward greater financial integration. The result could be the creation of the worlds biggest financial market. At the end of 1995, the market value of bonds, equities, and bank assets issued in EU countries amounted to more than $27 trillion (See table 1). By comparison, the market value of assets in the United States amounted to about $23 trillion, in Japan $16 trillion. If EMU will lead to the complete integration of Europes financial markets depends on many factors and much remains to be done at both the national and the EU levels to remove legal, regulatory, tax, and other barriers. Table 1 European Union, USA and Japan: selected indicators on the size of capital markets 1995 (in billions of US dollars) ----------------------------------------------------------------------------------------------------- GDP Stock market Debt Bank Bonds, Bonds,equities capitalisation securities assets equities bank assets bank assets (%GDP) ----------------------------------------------------------------------------------------------------- EU-158.427,03.778,58.673,014.818,027.269,5323,6EU-11*6.803,92.119,46.993,211.971,621.084,2310,0USA7.253,86.857,611.007,5 5.000,022.865,1315,2JAPAN5.114,03.667,3 5.325,8 7.382,216.375,2 320,2----------------------------------------------------------------------------------------------------- * Remark: EU member countries without Great Britain, Denmark, Sweden, Greece Source: Prati, A., Schinasi, G.J.,European Monetary Union and International Capital Markets: Structural Implications and Risks?, IMF Working Paper, WP/97/62, May 1997, p.7 4. Euro and its benefits for financial markets European financial markets have become more integrated and liquid over the past decade, caused by financial deregulation a global phenomenonchanging investment opportunities, and bank disintermediation. Large issues of sovereign debt have stimulated the development of efficient secondary bond markets and caused yields on government securities to rise, making them an attractive alternative to bank deposits. Capital mobility across EU countries has been made possible by the recent convergence of macroeconomic policies. Against this background, the introduction of the Euro will alter benefits in such a way so as to encourage the further securitization of European finance, the harmonization of market practices, and greater transparency in pricing. First, the adoption of a single currency will reduce the cost of spot transactions in foreign exchange markets. Because of that and the absence of bid and ask spreads for ex foreign currencies total cost in foreign trade between EMU countries will be less expensive. Second, the introduction of a single currency Euro together with the reduction of transaction costs will cause more competition between financial intermediaries and will lead to more breadth and depth of European financial markets. That means in concern of security trading that a lot of bonds or shares will be listed on several stock exchanges what will increase supply and demand and will result in more trading on the secondary markets. Third, the Euro will eliminate the foreign exchange risk or currency risk in long-term contracts between entities in EMU countries. The focus is not only on short-period fluctuations that characterise many foreign exchange markets, but also rather on the unpredictable longer-period swings observable in European exchange rates, which can destroy or diminish the effects of investment in export facilities. (Pitchford and Cox, 1997, p.23) On the other hand the relative importance of other types of risk will increase, especially credit risk, which is likely to become the most important determinant of securities prices, but other factors (e.g., liquidity, settlement,etc. ) will also influence pricing. For example, the bond issues of an Italian company and a German company with the same credit risk may be priced differently if issuing techniques and clearing, settlement, and legal procedures are different in Italy and Germany. Therefore countries will be motivated to improve their financial infrastructures. Taken together, the elimination of currency risk and the convergence of credit spreads and market practices may increase the depth and liquidity of European securities markets. Contracts in short-term markets will be denominated in euros and could be traded across national markets. For securities listed on more than one exchange, competition among exchanges could lead to the consolidation of trading in a single location. Even markets that remain somewhat segmented (because of larger credit spreads or more restrictions) will become more liquid thanks to lower transaction costs and fewer trading restrictions. Fourth, the barriers to cross-border investment will drop, and some intra-EMU foreign exchange and investment restrictions that now apply to pools of capital such as pension funds and insurance companies will become irrelevant. The size and diversification of portfolios managed by EU institutional investors could increase rapidly as a result. Indeed, the need for diversification as European markets integrate could guide investors to reduce their holdings of EU assets. Fifth, once the advantages of currency diversification disappear, investors and financial institutions will seek to diversify their portfolios with a broader range of Euro instruments as well as with assets outside the Euro area. Sixth, there will be further benefits from the expected greater attractiveness to international investors of European securities denominated in Euro, as compared with those in existing currencies. Such expectation could lead to some shift of international portfolio holdings into EMU area, but its size and speed are difficult to predict. Seventh, there are advantages if after its introduction Euro emerges as a global trading and investment currency on a par with the U.S. dollar and yen. Gains could arise from an international reserve currency which are similar to seignorage, the profits that go to authorities that issue money, such as the interest received on the securities held as backing for the note issue. Eighth, economic benefit sought from EMU and Euro is lasting improvement in inflation performance. That is important for domestic and international investors because real returs is what matters in financial markets in the long run. 5. EMU financial markets 5.1. Money markets - Interbank and repo markets The introduction of the Euro and of the single monetary policy will determine the establishment of a deep, liquid and standardised single European money market and thus an increase of competition in this area can be expected. The Euro will bring to an end the arbitrage between the different national money markets, which is currently common practice in larger institutions. The disappearance of the pricing advantage in the home interest rate is likely to have a negative effect on the profitability of banks specialised in dealing in the relevant currency. The concentration of substantial market values on a few markets, and within them on a few large banks is assumed. This tendency could also increase the trend towards concentration and the pressure for bank mergers. If the incentives mentioned above, encourage the development of deep and liquid short-term securities markets will depend, in part, on supply and demand factors; cross-border competition between financial intermediaries; the removal of legislative, regulatory, and tax impediments to cross-border investment; and the institutional arrangements for the implementation of monetary and financial policy. Historically, the role played by the central bank in private money markets has had an important bearing on the development of domestic securities markets. In contrast with the US Federal Reserve, which has played an active role in the development of efficient money and securities markets by intervening daily in the markets, European central banks rely on minimum reserve requirements, reserve averaging, and biweekly market interventions. The European style of central banking has tended to discourage the development of private securities markets and has led to the predominance of bank-intermediated finance. It is too early to say whether the European System of Central Banks (ESCB) which consists of the European Central Bank (ECB) and national central banks (NCBs) will more closely resemble the US or the European model. The current plan is that repurchase agreements (repos) will be the ECBs main instrument for implementing monetary policy and repo operations will be decentralised. The NCBs will collect repo bids from local markets, send them to a central computer in Frankfurt, and allocate the repo transactions according to instructions from the ECB. This reliance on repos could stimulate the development of an EMU-wide repo market. Although private repo markets now exist in some countries, with few exceptions (most notably, France) they are neither as highly developed nor as liquid as US repo markets. Another question is whether interbank markets in individual countries will retain their distinct national characteristics or whether market pressures will force them to merge into a single EMU-wide market. Integration has already increased slightly foreign interbank deposits have grown and discrepancies between interest rates on euromarket instruments and domestic markets have narrowed. With the elimination of foreign exchange risk, the establishment of ECB repo operations, and the provision of intraday liquidity for settlement purposes, there would be few, if any, impediments to keep first-, second-, and third-tier European banks from supplying each other directly with overnight funds. This could quickly lead to the creation of an efficient EMU wide interbank market, followed by the development of a private repo market. Large global financial institutions that now rely on the London and New York markets for liquidity management would become more active in short-term EMU markets. 5.2. Markets for sovereign bonds By removing currency risk and reducing transaction costs, having a single European currency will bring down the costs of issuing and investing in government securities. It is therefore likely to drive both supply and demand and to provide strong incentives for harmonising market practices and making them transparent and cost-effective. EMU members will no longer be able to take their home-currency market for granted when investors can search among different sovereign issuers for their preferred risk-return profiles. As credit risk gets more attention, cross-border competition is likely to increase between financial intermediaries in bringing new issues to market, rating new credit, and allocating investment funds across national markets. There may be a spate of mergers and acquisitions and a restructuring of the banking sector as European banks strive to develop the scale of operations needed to compete with each other and with UK and US banks. The pricing of credit risk will determine how integrated and how liquid European sovereign debt markets become. Several potential EMU members now have higher ratings on debt denominated in domestic currency than on debt denominated in foreign currency. For these countries, credit ratings on euro-denominated debt could be closer to the latter than to the former. However, countries that improve their fiscal positions to meet the Maastricht criteria could counteract pressures for ratings to deteriorate. Other factors will also influence credit spreads. Although the no-bailout clause in the Maastricht Treaty rules out the possibility of direct EU assistance to individual EMU member countries, sovereign debt is not likely to be priced as if it were corporate debt. The sheer size of public debt outstanding in any potential EMU member country means that an involuntary restructuring or outright default would have significant systemic implications. In the beginning of 1999, all new issues of government bonds and bills (at least those traded on the secondary market) will have to be denominated in euros, but countries will have a choice as to whether or not to redenominate outstanding stocks of debt. The coexistence of new euro-denominated bonds and old national-currency bonds could segment the new euro market for government securities and reduce its liquidity. At the same time, competition among European sovereign issuers seeking to provide the benchmark yield curve for pricing sovereign and private debt is possible to create pressures for more integration. 5.3. Markets for corporate bonds Even though EU financial market legislation and the fund-management industry have begun to chip away at regulatory and tax barriers to the development of European corporate debt markets, these markets have remained small. Of the total outstanding volume of debt securities issued by EU private entities (approximately $4 trillion, or roughly 87 percent of the US corporate debt market), only about 25 percent was issued in international markets. The volume of domestic issues in 1995 was low compared with other developed markets: $0.1 billion in Germany and $6.4 billion in France, compared with $20.7 billion in the United Kingdom, $77.2 billion in Japan, and $154.3 billion in the United States. Introduction of Euro and EMU are likely to accelerate the development of corporate bond markets. However, the development of a Europe-wide corporate debt market will probably take some time, primarily because of excessive regulation and a narrow institutional investor base. In Germany, for example, tax policy and issuance requirements prevented the development of commercial paper and private bond markets until very recently. More generally, regulators in almost all EU countries have discouraged issuance of lower-grade corporate debt securities. With respect to the investor base, corporate debt securities are often highly heterogeneous across issuers as well as across issues by the same issuer and the costs of evaluating risks are high. These markets therefore require a large institutional investor base, which is likely to develop gradually in Europe. Moreover, the present bank financing culture in Europe may, as it did earlier in Japan, continue to impede the development of corporate bond and equity markets. 5.4. Equity markets Euro and EMU are possible to accelerate the growth of competition, the consolidation, and the technological innovation that have characterised equity markets in recent years. In the late 1980s, the London Stock Exchange Europes largest equity market encouraged turnover in continental equities by creating a screen-based dealer market for non-UK stocks named SEAQ International (SEAQ-I) that was separate from the London dealer market. Since the early 1990s, continental exchanges have regained a substantial share of trading with new electronic continuous auction markets, particularly CAC in Paris and IBIS in Frankfurt, and the importance of SEAQ-I has diminished. However, London dealers are still the primary source of liquidity for large block trades and for program trading in a significant number of continental stocks. Combined with computerisation and the implementation of the EUs Investment Services Directive, the start of the euro could lead to the development of a European-wide equity market for blue-chip stocks in the form of a single electronic exchange with a screen-based, automated order-driven trading system like IBIS. However, the trading costs of such a system should be competitive with those of proprietary trading systems. National bourses may survive by specialising in trading low-capitalisation companies, and local trading may continue if local custody, settlement, and tax systems differ. Generally, it is expected that the introduction of Euro will lead to an increase in cross-border equity trading and improve the integration of equity markets as well as overall market liquidity. 5.5. Derivatives markets Euro will also have an important influence on Europes 16 futures and options exchanges. With only euro interest rates, there will be fewer derivatives contracts. This will probably initiate more competition between the three largest exchanges the London International Financial Futures Exchange (LIFFE), the Deutsche Terminbrse (DTB), and the March Terme International de France (MATIF) , although small exchanges may try to establish technical linkages and common settlement procedures. From the point of view of their specialisation in interest rate contracts, LIFFE and MATIF are likely to be most affected. DTB will be able to capitalise on its technological prominence owing to its fully electronic order-driven system that allows almost one-third of its members to trade from workstations outside Germany; its Frankfurt location might also give it a competitive edge. While LIFFE already has electronic capability, MATIF is likely to be handicapped by its failure to finalise a link with DTB. LIFFEs current leading position may be undermined, however, if the United Kingdom does not join EMU, while MATIF could benefit from the fact that the French government has been actively issuing ECU-denominated debt since 1989 and is the leading sovereign borrower in ECU. The straightest impact of Euro and EMU on the structure of derivatives contracts will be the elimination of currency derivatives between EMU countries. If EMU begins with the core countries of the exchange rate mechanism (ERM), the negative impact on trading volumes will be muted, because trading in intra-core currency derivatives is relatively limited. High-volume contracts between core and noncore currencies will simply change into contracts between the euro and noncore currencies, and contracts between dollars, yen, and deutsche mark-bloc currencies will be only slightly affected, with the euro substituting for European national currencies. But if EMU enhances trading within, and capital flows to, the euro area, the demand for currency derivatives could increase. After EMU, the market for interest rate swaps should become larger and more liquid, as contracts of participating currencies become perfectly fungible. Enhanced liquidity is also likely to increase the use of swaps outside the banking sector. EMU will boost the demand for options contracts on interest rate spreads and allow investors to hedge credit-risk spreads between bonds of high-debt countries and the euro benchmark. Interest-rate-spread-based contracts may also develop for private debt securities. In case of bond market futures, it is difficult to know whether the market will demand a futures contract for each national bond or a generic contract will emerge. This will depend on the volatility of credit spreads between the various national issues. If spreads are stable, the low basis risk could lead the market to develop a single, liquid 10-year futures contract similar to the US Treasury bond future. (Prati and Schinasi, 1997, p.37) Otherwise, there could be a range of futures contracts, one for each national benchmark issue. The selection of deliverable bonds will also be essential. If two or more national bonds are deliverable for a generic bond futures contract, the contract could favour the one that is cheapest to deliver and create liquidity of that bond at the expense of higher-quality bonds. 6. Conclusions EMU will reduce transaction costs and remove the volatile currency-risk component of intra-EMU cross-border financing costs and the introduction of the euro may result in greater reliance on direct financing in European capital markets. Investors and issuers of debt and equity will probably shift their focus to the less volatile components of risk and asset pricing. Currency risk will turn into credit risk. Borrowers will try to lower their financing costs by improving their credit ratings and borrowing in the lowest cost locations. Lenders will try to assess more accurately the underlying relative asset values and credit risk and take account of other risk components. And, if current plans for fiscal reform are implemented, a large number of investable funds, insurance companies and pension funds will leave the public sector and will invest more in European and international capital markets. The structural changes that will take place in Europes financial markets as a result of EMU and other developments will have a significant impact on international portfolio investments. To the extent the euro is perceived as a stable store of value, it will assume an important role as a reserve currency. Indeed, its role could be greater than the combined roles of the former currencies of EMU members. This would make the euro the worlds second most important reserve currency, after the US dollar. Whether the euro will also play a dominant role in international financial transactions on foreign exchange markets and in foreign trade is less sure, but this is obviously possible. In the end all markets will become less segmented and more efficient within EMU and more capital will go in and out from the so-called euroland. 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London: Kogan Page, 1997 Pohl, G., Jedrzejczak, G., Anderson, R.E., Creating Capital Markets in Central and Eastern Europe, The World Bank, Washington, 1995. Prati, A., Schinasi, G.J.,European Monetary Union and International Capital Markets: Structural Implications and Risks?, IMF Working Paper, WP/97/62, May 1997 Prohaska, Z., Miljan, I., European Financial Market and Financial Market in Croatia (A Comparative Approach), International Conference Economic System of European Union and Adjustment of The Republic of Croatia, University of Rijeka, Faculty of Economics, Universita Degli Studi di Trieste, Facolta di Economia, April 24-25, 1997 Ravell, J., Rybczynski, T., The Changing Face of European Banks and Securities Markets; Development of European Securities Markets, London, 1994. Teweles, R.J., Bradley, E.S., Teweles, T.M., The Stock Market. New York: John Wiley and Sons, 1992.     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