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.
''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.
