Could the Capital Markets Union aid Europe's recovery? - World -

The EU’s Capital Markets Union project could ensure companies get the financing necessary to drive the region’s post-pandemic recovery – but its completion is no easy task.

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In April 2020, French president Emmanuel Macron observed that the future of the EU is in peril.

It is not hard to see why. The coming global recession, originating from the Covid-19 pandemic, will hit the bloc hard as national economies enter freefall, debt levels balloon and fiscal deficits widen. These challenges are exacerbating political grievances among governments and fuelling anti-EU sentiment on the street.

Though Europe will likely muddle through the crisis for now – helped once again by aggressive interventions from the European Central Bank – many observers recognise the bloc’s need for longer-term solutions to these problems. 

Safeguarding the future

Against a backdrop of a changing global economy, as well as the UK’s departure from the EU, the region’s leadership is having to consider the ways it can conquer these challenges and safeguard the future of the European project. A well-integrated single market with a resilient financial system, capable of supporting the growth of businesses and the livelihood of consumers across the continent, will be crucial to this endeavour. This is why the EU’s proposed Capital Markets Union (CMU) could assume a renewed importance in the coming months and years. 

At its heart, the CMU is a project designed to diversify the EU’s financing landscape, while supporting capital formation and resilience. But since the European Commission launched its CMU Action Plan in 2015, with its focus on linking savings to growth across the EU and moving away from an over-reliance on the banking system, progress has been modest. In the coming years, however, the pace of implementation may need to increase if the bloc is to meet the challenges of the future. 

“I would say that the main positive is that the CMU was launched as a flagship EU project at the right time and with the right objectives. But we now need to go a step further and deepen the level of ambition,” says Pablo Portugal, managing director, advocacy, at the Association for Financial Markets in Europe (AFME). 

A financial step change

A CMU, if enacted more completely, will ultimately support stronger economic growth, boost livelihoods and stimulate the development of new sectors of the European economy, according to those keen to see its implementation. “The CMU, as a project, is trying to achieve something truly ambitious. It represents a big change in the way the financial sector will operate in Europe,” says Grégory Claeys, senior fellow at Bruegel, a Brussels-based think-tank. 

At present, Europe’s financing landscape is largely dominated by banks, which carries a number of downsides. For one, as European authorities discovered during the financial crisis, an over-dependence on the banking system is problematic if that system experiences extreme stress or is subject to failure. What is more, it comes with added costs and impediments for businesses and consumers alike. 

Research by the International Monetary Fund (IMF) lays out the scale of the challenge today. Bank assets are 300% of gross domestic product (GDP) in the euro area, compared with 85% of GDP in the US. On the other hand, listed equity is just 68% of GDP in the eurozone compared with 170% of GDP across the Atlantic.

And within this picture, Europe’s capital markets remain highly fragmented along national lines. Few non-financial companies make use of the capital markets to raise finance, as it is both difficult and expensive for consumers to invest on a cross-border basis. 

Lack of integration

This situation has profound implications for Europe’s real economy.

“We have found that the lack of capital market integration has three main effects: the first is a differential cost of funding for firms based purely on domicile; the second is that some collateral-constrained firms are rationed out of credit; and the third is that there is less cross-border consumption smoothing when shocks strike,” says Ashok Bhatia, director of IMF offices in Europe and senior resident representative to the EU, who co-authored an IMF study on the CMU in September 2019. 

The research indicates that companies in Greece, for instance, pay a 2.5% higher rate of interest on their debt than entities of a comparable size and focus, operating in the same sector, in France. This dynamic is mirrored across multiple markets, creating an unlevel playing field under the current financing landscape.

In addition, this situation is fuelling credit rationing for firms that are constrained by a lack of collateral. This suggests that early-stage start-ups working in advanced and innovation-based sectors, for example, are most at risk of being excluded from securing finance. And it is these firms that are likely to drive future growth in a knowledge-based economy. 

Yet change is unlikely to come quickly. “Even if all the regulations and legislative proposals made by the European Commission were enacted, I am not sure we would see the results very quickly. This is going to be a long-term project, which is why we haven’t seen a lot of progress in recent times,” says Mr Claeys.

Shortcomings highlighted

Nevertheless, the economic shock from the Covid-19 pandemic may provide an added impetus to the CMU agenda. As member states grapple with recession, the shortcomings of the status quo will become clear. 

“Covid-19-related stress has amplified the need for stronger European capital markets in every area. One driver is the need to continue to diversify funding sources in order to improve economic resilience and stability. A second driver stemming from the Covid-19 crisis is the need to promote growth and the economic recovery. Equity risk capital and other market mechanisms will be vital to provide financing to lockdown-affected businesses and high-growth companies, and start-ups in particular,” says Mr Portugal. 

Meanwhile, the impact of the UK’s decision to leave the EU could also stimulate an acceleration of the CMU’s development. Given that London has, until now, played a vital role in Europe’s wider capital market ecosystem, it seems clear that the city’s new status outside the union will require a shift in thinking. “I think Brexit is definitely relevant, especially once the transition period is over. Between 40% and 80% of all capital market activity in the EU is conducted in the UK, depending on which exact market segment you look at,” says Mr Claeys. 

These difficulties show why many are calling for an acceleration of efforts to implement the CMU. The benefits of a CMU are clear to many within the euro area and, as a concept, it enjoys broadly popular support from EU member states. But the devil, as ever, is in the detail. To progress the CMU beyond its current status will require individual countries to adjust their legislative frameworks across different domains, from taxation to insolvency, which is unlikely to be an easy feat. 

“In a general sense, I would say that all member states seem very supportive of the CMU; they see the need for the project. The difficulties come in reaching compromises on legislation that should effectively promote market-based mechanisms and Europeanise national frameworks,” says Mr Portugal. 

“Part of what CMU is about is promoting market finance. But that also means one has to be consistent in removing policies that make bank loans more attractive to small and medium-sized enterprises compared to market finance. For example, there is a need to foster equity investment by addressing any debt-equity bias in taxation frameworks,” he adds. 

Where now?

So where does the CMU go from here? EU authorities could focus their attention on the targets that are, in relative terms, easier to reach. This includes improvements to the securitisation framework. Securitisation levels have got better in Europe in recent years, though they remained at just 15% of US levels by the end of 2018, according to research from the Centre for European Policy Studies (CEPS) in Brussels. 

“From our perspective, there are some short-term actions that can be taken [to advance the CMU]. These include reviewing the securitisation framework as we see a need to recalibrate some overly conservative requirements in order to restore a well-functioning market in Europe,” says AFME’s Mr Portugal. 

Beyond the shorter-term objectives, realistic longer-term goals are also within grasp. For its part, the IMF has put forward three targeted initiatives that would help to progress the CMU to new heights.

These are focused on transparency and disclosure, regulatory quality and insolvency regimes. In terms of the first initiative, by improving access to information on firms inside the EU and by changing the rules around the disclosure of information, EU authorities could go a long way to ameliorating the environment for capital market activity across the bloc.

Central data repository

“The fundamental difference between bank and capital market finance is that banks lend on proprietary information. Ultimately, what banks have is knowledge of their customers. In the capital markets, the opposite holds true: the whole idea is for a firm to be able to issue a bond to a broad investor base on the back of truthful public disclosure,” says the IMF’s Mr Bhatia. 

“On this basis we developed one of our proposals around the need for Europe to have a central data repository for firms, akin to the US Securities and Exchange Commission’s well-known electronic data gathering, analysis and retrieval [Edgar] database. Among other things, this will eventually also require greater harmonisation of European national accounting standards,” he adds. 

Beyond this, the IMF also suggests efforts to sharpen regulatory qualities that include bringing systemic entities, such as central clearing houses, under an appropriate and centralised oversight. In tandem, it also recommends strengthening the European Securities and Markets Authority by introducing independent board members, among other suggestions. 

Finally, in relation to the question of diverging insolvency regimes, the IMF recommends developing a set of common standards for corporate insolvency and debt enforcement processes accompanied by a consistent monitoring process to check member states’ progress against meeting these objectives. Nevertheless, this last goal may be more difficult to achieve. “Insolvency practice cuts to the heart of national legal tradition. So we acknowledge that, while very important, it is not going to change overnight in the context of the CMU,” says Mr Bhatia. 

Finding consensus

It is clear that for the CMU to move forward, a herculean negotiating effort – coupled with patience and commitment to spare – will be needed to overcome national objections of this sort. Sensitive changes to member states’ legislative frameworks or their perceived national interests, as ever, will be difficult. The introduction of a euro area safe asset, for example, is proving elusive as discussions over what this could look like, and how it would function, continue. 

“There has been a lot of discussion around safe assets. A euro area safe asset will help to harmonise government bond markets, a core component of European capital markets, which remain very fragmented. So there has to be an ambition to harmonise these markets through concrete measures,” says Apostolos Thomadakis, a researcher at the CEPS. 

For the CMU, as for other EU integration projects, finding a consensus between member states that permits a sufficient degree of progress to achieve real and lasting change is the problem. “There has been too much focus on the small, legislative details and not enough attention has been paid to some of the bigger picture challenges and their impact on Europe’s capital markets. The European Commission does what it can but, in the end, it is up to the member states. Too often, ambitious ideas can end up being watered down during the negotiating process,” says Mr Thomadakis.

This time, the stakes are higher than ever. A decade of sub-optimal growth and, in some cases, austerity, have exposed many of the flaws in the EU architecture. But if the region’s leaders can push ahead with the CMU, they will be making an investment for the future. In the end, a healthier and more resilient financing landscape will promote opportunities for economic growth that, until now, have been absent. Achieving this would be good, not only for Europe, but for the rest of the world. 

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