The Best Is Yet to Come

Although its economic merits remain to be proved, it is already clear that Economic and Monetary Union is good for investors. The euro's godfathers--Jacques Delors, Helmut Kohl and Franois Mitterrand--saw it as a key step toward political union. But they are unlikely to have foreseen its effects on Europe's companies and financial markets. Even if their successors make a bad job of the fiscal discipline and structural reform required for EMU to succeed, the practical impact of the euro will be irreversible.

For investors, there are four key benefits. One, EMU has triggered a tsunami wave of merger activity, which will result in stronger and more profitable companies. Two, it will create bigger and more efficient capital markets. Three, it allows European investors to build better-balanced portfolios. And four, it will help keep inflation low. Whether or not EMU turns out to be a political or economic success, the first three of these, at least, should be for keeps.

European companies were involved in a record $550 billion of merger activity in 1998, and this year's tally will be considerably higher. Cross-border consolidation has been a long time coming. Europe's "Single Market" package of 1992 laid a foundation of industry liberalization and deregulation. Governments also gave Brussels jurisdiction over big cross-border deals which are now judged on a regional basis, thus allowing for much bigger combined companies. But to stimulate large-scale cross-border mergers, a common currency was also necessary. Freely floating currencies made building a regional business costlier and riskier. Over the next few years, European companies will be merging, first into dominant national players--or sub-regional champions in areas like Scandinavia, Benelux and Iberia--and ultimately into pan-European giants. The good news for investors is that this progressive consolidation will enable the new entities to achieve larger and faster cost savings, and to become stronger and more profitable global competitors.

EMU's second contribution is that it is triggering growth in Europe's capital markets. Now that all euro-zone government debt has been converted into euros, the U.S. Treasury bond market, at $1.8 trillion, is no longer the world's largest. The newly unified euro-zone market tops that, at $2.3 trillion. Companies have been heavy issuers of euro-denominated bonds this year. This will provide future finance for corporate acquisitions and leveraged buyouts, as well as giving bond investors a deeper and broader market. The euro-zone equity market is worth $4 trillion today, still low in relation to its $6 trillion GDP It accounts for only 15% of the global equity market today, but in another 10 years, its share could reach 24%, as extra demand by investors draws new supply of stocks onto the market, and restructuring boosts earnings growth. EMU will play an important part in the growth process by stimulating the extra demand and restructuring.

The third way EMU has altered the economy of Europe is that it allows euro-zone investors to diversify their portfolios. Pension funds and insurance companies can now match their domestic liabilities with assets from anywhere in the euro zone, not just their home market. If they cannot find appropriate companies in their own market, investors can buy them elsewhere instead. This will create a more liquid market for larger European companies' shares. Indeed, EMU is providing the impetus toward a common trading system for all of Europe's companies. Before long, investors will be able to buy, sell and settle transactions on a single exchange. And once companies are traded together, it will seem anomalous for them to be subject to different accounting and tax treatment. Pressure will grow for a common set of accounting standards to enable investors to compare earnings and performance ratios on a common basis.

Finally, EMU will hold back inflationary pressures. Pre-EMU Europe suffered from imperfect price competition, with 20-30% price differences for the same product, from cars to clothes to CDs. Euro price transparency will help consumers to see more clearly where the best bargains are to be found. And with the Internet, prices can be compared and orders placed without having to set off on a window-shopping marathon. This is bad news for some companies, whose profit margins will be squeezed. But it's good for most firms, because low inflation means low interest rates and bond yields. That in turn will support higher stock prices for equities relative to their profits.

Economic problems may well lie ahead. EMU's "one size fits all" monetary policy could result in lasting growth divergences within the euro zone, since real interest rates will tend to be highest where growth is weakest, and vice versa. But the euro, like the Internet, is an agent of radical change. Once unleashed, it sets its own agenda. It will bring Europe's fragmented capital markets together, trigger irreversible industrial consolidation, shake European companies out of a parochial mindset and instill a new readiness to compete with the world's best.

Mark Howdle is head of European Equity Strategy at Salomon Smith Barney in London