European Financial Integration and Equity Returns: A Theory-Based Assessment

Abstract

This paper reassesses, at the light of economic and financial theory, the well documented recent evolution of the euro area public debt and equity markets. Doing so leads to associating the EMU and the single market with the changes in fundamentals and financial integration with convergence in pricing. For the public debt market, we stress the observation, conform with predictions, that risk free interest rates are now less volatile in the euro area. But also the fact that the establishment of a single public debt market is still not completed. The current fragmentation is costly to Treasuries and tax payers and understanding its cause is important to evaluate the prospects of currently considered measures of financial integration. Theory predicted that the single currency would have a minor impact on equity markets since the currency component in euro area equity returns has historically been small. That the asset management industry has undergone a paradigmatic change, moving from a topdown country-based allocation to a top-down global sector-based allocation, is a puzzle in this light. A careful examination of the changing relative importance of country and industry factors for equity returns provides some weak rationale for the change in paradigm. A more complete assessment of the evolving nature of equity returns in terms of portfolio efficiency strengthens this evidence.