The European Integration and Its Effects on the European Monetary Union Stock Markets

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The European Integration and Its Effects on the European Monetary Union Stock Markets - Faarnaz Chavoushi


The issue of correlations among stock indices is essential for effective diversification strategies of portfolio managers. However, it is often claimed that the economic and financial integration of European markets has increased correlations between stock market indices, making it less attractive for portfolio managers to diversify among European assets. This paper examines the development of the correlation structure between country indices during monetary and economic integration in the European Monetary Union and finds that correlations increased considerably during the sample period of 1979 to 1999, and decreased again after the introduction of the euro. This paper seeks an economically sound explanation for this counterintuitive observation.


The issue of European stock market integration is of considerable importance to both investors and the economy as a whole.  Deregulation, elimination of crossborder restrictions on banking and securities transactions, and the abolishment of currency risks are all factors which have contributed to increased cross-border investment activity and accelerated equity capital flows between markets in the European Monetary Union (EMU).  With exchange rates no longer a barrier to equity trading in the euro area, the European Commission is now working on harmonizing and eliminating regulatory and structural obstacles such as crossborder trading restrictions, different accounting systems for financial reports, and cross-border trading costs.

The gradual creation of a single market for equities is expected to raise competitiveness levels through the efficient allocation of capital, by mobilizing savings to a larger and more liquid capital market and by disciplining managers. In fact, the creation of an integrated European capital market is seen as one of the strategies established to reach the goals of the Lisbon agenda and to outperform the American economy by 2010.  However, although the elimination of currency exchange risk and the high degree of integration probably have substantial positive effects on the competitiveness of the European economy, their implications for the portfolio management industry are somewhat ambiguous.

Until a few years ago, it was common practice among portfolio managers to follow a top-down approach to asset selection.  This approach concentrated on first dividing the money over several countries and second on spreading the investment within a country.  However, at the end of the 1990s, the argument was increasingly made that the country orientation of the top-down approach should give way, within the euro era at least, to an industry or sector orientation.  This proposal is based on the observation that, as stocks become more integrated and move together, the diversification benefits of investing in many countries may be reduced, as correlations among European country indices will increase.  Therefore, the focus of diversification should shift from a country level to the industry level across European markets.  As a result, superannuation funds and life insurance companies that hold long-term investment portfolios and adopt policies of passive international diversification are increasingly expected to switch portfolio compositions in order to achieve efficient portfolios.

This change in asset allocation strategy is not a minor one.  It implies that the teams of analysts, now organized along country lines, are to be reorganized along industry lines.  If investment firms were to follow this advice, they would put less time and effort into examining the macroeconomic outlook of a country, and could instead focus on analyzing the prospects of an industry and of specific firms within that industry.  Moreover, as the European stock markets become less distinct from one another, asset managers looking to diversify their stock portfolios might increasingly divert part of their assets from the European market to other regions where cross-market correlations are still at a lower level.  This would lead to a gradual withdrawal of investment flows away from the European stock markets, which could potentially have substantial implications for the size and liquidity of the European markets, not to mention the ability of continental companies to raise sufficient money for investment projects in the financial markets. As such, the process of financial and monetary integration that the European Union has actively pursued in order to enhance its role as a great economic power in the world can have adverse effects on an important engine of the European economy. Since neither local governments nor the EU as a supranational institution has the possibility of protecting the European financial markets against adverse shocks in investment flows, this could be a serious concern.  After all, the only instrument a government has at its disposal to protect its markets from external shocks is the imposition of capital flow restrictions.  Capital flow restrictions are not only controversial and deplorable from a liberal-market point of view, but also unsuitable as an instrument in this particular case, since the withdrawal of funds by investment managers would be based on rational economic foundations rather than being driven by short-term investment sentiments.

With the pursuit of great power come many unforeseen consequences, but the issue becomes particularly pressing when one does not have the instruments with which to take responsibility for these consequences.  Nevertheless, despite the lack of a responsive instrument for the government at the moment, it is extremely important to have at least an awareness of the possible future challenges that the pursuit of the process of closer monetary integration can have.  The aim of this paper is therefore to assess whether the recent shift of asset allocation strategy would indeed be rationally justified on the basis of financial economics theory.  If so, then that would potentially have grave consequences for the financial markets of the European countries.  If not, then we can retain the hope that economic rationale will settle the recent discussion on the optimal asset allocation strategies without bringing about a significant change in the direction of investment flows.

This paper evaluates the optimal asset allocation strategy by examining the effects of the process of monetary and economic integration in the EMU on the correlation levels of cross-country indices in Europe, both from a theoretical and empirical perspective. The paper will show that although intuition would lead one to expect that increased monetary and financial integration will lead to higher cross-market correlations, the theoretical and empirical evidence is rather ambiguous.  In fact, this study finds that although correlations among the EMU countries substantially increased from 1979 to 1999, cross-country correlations have almost informally dropped since the introduction of the euro.  The final section of this paper will discuss a number of theoretical premises that can reconcile our intuitive expectations with the empirical findings.

Market Integration in the European Union and its Effect on Stock Markets

In the portfolio management industry, financial investment and security firms base their optimal asset allocation strategies on the diversification benefits as suggested by the Modern Portfolio Theory.  First introduced by Markowitz (1952), Modern Portfolio Theory shows that the risk of a portfolio of assets is not equal to the sum of the weighted average of the variances of individual securities, but also depends on the correlations between the assets.  The weaker the correlations between assets are, the greater is the reduction in portfolio risk.  Therefore, a welldiversified portfolio (among low correlated stocks) can bring the same return for an investor at a lower risk level for investors.  The rationale of international diversification in portfolio management thus highly depends on low correlations between international equity markets.  It is therefore not surprising that a lot of research has been conducted on the evolution of correlations among country indices over time.  This chapter will discuss the issue of monetary and financial integration within Europe and its possible implications for cross-country correlations and portfolio management.

There are a number of mechanisms through which the strengthening of monetary and economic integration in the EMU can be expected to be accompanied by a substantial increase in cross-country correlations among European markets. The coming section will give a conceptual outline of the link between monetary and financial integration and correlations among stock markets.

The Possible Effects of Monetary and Economic Integration

The effect of monetary and economic integration on correlations is threefold. First, as a result of the opening of the market and increased levels of trade between nations, the profitabilities of companies across borders will become more interrelated.  Another important co-movement mechanism is the convergence of real economies as a result of the increased monetary coordination.  Having more similar business cycles and being more interdependent through trade could mean a convergence in expected cash flows and volatilities, resulting in a co-movement of profits and dividends of European firms, and thus a more homogeneous valuation of equities and an increased cross-country correlation in asset prices.

A second outcome of the economic integration is the effect of the convergence of monetary policy on the valuation of companies.  As inflation rates and interest rates converge at a European level, dividends and net profitability of companies are discounted at a similar rate, possibly leading to a convergence of stock prices across nations.  Furthermore, as exchange rate fluctuations diminish over time, the currency risk factor incorporated in stock prices should be eradicated as well.

Third, exchange rate fluctuations are mainly driven by national economic policies and form an important source of risk priced on capital markets.  A more volatile exchange rate of a country raises the national risk premium as investors require a higher return to compensate for the increased uncertainty.  In fact, the existence of exchange rate uncertainty can function as an important device for market segmentation.  The more volatile and unpredictable exchange rates are, and the more costly hedging against uncertainty is, the stronger the degree of market segmentation and the lower the degree of correlation across markets. Analogously, the reduction or elimination of currency risk, as entailed in the EMU and the introduction of the euro, may raise the degree of financial integration across countries and simultaneously lead to more homogeneous reward to risk ratios across European stock markets.

The Possible Effects of Financial Integration

Due to improvements in computer and communication technology, adjustments in delays in international prices are shorter and stock markets have become more synchronized.  Furthermore, since controls on capital movements and foreign exchange transactions are relaxed, shocks that have an effect on the valuation of many assets worldwide are more easily transferred across countries in an integrated market.  For example, after the accounting scandals concerning Ahold, many Dutch institutional investors temporarily lost market confidence and, as a reaction, sold a large part of their portfolio on a European level.  If transaction costs and barriers to trade had been higher (like before the start of the financial integration process), other financial markets in Europe probably would have been less affected by the market specific shock from the Dutch market.  Thus, as the barriers in the transmission channel of the financial markets are gradually eliminated (like envisioned in the Financial Service Action Plan), one can expect that shocks to common risk factors affect more countries with the same scope, leading to a higher co-movement between the markets.

Previous Empirical Research

Research has found substantial empirical evidence that correlations are timevarying and that correlations across markets increase during periods of higher economic and financial integration, which is bad news for portfolio managers in the modern era.  For example, Goetzmann, Li and Rouwenhorst (2001) collect information from 150 years of global equity market history in order to evaluate the evolution of equity correlation matrices through time.  They suggest that the structure of global correlations shifts considerably through time and that periods of free capital flows are associated with high correlations.  They find that today, in the beginning of the 21st century, global correlations are at a historical high (though approaching levels of correlation last experienced during the Great Depression).  Other researchers have also concluded that the international diversification potential today is very low compared to the rest of capital market history.  For example, Rouwenhorst (1999) looks at EMU correlations specifically and finds that both country and sector correlations are increasing over time in the period of 1978 to 1998, although the average increase is not as pronounced for sectors as it is for countries.

Surprisingly, however, more recent empirical research from other authors who examined the correlation structure of European stock markets is not in line with this earlier conclusion.  For example, in an early paper, Adjaoute and Danthine (2000) first identified a significant increase in the degree of correlation between national stock indices implying that diversification opportunities have been significantly reduced after the introduction of the euro.  However, after revisiting their earlier work in mid-2001 with an extended sample data, they find that more recent data convey a radically different message.  They find that the period after the introduction of the euro is characterized by lower correlations than those obtained for the immediately preceding period of the same length. Another example of a recent study that reports a trend in the cross-country return correlation within the EMU, is the paper by Ferreira (2003).  Examining the period from 1975 to 2001, it finds that both EMU country and industry correlations reach a peak in the 19951998 period and then decrease in the last period.

These findings are surprising since the introduction of the euro is said to have eased the transfer of capital within the European Union, and, based on the analysis of Goetzmann et al, one would expect higher correlations in such periods. In his paper, Ferreira (2003) suggests that the low correlations in the last subperiod of the sample may be related to a reduction in the average stock return of the EMU market. However, Goetzmann et al (2001) have shown convincingly that periods of poor market performance have been associated with high correlations, rather than low correlations.

Methodology and Data

As we have seen, the issue of cross-country correlations is essential for optimal diversification strategies of portfolio managers.  An increase in the correlation coefficients could indicate increased market integration over time and a possible reduction of diversification benefits for a mean-variance optimizing investor.   Yet empirical research so far has reached ambiguous and indefinite conclusions on the effects of economic market integration on stock market correlations in the EMU.  This paper will therefore take a pragmatic approach and will directly assess the developments of cross-country correlations in the EMU area since the start of the economic integration period.

Toward this purpose, the paper aims to examine the following hypothesis: Correlations between EMU country indices are rising as the level of economic market integration in the EMU increases over time.

A comparison of the correlation coefficients among the country indices is made over time to see whether there are significant changes in the four subperiods specified.  In order to capture the process of integration in the European stock markets, an analysis was performed over four separate sub-samples, each indicating a different phase of economic integration in the European Monetary Union.   Table 1 gives a description of the sub-periods.  The sample period is from January 1979 to July 2005.  The study employs total market indices composed by DataStream International.  Weekly, dividend adjusted, continuously compounded stock returns are used for 12 countries that have signed up for EMU.  Unfortunately, data is not available for Finland, Portugal, Spain, Greece, and Luxembourg for the pre-convergence and convergence period.  Therefore, data from these countries will only be taken into consideration for the pre-euro and euro era.  The sample contains weekly returns on country and industry indices.  In order to calculate continuous returns, the price series used in the study are transformed by taking natural logarithms of the raw data.  For further ease of comparison, all returns are expressed in the Dutch guilder until January 1, 1999, and afterward in the common euro currency.  This method is preferred to expression in local returns, since in practice most investors do not hedge their returns and are subject to exchange risk fluctuations.  However, expressing returns in a common currency may introduce a bias toward higher correlations of returns over the years when the EMU exchange rates have become more stabilized and correlated.  This makes it more difficult to draw conclusions from the evolution of the correlation matrices, since higher observed correlations can be caused by financial integration as well as a convergence of exchange rate fluctuations.  The use of local currency (Dutch guilder) returns are justified; however, since irrespective of the cause of the observed development of correlations over time, the practical implications to local investors are the same.

Main Empirical Results

This section will first give a description of the statistics and the correlation structure of the assets in the period from January 1979 until July 2005.  In the discussion chapter, these empirical observations are reviewed and put into perspective by making a comparison to the findings of other studies and by relating the results of this study to the theory of financial and monetary integration.

Table 2 shows summary statistics over the different sub-periods.  These include the average annual returns, annual standard deviations and corresponding risk-reward ratios (from now on referred to as Sharpe ratios).  The table illustrates a number of things.  First of all, it clearly shows that the mean returns of the capital markets went through different phases during the different sub-periods.  For example, the average mean return for the pre-convergence period was 18.3 percent. For the convergence period it was 10.4 percent, for the pre-euro period it was 19.4 percent, and during the euro period it was only 4.4 percent.  Although standard deviations also varied over time, the divergence was much smaller.  As a result we can see that the standardized returns (Sharpe ratios) vary considerably through time as well.  Correspondingly, during the pre-euro period, almost all stock markets experienced a dramatic value increase, only to deflate just as sharply a few years later during the euro era.

When we look within the asset classes in more detail, we see large differences between the individual assets. Ireland has the best absolute performance for countries (average annual return of 13.68 percent) but when corrected for its high average standard deviation, it does not have the best standardized return.  The best standard return is achieved by the Dutch index, with a Sharpe ratio of 0.84.

Table 3 shows the average correlations across country indices.  The table shows us first of all that the average correlation coefficients for countries with a smaller capital market (Austria, Greece, Ireland and Luxembourg) compared to the rest of the EMU stock markets (0.35) are much lower than average correlations of the larger markets (0.48).  Italy is the exception in this trend since it is the only country with a large market capitalization that is experiencing relatively low correlations with the rest of the EMU countries until the last sub-sample period. The results for the correlation coefficients depicted here reconfirm the findings of Yan, Min and Li (2003) who conclude that smaller European markets are less integrated with the rest of the European capital markets, since their small market and concerns of market illiquidity most probably withhold investors from investing in those markets, although they have the same macroeconomic linkages with the other EMU countries.

Table 4 also clearly depicts that correlations have increased considerably through time in order to reach a maximum in the 1994-1998 period, and then decrease slightly in the last sample period.   The finding that cross-country correlations have decreased after the introduction of the euro seems rather surprising and in contrast to the intuitive expectations of increased correlations. In order to test that the increase (and later the drop) in average correlation trends is not heavily influenced by the figures of a few countries only, the following graphical analysis is conducted following Adjaoute and Danthine (2001).  First, the country or sector index returns are used to compute the unconditional correlation matrices for the different periods.  Secondly, the correlation pairs are sorted in ascending order and plotted against the country pairs for each subperiod (i.e. pre-convergence period).  Third, the correlation pairs for the subsequent period (i.e. convergence period) are recomputed and plotted along the correlation pairs of the previous period (i.e. pre-convergence) correlation pairs.

The results are visible in figures 1A to 1C.  Figure 1A shows the evolution of country pair correlations by comparing the pre-convergence and convergence periods.  It is obvious that correlations between all country index pairs were uniformly larger in the second period than in the first.  The average increase of the correlation coefficient was remarkable: 0.324 points.  Figure 1B, however, shows a slightly different pattern for the convergence and pre-euro periods.  Coefficients for most correlation pairs are larger in the second period than in the first, but the average increase was a mere 0.076 points.  Figure 1C on the other hand, shows a radically different picture.  In the euro period, it is no longer the case that all correlations are uniformly higher than in the immediately preceding period.  In fact, 36 out of 65 correlation coefficients are lower in the euro sample than the preeuro sample.  The average decrease in correlations was a slight -0.030 points.

Discussion of Results

By illustrating the time-varying pattern of correlations, we have thus seen that cross-country correlations have varied very much in the different subperiods. During the convergence period, there was a drastic increase of correlations among both country and sector indices, illustrating the importance of the free market and the increased trade levels after the Single European Act.  However, we have also seen that the upward trend has been broken in the euro era, where cross-country correlations actually declined.  This last finding is in contrast to the research by Rouwenhorst (1999) and Goetzmann et. al. (2001) who find that periods of free capital flows are associated with higher correlations.  On the other hand, the findings here do correspond to those of other recent studies on this topic, most notably of Adjaoute and Danthine (2000) and Ferreira (2003).  This section will attempt to discuss the controversial observation of a plunge of correlation levels in the euro period and try to reconcile it with economic theories described previously.

First of all, despite what is sometimes suggested in the literature, the fact that in the euro period cross-country correlations have decreased does not have to mean that the disappearance of currency risk and the convergence of economic policies have been unimportant for financial markets.  Instead, this phenomenon might actually stress the importance of the convergence process before the introduction of the euro.

Ever since the establishment of the Single European Act, Europe has been in a process of increasing economic integration.  In that transitional phase, the fiscal policies of the member states were more synchronized to a common budget norm for all member states, which put a lot of pressure on the governments of some countries to reform their economic policies.  Furthermore, inflation rates were strongly reduced in all member states and interest rates and exchange rate fluctuations were diminished, all of which required deliberate action from the government of the EMU member countries.  As a result, this transitional phase has led to large identical macroeconomic shocks in most countries, which have apparently also had a strong impact on the stock markets (judging from the high correlations between national indices in that period).

However, since the establishment of the European Central Bank (ECB) in 1999 and the introduction of the euro, there have been few macroeconomic shocks.

The fiscal policies were already synchronized to the European norms in the 1990s, and after its installation, the ECB has kept the inflation rates at a consistently low level, without much fluctuation among the European interest rates.  In the absence of strong macroeconomic shocks, the European stock markets have possibly become less influenced by EU-wide macroeconomic shocks, and relatively more influenced by their domestic idiosyncratic shocks.

Although financial market integration in the EMU has accelerated in the last subperiod, higher financial integration in itself does not necessarily result in higher correlations.  Financial integration merely opens the channels through which international (EU-wide) shocks are transmitted, but in itself it does not amplify correlation levels.  After all, in a completely integrated market, returns on different assets may be divided into a common component and an idiosyncratic one.  In the absence of strong European shocks, the existence of the idiosyncratic component may be sufficient as to render ex post correlations rather low.

Alternatively, cross-country variation in investor sentiment drives a wedge between the return of firms that are in the same sector but located in different countries.  This indicates that differences in institutions across countries affect the transmission of global shocks to asset values.  Differences in interest sensitivity of aggregate demand (due to, for example, heterogeneous industrial structures) and the importance of the ‘credit channel’ (differences in the structure of the banking system, business firms’ reliance on bank loans, and financial stability) are potential determinants of the country-specific economic effect of global shocks (Mihov 2001). As such, even if a common monetary policy is carried out, as long the transmission of monetary policy to economic activity remains different among EMU countries, business cycles may not synchronize and correlations among EMU country indices may remain low.

Thirdly, the literature that predicts the waning of country factors is based on the assumption that the monetary and financial integration brings a convergence of risk-free rates and of risk premia which implies that stocks will have a tendency to be priced closer together.  However, although the pricing components of equity returns have indeed converged, the objects being priced might have changed over time, introducing increasing divergence in country returns.  In particular, if a country’s industrial structure becomes more specialized, the fundamentals of country indices become increasingly dissimilar leading to less synchronized returns (Adjaoute and Danthine 2004).

Fourth, as is argued by Beckers et al (1992), low correlations between different stock markets may be perfectly consistent with complete market integration.  Different industries may play a crucial role in each market: pharmaceuticals in Switzerland, oil in the United Kingdom, or forestry and paper in Finland.  Stocks within a given industry may be similarly impacted by global events: oil companies around the world in general should react in a similar way to changes in oil prices or the invasion in Iraq; financial institutions may broadly be affected in the same way by the overall level of interest rates regardless of the EMU country they are situated in; textile companies may react similarly to GATT decisions on production and import quotas.  Thus, the evolution of the correlation between two indices could be caused either by the industry or the country factors of each index return.

Random shocks that selectively affect different industries would therefore naturally lead to low correlations among nations when particular industries are more present in one country than another.  It is, for example, well known that particularly the information technology (IT) sector was severely hit by the market crash in the period after 2001.  It might be that companies from the IT sector are more heavily represented in the market index of some countries (for example Nokia in Finland has a weight of 64 percent in the market index).  As a result, the returns of the national indices diverge more from other countries when these particular sectors show strong fluctuations. Of course, that would also have implied that correlations should have been lower in the previous subperiod when the IT sector was experiencing extraordinary positive returns. But, assuming that industry effects have become more important than country effects in the recent years (as is suggested by much of the contemporary literature on this topic,[1] the combination of the increased importance of the sector effects and the recent collapse of the IT bubble can give a plausible explanation for the decrease in cross-country correlations.


Investments from the asset management industry constitute a very significant portion of the total investments that go into national stock markets.  As such, they are an important source of financing for large companies that attempt to finance their investment projects through their national stock markets.  A substantial decrease in the investment flows of the asset management industry in the European continent can thus have grave consequences for not only the national stock markets but for the vitality and functioning of the European economies as a whole.  Asset management firms base their decisions for their investment flows on the basis of modern portfolio theory, which stresses the importance of low correlations in the portfolio selection process.  The lower the correlation among stock markets, the more a portfolio manager can reduce the total risk of the portfolio and thus the higher the incentive to diversify the portfolio by investing in these stock markets.

The problem that has been identified is the fact that the economic and financial integration of European markets has the potential of having increased cross-country correlations through a number of mechanisms, making it relatively less attractive for portfolio managers to diversify their portfolios by spreading investments over the various European stock markets.  However, as we have seen, higher levels of market integration are neither a necessary nor sufficient condition for higher cross-country correlations.  This paper therefore takes a practical approach and directly examines the development of the correlation structure between country indices during the process of monetary and economic integration in the EMU.  The main empirical finding is that correlations among country indices have increased considerably during the period of closer economic cooperation and integration starting from 1979 until 1999.  However, the study also finds that after 1999, intra-country correlations have decreased substantially and that consequently, a geographic diversification strategy is optimal for most investors even after the introduction of the euro.

Unfortunately, it is difficult to say whether the upswing in dispersion and the recent phenomenon of lower correlations among EMU countries is a temporary, permanent, or cyclical event.  Unless the recent decrease in correlations is a permanent and continuing phenomenon, the contemporary plunge in the euro era in itself does not bring the correlations back to the levels experienced in the era before the process of integration in Europe started.  This means that diversification benefits for mean-variance optimizing investors are not as substantial as they used to be, and a case can indeed be made for the restructuring of the asset allocation grids of portfolio management firms on an industry rather than a country basis. Also, asset management firms would increasingly be tempted to move away part of their portfolio from some of the European indices and look for better diversification opportunities at stock market indices in other regions of the world where cross-country correlations have not yet reached similar high levels. Interestingly enough, however, this study also finds that the smaller European markets, thanks to their low liquidity and small market size, are still subject to low cross-correlations compared to the rest of the EMU countries.  As a result, instead of being unfavorably affected by the process of monetary integration, the smaller EMU stock markets may in fact have become increasingly attractive as international diversification options.  The increased appeal of these small stock markets for the asset management industry can, in the long-term, result in an increase in the size and liquidity of these small markets as portfolio managers seek their refuge in these markets for portfolio diversification purposes.  Hence, the process of monetary and financial integration in the EMU can substantially affect the size and liquidity of worldwide stock markets even beyond the increased cross-country correlation levels observed in this study.   As such, dealing with the distortion of financial market structures is one of the many responsibilities the European Union will have to undertake as a result of its pursuit of great power ambition and the pioneering policies associated with it.

Appendix I