On the Capital Markets Union. A discussion with Economist:
For numerous years, the Capital Markets Union (CMU), now recently rebranded as the Savings and Investments Union, has acted as a crucial element of European discussions. During the latter half of Ursula von der Leyen’s leadership, emphasis on enhancing the CMU to address Europe’s significant investment demands has been elevated, continuing an initiative that has persisted for many years. AK Europa remains highly critical of various proposals and measures within the CMU framework. From AK’s viewpoint, the safeguarding interests of individual retail investors and staff, along with the stability of the financial market, must not be compromised for the benefit of private capital interests.
The journey toward CMU has been intricate thus far. Even though numerous initiatives have been initiated, major structural and regulatory barriers still exist. How can we generate adequate public investment to finance the expenses associated with climate change mitigation and adaptation? What are the risks involved with the Capital Markets Union, and what obstacles hinder its finalization?
AK EUROPA: The Capital Market Union has been a subject of conversation for many years, involving a range of initiatives and projects, some of which are not connected.
The establishment of the Capital Markets Union was initiated by Jean-Claude Juncker’s inaugural speech before the European Parliament more than a decade ago, inspired by the Banking Union initiative of his predecessor. At that time, all 28 member states of the EU operated separate capital markets. The concept was that unifying those capital markets would create a more robust capital market. Thus, it would provide enhanced access to private capital for European businesses, contributing positively to the growth of the European economy.
Since the inception of the CMU, the US capital market has been the benchmark, which is indeed unmatched in its vast depth and capability to allocate substantial amounts of capital to businesses. Several initiatives have been undertaken with the aim of achieving a comparable market capitalization within the EU. From Finance Watch’s viewpoint, while some of those initiatives were sensible, others had limited relevance, and some were even considered ineffective. Specific examples include the simplification of the prospectus regulation for issuers, the encouragement of securitisation through the STS framework, or the establishment of a single tape to provide stock market price information. Additional examples comprise the creation of ELTIFs, European Long-Term Investment Funds, and the pension initiative PEPP, which aims to create, if not unified pensions, at least compatible and portable pension systems throughout the EU.
All of those contentious initiatives were easily accessible, the simplest targets, and it is clear that they did not result in a capital markets union. Why? Firstly, because the Capital Markets Union is concerned with having a single rule for everyone and ensuring a supervisor enforces the rules uniformly across all nations. Currently, we have 27 EU nations with 27 so-called NCAs, or National Competent Authorities, who have varied strategies, who hardly collaborate with one another, and who apply the regulations in a disjointed manner. In addition to this, there are very differing implementations of EU directives. The goal is to have one unified supervisor enforcing the same rule for all.
AK EUROPA: Will you only discuss financial capital market regulations or will you extend beyond that? For instance, insolvency regulations are also frequently referenced in relation to the Capital Markets Union.
Beyond capital market regulations, insolvency regulations, corporate law regulations and tax matters need to be considered as well. These are the three main concerns, in addition to having a single supervisor enforcing harmonized regulations for capital markets. Insolvency regulations are crucial when evaluating the bond market. Clearly, one of the inquiries for a bond investor is what occurs to me as a creditor if the company files for bankruptcy. As long as different insolvency regulations exist, by nature, you cannot maintain the same market for Austrian bonds and for Spanish bonds. Corporate law holds significant importance for equity investors. Generally, corporate law outlines how to conduct your Annual General Meetings, how the board operates, who possesses which authority, whether shareholders can make resolutions, and so on. The third concern is tax law. At present, there are significant inconsistencies within the EU regarding the tax treatment of issuers and corporations. Certain EU nations even leverage tax advantages to draw issuers to their markets. So-called regulatory arbitrage has become a standardized practice among member states, consistently eroding all serious attempts at establishing a Capital Markets Union.
When examining the Draghi report, the Letta report, and the Noyer report, one suggestion that repeatedly arises is the encouragement of private pension funds. Can the current discussions be viewed as a move towards the privatization of the pension system masquerading as the Capital Markets Union?
In addition to capital market regulations, insolvency regulations, corporate law regulations, and tax matters must also be considered. These are the three most significant concerns, in addition to having a unified supervisor enforcing harmonized rules for capital markets. Insolvency regulations are crucial when examining the bond market. Clearly, one of the key questions for a bond investor is what happens to them as a creditor if the company declares bankruptcy. As long as there are varying insolvency regulations, by definition, it is impossible to have a unified market for Austrian bonds and Spanish bonds. Corporate law plays a vital role for equity investors. Generally, corporate law outlines how to arrange Annual General Meetings, the functioning of the board, the distribution of power, whether shareholders can vote on resolutions, and so forth. The third key issue is tax law. Currently, there are significant inconsistencies within the EU regarding the tax treatment of issuers and corporations. Certain EU nations even exploit tax advantages to attract issuers to their markets. This so-called regulatory arbitrage has become a prevalent tactic among member states, consistently undermining all serious initiatives aimed at creating a Capital Markets Union.
While reviewing the Draghi report, the Letta report, and the Noyer report, a recurring suggestion is the encouragement of private pension funds. Can the current discussions be seen as a move toward privatizing the pension system under the pretext of the Capital Markets Union?
From a strictly financial technical perspective, if all pension systems invested their pension funds into capital markets, there would be a vast pool of capital accessible for companies. However, pensions are fundamentally about people and political decisions. Numerous capitalization-based pension systems are currently facing substantial financial difficulties. Commitments to future pensioners may not be fulfilled due to capital market performance. Beyond technicalities, the political and social consequences are significant. In many nations, labor unions strongly oppose such changes, and they will continue to resist them in the future.
Aside from private pension funds, what other initiatives do you anticipate with the Capital Markets Union, now referred to as the Savings and Investments Union?
At this moment, it is challenging to predict. Discussions have occurred regarding savings accounts for EU citizens that would simplify investments in capital markets. I am not convinced that this will lead to any change. Such a concept has been attempted before, for example in France, and despite the new legal framework, those accounts did not facilitate regular individuals in starting to invest in equity. The tax benefits associated with those equity accounts were primarily utilized by the affluent and privileged who were already investing in equity.
At the close of the day, I think it ultimately boils down to cultural differences. Denmark boasts an equity market capitalization of 190% of GDP, which is similar to the US, whereas Italy's stands around 35%. Those cultural distinctions will be difficult to address through regulation.
In the discussion regarding the CMU, there are proponents calling for a European safe asset. Could you provide more detail on the function of a safe asset and its relation to the CMU?
The discourse around safe assets arises from the prevailing investment approach. There exists a concept known as a risk-free interest rate, along with a credit spread that is added when funds are loaned to a borrower. The risk-free rate pertains to the interest paid by a safe asset, thus an asset deemed to be devoid of risk. Presently in the EU, since the Euro is an incomplete currency, there is no actual safe asset. Technically, when any Eurozone nation borrows in Euro, it is borrowing in a currency it does not have control over, a foreign currency. Contrarily, when the US borrows in dollars, it has control over its currency. Similarly, Japan, the UK, and Switzerland exercise control over their respective currencies as well. When Austria, Belgium, France, Italy, and even Germany borrow in Euro, they are unable to print the money required for repayment. Additionally, there is no centralized budget or common fiscal policy supporting the Euro. A safe asset could exist in the EU that would resemble a T-bond, with the T-bond serving as the US's safe asset. The solution to this is European bonds, which would necessitate resources at the EU level for repayment. This indicates either increased contributions from member states, which would be a challenge, or allocating the EU its own resources, a significantly larger and highly political debate.
The Capital Markets Union is frequently depicted as a vital measure for the future of the EU’s finances. However, your report indicates that even its thorough execution may not meet expectations. Could you clarify your findings?
The discussion began because we noticed numerous prominent EU officials stating that, since we typically have adequate investment capital in the EU, all we needed to do was finalize the Capital Markets Union, and upon its completion, the task would be finished. The fundamental premise for our report was that the Capital Markets Union would be effectively completed, which we know is a long way off. Does this imply that we have resolved the issue, that we have discovered all the funds we need? The outcome of our report ‘Europe’s coming investment crisis’ concludes that in the best-case scenario, only one-third of the required funds can be sourced from capital markets for one straightforward reason: private funds will only be invested if the anticipated return is sufficient to offset the risks evaluated at the time of the investment. No suitable return, no private funding.
Considering we may encounter a considerable gap in total investment, what implications could this have for the EU?
We require funding to establish the essential infrastructure necessary to adapt to climate change, for example, to cope with rising sea levels. The European Environment Agency projects that rising sea levels could cost the EU economy 1 trillion euros annually, translating to 6% of EU GDP. The repercussions of climate change on GDP will be significant. We must invest in infrastructure to shield the EU economy from these dangers. These investments, while critical, will not be financially rewarding as they will not produce cash flows. Therefore, private investments are unlikely to materialize. The alternative would be that in 20 or 30 years, the EU’s GDP would be reduced by 6% solely because of rising sea levels. A year ago, we released a report titled ‘Finance in a hot house world’, which estimated that the detrimental economic effects of climate change could range from 30% to 50% by 2070. This constitutes a disaster, not only from a humanitarian and social perspective but also concerning public funding. We must invest, and the CMU could be part of a solution, but we need to secure the remaining two-thirds of the funds we require from public sources.
You highlight public funding as crucial. How can we activate these public funds?
Our regulations regarding public funds are insufficient today. In our report, we propose three potential technical solutions. We must insist and state that we have no other option. We need to adjust to this rapidly and dramatically changing world. The first technical solution involves amending the Stability and Growth Pact rules, the SGP rules. We understand that it’s a very challenging discussion, but these rules are nonsensical. There’s no scientific basis for them; they simply represent a snapshot of EU financial conditions from 35 years ago. Back then, the EU's average debt stood at 56%, prompting a 60% limit. France had a public deficit of 2. 6%, allowing for a chosen 3% to provide some flexibility. Continuing to adhere to these rules will lead us to a dead end. The second potential solution, and we are very encouraged to see this acknowledged in the Draghi report, is the option of issuing debt at the EU level. This matter is also highly political. Merely three hours after the presentation of the Draghi report, Germany’s Mr. Lindner declared that borrowing money at the EU level was out of the question. The third technical possibility is monetary financing. We recognize that this topic is a significant taboo today.
Why does monetary financing continue to be such a contentious issue in economic debates?
No one, especially not us, asserts that monetary financing is always beneficial in every situation. However, the complete prohibition of monetary financing in the treaties at present is illogical. First, monetary financing is not a new concept. A century ago, when the UK was a dominant force, it relied heavily on monetary financing. The United States has consistently utilized monetary financing, particularly during wartime. Germany also employed monetary financing during the 1980s. Secondly, it is incorrect to claim that monetary financing inherently leads to inflation. Central banks have engaged in substantial money creation over the past 35 years to bolster financial markets. Nevertheless, the inflation we have witnessed over the last 3-4 years is not a monetary occurrence but rather a supply shock stemming from Russia’s war against Ukraine, which has influenced food and energy prices. Lastly, we operate under the assumption that we have capable and trustworthy central bankers equipped to handle robust financial instruments.
We must mature, as we are the sole jurisdiction globally where monetary financing is legally prohibited. Due to the ban on monetary financing of public deficits by central banks in the EU, we have what is referred to as QE, or quantitative easing. Private banks purchase the debt on the primary market and subsequently sell it to the European Central Bank on the secondary market. In effect, this is “monetary financing” with additional steps involved. This method generates vast reserves for private banks, and these reserves receive remuneration. In 2023, the remuneration in the EU totaled 140 billion euros or 1% of EU GDP. Therefore, if we are going to produce money, we might as well do so directly for the public budgets.
How practical is it to advocate for these concepts to finance the substantial investment requirements amid frequently suggested austerity and thrift measures?
The individuals who consider themselves frugal are not necessarily so. I believe that we are the frugal ones who understand that if we don't invest now, we will experience greater losses in the future. If we refrain from action, our deficits will worsen further. Regarding climate change adaptation, there are some intriguing studies indicating that the return on investment for adaptation is approximately one to ten. If you invest one euro today, you will prevent a loss of 10 euros tomorrow. Therefore, who is genuinely frugal? Is it the person who refuses to invest a euro today, or the one who aims to save 10 euros for tomorrow?
