Euro will shake up the Continent more than the UK. Myth or fact?

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The Independent Online
Many myths achieve the status of hallowed facts when they have been repeated often enough, and few are more hallowed than those concerning national economic performance.

Take the notion that there are two distinct varieties of capitalism - the market-loving, equity-financed Anglo-Saxon variety and the corporatist, bank-financed Rhineland version. It's a neat contrast. But it isn't true in at least one key respect. German and French companies do not, as a group, finance their investment through loans from supportive banks keen to establish a long-term relationship with them. Nor do US and UK companies in the aggregate raise funds for investment from the stock market. Indeed, British firms raise more net finance than German ones via bank debt.

On the other hand, there are tremendous national differences in how well companies perform in terms of profitability or return on capital: those short-termist Anglo-Saxons do significantly better than the Germans or Japanese. Investment in Britain has been far more worthwhile for at least the past six years. This in turn explains the much bigger stock market gains in the US and UK over that period, even if the listed companies do not actually raise much of their net finance from issuing equities.

These facts - the real ones, as opposed to the myths - are presented in a fascinating paper written for Merrill Lynch by David Miles, Professor of Economics at Imperial College, London. They raise the prospect that the big adjustment to the single currency when Britain eventually joins will have to be made, not by a laggardly UK economy, but by badly performing German and French companies. And, if there is an adjustment, it could give a big one-off boost to the continental stock markets.

Back to the figures first of all. Measured by market capitalisation, the UK makes up a higher proportion of the value of Europe's top 500 companies than any other country, with 31 per cent. By balance-sheet value of assets, it has 22 per cent, just ahead of Germany and France. Drugs companies, banks, utilities, insurers and oil and gas producers are among the biggest companies. So it is groups such as Glaxo Wellcome and BP, SmithKline Beecham and BT, along with two Anglo-Dutch companies, Shell and Unilever, that make up the biggest elements of Britain's corporate might.

Looking at the corporate sector as a whole in each country, there is no evidence of any significant difference in how net new finance for investment is raised. German companies actually have the lowest share of debt to market capitalisation in Europe, and it is not significantly different from gearing in the UK, according to the statistical tests. Germany's big corporate bond market, which dwarfs the UK's, consists 99 per cent of asset-backed securities issued by banks. Bonds and bank loans are an insignificant source of funds outside the financial sector.

The reason the differences in equity versus bond financing turn out to be insignificant is that in all countries the corporate sector uses internal funds, retained profits, to fund investment. Internal finance is hugely dominant. In the aggregate, funds raised externally are matched more or less by the acquisition of financial assets, although of course some individual companies raise external funds and different companies acquire the assets. These flows are what is mediated by the bond and equity markets and the banks.

So, over the years 1970-94, bank finance accounted for 11.9 per cent of the net funds raised by Germany's corporate sector, just higher than the 11.1 per cent in the US, but lower than the 14.6 per cent in the UK. Japanese firms did raise more this way, at 26.7 per cent of total net finance. Both corporate Germany and Japan raise small amounts via equities, but corporate Britain and America repaid share capital to a small extent. German firms made net repayments of corporate bonds. Only in the US did net bond financing amount to anything noticeable, at 15.4 per cent of the total - presumably thanks to the junk bond era. The patterns have altered slightly in the 1990s. British companies have raised net equity financing and seen a fall in the share of funds internally generated. Bond financing has dropped off in the US, and bank financing in Japan, with the slack taken up by internal funds. But the overall picture remains a reality conforming not at all to stereotype.

If countries are alike in how they raise new finance, mainly by retaining profits, they differ in the use to which they put that capital. Professor Miles finds that on any measure of performance the Rhineland capitalists are the dullards. Whether measured by earnings yield or return on assets, British companies have performed best since 1991, along with the Dutch, Irish and Swedish corporate sectors. Germany, France, Belgium and Austria have competed for bottom place. The return on assets in the UK, at 8.23 per cent from 1991-96, was more than twice France's 4.03 per cent, and much better too than Germany's 5.84 per cent. The difference might well reflect industrial structure, with Britain having more companies in the best-performing sectors such as utilities, retailing, leisure and drugs, and fewer in weaker performers such as cars and aerospace. If true, this explanation sheds an interesting light on the sale to foreigners of the British car industry.

What does this myth-demolition imply for the future? The launch of the single currency is likely to trigger some significant restructuring, and the assumption has always been that because Britain is so different from the continental economies, Britain would have to adjust most. But it might be that the introduction of the euro, and a genuine single market, delivers more of a jolt to France and Germany. For example, the powerful home-country bias in equity investment by the big institutions will diminish, and funds will make allocations based on sector or company comparisons but not on a national basis. The pressure will be for the worse-performing companies to buck up their act. The German and French and Belgian corporate sectors might tend to become more profitable.

According to the paper, there will be a separate and enormous boost to the German stock market. At present, company pension funds are heavily invested in their own company, but they will increasingly diversify to invest in other companies. It makes no sense anyway for workers' pensions to be mainly invested in the company for which they work, putting all their financial eggs in the one basket.

The idea of portfolio diversification is likely to catch on generally with continental funds. German companies will therefore lose an internal source of funds and will have to fill the gap externally, which could represent a huge boost to the stock market.

Thirdly, transactions costs in Europe's stock markets will probably converge on the cheapest - London's - under the euro. Other markets could see a fall of 10 to 25 per cent in dealing spreads.

What it all adds up to is a boost for activity and share prices on the continental bourses during the first years of the single currency as the rest of Europe tries to catch up to Britain's secret corporate success. Only a hardened Euro-phobe would see this as another reason for the UK to stay outside the single currency, though; you can only keep ahead if you stay in the race.

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