Morgan Stanley: Rise and Fall of Euroland Home Bias

In a follow-up to an analysis of Morgan Stanley's hypothesis behind the euro's overvaluation, Stephen Jen highlights two opposing forces that dictate the extent of Euroland's financial home bias, in Morgan Stanley's latest Global Economic Forum:

On the one hand, Euroland’s financial ‘home bias’ should increase over time because of the enhanced liquidity and depth of the EUR capital markets. On the other hand, gradual economic and financial convergence within Euroland will eventually erode the benefits of intra-EMU diversification and force European institutional investors to allocate more assets outside the EMU. So far, the first force has dominated. But we expect the second force to eventually kick in and lead to a reduction in the EMU’s financial ‘home bias’.

As for the first factor, once the euro was introduced, the liquidity conditions of most assets in Europe "improved exponentially", and hence the higher the home bias, the greater the benefits that could be reaped. But as for the second and opposing force - the cost of not diversifying out of the EMU - Jen remarks that the pace of economic and financial convergence was slower than than that of the growing asset market liquidity, although the convergence should accelerate over time. This theory would suggest a surge in the home bias in the initial years of the euro, followed by a decline as EMU economies fell into sync with each other.

And indeed Jen reports that Europe's bond market has shown dramatic improvement in its liquidity, with a deepening EUR bond market. The bills market and money market showed similar improvement. As for the equity markets, these two have shown increasing convergence:

For example, the correlation between the markets in France and Germany rose from 0.66 in the 1980s, to 0.83 in the 1990s, and 0.93 in the last decade. Similarly, such correlations have broadly risen across most European countries, and the trend has accelerated further since the introduction of the EMU.

This implies that, all else equal, the benefits of diversification within the EMU are declining (or the benefits of diversifying out of the EMU are rising), as the EMU markets no longer offer uncorrelated returns. At some point, we think the positive liquidity effect, which argues for a higher financial ‘home bias’, will become saturated, and the negative diversification effect will lead to some decline in financial ‘home bias’.

As Jen remarks in his conclusion, such a decline will remove what has been an important support for the EUR in recent years.