Ebook Does the introduction of the euro affect the debt-equity choice?
The introduction of the common European currency — the euro — on the 1st of January 1999 was an important step by the European community. Well before that, in 1990 the European Commission (European Commission (1990)) discussed the benefits of the euro introduction. Among other benefits it was argued that the introduction of the euro may cause a decrease in the risk premium on capital, which could lead to more investment due to the increase in positive net present value projects and hence to a higher growth level of the economy. In the present paper we study the companies’ security issue choices to detect the probable decrease in cost of capital due to the introduction of the common currency.
The elimination of exchange rate risk between the countries in the European Monetary Union (EMU) is a key factor spurring the integration of the twelve national financial markets. A larger pool of euro-denominated funds (increased competition between providers of capital), wider risk sharing and better diversification opportunities for capital allocation became available. A report by Baele, Ferrando, Hördahl, Krylova, and Monnet (2004) from the European Central Bank confirms that the home-country bias of European institutional investor portfolios has decreased substantially in the last few years after the introduction of the euro. At the same time the continent-wide diversification of portfolios caused the higher co-movement of stock returns. The study above reports evidence that the explanatory power of common economic news in European stock return variance has increased from 20% to 40% in the post-Euro period. By contrast, the integration of the European bank credit markets has been slow according to Baele, Ferrando, Hördahl, Krylova, and Monnet (2004). Rajan and Zingales (2003) show that the bond issues to GDP have increased within EMU countries compared to others after the introduction of the common currency. Hence, we observe the deepening of the financial markets.
The benefits of the introduction of the euro has been studied in a couple of recent empirical papers. Bris, Koskinen, and Nilsson (2005) has found an positive effect on corporate investments. They detect the positive effect of the euro on investment for firms from countries with previously weak currencies as well as for financially constrained firms. This confirms the prediction of the European Commission (1990) claiming that the small open and less developed economies have the most to gain from the introduction of the common currency. Bris, Koskinen, and Nilsson (2003) detect a positive effect of the euro introduction on firms valuations (Tobin’s Q) for firms from countries with previously weak currencies. Hence, both papers by Bris, Koskinen, and Nilsson detect that the introduction of the euro has had a positive effect on firms.
Our study complements the existing literature by looking at the capital structure of the firm. We combine the capital structure literature with the finance and growth literature. We study the equity and debt issues before and after 1999 across firms from EMU and non-EMU countries. To identify the effect of the introduction of the euro due to the decrease in the cost of financing we control for the external finance dependence (EFD) of the firm’s industry in our analysis. The firms from industries with higher EFD are the ones to benefit the most from the decrease in the cost of finance.
There are empirical studies in the literature dealing with financial development and economic growth. For example, Rajan and Zingales (1998) report that industries relying relatively more on external finance have higher growth rates in countries with more developed financial markets. The authors argue that the lower cost of external finance provides a channel through which the financial market development facilitates growth. Accordingly, if we observe an exogenous reduction in the cost of issuing equity and debt for the Euro area firms after 1999 we should find the Eurozone firms from industries with higher EFD issue more debt and equity after 1999 compared to companies from other countries. We also study whether the introduction of the euro affects more equity than debt issues.
The analyses in this paper are based on firm-level data from Amadeus database provided by Bureau Van Dijk. The analysis focuses on firms from 14 Western European countries, among which 10 belong to EMU. The time period covered in this study is 1995-2002. Our firm-level panel data study is a methodological improvement in the finance and growth literature. The estimation methodology follows Hovakimian, Opler, and Titman (2001), where we control for the introduction of the euro in the security issue choice regression.
We find that Eurozone firms from higher external finance dependent industries do issue more equity compared to other firms but we do not find that they would issue more debt after 1999. When we compare the firms issuing equity versus firms issuing debt we find that Euro area firms from industries with higher EFD are more likely to issue equity than debt. Hence, the introduction of the euro (the financial market integration) does reduce costs of financing and in particular make the equity finance more appealing. This result gives an extra motivation for the new EU member countries to adopt the euro. The firms from Eastern Europe rely much less on external finance compared to Western European firms (J˜oeveer (2006)) indicating that changes in the cost of finance could change the firms financial structures substantially. Our paper makes a contribution to the capital structure literature as well by confirming the mean reverting behavior of leverage — over-leveraged firms are less likely to issue debt and more likely to not issue any securities or to issue equity.
This paper is organized as follows: in the next section, we explain our working hypothesis and the empirical estimation methodology. The data section follows. In section 4 we presents the results. Finally, we conclude in section 5.
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