Julian Callow

3 JULY 2007

  Q44  Chairman: Good morning, Mr Callow. Thank you very much for coming. Can I just say that this session is on the record, which means it is being recorded for webcast; therefore, could you use the microphone. Witnesses do get a transcript of all that is said during the session. How would you like to start; do you want to make a general statement or shall we start with the questions?

  Mr Callow: I am happy to pursue in whatever manner you are happy with; thank you.

  Q45Chairman: There is a list of questions but we hope this is going to be a fairly wide discussion and people will come in on questions, and stray, no doubt, from the subject matter. If I may start; really we are interested in the effect of the introduction of the euro on the functioning of European capital markets. This is factual: what has happened? The evidence we have received so far suggests that debt markets have integrated much more quickly than equity markets. Do you believe that is the case, and, if so, why?

  Mr Callow: I think certainly it is true to say that there has been a tremendous expansion of the euro area debt markets. If we consider, for example, the outstanding quantity of euro-denominated fixed-income securities, in the first quarter of 1999 this was €6.4 trillion, whereas by the fourth quarter of 2006 it was €11.7 trillion. The bulk of that has been issued by euro area issuers, and in terms of the outstanding global stock of debt securities those denominated in euro now account for about 27% of the total. That is up from 22% in 1999 and it compares with a figure of 43% for those denominated in dollars and 14% denominated in yen, so you can see that there has been a very substantial expansion in the euro area debt markets. Of course I think it must be stated that equally there has been tremendous change in the European equity markets. For example, if we consider the 36 biggest companies which constitute the main stock market index for France, which is referred to as the CAC 40, then the actual proportion of those equities which were held by foreigners last year was 46%, up slightly from 45% in 2005. For example, another interesting statistic, I think, is that in Italy, if we consider the entire proportion of the equity market held by foreigners of listed companies then last year this ratio was 17.5% of the outstanding equity stock, up from 15.5% in 2005, it would seem to me that there has been a substantial degree of integration in equity markets. You were asking why the fixed-income integration has been seen perhaps to be pursuing at a more rapid pace. I think that is partly to do with the nature of the fixed-income markets themselves. Obviously, you do not need to have a particular understanding of individual companies to be investing in fixed-income markets, if they are issued by the public sector, for example; so in a way the market can be considered a little simpler. As well you have had, I think, a long culture in continental Europe of focusing more on what we can call the credit markets, the fixed-income markets, for financing the economy, as opposed to the equity culture, which obviously is much more prevalent in the United Kingdom and in the United States. I think there could be some historic and cultural reasons why we might be seeing some differentiation here, but certainly I would suggest also that, in terms of how the equity markets have been transformed in the last ten years, the transformation I would say really is quite similar in scale to what we have been seeing in the fixed-income capital markets.

  Q46  Chairman: The proportions you give for the equity markets, the CAC 40 held 46% by foreigners, are foreigners anybody who is not French or anybody who is not euro zone?

  Mr Callow: Anyone not French.

  Q47  Chairman: The Italian proportion, I have reason to know, being a Director of the London Stock Exchange, is quite low?

  Mr Callow: Yes. I think obviously this will reflect local conditions, in particular, as I am sure you are aware, My Lord Chairman, that we find differences in the standards of corporate governance which apply in different countries in Europe. The standards, for example, for issuing a fixed-income security will be very similar, whoever you are, wherever you are from, in terms of disclosure of information, and so on. I think, historically, it has been the case that we have had quite substantial differences in the level of regulation, for example, in ownership restrictions. It is an interesting fact, as well, I think, that if we consider ownership concentration then this tends to be much heavier among continental European equity markets than it does in the case of the United States or the United Kingdom; in other words, the proportion of outstanding equity that is held by one individual, for example. Again, here is some evidence perhaps to suggest that things have been different but, there again, they are changing, and I think the euro is certainly part of this and the focus on having very integrated capital markets. I think many international investors would say that there has been a tremendous transformation in the standards of corporate governance that apply to European companies as a whole, in terms of their accountability to shareholders, their level of transparency that they present to investors and their general focus on profitability also.

  Q48  Chairman: The point you are making, if I make a shot at paraphrasing it, is that it is always a matter of loss and debt and fixed interest, about corporate governance, or how much you know about what you are buying, and of course it matters very much if you are buying equity?

  Mr Callow: That is right; it reflects it.

  Q49  Chairman: You do believe also there has indeed been an increase in people buying equities in each other's countries?

  Mr Callow: Yes; without doubt that has been very important. With equities, as I say, really you need to have a lot more information, because you are investing in a specific company and obviously you need to understand its products and its strategy and its balance-sheet. For investing in fixed-income securities, you are investing in something which has a credit rating, and I think, in a way, the investment decision is a little easier, for one thing, which can make it easier for institutions to be investing across borders in fixed-income securities. If we look at who the investors are, they tend to be large institutions, mutual funds and pension funds, typically, for example, and again they have got this background of being very much inclined to be investing in fixed-income securities in Europe. In a way, this reflects the fact that many European countries historically have had very high levels of government debt so there has not been a lot of alternative.

  Q50  Chairman: In all of this inquiry, the trick is, what all of it is trying to do is strip out the euro effect, the effect of increased trade, people knowing more about each other. Would you suggest that there was a great deal of euro effect in this, that we are all buying fixed-interest and bonds, and so on, because it is in the same currency, because it is an easier currency?

  Mr Callow: Yes. I think that must be true, really, and you can see some evidence for that in terms of the very sharp compression of margin in the yields that you obtain if you invest in government bonds. Obviously, when we had monetary union there was a tremendous yield compression here and at the current stage, if you invest in an Italian bond, for example, or a Spanish bond, you are getting only a very small margin, a few basis points, as we would say in the markets, over what you would have if you invested in a German bond. That was made possible by monetary union, and in turn that has promoted liquidity in the financial markets. I think, as a precondition of EMU, we must not forget a vital precondition was the abolition of capital controls within Europe. That could have happened perhaps without EMU, but without doubt EMU required that to be brought about, and in turn that accelerated the process, and that is fundamentally very important for this particular topic. Lastly, I would just mention how EMU has really concentrated investors' minds. For example, if you are a central bank based in Asia and you wish to invest in government securities, I think you will have much greater confidence in investing in, for example, Italian government securities, knowing that Italy is part of EMU. I think the process of monetary union has been such as to cause investors to treat the European capital markets much more as one and to look for differences between them, rather than perhaps just investing in, say, Germany and forgetting what is happening in Italy because it was too complicated to establish. I think EMU has also been substantially accelerating the integration of the markets themselves, clearly, for reasons to which I alluded, also in terms of raising best practice for issuance, for example, and for transparency and fixed income as well as for equity.

  Q51  Lord Blackwell: Mr Callow, putting sovereign debt to one side for a moment, could you comment more on what benefits you think may have come about from the deepening of this euro bond market, both from the debt issues and the capital markets? You could argue that companies have always been able to issue debt and if they wanted to remove the counter risk there is a big dollar bond market. The capital markets happily trade whatever bonds are being issued, in whatever currencies, so the fact that bonds denominated in euros have grown, how do you argue that has any economic benefit?

  Mr Callow: I must confess, in preparing for this hearing, I obtained some information from a European Central Bank report, and this was actually considering the proportion of debt liabilities, that is loans and debt securities, which is accounted for by debt securities only; this is the ECB Occasional Paper No.63, which was published in June of this year. For 1999, a table on page 17 gives us a ratio of 8.7% for debt securities as a proportion of debt liabilities, rising to 10.8% in 2005, so an increase of roughly two percentage points, in other words, the share of loans as a proportion of interest rate liabilities is still nearly 90%. That is the euro area. If we compare the situation in the UK in 1999, the ratio of debt securities, on the same basis, in the same table, is 25.3%, rising to 26.5% in 2005. In the United States, the ratio in 1999 was 41.1%, in other words, the actual loan proportion was 58.9% then, and the debt security ratio in 2005 actually fell slightly to 39.3%. What I am trying to show you here is that there has been some increase in the debt securities as a proportion of the non-financial corporate sector's balance-sheet; nonetheless, the overall ratio is still actually quite low.

  Q52  Lord Blackwell: It is mirrored in an increase equally in sterling and dollars, is it?

  Mr Callow: If I may say so, the dollar share actually fell slightly, from 41% in 1999 to 39% in 2005, and in sterling the increase was a little over one percentage point; so, yes, it is only a small degree of evidence. I think where we have seen much greater issuance, however, has been in the financial sector, which is, in particular, obviously, the banking sector but also non-bank financial institutions, which have really accounted for over 90% of the growth in the issuance in euro-denominated debt securities that I referred to at the start of my comments. Clearly, those institutions therefore have done so, in terms of issuing euro-denominated, for the reason that they can actually diversify their funding base and obtain capital more cheaply. I think there is clearly substantial room for improvement here, certainly it seems to me that there is quite a long way to go in terms of the financing of the non-financial corporate sector, which was the figures I was just referring to in response to your question, for the Euro Area. Nonetheless, still, for me, I think it is true to say that in my experience the euro has acted as a kind of focal point which has enabled some growth in these markets.

  Q53  Lord Inglewood: Forgive me, if I might, just to go back right to the start of your remarks, there was something which I think I just did not hear quite clearly; which was, first, in response to the Chairman's questions, you explained that the amount of fixed-interest debt had gone up from, I think it was, 2001 to 2005. Then you referred to the amount of equities in the French premier league, if I can put it that way, which were owned by those outside France and how that had increased. What I am not clear about is the timeframe over the increase you described; was it from 2001 to 2005, or what to 2005?

  Mr Callow: One of the issues obviously is retaining information from different sources. I have to say, from my own perspective, related to the work I do, it is considerably easier to obtain information on the fixed-income markets than on the equity markets, but nonetheless I wanted to give some observations. For the equity markets, all the figures I mentioned related to the end of last year and comparisons with the end of 2005.

  Q54  Lord Inglewood: That is a year, is it not?

  Mr Callow: It is only a year. I think we would find that, had I dug down and got the information—- -

  Q55  Lord Inglewood: What I was really pushing towards was the rate of increase over that year; is that, in your judgment, a rate of increase that if you went back to, say, 2001, probably you have seen that, roughly, year on year?

  Mr Callow: I think we would be seeing a similar rate of increase, if we were to go back to, particularly, for example, 1997, before EMU had got going. I mention that simply because in my career I have been focusing on the European economy since about 1990 and I was very conscious, in the mid and the later part of the 1990s, that there was a tremendous explosion of interest among investors in the European equity market. I think that would correspond with a substantial degree of increase in the foreign ownership; so I agree with your comment, yes. Just as a point of clarification, the figures I gave initially, the initial figure of €6.4 trillion of euro-denominated debt outstanding, this refers to the first quarter of 1999.

  Q56  Lord Kerr of Kinlochard: Thinking of fixed-income instruments, can you give us a feel for how the geographical distribution of the markets has changed in the last eight years? I am thinking both of issuance and of trading. Which markets have grown more than others?

  Mr Callow: Really I can only give you figures based a little bit on my own perception for this, but I think clearly it was the case that before monetary union began the debt markets in general across Europe were relatively fragmented, in other words, if you wanted to issue debt you would probably be very much inclined to be using a bank from your local country. I think what EMU did was a revolution for the capital markets, of which obviously London has been a very important beneficiary, because it meant that expertise was no longer confined to just one country. What you have seen, if we take the last ten years here, I think, has been a consolidation of the ways in which bonds are being issued, a much greater degree of specialisation, which has been particularly centred out of London in this respect, and therefore a much greater degree of internationalisation in terms of the financial institutions which are arranging the debt issuance. I am afraid I do not have on me precise information about the share of London in terms of Euro Area debt issuance, but what I think is very true is that, if we compare the situation as we have it today, where we have, of course, many American firms and some British firms as well which have a very important position in terms of issuing euro-denominated debt, including of course my own bank, we can see that this is something which was coming about as a result of the creation of the single currency and the unified capital markets in Europe. I hope that goes some way to answering your question.

  Q57  Lord Kerr of Kinlochard: I would be right to conclude that, although all have gained, some have gained more than others and London is one of those?

  Mr Callow: I think that would be the view of many people in the financial markets, including myself, yes. If we consider London as a financial centre and think back to a kind of discussion we might have had in 1998, when we were also conscious of Frankfurt as a financial centre, or Paris as a financial centre, and think to where we are now, in a way you could say that monetary union has been, I think, very important for London, but in a way this has helped to spur London on to being a truly global financial centre.

  Q58  Lord Kerr of Kinlochard: Can I ask what barriers to further integration of these markets you think still exist?

  Mr Callow: In the fixed-income markets, I do not consider that there are particularly substantial barriers operating within the markets. There are differences in the settlement procedures of securities and this is something which the European Central Bank is seeking to examine and to change, with its so-called Target2 initiative, but in general I think the fixed-income barriers are really not substantial. In terms of equity markets, I think we find that there are clearly different stock exchanges, they have, to a degree, different rules, there is obviously an attempt to be moving towards harmonisation, but it would seem that the equity markets, I think, again, for historic reasons and also because they are focused of course on retail as well as institutional investors, have a greater degree of harmonisation still to be seen. I think the most important distinction though is that we do have still differences in regulation across Europe; really we have one Central Bank but we do not have one regulator. That means, therefore, a tremendous panoply of different regulations, which, particularly in terms of integration in the financial sector more generally, with banking and with insurance, certainly can be a complicating factor. Even this is beginning to change in some respects but, nonetheless, that is perhaps where, in terms of the financial markets, I think we see the most significant barriers to integration at the current stage.

  Q59  Chairman: There has been a most useful discussion. Do you feel that the ECB's monetary policy has been too restrictive? Do you feel the policy of an upper inflation limit rather than a symmetrical target contributes to this; and should ECOFIN or the Eurogroup have the power to set the inflation target? How is this going, from a banker's point of view?

  Mr Callow: This is very much on my home turf, so I am delighted to be able to comment on it. Of course the European Central Bank was created in June 1998. Let us take the average level of the Harmonised Index of Consumer Prices for the Euro Area which was prevailing in 1998 and consider its change up until 2006. The annualised rate of change in this HICP, the key price index for the European Central Bank, during the eight-year period, was 2.05%. The Governing Council of the European Central Bank has said that it considers an inflation rate of "below but close to 2%" for HICP inflation to be an appropriate definition of price stability. We can consider, therefore, if the policy has been restrictive by reference to the outcome, and the outcome, as I say, over the last eight years, has been an average annualised inflation rate of 2.05%, which is narrowly higher than the objective which the European Central Bank has set itself. On that definition, of looking at the outcome, one might argue that the policy has been slightly on the loose or the accommodative side. There are other ways we can consider restrictiveness. We can consider the so-called real interest rate, where we take the ECB's actual interest rate, which is called the refi rate, and subtract the inflation rate from that; this real interest rate, since EMU began, in 1999, has averaged 80 basis points, that is, 0.8 percentage points. That is actually considerably below what most estimates of a neutral interest rate by economists would be, which tend to be around 2% for the real interest rate. Again, if we consider the actual historic real interest rate, compared with what we might consider the neutral real interest rate to be, it has been around 0.8 percentage points and the neutral real interest rate, in many economists' opinion, would be considered to be around two percentage points. Again, on this basis, policy cannot be considered to have been restrictive. Finally, if we were to consider the policy with respect to the growth of nominal income in the economy, what economists call nominal GDP, the ECB's refi rate has been, on average, one full percentage point below the rate of nominal GDP expansion in the Euro Area, which again constitutes a loose policy. If you consider the experience of the Bank of England over that period, since 1999, the Bank of England's repo rate, its key policy rate, averaged about half a percentage point below nominal GDP expansion. On all of these three measures I would argue that ECB's monetary policy has not been restrictive but rather on the accommodative side; we see this as well in the tremendous inflation of asset prices which has prevailed since the ECB was created in 1998. In terms of an upper inflation limit rather than a symmetrical target, yes, I agree, I think it is preferable to be having a symmetric inflation target. I think the problem that the European Central Bank had was that when it formulated its definition of price stability it did so in 1998 when the headline inflation rate was very low, in fact approaching only 1%. As a result of that, it felt that it could not really set an inflation objective of 2%, even though many of the key central banks forming monetary union previously had adopted a target of 2% inflation. It adopted this rather strange definition of below 2%, which then, in 2003, it redefined to be below but close to 2%; but, I must say, that is quite a mouthful and I think that to say simply around 2% would be understood better by economic agents and therefore would be a preferable definition, with a band around that. I would say also, certainly, in the ECB's favour, that to have achieved inflation of 2.05% over the last eight years is a considerable achievement, because there have been many shocks which generally have been in a positive direction for prices, such as the rises in energy prices and commodity prices and food prices, and German Value Added Tax went up recently, of course, as well, many other charges by the Government, set too in Europe, having gone up sharply too. In this sense, the ECB, I think, has done an extremely good job at keeping inflation almost in line with its self-defined objective. I think, as well, the focus on asset prices is appropriate for the European Central Bank; so we should not consider, I believe, just a pure CPI-based inflation objective but we should consider the longer term and issues concerning financial stability, and, of course, related to that, debt. In terms of whether politicians should have the power to set the inflation target, I think that is a reasonable request, actually. I think we need to have democratic accountability in setting monetary policies. The politicians, of course, set the mandate for the ECB to maintain price stability; that is the primary objective of the ECB in the Maastricht Treaty. They did not define this further. It seems that they might have had in mind something around 2% inflation, but they have never been explicit on this. I think, again, it would help the transparency and the robustness of the monetary policy framework of the Euro Area if we did have the politicians, or a political group, such as ECOFIN, or the Eurogroup, establishing the inflation target. I hope that addresses your questions.