capital integration, financial markets and the euro

© Baldwin&Wyplosz The Economics of European Integration

Capital integration, Financial Marketsand the Euro


The Maastricht treaty

• A firm commitment to launch the single

currency by January 1999 at the latest

• A list of five criteria for admission to the

monetary union

• A precise specification of central banking

institutions

• Additional conditions mentioned (e.g. the

excessive deficit procedure)


The Maastricht convergence criteria

• Inflation– Not to exceed by more than 1.5% the average of the

three lowest rates among EU countries

• Long-term interest rate– Not to exceed by more than 2% the average interest rate

in the three lowest inflation countries

• ERM membership– At least two years in ERM without being forced to

devalue

• Budget deficit– Deficit less than 3% of GDP

• Public debt– Debt less than 60% of GDP

• NB: observed on 1997 performance for decision in 1998


Interpretation of the convergence criteria: inflation

• Straightforward fear of allowing in unrepentant inflation-prone countries

0.00

5.00

10.00

1991 1992 1993 1994 1995 1996 1997 1998

France Italy

Spain Germany

Belgium PortugalGreece average of three lowest + 1.5%


Interpretation of the convergence criteria: long-term interest rate

• A little bit too easy to bring inflation down in 1997 – artificially or not – and then let go again

• Long interest rates incorporate bond markets expectations of long term inflation

• So criterion requires convincing markets• Problem: self-fulfilling prophecy

– If markets believe admission to euro area, they expect low inflation and long term interest rate is low, which fulfils the admission criterion

– Conversely, if …


Interpretation of the convergence criteria:

• Same logic as the long-term interest rate: need to convince the exchange markets

• Same aspect of self-fulfilling prophecy


Interpretation of the convergence criteria: budget deficit and debt (1)

• Historically, all big inflation episodes born out of runaway public deficits and debts

• Hence requirement that house is put in order before admission

• How are the ceilings chosen?– Deficit: the German golden rule– Debt: the 1991 EU average


Interpretation of the convergence criteria: budget deficit and debt

• Problem No.1: a few years of budgetary discipline do not guarantee long-term discipline– The excessive deficit procedure will look to

that once in euro area, more later

• Problem No.2: articifial ceilings


The debt and deficit criteria in 1997Maastricht fiscal criteria 1997

0

20

40

60

80

100

120

-3 -2 -1 0 1 2 3 4 5

Deficit (% GDP)

Pu

bli

c D

ebt

(%G

DP

)


A tour of the acronyms

• N countries with N National Central Banks (NCBs) that continue operating but with no monetary policy function

• A new central bank at the centre: the European Central Bank (ECB)

• The European System of Central Banks (ESCB): the ECB and all EU NCBs (N=15)

• The Eurosystem: the ECB and the NCBs of euro area member countries (N=12)


How does the Eurosystem operates?

• Objectives– What it is trying to achieve?

• Instruments– What are the means available?

• Strategy– How is the system formulating its actions?


The two-pillar strategy

• The monthly Eurosystem’s interest rate decisions (every month) rests on two pillars:

• Economic analysis– Broad review of economic conditions

• Growth, employment, exchange rates, abroad

• Monetary analysis– Evolution of monetary aggregates (M3,

etc.)


Comparison with other strategies

• The US Fed– Legally required to achieve both price

stability and a high level of employment

– Does not articulate an explicit strategy

• Inflation-targeting central banks (Czech Republic, Poland, Sweden, UK, etc.)– Announce a target (e.g. 2.5% in the UK), a

margin (e.g. ±1%) and a horizon (2-3 years)

– Compare inflation forecast and target, and act accordingly


Taylor rule interpretation

• Taylor rule

• i = i* + a( - *) + b (y - y*)– Take: = 2%

– i = 4% (2% real, 2% target inflation)

• Choose a and b– a = 2.0, b = 0.8


A Taylor rule example

Output gap

-2.5-2

-1.5-1

-0.50

0.51

1.52

2.5

Q1-1999 Q1-2000 Q1-2001 Q1-2002 Q1-2003

0

1

2

3

4

5

6

7

8

Q1-1999 Q1-2000 Q1-2001 Q1-2002 Q1-2003

EONIA Taylor rule

Inflation

0

0.5

1

1.5

2

2.5

3

3.5

Q1-1999 Q1-2000 Q1-2001 Q1-2002 Q1-2003


Independence and accountability

• Current conventional wisdom is that central banks ought to be independent– Governments tend not to resist to the “printing

press” temptation– The Bundesbank has set an example

• But misbehaving governments are eventually punished by voters

• What about central banks? Independence removes them from such pressure

• A democratic deficit?


Redressing the democratic deficit

• In return for their independence, central banks must be held accountable– To the public– To elected representatives

• Examples– The Bank of England is given an inflation

target by the Chancellor. It is free to decide how to meet the target, but must explain its failures (the “letter”).

– The US Fed must explain its policy to the Congress, which can vote to reduce the Fed’s independence.


The record so far

• A difficult period– An oil shock in 2000– A worldwide slowdown– September 11– The stock market crash in 2002– Afghanistan, Iraq


Inflation: missing the objective, a little

0.5

1

1.5

2

2.5

3

3.5

Jan.99 Jan.00 Jan.01 Jan.02 Jan.03


Euro/Dollar Exchange and Interest Rates


But no seriously asymmetric shocks

Inflation

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

1991 1993 1995 1997 1999 2001 2003

Average Min Max

GDP growth

-5.0

0.0

5.0

10.0

15.0

20.0

1991 1993 1995 1997 1999 2001 2003

Average Min Max


The potential role of the Euro

Euro area EU USA

Population in 2003 (million) 309 383 291

GDP (€ billion) 7.298 9.458 11.035

Stock market capitalization 2002 (€ billion)

3.000 4.900 8400

Currency used in foreign exchange transactions: average daily turnover 2001 ($ billion)

€

---------

441

£

-------

155

$

-------

1160


Two different questions

• Will financial markets change and grow?

• Will the euro become an international currency alongside the US dollar?


What are financial markets doing?

• Borrowing and lending, acting mostly as

intermediaries

– Lending is inherently risky

– Risk is to those who lend to financial

institutions


Examples of financial institutions

• Banks– Take deposits, i.e. borrow– Make loans

• Bond markets– Deal in standardized large-scale loans– Allow borrowers and lenders to meet

• Stock markets– Deal in shares, i.e. titles to corporate ownership– Allow borrowers and lenders to meet

• Collective funds– Intermediaries who collect funds from private savers


Dealing with risk

• Every investor wants high returns and no risk

• But she is also willing to give up some return for less risk, or to take more risk for a better return: the basic trade-off

•Markets price risk

•Asset’s risk-return characteristics adjust to meet investors’ willingness


Risk premium

Risk-adj return

Risk

Risk-free rate


What financial markets do about risk

• Markets price risk– Asset’s risk-return characteristics adjust to

meet investors’ willingness

• Markets reduce risk via diversification– Pooling toegether assets with negative risk

correlation reduce overall risk– Example:

• Asset R pays € 100 if it rains today

• Asset S pays € 100 if it does not rain today

• Markets can bundle R and S into one riskless asset that pays € 50 everyday


What makes financial markets special

• Scale economies– Matching needs of borrowers and lenders– Diversification

• Scale economies lead to networks• Risk and asymmetric information

– Borrowers have incentives to conceal the risks that they may impose on lenders

– Lenders are aware and may• Overprice risk• Refuse to lend

• Consequence: financial markets cannot operate freely, they must be regulated


Effects of the euro on financial markets

• The euro eliminates the currency risk within the area– Should enhance the exploitation of scale

economies• More competition among institutions• Emergence of large institutions (banks, market

exchanges) and less competition• Overall effect?

• If financial markets are more efficient, economic growth should benefit

• Large European institutions may promote the euro as an alternative to the dollar


Implication for banks: the principles

• In principle, no reason for banks to compete head on throughout the euro area

• In practice, many limits to this scenario– Good to be known by your banker

(information asymmetry)

– Large costs of switching banks

– Importance of wide branch networks

•Banks merge, but mostly within countries


K2

Capital market integration

MPK

Euros Euros

MPK*

Homecapital

O Foreigncapital

O*

B

C

K1

Capital Flow

Total world capital


Implication for banks: the early facts

• Banks merge, but mostly within countries– Regulations remain local in spite of

harmonization efforts– Cultural differences– Tax considerations

• Early effect– More concentration and less competition


Bank concentration on the rise

Market share of five largest banks (%)

0

10

20

30

40

50

60

70

80

90

Belgium France Finland Germany Italy Netherlands Portugal Spain

1985 1999


Implication for banks: the early facts

• Banks merge, but mostly within countries– Regulations remain local in spite of

harmonization efforts– Cultural differences– Tax considerations

• Early effect– More concentration and less competition– Merger is not the only possibility: banks could

establish branches abroad: they don’t, really


Little change in market penetration

Share of branches of foreign banks (%)

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

Bel

gium

Ger

man

y

Spa

in

Fra

nce

Ital

y

Net

herla

nds

Aus

tria

Por

tuga

l

Fin

land

Sw

eden

U.K

.

1997

2001


Implication for bond markets: the principles

• Bond markets deal in highly standardized loans

• They used to be segmented by currency risk– Risk of devaluation implies higher interest rates

• Gone currency risk, convergence has happened, and is nearly complete– Not fully complete, though– Maybe the effect of national regulations


Implication for bond markets: the facts

Long-term rates Short-term rates

3

5

7

9

11

13

15

17

19

Jan.1995 Jan.1996 Jan.1997 Jan.1998 Jan.1999 Jan.2000 Jan.2001 Jan.2002 Jan.2003

France GermanyGreece ItalySpain United Kingdom

EMU starts Greece joins

0

5

10

15

20

25

Jan.1995 Jan.1996 Jan.1997 Jan.1998 Jan.1999 Jan.2000 Jan.2001 Jan.2002 Jan.2003

France GermanyGreece ItalySpain United Kingdom

Greece joinsEMU starts


Implication for stock markets: the principles

• Worldwide stock markets have remained surprisngly national: the home bias– Information asymmetries– Currency risk

• With the single currency, euro area stock markets should be less subject to home bias


Implication for stock markets: the facts

• Some increase in the use of the euro in world portfolios, nothing dramatic yet

• Mergers of exchanges– Euronext (Amsterdam + Brussels + Paris)– Failed attempt between London, Frankfurt and

Stockholm

• Overall, European markets remain small relatively to the US


Loose ends: regulation and supervision

• A single financial market would seem to require a single regulator and a single supervisor

• Instead, the chosen route has been to:– harmonise and recognise each other’s

regulation– foster cooperation among supervisors

• This can be a cause of inefficiencies– Rampant protectionsim– Inadequate information in case of crisis


The international role of the euro

• 19th century: the pound Sterling

• 20th century: the US dollar

• 21th century: the euro?


The international role of the euro

• As it is internally, a currency can be:– An international unit of account: trade

invoicing– An international medium of exchange: a

vehicule currency– An international store of value: foreign

exchange reserves, individual hoarding

• Internally, these functions are established by law.

• Externally, they have to be earned


Trade invoicing

• Small changes so far

• The dollar remains the currency of choice in international trade and for pricing commodities (oil, wheat, etc.)


Vehicle currency: exchange markets

• Currencies are used on exchange markets:– Directly for conversion into/from other

currencies– Indirectly as intermeadiary for other bilateral

conversions

• Realtive to its constitutent currencies, the euro’s overall share on world exchange markets has declined following the disappearance of within-EU conversions.


Vehicle currency: international reserves

• The euro remain a small part of international reserves of central banks

• The euro is used as anchor currency by 35 countries, mostly succeeding its constituent currencies.

$ € £ ¥ CHF

2001 share (%) 64.6 14.2 5.3 4.7 1.1


Parallel currency

• In troubled countries, foreign currencies circulate alongside the national currency

• The dollar has long dominated

• The euro takes up the role of the DM and the French franc in areas close to the EU and Africa

• Overall, the ECB has shipped abroad 8% of its initial production of euros, more has leaked


Does it matter?

• Trade invoicing in euro reduces currency risk for euro area exporters

• Large financial markets are more efficient

• Seigniorage is small

• Some cherish the symbol

• The ECB has taken a hands-off attitude

capital integration, financial markets and the euro

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