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Chapter 16: The Financial Markets and the Euro © Baldwin&Wyplosz The Economics of European Integration The potential role of the Euro Euro area EU USA 309 383 291 GDP (€ billion) 7.298 9.458 11.035 Stock market capitalization 2002 (€ billion) Currency used in foreign exchange transactions: average daily turnover 2001 ($ billion) 3.000 4.900 8400 € --------441 £ ------155 $ ------1160 Population in 2003 (million) © Baldwin&Wyplosz The Economics of European Integration Two different questions • Will financial markets change and grow? • Will the euro become an international currency alongside the US dollar? © Baldwin&Wyplosz The Economics of European Integration 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 © Baldwin&Wyplosz The Economics of European Integration 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 © Baldwin&Wyplosz The Economics of European Integration 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 Insert text fig 16-1 © Baldwin&Wyplosz The Economics of European Integration What financial markets do about risk • Markets price risk – Asset’s risk-return characteristics adjust to meet investors’ willingness Insert (again) text fig 16-1 © Baldwin&Wyplosz The Economics of European Integration 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 © Baldwin&Wyplosz The Economics of European Integration 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 © Baldwin&Wyplosz The Economics of European Integration 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 © Baldwin&Wyplosz The Economics of European Integration 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 © Baldwin&Wyplosz The Economics of European Integration Implication for banks: the early facts • Banks merge, but mostly within countries Insert text fig 16.2 © Baldwin&Wyplosz The Economics of European Integration 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 © Baldwin&Wyplosz The Economics of European Integration Bank concentration on the rise Market share of five largest banks (%) 90 80 1985 1999 70 60 50 40 30 20 10 0 Belgium France Finland Germany Italy Netherlands Portugal Spain © Baldwin&Wyplosz The Economics of European Integration 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 © Baldwin&Wyplosz The Economics of European Integration Little change in market penetration Share of branches of foreign banks (% ) 1.60 1.40 1997 1.20 2001 1.00 0.80 0.60 0.40 0.20 U.K. Sweden Finland Portugal Austria Netherlands Italy France Spain Germany Belgium 0.00 © Baldwin&Wyplosz The Economics of European Integration 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 © Baldwin&Wyplosz The Economics of European Integration Implication for bond markets: the facts Long-term rates 19 17 Short-term rates 25 France Greece Spain Germany Italy United Kingdom France Greece Spain Germany Italy United Kingdom 20 15 EMU starts EMU starts Greece joins Greece joins 13 15 11 9 10 7 5 3 Jan.1995 Jan.1996 Jan.1997 Jan.1998 Jan.1999 Jan.2000 Jan.2001 Jan.2002 Jan.2003 5 0 Jan.1995 Jan.1996 Jan.1997 Jan.1998 Jan.1999 Jan.2000 Jan.2001 Jan.2002 Jan.2003 © Baldwin&Wyplosz The Economics of European Integration 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 © Baldwin&Wyplosz The Economics of European Integration 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 © Baldwin&Wyplosz The Economics of European Integration 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 © Baldwin&Wyplosz The Economics of European Integration The international role of the euro • 19th century: the pound Sterling • 20th century: the US dollar • 21th century: the euro? © Baldwin&Wyplosz The Economics of European Integration 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 © Baldwin&Wyplosz The Economics of European Integration Trade invoicing • Small changes so far • The dollar remains the currency of choice in international trade and for pricing commodities (oil, wheat, etc.) © Baldwin&Wyplosz The Economics of European Integration 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. © Baldwin&Wyplosz The Economics of European Integration Vehicle currency:bond markets • The share of the euro is international bond issues has risen Insert text fig 16-10 © Baldwin&Wyplosz The Economics of European Integration Vehicle currency: international reserves • The euro remain a small part of international reserves of central banks $ € £ 2001 share (%) 64.6 14.2 5.3 ¥ CHF 4.7 1.1 • The euro is used as anchor currency by 35 countries, mostly succeeding its constituent currencies. © Baldwin&Wyplosz The Economics of European Integration 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 © Baldwin&Wyplosz The Economics of European Integration 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 © Baldwin&Wyplosz The Economics of European Integration