Download Introduction to Management and Organisational Behaviour

The Economics of
European Integration
© Baldwin & Wyplosz 2006
Chapter 19
The Financial
Markets and
the Euro
© Baldwin & Wyplosz 2006
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)
3.000
4.900
8400
Currency used in foreign
exchange transactions:
average daily turnover, 2004
(% of total of $ 1,880 billion)
€
--------18.6%
£
------8.4%
$
------44.3%
Population in 2003 (million)
© Baldwin & Wyplosz 2006
Four Questions
• What is special about financial markets?
• What to expect from financial market
integration?
• Will financial markets change and grow
after the Euro?
• Will the euro become an international
currency alongside the US dollar?
© Baldwin & Wyplosz 2006
What Do Financial Markets Do?
• Borrowing and lending, acting mostly as
intermediaries:
– lending is inherently risky
– risk is to those who lend to financial
institutions.
© Baldwin & Wyplosz 2006
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 2006
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:
this is the basic trade-off.
Risk adjusted return
Risk.free
rate
© Baldwin & Wyplosz 2006
Markets Price Risk
Markets price risk: the risk premium
Asset’s risk-return characteristics adjust to
meet investors’ willingness.
Risk adjusted return
Risk premium
Risk.free
rate
© Baldwin & Wyplosz 2006
What Do 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 2006
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 2006
Effects of Financial Market
Integration
• Allocation efficiency
© Baldwin & Wyplosz 2006
Effects of Financial Market
Integration
• Allocation efficiency
Before
© Baldwin & Wyplosz 2006
Effects of Financial Market
Integration
• Allocation efficiency
Before
After
© Baldwin & Wyplosz 2006
Effects of Financial Market
Integration
• Allocation efficiency
• Diversification
• Competition
• Economies of scale
© Baldwin & Wyplosz 2006
Effects of Financial Market
Integration
• Allocation efficiency
– Same returns from saving
– Same borrowing costs
– Capital goes where it is more productive
– But not everyone gains
© Baldwin & Wyplosz 2006
Winners and Losers
• At home, before integration:
© Baldwin & Wyplosz 2006
Winners and Losers
• Home capital was
scarce
– Capital owners lose A
© Baldwin & Wyplosz 2006
Winners and Losers
• Home capital was
scarce
– Capital owners lose A
– Labour gains A + B
© Baldwin & Wyplosz 2006
Winners and Losers
• Home capital was
scarce
– Capital owners lose A
– Labour gains A + B
– Home gains B
© Baldwin & Wyplosz 2006
Winners and Losers
• At home capital was
scarce
– Capital owners lose A
– Labour gains A + B
– Home gains B
• Abroad capital was
abundant
–
–
–
–
Capital gains F
Labour loses D+F
Foreign loses D
But they receive C+D from
home
– Total gain is C.
© Baldwin & Wyplosz 2006
Winners and Losers
• At home capital was
scarce
– Capital owners lose A
– Labour gains A + B
– Home gains B
• Abroad capital was
abundant
–
–
–
–
Capital gains F
Labour loses D+F
Foreign loses D
But they receive C+D from
Home
– Total gain is C
© Baldwin & Wyplosz 2006
Effects of Financial Market
Integration
• Diversification
– More choice to borrowers and lenders
– Risk is reduced
© Baldwin & Wyplosz 2006
Effects of Financial Market
Integration
• Competition should increase
– Currencies act as non-tariff barriers
– Rents from dominating position reduced or eliminated
– Better service to customers
• Scale economies better exploited
– emergence of large institutions (banks, market
exchanges)
• Note that these two effects work in opposite
directions
© Baldwin & Wyplosz 2006
Implication for Banks:
the Principles
• In principle, banks should compete
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 2006
Implications for banks: facts
• Number of banks in
Euro area
• Percent of crossborders mergers
Luxembourg
Ireland
Netherlands
Portugal
Spain
Berlgium
Austria
Greece
Finland
France
Germany
Italy
Lots of mergers (scale economies)
.... but mostly within countries
Euro area
0
20
40
60
80
100
© Baldwin & Wyplosz 2006
Implication for Banks: So
far...
• 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 2006
Bank Concentration on the Rise
Concentration in national banking
Market share of five largest banks (%)
100
90
1997
80
2003
70
60
50
40
30
20
10
Finland
Portugal
Austria
Netherlands
Luxembourg
Italy
Ireland
France
Spain
Greece
Germany
Denmark
Belgium
0
© Baldwin & Wyplosz 2006
Implication for Banks: the Early
Facts
• Banks merge, but mostly within countries:
– regulations remain local in spite of
harmonisation 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 2006
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 2006
Implication for Bond
Markets: the Principles
• Bond markets deal in highly standardised
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 2006
Implication for Bond Markets:
the Facts
Short-term rates
13.00
Long-term rates
Germany
Greece
Italy
Spain
Germany
Italy
United Kingdom
13.00
United Kingdom
11.00
Greece
Spain
11.00
Euro launched
9.00
9.00
Euro launched
7.00
5.00
5.00
3.00
3.00
1.00
1995M1
Greece joins
7.00
Greece joins
1.00
1997M1
1999M1
2001M1
2003M1
2005M1
1995M1
1997M1
1999M1
2001M1
2003M1
2005M1
© Baldwin & Wyplosz 2006
Implication for Stock
Markets: the Principles
• Worldwide stock markets have remained
surprisingly national (home bias):
– information asymmetries
– currency risk.
• With the single currency, euro area stock
markets should be less subject to home
bias.
© Baldwin & Wyplosz 2006
Implication for Stock Markets:
the Facts
• Some increase in the use of the euro in
world portfolios.
© Baldwin & Wyplosz 2006
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 2006
Overall, European markets
remain small relatively to the
US.
Exchange
New York
Tokyo
London
Euronext
Frankfurt
Madrid
Zurich
€ bn
10,729
2,850
2,284
1,910
936
769
667
€ bn
% GDP
112.7
76.5
131.3
78.0
42.1
91.8
221.5
OMX
Milano
Oslo
Athens
Vienna
Dublin
Warsaw
593
592
134
100
93
89
57
€ bn
% GDP
90.6
42.0
58.9
57.5
37.9
55.7
25.7
Luxembourg
Budapest
Prague
Cyprus
Bratislava
Malta
40
26
25
4
4
2
% GDP
145.3
28.8
27.4
35.7
11.3
56.7
© Baldwin & Wyplosz 2006
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 2006
The International Role of the
Euro
• 19th century: the pound Sterling.
• 20th century: the US dollar.
• 21th century: the euro?
© Baldwin & Wyplosz 2006
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
vehicle 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 2006
Trade Invoicing
• Small changes so far.
• The dollar remains the currency of choice in
international trade and for pricing commodities
(oil, wheat, etc.).
Share of exports invoiced in euros
70
60
50
40
30
20
10
2002
Spain
Portugal
Italy
2003
Luxembourg
2001
Greece
Germany
France
Belgium
0
© Baldwin & Wyplosz 2006
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 2006
Vehicle Currency: Bond Markets
• The share of the euro in international bond
issues has risen.
© Baldwin & Wyplosz 2006
Currency Shares of
International Bonds
© Baldwin & Wyplosz 2006
Vehicle Currency:
International Reserves
• The euro remains a
small part of
international reserves
of central banks.
90
80
70
60
50
40
30
20
10
0
1965 1969
1973 1977
1981 1985
1989 1993
U.S. dollar
Japanese yen
Deutsche mark
ECUs
1997 2001
Euro
© Baldwin & Wyplosz 2006
Vehicle Currency:
International Reserves
• The euro remains a small part of
international reserves of central banks.
• The euro is used as anchor currency by
35 countries, mostly succeeding its
constituent currencies.
© Baldwin & Wyplosz 2006
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
per cent of its initial production of euros,
more has leaked.
© Baldwin & Wyplosz 2006
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 2006