Download Financial stability

THE EURO AND
THE FINANCIAL
MARKET
Week 10
References
• De Grauwe, ch.11
• Reading material
……whatever you think can be informative in this
mess….
LECTURE PLAN
• 1) THE INTEGRATION OF FINANCIAL
MARKETS
• 2) THE EURO AS INTERNATIONAL
CURRENCY
What are financial markets?
• 1) The bond market
• 2) The equity market
• 3) The banking sector
• 1)+2)+3) = financial markets
Why is financial markets integration
important in a monetary union?
• It provides a (market-based) insurance
mechanism which facilitates adjustments
after asymmetric shocks
• Asymmetric shocks are a danger for the creation
and maintainance of a monetary union, because
two of the three macro-economic policy branches
are taken away from national hands, and the
third one (fiscal policy) has to be subject to rules
(SGP).
• Remember from week 8:
Germany
France
PF
PG
SG
SF
D’G
DF
D’F
DG
YF
YG
Risk-sharing channels with integrated
financial markets
• 1) Bond market
• Firms in France makes losses and even go bankrupt; this
lowers the value of French bonds, which are held also by
German residents. So they will share the price of economic
hardness in France. The opposite happens in Germany, and
French consumers will partly enjoy the rise in value of
German’s firms bonds.
• 2) Equity market
Same thing. The boom in Germany raises the price of
German firms’s shares in the stock market (since expected
benefits increase, due to better economic conditions); some
of these shares are held by French residents, who enjoy the
resulting capital gain (which help sustaining French
aggregate demand). Similarly, the drop in French stock
market affects also German consumers, and this mitigates
the boom in Germany.
• 3) Banking sector
• Deutsche Bank has a large portfolio of French loans
(allowed to French firms, consumers, homeowners), and so
does Credit Lyonnais in Germany. The negative shock in
France makes part of the French loans “non-performing”
(=French firms and consumer do not pay bakc the loan). As
a result, Deutsche Bank looses money. Similarly, Credit
Lyonnais will be compensated for its losses on domestic
loeans, by enjoying higher profits from its German
activities.
• Also, an integrated mortgage market (part of the financial
sector) provides risk-sharing. French real estates prices
drop, decreasing the value of French mortgage-backed
bonds. Similarly, we have an housing boom in Germany,
and those mortgage-backed bonds increase their value. The
cross-holdings of these financial assets provides risksharing and mutual compensation.
In other words
• Financial markets integration mitigates the
impact of the negative output shock in one
country (obviously at the expense of the
booming-country income), thereby providing risksharing.
• This is ever more important if a centralized
budget (=common fiscal policy) is not in place,
and national fiscal policies are constrained by the
Stability and Growth Pact.
How much risk-sharing do integrated
financial markets provide?
• Asdrubali et al. (1996): risk-sharing through financial
market in the US is twice as important as the risk-sharing
provided by US federal budget.
• Marinheiro (2002): comparison between risk-sharing in the
US and in EU.
• US financial market redistributes 48% of asymmetric
shocks that occur between states
• EU financial market only redistributed 16% of asymmetric
shocks occurring among national states.
• When output in Massachusetts declines by 10% relative to
other US states, the US capital market redistributes about
5% back to Massachusetts.
• When the same happens in Italy, EU capital market only
redistributes 1.5%.
Other US-EU differences
• USA also have the other risk-sharing tool:
• When income of a US state declines by 10%, the
federal budget redistributes back about 2.5%
• In EU, there’s no common budget (see week 12).
• National budget are in place and, according to
Marinheiro (2002), they “correct” for about 2.1%
of a -10% negative shock.
• But in this case (see week 10), redistribution is
from next generations to the present one, and
not among national states.
• EU risk-sharing mechanisms (common budget
and financial markets integration) are weak.
• Last week we analyzed the former.
• Now let’s look at the latter.
Does a common currency accelerate
financial integration?
• Yes.
• Financial market are integrated when financial
products (=assets) of one country can easily and
efficiently be traded across countries.
• Easily = freedom of capital circulation (single
market feature, since 1993)
• Efficiently= euro eliminated exchange-rate risk:
now bonds are priced purely on corporate risk
(=the structural features of the company issuing
the bond), and not on the expected exchange
rate movements, which are not under
companies’control.
• So elimination of national currencies has removed
the most important obstacle to financial market
integration; having assets denominated in the
same currency is the pre-condition for having a
single market (as it happened in the product
market).
• But there are other obstacles.
• Let’s look at the current state of integration in
each of the financial market’s branches:
• 1) The bond market
• 2) The equity market
• 3) The banking sector
1) The integration in the bond market
• a) Government bonds (issued by States to
finance public deficits)
• b) Corporate bonds (issued by private firms to
finance investments)
• Integration for a) was relatively easy. Since the
starting of the euro (1999), spreads between
national states’bonds became very small
(national bonds became close substitutes).
• 10 years ago only 10% of italian public debt was
owned by non-italian residents.
• Today is 55%.
• Integration in b) is not as easy.
• Different legal system still make a difference.
• Different accounting rules, corporate taxation,
shareholders’rights, takeovers regulations.
• Those factors allow price differentials to reflect
not only different corporate risks, but also
external issues such as the ones we mentioned.
• As result, corporate bonds issued in different EU
states are not enough substitutes.
• The book provide an example that, in these
months, I really don’t feel comfortable in
repeating…….
2) The integration in the equity market
• Here the “home bias” is strong….
• Even with free movement of capital, domestic
investors tend to buy mostly (90% or more)
domestic equities in the domestic stock market.
• To address this issue properly, steps should be
taken towards a EU stock market.
• Something is going on here (merger between
London and Milan; next likely merger with
Frankfurt), but we are still far from having a
unified stock market.
3) The integration in the banking
sector
• We can note two issues here:
• 1) Companies in (continental) EU rely on bank
financing much more than US or UK firms
Share of corporate loans in financial liabilities:
• Germany: 73.7% (1990), 58.9% (1997), 32.1%
(2001)
• Italy:
74.8% (1990), 70.9% (1997), 53.1%
(2001)
• USA: approximately 10% stable
• 2) Banking sector is very segmented (= in each
member state, market shares of foreign banks
are incredibly low).
• Germany: 4.9%
• Spain: 8.7%
• France: 10.6%
• Italy: 3.7%
• Average EMU zone: 12.4%
• This is in sharp contrast with what’s happening in
all other markets.
• The reason has mainly to do with:
• - lack of centralized banking regulation (we still
have 27 different financial supervising
authorities)
• - the reluctance to “give up” national banks.
• However, you cannot avoid the unavoidable….in
recent years, we have been observing a wave of
mergers and acquisition aimed at creating big
transnational groups able to compete on the EU
market.
• Which is the rationale of the european economic
integration, after all.
EURO Vs DOLLAR ?
• What does it take to a currency to become
an….international currency?
• 1) Structural factors
• 2) The policy environment
• Let’s start from 1).
• a) Size
• b) Financial liberalization
a) Size
As far as the real economy, EU is as big as US.
Financially speaking, there is still a big gap.
Euroland’s real economy
at least as big as US
Share of output and trade in world totals
35
30
percent
25
20
output
15
trade
10
5
0
EU
US
Japan
Size of equity and bond markets
Outsta nding e quity a nd bonds
14000
b illio n d ollars
12000
10000
8000
equity
6000
bonds
4000
2000
0
EU
US
Japan
Degree of securitization low in
euroland
Securitization Ratio
equity and bonds over GDP
US
EU
0
0,5
1
1,5
2
• b) Financial liberalization
• “Over-regulated financial markets do not provide
the most suitable conditions for financial
innovations and the development of new financial
products and markets”
• ……I MUST put it as a quote…………..
2) The policy environment
• A currency can graduate to an international role
only if there exists monetary and financial
stability at home.
• Otherwise, financial investors all over the world
won’t be willing to hold it as store of value.
• The foremost indicator of monetary stability is
the rate of inflation (which measures the stability
of the purchasing power of money).
• In both Europe and the USA, price stability has
become the major objective of policy-making.
Figure 10.5 Inflation in the EU, USA and Japan
6
EU-12
5
USA
Japan
4
per cent
3
2
1
0
-1
-2
1990
1992
1994
1996
1998
2000
2002
• Financial stability matters
• Japan was even more successful in maintaining
price stability than Europe and the USA during
the 1990s and the early 2000s
• Yet a financial crisis erupted that has led to a
serious setback for the yen as an international
currency.
• Financial stability conditions have to do with
government debts and deficits, and the stability
of the financial system.
80
Figure 10.6: Government debt in the EU and USA
(per cent of GDP)
75
70
per cent
65
60
55
50
45
EU-12
USA
40
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
INTERNATIONAL CURRENCY =
STRONG CURRENCY ?
NO: factors that affect potential for a currency to become a
global one are not directly related to factors that affect
strength of a currency
An international currency DOES NOT mean a strong currency.
Common sense think that since everybody wants to hold the
currency, its price will increase, so it has to appreciate.
But that’s only one side of the story.....
While investors buy euro, the issuers of bonds sell euro,
thereby putting downward pressure on the euro.
A brazilian company issuing bonds denominated in euro, will
later sell them to buy local currency, in order to make the
investment they wanted to do.
• The most important condition to become an
international currency seems to be:
• 1) size of the economy (real and financial)
• 2) monetary and financial stability
EU proved to be strong in 2), also in the sub-prime
crisis management.
But it needs to maintain that feature, while
improving and deepening financial integration.
“CONCLUSION” of the course
• The “quote” is for two reasons:
• - If I wanted to write conclusions of 10 weeks
course we’ll spend the rest of the afternoon here
• - Conclusions are appropriate when you finish
telling a story. That is over, or approximately
over.
• European integration is a on-going train.
• It made many important stops (custom union,
economic union, monetary union).
• It had some machinery failures (70s, foreign
policy, EU constitution).
• It has so many stops ahead (completion of the
single market, financial integration, reform of the
common budget, better institutional framework).
• But there’s something I like to think every since I
started studying these issues:
• 60 years ago boys of our age killed each other,
hated each other, tortured each other in
concentration camps. They were from Germany,
Italy, Netherland, Austria, Poland, and so on.
• Now those same boys are grandfathers, but they
have the same currency in their wallets.
• They benefit from the same money, they vote for
the same Parliament, they obey the same
Directives.
• And they share a common journey.
• The hardest task is left to their grandchildren’
shoulders: considering ourselves not as italians,
spanish, germans, but Europeans.
• At the end of the day, and after all these
numbers and formulas, maybe that’s what all this
great story is all about.
THANK
YOU