Download Slides - Rosella Nicolini

Capital integration, Financial Markets
and the Euro
© Baldwin&Wyplosz The Economics of European Integration
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)
© Baldwin&Wyplosz The Economics of European Integration
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
© Baldwin&Wyplosz The Economics of European Integration
Interpretation of the convergence criteria:
inflation
• Straightforward fear of allowing in
unrepentant inflation-prone countries
10.00
5.00
0.00
1991
France
Spain
Belgium
Greece
1992
1993
1994
1995
1996
1997
1998
Italy
Germany
Portugal
average of three lowest + 1.5%
© Baldwin&Wyplosz The Economics of European Integration
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 …
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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
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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
© Baldwin&Wyplosz The Economics of European Integration
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
© Baldwin&Wyplosz The Economics of European Integration
The debt and deficit criteria in 1997
Maastricht fiscal criteria 1997
120
Public Debt (%GDP)
100
80
60
40
20
0
-3
-2
-1
0
1
2
3
4
5
Deficit (% GDP)
© Baldwin&Wyplosz The Economics of European Integration
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)
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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?
© Baldwin&Wyplosz The Economics of European Integration
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.)
© Baldwin&Wyplosz The Economics of European Integration
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
© Baldwin&Wyplosz The Economics of European Integration
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
© Baldwin&Wyplosz The Economics of European Integration
A Taylor rule example
Inflation
3.5
8
3
2.5
7
2
1.5
6
1
0.5
0
Q1-1999
5
Q1-2000
Q1-2001
Q1-2002
Q1-2003
3
Output gap
2.5
2
1.5
1
0.5
0
-0.5
-1
-1.5
-2
-2.5
Q1-1999
4
2
1
0
Q1-1999
Q1-2000
Q1-2001
EONIA
Q1-2000
Q1-2001
Q1-2002
Q1-2002
Q1-2003
Taylor rule
Q1-2003
© Baldwin&Wyplosz The Economics of European Integration
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?
© Baldwin&Wyplosz The Economics of European Integration
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.
© Baldwin&Wyplosz The Economics of European Integration
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
© Baldwin&Wyplosz The Economics of European Integration
Inflation: missing the objective, a little
3.5
3
2.5
2
1.5
1
0.5
Jan.99
Jan.00
Jan.01
Jan.02
Jan.03
© Baldwin&Wyplosz The Economics of European Integration
Euro/Dollar Exchange and Interest Rates
© Baldwin&Wyplosz The Economics of European Integration
But no seriously asymmetric shocks
Inflation
GDP growth
14.0
20.0
12.0
15.0
10.0
8.0
10.0
6.0
5.0
4.0
0.0
2.0
-5.0
0.0
1991 1993 1995 1997 1999 2001 2003
Average
Min
Max
1991 1993 1995 1997 1999 2001 2003
Average
Min
Max
© 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
•Markets price risk
•Asset’s risk-return characteristics adjust to
meet investors’ willingness
© Baldwin&Wyplosz The Economics of European Integration
Risk-adj
return
Riskfree rate
Risk
premium
Risk
© 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
•Banks merge, but mostly within countries
© Baldwin&Wyplosz The Economics of European Integration
Capital market integration
Euros
Euros
B
C
MPK
MPK*
O
Home
capital
K2
K1
Foreign
capital
O*
Capital Flow
Total world capital
© 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: 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