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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 … © Baldwin&Wyplosz The Economics of European Integration 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 © Baldwin&Wyplosz The Economics of European Integration 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) © Baldwin&Wyplosz The Economics of European Integration 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