Measuring Financial Integration in New EU Member Stats

1. Measuring Financial Integration in New EU Member Stats M. Baltzer, L. Cappiello, R. De Santis and S. Manganelli Frankfurt, 13-14 February 2008

2. Motivation • Integration in financial markets is an issue of continuing interest for policymakers and market participants • A high degree of economic and financial integration is beneficial since it can increase risk sharing, contribute to an efficient allocation of savings, reduce the cost of capital and foster economic growth • It may also lead to high cross border economic interdependence and transmission of shocks • Due to the recent accession of new countries to the EU and their future entry in the euro area, it is important to follow developments in new EU member states • These countries went from being centrally planned economies to fully opened market economies • Their financial markets underwent a rapid development and liberalisation

3. Goal of the paper • Provide a comprehensive overview on the state of financial integration in the new EU member states • Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland and Slovakia (which joined the EU on 1 May 2004) • Romania and Bulgaria (which joined the EU on 1 January 2007) • Since the bulk of the analysis covers the period from 1996 until 2006, we also include • Slovenia (which joined the euro area on 1 January 2007) • Cyprus and Malta (which joined the euro area on 1 January 2008)

4. Definition (Baele et al., 2004) • “The market for a given financial instrument and/or service is considered fully integrated if all economic agents with the same relevant characteristics acting in that market face a single set of rules, have equal access, and are treated equally” • This definition describes an ideal state of perfect integration – Nevertheless it provides a useful benchmark to assess the degree of financial integration

5. Methodology • Financial integration is measured following the framework adopted by Baele et al. (2004) • Advantages: • We follow an established methodology • We can directly compare developments in new EU Member States with those in the euro area • We consider three broad categories of financial integration measures: • (i) price-based, which capture discrepancies in asset prices across different national markets; • (ii) news-based, which analyse the impact that common factors have on the return process of an asset; • (iii) quantity-based, which aim at quantifying the effects of frictions on the demand for and supply of securities

6. Price-based measures • Law of one price: assets with identical cash flow and risk characteristics should have the same price, independently of the location where they are traded • Money, government bond and credit markets exhibit sufficiently comparable cash flow and risk characteristics

7. Price-based measures – continued • The law of one price can be tested using changes in returns dispersion – Intuition: • If returns are highly correlated • they tend to move together in up and down markets • then the instantaneous cross-sectional variance of these returns will be low • Conversely, lower correlations mean that returns often diverge, inducing a high level of dispersion • Dispersions and correlations are inversely related

8. Drawbacks of price-based measures • The reliability of changes in dispersion as an indicator of market integration is questioned in dynamic environments in which idiosyncratic volatility and exposure to common shocks change over time • Example: consider a set of markets fully segmented and uncorrelated and subject to time-varying idiosyncratic shocks • A decrease in return dispersion only indicates a decrease in average idiosyncratic volatility and not an increase in the degree of market integration

9. News-based measures • In integrated markets, local shocks can be effectively diversified away and prices are mainly driven by common factors • News-based measures examine how national returns depend on returns on a (common) benchmark asset • Ceteris paribus, the greater the proportion of price variation explained by common factors, the greater the degree of integration • News-based measures are appropriate measures of integration for fixed income securities and equities

10. Quantity-based measures • The aim of quantity-based indicators is to determine whether the share of euro area capital inflows to the new EU member states increases relative to that of the rest of the world • Moreover, we control for global trends, measuring the capital inflows from developed countries to five developing regions • If capital flows from euro area to new EU member states increase relative to other developing regions  this suggest a higher degree of integration

11. Money markets • Money market covers debt instruments with maturity up to one year – overnight, one-month, 12-month inter-bank lending rates and the one-year swap rate • Money markets are becoming increasingly integrated both among themselves and vis-à-vis the euro area • To illustrate, we show the dispersion of one-month lending rates vis-à-vis their average and the Euribor (price-based measure)

12. Dispersion of one-month lending rates

13. Government bond markets • In this market segment only the largest economies (the Czech Republic, Poland and to a lesser extent Hungary) exhibit signs of integration • Caution is needed in the interpretation of the results, as the liquidity of the underlying markets may distort some of the integration measures – typically shallow markets tend to be relatively noisy • To illustrate we report the slope coefficients of the regression

14. Slope coefficients

15. Share of long-term debt securities • Share of long-term debt securities issued by new EU Member States (plus Cyprus, Malta and Slovenia) and held by euro area residents

16. Banking markets • Banking market data cover interest rates on mortgage loans; consumer loans; short, medium and long-term loans to enterprises • Banking markets are becoming increasingly integrated both among themselves and vis-à-vis the euro area • A strong foreign, mainly EU, banking presence could be a factor driving integration • To illustrate we show the dispersion of loans to enterprises (price-based measure)

17. Dispersion of loans to enterprises

18. Equity markets • Evidence for equities suggests a relatively low level of integration • The sensitivity of national market returns to the euro area common factor increases after the accession date (May 2004) • However, global factors continue to be important in explaining national returns (news-based measures) • Quantity based measure show that since 2002 most developing and emerging market economies have been receiving equity inflows from developed countries

19. Euro area and US shock spill-over intensity

20. Conclusion • In this study we measure the degree of financial integration in the new EU Member States (plus Cyprus, Malta and Slovenia) following the methodology of Baele et al. (2004) • The main findings of the paper are: • Financial markets in this region are significantly less integrated than those in the euro area • The process of integration is well under way and accelerated following the accession to the EU • Money and banking market are becoming increasingly integrated both among themselves and vis-à-vis the euro area • In government bond markets only the largest economies (CZ, PL and to a lesser extent HU) exhibit signs of integration • Equity markets are less integrated, although they are increasingly affected by euro area shocks