The Economics of European Integration

1. The Economics of European Integration

2. Chapter 19The Financial Markets and the Euro

3. The Potential Role of the Euro Euro area EU USA Population in 2003 (million) 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%

4. 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?

5. 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.

6. 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.

7. 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.

8. Markets Price Risk Markets price risk: the risk premium Asset’s risk-return characteristics adjust to meet investors’ willingness.

9. 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.

10. 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.

11. Effects of Financial Market Integration • Allocation efficiency

12. Effects of Financial Market Integration • Allocation efficiency Before

13. Effects of Financial Market Integration • Allocation efficiency Before After

14. Effects of Financial Market Integration • Allocation efficiency • Diversification • Competition • Economies of scale

15. 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

16. Winners and Losers • At home, before integration:

17. Winners and Losers • Home capital was scarce • Capital owners lose A

18. Winners and Losers • Home capital was scarce • Capital owners lose A • Labour gains A + B

19. Winners and Losers • Home capital was scarce • Capital owners lose A • Labour gains A + B • Home gains B

20. 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.

21. 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

22. Effects of Financial Market Integration • Diversification • More choice to borrowers and lenders • Risk is reduced

23. 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

24. 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.

25. Number of banks in Euro area Percent of cross-borders mergers Implications for banks: facts Lots of mergers (scale economies) .... but mostly within countries

26. 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.

27. Bank Concentration on the Rise Concentration in national banking

28. 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.

29. Little Change in Market Penetration

30. 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.

31. Short-term rates Long-term rates Implication for Bond Markets: the Facts

32. 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.

33. Implication for Stock Markets: the Facts • Some increase in the use of the euro in world portfolios.

34. 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.

35. Overall, European markets remain small relatively to the US.

36. 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.

37. The International Role of the Euro • 19th century: the pound Sterling. • 20th century: the US dollar. • 21th century: the euro?

38. 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.

39. Trade Invoicing • Small changes so far. • The dollar remains the currency of choice in international trade and for pricing commodities (oil, wheat, etc.).

40. 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.

41. Vehicle Currency: Bond Markets • The share of the euro in international bond issues has risen.

42. Currency Shares of International Bonds

43. Vehicle Currency: International Reserves • The euro remains a small part of international reserves of central banks.

44. 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.

45. 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.

46. 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.