Capital integration, Financial Markets and the Euro

1. Capital integration, Financial Marketsand the Euro

2. 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)

3. 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

4. Interpretation of the convergence criteria: inflation • Straightforward fear of allowing in unrepentant inflation-prone countries

5. 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 …

6. 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

7. 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

8. 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

9. The debt and deficit criteria in 1997

10. 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)

11. 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?

12. 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.)

13. 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

14. 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

15. A Taylor rule example

16. 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?

17. 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.

18. 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

19. Inflation: missing the objective, a little

20. Euro/Dollar Exchange and Interest Rates

21. But no seriously asymmetric shocks

22. The potential role of the Euro

23. Two different questions • Will financial markets change and grow? • Will the euro become an international currency alongside the US dollar?

24. 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

25. 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

26. 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

27. Risk-adj return Risk premium Risk-free rate Risk

28. 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

29. 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

30. 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

31. 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

32. Euros Euros B C MPK MPK* Home capital K2 K1 Foreign capital O* O Capital Flow Total world capital Capital market integration

33. 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

34. Bank concentration on the rise

35. 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

36. Little change in market penetration

37. 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

38. Implication for bond markets: the facts

39. 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

40. 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

41. 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

42. The international role of the euro • 19th century: the pound Sterling • 20th century: the US dollar • 21th century: the euro?

43. 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

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

45. 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.

46. Vehicle currency: international reserves • The euro remain a small part of international reserves of central banks • The euro is used as anchor currency by 35 countries, mostly succeeding its constituent currencies.

47. 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

48. 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