Transcript Financial Integration in the EU

Financial Integration in the EU
Gianpaolo Rossini
[email protected]
http://www2.dse.unibo.it/dsa/profile.php?id=72
03/07/2007
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LESSON 1
• Financial integration in the EU: positive
aspects and drawbacks
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The benefits of financial integration
• Financial integration is crucial for the allocation
of capital internationally among alternative and
competing opportunities.
• Provides a discipline for firms (and financial
intermediaries such as banks) and public
entities.
• Allows for deeper and more liquid markets
where transactions may take place with lower
costs and in a less risky manner.
• Allows for the exchange of saving (finance)
between countries with different age structure
and growth speed (avoid deflation and inflation).
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Costs and risks of financial
integration
• More likely contagion since fewer operators are
isolated and most are internationally diversified.
• Indirect costs due to barriers in the real markets
for goods (Six Puzzles – Obstfeld Rogoff- NBER 7777, 2000)
• Loss of power of national economic policies
• Distributive effects if capital is more mobile than
labour
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A further effect (good or bad?)
• “Financial globalization has not just established
increasingly dense and rapid interactions among
existing financial systems, it has also tended to
change the nature of financial systems, away
from classical banking activities towards the
finance of both governments and corporations
by the direct sale of securities to the investing
public” (Berger, Demsetz, Strahan 1999 Journal of Banking and
Finance)
• This change has been called either
disintermediation or securitization.
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Reasons
• Changes occurred in the 1980’s made banking
credit relatively expensive -> greater use of both
bond and stock markets for both private and
public borrowers. BUT this process was made
possible by the enlargement of markets as a
result of integration due to higher international
capital mobility.
• “The larger the securities markets, the easier
and cheaper it becomes to trade on these
markets and the more likely they are to develop
further”.(Grahl and Teague, 2005 Journal of
European Public Policy)
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In Europe (Euroland)
• This process has been enhanced in Euroland by
the elimination of exchange rates risks due to
the euro. This has allowed for a catch up by
Europe on the disintermediation process. But
still there are large differences between the EU
and the rest of the world.
• The Financial Services Action Plan (FSAP)
(1998 EU council, Stockholm, Lisbon)
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The 3 main aims of FSAP
A) integration of wholesale markets for securities
since technical and regulatory differences made
it diffcult to issue new securities on primary
markets across EU and trade existing securities
on EU secondary markets The most contentious
section was the takeover directive aimed at a
uniform takeover code in the EU- rejected by the
EU parliament upon strong German opposition.
Germans wanted to keep some defense for
managers who were defending against hostile
bids.
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B) Integration of retail financial markets
against fraud and to increase internet
financial services
C) Financial regulation. High consumer
protection. Already existing in many EU
countries but in need of harmonization to
facilitate intra EU competition among
intermediaries.
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Impasses
• Harmonization is difficult -> Single EU Act:
approximation and mutual recognition
principles.
• Bankruptcy rules
• Underdevelopment of the EU payments
system: efficient for banks via the ECB
TARGET system. Not as efficient for small
scale crossborder payments by
households.
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Further impasses
• Clearing and settlements in securities: too many
operators. Many operating only at a national
level
• The question of the “lender of last resort” (LLR).
The ECB is not a LLR. Countries want to retain
the power to bail out banks or other
intermediaries in case of financial strain. This is
possible if there is not a large financial crisis. If
the crisis touches the entire EU a LLR should be
found.
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The Global financial position of the
EU
• The EU is one of the main actors in international
financial markets, together with the US and J. Depending
on the market segment the EU holds between 20% and
40% of world markets.
• Prevalence in the EU financial sector of commercial
banking is reflected in a share of 45% of world banking
total assets. Also a high share in global reinsurance
business: 35% of total non-life net written premiums.
Debt securities: the share is 30% close to that of USA.
USA have a much higher share in stock markets (40%
against 25% in the EU) and investment funds (50% of
world against 34 % of the EU)
(SOURCE: EU – Financial Integration Monitor published yearly at the end of
July)
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Some more facts
1. US shareholders tend to hold much
higher stakes in major EU banks (3-23%)
than Europeans in US banks (1-7%). The
same for insurance sector: USA investors
are holding between 9 and 40% of capital
of EU insurers, while Europeans only
between 1 to 6% of USA insurers capital.
2. The EU is a net exporter of financial
services and also reinsurance services.
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• 3. EU international investment position
(IIP): the value of an economy outstanding
financial claims/liabilities to the rest of the
world (ROW). During the period 19992005 (and mostly after 2002) it increased
from around 100% to some 140% of GDP.
Euro has increased financial integration of
EU with the ROW.
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First conclusion
• Financial integration has increased in the
EU. It provides more liquid markets and
better opportunities for risk diversification.
• It is not clear whether the whole system is
safer (contagion) since surveillance is
more difficult. Consumers may not benefit,
unless markets are safer (better
surveillance) and dominant positions are
absent or do not imply higher costs.
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LESSON 2
• The optimum currency area requirements
and the effects of the Euro.
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Criteria
A) Labour mobility: intra EU labour should
move responding to labour market
disequilibria in EMU member states. This
was a much debated criterion which
inspired also some policies as to industrial
relationships. (Robert Mundell stressed
this point)
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B) Intraindustry trade (IIT) : countries should
not be specialized the traditional
(Hekscher, Ohlin, Samuelson or Ricardo)
way: an exporting sector does not
simultaneously import. Countries largest
trade share should be IIT or overlapped
trade: imports and exports in the same
industries
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C) Degree of trade openess. Only countries
with a high share of trade over GDP
should be eligible for OCA. The more
closed is a country the more likely it is to
be hit by idiosyncratic shocks and not be
able to sustain a lack of independent
monetary policy such as that required in a
OCA.
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• D) There must be the possibility of fiscal
transfers between different areas of the
OCA. This requires a conspicuos federal
budget. In the case of the EU the federal
budget is used for transfers but it is quite
tiny. In the US the federal budget is much
higher.
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E) Countries should have similar
preferences as to consumption and also
assets. If countries have very distant asset
preferences it will be difficult to have a
single monetary policy. Think of different
preferences for liquidity due to largely
different cash holding habits. Also very
distant consumption preferences may
switch to a trade specialization far from IIT
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F) Political cohesion. This is something that
is necessary since countries give up a
share of their sovereignty and this can be
done only if the federal institution is run by
a legitimate board coming from a politically
cohesive group of countries.
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The paradox
• Labour mobility: low in Euroland in the
1990’s and 2000’s. Worries about the
failure of EMU because of scacely intra Eu
labour mobility and highly regulated labour
markets. Countries hit by saymmetric
shocks would end up by suffering major
crisis in terms of unemployment because
of the lack of an independent national
monetary policy.
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Surprise!!!!
Internal labour mobility was not actuallly
necessary. External labour mobility
(migration from third countries – Albania
etc. -) played the role that internal labour
mobility should do.
The worries of many pessimistic economists
were totally rejected, thanks to external
migration.
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LESSON 3
• The costs of integration when there are
international transaction costs in goods
and services (financial assets).
• QUESTION: if the interest rate (r) is not
the same for lenders and borrowers - due
to international transaction costs - how
expensive (or profitable) is a CA
disequilibrium?
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Obstfeld - Rogoff MODEL
(2000-NBER 7777)
• Let us consider a 2 periods horizon and a
small open economy model (takes as
given prices of goods and r).
• We maximize utility over the 2 periods
U(c1,c2)
• subject to a double budget constraint over
the 2 periods:
• a) p1 y1 + D = p1 c1
• b) p2 y2 - (1+i*) D = p2 c2
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• where D is the foreign debt of the first
period to be given back in the second
period, i* is the international rate of
interest which is given and equal to the
foreign real interest rate since we assume
constant prices abroad over the two
periods,
i* nominal = i* real.
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Combining a) and b) over two periods we have:
c1 + [(p2 c2) / (p1(1+i*))] =
= y1 + [(p2 y2) / (p1(1+i*))]
If we assume perfect international capital mobility
we must have:
1+r ≡ (1+i*) p1 / p2
(##)
where r is the domestic real rate of interest, i.e.
(1+r) is the relative price of today output in terms
of next period product.
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THESIS:
The rate r depends on the sign of CA, when
there are international transaction costs: r
depends on (1-t) (transaction cost).
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PROOF
• Suppose there exists an international
price, which is constant, p* of consumption
and assume transport costs of the
"iceberg" type, i.e. t Є [0,1].
• This means that (1- t) disappears since it
is used up during shipment abroad.
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If our country in period 1 has c1 > y1, then
international arbitrage requires that
p1 = p* / t
since our country imports, yet does not
export, in other words p1 > p*,
which means that the domestic price is
larger than the international price.
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In period 2, when we export, we shall get:
p2 = p* t
domestic prices will be lower than abroad.
In period 1 domestic prices are larger than
foreign ones;
the opposite in period 2.
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If we substitute p1 and p2 in (##), we have:
1+ r = (1+i*) (p* / t)[1 / (p* t)]
or
1+ r = (1 + i*) / t²
then r > i*.
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OPPOSITE SITUATION
If instead we lend in period 1, by arbitrage
(since we are exporters in period 1)
p1 = p* t
and
p2 = p* / t
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and by substituting in (##) we have:
(1+r) = (1+i*) p* t ( t / p*)
or
(1+r) = (1+i*) t²
then
r < i*
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Conclusions on t
Even small "transport" costs cause large
spreads between domestic real interest
rates and international or foreign real
rates.
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EXAMPLE
• Interest rate that Brazil must pay to get
foreign credit compared to the rate that
Brazil gets on a foreign deposit.
• Suppose the real interest rate is 5% and
that t = 0.9. [average tariffs in OECD are
4%, average transport costs are 5%,
forget about non tariff barriers].
In
this case the real rate for a borrowing
country is at least 30% higher.
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• Borrower
Lender
1+r = (1+i*) / (0.81)
1+r = (1+i*) 0.81
If i = 5%:
B -> 1+r = 1.05 / 0.81 = 1.29
L -> 1+r = (1.05)0.81 = 0.85
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If there exists this large spread (1.29 - 0.85)
consumption smoothing or financing
growth with CA deficits or inflows of
capitals may be very expensive .
We understand why many countries tend to
shun it and accumulate foreign exchange
reserves (after 1997 - new
mercantilism??)
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Criticisms
1. Perfect financial arbitrage in international
securities makes for a unique - or not
much variable - nominal i* on loans
independently of whom gets them. (not
much true because of country risk and
large observed spreads)
2. What drives finance is the real interest
rate
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3. Differences that emerge in this model may
be too large (among advanced countries).
What happens in Euroland? And USA?
(do not forget the small country assumption).
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REFERENCES
Obstfeld, M. - Rogoff, K. 2000, Six puzzles in international
macroeconomics. NBER wp. 7777
Blanchard - Giavazzi - 2002 CA deficits in the Euro area: the end of the
Feldstein Horioka puzzle? Brookings Papers on Economic Activity;
Rossini and Zanghieri, 2003 The role of FDI in the Feldstein-Horioka
puzzle. Applied Economics Letters, 10, 39-41.
Rossini - Salituro“Mercato dei cambi e riserve valutarie” Il Mulino,vol.
56, n. 430, p.331-340.
Rossini – Zanghieri "Current account composition and the sustainability of
external debt." Forthcoming in: Applied Economics
http://www2.dse.unibo.it/wp/568b.pdf
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Puzzles due to t costs
•
•
•
•
McCallum's home bias in trade puzzle (1995)
Feldstein-Horioka saving-investment puzzle,
French-Poterba equity home bias puzzle,
Backus-Kehoe- Kydland consumption
correlations puzzle.
• purchasing power parity puzzle Rogoff
• exchange-rate disconnect puzzle (Meese-Rogoff
exchange rate forecasting puzzle and the
Baxter-Stockman neutrality of exchange rate
regime puzzle)
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1
• Trade among Canadian provinces is about
20 times trade between Canada provinces
and the US
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2
• Feldstein Horioka (1980) : correlation
between S and I in open economies
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3
• Home bias in portfolios. French and
Poterba, 1991 etc. Some 94% of assets in
portfolios are domestic. Tesar and Werner
1998: decreased for small countries
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4
International Consumption correlation is low
(corollary of F – H puzzle).
Backus Kehoe and Kydland (1992)
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5
• Rogoff 1996 very weak link between
prices of countries and exchange rates.
• PPP failure in short and medium run
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6
• Exchange rate disconnect: corollary of the
5 pricing puzzle.
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Final conclusions
• EU and International Financial integration:
Beneficial since it increases liquidity, exchangeability and
decreases local risk. It allows consumption smoothing
through CA deficits and surpluses and it allows countries
to get up to date technology via FDI. But sometimes
financial markets are too expensive for emerging
countries. Not for Europe
Bad since it increases global risk and it generates a
decrease in the labour share of income since labour is
less mobile than capital and – paradoxically – is more
taxed. Is Europe more risky after the EMU?
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