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THE EURO AND THE FINANCIAL MARKET

THE EURO AND THE FINANCIAL MARKET. Week 10. References. De Grauwe, ch.11 Reading material ……whatever you think can be informative in this mess…. LECTURE PLAN. 1) THE INTEGRATION OF FINANCIAL MARKETS 2) THE EURO AS INTERNATIONAL CURRENCY. What are financial markets?. 1) The bond market

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THE EURO AND THE FINANCIAL MARKET

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  1. THE EURO AND THE FINANCIAL MARKET Week 10

  2. References • De Grauwe, ch.11 • Reading material……whatever you think can be informative in this mess….

  3. LECTURE PLAN • 1) THE INTEGRATION OF FINANCIAL MARKETS • 2) THE EURO AS INTERNATIONAL CURRENCY

  4. What are financial markets? • 1) The bond market • 2) The equity market • 3) The banking sector • 1)+2)+3) = financial markets

  5. Why is financial markets integration important in a monetary union? • It provides a (market-based) insurance mechanism which facilitates adjustments after asymmetric shocks • Asymmetric shocks are a danger for the creation and maintainance of a monetary union, because two of the three macro-economic policy branches are taken away from national hands, and the third one (fiscal policy) has to be subject to rules (SGP). • Remember from week 8:

  6. Germany France PF PG SG SF D’G DF D’F DG YG YF

  7. Risk-sharing channels with integrated financial markets • 1) Bond market • Firms in France makes losses and even go bankrupt; this lowers the value of French bonds, which are held also by German residents. So they will share the price of economic hardness in France. The opposite happens in Germany, and French consumers will partly enjoy the rise in value of German’s firms bonds. • 2) Equity market Same thing. The boom in Germany raises the price of German firms’s shares in the stock market (since expected benefits increase, due to better economic conditions); some of these shares are held by French residents, who enjoy the resulting capital gain (which help sustaining French aggregate demand). Similarly, the drop in French stock market affects also German consumers, and this mitigates the boom in Germany.

  8. 3) Banking sector • Deutsche Bank has a large portfolio of French loans (allowed to French firms, consumers, homeowners), and so does Credit Lyonnais in Germany. The negative shock in France makes part of the French loans “non-performing” (=French firms and consumer do not pay bakc the loan). As a result, Deutsche Bank looses money. Similarly, Credit Lyonnais will be compensated for its losses on domestic loeans, by enjoying higher profits from its German activities. • Also, an integrated mortgage market (part of the financial sector) provides risk-sharing. French real estates prices drop, decreasing the value of French mortgage-backed bonds. Similarly, we have an housing boom in Germany, and those mortgage-backed bonds increase their value. The cross-holdings of these financial assets provides risk-sharing and mutual compensation.

  9. In other words • Financial markets integration mitigates the impact of the negative output shock in one country (obviously at the expense of the booming-country income), thereby providing risk-sharing. • This is ever more important if a centralized budget (=common fiscal policy) is not in place, and national fiscal policies are constrained by the Stability and Growth Pact.

  10. How much risk-sharing do integrated financial markets provide? • Asdrubali et al. (1996): risk-sharing through financial market in the US is twice as important as the risk-sharing provided by US federal budget. • Marinheiro (2002): comparison between risk-sharing in the US and in EU. • US financial market redistributes 48% of asymmetric shocks that occur between states • EU financial market only redistributed 16% of asymmetric shocks occurring among national states. • When output in Massachusetts declines by 10% relative to other US states, the US capital market redistributes about 5% back to Massachusetts. • When the same happens in Italy, EU capital market only redistributes 1.5%.

  11. Other US-EU differences • USA also have the other risk-sharing tool: • When income of a US state declines by 10%, the federal budget redistributes back about 2.5% • In EU, there’s no common budget (see week 12). • National budget are in place and, according to Marinheiro (2002), they “correct” for about 2.1% of a -10% negative shock. • But in this case (see week 10), redistribution is from next generations to the present one, and not among national states. • EU risk-sharing mechanisms (common budget and financial markets integration) are weak. • Last week we analyzed the former. • Now let’s look at the latter.

  12. Does a common currency accelerate financial integration? • Yes. • Financial market are integrated when financial products (=assets) of one country can easily and efficiently be traded across countries. • Easily = freedom of capital circulation (single market feature, since 1993) • Efficiently= euro eliminated exchange-rate risk: now bonds are priced purely on corporate risk (=the structural features of the company issuing the bond), and not on the expected exchange rate movements, which are not under companies’control.

  13. So elimination of national currencies has removed the most important obstacle to financial market integration; having assets denominated in the same currency is the pre-condition for having a single market (as it happened in the product market). • But there are other obstacles. • Let’s look at the current state of integration in each of the financial market’s branches: • 1) The bond market • 2) The equity market • 3) The banking sector

  14. 1) The integration in the bond market • a) Government bonds (issued by States to finance public deficits) • b) Corporate bonds (issued by private firms to finance investments) • Integration for a) was relatively easy. Since the starting of the euro (1999), spreads between national states’bonds became very small (national bonds became close substitutes). • 10 years ago only 10% of italian public debt was owned by non-italian residents. • Today is 55%.

  15. Integration in b) is not as easy. • Different legal system still make a difference. • Different accounting rules, corporate taxation, shareholders’rights, takeovers regulations. • Those factors allow price differentials to reflect not only different corporate risks, but also external issues such as the ones we mentioned. • As result, corporate bonds issued in different EU states are not enough substitutes. • The book provide an example that, in these months, I really don’t feel comfortable in repeating…….

  16. 2) The integration in the equity market • Here the “home bias” is strong…. • Even with free movement of capital, domestic investors tend to buy mostly (90% or more) domestic equities in the domestic stock market. • To address this issue properly, steps should be taken towards a EU stock market. • Something is going on here (merger between London and Milan; next likely merger with Frankfurt), but we are still far from having a unified stock market.

  17. 3) The integration in the banking sector • We can note two issues here: • 1) Companies in (continental) EU rely on bank financing much more than US or UK firms Share of corporate loans in financial liabilities: • Germany: 73.7% (1990), 58.9% (1997), 32.1% (2001) • Italy: 74.8% (1990), 70.9% (1997), 53.1% (2001) • USA: approximately 10% stable

  18. 2) Banking sector is very segmented (= in each member state, market shares of foreign banks are incredibly low). • Germany: 4.9% • Spain: 8.7% • France: 10.6% • Italy: 3.7% • Average EMU zone: 12.4% • This is in sharp contrast with what’s happening in all other markets.

  19. The reason has mainly to do with: • - lack of centralized banking regulation (we still have 27 different financial supervising authorities) • - the reluctance to “give up” national banks. • However, you cannot avoid the unavoidable….in recent years, we have been observing a wave of mergers and acquisition aimed at creating big transnational groups able to compete on the EU market. • Which is the rationale of the european economic integration, after all.

  20. EURO Vs DOLLAR ? • What does it take to a currency to become an….international currency? • 1) Structural factors • 2) The policy environment • Let’s start from 1). • a) Size • b) Financial liberalization a) Size As far as the real economy, EU is as big as US. Financially speaking, there is still a big gap.

  21. Euroland’s real economy at least as big as US

  22. Size of equity and bond markets

  23. Degree of securitization low in euroland

  24. b) Financial liberalization • “Over-regulated financial markets do not provide the most suitable conditions for financial innovations and the development of new financial products and markets” • ……I MUST put it as a quote…………..

  25. 2) The policy environment • A currency can graduate to an international role only if there exists monetary and financial stability at home. • Otherwise, financial investors all over the world won’t be willing to hold it as store of value. • The foremost indicator of monetary stability is the rate of inflation (which measures the stability of the purchasing power of money). • In both Europe and the USA, price stability has become the major objective of policy-making.

  26. Financial stability matters • Japan was even more successful in maintaining price stability than Europe and the USA during the 1990s and the early 2000s • Yet a financial crisis erupted that has led to a serious setback for the yen as an international currency. • Financial stability conditions have to do with government debts and deficits, and the stability of the financial system.

  27. INTERNATIONAL CURRENCY = STRONG CURRENCY ? NO: factors that affect potential for a currency to become a global one are not directly related to factors that affect strength of a currency An international currency DOES NOT mean a strong currency. Common sense think that since everybody wants to hold the currency, its price will increase, so it has to appreciate. But that’s only one side of the story..... While investors buy euro, the issuers of bonds sell euro, thereby putting downward pressure on the euro. A brazilian company issuing bonds denominated in euro, will later sell them to buy local currency, in order to make the investment they wanted to do.

  28. The most important condition to become an international currency seems to be: • 1) size of the economy (real and financial) • 2) monetary and financial stability EU proved to be strong in 2), also in the sub-prime crisis management. But it needs to maintain that feature, while improving and deepening financial integration.

  29. “CONCLUSION” of the course • The “quote” is for two reasons: • - If I wanted to write conclusions of 10 weeks course we’ll spend the rest of the afternoon here • - Conclusions are appropriate when you finish telling a story. That is over, or approximately over. • European integration is a on-going train. • It made many important stops (custom union, economic union, monetary union). • It had some machinery failures (70s, foreign policy, EU constitution).

  30. It has so many stops ahead (completion of the single market, financial integration, reform of the common budget, better institutional framework). • But there’s something I like to think every since I started studying these issues: • 60 years ago boys of our age killed each other, hated each other, tortured each other in concentration camps. They were from Germany, Italy, Netherland, Austria, Poland, and so on. • Now those same boys are grandfathers, but they have the same currency in their wallets. • They benefit from the same money, they vote for the same Parliament, they obey the same Directives. • And they share a common journey.

  31. The hardest task is left to their grandchildren’ shoulders: considering ourselves not as italians, spanish, germans, but Europeans. • At the end of the day, and after all these numbers and formulas, maybe that’s what all this great story is all about.

  32. THANK YOU

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