Financial Integration in the EU

1. Financial Integration in the EU Gianpaolo Rossini gianpaolo.rossini@unibo.it http://www2.dse.unibo.it/dsa/profile.php?id=72 03/07/2007 Gianpaolo Rossini - Financial Integration

2. LESSON 1 • Financial integration in the EU: positive aspects and drawbacks Gianpaolo Rossini - Financial Integration

3. 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). Gianpaolo Rossini - Financial Integration

4. 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 Gianpaolo Rossini - Financial Integration

5. 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. Gianpaolo Rossini - Financial Integration

6. 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) Gianpaolo Rossini - Financial Integration

7. 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) Gianpaolo Rossini - Financial Integration

8. 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. Gianpaolo Rossini - Financial Integration

9. 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. Gianpaolo Rossini - Financial Integration

10. 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. Gianpaolo Rossini - Financial Integration

11. 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. Gianpaolo Rossini - Financial Integration

12. 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) Gianpaolo Rossini - Financial Integration

13. 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. Gianpaolo Rossini - Financial Integration

14. 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 1999-2005 (and mostly after 2002) it increased from around 100% to some 140% of GDP. Euro has increased financial integration of EU with the ROW. Gianpaolo Rossini - Financial Integration

15. 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. Gianpaolo Rossini - Financial Integration

16. LESSON 2 • The optimum currency area requirements and the effects of the Euro. Gianpaolo Rossini - Financial Integration

17. 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) Gianpaolo Rossini - Financial Integration

18. 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 Gianpaolo Rossini - Financial Integration

19. 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. Gianpaolo Rossini - Financial Integration

20. 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. Gianpaolo Rossini - Financial Integration

21. 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 Gianpaolo Rossini - Financial Integration

22. 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. Gianpaolo Rossini - Financial Integration

23. 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. Gianpaolo Rossini - Financial Integration

24. 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. Gianpaolo Rossini - Financial Integration

25. 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? Gianpaolo Rossini - Financial Integration

26. 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 Gianpaolo Rossini - Financial Integration

27. 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. Gianpaolo Rossini - Financial Integration

28. 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. Gianpaolo Rossini - Financial Integration

29. THESIS: The rate r depends on the sign of CA, when there are international transaction costs: r depends on (1-t) (transaction cost). Gianpaolo Rossini - Financial Integration

30. 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. Gianpaolo Rossini - Financial Integration

31. 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. Gianpaolo Rossini - Financial Integration

32. 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. Gianpaolo Rossini - Financial Integration

33. 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*. Gianpaolo Rossini - Financial Integration

34. 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 Gianpaolo Rossini - Financial Integration

35. and by substituting in (##) we have: (1+r) = (1+i*) p* t ( t / p*) or (1+r) = (1+i*) t² then r < i * Gianpaolo Rossini - Financial Integration

36. Conclusions on t Even small "transport" costs cause large spreads between domestic real interest rates and international or foreign real rates. Gianpaolo Rossini - Financial Integration

37. 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. Gianpaolo Rossini - Financial Integration

38. Borrower 1+r = (1+i*) / (0.81) Lender 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 Gianpaolo Rossini - Financial Integration

39. 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??) Gianpaolo Rossini - Financial Integration

40. 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 Gianpaolo Rossini - Financial Integration

41. 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). Gianpaolo Rossini - Financial Integration

42. 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 Economicshttp://www2.dse.unibo.it/wp/568b.pdf Gianpaolo Rossini - Financial Integration

43. 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) Gianpaolo Rossini - Financial Integration

44. 1 • Trade among Canadian provinces is about 20 times trade between Canada provinces and the US Gianpaolo Rossini - Financial Integration

45. 2 • Feldstein Horioka (1980) : correlation between S and I in open economies Gianpaolo Rossini - Financial Integration

46. 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 Gianpaolo Rossini - Financial Integration

47. 4 International Consumption correlation is low (corollary of F – H puzzle). Backus Kehoe and Kydland (1992) Gianpaolo Rossini - Financial Integration

48. 5 • Rogoff 1996 very weak link between prices of countries and exchange rates. • PPP failure in short and medium run Gianpaolo Rossini - Financial Integration

49. 6 • Exchange rate disconnect: corollary of the 5 pricing puzzle. Gianpaolo Rossini - Financial Integration

50. 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? Gianpaolo Rossini - Financial Integration