Introduction to Management and Organisational Behaviour

1
The Economics of European Integration
2
Chapter 19The Financial Markets and the Euro
3
The Potential Role of the Euro
Euro area
USA
EU
309
291
383
Population in 2003 (million)
7.298
11.035
9.458
GDP ( billion)
3.000
8400
4.900
Stock market capitalization 2002 ( billion)
--------- 18.6
------- 44.3
------- 8.4
Currency used in foreign exchange transactions
average daily turnover, 2004 ( of total of
1,880 billion)
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
• Assets risk-return characteristics adjust to
  meet investors willingness.

9
What Do Financial Markets Do About Risk?

• Markets price risk
• assets 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 DF
• Foreign loses D
• But they receive CD 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 DF
• Foreign loses D
• But they receive CD 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
Implications for banks facts

• Number of banks in Euro area

• Percent of cross-borders mergers

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 dont, 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
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 others 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
  euros 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.