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Financial Integration in Europe in Light of the Euro Area Crisis Max Watson Director, Political Economy of Financial Markets (PEFM) Co-ordinator, Political.

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Presentation on theme: "Financial Integration in Europe in Light of the Euro Area Crisis Max Watson Director, Political Economy of Financial Markets (PEFM) Co-ordinator, Political."— Presentation transcript:

1 Financial Integration in Europe in Light of the Euro Area Crisis Max Watson Director, Political Economy of Financial Markets (PEFM) Co-ordinator, Political Economy of Southeast Europe European Studies Centre, Oxford Reflecting PEFM Working Group discussions with, and inputs from, Gillian Edgeworth, Gene Frieda, Valerie Herzberg and Russell Kincaid University of Sarajevo

2 Motivation (1) Expectations that financial integration would: revitalise economies of EU core boost catching-up in all of periphery achieve risk-sharing in euro area...

3 Motivation (1) Expectations that financial integration would: revitalise economies of EU core boost catching-up in all of periphery achieve risk-sharing in euro area... Rapid financial integration from late 1990s End of Feldstein-Horioka Puzzle

4 Motivation (2) But from 2008 integration stalls, reverses Experience of boom-bust cycles in euro area periphery, Baltic States, Balkans Contagion, and sudden stops in capital flows

5 Motivation (2) But from 2008 integration stalls, reverses Experience of boom-bust cycles in euro area periphery, Baltic States, Balkans Contagion, and sudden stops in capital flows Did integration promote risk-sharing and healthy growth - or what went wrong...?

6 Narrative – Main Points Flows driven by perfect storm of factors In boom economies, mutually-reinforcing National policies able to avoid meltdown Under EMU, some key factors will recur Implies change in how to manage policy Key for euro area and linked economies But political-economy threatens success

7 Macrofinancial Drivers Six mutually-reinforcing framework factors: Global financial push factors

8 Long-term interest rates in percent* Broad money and GDP* Source: OECD *Long-term government bond yields (10 years). *Nominal GDP converted at constant PPP and broad Weighted average of the US, Japan and Euro Area. money (M3) in the US, Japan and Euro Area. Global Conditions

9 Macrofinancial Drivers Six mutually-reinforcing framework factors: Global financial push factors Global trade shocks Real convergence play Currency convergence area monetary conditions

10 Real short-term interest rates * Source: OECD *3-month interbank interest rates deflated by the harmonised index of consumer prices. Euro Area Conditions

11 Macrofinancial Drivers Six mutually-reinforcing framework factors: Global financial push factors Global trade shocks Real convergence play Currency convergence area monetary conditions National fiscal, prudential policy

12 Source: IMF Struct. Budget Balance in % of GDP 2006 Seen then Seen now 2007 Seen then Seen now Ireland Budget Spain Budget1.81.2

13 Source: IMF Struct. Budget Balance in % of GDP 2006 Seen then Seen now 2007 Seen then Seen now Ireland Budget Spain Budget

14 Political-Economic Roots These financial factors had deep roots... ideological capture: US (efficient markets) but also euro area (BoP abolished) political factors: China (surplus); US (housing); EU (bank supervision and resolution); national (budget, banking) Note: Canada, Sweden, Turkey had coalitions for sound finance after earlier crises

15 Integration & Imbalances Integration analysis featured spreads, assets, bank groups, not current account imbalances: Composition: equity or debt? Sector: traded or nontraded goods? Obligors: firms or banks & govts?

16 *This chart was prepared by Gillian Edgeworth, a member of the Oxford financial markets working group on financial integration Capital Flows: EU Periphery

17 *This chart was prepared by Gillian Edgeworth, a member of the Oxford financial markets working group on financial integration Capital Flows: CEE

18 *This chart was prepared by Gillian Edgeworth, a member of the Oxford financial markets working group on financial integration Capital Flows: CZ, PL, SK

19 *This chart was prepared by Gillian Edgeworth, a member of the Oxford financial markets working group on financial integration Capital Flows: Baltics

20 *This chart was prepared by Gillian Edgeworth, a member of the Oxford financial markets working group on financial integration Capital Flows: Balkans

21 Integration & Imbalances Integration analysis featured spreads, assets, bank groups, not current account imbalances: Composition: equity or debt? Sector: traded or nontraded goods? Obligors: firms or banks & govts? area: not + for risk-sharing/debt capacity. Eastern Europe: higher % of FDI... esp. CZ, PL, SK (with lower levels of imbalances).

22 Policies in a Stable State Interim steady state in area will probably feature limited, conditional fiscal back-stops So national fiscal and prudential policies still key to dampen private sector imbalances in euro area as well as euro-linked economies But preventative policies prone to capture – so need clear goal & triggers

23 Prevention (1) Goal in real time is macrofinancial risk (not misallocation or competitiveness loss per se) external deficit driven by credit growth, financed by short-term/portfolio inflows

24 External Balance: Ireland

25 Source: Central Bank of Ireland Includes subsidiaries of foreign banks in Ireland Includes securitised residential mortgages Private Sector Credit: Ireland

26 Source: IMF Loan-to-Deposit Ratios: Ireland

27 Prevention (1) Goal in real time is macrofinancial risk (not misallocation or competitiveness loss per se) external deficit driven by credit growth, financed by short-term/portfolio inflows accompanied by competitiveness loss with rigid wages

28 Source: OECD * Unit labour costs compared to Euro Area, total economy, double export weights Relative Unit Labour Costs*

29 Prevention (1) Goal in real time is macrofinancial risk (not misallocation or competitiveness loss per se) external deficit driven by credit growth, financed by short-term/portfolio inflows accompanied by competitiveness loss with rigid wages, and domestic and external balance sheet risks

30 Allied Irish BanksBank of IrelandAnglo Irish BankIrish Nationwide Building Society Construction and property (% of total loans, 2006) Construction and property (as a multiple of capital base, 2006) *Data exclude residential mortgages and can thus be taken as representing the exposure of banks to commercial property in a broad sense. Source: Annual Reports 2006 Specifically the data are for: Allied Irish Banks and Irish Nationwide December 2006; Bank of Ireland March 2007; Anglo Irish Bank September 2007, estimated based on data in the 2008 annual report. Commercial Property Loans and Capital: Ireland

31 Prevention (2) How overcome political-economic resistance to pre-emption, risks of policy capture?... clear triggers, incl. C/A/C norms; output risks; mismatched monetary conditions which EU body avoids capture (IMF 2006)? MIP and ESRB not encouraging so far can co-ordination work, esp outside euro?

32 Conclusions A new stable state will involve limited and conditional fiscal backstops in/out of area Financial integration will work only if national fiscal, prudential policies are pre-emptive Serious concern pre-emptive policies may be subject to capture – and not just in EU Major question: macroprudential coordination


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