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Mar 4 2004 Lesson 9 By John Kennes International Monetary Economics.

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Presentation on theme: "Mar 4 2004 Lesson 9 By John Kennes International Monetary Economics."— Presentation transcript:

1 Mar Lesson 9 By John Kennes International Monetary Economics

2 Mar The Potential Role of the Euro Euro area EUUSA Population in 2003 (million) GDP (€ billion) Stock market capitalization 2002 (€ billion) Currency used in foreign exchange transactions €£$ Average daily turnover 2001 ($billion]

3 Mar Will financial markets change and grow? Will the euro become an international currency alongside the US dollar? Two Different Questions

4 Mar Borrowing and lending, acting mostly as intermediaries: –Lending is inherently risky –Risk is to those who lend to financial institutions What are Financial Markets Doing?

5 Mar Banks: –Take deposits, i.e. Borrow –Make loans Bond marets –Deal in standardized large-scale loans –Allow borrowers and lenders to meet Stock markets –Deal in shares, i.e. Titles to coporate ownership –Allow borrowers and lenders to meet Collective funds: –Intermediaries who collect funds from private savers Examples of Financial Institutions

6 Mar Every investor wants high returns and no risk But she is also willing to give up some return for less risk, or to make risk for a better return: the basic trade-off. Dealing with Risk

7 Mar Markets price risk: –asset’s risk free-return characteristics adjust to meet investors willingness Market reduce risk via diversification: –Pooling together 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 Market can bundle R and S into one riskless asset that pays €50 everyday What Financial Markets do about Risk

8 Mar Scale economies: –Matching needs of borrowers and lenders –Diversification Scale economies lead to networks –Borrowers have incentives to conceal the risk 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. What makes Financial Markets Special

9 Mar Commercial platforms increasing used to perform regulatory activities for communities of buyers and sellers –Example: reputation system –Some research by Kennes and Schiff (2003) ”The Value of a Reputation System” working paper Aside: The Commercialization of Regulation

10 Mar The euro eliminates the currency risk within the area –Should enhance the exploitation of scale economies: More competion among institutions Emergence of large institutions (banks, market exchanges) and less competition Overall effect? If financial markets are more efficient, economic growth should benefit Large European institutions may promote the euro as an alternative to the dollar. Effects of the euro on Financial Markets

11 Mar In principle, no reason for banks to compete head on throughout the euro area In practice, many limits to this scenerio –Good to to be known by your banker (information asymmetry) –large costs of switching banks –Importance of wide branch networks Implications for Banks: the Principles

12 Mar Banks merge, but mostly within countries. Implications for Banks: the Early Facts

13 Mar Banks merge, but mostly within countries. –Regulation remains local in spite of harmonization efforts –Cultural differences –Tax considerations Early effect: –More concentration and less competition Implications for Banks: the Early Facts

14 Mar Bank Concentration on the Rise

15 Mar Banks merge, but mostly within countries. –Regulation remains local in spite of harmonization 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. Implications for Banks: the Early Facts

16 Mar Little change in Market Penetration

17 Mar Bond markets deal in highly standardized 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 Implications for Bond Markets: the Principles

18 Mar Long-term rates Short-term rates Implications for Bond Markets: the Facts

19 Mar Worldwide stock markets have remained surprisingly national: the home bias –Information asymmetries –Currency risk With the single currency, the euro area stock markets should be less subject to home bias Implications for Stock Markets: the Principles

20 Mar 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 relative to the US Implications for Stock Markets: the Facts

21 Mar A single financial market would seem to require a sigle regulator and a single supervisor. Instead, the chosen route has been to: –Harmonize and recognise each other’s regulation –Foster competition among supervisors This can be a cause of inefficiencies –Rampant protectionsm –Inadequate information in case of crisis. Loose Ends: Regulation and Supervision

22 Mar th century: the pound sterling 20th century: the US dollar 21th century: the euro? The International Role of the Euro

23 Mar As it is internally, a currency can be: 1.An international unit of account: trade invoicing 2.An international medium of exchange: a vehicle currency 3.An international store of value: foreign exchange reserves, individual hoarding Internally, these functions are established by law Externally, they have to be earned The International Role of the Euro

24 Mar Small changes so far. The dollar remains the currency of choice in international trade and for pricing commodities (oil, wheat, etc). Trade Invoicing

25 Mar Currencies are used on exchange markets: –Directly for conversion into/from other currencies –Indirectly as intermediary for other conversions Relative to its constituent currencies, the euro’s overall share on world exchanges has declined following the disappearance of within-EU conversions Vehicle currency: Exchange markets

26 Mar The share of the euro in international bond issues has risen Vehicle currency: Bond markets

27 Mar Currency Shares of International Bonds

28 Mar The euro remains a small part of international currency reserves of central banks The euro is used as anchor currency by 35 countries, mostly succeeding its constituent currencies Vehicle currency: International Reserves Currency$€£¥CHF 2001 share (%)

29 Mar In troubled counries, 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 EU and Africa Overall, the ECB has shipped abroad 8 percent of its initial production of euros, more has leaked. Parallel Currency

30 Mar 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 Does it matter?


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