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© Baldwin&Wyplosz The Economics of European Integration Chapter 16: The Financial Markets and the Euro.

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Presentation on theme: "© Baldwin&Wyplosz The Economics of European Integration Chapter 16: The Financial Markets and the Euro."— Presentation transcript:

1 © Baldwin&Wyplosz The Economics of European Integration Chapter 16: The Financial Markets and the Euro

2 © Baldwin&Wyplosz The Economics of European Integration The potential role of the Euro Euro areaEUUSA Population in 2003 (million) GDP (€ billion) Stock market capitalization 2002 (€ billion) Currency used in foreign exchange transactions: average daily turnover 2001 ($ billion) € £ $

3 © Baldwin&Wyplosz The Economics of European Integration Two different questions Will financial markets change and grow? Will the euro become an international currency alongside the US dollar?

4 © Baldwin&Wyplosz The Economics of European Integration What are financial markets doing? Borrowing and lending, acting mostly as intermediaries –Lending is inherently risky –Risk is to those who lend to financial institutions

5 © Baldwin&Wyplosz The Economics of European Integration 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

6 © Baldwin&Wyplosz The Economics of European Integration 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: the basic trade-off Insert text fig 16-1

7 © Baldwin&Wyplosz The Economics of European Integration What financial markets do about risk Markets price risk –Asset’s risk-return characteristics adjust to meet investors’ willingness Insert (again) text fig 16-1

8 © Baldwin&Wyplosz The Economics of European Integration What financial markets do about risk Markets price risk –Asset’s 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

9 © Baldwin&Wyplosz The Economics of European Integration 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

10 © Baldwin&Wyplosz The Economics of European Integration Effects of the euro on financial markets The euro eliminates the currency risk within the area –Should enhance the exploitation of scale economies More competition 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

11 © Baldwin&Wyplosz The Economics of European Integration Implication for banks: the principles In principle, no reason for banks to compete head on 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

12 © Baldwin&Wyplosz The Economics of European Integration Implication for banks: the early facts Banks merge, but mostly within countries Insert text fig 16.2

13 © Baldwin&Wyplosz The Economics of European Integration Implication for banks: the early facts 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

14 © Baldwin&Wyplosz The Economics of European Integration Bank concentration on the rise

15 © Baldwin&Wyplosz The Economics of European Integration Implication for banks: the early facts 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 –Merger is not the only possibility: banks could establish branches abroad: they don’t, really

16 © Baldwin&Wyplosz The Economics of European Integration Little change in market penetration

17 © Baldwin&Wyplosz The Economics of European Integration Implication for bond markets: the principles 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

18 © Baldwin&Wyplosz The Economics of European Integration Implication for bond markets: the facts Long-term ratesShort-term rates

19 © Baldwin&Wyplosz The Economics of European Integration Implication for stock markets: the principles Worldwide stock markets have remained surprisngly national: the home bias –Information asymmetries –Currency risk With the single currency, euro area stock markets should be less subject to home bias

20 © Baldwin&Wyplosz The Economics of European Integration 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

21 © Baldwin&Wyplosz The Economics of European Integration 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 other’s regulation –foster cooperation among supervisors This can be a cause of inefficiencies –Rampant protectionsim –Inadequate information in case of crisis

22 © Baldwin&Wyplosz The Economics of European Integration The international role of the euro 19th century: the pound Sterling 20th century: the US dollar 21th century: the euro?

23 © Baldwin&Wyplosz The Economics of European Integration 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 vehicule currency –An international store of value: foreign exchange reserves, individual hoarding Internally, these functions are established by law. Externally, they have to be earned

24 © Baldwin&Wyplosz The Economics of European Integration Trade invoicing Small changes so far The dollar remains the currency of choice in international trade and for pricing commodities (oil, wheat, etc.)

25 © Baldwin&Wyplosz The Economics of European Integration 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 euro’s overall share on world exchange markets has declined following the disappearance of within-EU conversions.

26 © Baldwin&Wyplosz The Economics of European Integration Vehicle currency:bond markets The share of the euro is international bond issues has risen Insert text fig 16-10

27 © Baldwin&Wyplosz The Economics of European Integration Vehicle currency: international reserves The euro remain a small part of international reserves of central banks The euro is used as anchor currency by 35 countries, mostly succeeding its constituent currencies. $€£¥CHF 2001 share (%)

28 © Baldwin&Wyplosz The Economics of European Integration 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% of its initial production of euros, more has leaked

29 © Baldwin&Wyplosz The Economics of European Integration 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


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