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 Budget2.70.7 Spain Budget1.81.2

13. Source: IMF Struct. Budget Balance in % of GDP 2006 Seen then Seen now 2007 Seen then Seen now Ireland Budget2.7-4.00.7-7.2 Spain Budget1.8-1.21.2-1.1

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. 3.5 3.0 12.5 7.4 0 10 20 30 40 50 60 70 80 90 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