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

Financial Integration in Europein 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

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...

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’

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

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...?

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

Macrofinancial Drivers

Six mutually-reinforcing framework factors:

• Global financial ‘push’ factors

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

Macrofinancial Drivers

Six mutually-reinforcing framework factors:

• Global financial ‘push’ factors• Global trade shocks• Real convergence play• Currency convergence• € area monetary conditions

Real short-term interest rates*

Source: OECD*3-month interbank interest rates deflated by the harmonised index of consumer prices.

Euro Area Conditions

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

Source: IMF

Struct. Budget Balancein % of GDP

2006Seen then Seen now

2007Seen then Seen now

Ireland

Budget 2.7 0.7

Spain

Budget 1.8 1.2

Source: IMF

Struct. Budget Balancein % of GDP

2006Seen then Seen now

2007Seen then Seen now

Ireland

Budget 2.7 -4.0 0.7 -7.2

Spain

Budget 1.8 -1.2 1.2 -1.1

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

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 & govt’s?

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

Capital Flows: EU Periphery

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

Capital Flows: CEE

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

Capital Flows: CZ, PL, SK

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

Capital Flows: Baltics

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

Capital Flows: Balkans

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 & govt’s?

€ area: not + for risk-sharing/debt capacity. Eastern Europe: higher % of FDI... esp. CZ, PL, SK (with lower levels of imbalances).

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

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

External Balance: Ireland

0%

5%

10%

15%

20%

25%

30%

35%

2003 2004 2005 2006 2007 2008

Source: Central Bank of IrelandIncludes subsidiaries of foreign banks in IrelandIncludes securitised residential mortgages

Private Sector Credit: Ireland

0%

50%

100%

150%

200%

250%

Ireland Portugal Spain

2004

2005

2006

2007

2008

Source: IMF

Loan-to-Deposit Ratios: Ireland

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

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

Relative Unit Labour Costs*

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

3.5 3.0

12.57.4

0

10

20

30

40

50

60

70

80

90

Allied Irish Banks Bank of Ireland Anglo Irish Bank Irish 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 Loansand Capital: Ireland

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?

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