Lecture 17. The Financial Markets and the Euro

Transcription

1 Lecture 17 The Financial Markets and the Euro

2 The Potential Role of the Euro Euro area EU USA Population in 2003 (million) GDP ( billion) Stock market capitalization 2002 ( billion) Currency used in foreign exchange transactions: average daily turnover 2001 ($ billion) $

3 The US and Europe The US and the euro area have similar size. But the euro and its financial markets are so far largely segmented along national lines Will they evolve towards the US model? Answering this kind of questions requires understanding how financial markets work and what makes a currency widely utilized. These are two largely unrelated issues, however, to be examined one by one.

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

5 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.

6 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.

7 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.

8 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 Summarizing Financial markets play a crucial role: they allow savers and borrowers to meet to their mutual benefit. They also set a price on risk and offer ways to reducing exposure to risk via diversification.

10 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.

11 In other words Financial markets are special. They are subject so scale economies, they operate as networks, and they face important information asymmetries. As a consequence, they do not conform to the perfect market assumption. In particular, they are prone to systemic instability. They must be regulated.

12 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.

13 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.

14 Implication for Banks: the Early Facts Banks merge, but mostly within countries.

15 Bank Concentration on the Rise 90 Market share of five largest banks (%) Belgium France Finland Germany Italy Netherlands Portugal Spain

16 Implication for Banks: the Early Facts Banks merge, but mostly within countries: regulations remain local in spite of harmonisation 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.

17 Little Change in Market Penetration Share of branches of foreign banks (%) Belgium Germany Spain France Italy Netherlands Austria Portugal Finland Sweden U.K.

18 Implication for Bond Markets: the Principles Bond markets deal in highly standardised 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.

19 Implication for Bond Markets: the Facts Long-term rates Short-term rates France Greece Spain EMU starts Germany Italy United Kingdom Greece joins France Greece Spain EMU starts Germany Italy United Kingdom Greece joins Jan.1995 Jan.1996 Jan.1997 Jan.1998 Jan.1999 Jan.2000 Jan.2001 Jan.2002 Jan Jan.1995 Jan.1996 Jan.1997 Jan.1998 Jan.1999 Jan.2000 Jan.2001 Jan.2002 Jan.2003

20 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.

21 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.

22 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.

23 The International Role of the Euro 19th century: the pound Sterling. 20th century: the US dollar. 21th century: the euro?

24 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 vehicle currency an international store of value: foreign exchange reserves, individual hoarding. Internally, these functions are established by law. Externally, they have to be earned.

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

26 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. The share of the euro is international bond issues has risen.

27 Currency Shares of International Bonds

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

29 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 per cent of its initial production of euros, more has leaked.

30 Summarizing: Does it Matter? 1. The euro has the potential for challenging the dollar as in international currency. 2. Still, old habits die hard and, despite some changes, the dollar s supremacy has not yet been seriously dented. 3. Some progress has been achieved in trade invoicing, bond issuance and, in the periphery of the euro area, the role as anchor for currencies and parallel currency. 4. Little change is reported regarding the function of vehicle currency or foreign exchange reserves holdings.