The European Union, the Euro, and Equity Market Integration

Transcription

1 The European Union, the Euro, and Equity Market Integration Geert Bekaert, Columbia University Campbell R. Harvey, Duke University Christian T. Lundblad, University of North Carolina Stephan Siegel, University of Washington Rome, Italy November 2011

2 Milestones in European Integration 1948 Brussels Treaty Western European defense commitment 1951 Paris Treaty European Coal and Steel Community 1957 Rome Treaty European Economic Community (EEC): Customs union (within 12 years) Common policies for agriculture, transport, and trade 1986 Single European Act Create a single market by end of 1992: Freedom of movement in goods, capital, people and services 1992 Maastricht Treaty Creation of common currency by Lisbon Treaty Institutional reform of the European Union 2

3 Membership over Time Expanding EU Membership BEL, FRA, DEU, ITA, LUX, NLD DNK, IRL, GBR GRC PRT, ESP AUT, FIN, SWE CYP, CZE, EST, HUN, LVA, LTU, MLT, POL, SVK, SVN 2007 BGR, ROM 3

4 Is Economic and Financial Integration More Pronounced for EU Members? Aside from the obvious focus on goods trade (more on this later): Goods Market Nicoletti, et al. (2001) show greater alignment of goods prices within EU than among OECD countries Labor Market Krueger (2000) finds little increase in labor mobility post 1992 Synchronized Business Cycles Fatas (1997) finds strong increase in BC synchronization Clark and van Wincoop (2001) find modest increase in BC synchronization 4

5 Is Economic and Financial Integration More Pronounced for EU Members? Capital Markets Blanchard and Giavazzi (2002) document a weaker association between savings and investments among EU (and Euro) members than among other OECD countries. Debt Markets Baele et al. (2004) document strong convergence in money market and government bond yields for Euro countries. Equity Markets Baele (2005) shows increased volatility spillover effects in EU equity markets Hardouvelis et al. (2006) find increased integration for Euro countries, but not for the UK 5

6 Motivation 1 Study financial / economic integration in Europe Objective of European Union (EU) has been free movement of goods, labor, and capital Most ambitious voluntary integration effort in modern history 2 The Euro Has the effort paid off? Is financial integration stronger for EU member countries? Recent Developments? In 1999, several EU countries formed a currency union Evidence of strong integration effects of currency unions How does the EU effect compare to the Euro effect? 6

7 Motivation 3 Causality Global trend of financial integration EU membership decision not exogenous Does EU membership have a causal effect on integration? 4 Channels of integration Increased economic links (trade, investment) Harmonized regulation and financial development Information and labor flows What is most affected by EU membership? What matters most for integration? 7

8 Cross-sectional Standard Deviation of Average Country Overnight Rate 8

9 10-year Government Bond Yield Spreads over German Bonds 9

10 Measuring Economic and Financial Integration The famous Gordon growth model assumes a (constant) discount rate, r, and the (constant) expected earnings growth rate, g. If a firms pays out all of its earnings: EY = r g Discount rates and growth opportunities are linearly related to the earnings yield. 10

11 Measuring Economic and Financial Integration Assume: Systematic risk (of the unlevered firm) is industry, but not firm or country-specific In two financially integrated economies, systematic risk is priced identically (r) Industries in two economically integrated economies have access to the same growth opportunities (g) Market integration should cause earnings yields differentials between industries in different countries to converge 11

12 Pricing industry portfolios: Valuation: A Measure of Equity Market Segmentation H 0 : (Strong) Market Integration: H 0 : (Strong) Market Segmentation: 13

13 A Measure of Bilateral Equity Market Segmentation Let EY i,k,t = earnings yields for industry k in country i, Define bilateral industry valuation differential for countries i and j for industry k: EY i,k,t - EY j,k,t Define the degree of bilateral equity market segmentation between countries i and j: where IW i,j,k,t is the relative market capitalization of industry k in countries i and j combined. 14

14 Global Equity Valuation Differentials Bekaert, Harvey, Lundblad, and Siegel (2010) Prices are converging! 16

15 Construct Bilateral SEG for 33 European Countries between 1980 and 2007 Identify all local, publicly traded equity securities covered by Datastream (exclude DRs and preferred stocks) Obtain monthly 12-month trailing earnings yield, market cap (USD), and USD returns (negative yields set to zero, yields larger than one set to missing) For each country, form up to 38 value weighted industry portfolios. Calculate up to 521 annual bilateral segmentation measures (observations above the annual 99 th percentile set to missing) 17

16 B A C K U P Summary Statistics 18

17 27 EU Members plus HRV, ISL, NOR, RUS, CHE, TUR 19

18 An Empirical Model of Bilateral Segmentation EU i,j,t 1 if both countries are in EU members in a given year X i,j,t control variables d t year fixed effects ε i,j,t error term (accounting for heteroscedasticity, arbitrary time-series correlation per pair, arbitrary cross-sectional correlation in a year, see Thompson (2009)) 22

19 EU Membership and Segmentation 23

20 EU Membership and Segmentation (DID) 24

21 U.S. Benchmark for EU Member Pairs

22 Crisis? 10-year Government Bond Yield Spreads over German Bonds 26

23 Crisis? Average Bilateral Valuation Differentials in Europe:

24 Crisis? Average Bilateral Valuation Differentials in Europe:

25 The EU or the Euro? Currency unions are the subject of a large body of research. Mundell (1961), Alesina and Barro (2002), and Frankel (2005) Most of this research focuses on trade, with relatively little agreement on the magnitudes. Rose (2000), Frankel and Rose (2002), Glick and Rose (2002), Persson (2001), Barro and Tenreyro (2007), and Baldwin (2006) Euro-focused studies also fail to agree on the trade impact. Micco, Stein, and Ordonez (2003) & Santos Silva and Tenreyro (2010) An active literature also considers the effect on the product and labor markets Fratzscher (2002), Engel and Rogers (2004), Goldberg and Verboven (2005), Alesina, Ardagna, and Galasso (2008), and Parsley and Wei (2008) 30

26 The EU or the Euro? Most, but not all, EU countries adopted the Euro. Is financial market integration related to the introduction of the Euro? And, today? What are the potential implications of Euro-area struggles? Or, did the reforms associated with EU membership and the push toward global market integration precede the advent of the Euro? We augment our analysis with (1) a Euro-in pair indicator (2) an exchange rate stability measure (1/exp(100σ)) (Fratzscher (2002) & Frankel (2005)) (3) a 1993 Euro-in pair indicator (Maastricht Treaty) 31

27 What about the Euro? 32

28 What about the Euro? 33

29 What about the Euro? 34

30 Robustness of the EU and Euro effects? The EU effect (Table 3) is also robust to (1) an equally weighted version of the SEG measure (2) a logged version of SEG (3) a minimum number of firms required to compute SEG (4) alternative measurement frequency (monthly) (5) a balanced sample The Euro effect (Table 4) remains relatively weak and often statistically insignificant. With standard controls, the Euro effects is never statistically significant. And today? 35

31 Does EU Membership Cause Market Integration? Decision to enter the European Union is not exogenous. However, EU indicator is one only if both countries in a pair are members. Equity markets might be more integrated for a country-pair due to other, unobserved pair characteristics. Two approaches: 1 include country-pair fixed effects (c i,j ) (discussed above) 2 find an instrumental variable for (joint) EU membership 36

32 An Instrument for (Joint) EU Membership: Distance to Brussels Brussels has played a central role in European integration: Brussels Treaty, NATO headquarters Primary location of EU institutions (Council, Commission, Parliament) Distance to Brussels might negatively affect a country s likelihood of being an EU member. Nicolaides and Boean (1996), Fischer, Sahay and Gramont (1998), and Berezin and Diez- Medrano (2008) For a country pair, we propose the maximum distance to Brussels as an instrument for joint EU Membership (EU = 1) 37

33 There is no room for amateurism... Boost your EU Skills! Brussels' leading training centre in EU Public Affairs and Lobbying 38

34 First Stage Results (LPM) 39

35 Second Stage Results 40

36 Channels of Integration Through which mechanism/channel does EU membership lead to market integration? We explore several potential channels: Trade and FDI Financial regulation and reform Financial development and real interest rate differentials Labor and information flow We first explore the effect of EU membership on each channel and then augment our empirical model by the channel variable 41

37 Summary Statistics 42

38 EU Membership and Channels 43

39 EU Membership and Channels 44

40 Conclusions We show that bilateral valuation differentials (market segmentation) are significantly lower for EU members. Robust to country-pair characteristics and global integration trends country-pair fixed effects a new instrumental variable approach EU effect does not depend on adoption of the Euro, and the Euro is largely irrelevant. EU membership is associated with elevated trade and cross-border investment, harmonized financial reform, financial openness and development, and smaller real interest rate differentials. Controlling for these channels does not explain the full EU effect 45