Title: Financial Integration, Monetary Unions, and Symmetry (Correlation of Cyclical Fluctuations)
1Financial Integration, Monetary Unions, and
Symmetry (Correlation of Cyclical Fluctuations)
2Recap Financial Integration Pros Cons
- Functions of international financial markets
include - Consumption Smoothing
- break the timing between production consumption
- Risk Diversification
- insurance against shocks
- Efficient Allocation of Capital
- capital is at its most productive use
- investors earn a higher return.
- Cons
- These come with costs, such as volatility
crises. - Capital does not always seem to flow the right
direction!
3Evidence from International Data
- The theoretical benefits of financial integration
do not match evidence from international data. - Feldstein-Horioka Puzzle
- High saving-investment correlations
- Risk Sharing Puzzle
- Low consumption correlations
- Lucas Paradox
- Capital does not flow from rich to poor.
4The Feldstein-Horioka Puzzle
- Feldstein-Horioka regression
(I/GDP) a ß (NS/GDP) v.Feldstein (1980)
argued that if capital were perfectly mobile, he
would find ß 0. Instead, ß was much closer
to 1. -
- The coefficient (saving retention)fell a
bit subsequently, but still high.
5 See Table 2,
Appendix I
in this powerpoint.
6There are many critiques of Feldstein-Horioka
- (I) National Saving is endogenous
- The intertemporal optimization critique
--Private saving varies with the business cycle, - or with population or productivity growth.
- Often A theoretical model can be constructed in
which capital mobility is perfect and yet the
saving-investment correlation is high. - Obstfeld, Summers, Tesar
- The maintained external balance critique
- Fiscal policy is endogenous governments react to
trade imbalances - Tobin, Westphal, Caprio Howard, Roubini,
Bayoumi, Buiter. - (II) The world real interest rate is endogenous
- The big-country critique.
- Murphy, Tobin, Obstfeld.
- But that doesnt help explain the cross-section
findings.
7 The most common critique is that NS is
endogenous,
- which should call for an Instrumental Variable.
- IV for Public Saving (BS) military spending
- IV for Household Saving dependency ratio.
See Table 3,
Appendix I in this powerpoint.
- Yet the IV estimates of the F-H coefficient
(saving retention) are as high as the OLS
estimates !
8Evidence from Intra-national Data Studies of
data among regions within a common currency do
not show the puzzles current account deficits
surpluses are big enough to allow saving and
investment to go their separate ways
- Feldstein-Horioka tests on regions within a
common currency - Sub-regions within the UK
- Bayoumi, Tamim, Andrew Rose (1992), "Domestic
Saving and Intra-National Capital Flows,"
European Economic Review. - Provinces within Canada (for 1961-1990)
- Bayoumi, Tamim, Gabriel Sterne (1992),
"Regional Trading Blocs, Mobile Capital and
Exchange Rate Coordination," IMF. - Prefectures of Japan
- Dekle, Robert (1996) "Saving-investment
associations and capital mobility On the
evidence from Japanese regional data," JIE, Aug. - Iwamota van Wincoop (2000) Estimated
coefficient is 0.3 in cross section, 0.2 in
panel. Intranational versus International
Saving and Investment co-movements, in
Intranational Macroeconomics, Hess van
Wincoop, eds.. - States within the US (1950s data)
- Sinn, Stefan (1992), "Saving-Investment
Correlations and Capital Mobility On the
Evidence from Annual Data," Economic Journal. - The same for nations under the gold standard
(Bayoumi, 1990). - The finding is never a high positive correlation
between NS I - as is standard in international studies.
9The prediction of the full risk sharing model
also holds up better on intra-national data
- Crucini Hess (2000) cross-region consumption
correlations gt output correlations. - On data from US states, Canada provinces Japan
prefectures. - International versus Intranational Risk
Sharing, in Intranational Macroeconomics, Hess
van Wincoop, eds. - Kalemli-Ozcan, Sorensen Yosha (AER, 2003)
intranational risk sharing gtgt international risk
sharing. - On data from US states, Canada provinces, Japan
prefectures, UK regions, Italian regions,
Spanish regions - Summary
- Regions that are known to share a common currency
and to be highly integrated with respect to their
goods markets pass the Feldstein-Horioka and risk
sharing tests, while standard international data
fail the tests. - Also, recall that tests by price-based criteria
such Covered Interest Parity, financial markets
are highly integrated. - An implication exchange rate variability or
other sources of imperfect integration of goods
markets may be the source of real interest
differentials and quantity-based findings of low
capital mobility - although this is not necessarily the authors
interpretations of their own results.
10Role of Common Currency
- Can common currency be important for reaping
benefits of financial integration? - When is a currency area optimal?
- What are the implications of the current European
crisis?
11Optimal Currency Areas
- Symmetry of GDP fluctuations is one of the main
criteria for Optimal Currency Areas (OCA). - It goes back to Mundell (1961).
- OCA theory says that the benefits of a common
currency outweigh the costs if - the shocks and cycles are similar
- the countries are open to trade with each other
- the degree of labor mobility is high
- a system of risk-sharing is in place
- through stabilizing fiscal transfers
- or through stabilizing private capital flows.
12Endogeneity Lucas Critique
- OCA theory talks as if trade patterns and other
parameters are exogenous and unchanging. - But the original motivation for currency unions
such as EMU was to promote trade within the
region! - Rose (2000) showed that countries with a common
currency do indeed trade more, as much as x2 or
x3. - An application of Lucas Critique you cannot
rely on ex ante statistical estimates to analyze
the outcome of a change in regime (joining),
because the parameters will change after the
new regime is in effect! - You do not know in advance if it is optimal or
not. - One would have to derive everything from deeper
parameters that dont change.
13If intra-regional trade is endogenous with
respect to MU decision, then cyclical
correlations are likely to be as well. (I)
Eichengreen-Krugman hypothesis on the sign of
the endogenous effect of on correlations.
- Krugman (1993) when MU boosts intra-regional
trade, - countries specialize according to comparative
advantage. - So trade shocks become more idiosyncratic
(asymmetric). - Countries share production risk via integrated
capital markets. - More specialization in production induces a
higher degree of asymmetry (lower correlation of
cycles) - gt Even if countries appear to satisfy OCA
criterion ex ante, - they may fail it ex post.
14(II) Frankel-Rose hypothesison the sign of the
endogenous effect on correlations.
- Once countries are in EMU and trade more
- it leads to a lower degree of asymmetry,
- more highly correlated business cycles.
- gt Even if countries appear to fail OCA criterion
ex ante, - they may satisfy it ex post.
- FR empirically, more trade leads to more
symmetry - Frankel-Rose (1998), The Endogeneity of the
Optimum Currency Area Criteria, Econ.J.
15Frankel-Rose Regression
- Corr (GDPi, GDPj) a b Tradeij controls
error - i-j are countries (pair-wise regression)
- Cross-section estimated over 5 year window
- b is estimated to be positive
- with strong statistical significance,
- even when endogeneity of trade is handled by IV
- from the gravity model (proximity of pair, size,
etc.). - Supports F-R hypothesis over Eichengreen-Krugman.
16Frankel-Rose Both OCA criteria, not just
intra-union trade but also symmetry, are more
likely to hold ex post than ex ante.
OCA criterion line
Countries should adopt common currency
Countries should float
Correlation of Business Cycles Across Countries
symmetry of shocks
17Evidence on the Competing Channel Building Block
I
- Kalemli-Ozcan, Sorensen Yosha (2003)more
capital market integration gt more
specialization, using data from US states - Regression Spec_iab integration_i error
- i is a state/region within a country
- Spec_i measures how much is production differs
from the rest of states within the country - Integration_i measures how financially integrated
is Iwith the rest of the states within the
country. - Estimate of b is positive and significant.
-
18Evidence on Competing Channel Building Block II
- Kalemli-Ozcan, Sorensen, Yosha (2001) (KSY)
more specialization gt less asymmetry. - Recall FR Regression
- Corr (GDPi, GDPj) a b Tradeij controls
error. - KSY Regression
- Corr (GDPi, GDPagg) a b Integrationi
controls error - Dependent Variable correlation of i with the
aggregate - (country i is in)
19To Summarize
- Trade Finance Policy Knowledge
- Intra-Industry Inter-Industry
- Fluctuations Asymmetry
MORE
MORE
LESS
LESS
MORE
LESS
20Which one dominates?
- Empirical papers above show both are important.
- No study yet runs a horse race between the two
channels - which would require pair-wise data both on trade
linkages and on financial linkages - But we have an experiment to evaluate
- European Crisis 2010-..
21Joining Euro Zone
- One of the arguments made in favor of Euro zone
in the past is that even when member countries
are hit by asymmetric shocks, they still do not
need independent monetary policies - The reason is risk sharing consumption smoothing
will be achieved via capital markets! - Even if output shocks are asymmetric, consumption
will not be, thanks to integrated capital
markets! - Sure enough, the periphery countries ran huge CA
deficits after joining NS ltlt I .
22Current Crisis
- The current crisis is a clear indication that
such insurance has not been achieved among Euro
zone countries! - In the absence of fiscal transfers or bail out,
periphery members would have defaulted by now (
devalued) similar to the case of Argentina.
23Smoothing Fluctuations Evidence
- US Smoothing (1999-2005)
- Capital Markets 55
- Federal Government 15
- Credit Markets 30
- Euro Zone Smoothing (1999-2005)
- Capital Markets 10
- Euro Zone Government 0 (there is no such gov)
- Credit Markets 35
24Euro Zone Fluctuations and Smoothing
- Clearly capital markets did not do the job,
whether because - Not integrated enough
- Not enough time passed since common currency
- Markets still segmented with different laws and
jurisdictions - And of course this is not a fiscal union
- so there are supposed to be no fiscal transfers.
25Spreads over German Bunds show integrated markets
Big question why did markets think these
periphery countries were as safe as Germany upon
joining euro?
26Maastricht Criteria
- Many viewed that convergence according to
Maastricht criteria will prepare the countries
for OCA. Most important criteria - No more 60 GDP debt levels
- All countries violated
27European Debt Levels
28Why it is a political problem in a currency area
with no fiscal union Exposure to Greek Debt
- ECB (bought in open market) 55.0
- Greek banks (held as collateral by the ECB) 40.0
- Greek pension funds and insurance comp. 30.0
- French banks 56.9
- German banks 28.3
- UK banks 14.7
- Portuguese banks 10.2
- US banks 8.7
- Dutch banks 5.2
- Italian banks 4.5
- Austrian banks 3.3
- Swiss banks 3.0
- Belgian banks 2.0
- Japanese banks 1.3
- Spanish banks 1.1
- Others (insurance, hedge funds) 20.0
29- Frankel Appendices on MeasuringInternational
Capital Mobility - Feldstein-Horioka for developing countries.
- Interest Rate Parity Country premium
- vs. currency premium for Latin America in 1994.
- Periphery euro countries versus emerging markets
2006-10.
30Appendix 1The Feldstein-Horioka coefficieint
(saving retention)appears no higher for
developing countries than for industrialized
countries the opposite of what one would expect
if measured barriers to capital mobility.
31- IV for Public Saving (BS) military spending
- IV for Household Saving dependency ratio.
?
?
- Yet the IV estimates of the F-H coefficient
(saving retention) are as high as the OLS
estimates !
32Appendix 2Measuring factors in interest
differentials
- Sometimes the effect of capital controls can be
isolated by offshore-onshore interest
differentials - including by the covered interest differential
to take out currencies difference (for countries
with forward markets), - or differential in local -linked bonds vs. US
T-bills. - Sometimes currency premia can be decomposed.
- The effect of default risk can be isolated by the
sovereign spread on bank loans or bonds (EMBI).
33Appendix I
Total interest differential (Local US )
(Currency premium) (country
premium) (?se exchange risk
premium) (country premium)
34Sovereign interest rates, in 3 crises
Source IMF
35Worst mis-pricing Greeces sovereign spreads
2003-08