Measuring Financial Integration in New EU Member Stats

1
Measuring Financial Integration in New EU Member
Stats

• M. Baltzer, L. Cappiello, R. De Santis and S.
  Manganelli
• Frankfurt, 13-14 February 2008

2
Motivation

• Integration in financial markets is an issue of
  continuing interest for policymakers and market
  participants
• A high degree of economic and financial
  integration is beneficial since it can increase
  risk sharing, contribute to an efficient
  allocation of savings, reduce the cost of capital
  and foster economic growth
• It may also lead to high cross border economic
  interdependence and transmission of shocks
• Due to the recent accession of new countries to
  the EU and their future entry in the euro area,
  it is important to follow developments in new EU
  member states
• These countries went from being centrally planned
  economies to fully opened market economies
• Their financial markets underwent a rapid
  development and liberalisation

3
Goal of the paper

• Provide a comprehensive overview on the state of
  financial integration in the new EU member states
• Czech Republic, Estonia, Hungary, Latvia,
  Lithuania, Poland and Slovakia (which joined the
  EU on 1 May 2004)
• Romania and Bulgaria (which joined the EU on 1
  January 2007)
• Since the bulk of the analysis covers the period
  from 1996 until 2006, we also include
• Slovenia (which joined the euro area on 1 January
  2007)
• Cyprus and Malta (which joined the euro area on 1
  January 2008)

4
Definition (Baele et al., 2004)

• The market for a given financial instrument
  and/or service is considered fully integrated if
  all economic agents with the same relevant
  characteristics acting in that market face a
  single set of rules, have equal access, and are
  treated equally
• This definition describes an ideal state of
  perfect integration Nevertheless it provides a
  useful benchmark to assess the degree of
  financial integration

5
Methodology

• Financial integration is measured following the
  framework adopted by Baele et al. (2004)
• Advantages
• We follow an established methodology
• We can directly compare developments in new EU
  Member States with those in the euro area
• We consider three broad categories of financial
  integration measures
• (i) price-based, which capture discrepancies in
  asset prices across different national markets
• (ii) news-based, which analyse the impact that
  common factors have on the return process of an
  asset
• (iii) quantity-based, which aim at quantifying
  the effects of frictions on the demand for and
  supply of securities

6
Price-based measures

• Law of one price assets with identical cash flow
  and risk characteristics should have the same
  price, independently of the location where they
  are traded
• Money, government bond and credit markets exhibit
  sufficiently comparable cash flow and risk
  characteristics

7
Price-based measures continued

• The law of one price can be tested using changes
  in returns dispersion Intuition
• If returns are highly correlated
• they tend to move together in up and down
  markets
• then the instantaneous cross-sectional variance
  of these returns will be low
• Conversely, lower correlations mean that returns
  often diverge, inducing a high level of
  dispersion
• Dispersions and correlations are inversely
  related

8
Drawbacks of price-based measures

• The reliability of changes in dispersion as an
  indicator of market integration is questioned in
  dynamic environments in which idiosyncratic
  volatility and exposure to common shocks change
  over time
• Example consider a set of markets fully
  segmented and uncorrelated and subject to
  time-varying idiosyncratic shocks
• A decrease in return dispersion only indicates a
  decrease in average idiosyncratic volatility and
  not an increase in the degree of market
  integration

9
News-based measures

• In integrated markets, local shocks can be
  effectively diversified away and prices are
  mainly driven by common factors
• News-based measures examine how national returns
  depend on returns on a (common) benchmark asset
• Ceteris paribus, the greater the proportion of
  price variation explained by common factors, the
  greater the degree of integration
• News-based measures are appropriate measures of
  integration for fixed income securities and
  equities

10
Quantity-based measures

• The aim of quantity-based indicators is to
  determine whether the share of euro area capital
  inflows to the new EU member states increases
  relative to that of the rest of the world
• Moreover, we control for global trends, measuring
  the capital inflows from developed countries to
  five developing regions
• If capital flows from euro area to new EU member
  states increase relative to other developing
  regions ? this suggest a higher degree of
  integration

11
Money markets

• Money market covers debt instruments with
  maturity up to one year overnight, one-month,
  12-month inter-bank lending rates and the
  one-year swap rate
• Money markets are becoming increasingly
  integrated both among themselves and vis-à-vis
  the euro area
• To illustrate, we show the dispersion of
  one-month lending rates vis-à-vis their average
  and the Euribor (price-based measure)

12
Dispersion of one-month lending rates
13
Government bond markets

• In this market segment only the largest economies
  (the Czech Republic, Poland and to a lesser
  extent Hungary) exhibit signs of integration
• Caution is needed in the interpretation of the
  results, as the liquidity of the underlying
  markets may distort some of the integration
  measures typically shallow markets tend to be
  relatively noisy
• To illustrate we report the slope coefficients of
  the regression

14
Slope coefficients
15
Share of long-term debt securities

• Share of long-term debt securities issued by new
  EU Member States (plus Cyprus, Malta and
  Slovenia) and held by euro area residents

16
Banking markets

• Banking market data cover interest rates on
  mortgage loans consumer loans short, medium and
  long-term loans to enterprises
• Banking markets are becoming increasingly
  integrated both among themselves and vis-à-vis
  the euro area
• A strong foreign, mainly EU, banking presence
  could be a factor driving integration
• To illustrate we show the dispersion of loans to
  enterprises (price-based measure)

17
Dispersion of loans to enterprises
18
Equity markets

• Evidence for equities suggests a relatively low
  level of integration
• The sensitivity of national market returns to the
  euro area common factor increases after the
  accession date (May 2004)
• However, global factors continue to be important
  in explaining national returns (news-based
  measures)
• Quantity based measure show that since 2002 most
  developing and emerging market economies have
  been receiving equity inflows from developed
  countries

19
Euro area and US shock spill-over intensity
20
Conclusion

• In this study we measure the degree of financial
  integration in the new EU Member States (plus
  Cyprus, Malta and Slovenia) following the
  methodology of Baele et al. (2004)
• The main findings of the paper are
• Financial markets in this region are
  significantly less integrated than those in the
  euro area
• The process of integration is well under way and
  accelerated following the accession to the EU
• Money and banking market are becoming
  increasingly integrated both among themselves and
  vis-à-vis the euro area
• In government bond markets only the largest
  economies (CZ, PL and to a lesser extent HU)
  exhibit signs of integration
• Equity markets are less integrated, although they
  are increasingly affected by euro area shocks