FRBSF Economic Letter
2004-20; August 6, 2004
Monetary and Financial Integration: Evidence from the EMU
Most economists would argue that
monetary integration leads to financial integration; in other words,
when a set of countries has a common currency, as in the European
Monetary Union (EMU), for example, those countries also would tend
to have more extensive international financial activity. Two main
reasons are generally cited. First, monetary integration reduces "currency
risk," which is the risk that the value of debt obligations
would change due to fluctuations in currency values. Second, membership
in a monetary union might make a borrowing nation more averse to
defaulting on its debt obligations for fear of sanctions from the
other members.
These two channels by which monetary integration
can enhance financial integration lead to different predictions
about whether a new monetary
union member's increased international borrowing and lending
would be biased towards the other members. For example, if currency
risk
were the main determinant, then the reduction in currency risk
resulting from monetary union accession would disproportionately
lead to borrowing from monetary union partners. Currency risk
in lending to monetary union partners would be completely eliminated
by the formation of a monetary union, as debts would be serviced
in the union currency. In contrast, if the increased default
penalty
were the main determinant, then it is unclear that joining the
monetary union would bias borrowing towards a nation's monetary
union partners. In all recent cases, when sovereign default occurs,
it occurs on all international obligations simultaneously. As
such, anything that increased the severity of a default penalty
would
make a nation an equally safer borrower from monetary union and
non-union partners alike.
Because these alternative channels
lead to different predictions about whether or not financial
activity would be biased towards
union partners, we can look at the impact of monetary union
accession on the pattern of lending among its members to assess
their relative
plausibility. In this Economic Letter, I summarize
the results of a recent paper that focuses on lending patterns
in Portugal
before and after the 1999 launch of the EMU (Spiegel 2004). Why focus on Portugal?
The Bank of International Settlements (BIS) publishes consolidated
data on bilateral foreign claims of reporting banks for 20 creditor
countries and a large number of borrowing countries. However, the
BIS did not release data on bilateral borrowing by the 20 creditor
countries themselves before 1999. As those creditor countries include
the great majority of the original EMU members, this would appear
to pose an insurmountable obstacle to observing the change in bilateral
lending patterns resulting from the launch of the EMU.
Fortunately,
there is one exception: Portugal was not a reporting BIS creditor
country before 1999, so bilateral claims on that country
from all 20 creditor nations are available before and after the
launch of the EMU. Therefore, disparities in lending to Portugal
by EMU and non-EMU countries before and after the launch of the
union can provide an indicator of the impact of the monetary
union on financial integration.
 Figure 1 illustrates the changes
in the pattern of bilateral lending to Portugal from 1986 to
the present for the 16 creditor
countries
in our sample. Two broad patterns emerge from the picture.
First, as noted by Blanchard and Giavazzi (2001), there was a dramatic
increase in Portuguese borrowing throughout the 1990s. Second,
there was an equally dramatic movement towards borrowing from
EMU partner countries. The share of borrowing from the EMU-partner
nations in the sample more than doubled, from 37.5% of overall
borrowing on average per year during the period before 1991,
to
85.6% of overall borrowing on average per year after 1999.
Statistical evidence of financial
integration
Spiegel (2004) uses disparities in lending to Portugal by EMU
and non-EMU countries before and after the launch of the union
as an indicator of the impact of the monetary union on financial
integration. The methodology used in the paper is commonly known
as a "difference-in-differences" exercise, and it is
used in a wide variety of applications in economics to assess the
impact of a policy change. With this methodology, we can compare
the impact of the policy change in the experimental group to observed
changes in an identified control group. In the case of EMU formation,
the experimental group is the set of creditor countries that joined
the EMU in 1999, and the control group is the set of countries
that did not join the EMU. Because creditor countries differ in
other characteristics that might influence their proclivity to
lend to Portugal, Spiegel allows for fixed and random creditor
country effects and introduces a number of conditioning variables
to adjust for differences among creditor countries.
The primary
result is that the formation of the EMU had a positive and statistically
significant impact on bilateral borrowing from
EMU partner nations in all specifications. More importantly,
the test shows that EMU formation had an economically significant
impact
on the pattern of Portuguese borrowing, indicating that EMU accession
was expected to result in a tripling of bilateral commercial
bank claims on Portugal, holding all else equal, from an average
level
of $536 million to $1.46 billion.
Testing for the robustness of
the results
The above result was subjected to a number of robustness checks.
First, Portugal's entry into the EMU was widely anticipated. From
the ratification of the Maastricht Treaty at the end of 1993, it
was considered almost certain that some form of monetary union
would emerge in Europe and that Portugal would be a member. This
implies that Portugal's accession to the EMU was anything but a
surprise and raises the possibility that banks responded in anticipation
of the EMU launch to gain an early market share advantage. From
the changes in market share in Figure 1, it is clear that lending
patterns to Portugal, particularly those from prospective EMU partner
countries, changed dramatically long before the EMU's formal launch.
To accommodate the possibility that lending patterns changed in
anticipation of the EMU launch, Spiegel repeats the exercise
for earlier break dates. The earlier intervention dates correspond
to the ratification of the Maastricht Treaty at the end of 1993
and the announcement of the launch date for the EMU at the end
of 1995. Specifications using these earlier intervention dates
are again shown to enter positively and significantly for all
of
the specifications considered with estimated coefficient values
comparable in magnitude to those obtained with the 1999 launch
date.
Second, there is likely to be an information advantage to
producers in creditor countries with greater Portuguese lending
relations,
giving exporters from creditor countries with more lending
to Portugal a competitive edge over those from nations with less
financial
contact. Spiegel therefore also uses instrumental variables
estimation
to allow for this possibility, first using the geographic variables
as instruments and then examining the robustness of the results
using these instruments by using lagged values of the time-varying
variables as instruments. The results are robust to this correction.
Finally,
the observations prior and subsequent to policy changes often
have correlated errors, commonly referred to as serial
correlation, which implies that that they are not truly independent.
A simple
robustness check advocated by Bertrand et al. (2004) to deal
with this issue is to remove the time dimension in the sample
by aggregating
the data into two time periods. This approach can work only
for applications where the treatment is applied simultaneously,
which
is the case of accession to EMU. Spiegel repeats the difference-in-differences
exercise with this aggregation. Again, EMU accession is shown
to lead to increased borrowing by Portugal from its monetary
union
partners.
Preliminary evidence
from Greece
Greece was a late entrant into the EMU at the beginning of 2001.
Because the sample extends only through the end of 2002, this leaves
just four semiannual observations for each creditor country to
examine whether the composition of Greek borrowing was also focused
towards its EMU partners after its accession to the monetary union.
However, Spiegel examines this preliminary evidence as a check
on the Portugal results.
The results for Greece with the same specification
treating the start of 2001 as the intervention date show the Greek
experience
to be quite similar to the Portuguese one. The policy intervention
variable is again positive and significant, entering with an even
larger coefficient than that obtained for Portugal. The Greek results
also survive the battery of robustness tests described above, suggesting
that Greek accession to the EMU also skewed its borrowing towards
its EMU partner nations.
While the Greek results are preliminary,
they provide important support for the Portuguese results in light
of the extensive liberalization
that was simultaneously taking place in the Portuguese financial
market during the 1990s. While there is no a priori reason that
this liberalization should skew borrowing towards Portugal’s
monetary union partners, the similarity of Greece's experience
supports the conclusion that the motivation for the increased financial
integration was the formation of the EMU. Greece also liberalized
its financial markets in some dimensions during the 1990s, but
the degree of change was nothing like that which took place in
Portugal.
Policy implications
The results strongly suggest that monetary integration facilitates
financial integration. Moreover, the results suggest that the increased
opportunities for borrowing or lending afforded by accession to
a monetary union are skewed towards their monetary union partner
nations. These changes in the pattern of Portuguese borrowing raise
the possibility of "financial diversion," in other words,
the possibility that increased Portuguese borrowing from its monetary
union partners after EMU accession came at the expense of borrowing
from non-EMU sources. There is a large literature on the possibility
of "trade diversion" resulting from the formation of
free trade areas. This literature demonstrates that the potential
for lost trade with countries outside of a free trade zone makes
it possible that a free trade zone reduces welfare, even for free
trade zone members.
The question then naturally arises whether the
concept of welfare reduction due to trade diversion also applies
to financial diversion
due to the formation of a monetary union. Fortunately, the analogy
is not exact. Financial diversion is likely to be the result
of true cost reductions in borrowing from monetary union partner
nations,
such as those that would emerge from a reduction in the level
of currency risk associated with international borrowing. If this
were the case, it would be likely that the financial integration
effect of monetary integration would further increase overall
welfare,
although lenders from non-EMU nations may suffer from lost market
share.
Mark M. Spiegel
Senior Research Advisor
References
Bertrand, Marianne, Esther Duflo, and Sendhil
Mullainathan. 2004. "How Much Should We Trust Difference-In-Differences
Estimates?" Forthcoming in Quarterly Journal of Economics.
Blanchard, Olivier, and Francesco Giavazzi.
2002. "Current Account Deficits in the Euro Area: The End
of the Feldstein-Horioka Puzzle?" Brookings Papers on
Economic Activity 2, pp. 147-186.
Spiegel, Mark M. 2004. "Monetary and
Financial Integration: Evidence from Portuguese Borrowing Patterns." FRBSF
Working Paper 2004-07. http://www.frbsf.org/publications/economics/papers/2004/wp04-07bk.pdf
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