Introduction

The introduction of the euro and the establishment of Economic and Monetary Union (EMU) have in a very short time changed the financial landscape of Europe. Major restrictions on financial flows across the borders of the Member States have been abolished, and exchange rate risks eliminated. The European Union, more broadly, is gradually being transformed into a single common financial market. This ongoing process is having farreaching consequences. The financial transformation of Europe raises a number of issues concerning financial stability and fragility, financial supervision, risk sharing across capital markets, the transmission mechanism of monetary policy, and the character and speed of the adjustment process in the euro area – to name but a few. The deep and far-reaching effects of financial integration in Europe have attracted

increasing interest from researchers and policy-makers alike. The purpose of this volume is to make available some major contributions to this new field, as presented at the Annual Research Conferences of DG ECFIN in 2005 and 2006. Both these conferences dealt with financial aspects of the European integration process. A major message emerging from the conferences and thus from this volume is that

financial integration is a fundamental consequence of monetary unification as well as a necessary condition for making a monetary union work satisfactorily. In short, there is an important interaction between monetary and financial unification. They are closely related processes. In short, the euro causes financial integration and financial integration drives the euro project. We consider this message in detail in the following account of the separate contributions. In Chapter 2, ‘Financial markets in the euro area: realizing the full benefits of integra-

tion’, Klaus Regling and Max Watson present an overview of the issues considered in the volume. They explore the ways in which financial markets contributed to growth, adjustment and real convergence during the first decade of the euro, and ask how policy-makers can tap the full benefits that financial integration can bring. They emphasize the potential gains to be realized in terms of efficient adjustment to demand and supply shocks under monetary union, as well as the ways in which financial development and integration can support economic catching-up in present and future euro-area members. Experience in the early years of the euro, they suggest, shows the financial sector playing

a larger than expected role as a source and transmission channel of country-specific developments. This mainly occurred in connection with positive shocks in the form of lower risk premia, easier borrowing constraints and asset market booms – although economies did not always have policy frameworks in place to get the best out of these opportunities. Some of these developments – such as falling risk premia – reflected the initial gains of nominal convergence as the monetary union was created. But Regling and Watson consider that

financial market influences on real activity will continue to be very important, and potentially benign, in the long run. Particularly important under EMU is the continuing growth of cross-border risk sharing,

since this ‘insures’ economies against country-specific shocks – thus helping to stabilize them, and indeed encouraging greater economic specialization. Catalysing stronger stabilization benefits through financial integration is especially valuable for euro-area economies, since other conventional cross-country stabilization mechanisms – such as labour mobility or fiscal transfers – play a less prominent role. The financial sector can also help to reallocate resources smoothly after shocks, and dampen the effect of localized credit crunches. More generally, an integrated and diversified financial sector can increase the resilience of the economy, provided policies – including financial supervision – are well designed and effective. Several key messages for policy are seen to emerge from the early years of EMU. The

first is the importance of making strides with fiscal consolidation during nominal convergence booms. Taking advantage of such booms to move strongly towards fiscal balance, or a modest surplus, has two benefits. It helps to moderate the course of country-specific booms (counterbalancing financial accelerator effects to some degree); and it also creates greater budgetary room for manoeuvre, which will be especially important if the countryspecific boom is followed by a demanding adjustment period. A second lesson from experience is the way financial channels have operated to support

real convergence under EMU. Regling and Watson highlight work on this topic carried out by the Commission (and described in more detail later in this volume), pointing out that this is relevant also to future euro-area members. A key finding is that economies undergoing real convergence stand to benefit greatly

from the increased savings flows allowed by financial integration, but only if macro-and microeconomic policy frameworks are supportive. Given the speed with which financial integration is taking place, structural and institutional policy environments are particularly important in influencing patterns of resource allocation. Notably, there will be advantages if resources flow strongly to the traded goods sector, and other productive activities: this can underpin productivity growth, and may tend to moderate cycles in competitiveness and the current account. Strong productivity growth also eases any corrections in competitiveness, since it lessens the burden that has to be borne by nominal wage restraint. The public sector needs to support this process through good education and good investment. But in these and in other economies, vigilance is needed to make sure that the transitory revenue gains that occur during extended financial booms are not counted as permanent. In sum, Regling and Watson note that financial integration can bring important gains in

terms of growth, adjustment and convergence, including during economic catching-up. But this integration can also transmit adverse shocks more swiftly, or amplify policy errors. Thus financial markets bring opportunities that policy-makers may seize, rather than conferring automatic benefits. To foster growth and adjustment in the euro area, and to allow new members to share in its benefits, well-designed policies are crucial. These relate to fiscal policy, to the functioning of real sector markets, and to financial regulation and supervision. In all these domains, policy-makers need to internalize fully the opportunities and the challenges of deeper financial integration. EU policy frameworks, the authors emphasize, provide a benign setting to reap the benefits of such integration. And for economies already in EMU, the case for pressing forward in implementing those policies is all the more compelling. In Chapter 3, ‘Catch-up, the transition to full participation in EMU and financial stabi-

lity’, Iain Begg explores the challenges facing EU Member States in Eastern Europe as they navigate their approach to euro-area membership. He notes the impressive degree of real

convergence they have already attained, but stresses that the remaining sizeable income gap vis-à-vis the EU average makes it especially important to ensure that policies for nominal convergence do not create serious tensions for a continued process of sustainable catchingup. A major change in monetary regime, he recalls, will have profound effects on the real economy and could imperil financial stability. Begg focuses on three issues. First, there is the question whether the policy regimes

required for euro adoption could constrain development – for example by limiting needed investment in public infrastructure. Second, policy-makers need to evaluate the implications of their pace of transition towards the euro in terms of the depth of shake-ups still required in the real economy. Third, while sound fiscal and monetary regimes should favour financial stability, the impact of changing patterns of capital inflows remains less clear. These issues are portrayed as a J-curve, featuring some potential upfront costs of pressing on to euro adoption, but major benefits down the line in terms of trade and stability benefits. Begg considers that these factors may stack up differently in light of the varying economic

characteristics of the eastern Member States. For small, open economies such as the Baltic States, he considers that the balance of advantage will tend to favour entering Stage III of EMU as quickly as possible. While their starting point in transition was inauspicious, they subsequently adopted regimes that have already transformed their macroeconomic policy performance and shaken up the supply side of the economy successfully. He sees analogies here with Ireland’s very successful experience with real convergence and euro adoption. Poland would be at the other end of the spectrum in terms of factors influencing the

timing of euro adoption. It still faces significant challenges in tackling unemployment and handling further deep transformations in an economy still quite heavily based on rural activity. And like the Czech Republic, Poland has demonstrated its ability to manage a national currency successfully under inflation targeting. There is some analogy, Begg suggests, with the case of Spain. The experience of Spain, nonetheless, shows that the path to euro-area membership can be covered successfully in a much shorter time than observers had considered feasible, if current policies are right. In conclusion, Begg evaluates the financial stability dimension of these challenges.

Notwithstanding a degree of fiscal deterioration in some cases, he sees the core risk as lying in capital inflows, including sizeable EU cohesion transfers. The most obvious risk is vulnerability to a reversal of the more mobile forms of capital flows, and in this regard the switch from inflation targeting to ERM II will require careful handling. A further risk lies in asset bubbles or securities market disturbances. Payment systems and financial supervision will be particularly important, including effective relationships between supervisors and central banks in monitoring financial stability. Amid the manifold and complex consequences of participating in a monetary union,

Gabriel Fagan and Vítor Gaspar focus in Chapter 4, ‘Adjusting to the euro’, on the catalytic function of the financial dimension. Two main rationales underlie the key role of financial forces in shaping countries adopting the euro. First, compared with other economic aspects from euro-area participation, nominal interest rate convergence and financial integration are easy to document on the basis of available statistical information as both happened relatively fast. Second, the available evidence indicates that the effects are large and significant. The

authors argue that, for countries like Greece, Spain, Ireland, Italy and Portugal (hereafter referred to as ‘converging countries’), one important aspect of the process of adjustment to participation in the euro area was associated with the convergence of high short-and longterm domestic interest rates to the relatively low levels prevailing in Germany. From the

viewpoint of these countries, participation in the euro area entailed easier access to international financial markets, a fall in the risk premium combined with financial liberalization and financial integration. Fagan and Gaspar first document stylized facts regarding the macroeconomic effects of

interest rate convergence on the converging countries. Second, they examine the ability of simple macroeconomic models to explain the observed patterns of adjustment. Several stylized facts are highlighted. The convergence in interest rates has been associated with a sharp increase in household expenditures and a pronounced increase in household debt ratios in the converging countries. However, the expansion in expenditure does not seem to have been associated with noticeable effects on output or with sizeable effects on private sector productive investment. Instead, it has been allied with deterioration in the current account deficit and with the accumulation of sizeable negative net foreign asset positions. At the same time, the converging countries recorded inflation differentials which, under exchange rate stability followed by the adoption of the euro, implied significant real appreciation and loss of competitiveness, according to standard indicators. Fagan and Gaspar develop an approach that relies on a model endowment economy set-

up, with traded and non-traded goods, to discuss the real exchange rate implications of changing the geographical patterns of world expenditure. Their setting allows the effects on the real exchange rate of changing expenditures patterns over time to be studied. Their model is able to account qualitatively for all the stylized facts reported above. However, with standard time-separable preferences, expenditure increases on impact and, immediately thereafter, its growth rate declines below the baseline. Moreover, the steady-state effects on the net foreign asset position seem implausibly large. Chapter 4 shows that the introduction of external habit formation makes the model used

more ‘realistic’. The initial build-up in expenditure is more gradual and the size of effects on the steady state is much diminished. The conclusion is therefore that the model they adopt of a small, open, endowment economy, with habit formation and traded and nontraded goods, goes a long way towards explaining the adjustment process of the converging countries to the euro. In Chapter 5, ‘Booms and busts: experiences with internal and external adjustment’,

Reiner Martin and Ludger Schuknecht assess the implications of differing exchange rate strategies during financial cycles in industrialized and emerging market economies over the past twenty years. They make a key distinction between countries that made the external adjustment through a major change in the nominal exchange rate and those that adjusted mainly by re-orienting the economy without devaluation. In performing this analysis, the chapter focuses on real and financial sector transmission channels for shocks during a crisis, including the role of balance sheet risks. It is concerned with identifying empirical regularities rather than causality in these two cases. Martin and Schuknecht examine a number of flow and stock variables that characterize

the interaction between various transmission channels that contribute to boom-bust and crisis phenomena. Their findings confirm that real and financial channels interact in such episodes: indeed a cycle of deterioration and subsequent repair in sector balance sheets is an important driving force of the boom-bust cycle. Martin and Schuknecht find somewhat similar patterns in industrialized and emerging

market economies, while acknowledging that the latter may be more vulnerable to systemic risks and capital flow reversals. These common patterns feature a significant difference in the downturn and recovery path of countries depending on whether they used the real exchange rate as a main element in their adjustment strategy. Those cases that they term

‘external adjusters’ tended to experience more pronounced booms: greater overheating of demand, loss of competitiveness and private and public sector balance sheet vulnerabilities. The external adjusters’ imbalances were initially more severe, causing steeper downturns, but their recoveries were also more rapid. It is noted that some of the Member States that joined the EU in 2004 display either the

early or the more advanced stages of a boom-bust cycle. However, data are less reliable in these countries than in the other industrialized economies, so such indications are tentative and at most can serve as a warning sign of potential challenges ahead. Martin and Schuknecht note that their findings confirm many ‘orthodox’ messages about

sectoral and systemic risks. These include the advantages of adopting preventive strategies, which can help avoid countries finding themselves experiencing the more acute crisis features of the external adjusters. Prudent monetary and wage policies may help moderate the scale of boom-bust cycles. Several lessons also emerge about the contribution of fiscal performance. In particular, fiscal policies should avoid stoking a boom, and here sound headline figures may be misleading due to transient revenue gains during a boom. Low initial public debt can also help by giving scope to socialize the costs and losses of a crisis. The Maastricht criteria are noted to be well chosen from this angle of crisis analysis: they

provide a significant amount of information about the sustainability of economic developments. However, experience across countries during boom-bust cycles also underscores the importance of monitoring balance sheet developments in the private sector, since these may play a major role over time in influencing economic outcomes. In Chapter 6 ‘Financial stability in emerging Europe’, Piroska M. Nagy and Richard Fox

set out to apply an approach they had developed at Fitch Ratings to assess financial stability for the economies of Eastern Europe. This marries concepts of macro-prudential vulnerability developed by Claudio Borio and co-authors at the Bank for International Settlements (BIS) with banking sector systemic risks as captured by ratings of systemically important banks. There are thus two strands to the analysis. The first is macro-prudential, and is based on

a methodology to identify where excessive optimism about earnings and asset prices, compounded by strong capital inflows, may lead banks to underestimate risk over time. This builds on insights in the BIS literature, highlighting strong, simultaneous departures from trend in credit as well as asset prices and/or the real exchange rate. These developments are seen as potential forerunners of financial crises, to the extent the latter arise from procyclicality in the financial sector. The second strand in the authors’ analysis is a conventional approach to assessing bank robustness. It is based on Fitch Ratings’ assessment of banks, supplemented with an analysis that factors in common weaknesses across the banking sector. An insight is that stronger banking systems can better withstand macro-prudential shocks than weak ones. Applying this methodology to advanced and emerging market economies, Nagy and Fox

develop a matrix to categorize them along dimensions of macro-prudential risk and banking system strength. In the EU, only Luxembourg receives the highest score on both counts, but most ‘EU-15’ Member States are quite close to this ranking. Estonia is the only eastern Member State (or former transition economy) to rank alongside most EU-15 Member States. By contrast, Hungary receives a weaker ranking, due notably to macro-prudential risk and indirect foreign currency exposure in the banking system. In south-eastern Europe, Serbia is particularly weak, due to concerns about banking system robustness. Other economies that joined the EU in 2004 receive intermediate rankings, with weaknesses most frequently apparent in the field of banking robustness, at least when the assessment was made.