Memorandum by Philippe Maystadt, President,
European Investment Bank
1. What contribution has the introduction
of the euro made to levels of trade within the Euro zone, and
between the Euro zone and the rest of the world?
1.1 The early literature on trade effect of
currency unions tended to exaggerate the gains
1.1.1 The issue of whether currency unions
boost trade did not arise only with the euro, but the question
certainly received renewed attention with the single currency.
One very influential empirical study of the trade effects of a
common currency prior to EMU was by Andrew Rose, released in 2000.[5]
Applying a standard gravity-equation framework[6]
to bilateral trade data of 186 countries, he found that countries
that shared a common currency on average traded three times as
much with each other as those that did not. In the discussion
that followed it soon became apparent, however, that these results
offered little insight to the possible trade effects of the euro.
Currency unions prior to EMU, included those in Rose's study,
tended to involve small and relatively poor countries, typically
in a post-colonial context. That these countries traded much more
with their currency union partners was the result of many other
factors than the shared currency per se.
1.2 New empirical evidence points to substantial
trade creation as a result of the euro, both within EMU and with
outsiders
1.2.1 The euro area countries have relatively
little in common with those studied by Rose and his followers.
All the members of the euro area were highly developed, with a
high degree of trade openness and integration in the wake of the
single market. A few years into EMU, there is now enough data
to make a more reliable assessment on the euro's trade effects.
1.2.2 I will focus this discussion on one
recent paper, by authors who have been recognised to provide one
of the methodologically most solid studies on this topic. Harry
Flam and Håkan Nordström released the first version
of their study in 2003[7]
but has updated this extensively in a new paper released in late
2006[8].
These studies have been particularly influential because they
have paid attention to problems that have plagued other studies,
in particular the distorting influence of exchange rate movements.
By limiting their data to that of exports (as opposed to two-directional
trade flows), their work also conforms better to the theoretical
underpinnings of the applied trade model.
1.2.3 Flam and Nordström use bilateral
export data in a sample consisting of the euro area countries
and another 10 OECD countries (OECD-10) of comparable level of
developments.[9]
The sample period is 1995-2005.[10]
1.2.4 The chart below differentiates between
three series: (1) exports between euro area members; (2) exports
from members to non-members; and (3) exports from non-members
to members. All series are shown relative to exports between the
10 OECD countries in the sample that are not members of the currency
union.
1.2.5 This chart is suggestive of the euro's
trade effects. While the exports of euro area members (both to
each other and to the non-members in the sample) rose by around
25% relative to trade between non-members, exports of non-members
to euro area countries rose by a more moderate 5-10% .
1.2.6 While indicative, these observations
do not provide hard evidence of the euro's trade effects. It could
be that other factors—unrelated to the euro—coincided
with the euro's launch to boost trade between euro area members.
The authors thus proceed with econometric analysis to discern
how much of the increase in trade is accounted for by the euro
itself, when we also take these other factors into consideration.
1.2.7 Like Rose, the authors estimate a
gravity trade model, which assumes that bilateral trade flows
between two countries increase with their combined economic size
(measured as the product of their GDP) and decrease with trade
costs (which include distance between the two economies, language
differences and various trade restrictions). They also control
for bilateral real exchange rates. The way the euro effect is
tested is to compare the trade of euro area members with the outsiders.
To use terminology borrowed from medical research, they test whether
trade that has been given a "euro treatment" is higher
in a given year than trade that has not received such treatment.
The timing of the euro effect is obviously crucial here, as the
"euro effect" should not normally occur before 1999.[11]
1.2.8 The results are shown in the chart
above. When compared with 10 non-euro area OECD countries, intra-euro
area trade was found to rise substantially and immediately after
the launch of the single currency (dark blue bars in the chart).
When comparing the average of 2002-05 with the average of 1995-98,
the authors find a 26% increase in intra-euro area trade that
can be accounted for by the single currency alone.
1.2.9 Trade between euro area countries
and the other OECD countries also grew noticeably from 1999 onwards
(in both directions), relative to trade between non-euro countries.
Exports from non- members to the euro area were 13% higher in
2002-05 relative to 1995-98 as a direct result of the euro. Outward
exports from the euro area were 12% higher. While only half the
size of the intra-euro area trade effect, these increases are
still surprisingly large from the point of view of traditional
currency union theory.
1.2.10 All estimates for trade within, to
or from the euro area members are significant either at the 1
or 5% level soon after 1999 (in a few cases only at the 10% level
until 2001). The authors thus conclude that there is solid evidence
fora substantial trade effect of the euro, both within the euro
area and in trade with outside countries. They are not surprised
to find effects already in 1999 as decisions on euro adoption
were taken in early 1998.[12]
2. What effect has the introduction of the
Euro had on the functioning of European capital markets?
2.0.1 One of the main channels through which
the euro has affected European capital markets is by reducing
so-called "home bias" in asset portfolios. This has
markedly improved risk sharing across Europe, allowing investors
to tap a much larger home currency pool of savings. This has,
in turn, led to notable expansion of euro denominated securities
markets.
2.1 Home bias at the global level
2.1.1 Finance theory has shown that in a
fully integrated world where purchasing power parity holds, all
investors should in equilibrium hold the same world market portfolio
of financial assets. This portfolio should consist of assets from
different countries (or currency areas) in proportion to their
market capitalisation, as illustrated in the chart below (although
this chart is only indicative as not all capital markets are included).
2.1.2 With the exception of the United States,
whose large capitalisation share warrants a large share of domestic
assets in the optimal portfolio, investors in most countries should,
according to this theory, hold mostly foreign assets. The smaller
the home country capital market, the larger the foreign asset
share in the optimal portfolio. Even in the largest European countries,
domestic securities should not account for more than 5-6% of the
investment portfolio.
2.1.3 The strict assumptions of this theory
typically do not hold in practice, however. Purchasing power parity
certainly does not hold except possibly in the very long run.
Nor is the world fully integrated. As a result of these factors,
actual investment portfolios tend to be characterised by notable
"home bias", which can be broadly defined as a tendency
of investors to hold a much larger share of domestic assets than
suggested by market capitalisation shares.
2.1.4 This is changing. As observed by the
IMF in its September 2005 Global Financial Stability Report, there
has been a pronounced increase in the acceptance of foreign assets
among developed country investors. The general trend towards more
internationally diversified portfolios is observable for most
developed countries included in the IMF study, though there is
a notable difference between equities and bonds. In equity portfolios,
the share of foreign assets has risen in all countries studied.
In bonds, however, the international diversification is primarily
concentrated to euro area countries.
2.2 Reduction of home bias in the euro area:
influence of the single currency
2.2.1 The IMF study does not focus on the
impact of the euro on the reduction in home bias. Still, the observation,
that much of the global decline in home bias in bond portfolios
is driven by euro area countries does suggest that it has played
a key role. Several recent papers seem to confirm this conclusion.
2.2.2 Setting the stage for this research,
the two charts below are suggestive of the impact of the euro
on asset portfolios in very general terms. They show the share
of non-domestic EMU assets in the debt and equity portfolios of
different country groupings. The share of assets from other EMU
countries has increased notably in the portfolios of EMU countries
and—to a slightly lesser extent—in the three non-EMU
countries of the old EU-15. In non-EU countries, on the other
hand, EMU asset shares have not changed dramatically. There is
no marked difference in this respect between equity and debt.
2.3 EMU substantially reduced home bias,
especially in bond portfolios
2.3.1 New empirical evidence suggests that,
indeed, home bias has fallen more in the euro area than in the
rest of the world. A new study by De Santis and Gérard
(2006)[13]
computes home bias in the traditional way, ie as the difference
between the actual and optimal share of foreign assets, divided
by the optimal share. Hence, the home bias is 100% if there are
no foreign assets in the portfolio and 0 if the actual foreign
asset share is the same as the "optimal" share, as defined
by capitalisation shares. The ECB study draws several conclusions
from its results. Three key observations are worth emphasising
(as shown in the two charts below). First, the reduction in home
bias is indeed much more pronounced in euro area countries than
elsewhere. Second, the reduction in home bias of euro area investors
has been much more pronounced in bonds than in equities. Third,
while there has also been a marginal reduction in the home bias
of other EU countries, there is little to suggest that this is
a global trend, supporting conclusions made by the IMF that observed
home bias is typically consistent with "optimal" portfolio
diversification given current market conditions.
2.3.2 Also, when excluding assets from other
EMU countries, the decline in home bias in euro area bond portfolios
was notably smaller (far-right bars in the charts). This supports
the conclusion that the reduction in home bias in euro area countries
was primarily euro driven, and not part of financial integration
at the global level. From a currency perspective, the home bias
of euro area investors is thus not so much reduced as replaced
with a "euro area home bias".
2.4 Concluding remarks
2.4.1 Growing cross-border asset holdings
within the euro area and the reduced home bias of euro area investors
are indicative of the much larger capital market that individual
issuers in euros can now tap. This increases the liquidity of
the capital market, which has contributed to the steadily growing
share of large bond issues, and of longer maturity.
2 April 2007
5 Rose, A. (2000) "One Money One Market: Estimating
The Effect of Common Currencies on Trade," Economic Policy,
Vol. 15 (April), 7-45. Back
6
"Gravity" models are based on the notion that the size
of bilateral trade flows between countries can be derived on the
basis of their respective size (GDP) and distance from each other.
This model, in its simplicity, has long been remarkably accurate
in replicating actual trade flows. Back
7
Flam, H, Nordström, H. (2003) "Trade Volume Effects
of the Euro: Aggregate and Sector Estimates ", mimeo, August. Back
8
Flam, H, Nordström, H. (2006) "Trade Volume Effects
of the Euro: Aggregate and Sector Estimates", Seminar Paper
No. 746, Institute for International Economic Studies, Stockholm
University. Back
9
Australia, Canada, Denmark Japan, New Zealand, Norway, Sweden,
Switzerland, UK and the US. Back
10
This time period was chosen for several reasons First, Austria,
Finland and Sweden joined the EU in 1995, so their change of status
does not have to be accounted for. Second by 1995 the single market
programme was well under way. A longer time period would risk
misinterpreting some trade creation from the single market as
coming from the euro. Still, the authors take measures to control
both for the effects of EU membership and single market participation
in the estimates. Back
11
The decision on EMU membership was taken in the spring of 1998,
which suggests that 1999 should be the first year for which the
trade effect is visible. Back
12
The authors also produced a separate estimate of the euro's trade
effects when the control group is limited to the three EU-15 countries
that have not yet adopted the euro. Also in this case there is
a substantial (21%) jump in intra-euro area trade relative to
the control group. However, the small size of the control group
is problematic and no significant euro effect is detected on trade
between the euro area and non-member countries. Back
13
De Santis, R A and Gérard B. (2006) "Financial integration,
international portfolio choice and the European Monetary Union",
ECB Working Paper No. 626, May. Back
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