The report contains a review of the literature on price based measures of financial markets integration. We survey different approaches, all based on the idea that integration exists when the law of one price holds. This golden rule of financial integration literature claims that with markets integration, there should not be space for unexploited international arbitrage and the prices of the same item in different currencies would only reflect the differences in exchange rates. Several variables have been traditionally used to verify the law of one price: the cost of interbank funds denominated in the same currency; the covered interest-rate parity (no interest rate arbitrage opportunities between two currencies) or the co-movements of stock prices or volumes across countries. In this report we follow that latter approach and confine our analysis to stock and bond markets. The report proposes two methods to derive indicators of financial integration based on the sensitivity of domestic European stock (sovereign bond) markets to global, US or European shocks. Our time frame goes from 2000 to 2015. The common rationale is to measure the extent to which domestic stock (bond) market volatility incorporates external shocks, following the idea that in more integrated markets shocks transmit more easily. The first method, based on correlation of stock market returns, estimates two measures of integration. Firstly, the proportion of shocks generated in EU and US markets that actually hit EU domestic markets and secondly domestic sensitivity to foreign shocks (spill over intensity). We find that during the EU sovereign crisis over 30 (20) percent of the EU (US) originated shocks were shifted into domestic volatility in distressed countries while they had little impact in Eastern countries. For Denmark, Sweden and UK the proportion of variance in domestic returns that could be explained by US generated shocks was similar to that of the EA core countries (about 45%), while the EU influence was about 10 percentage points smaller. Spill over intensity originating from EU is larger for distressed Euro area countries than for the core ones while the reverse occurs for that originated from US. For eastern countries spill over intensity (either from EU or from US) is negligible. The third method, based on common factor portfolios, identifies a set of recurrent common factors in EU and World stock and bond markets, interpreted as integration drivers, and derive a measure of domestic integration by calculating to what extent domestic returns reflect the common factors. For the equity market results indicate that Euro area distressed countries present lower integration for all the period analysed. Denmark, Sweden and UK show patterns similar to core EA countries with higher sensitivity to idiosyncratic effects after 2009. Local influences dominate for Eastern countries where, with the exception of 2008, global factors have little explanatory power. The disintegration phase after 2008 is much more evident in the bond market where idiosyncratic effects prevail especially for distressed Euro area countries. Finally, we discuss the drivers of integration in the equity market by estimating a panel model relating integration, as measured by common factor portfolios, with many macro and institutional variables. Our analysis shows that macro-economic variables reflecting the country’s economic prospects (eg. GDP, deficit and inflation) and the development of the domestic financial market have an impact on the degree of integration. Credit ratings, trade openness and measures of governance overall do not affect financial integration. This policy report merges the JRC contribution to the European Financial Stability and Integration Review1 (EFSIR) with a more in depth analysis on the issue of financial integration. The policy context of our work relates to the EFSIR which provides a general view on how financial markets performed in the previous year and identifies indicators relevant to the key objectives in the Capital Markets Union (CMU) Action Plan2. The Action Plan sets out a set of measures3 to achieve a single market for capital in the European Union, aiming to mobilise capital, to foster economic growth and create jobs. CMU also aims at promoting financial stability by complementing the actions undertaken under the Banking Union4 initiative.

Measures and drivers of financial integration in Europe

ROSSI Eduardo;
2017-01-01

Abstract

The report contains a review of the literature on price based measures of financial markets integration. We survey different approaches, all based on the idea that integration exists when the law of one price holds. This golden rule of financial integration literature claims that with markets integration, there should not be space for unexploited international arbitrage and the prices of the same item in different currencies would only reflect the differences in exchange rates. Several variables have been traditionally used to verify the law of one price: the cost of interbank funds denominated in the same currency; the covered interest-rate parity (no interest rate arbitrage opportunities between two currencies) or the co-movements of stock prices or volumes across countries. In this report we follow that latter approach and confine our analysis to stock and bond markets. The report proposes two methods to derive indicators of financial integration based on the sensitivity of domestic European stock (sovereign bond) markets to global, US or European shocks. Our time frame goes from 2000 to 2015. The common rationale is to measure the extent to which domestic stock (bond) market volatility incorporates external shocks, following the idea that in more integrated markets shocks transmit more easily. The first method, based on correlation of stock market returns, estimates two measures of integration. Firstly, the proportion of shocks generated in EU and US markets that actually hit EU domestic markets and secondly domestic sensitivity to foreign shocks (spill over intensity). We find that during the EU sovereign crisis over 30 (20) percent of the EU (US) originated shocks were shifted into domestic volatility in distressed countries while they had little impact in Eastern countries. For Denmark, Sweden and UK the proportion of variance in domestic returns that could be explained by US generated shocks was similar to that of the EA core countries (about 45%), while the EU influence was about 10 percentage points smaller. Spill over intensity originating from EU is larger for distressed Euro area countries than for the core ones while the reverse occurs for that originated from US. For eastern countries spill over intensity (either from EU or from US) is negligible. The third method, based on common factor portfolios, identifies a set of recurrent common factors in EU and World stock and bond markets, interpreted as integration drivers, and derive a measure of domestic integration by calculating to what extent domestic returns reflect the common factors. For the equity market results indicate that Euro area distressed countries present lower integration for all the period analysed. Denmark, Sweden and UK show patterns similar to core EA countries with higher sensitivity to idiosyncratic effects after 2009. Local influences dominate for Eastern countries where, with the exception of 2008, global factors have little explanatory power. The disintegration phase after 2008 is much more evident in the bond market where idiosyncratic effects prevail especially for distressed Euro area countries. Finally, we discuss the drivers of integration in the equity market by estimating a panel model relating integration, as measured by common factor portfolios, with many macro and institutional variables. Our analysis shows that macro-economic variables reflecting the country’s economic prospects (eg. GDP, deficit and inflation) and the development of the domestic financial market have an impact on the degree of integration. Credit ratings, trade openness and measures of governance overall do not affect financial integration. This policy report merges the JRC contribution to the European Financial Stability and Integration Review1 (EFSIR) with a more in depth analysis on the issue of financial integration. The policy context of our work relates to the EFSIR which provides a general view on how financial markets performed in the previous year and identifies indicators relevant to the key objectives in the Capital Markets Union (CMU) Action Plan2. The Action Plan sets out a set of measures3 to achieve a single market for capital in the European Union, aiming to mobilise capital, to foster economic growth and create jobs. CMU also aims at promoting financial stability by complementing the actions undertaken under the Banking Union4 initiative.
2017
978-92-79-65709-2
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Utilizza questo identificativo per citare o creare un link a questo documento: https://hdl.handle.net/11571/1211158
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