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Transcript of Financial Region integration
Regional Monetary and Financial Integration:
A Case Study from EU
WHAT IS REGIONAL INTEGRATION?
After two centuries of nation-building, the world has entered an era of region-building in search
of political stability, cultural cohesion, and socio-economic development. Nations involved in the
regional structures and integration schemes that are emerging in most regions of the world are
deepening their ambitions, with Europe’s integration experience often used as an experimental
template or theoretical model.
Regional integration can be defined along three dimensions:
(i) Geographic scope illustrating the number of countries involved in an arrangement (variable
geometry)
(ii) the substantive coverage or width that is the sector or activity coverage (trade, labor
mobility, macro-policies, sector policies, etc.), and
(iii) the depth of integration to measure the degree of sovereignty a country is ready to
surrender, that is from simple coordination or cooperation to deep integration.
Integration also occurs at various levels of society (local, national, regional and international)
and takes economic, social and political forms and its success or failure is determined by the
interaction of enabling and inhibiting variables.
Integration as an Outcome
Defining integration as an outcome means that one describes integration as something static,
whereby a situation of integration is achieved only when certain predefined criteria are fulfilled.
Integration is thus seen as a property of a system, which characterizes the structure or a particular
conjuncture. Scholars define the criteria of what they believe constitutes integration, and then
examine whether case studies match their standards. For instance, if we consider the formation of
the EU as a process of institutionalization, we could examine how "integrated" the EU is at a
certain point in time, thus study the degree and type of integration as a characteristic of the EU.
Integration as a Process
Integration as a dynamic process refers to the development of a state of isolation to a condition
of integration. Research in this case is concerned with the variables, which are likely to induce or
inhibit integration. If we resume our example of the EU as a process of institutionalization, we
might then study the process through which the EU has been integrated.
Integration as a Combination of Outcome and Process
A combination of both integration as an outcome and integration as a process defines integration
as any level of association ascertained by specified measures or as any level of association
between actors, on one dimension or another. This way of defining integration allows the
researcher to speak of various types of integration (economic, social, political et cetera), and of
various levels of integration. This enables researcher to do comparative research.
It is obvious that the static and dynamic approaches are complementary, for at any given point in
time, the units will be situated at any point along the spectrum of integration.
GAINS/ BENEFITS OF REGIONAL INTEGRATION:
From the literature and experience, some traditional and non-traditional gains from regional
integration arrangements could be identified, including:
Traditional Gains from Regional Integration Arrangements
(i) Trade gains: If goods are sufficiently strong substitutes, regional trade agreements
will cause the demand for third party goods to decrease, which will drive down
prices. In addition, more acute competition in the trade zone may induce outside firms
to cut prices to maintain exports to the region. This will create a positive terms of
trade effect for member countries. However, the move to free trade between partners
who maintain significant tariffs vis-à-vis the rest of the world may well result in trade
diversion and welfare loss. The risk of trade diversion could be mitigated if countries
implement very low external tariffs (“open regionalism” arrangements).
(ii) Increased returns and increased competition: Within a tiny market, there may be a
trade-off between economies of scale and competition. Market enlargement removes
this trade-off and makes possible the existence of (i) larger firms with greater
productive efficiency for any industry with economies of scale and (ii) increased
competition that induces firms to cut prices, expand sales and reduce internal
inefficiencies. Competition may lead to the rationalization of production and the
removal of inefficient duplication of plants. However, pro-competitive effects will be
larger if low external tariff allows for a significant degree of import competition from
firms outside the zone. Otherwise, the more developed countries within the regional
integration scheme would most probably dominate the market because they may have
a head-start. On the other hand, current technology may be obsolete in these countries
compared to current and future needs of the regional market. Firms may then decide
to re-deploy new technology and relocate in other areas depending on factor costs. In
this case, countries with the most cost effective infrastructure and human resources
would be the beneficiaries.
(iii) Investment: Regional trade agreements may attract FDI both from within and outside
the regional integration arrangement (RIA) as a result of (i) market enlargement
(particularly for “lumpy” investment that might only be viable above a certain size),
and (ii) production rationalization (reduced distortion and lower marginal cost in
production). Enlarging a sub-regional market will also bring direct foreign
investment, which will be beneficial, provided that the incentive for foreign investors
is not to engage in “tariff-jumping”. This advocates once again for the necessity to
reduce protection and more specifically external tariffs.
Non-traditional Gains from Regional Integration Arrangements
The theoretical as well as applied literatures indicate that there are several “non traditional gains”
from regional integration arrangements.
(i) Lock in to domestic reforms: Entering into regional trade agreements (RTAs) may
enable a government to pursue policies that are welfare improving but time
inconsistent in the absence of the RTA (e.g. adjustment of tariffs in the face of terms
of trade shocks, confiscation of foreign investment, etc.). There are two necessary
conditions for an RTA to serve as a commitment mechanism. One is that the benefit
of continued membership is greater than the immediate gains of exit and the value of
returning to alternative policies. The other is that the punishment threat is credible.
Regional integration arrangements work best as a commitment mechanism for trade
policy. But RTAs can also serve to lock the country into micro and macroeconomic
reforms or democracy if (i) those policies or rules are stipulated within the agreement
(deeper integration arrangements) and (ii) the underlying incentives have changed
following the implementation of the RTA. RIAs may be an instrument for joint
commitment to a reform agenda, but their effectiveness may be limited by the low
cost of exit and difficulties in implementing rules and administering punishment.
With respect to other macroeconomic reforms, one may argue that the degree of
openness of RIAs may help discipline in macro policies (especially if the zone shares
or target a common exchange rate).
(ii) Signaling: Though entering RTAs is costly (investment in political capital and
transaction costs), a country may want to do so in order to signal its policy orientation
/ approach, or some underlying conditions of the economy (competitiveness of the
industry, sustainability of the exchange rate) in order to attract investment. This may
be especially important for countries having a credibility and consistency problem.
(iii) Insurance: RTAs can also be seen as providing insurance to its members against
future hazards (macroeconomic instability, terms of trade shocks, trade war,
resurgence of protectionism in developed countries, etc.). Given that countries are in
the “same boat”, the insurance argument may not be an important rationale for
regional arrangements between developing countries. But with asymmetric terms-of-
trade shocks (such as with oil in Nigeria and the rest of ECOWAS), “insurance” may
become an important rationale for integration.
(iv) Coordination and bargaining power: Within RTAs, coordination may be easier
than through multilateral agreements since negotiation rules accustom countries to a
give-and-take approach, which makes tradeoffs between different policy areas
possible. Since RTAs may enable countries to coordinate their positions, they will
stand in multilateral negotiations (e.g. World Trade Organisation - WTO) with at least
more visibility and possibly stronger bargaining power. The collective bargaining
power argument is especially relevant for the poor and fractioned countries within a
sub-region. It may help countries to develop common positions and to bargain as a
group rather than on a country by country basis, which would contribute to increased
visibility, credibility and even better negotiation outcomes.
(v) Security : Entering RTAs may increase intra-regional trade and investment and also
link countries in a web of positive interactions and interdependency. This is likely to
build trust, raise the opportunity cost of war, and hence reduce the risk of conflicts
between countries4. Regarding security, RTAs could also create tensions among
member countries should it result in more divergence than convergence by
accelerating the trend of concentration of industry in one or a few countries. On the
other hand, by developing a culture of cooperation and mechanisms to address issues
of common interest, RIAs may actually improve intra-regional security. Cooperation
may even extend to “common defense” or mutual military assistance, hence
increasing global security.
COSTS OF REGIONAL INTEGRATION
Regional co-operation and integration do not always lead to peace nor to development. Contrary
to the dominant discourses, efforts at regional integration may generate conflicts and tensions
within and between states, especially when opposing ideological and political systems are
involved or when the economic benefits of integration are perceived to be uneven.
Regional integration also has costs. Among others, these include:
(i) interference in internal affairs, which may compromise sovereignty.
(ii) The pressure and obligation to confirm to the values, principles and protocols of the
regional grouping may also negatively affect domestic policy.
(iii) Similarly, payment of membership fees may be a burden to the tax payer of
impoverished member states.
(iv) Finally, in the event of violent conflict in a member country, member states may pay
with the lives of their citizens, for example as happened for Angola, Namibia and
Zimbabwe during the DRC conflict.
In general, however, the benefits of integration must exceed the costs for membership to a
regional grouping to be attractive.
BARRIERS TO REGIONAL INTEGRATION
(i) Very often, progress towards free trade is hampered by a lack of political will.
(ii) Many countries are reluctant to abolish customs duties which make an important
contribution to their national budgets.
(iii) High levels of protectionism not only raise costs for both producers and consumers,
they systematically discourage investment in export-oriented activities and inhibit
economic transformation.
(iv) National monopolies constitute restraints on competition, free trade and investment;
and the thrust of national reform programs is, among other things, to eliminate them.
But as the market expands beyond national boundaries as part of the integration
process, the subregion must guard against the appearance of subregional monopolies.
(v) Differences in approach and pace inevitably occur from diverse priorities and
understandings of the costs, benefits and risks of regional cooperation.
(vi) While cooperation and integration are desirable policy objectives, the mechanisms for
cooperation and integration call for linkages of disparate institutions or organisations,
which require commonalities or interconnectivity in standards, codes and regulatory
rules.
(vii) High on the list of barriers to cooperation is the lack of clarity as to how much
individual countries can benefit from opening up their markets and what the costs are.
A process is, therefore, needed to build consensus towards reaching commonality of
purpose and to fostering confidence that regional financial integration is in the
interest of all stakeholders. Against this background, a wide range of fresh efforts are
being initiated by ASEAN +3 governments and central banks and by the ADB to
build consensus on, and initiate processes in support of, regional capital market
integration.
(viii) Sometimes, the main impediment to closer economic integration among the countries
can be attributed more to political rather than economic factors. The main reasons
why regionalism in East Asia was slow to take off despite the strong economic
grounds are political in nature. Since the end of World War II, the United States has
sought to protect and advance its major interests in East Asia. These interests include
preventing any single power from dominating the region, maintaining a reasonable
degree of order and regional stability, and safeguarding its economic partnerships in
the region. To achieve this, the United States has arrogated the role of regional
hegemony. There has been no indication that the United States is willing to allow any
East Asian country, not even an ally such as Japan, to share equal responsibility in
preserving stability in the region. This explains why the United States has been highly
sensitive to any move, economic or otherwise, that would bring the East Asian
countries together to the exclusion of the United States. Closer economic integration
in East Asia could adversely affect the influence of the United States and its interests
in the region.
Monetary and Financial Integration:
Monetary integration is crucial in regional economic integration. Strong monetary integration is
required if regional integration objectives go beyond free trade agreements or custom unions to a
truly unified common market (Eichengreen,1998). International trade increases significantly
when countries adopt an advanced form of monetary cooperation such as a common currency
(Rose 1999;Glick and Rose 2001;Bun and Klaassen 2002).So does economic performance and
output per capita participating countries (Frankel and Rose 2000).
Different levels of monetary integration impose different constraints on the macro-economic
policies of participants. The most common case is a pegged exchange rate. Pegging mechanisms
differ in strength and reversibility. With standard pegs (systems with exchange rate bands) the
decision of monetary authorities to realign parity is not subject to formal constraints, but with
harder pegs (a currency board),legal and institutional constraints make realignment more difficult
and costly. The debate over optimal exchange rate arrangements suggests that countries should
go for either flexible exchange rates or for the hardest forms of peg (Obstfeld and Rogoff 1995).
Formation of a monetary union requires:
•Identifying the objectives, policy rule, accountability, and degree of independence from national
governments of the common central bank.
• Allocating responsibility for bank supervision and lending of last resort.
•Establishing mechanisms and procedures for making national fiscal policies consistent with the
union’s monetary objective.
Macroeconomic convergence criteria
The transition towards a monetary union can be gradual or fast. The gradual strategy involves a
long transition of macroeconomic convergence among prospective members and the
development of institutions. A typical example is the European Monetary Union. A “big bang”
strategy entails a much faster transition, without convergence. An example is the monetary
unification in Germany in 1990.
Macroeconomic convergence criteria, generally defined as upper or lower bounds for
macroeconomic variables, are intended to guide the economic policy of future members in the
transition period.
Macroeconomic convergence criteria ensure that, prior to the formal start of the union, all
prospective members commit to low inflation and prudent fiscal policies. The intention is to
avoid the distortionary effects that may arise from the participation of countries whose
macroeconomic policy stance and fundamentals are not consistent with the common central
bank’s monetary objectives. The main variables of concern are the inflation rate, the budget
deficit, and the stock of public debt. To meet a low inflation target, countries must commit to
tough anti-inflationary policies and bear the associated output loss. Their willingness to pay these
real costs will be evidence of their commitment to monetary stability. Budget and debt
requirements will force countries to adjust their fiscal policies to maintain an overall balance
between spending and revenues. These adjustments, too, can be large and costly (expenditure
cuts, increased taxation). A government that carries them out will thus signal its commitment to
sound fiscal management.
Political economy constraints
The success of monetary integration also depends on the interplay of various political economy
factors. The experience of the European Monetary Union, among others, suggests that the
balance between the costs and benefits of integration as well as its long-term sustainability are
heavily affected by the ability to design institutions that take political economy constraints into
account.
Policy conflicts. The basic issue concerns the possibility of policy conflicts. Such conflicts can
arise even when shocks are perfectly correlated across countries, to the extent that policy
preferences are heterogeneous. A typical case concerns the different preferences that countries
have in terms of the unemployment-inflation tradeoff when asymmetric shock hits the region.
When policies are evaluated on the basis of different
The success of monetary integration also depends on the interplay of various political economy
factors social welfare functions, monetary integration might have welfare reducing effects for
countries whose preferred policy from the common policy response.
The heterogeneity of policy preferences can thus pose a threat to the sustainability of monetary
integration in the long run. Careful institutional design is needed to prevent this. If decision
making power in the common monetary authorities is not equally shared among member
countries, then disadvantaged countries will be more likely to drop out. Thus allocating decision
making power in the common central bank on the basis of country size might impede monetary
integration.
One way to address the problem of policy conflicts is to ensure that countries share substantially
similar objectives and evaluate policies on homogeneous grounds. This is possible if monetary
integration is matched by political integration. The formation of supranational political
institutions is, however, a long and difficult process that poses clear problems of institutional
design. Monetary integration is often regarded as a way to achieve political union. The
imposition of macroeconomic convergence criteria during the transition to monetary integration
can help push countries to adopt common objectives.
Fiscal redistribution
Another important political economy dimension relates to seignior age revenues. When the
monetary policy is delegated to a common central bank, seignior age revenues constitute a
common pool of resources to be shared by countries. Conflicts are likely to arise over the
splitting rule. The problem can be exacerbated by the probable shrinking of the common pool of
revenues if the common central bank takes a tight monetary policy stance. The political economy
implications are clear.
Countries unhappy with the splitting rule might decide to drop out, while those that remain might
experience an under provision of public goods. Alternatively, the common central bank, if not
adequately protected from the pressures of national fiscal authorities, might be induced to take a
loose monetary policy stance, thus eliminating most of the benefits expected from monetary
integration.
The allocation of seigniorage revenues is an instance of the more general issue of fiscal
redistribution in a monetary union. Centralization of monetary policy requires the establishment
of compensation mechanisms to transfer resources across countries.
One way to address policy conflicts is to ensure that countries share substantially similar
objectives and evaluate policies on homogeneous grounds typical case is the one where shock
asymmetries imply recessions in some countries and expansions in others. The political
feasibility of such mechanisms cannot be taken for granted, however. Rules are required to
promote the credible commitment of national governments to the system of cross-country
redistribution. Lack of enforcement would put the continuation of the integration process at risk.
Economic and financial integration in Europe: A Case Study
In the next section three aspects of economic integration in Europe, namely trade, labour
mobility and business cycle synchronization will be discussed.
i) First, economic integration has been reflected in a marked increase in intra-euro area trade in
goods and services. The share of exports and imports of goods in terms of GDP within the euro
area increased by 6 percentage points between 1998 and 2006, to stand at around 32% of GDP.
The share of intra-euro area exports and imports of services increased by about 2 percentage
points in this period, to almost 7% of GDP.
ii) A second aspect of the process of economic integration is the degree of synchronization or co-
movement between different cyclical positions across the euro area countries. This degree of
synchronization has increased since the beginning of the 1990s. In other words, a large number
of euro area economies now share similar business cycles.
In addition, the decline in inflation differentials across the euro area countries has been
impressive in recent years. The level of dispersion is currently at a lower level than that among
14 US Metropolitan Statistical Areas. Dispersion in real GDP growth rates across the euro area
countries has been fluctuating around a level similar to the one observed in output growth across
regions within the United States.
iii) Labour mobility within the EU constitutes a third aspect of economic integration. Labour
mobility offers additional choices to workers. It can dampen the effects from country-specific
shocks and decrease the risks of wage pressures as labour markets tighten. Available evidence
suggests that, overall, cross-border labour mobility is still limited within the European Union
with regulatory barriers still existing, even within the euro area itself with respect to labour from
Slovenia, for example. Germany belongs to the countries which currently prevent labour
mobility from some EU countries. This comes at a time when many companies are reporting
problems in finding properly skilled labour. For instance, the German industry currently reports
very significant shortages of labour, according to a survey by the European Commission.
Financial integration in Europe
The introduction of the euro has contributed to intra-European financial integration which, in
turn, has facilitated the free movement of capital in the euro area. Financial integration
strengthens competition and raises the potential for stronger non-inflationary economic growth.
It also improves the smooth and effective transmission of the single monetary policy throughout
the euro area.
Financial integration also helps financial systems to channel funds from those economic agents
that have a surplus of savings to those with a shortage; in particular, it enables agents to
effectively trade, hedge, diversify and pool risks. As a result, there is a better sharing and
diversification of risk.
According to academic research, in the United States, over the period 1963-90, capital markets
smoothed out 39% of the shocks to gross state product (the equivalent to GDP), the credit
channel smoothed out 23% and the federal government, through the fiscal channel, 13%. Around
25% of the shocks were not smoothed out. Hence financial markets and financial institutions
contributed 62% to the absorption of idiosyncratic state shocks. We therefore see from the US
example that the financial channel can be much more important than the fiscal channel. This is
an additional reason for speeding up financial integration in Europe. In a more recent study, it
was found that the situation in the euro area countries has begun to converge towards that of the
United States as inter-euro area country capital flows increase. It was found that in what would
become the euro area countries (excluding Luxembourg), capital markets would have smoothed
out about 10% of the country-specific shocks to GDP between 1993 and 2000.
A set of indicators, published by the ECB, points to an increasing degree of integration of euro
area financial and banking markets since 1999. Moreover, the size of capital markets — in terms
of the ratio of the total value of stock, bond and loan markets to GDP — has increased
substantially since 1999, and has the potential to grow even further, as seen from a comparison
with the United States. In the period 1995-99, it was 177% of GDP in the euro area and 279% in
the United States; in 2005-06 it had increased to 256% in the euro area, and 353% of GDP in the
United States. In Germany this ratio rose from 202% to 229% of GDP.
Integration in retail banking, by contrast, has been slow so far. There are still significant
differences in bank deposit and lending interest rates across euro area countries. In the euro area,
the cross-country dispersion is higher than the intra-regional dispersion of the same rates in the
United States.
This notwithstanding, overall there is evidence of growing economic and financial integration
among the countries of the European Union. The adoption of the euro has contributed to this
development by reducing information costs, enhancing price transparency and eliminating
exchange rate risk between countries in the euro area. Nonetheless, in some fields, a lot remains
to be done, for example, that of increasing intra-euro area labour mobility and financial
integration in retail banking.
Reference:
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