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The literature on international financial integration from the past four decades is numerous and wide in scope. It is surveyed in this chapter from the viewpoint of its measurement. From the overview of theories that have this more quantitative focus and their empirical application, the aim is to resolve the process, degree and state of financial integration, particularly in Europe. The eclectic approach adopted in this chapter starts off by organizing macroeconomic theory-based methodologies into three strands. The first uses deviations from interest parity to test if financial markets are internationally integrated. The second uses savings-investment correlations on the basis of Feldstein and Horioka’s condition that with perfect capital mobility, no relation between domestic savings and domestic investment should be apparent. The third uses consumption correlations derived from intertemporal consumption smoothing behavior and risk sharing across countries as measures of perfect financial integration.

In the review of each of these theories and the conditions they bring forward, it transpires that deviations of interest parity are in the category of price-based measures and measure financial integration in the narrowest sense. Often applied to specific instruments and to the short end of fixed income markets,

it measures the financial integration of the markets they are traded in, such as onshore and offshore money market securities. Imperfect financial integration is interpreted as evidence that capital controls,

transaction costs, exchange rate and other such barriers between these markets still exist. The broadest among these conditions, real interest parity (RIP), is a measure of both financial and non-financial integration. It is shown that the Feldstein-Horioka condition of no correlation between savings and investment is yet broader that RIP. It requires in addition the assumption of endogeneity of savings and investment and exogenously determined world interest rates. As such it is a measure of financial and non- financial integration in a net sense and therefore no longer of the price-based but of the quantity-based variety. Tests resulting from the theory on consumption correlations are also very broad and quantity- based. They rely on even stronger assumptions, namely that of perfect financial market integration and prefect intertemporal consumption smoothing behavior according to the model specification or complete markets.

Knowing the theoretical foundations and assumptions underlying the various measures of financial integration, it is logical that in the review of the evidence of their empirical study the interest parity conditions bring out the clearest results. Covered nominal interest parity (CIP) holds to close approximation for most short-term markets in the industrialized world already in the 1980s. Uncovered interest parity (UIP) often tends to break down and the interpretation given to this result is that financial assets

denominated in different currencies are imperfect substitutes. It is even rarer for real interest parity (RIP) to hold between countries. Empirical studies based on the Feldstein-Horioka (FH) condition of no

correlation between domestic savings and investment consistently find evidence of weak financial integration among industrialized countries. In the discussion of the various responses to this so-called FH puzzle it becomes apparent that savings-investment correlations are widely challenged as an appropriate measure for international financial integration. Consumptions correlations also suffer from such

interpretation issues and produce altogether weak results. Though empirical studies from this strand do seem to indicate (weak) evidence that markets are integrating, consumption growth of countries are by far not completely correlated and consumption risks not fully insured in financial markets. In light of the weak and conflicting empirical evidence the savings-investment correlations and consumption correlations provide, they become further discarded in the theoretical debate because of questions around the structural parameters they measure.

The debate on capital controls, discussed as a fourth macroeconomic strand, proceeds alongside all the while. It has insofar as real measures of financial market integration are concerned focused on the quantification of the structural determinants of capital controls. From this, it is found that capital controls are more likely imposed by strong or large governments with less independent monetary authorities and are more likely also in poorer countries. A historical account of capital controls in the OECD confirms a well-

known fact; that industrialized countries have progressively dismantled capital and exchange controls since the 1980s to the extent that financial markets are almost completely liberalized in this sense. In Europe, on which the analysis is focused henceforth in the chapter, EEC ministers agree to the complete removal of capital controls by 1990. While the course to a single market is set, national currencies remain a reality for the rest of nearly the whole decade. Evidence from financial integration measures in that period do detect a positive EEC-effect.

Following EMU and the successful transition of capital markets to the Euro, the assessment of their financial integration is reinvigorated. It is shown that the measures of financial integration discussed so far in this chapter are not given priority in the selection of tools to be applied to the new constitution of markets under the Euro. It is speculated that this is because some measures are clearly redundant (such as determinants of capital controls) and others have proven to be too difficult to interpreted in practical sense (such as savings-investment and consumption growth correlations). The remaining and most credible of measures, the interest parity conditions, have proven their use mostly in short-term money markets but rarely beyond that. In the new setting of European markets, with the elimination of intra-market currency risk, they either measure the one extreme of closed interest parity, already broadly shown to hold, or the other extreme of real interest parity, rarely shown to hold. Thus instead new measures are adopted borrowing from the economic growth literature and from financial economics studies on equity returns. With this, inherently the scope shifts from measuring financial integration in a narrow sense (if one considers the interest parity conditions) to measuring economic ánd financial integration. The

comprehensive set of measures reveal a cascading of different levels of integration of different segments of the Euro capital markets. An almost complete level of integration is observed for the unsecured money markets (the repo market remains fragmented), a high level of integration for the government bond markets and related derivatives markets, a lower but increasing level of integration for the corporate bond markets and equity markets and the lowest level of integration for bank credit markets.

The ability of investors to make uninhibited asset allocation choices in fixed income markets in Europe is thus shown to have significantly improved pre to post-EMU. Pre-EMU, capital controls are abolished and the degree of integration of the money markets, the foundation of fixed income markets, is already significant. Currency volatility in the Exchange Rate Mechanism (ERM) in the 1990s is shown to be the largest remaining obstacle to further integration. For this reason alone, EMU has by virtue of its elimination of intra-market currency risk a severe positive impact on financial integration. Post-EMU, a comprehensive set of measures show that this integration within the fixed income markets of the Euro further extends itself beyond the unsecured money markets to the bond markets. Within the bond markets, the government sector enjoys a higher level of integration than that of corporate eurobonds.

Lastly in this chapter three new avenues of research that are emerging from the literature are pointed out. In recognition of the growing complexity of capital markets, I note that one branch is

concerned with the application to specialized sectors of the capital markets, such as mortgages. The second branch is an off-shoot from consumer growth correlations models and studies risk sharing and industry specialization as measures of financial integration. It also incorporates separately the study of the consequences of financial integration for consumer welfare. The third branch combines methods from macroeconomics on international financial integration with methods from financial economics on equity return variation. Cross-fertilization between these two fields has to date been rare but examples of studies that do for the wider set of bond markets that include eurobonds look promising. The decomposition methodology enables the determination of country and industry effects in bond returns and offers a new perspective on financial and economic integration under EMU. These results can be expanded on in a study of the mean-variance performance of bond portfolios allocated on a country and industry basis through the methodology of spanning and efficiency tests. The two methodologies put together provide fertile ground to further study the scope for the financial integration of bond markets in Europe and best portfolio diversification before and after EMU. The empirical analysis described in Chapters 4 and 5 sits in this fertile cross-over territory. Before this is embarked upon, Chapter 3 provides indications from market practice on changing bond allocations as a result of EMU to provide further background to this empirical research.

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Bond markets and bond portfolio allocation before and after EMU:

Indications from market practice

1. Introduction

The aim of this chapter is to provide a descriptive account of the impact of EMU on fixed income markets in Europe, both immediate and over the years to follow. This is done mostly in comparison to the ways in which markets had operated before national currencies were irrevocably locked to the Euro. A portrayal of evidence from market practice cites the fundamental and lasting changes the monetary union has brought about to the financial markets it incorporated. Securities volumes and trading data is put together with evidence from the finance literature and anecdotal substantiation to give testimony to the evolution of fixed income markets in Europe from the early 1990s to more or less the present day. Once the context of the changing landscape of fixed income markets in Europe is adequately described, the chapter turns its attention to changing asset allocation and diversification opportunities for bond portfolio managers. Prior to the creation of EMU, bond markets in Europe are segregated along national currency lines. This segregation of markets is more than by currency alone as issuance practices, trading conventions, settlement arrangements and the like tend to differ between markets even for similar types of securities. Not only is the bond market itself, but also the infrastructure underlying this market highly dispersed. In addition to these supply-side factors, there are important factors on the demand-side that cause the operations of the European bond markets in those days to be a largely national domestic affair. Institutional investors are often constrained by national regulations on their investment portfolio purchases, through currency matching rules among others, which make them strong natural buyers of domestic government debt.

It is described in this chapter that the establishment of EMU implies significant changes to this constitution of markets. The various impacts of EMU are categorized into direct and indirect effects. Financial markets in Europe directly adopt the single currency with a Big Bang. In the bond markets, outstanding issues are redenominated and new issues are for the vast majority issued in Euro. Bond conventions are harmonized and EMU sovereigns coordinate and synchronize issuing and trading practices of their debt. These direct effects irreversibly transform the patchwork of national European bond markets to a more harmonized and large domestic bond market denominated in one and the same currency almost immediately. These direct effects are by now well known and in the finance literature universally attributed to EMU. What gives more ground for dispute among financial economists is to what extent the subsequent changes that can be observed in Europe’s financial markets can be indirectly attributed to EMU.

In this chapter it is argued with respect to the fixed income markets at large and the bond markets therein, that the indirect impact of EMU has also been considerable in many ways. Through an abundance of fixed income securities data, mainly from the Bank of International Settlements (BIS) and Dealogic, it is demonstrated that following the launch of EMU, the Euro markets quickly sum up to more than its parts. The new market environment strongly encourages the growth of the credit sector. A more liquid and transparent domestic government bond sector where internal prices differences are on a downward trend leads to much higher corporate and financial institutions issuance. The elevation of the fixed income markets to a pan-European level strongly contributes to this and to other developments, which altogether give rise to a new landscape of fixed income markets in Europe and which continues to be shaped by these developments. It is a market that, as will be seen, also remains segregated in some ways. With the benefit of hindsight of approximately a decade of data, the contours of this new landscape can be accurately drawn. This is done in the first part of this chapter.

The latter part of this chapter then focuses on the way in which the new fixed income market environment created directly and indirectly by EMU has caused bond investors to respond with respect to their portfolio allocation decisions and strategies. Again, indications from market practice are taken to create as accurate an account as possible. As consistent and comprehensive data on portfolio flows and compositions are not readily available, evidence on this from the finance literature and investor surveys are pieced together. From this, the picture emerges that bond investors indeed have responded along with the new ability and opportunities for diversification that the Euro bond market offers compared to the old set of markets. It is shown in this chapter that this goes in broadly two directions. The first is a more

‘international’ composition of bond holdings, as the fading of borders results in a more even spreading of portfolios. The second is a broader ‘credit’ composition of bond portfolios, as investors have the intention to incorporate more corporate eurobonds. Particularly this latter change, for which the evidence to date seems merely circumstantial and incomplete, leads to further questions on whether bond investors in Europe have changed their diversification strategy in tow.

The remainder of this chapter is organized as follows. To start with, in Section 2, the landscape of Europe’s fixed income markets pre and post-EMU is compared in detail. This data rich section

demonstrates the development of various segments of the Euro bond market and also contains market data supporting fundamental shifts in the investment opportunity set for bond portfolio managers. Section 3 cites anecdotal evidence from market practice on the response from investors with respect to this new market environment. Section 4 surveys the finance literature for theoretical guidance on optimal asset allocation strategies in Europe for bond investors. Finally, Section 5 concludes.