The EZ Crisis that has been ongoing since 2009 forced policymakers and academics to think hard about what more needs to be done to reduce frequency of future EZ crises and to reduce severity when they do occur. As have been argued in the ‘Consensus Narrative’ essay, the EZ Crisis was a sudden stop crisis that constitutes a dry up in external financing provided by capital flows for several countries. To be able to formulate meaningful solutions for potential future crises, first and foremost, we have to understand the importance of differences in types of capital flows that funded the intra-EZ imbalances.
Figure 1 plots net capital inflows together with net external debt, both as fractions of GDP. Figure 1 shows that most of the capital inflows were debt flows during the first decade of the euro, especially for the periphery countries (denoted with P), whereas non-periphery countries (non-P) were mainly net lenders of such debt (see Kalemi-Ozcan et al. 2014). These financial intermediation patterns within the EZ were shown elsewhere and discussed extensively, but the implications of equity versus debt flows in terms of risk sharing during the Crisis and in terms of slow recovery in the aftermath of the Crisis have been overlooked. I would like to focus on these issues in this essay.
Figure 1. Net capital inflows and net external debt in EZ
Risk sharing benefits
If the main form of financial integration is in terms of cross-border debt flows, such flows have no risk sharing benefits during a severe financial crisis. To obtain risk sharing benefits, the financial integration should involve cross-border ownership of assets, that is foreign investment in the form of equity ownership such as foreign direct investment (FDI) and portfolio equity flows. The difference between FDI and portfolio equity investment is the amount of ownership of capital. Capital ownership exceeding more than 10% is classified as FDI, and ownership of capital that amounts to less than this amount as portfolio equity investment (according to standard balance of payments accounting).1 Both with FDI and portfolio equity investment, foreign equity investors share the risk when the stock market plummets and companies lay off workers since profits of the businesses go down. If such investment is limited, then risk sharing will depend on government and private savings. The problem then is that governments cannot provide risk sharing in the middle of a severe crisis unless they had saved in advance, leaving the burden of risk sharing during a crisis to private savings. This implies a rapidly declining consumption and a deepening recession.
Savings and consumption fluctuations
One can measure how much of the output risk is shared in terms of accounting the fluctuations in consumption as a function of fluctuations in GDP; that is for every 1 euro fall in GDP, how much consumption falls, and vice versa.2 If we focus on periphery countries during 1999-2009, such risk sharing via capital markets (that is cross-border ownership of EZ assets) only amounts to 10%, and for the non-periphery countries to 12%. This means 10-12% of the shocks to GDP are smoothed out via cross-border asset ownership within the EZ and hence not reflected in changes in consumption. Rest of the shocks to GDP is either smoothed ex-post via savings or not smoothed at all, directly affecting consumption. Such ex-ante smoothing via financial markets in the US, among the US states, is 50%. Notice that there is no role for government transfers in such consumption smoothing, where it is purely achieved via integrated financial markets.
When we measure how much savings help to smooth out GDP fluctuations during the first decade of the euro, we see that for periphery countries it is 30%, and for non-periphery countries it is 35%. This means that a big portion of GDP fluctuations, 55% in non-periphery and almost 60% in periphery countries, were not smoothed out. If we further divide the smoothing role of savings between government and private savings, we see that it was half-half; that is half of the amount smoothed by savings is due to government savings and other half is due to private savings in both set of countries. It is not hard to see then what will happen when all governments were forced to save in the middle of the Crisis after 2009. Risk sharing collapses completely, where unsmoothed part of GDP fluctuations comes close to 100%; leaving private saving to carry the entire burden and to the extent that private savings cannot do the job, consumption collapses with falling GDP.
Increasing equity market integration
It is essential that policymakers aim to increase equity market integration within the EZ which will reduce the severity of the crises substantially when they happen and might also reduce their frequency since financial market segmentation will decrease as a result of equity market integration. In addition, if financial integration is in the form of too much debt and too little equity, there is a big problem in terms of sluggish and prolonged recovery as we had observed before during the debt crises of emerging markets and have been observing for the EZ area since 2010.3 As shown in Figure 2 the Eurozone, especially the periphery countries, had accumulated too much corporate debt relative to firms in the US and Japan.4 A natural consequence of such accumulation is increasing levels of corporate debt overhang, measured as debt to earnings ratio of corporates plotted in Figure 3. Such corporate debt overhang is one of the key reasons for sluggish investment and slow recovery in the EZ as shown in Figure 4, where net investment by high and low debt overhang firms plotted separately. The difference between the collapse in investment during the Crisis and the divergence in investment rates in the aftermath of the Crisis at the end of the sample is clearly visible.
Figure 2. Corporate debt in Europe versus US and Japan
Sources: Organisation for Economic Co-operation and Development, and World Bank Organization.
Figure 3. Corporate debt overhang in EZ (aggregated from firm-level data)
Note: Unbalanced sample of all firms in our dataset.
Figure 4. Corporate investment by debt level in EZ
Source: Unbanlanced sample of all firms in our databases.
Why limited degree of equity investment in the EZ
What are the reasons behind the limited degree of equity investment financial integration in the EZ? The ongoing research shows that there are two key elements that hinder equity integration in the EZ.
- First one is cultural that is ‘trust’.
As shown in Figure 5, there is great deal of heterogeneity in terms of trust within Europe. What is plotted in Figure 5 is a typical measure of trust as measured by World Value Surveys as individual responses to questions such as: ‘most people can be trusted’, ‘ECB can be trusted’, and so forth. Research shows that ownership of capital within the EZ is less than fully diversified even within countries or regions sharing the same country-level institutions. Regions of a country where their residents have low levels of trust will also have lower degrees of financial integration.5
Figure 5. Trust within EU
- The second reason for the low levels of equity market integration within the EZ is the fragmentation in laws and regulations.
Such fragmentation leads to segmented financial markets. A significant ongoing effort on banking union will certainly help in mending such segmented markets but as we know such a banking union is only the first step in achieving full-fledge financial integration. Banking union itself is not a panacea in terms of reducing the frequency of crises and their severity in terms of crises’ effect on output. Banking union can easily make output cycles divergent depending on the source of the shock to the economy. If the shock is a common shock to all banks in the EZ then they all cut lending and lead to a credit supply driven fall in GDP in all countries. If the shock is idiosyncratic in terms of a single country banking system, under a banking union, this can be smoothed out. However, if the shock is idiosyncratic in terms of a single country’s firms and households (a real shock instead of a financial shock), then all the union banks will stop lending in that country and lend in the other more productive countries leading to a credit supply driven divergence in output cycles.
Divergence in output growth is not an issue if consumption growth converges among the EZ countries, which in turn, again, can be achieved only with full financial integration based on equity flows that is cross-border asset ownership. If we track the patterns of foreign asset ownership in European countries using a harmonised bilateral firm-level dataset during 1999–2012, we observe the amount of foreign investment into each firm over time together with the identity of direct and ultimate investors.6 Such an investigation reveals that the majority of equity investment in Europe comes from other European countries. However, a much larger share of ultimate foreign ownership of European firms are from north America and Asia, reflecting that such investors invest in European firms indirectly, through European financial centres. The ultimate foreign investors prefer to invest in countries with similar regulatory frameworks to theirs, highlighting the fact that ultimate risk bearers prefer non-segmented legal infrastructures.
Without a harmonised legal infrastructure, both equity integration and banking union will suffer from legal complications moving forward as happened during the first 10 years of the euro. Financial Services Action Plan (FSAP) across EU countries was launched in 1999 and included 42 measures aimed at creating a harmonised EU market for banking, securities, and insurance. The most important part of the project consisted of 27 EU-level directives and two regulations. While regulations become enforceable immediately across the EU, the directives are legislative acts that require from member states to achieve some well-specified results without clearly dictating the means. Most importantly, EU countries have some discretion in the timing of the adoption (transposition) of the directives into the domestic legal order. European governments usually delayed the transposition of the directives to national law for various reasons such as shielding local firms from competition and protecting domestic interests. Hence, the transposition of the directives took several years and differed considerably across the continent.
An alternative is, of course, a fiscal union, where government transfers will do the job of smoothing consumption during severe financial crises if all governments were not in trouble at the same time. A banking union and a broader financial union based on equity ownership are both easier to achieve politically than a fiscal union and will induce a faster recovery in the aftermath of the crisis compared to a fiscal union combined with financial integration based on debt flows.
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Cochrane J H (1991), “A simple test of consumption insurance”, Journal of Political Economy, Vol. 99, 5, pp.957-76.
Ekinci, M F, S Kalemli-Ozcan, and B Sorensen (2007), “Financial Integration within EU Countries: The Role of Institutions, Confidence and Trust,” Chapter in NBER book International Seminar on Macroeconomics.
Kalemli-Ozcan, S, L Laeven, and D Moreno (2015), “Debt Overhang in Europe: Evidence from Firm-Bank-Sovereign Linkages,” working paper.
Kalemli-Ozcan,S, E Luttini, and B Sorensen (2014), “Debt crises and risk sharing: The role of markets versus sovereigns,” Scandinavian Journal of Economics, Special EZ Crisis issue.
Kalemli-Ozcan, S, B Sorensen, and O Yosha (2003), “Risk Sharing and Industrial Specialization: Regional and International Evidence”, American Economic Review, Vol. 93, No.3.
Navaretti G B, A J Venables (2008), Multinational firms in the world economy, Princeton University Press.
Rebooting Consensus Authors (2015), “Rebooting the Eurozone: Step 1—Agreeing a Crisis narrative”, VoxEU.org, 20 November.
Reinhart, C and K Rogoff (2009), This Time is Different: Eight Centuries of Financial Folly, Princeton University Press.
1 100% ownership, that is greenfield FDI, is rare. Most FDI (over 90%) takes the form of mergers and acquisitions in Europe, and among the advanced countries in general, see Navaretti and Venables (2008).
2 This methodology is first developed by Cochrane (1991), and Asdurubali et al. (1996) for the US, and applied to Europe by Kalemli-Ozcan et al. (2003).
3 See Reinhart and Rogoff (2009).
4 Figures 2,3,4 are taken from Kalemli-Ozcan et al. (2015).
5 See Ekinci et al. (2007).
 Kalemli-Ozcan, Sorensen, Villegas-Sanchez, Volosovych, 2015, “Who Owns Europe’s firms?,” working paper.