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.

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