Financial Market Integration and the New OFA Theory

When examining examples of financial market integration over the past 300 years, some could argue that the slow but steadfast progress towards consolidation of financial economic regions is inevitable. In order to perform analysis upon the governance of these financial integrations, can and should the lessons of the United States, Canada and, more recently, Europe be transplanted to other areas of the world such as Asia?

Erik Jones, Director of European & Eurasian Studies at the Paul H. Nitze School of Advanced International Studies of the Johns Hopkins University, and Geoffrey Underhill, Director of the Political Economy & Transnational Governance research programme at the Amsterdam Institute for Social Science Research, think they should. They have developed a paper sponsored by the SWIFT Institute that develops the idea of Optimum Financial Areas (OFAs) as a more pertinent and modern tool for policymakers when determining economic policy in the aim towards financial stability. In this increasingly integrated world, Jones and Underhill encourage policymakers to utilise the OFA framework in order to better weigh up the costs versus benefits of the wider technical market substructures and macro-prudential elements in play.

The SWIFT Institute spoke to Erik Jones regarding his paper, Theory of Optimum Financial Areas: Retooling the Debate on the Governance of Global Finance (co-written with Underhill), as well as to Masayuki ‘Mike’ Tagai, Global Market Infrastructure Executive for Asia at J.P. Morgan’s Corporate & Investment Bank, and Robert Jenkins, Adjunct Professor, Finance at London Business School and former member of the interim Financial Policy Committee (FPC) of the Bank of England, in order to gain their perspectives of the reality in application of OFAs to areas outside of Europe.

Optimum Financial Areas (OFAs)

The theory of Optimum Financial Areas builds on the economic theory of Optimum Currency Areas (OCA), but instead of concentrating on exchange rates or macroeconomic adjustment, there is rather a focus on capital mobility and cross-border financial transactions.

The paper describes in interesting detail the evolution of financial market integration, prior to the more recent European experiment, in three national cases including the UK, the US and Canada. From these case studies, Jones and Underhill have extrapolated that six criteria were necessary for each in order to reach stable financial integration. Three of these criteria relate to the technical substructure of markets, and include a shared risk-free asset, centralised common debt management, and common market infrastructures for communication, clearing, settlement and depository. Three further criteria focus on the macro-prudential considerations such as shared rules for financial supervision, centralised lender of last resort facilities for private- and public-sector market participants, and common provision for the resolution of failed private- and public-sector borrowers.

Europe: what will it take?

When examining the recent Euro crisis, Jones points out that contrary to popular opinion the crisis was not a result of a design flaw with the Euro. In his opinion it was the lack of agreement and coordination regarding the six financial criteria (as identified above), two of which are most critical in the European case: a common risk-free asset, and a centralised system for common debt management. According to Jones, European policymakers should come to grips with the fact that when they talk about macro-prudential oversight, they also need to include the technical substructure of market infrastructure.

The first criterion is the development of a common risk-free asset, perhaps better known as a Eurobond. Jones compared the European systems to that of the United States. When investors in the US become afraid, they sell risky assets and buy US Government Bonds. In Europe bonds are likewise bought, but unlike in the US, there is a choice of national bonds and some are deemed safer than others (e.g. German bonds vs. Italian bonds). Jones emphasised: “Can you imagine what would happen if in the US, people could sell Mississippi to buy New York? It would be an uncontrollable disaster. Yet that is that the situation we have in the European context. Mario Draghi, President of the European Central Bank, was forced as a result to promise to buy unlimited amounts of sovereign debt from unstable Eurozone countries because he recognised that these ‘flight to quality’ or ‘flight to liquidity’ dynamics were going to tear the Euro apart. Well, unfortunately those dynamics are still potentially available.”

The second critical criterion is a centralised system for common debt management similar to popular credit card systems such as Visa and MasterCard. A centralised debt management authority, run potentially by the European Council, would need to be responsible for issuing Eurobonds and insuring that they retain their market status (senior in the market to nationally-issued sovereign debt instruments). Just as in the credit card system, a limit in borrowing would need to be enforced. The benefits of greater transparency in government accounting and more frequent reporting would outweigh the likelihood that a country would default due to the disincentive of being locked out of the ability to borrow with this shared instrument. Germany, however, did not agree with this approach and ended up rejecting the Eurobond proposal. Jones, emphasised that, “Germany sees this as a country-specific problem. But it is rather a structural problem in that there is something in the relationship between all of the Eurozone countries that makes this situation inevitable.”

In Jones’ opinion, Europe will have to go through another crisis in order for policymakers to re-review the governance behind the Euro. He observed that, “We seem to be scurrying perilously quite close to that right now. Without the design fixes that we propose in our paper, the likelihood of a crisis is unlikely to resolve itself. Policymakers are just going to struggle along for a while until something bad happens, and that is a big concern.”

Politics trumps economics

Robert Jenkins, at the London Business School, has reservations, however, about the practical applicability of OFAs. He explained, “Economics shapes politics but politics trumps economics. Politics created the common currency. Politics has saved (for now) the common currency. Though the Eurozone’s problems were economic in origin, the solution is ultimately a function of political commitment.”

Jones empathised with the understandable reluctance of national leaders to sacrifice the necessary sovereignty and of elected officials in surplus countries to be seen to pick up the tab for deficit countries still in need of debt restructuring. He believed that political consensus and commitment for the next level of Eurozone integration would take time to build. He commented that, “The Euro will remain vulnerable until this consensus is achieved and be more vulnerable the more difficult the economic backdrop.  Building the necessary consensus will take a long time.”

Asian take-away?

The hope remains that lessons learned from the recent Eurozone crisis can be applied to other regions developing the idea of financial market integration, such as the Association of Southeast Asian Nations (ASEAN) where political commitment towards further economic integration is evident.

J.P. Morgan’s Masayuki Tagai believes that exploratory papers such as the development of the OFA theory are extremely useful, specifically in the advancement of forward-looking frameworks. In terms of comparing the ASEAN region to the Eurozone, however, the differences between the drivers of the two regions should not be overlooked. Asia has already gone through its crisis 15 years ago and capitalised on its lessons learned in that the domestic currency denominated bond markets have grown significantly within each economy. Furthermore, the historical drivers within Europe, in terms of destruction as a result of two World Wars and subsequent reconstruction, has created a strong political will towards financial integration. When drivers exist due to these extreme occurrences, the benefits clearly outweigh the costs. When these drivers have not been experienced to the same level of intensity, Tagai is sceptical, for example, that ASEAN or the wider Asia will go down the route of a single currency.

Tagai explained: “It looks simple, but the pain or the cost to get there outweighs the benefit of staying as we are today. Instead of going through the pain of abolishing one currency and then going into another, could several currencies co-exist and still create an integrated single market?” He concluded, “If you put all that into context, I’m probably saying Asia is happy being Asia.”

Future frameworks

In Europe, Jones and Underhill have shown that the lessons of the recent euro crisis can indeed be extrapolated upon; nonetheless, complete European financial integration still remains a long way off. Steps toward governance of financial market infrastructures to include technical substructures of the market will most likely take years before implementation, with the very real likelihood that it will take another Euro crisis in order for any real change to be made. It all comes down to the drivers.

ASEAN in the meantime will be politically weighing up the cost (or the ‘pain’) versus benefit with regard to the actual degree of financial integration. Learning from European lessons might prove difficult given that they are incomplete. Notwithstanding, possibilities abound for ASEAN including the potential creation of an integrated single market area and several currencies co-existing within.

Given the unique historical drivers behind each of the individual regions desiring further financial market integration, the development of the OFA theory is useful in providing, not a cookie-cutter policy approach, but rather the development of a future-looking framework so that policymakers can transparently weigh up costs and benefits in order to assess how deep, in terms of financial market integration, they are willing to go.

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