Financial Integration among New EU Member States and the Euro Area

Since monetary policy is by large implemented through the financial system, the later must be as efficient as possible in order to guarantee a smooth and effective transmission of monetary policy. The degree of financial integration (integration of money markets, FX markets, bond markets and equity markets) is therefore important in determining how effectively this transmission will work in practice. In the case of new EU Member States, which are committed to adopt the euro, it is especially important to analyze the alignment of their economies with those of the euro area.
Financial market integration should take place when financial assets having similar risk factors and yields are priced identically by the markets no matter where they are traded. This follows from the law of one price. The more the individual segments of the financial markets of countries planning to adopt the euro become integrated with the European market, the more financial asset prices will be affected by global (European) factors associated with symmetric shocks rather than by local (national) effects associated with asymmetric shocks. Such shocks may be due to any factors capable of affecting asset prices. It can be assumed that with increasing integration the individual financial market segments will become a less likely source of asymmetric shocks. These reasons make it desirable for monetary policy makers to know the degree of, and trends in, integration of financial market segments. This analysis focuses on the integration of the money, foreign exchange, bond and stock markets.
The paper focus on integration of financial markets (money, FX, bond and stock-exchange markets) in five new European Union member states (Czech Republic, Hungary, Poland, Slovakia and Slovenia) and three older EU members (Germany, Austria, Portugal) in comparison with the Euro Area. The main objective is to test for the existence and determine the degree of financial integration among these countries relative to the Euro Area (EU-12). The analysis is performed by means of the (i) application of the concept of beta convergence (through the use of time series, panel, and state-space techniques) to identify the speed of integration; and (ii) the application of so-called sigma convergence to measure the degree of integration. The calculations were made using weekly data (averages of daily data) from Bloomberg, covering 1995/01 to 2008/08 for the foreign exchange and stock markets, 2001/01–2008/08 for the money market and 2002/01–2008/08 for the bond market. We find that the most integrated financial market seems to be the bond market followed by the FX, money and stock market.
JEL Classification: C23, G15, G12
Keywords: financial integration, new EU member states, beta convergence, sigma convergence