Eurozone s leader and its followers: Are their markets integrated enough?

Transcription

1 Eurozone s leader and is followers: Are heir markes inegraed enough? Nikolaos Giannellis* Deparmen of Economics, Universiy of Cree, Universiy Campus, 700 Rehymno, Greece Telephone: Fax: giannellis@uoc.gr Minoas Koukouriakis Deparmen of Economics, Universiy of Cree, Universiy Campus, 700 Rehymno, Greece Telephone: Fax: m.koukouriakis@uoc.gr Absrac: This paper invesigaes wheher commodiy and capial markes inegraion has srenghened afer he EMU formaion. Focusing on he dominan role of Germany as he leading economy in he EMU, we es he progress of markes inegraion beween Germany and seleced EMU counries. For comparison reasons, we examine he same research quesion beween Germany and seleced non-emu counries. Our research was based on he analysis of he PPP and UIP condiions and wheher hese wo condiions hold joinly or individually. Our evidence implies ha afer he launch of he euro, here is sronger inegraion beween Germany and non-emu counries, such as Japan and he USA, raher han beween Germany and EMU counries. These resuls can be explained by he fac ha even hough here is increased heerogeneiy across EMU counries, hese counries canno adjus heir exchange raes in order o respond o shocks and resore equilibrium in commodiy and capial markes. * Corresponding auhor The auhors would like o hank Carsen Trenkler for kindly providing hem wih he Gauss codes for he SLT coinegraion ess. Of course, all he remaining errors are of our own.

2 . Inroducion The esablishmen of he European Economic and Moneary Union (EMU) was admiedly a remarkable sep in he direcion of enhancing economic inegraion among European counries. The launch of he common currency was expeced o lead o price sabiliy, lower ransacion coss, sronger inra-euro rade relaionships and hus, o higher growh for counry-members. This opimisic view is obviously relaed o McKinnon s (96) conribuion o he heory of Opimum Currency Areas (OCA). However, a fundamenal weakness of he EMU, such as he lack of homogeneiy across member-counries, should no be ignored. A number of divergen facors, such as dissimilar naional policies (apar from he moneary policy) and differen naional regulaions on goods and labour markes, may increase he possibiliy of emergence of asymmeric shocks in he Eurozone. On he oher hand, his view is relaed o Mundell s (96) original conribuion o OCA heory. Having in mind he aforemenioned heerogeneiy and he resuling asymmeries across counries, academics and policy makers focus on answering he quesion of wheher he EMU achieved is goals. The main reservaion in his analysis arises from he presence of asymmeries and he lack of auonomous moneary policy for member-counries. This is because an asymmeric shock could be managed by an exchange rae adjusmen. However, in a moneary union, like he EMU, his is no he case. Thus, he main quesion is wheher he common moneary policy (including he exchange rae policy) can achieve higher growh raes and higher economic and financial inegraion in he Eurozone. De Grauwe (009) argues ha in he firs decade of euro s life and before he deb crisis arises, here is lile evidence ha he euro caused higher growh raes in he Eurozone. On he oher hand, nobody can argue ha he euro had negaive impacs on growh. However, i is also rue ha he EMU suffers from significan design weaknesses, which became more eviden and sronger during he sovereign deb crisis. Wha may be indicaive of he progress of economic inegraion among EMU members is ha real effecive exchange raes deviae among hem, hereby implying ha heir compeiive posiions have diverged (De Grauwe, 009, 00). Norhern European counries such as Germany, Ausria and he Neherlands, De Grauwe (00, 009) argues ha he focus of he European Cenral Bank (ECB) on he low inflaion objecive is problemaic, because a low levels inflaion is no a reliable signal in sabilising flucuaions in oupu. Moreover, based on he EMU experience, he also argues ha money (M) has almos no predicive power for fuure inflaion because of he same reason. De Grauwe and Ji (0) show ha member-counries of a moneary union face a self-fulfilling liquidiy crisis, because hey issue deb in a currency ha hey do no conrol. In addiion, De Grauwe and Ji (0) argue ha he common ineres rae allows for booms and buss, i.e. he ineres rae is oo low for overheaing economies, bu i is oo high for economies in recession.

3 gain in erms of inernaional compeiiveness, while compeiveness in inernaional rade for Souhern European counries, such as Greece, Ialy and Spain, has deerioraed. In his conex, he presen paper aims o find wheher economic and financial inegraion has increased among counries afer he creaion of he EMU. To be precise, we invesigae wheher EMU counries as well as seleced non-emu counries are financially inegraed wih Germany, which is he leading counry in he EMU as i has he highes influence on he common moneary policy. We iniially expec ha he euro has led o inegraed commodiy and capial markes in he Eurozone because of sronger rade linkages among is member-counries. On he oher hand, given he high degree of heerogeneiy across counries and he absence of (inra-euro) exchange rae flucuaions, i is doubful ha higher economic inegraion can be achieved among EMU counries (especially for hose ha are srucurally differen from Germany). The exisence of economic and financial inegraion beween Germany and he res of he Eurozone s counries (and he non-emu counries) is esed hrough wo well-known inernaional pariy relaionships, i.e. he Purchasing Power Pariy (PPP) and he Uncovered Ineres Pariy (UIP). The empirical validiy of he PPP hypohesis implies ha goods markes are inegraed, while he validiy of he UIP condiion implies he exisence of capial marke inegraion beween counries. A survey on he relaed empirical lieraure implies ha he inroducion of he euro may have failed o increase commodiy and financial markes inegraion among EMU counries. Koedijk e al. (00) find evidence in favour of he PPP hypohesis wihin he euro area only when common mean reversion among counries is assumed. Seing Germany as he benchmark counry and assuming heerogeneous mean reversion coefficiens, heir evidence is srenghened only for France, Finland and Spain, while hey found no evidence regarding he validiy of he PPP beween he EMU and major non-emu counries. Furhermore, Chrisidou and Panagioidis (00) and Wu and Lin (0) repor ha he adopion of he euro has weakened he evidence in favor of he PPP. Similarly, Huang and Yang (05) find ha afer he launch of he euro, he evidence in favour of he PPP is sronger for non-emu counries raher han EMU counries. When i comes o capial markes inegraion (i.e. he The full sample (99:0 o 05:0) is spli ino wo sub-periods, i.e. he pre-emu period (99:0 998:) and he pos-emu period (999:0 05:0). To find wheher inegraion has increased due o he EMU, we firs es our hypoheses on he pre-emu period and hen o he whole period (which includes boh he pre and he pos EMU periods). Chrisidou and Panagioidis (00) es he PPP hypohesis beween he EU and he USA, while Wu and Lin (0) es he same pariy hypohesis among EMU counries.

4 UIP hypohesis), Kim e al. (006) find ha he degree of inegraion among European bond and sock markes has declined afer he inroducion of he euro. However, he above sudies have esed he PPP and UIP hypoheses only as independen pariy condiions. This implies ha he possibiliy ha deviaions from he PPP equilibrium are uilized by invesors when forming expecaions has been overlooked. Moivaed by he seminal papers of Johansen and Juselius (99) and Juselius (995), we expec ha PPP deviaions may inerac wih UIP deviaions. In he presen paper, we exend he empirical lieraure on economic and financial inegraion in he Eurozone by esing he PPP and he UIP joinly. To he bes of our knowledge, we argue ha he presen paper is he firs ha ess joinly he PPP and UIP condiions beween Germany (as he leading economy of he EMU) and he remaining EMU counries. 5 Anoher conribuion of he paper is ha, compared o he majoriy of he empirical sudies in he lieraure, i uses more accurae price indices. Specifically, we uilise consruced Traded-goods Price Indices (TPI) insead of Consumer Price Indices (CPI) in order o avoid he presence of non-raded goods prices, which biases negaively he empirical validaion of he PPP hypohesis. Moreover, we use sae-of-he-ar ime series economeric echniques, which allow he presence of srucural breaks in coinegraion analysis. Admiedly, he launch of he euro in 999 and he global financial crisis of 007 have alered he behaviour of variables under consideraion. Hence, hese wo facs have caused an equal number of srucural breaks, which should no be ignored by our analysis. Finally, he use of Germany as a benchmark counry allows us o shed more ligh on Germany s leading role in he Eurozone. Does he degree of economic inegraion beween Germany and he res of he Eurozone s counries allow he characerisaion of Germany as he represenaive EMU counry? Given Germany s dominaion in he Eurozone, a number of policy-relaed issues arise for he fuure of he EMU. The srucure of he paper is as follows. The nex secion describes he heoreical framework and secion illusraes he economeric mehodology. Secion presens he daa se and he empirical findings, while heir implicaions are discussed in secion 5. A final secion concludes. 5 Canarella e al. (0) and Czudaj and Pruser (05) have already esed joinly he wo condiions, bu no wihin he Eurozone. They es he inernaional relaionships of Germany agains he UK and he USA, respecively. On he oher hand, an indirec combinaion beween he PPP and UIP condiions in he Eurozone is performed by Arghyrou e al. (009). These auhors examine he inernaional Fisher effec wihin Europe (for EMU and non-emu counries agains he EMU average real ineres rae). Similarly, Dreger (00) ess he real ineres pariy in a se of 5 counries (including seleced European counries, Japan and he USA), bu in his sudy he USA has been used as he base counry.

5 . Theoreical Framework The economic inegraion beween Germany and he res of he Eurozone s counries is heoreically modeled hrough wo well-known inernaional pariy relaionships, i.e. he Purchasing Power Pariy (PPP) and he Uncovered Ineres-rae Pariy (UIP). The empirical validiy of he PPP hypohesis implies ha goods markes are inegraed, while he validiy of he UIP condiion implies he exisence of capial marke inegraion beween counries.. Purchasing Power Pariy Purchasing Power Pariy is based on he Law of One Price (LOP), which saes ha idenical goods across counries should have he same price once hey are convered o a common currency. On he same basis, he absolue version of PPP can be wrien as follows: where P is he domesic price level, P () S * P, * P corresponds o he foreign price level and S is he nominal exchange rae measured as unis of domesic currency per uni of foreign currency. Taking he naural logarihm of equaion () and rearranging i properly, we ge: 6 p p s 0. () * Equaion () reflecs he basic idea of he relaive PPP form. I implies ha he nominal exchange rae adjuss in he long-run so ha o offse price differenials and resore equilibrium in inernaional goods markes. This means he exchange rae and relaive prices form a long-run equilibrium relaionship. Equivalenly, relaive PPP holds if he real exchange rae is saionary, i.e.: * p p s ~ I 0. (). Uncovered Ineres-rae Pariy On he oher hand, he fundamenal idea of he Uncovered Ineres-rae Pariy condiion is ha if he expeced reurns on domesic and foreign equivalen asses are differen, hen economic agens will borrow a he low rae and inves he proceeds a he high rae. This procedure will sop when boh raes are equalised plus he expeced rae of change in he exchange rae. Thus, he UIP condiion can be expressed in he following log-linear form: where i and i * are he domesic and foreign ineres raes, * i i EΔ s k, () E is he condiional expecaions 6 Lower-case leers correspond o naural logarihms of he variables of equaion. 5

6 operaor a ime and EΔs denoes he expeced rae of change of he nominal exchange k rae from period o k. In oher words, he UIP condiion describes how asses arbirage resores equilibrium in inernaional capial markes. Furher, under he assumpion ha agens form raional expecaions, which implies ha hey do no make sysemaic forecas errors, UIP condiion will be empirically validaed if he change of he nominal exchange rae and he ineres rae differenial form a saionary long-run relaionship, i.e.: * k i i Δ s ~ I 0. (5) Having in mind ha he firs difference of he nominal exchange rae is usually nonsaionary, he empirical evidence in favour of he UIP condiion requires ha: * i i ~ I 0. (6). Ineracion beween PPP and UIP Boh inernaional pariy condiions may hold as independen long-run equilibrium relaionships. 7 However, based on he seminal papers of Johansen and Juselius (99) and Juselius (995) and he subsequen papers in lieraure (see, iner alia, MacDonald and Marsh, 997; Juselius and MacDonald, 00), we expec a possible ineracion among prices, ineres raes and exchange raes. Hence, PPP and UIP condiions should no be examined independenly. The cenral idea of he connecion beween commodiy and capial markes is ha deviaions from PPP equilibrium are uilised by invesors when formaing expecaions for he fuure exchange rae. 8 In his sense, if invesors form raional expecaions and he * expeced exchange rae is given by E s k p p, he relaion ha combines he PPP and he UIP condiions is as follows: s p p i i 0. (7) * * Likewise, he ineracion beween PPP and UIP condiions forms saionary long-run relaionships if: * s p p i i * ~ I 0. (8) The condiion expressed in equaion (8) can be saisfied if PPP and UIP hold joinly, ha is: 7 On he oher hand, we should no ignore he presence of a number of heoreical and empirical facors which preven he empirical validaion of he above inernaional pariies. For example, ransporaion coss, ariff and non-ariff barriers, pricing o marke and he Balassa-Samuelson effec explain deviaions from PPP. Similarly, UIP deviaions may be explained by ransacion coss, differences in axaion and risk, and capial conrols. 8 In addiion, he connecion beween PPP and UIP condiions implies ha expeced real reurns are equal across counries. Moreover, PPP and UIP condiions are also combined in heoreical and empirical lieraure o build one more approach o equilibrium exchange raes, which is he Capial Enhanced Equilibrium Exchange Rae (CHEER). 6

7 * * ~ 0 and i i ~ I 0 p p s I Alernaively, he above condiion can also be saisfied if: (9) * * ~ and i i ~ I, bu s p p i i I p p s I * * ~ 0. (0) In erms of coinegraion, equaion (0) implies exploiing he following vecor: y [ s, p, p, i, i ]. () / * * Expression (0) shows ha PPP and UIP condiions are no idenified as independen long-run relaionships, bu hey form a saionary equilibrium relaion when considered joinly. This implies ha PPP deviaions inerac wih UIP deviaions and generae a long-run equilibrium relaionship. In oher words, he nominal exchange rae adjuss o price level and ineres rae differenials o resore simulaneous equilibrium in commodiy and capial markes.. Theoreical Hypoheses To es wheher PPP and UIP condiions hold joinly or individually, we firs define he heoreical hypoheses under invesigaion. However, he form of he heoreical resricions is subjec o he number of long-run relaionships (i.e. coinegraing relaions) found among he variables of ineres. A firs sigh, we expec wo long-run relaionships, which may correspond o he PPP and UIP relaions, respecively. The wo long-run relaionships may be eiher individual or inerdependen. In his case, he heoreical resricions, as suggesed by Johansen and Juselius (99), are formed as follows: H : PPP condiion is idenified wih unresriced ineres raes, and UIP condiion is idenified wih unresriced price levels. H : PPP condiion is idenified as a sric individual relaionship, and UIP condiion is idenified as a sric individual relaionship. H : PPP condiion is idenified while ineres raes have equal and opposie signs, and UIP condiion is idenified while price levels have equal and opposie signs. H ess he hypohesis ha PPP and UIP hold. If H canno be rejeced we proceed o H, which ess he hypohesis ha PPP and UIP hold only individually. Once he laer hypohesis is rejeced, we es he hypohesis ha PPP and UIP hold joinly (H ), hereby implying srong ineracion beween goods and capial markes. The above represenaion of he heoreical hypoheses applies when wo long-run relaionships exis among variables. Bu, his is no he only possible case. I is rue ha we 7

8 canno exclude he possibiliy ha he variables of ineres may form only one long-run relaionship. In his case, heoreical resricions need o be slighly modified. Alhough he lieraure abou he ineracion beween PPP and UIP condiions is rich, none of he previous sudies has provided insighs on how heoreical resricions should be modified in he case of a unique long-run relaionship. In his paper, we exend he lieraure by esing he join idenificaion of PPP and UIP condiions under a unique long-run relaionship. Hence, heoreical hypoheses are modified as follows 9 : H : PPP condiion is idenified wih unresriced ineres raes. H 5 : UIP condiion is idenified wih unresriced price levels. H 6 : PPP condiion is idenified as a sric individual relaionship. H 7 : UIP condiion is idenified as a sric individual relaionship. H 8 : PPP condiion is idenified while ineres raes have equal and opposie signs. H 9 : UIP condiion is idenified while price levels have equal and opposie signs. H 0 : PPP and UIP condiions are fully idenified joinly. The esing procedure is he same as above. One can easily observe ha H and H 5 correspond o he join hypohesis H. Similarly, H 6 and H 7 refer o H, while H 8 and H 9 correspond o H. The reason ha he iniial hypoheses are spli is he exisence of a single long-run relaionship. Hence, he unique long-run relaionship may represen he PPP condiion or he UIP condiion. One he oher hand, price level and ineres rae differenials may form a single long-run relaionship wih he nominal exchange rae. In his case, he PPP and UIP condiions hold joinly under he same long-run relaionship. This hypohesis is expressed by H 0.. Coinegraion Models The curren analysis is mainly based on coinegraion ess. We perform wo ypes of ess: hose wihou srucural breaks in he daa and hose ha include srucural breaks. For he cases ha we do no include srucural breaks, we implemen he sandard mulivariae approach of Johansen along wih he mehodology developed by Saikkonen and Lükepohl (000a,c) [SL]. Concerning coinegraion ess in he presence of srucural breaks in he daa, 9 The modificaion of he resricions imposed in he coinegraed space and he revised design marices are illusraed in he empirical resuls secion. 8

9 here is a recen large lieraure on differen approaches and echniques. 0 For reasons of comparison and consisency wih he cases ha we do no include srucural breaks, we employ he approach of by Johansen e al. (000) [JMN] as well as he approach developed by Lükepohl and his co-auhors (Lükepohl and Saikkonen 000; Saikkonen and Lükepohl 000b; Trenkler e al. 008) [LST]. The JMN approach exends he Johansen coinegraion analysis by adding in he VECM several dummy variables, in order o accoun for q possible exogenous breaks in he levels and rends of he deerminisic componens of a vecor-valued sochasic process. Using he response surface mehod, his approach derives he asympoic disribuion of he race saisic for coinegraion and obains criical values or p-values. Similarly, he LST approach exends he coinegraion mehodology developed by Saikkonen and Lükepohl. Again i is assumed ha in he daa generaing process (DGP) for a vecor-valued process y, is deerminisic par ( ) does no affec is sochasic par ( x ). Thus, he deerminisic par can be removed in he firs sage, and he likelihood raio (LR) coinegraion es can be applied in he second sage using he derended sochasic par of y. In he case of a single exogenous break a ime T B in he DGP for y is, in boh he level and he rend of y, y x 0 0b d x,,..., T, () where is a linear ime rend, i ( i 0,) and i ( i 0,) are unknown ( v ) parameer vecors, b and d are dummy variables defined as b d 0 for TB, and b and d TB for TB. The unobserved sochasic error x has he following VECM represenaion: k, ~ (0, ),,..., i i i. () x x x iidn T I is also assumed ha he componens of x are a mos I () and coinegraed (i.e., / ) wih coinegraing rank r 0. Based on equaions () and (), esimaes of 0,, 0 and can be obained wih he use of a feasible GLS procedure under he null hypohesis H0( r0 ) : rank( ) r0 : vs. H( r0 ) : rank( ) r0. Using hese esimaes, he derended series 0 Perron (006) provides a comprehensive review of he lieraure. Noe ha srucural breaks along wih deerminisic componens are included in he deerminisic par of y. 9

10 xˆ y ˆ ˆ ˆ d ˆ b are compued. Finally, x is replaced by x ˆ in he VECM 0 0 expressed in equaion () and he following race saisic is compued: LST p ln, Trace T ir i () 0 where he eigenvalues ' s can be obained by solving a generalised eigenvalue problem, i along he lines of Johansen (988). Asympoic resuls and criical values for he case of one break were derived by Trenkler e al. (008), using response surface echniques.. Daa and Empirical Resuls. Daa The daase consiss of monhly observaions from 99:0 o 05:0 on nominal exchange raes, ineres raes and raded-goods price indices (based on expor and impor price indices and oal expors and impors) for nine core EMU counries, hree EU (bu non-emu) counries and wo non-eu counries. The cluser of he EMU counries includes Belgium, Finland, France, Germany, Greece, Ireland, Ialy, The Neherlands and Spain, while he whole sample is filled wih Denmark, Sweden, UK (EU bu non-emu counries) and Japan, USA (non-eu counries). Throughou he paper, he benchmark counry is Germany. Therefore, all nominal exchange raes correspond o naional currencies agains he Deusche mark. For he pre-emu period, Deusche mark exchange raes were rerieved from he saisical daabases of Eurosa and Bundesbank. Obviously, here is no official exchange rae beween Germany and any EMU member counry for he pos-emu period. However, here was an exchange rae relaionship beween EMU counries a he ime of he adopion of he single currency, which remained fixed since hen. This could imply ha here is a hypoheical and consan exchange rae beween Germany and EMU counries. To derive his hypoheical exchange rae (for he pos-emu period), we calculae cross exchange raes based on he fixed euro conversion raes of EMU counries. For example, he pos-emu exchange rae beween Germany and France is calculaed as /.9558 =.5855 and remains unchanged unil he end of he esimaion period. All nominal exchange raes are ransformed ino a logarihmic form. Traded-goods price indices could no be calculaed for Ausria, Luxembourg and Porugal due o daa unavailabiliy. Hence, hese counries have been excluded from our daase. Moreover, he sample period for Belgium is 99:0 05:0, while he saring dae for Denmark is 995:0. For non-emu members (Denmark, Sweden, Japan, UK and USA) Deusche mark exchange raes have been rerieved by Eurosa and Bundesbank for he whole period of esimaion. 0

11 Moreover, ineres raes correspond o he yield of 0-year governmen bond and are colleced from he saisical daabase of Eurosa. We have preferred he use of long-run ineres rae insead of shor-run ineres rae for various reasons. Firs, because of he common moneary policy, shor-run ineres raes do no fully reflec members individual characerisics. For example, money marke raes mosly reflec European Cenral Bank s policy decisions. Second, long-run ineres raes reflec he long-run process of he economy and hus, are more appropriae when he long-run exchange rae is examined. Finally, he yield of governmen bonds is able o capure he impac of he EMU sovereign-deb crisis on capial markes and financial inegraion wihin Eurozone. For naional price levels we have used consruced raded-goods price indices (TPI) insead of consumer price indices (CPI) so ha o avoid he presence of non-raded goods prices, which biases negaively he empirical validaion of he PPP hypohesis. Following Xu (00) and Giannellis and Papadopoulos (00) iner alia, we consruc he raded goods price index (TPI) as a weighed average of he log of expor price index ( price index ( x p ) and he log of impor m p ). The weighs are he shares of oal expors and oal impors in oal rade. The formula of he TPI is he following: where expors expors impors and x m, TPI p p (5) impors. The above inernaional rade daa expors impors were rerieved from he Inernaional Financial Saisics of he Inernaional Moneary Fund daabase. Concerning prices and depending on daa availabiliy, we have used eiher expor and impor price indices or expor and impor uni value indices. The base year for all indices is 00. Also, he value of expors and impors is expressed in US dollars.. Uni Roo Tess Resuls The sample is spli ino wo sub-periods, i.e. pre-emu period (99:0 998:) and pos- EMU period (999:0 05:0), bu he esimaion period is focused on he pre-emu period and he whole period (which includes boh he pre and pos EMU periods). As a preliminary analysis of he daa, we have employed a number of uni roo ess, such as he Augmened Dickey-Fuller (Dickey-Fuller, 98); he Ellio e al. (996) and Ellio (999) GLS augmened Dickey-Fuller; and he Kwiakowski e al. (99) KPSS ess. The null For Greece, he pre-emu period is up o 000:. Moreover, he saring dae for Denmark is 995:0 due o resricions on daa availabiliy. As pre-emu period ( ) is oo shor in he case of Denmark, we do no presen resuls for his sub-period, bu only for he whole sample.

12 hypohesis in he firs wo ess (ADF and DF-GLS) is ha a series conains a uni roo. In conras, he KPSS es includes he opposie hypohesis (i.e. a series is saionary). 5 The resuls from hese ess imply ha all series, apar from he pre-emu exchange rae in he case of Belgium, are difference saionary, i.e. hey are I in levels, bu 0 I in firs differences. However, he Belgian exchange rae in he pre-emu period is an unambiguous excepion. All ess unanimously reveal ha his series is inegraed of order zero, i.e. Therefore, we consider his series as covariance saionary. 6 I 0, in levels.. Coinegraion Space and is Srucure As noed above, he esimaion period is focused in he pre-emu period and he whole period. For he pre-emu period esimaion we do no include srucural breaks in he VECMs, and hus we implemen he Johansen and SL coinegraion mehodologies. On he conrary, for he whole period esimaion we include wo srucural breaks in he coinegraion ess, which were deeced exogenously as suggesed by economic heory. Of course, his deecion was based on specific economic evens ha ook place during he sample period. For all sample counries excep Greece, he firs srucural break is allowed o be a he formaion of he EMU in January 999. For Greece, he firs break is placed in January 00, when he counry joined he EMU. Also, for all sample counries he second break is allowed o be a he beginning of he recen global financial crisis. According o he U.S. Naional Bureau of Economic Research his crisis began in December 007. Thus, for he whole period esimaion we implemen he JMN and LST coinegraion approaches. Especially for he LST es, we exended equaion () by adding a second sep dummy and a second linear rend dummy. Then, for each counry, he LST race saisic and he corresponding response surface p-values were compued using GAUSS codes. Also, he lag lengh for each VECM was seleced using he Akaike informaion crierion (AIC). Concerning he srucure of he coinegraing vecors, he heoreical hypoheses were analysed in Secion.. For a p dimensional sysem, resricions on he coinegraion srucure can be ess by formulaing [ H,..., H r r ], where H i are ( p q i ) design marices and i are ( qi ) vecors of q i free parameers. When wo long-run relaionships exis among variables, he heoreical hypohesis H implies ha he firs coinegraing vecor describes he PPP condiion wih unresriced ineres raes, while he second coinegraing 5 None of he uni roo ess could be applied on pos-emu exchange raes as hey are sricly consan. 6 Uni roo ess resuls are no repored here o save space. However, hey are available upon reques.

13 vecor describes he UIP condiion wih unresriced prices. Thus, he coinegraing vecors [,,,, ] and [,,,, ], while he respecive design marices are are he following: H A and H B This LR es, which capures he proporionaliy and symmery condiions, is disribued asympoically as wih degrees of freedom. If H canno be rejeced we proceed o he heoreical hypohesis H, which implies ha PPP and UIP hold only individually. In his case, he coinegraing vecors are [,,, 0, 0] and [, 0, 0,, ], he respecive design marices are H A 0 0 and H B 0 0, while he LR es is disribued asympoically as wih 6 degrees of freedom. If he laer hypohesis is rejeced, we es he heoreical hypohesis H, which implies ha PPP and UIP condiions hold joinly and hus, here is srong ineracion beween goods and capial markes. In his case, he coinegraing vecors are [,,,, ] and [,,,, ], he respecive design marices are H A and H B 0 0 0, 0 0 while he LR es is disribued asympoically as wih degrees of freedom. When a single long-run relaionship exiss among variables, he heoreical resricions are slighly modified. Thus, for he heoreical hypoheses H and H 5, which correspond o

14 he join hypohesis H, he coinegraing vecor is eiher [,,,, ] or [,,,, ], respecively. The design marix is eiher H or H5 0 0, respecively, while for boh cases he LR es is disribued asympoically as wih degrees of freedom. Similarly, for he heoreical hypoheses H 6 and H 7, which correspond o he join hypohesis H, he coinegraing vecor is eiher [,,, 0, 0] or [, 0, 0,, ], respecively. The design marix is eiher H6 0 0 or H7 0 0, respecively, while for boh cases he LR es is disribued asympoically as wih degrees of freedom. Also, for he heoreical hypoheses H 8 and H 9, which correspond o he join hypohesis H, he coinegraing vecor is eiher [,,,, ] or [,,,, ], respecively. The design marix is 0 0 eiher H or H9 0, 0 0 while for boh cases he LR es is disribued asympoically as wih degrees of freedom. Finally, for he heoreical hypohesis H 0, which implies ha he PPP and UIP condiions hold joinly under he same long-run relaionship, he coinegraing vecor is [,,,, ], he respecive design marix is

15 H 0, while he LR es is disribued asympoically as wih degrees of freedom.. Resuls for he Pre-EMU Period Table repors he Johansen and SL race saisics and he respecive p-values for each of he sample counries, for he pre-emu period. As shown in his able, he resuls indicae wo coinegraing vecors for he cases of Greece, Ialy, Spain, The Neherlands and he USA, a he 5 per cen level of significance. 7 In he case of Belgium, boh ess indicae hree coinegraing vecors. However, he hird vecor may be aribued o he saionariy of he Belgian exchange rae in he pre-emu period. To make i clear, we es he hypohesis ha one of he hree coinegraing vecors is deermined only by he saionary exchange rae. This es s resul (χ =.50 and p-value = 0.9) indicaes ha he above hypohesis canno be rejeced. Finally, boh ess provide evidence of a single coinegraing vecor for he cases of Finland, France, Ireland, Japan, Sweden and he UK. Table repors he es resuls regarding he srucure of he coinegraing vecors for he six counries ha here is evidence of wo coinegraing vecors. As shown in he second column of able, he heoreical hypohesis H, which implies ha he firs vecor describes he PPP condiion wih unresriced ineres raes and he second vecor describes he UIP condiion wih unresriced prices, canno be rejeced for Belgium, The Neherlands and Spain, a he 5 per cen level of significance. This hypohesis is marginally rejeced for Greece (p-value = 0.0) and srongly rejeced for Ialy and he USA, a he same level of significance. Column of able indicaes ha he heoreical hypohesis H, which implies ha PPP and UIP hold only individually, is srongly rejeced for all counries. Finally, as shown in column of able he heoreical hypohesis H, which implies srong ineracion beween goods and capial markes, canno be rejeced only for he case of Greece. As he hypohesis H is marginally rejeced for Greece, we can conclude ha for his counry he PPP and UIP condiions hold joinly. The laer resul seems reasonable as he counry performed 7 In he case of The Neherlands, he SL race saisic indicaes wo coinegraing vecors, while he Johansen es indicaes hree vecors. However, Lükepohl e al. (00) found ha heir es has beer size and power properies in finie samples. For his reason, we consider wo coinegraing vecors also for The Neherlands. 5

16 significan economic adjusmen in he second half of he 990s, in order o fulfil he convergence crieria for joining he EMU. Table repors he respecive es resuls for he six counries ha here is evidence of a single coinegraing vecor. As shown in columns and of able, he heoreical hypohesis H is rejeced for all cases, while he heoreical hypohesis H 5 canno be rejeced only for he cases of Finland and France, a he 5 per cen significance level. This implies absence of commodiy marke inegraion, bu insead here is indicaion of capial markes inegraion in he cases of France and Finland. Columns and 5 of able indicae ha boh he heoreical hypoheses H 6 and H 7 are rejeced for all cases. Following he esing procedure, columns 6 and 7 of able indicae ha he heoreical hypohesis H 8 is rejeced for all cases, while he heoreical hypohesis H 9 canno be rejeced only for Finland. Namely, when hypoheses become more resricive (i.e.h 8 compared o H and H 9 compared o H 5 ), here is evidence of capial marke inegraion only beween Germany and Finland, while he evidence of commodiy marke inegraion is sill absen. Similarly, as shown in he las column of able he heoreical hypohesis H 0, which implies ha he PPP and UIP condiions hold joinly under he same long-run relaionship, canno be rejeced only beween Germany and Finland. Summarising he above resuls for he pre-emu period, we conclude ha here is evidence of parial economic inegraion beween Germany and each of Belgium, The Neherlands and Spain, as for hese hree counries he wo coinegraing vecors can be idenified as he PPP condiion wih unresriced ineres raes and he UIP condiion wih unresriced prices. There is also evidence of parial financial inegraion beween Germany and France, as he single coinegraing vecor can be idenified as he UIP condiion wih unresriced prices. Our resuls imply evidence of full economic inegraion beween Germany and each of Finland and Greece due o he ineracion beween commodiy and capial markes. For he former counry he single coinegraing vecor idenifies he join exisence of he PPP and UIP condiions, while for he laer counry he wo coinegraing vecors can be idenified as he PPP condiion wih equal and opposie signs in ineres raes and he UIP condiion wih equal and opposie signs in prices. On he oher hand, our evidence implies absence of economic inegraion beween Germany and each of Ireland, Ialy, Sweden, he UK, Japan and he USA, in he pre-emu period..5 Resuls for he Whole Period 6

17 Moving o he whole period esimaion, he JMN and LST race saisics for all sample counries are repored in Table. As shown in his able, boh ess indicae wo coinegraing vecors only for he case of Belgium. For he cases of Finland, France, Spain, Denmark, Japan and Sweden, he JMN es indicaes differen number of coinegraing relaions han he LST es. As noed above, he LST es has beer size and power properies han he JMN es in finie samples, and hus we can conclude ha for he above six counries here is a single coinegraing vecor. Finally, boh ess also provide evidence of a single coinegraing vecor for he cases of The Neherlands, he UK and he USA, and no evidence of coinegraion for he cases of Greece, Ireland and Ialy. Table 5 repors he es resuls regarding he srucure of he coinegraing vecors for he case of Belgium, for which here is evidence of wo coinegraing vecors. As shown in he second column of able 5, he heoreical hypohesis H, which implies ha he firs vecor describes he PPP condiion wih unresriced ineres raes and he second vecor describes he UIP condiion wih unresriced prices, canno be rejeced, a he 5 per cen significance. On he conrary, as shown in columns and of able 5 boh heoreical hypoheses H and H are srongly rejeced. The respecive es resuls for he nine counries wih a single coinegraing vecor are repored in able 6. As shown in columns and of able 6, he heoreical hypohesis H canno be rejeced for he cases of Finland, The Neherlands, Denmark, Japan and marginally for he USA, while he heoreical hypohesis H 5 canno be rejeced only for he cases of Sweden and he USA, a he 5 per cen significance level. To his poin, here is evidence of parial commodiy markes inegraion in he cases of Finland, The Neherlands, Denmark and Japan; evidence of parial capial markes inegraion in he case of Sweden and indicaions of join commodiy and capial markes inegraion in he case of he USA. Columns and 5 of able 6 indicae ha boh he heoreical hypoheses H 6 and H 7 are rejeced for all cases, hereby implying ha PPP and UIP condiions do no hold sricly as independen relaionships. Following he same esing procedure as in he previous subsecion, columns 6 and 7 of able 6 indicae ha he heoreical hypohesis H 8 canno be rejeced only for he case of Finland, while he heoreical hypohesis H 9 is rejeced for all cases bu marginally for Sweden, a he 5 per cen level of significance. Finally, as shown in he las column of able he heoreical hypohesis H 0 is rejeced for all cases. Likewise, when hypoheses 7

18 become more resricive, he evidence in favour of economic and financial inegraion is weakened. Summarising he esimaion resuls for he whole period and comparing hem wih hose of he pre-emu period, we can conclude he following: Regarding he EMU member saes, parial economic inegraion beween Germany and each of Belgium and The Neherlands remains. There is also evidence of almos full inegraion in he goods marke beween Germany and Finland. On he oher hand, here is absence of economic inegraion beween Germany and each of Ireland and Ialy as before. However, our resuls indicae absence of economic inegraion also beween Germany and each of France, Greece and Spain. This resul can be probably aribued o he global financial crisis ha harmed he economies of hese hree counries. Regarding he EU bu non-emu member saes, here is evidence of parial inegraion in he goods marke beween Germany and Denmark, and almos full financial inegraion beween Germany and Sweden. Finally and regarding he non-eu counries, our resuls imply evidence of parial inegraion in he goods marke beween Germany and Japan, and parial financial inegraion beween Germany and he USA. On he oher hand, absence of economic inegraion beween Germany and he UK remains. 5. Discussion Surprisingly or no, our resuls imply sronger evidence of financial inegraion beween Germany and he seleced EMU counries before he launch of he euro. For he pre-emu period, Germany was found o be inegraed wih mos of he EMU counries, while sronger evidence of commodiy and capial markes inegraion was found in he cases of Finland and Greece. The laer resul reflecs he radiionally high culural and rade linkages beween Finland and Germany and he adjusmen of he Greek economy owards he requiremens of he Maasrich reay, respecively. On he oher hand, economic and financial inegraion could no be esablished beween Germany and each of Ialy and Ireland. When he whole sample is examined, here is weaker evidence of economic and financial inegraion beween Germany and he res of he EMU counries. Our resuls indicae evidence of simulaneous commodiy and capial markes inegraion only beween Germany and Belgium, while here is evidence of only commodiy marke inegraion beween Germany and each of Finland and he Neherlands. In conras, we found no evidence of eiher commodiy or capial marke inegraion beween Germany and each of France, Greece, Ialy, Ireland and Spain. 8

19 These resuls imply ha despie he launch of he common currency, Germany has financially diverged from mos of he EMU counries under invesigaion. One could argue ha his is an oucome of he bad archiecure of he Eurozone. In conras, one could say ha his is because of he use of longer span of daa in our analysis (i.e. whole period compared o pre-emu period). 8 Before we adop any of he above argumens, i is useful o invesigae he same research quesion when non-emu counries are considered. This analysis reveals ha, a he pre-emu period, Germany was no financially inegraed wih any of he seleced non-emu counries. However, when he whole sample was he case, we found evidence of simulaneous commodiy and capial markes inegraion wih he USA. In addiion, here was evidence of commodiy marke inegraion wih Denmark and Japan and evidence of capial marke inegraion wih Sweden. Finally, he lack of inegraion wih he UK remains. Hence, we could no argue ha he aforemenioned poor evidence of financial inegraion wihin he Eurozone can be aribued o any global phenomenon. A he same period, our resuls imply sronger evidence of financial inegraion beween Germany and he seleced non-emu counries raher han beween Germany and he seleced EMU counries. In conras o he aim of he moneary union, his could mean ha Germany seeks sronger economic and financial relaionships ouside he EMU. Cerainly, his is no rue. Bu, wha is his ha prevens he inegraion wih some EMU counries? Moreover, wha explains he fac ha Germany is shown o be more inegraed wih non-emu counries? Boh quesions have he same answer. This is he exchange rae! Normally, he nominal exchange rae adjuss in he long-run o offse any differenials and resore equilibrium. This is he case beween Germany and he non-emu counries. Obviously, he lack of exchange rae adjusmen wihin EMU prevens he PPP and UIP condiions o hold in he long-run. However, his does no mean ha hese condiions are no possible o hold in moneary unions. We jus need o consider in which cases he exchange rae necessarily adjuss. Nominal exchange raes should change if permanen disequilibria exis, as a resul of he heerogeneiy across counries. Moreover, exchange raes are sensiive o moneary policy changes. In a moneary union, if counry-members respond symmerically o shocks, equilibrium may be resored wihou any exchange rae adjusmen. In our empirical exercise, his is shown in he cases of Belgium, Finland and he Neherlands. On he oher hand, equilibrium could no be resored in he remaining seleced EMU counries. As a consequence, his evidence implies ha commodiy 8 Alhough we allow for he presence of wo srucural breaks, his view implies ha some oher facs ha ook place in he global economic sysem may have affeced he evidence in favour of he PPP and UIP hypoheses. These effecs, if hey exis, are possibly capured by he whole sample. 9

20 and capial markes disequilibrium exis, which canno be resored along he lines of he moneary union. Inuiively, his evidence reveals ha he common moneary policy canno ensure higher financial inegraion in he Eurozone. I is apparen ha he key prerequisie for a successful moneary union is homogeneiy across counry-members. Our empirical resuls confirm he above argumen. In one hand, counries ha share economic similariies wih Germany, such as Finland, he Neherlands and Belgium, are shown o be financially inegraed wih i. On he oher hand, here is no evidence of financial inegraion wih counries ha are srucurally differen from Germany. The cases of Greece, Ialy, and Ireland arac special aenion as no long-run relaionship could be idenified among he variables of ineres. A number of deviaions in naional policies and marke regulaions (compared o Germany) may explain he above evidence. In oher words, he exising heerogeneiy causes permanen disequilibrium in markes, which canno be handled wihou exchange rae adjusmen. To pu i differenly, our empirical invesigaion provides evidence agains he wellknown saemen one size fis all. The above analysis implies ha he unique moneary policy does no fi o all counry-members. This awareness raises serious concerns abou he fuure of he Eurozone. Furher, Germany s leading role in he Eurozone is in quesion. How saisfacory is he fac ha he leading counry in he Eurozone has financially diverged from mos of he oher counry-members? Does he common moneary policy really reflec he needs and objecives of all counry-members of he Eurozone? Is he figh agains inflaion able o solve he curren problems in he Eurozone? These concerns reveal ha EMU is, or will be soon, in rouble. Alhough, a generous modificaion of he applied moneary policy could make he differences among counries smooher, he EMU will have he opporuniy o solve is problems if efficienly addresses is design weaknesses. Homogeneiy across counry-members can be achieved hrough he harmonizaion of naional economic policies and marke srucures. EMU auhoriies are currenly aemping o achieve marke srucure synchronizaion by promoing srucural reforms in naional economies. However, economic policy synchronizaion requires even sronger economic inegraion, which in urn canno be achieved wihou poliical unificaion. 6. Concluding Remarks 0

21 The Eurozone is admiedly on a criical phase. Afer a decade of general sabiliy, a number of problems have been appeared on he surface indicaing he design weaknesses of he Eurozone (see, De Grauwe and Ji, 0; 0). The emergence of he public deb crisis in some souhern European counries (known as EMU sovereign-deb crisis) as well as he exising heerogeneiy across counry-members causes serious worries abou he Eurozone s fuure. How poenial asymmeric shocks can be handled by he unique moneary policy? Furher, are counry-members inegraed enough so ha o respond symmerically o common disurbances? In his perspecive, he primary aim of he presen paper is o es wheher seleced EMU counries are financially inegraed wih Germany, which has he highes influence on he Eurozone. Nex, we exend his empirical invesigaion o non-emu counries as well. By employing sae-of-he-ar economeric echniques and accurae price indices, we es joinly he exisence of commodiy and capial markes inegraion beween Germany and each of he seleced counries. Our resuls shed ligh o a somewha odd sory for a moneary union, such as he EMU. Before he launch of he euro, commodiy or capial markes inegraion could no be idenified only beween Germany and each of Ialy and Ireland. Insead, when he sample was exended by he pos-emu period, we found evidence of commodiy or capial markes inegraion only beween Germany and each of Belgium, Finland and he Neherlands. A compleely differen sory is implied for he case beween Germany and he seleced non-emu counries. Germany was no financially inegraed wih any of hese counries during he pre-emu period. However, afer he launch he euro, Germany was found o be financially inegraed wih Denmark, Sweden, Japan and he USA. Sricly speaking, i is shown ha since he esablishmen of he EMU, he leading economy of he EMU has financially diverged from mos of he EMU s economies. Bu, a he same ime, financial inegraion wih non-emu economies has been sronger. We argue ha he lack of exchange rae adjusmen combined wih he exising heerogeneiy across counry-members can explain his embarrassing finding. A number of concerns abou he fuure of he Eurozone and he leading role of Germany arise. Rephrasing he well-known saemen one size fis all, we conclude ha our analysis implies ha Germany s size does no fi all. Finally, o avoid curren and fuure problems, he EMU has o figh is design weaknesses.

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