Short-term and long-term capital market integration in the European Union : an investigation using interest rate and currency swaps data

The objective of this thesis is to evaluate the degree of financial integration achieved by the main European Union (EU) members. The study is motivated by the necessity of alternative adjustment mechanisms in countries affected by asymmetric shocks. Economic theory suggests that capital flows may have equilibrating effects in such circumstances, if international markets are integrated. There is therefore a case for evaluating the level of integration already achieved by the EU financial markets, especially in areas less explored in the literature. The empirical application evaluates the level of financial integration between Germany and five EU countries (Belgium, France, Italy, the Netherlands and the UK). The analysis comprises the investigation of covered, uncovered and real interest rate parity conditions, for onshore and offshore assets with maturities between one month and ten years, within the period 1987 to 1997. The use of currency swaps differentiates this work from the usual studies of interest parity relationships, by allowing the analysis of a larger spectrum of maturities, and also a distinct assessment of connections between term-structures of interest rates across countries. The econometric methodologies adopted include cointegration, the ARDL approach (employed to examine long-run relationships between stationary and nonstationary variables), and Granger-causality analysis. The empirical results suggest that, although capital is fairly mobile across borders, asset substitutability is still low, and domestic and foreign (i.e., non-German) real interest rates continue to differ, especially for longer maturities. There is also evidence of links between domestic and foreign term-structures of interest rates, but most foreign long-term rates are independent from German short-term ones. These findings may have implications for the issue of fiscal discipline in the context of a single capital market, as they suggest that longterm interest rates may continue to differ across countries and, consequently, it will not be possible for national governments to borrow at a given common interest rate.