The euro and us: Crises and their reflection on financial market integration
This article focuses on financial markets, and through it we will seek to briefly introduce the reader to the essence of the idea of financially integrated markets, and outline the possibilities for a general measurement of alignment. We will then try to assess the progress of financial alignment across markets over the quarter of a century of euro-area existence that we are commemorating this year. In this spirit, we will look at how similar the movements in the foreign exchange, money and equity markets of selected euro candidates have been to those in the euro area and, in the case of the government bond market, to those in Germany, in response to the ongoing turbulent events. Our goal is to show how events like the global crisis, the Covid-19 pandemic, the security crisis and the subsequent energy crisis have manifested themselves in the degree of (mis)alignment of individual parts of the financial market.
EU membership and accession to the four freedoms of the internal market have further increased the already visible interconnectedness of European states and their populations. EU states have guaranteed the free movement of goods, services, people and capital throughout the EU. Furthermore, participation in this European integration project enables EU citizens to live and work anywhere in the EU, providing them with better opportunities for employment and personal fulfilment. We can especially see the indisputable benefit of EU membership in the post-socialist states, which have undergone rapid transformation into market economies[1]. Although these processes have proceeded differently in the various states, they have also contributed to the visible integration of the financial markets of EU states. This should be even more visible for states using the single currency, the euro.
So what are the advantages and disadvantages of greater financial market integration? Financial integration brings both benefits and costs to individual entities, whether directly or indirectly[2]. The experience of the global financial crisis after the collapse of the Lehman Brothers investment bank in 2008, and then the turbulent period after 2020, have amplified the importance of this debate. The most frequently cited benefits of financial market integration include: (i) a smoothing of consumption through international risk diversification, (ii) the positive impact of capital flows on domestic investment and economic growth[3], (iii) improved financial system efficiency, and (iv) more prudential behaviour by financial market operators and a higher degree of financial stability. Although it is generally accepted that a higher degree of market integration benefits a state, under certain conditions it can also have less positive effects. In states insufficiently prepared for financial integration (where the financial sector is less developed, or has a very different structure and/or legal framework), the costs associated with market integration may outweigh the benefits. However, this should not apply to the euro candidates, which should already be largely aligned with the other EU states by virtue of their membership in the EU. Substantial financial integration costs include: (i) a lack of access to financial resources in periods of financial instability, including the concentration and procyclicality of capital, (ii) the inadequate allocation of capital flows, (iii) a loss of macroeconomic stability, (iv) herd behaviour among investors, contagion propagating through interconnected financial markets, and the high volatility of cross-border capital flows[4].
Global megatrends[5] and the increasing degree of interconnectedness of economies have further effects on all actors, meaning households, companies, governments and financial institutions. A higher degree of financial market integration can improve their investment opportunities, thus enabling them to get higher returns at the same risk levels. On the other hand, if they are all exposed to similar risks, their balance sheets may not be sufficiently diversified and the original positive effect of integration may be reduced. In addition, where there is a high degree of geographical and sectoral interdependence of financial institutions (banks) and individual parts of the financial market, the financial sector as a whole may be more susceptible to the aforementioned risk of contagion, which could reach a systemic dimension. Whether the benefits of deepening financial integration outweigh its risks, and whether this process will lead to improved financial stability, depends to a large extent on the resilience and flexibility of the financial system itself and the fulfilment of the prudential role of national and international institutions.
One key prerequisite for measuring integration is the validity of the law of one price. Most definitions of financial integration are closely related to, or even directly defined by, the law of one price. This tells us that "assets (exchange rates, bonds, stocks, ...) with identical risk and return should be priced identically regardless of where they are traded." We can imagine it, for example, as the sea level, which is the same everywhere on earth due to the laws of physics. This is because there are no artificial barriers around the planet that locally increase or decrease the sea level. The following formulation is considered a generally applicable definition of a financially integrated market in the relevant literature (Baele et al., 2004; Weber, 2006): “The market for a given set of financial instruments and/or services is fully integrated if all potential market participants (i) face a single set of rules when they decide to make transactions, (ii) have equal access to the above-mentioned set of financial instruments and/or services, and (iii) are treated equally when they are active in the market.”
To measure the integration or alignment of financial markets, the concepts of beta- and sigma-convergence can be used.[6] Beta-convergence makes it possible to determine the speed at which differences in yields are reduced on individual financial markets. If the beta coefficient is negative, it means that convergence is in progress. The closer its value is to -1, the higher the convergence speed. Beta-convergence can be assessed using a derived convergence half-life indicator, which allows an intuitive interpretation of the speed at which the gap between yields across markets is shrinking. Convergence half-life refers to the time it takes for differences between asset yields to fall to half their original value. The other side of the same convergence coin is the concept of sigma-convergence, which focuses on the dispersion of the differences between the yields on the same assets in different states at a given point in time. This concept determines the level of alignment achieved by the individual financial market segments. Sigma-convergence is when the dispersion falls to zero. It is important to note that beta-convergence may or may not be accompanied by sigma-convergence. There may even be sigma-divergence. For this reason, both concepts need to be monitored simultaneously when assessing financial integration.
The following text presents the beta- and sigma-convergence results for the financial markets of selected euro candidates (the Czech Republic, Hungary and Poland) and selected euro area member states (Austria, Portugal, Italy and Slovakia) with the euro area, respectively with Germany, for the period from January 1995 to June 2024. The calculations were made on weekly data (averages from daily data) from Bloomberg and Refinitiv from January 1995 for the foreign exchange and equity markets, from January 1999 for the money market and from January 2000 for the bond market. The dataset ends in June 2024 for all the markets. Three-month interbank market rates were used for the money market, quotes of national currencies against the USD for the foreign exchange market, five-year government bonds for the bond market, and national stock indices for the equity market. Beta coefficients were estimated using regression analysis as in the work by Babecký, Komárek and Komárková (2017).
Table 1 – Beta-convergence of the foreign exchange and money markets vis-à-vis the euro area
(convergence half-life values; in days)
| Foreign exchange market | Money market | |||||
|---|---|---|---|---|---|---|
| 7/07 | 12/19 | 6/24 | 7/07 | 12/19 | 6/24 | |
| Czech Republic | 1.8 | 2.0 | 2.2 | 5.8 | 6.8 | 1.2 |
| Hungary | 1.4 | 1.8 | 2.1 | 3.1 | 2.8 | 1.7 |
| Poland | 2.4 | 2.0 | 2.1 | 2.5 | 2.8 | 3.3 |
| Euro area | B | B | B | B | B | B |
Source: Bloomberg, Refinitiv, authors’ calculations
Note: The half-life is the time it takes for the difference in yields to be halved. The lower the half-life value, the faster the convergence. The first milestone indicates the period before the onset of the financial crisis (to July 2007), the second the period before the pandemic (to December 2019) and the third the current period (to June 2024). Other symbols: B – benchmark.
Beta-convergence in the foreign exchange and money markets is proceeding relatively rapidly, but there are significant differences between states. Table 1 shows beta-convergence in the foreign exchange and money markets vis-à-vis the euro area for the selected euro candidates. In all three states, the convergence half-life is less than a week, indicating a relatively high pace of alignment with the euro area. In the foreign exchange market in particular, the convergence half-life is within a narrow range of two days in all reference periods, thus confirming the stable and rapid alignment of this segment across states. In the money market, we see a decline in the convergence half-life in the Czech Republic and Hungary to values below two days, suggesting an acceleration in alignment towards the end of the period under review. By contrast, in Poland there was a slight increase in the convergence half-life from 2.5 to 3.3 days, indicating a slowdown in alignment in this segment of the financial market.
Table 2 – Beta-convergence in the bond and equity markets
(convergence half-life values; in days)
| Bond market | Equity market | |||||
|---|---|---|---|---|---|---|
| 7/07 | 12/19 | 6/24 | 7/07 | 12/19 | 6/24 | |
| Czech Republic | 3.8 | 3.8 | 3.8 | 3.1 | 3.0 | 3.0 |
| Hungary | 3.7 | 3.8 | 4.0 | 2.9 | 2.7 | 2.7 |
| Poland | 2.9 | 2.9 | 3.1 | 2.9 | 2.8 | 2.8 |
| Germany | B | B | B | 3.2 | 3.1 | 3.2 |
| Austria | 1.3 | 3.4 | 3.4 | 2.3 | 2.5 | 2.5 |
| Portugal | 2.6 | 2.3 | 2.3 | 1.9 | 2.0 | 2.1 |
| Italy | 2.0 | 2.1 | 2.1 | 3.0 | 3.1 | 3.0 |
| Slovakia | 3.4 | 3.1 | 3.0 | 3.8 | 3.0 | 3.0 |
| Euro area | - | - | - | B | B | B |
Source: Bloomberg, Refinitiv, authors’ calculations
Note: The half-life is the time it takes for the difference in yields to be halved. The lower the half-life value, the faster the convergence. The first milestone indicates the period before the onset of the financial crisis (to July 2007), the second the period before the pandemic (to December 2019) and the third the current period (to June 2024). Other symbols: B – benchmark, “-” – data not available.
Beta-convergence in the bond and equity markets shows differing alignment speeds, with euro-area states generally more strongly integrated than the euro candidates. As shown in Table 2, convergence half-lives in the bond market are below four days in all states under review, while in the Czech Republic and Hungary they remain stable or are rising slightly, suggesting slower alignment. Poland shows a slight increase in the convergence half-life to 3.1 days, while euro area states like Portugal and Italy have lower values (1.3 to 2.3 days), suggesting stronger integration. On the equity market, the convergence half-life is stable at less than three days in most of the states under review, including the Czech Republic, Hungary and Poland, indicating the sustained and relatively rapid integration of this financial market segment.
The dynamics of sigma-convergence in the foreign exchange and money markets reflect different responses to the global financial crisis and the recent inflationary episode. As shown in Chart 1, sigma-convergence in the foreign exchange market was most affected by the global financial crisis (2008–2009) and subsequently by the recent wave of inflation. During these periods, there was a significant increase in the dispersion of yield differences, signalling a temporary disruption in the market alignment. With the fading of the crisis, this dispersion has gradually narrowed, suggesting a renewed integration of foreign exchange markets within the euro area.
Chart 1 – Sigma-convergence of the foreign exchange market vis-à-vis the euro area
Source: Bloomberg, Refinitiv, authors’ calculations
By contrast, the effect of the global financial crisis was less pronounced in the money market than on the foreign exchange market (see Chart 2), indicating greater stability in this segment during the crisis. However, the recent inflationary wave (2021–2024) had the greatest impact on money market sigma-convergence. The increased interest rate volatility in response to inflation led to an increase in the dispersion of yield differentials, signalling a deterioration in market alignment.
Chart 2 – Sigma-convergence of the money market vis-à-vis the euro area
Source: Bloomberg, Refinitiv, authors’ calculations
In the government bond market of the euro candidates, the sigma-convergence dynamics were most influenced by two key periods – the global financial crisis and the recent inflationary wave. As shown in Chart 3a, the global financial crisis led to an increase in the dispersion of differentials between government bond yields vis-à-vis Germany, signalling a temporary disruption in alignment. The security and energy crises further disrupted sigma-convergence due to the differing reactions by the national economies to high inflation, including the related interest rate policies of central banks.
Chart 3a – Sigma-convergence of the government bond market vis-à-vis Germany (euro candidates)
Source: Bloomberg, Refinitiv, authors’ calculations
The most important factor influencing sigma-convergence in the government bond market of selected euro area states was the debt crisis (2010–2012). As Chart 3b shows, this crisis led to a sharp increase in the dispersion of these states’ government bond yields vis-à-vis Germany, which temporarily disrupted alignment. After the debt crisis ended, the market saw a renewal of sigma-convergence, which has remained mostly stable over the last few years. The exception is Italy, with temporary sigma-divergence probably reflecting the bleak state of its public finances.
Chart 3b – Sigma-convergence of the government bond market vis-à-vis Germany (euro area states)
Source: Bloomberg, Refinitiv, authors’ calculations
In equity markets, historical volatility and the global financial crisis period have had the greatest influence on sigma-convergence. Both the euro candidates (the Czech Republic, Hungary and Poland) and the euro area states were significantly impacted by the global financial crisis of 2008–2009, which saw a sharp and synchronised increase in volatility in all the states under review (Chart 4). By contrast, the Covid-19 pandemic and inflation episode had a much smaller impact on sigma-convergence, suggesting that the equity markets have been relatively resilient to the recent economic shocks.
Chart 4a – Sigma-convergence of the equity market vis-à-vis the euro area (euro candidates)
Source: Bloomberg, Refinitiv, authors’ calculations
Chart 4b – Sigma-convergence of the equity market vis-à-vis the euro area (euro area states)
Source: Bloomberg, Refinitiv, authors’ calculations
Conclusions
The analysis of beta- and sigma-convergence indicates that European financial markets show different degrees of alignment. While beta-convergence indicates a relatively rapid process of closing yield differentials, sigma-convergence reveals that alignment can be temporarily disrupted by crises and economic shocks.
The dynamics of sigma-convergence differ depending on financial market type. While the foreign exchange market was most affected by the global financial crisis, the euro candidates' money and bond markets were most affected by a deterioration in alignment during the recent inflation episode. However, all the markets are showing a gradual return to lower dispersion values after the crises, demonstrating their ability to regain higher alignment levels.
The relatively high alignment of European equity markets. The equity markets across all the monitored states are showing stable and relatively rapid beta-convergence. Equity market sigma-convergence has been most affected by historical volatility and the global financial crisis, while the pandemic and the inflation episode have had a lesser impact, suggesting higher stability for this segment.
Differences between the euro candidates and euro area states. The Czech Republic, Hungary and Poland generally exhibit slower beta-convergence and higher sigma-convergence (dispersion), suggesting a longer process for the alignment of their financial markets with the euro area. By contrast, the euro area states are achieving lower dispersion and faster beta-convergence, especially in the bond and money markets.
Conclusion on overall alignment. The combination of beta- and sigma-convergence reveals an important dynamic: although yield differences (measured by beta-convergence) can be eliminated quickly, their dispersion (sigma-convergence) can be disrupted by external shocks in the short term. This phenomenon highlights the need to monitor both types of convergence simultaneously to gain a comprehensive understanding of financial market alignment. However, this approach does not make it possible to directly identify the reasons behind a change in the financial market alignment. These can thus be deduced indirectly with knowledge of developments in individual states.
Written by Jan Babecký, Luboš Komárek and Zlatuše Komárková. The views expressed in this article are those of the authors and do not necessarily reflect the official position of the Czech National Bank.
Sources
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Keywords
Equity markets, financial markets, sigma convergence, bonds
JEL Classification
E58, F31, F41
[1] See e.g. Kábrt et al. (2024).
[2] See e.g. ECB (2024), Coeurdacier et al. (2020) or earlier works, e.g. Agénor (2003), Baele et al. (2004) and Babecký, Komárek and Komárková (2012).
[3] It leads to higher economic growth by creating additional opportunities for risk diversification and efficient capital allocation.
[4] See Agénor (2003).
[5] Population ageing, electromobility, new technologies and artificial intelligence, environmental awareness, the interconnectedness of global production chains, etc.
[6] See e.g. Baltzer et al. (2008), Baele et al. (2004). The terms beta-convergence and sigma-convergence originate from the literature on economic growth and its dynamics; see, for example, Barro and Sala-i-Martin (1992). Their first application to financial markets was performed by Adam et al. (2002).