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AN EVALUATION OF THE IMPACT OF A COMMON EUROPEAN CURRENCY (EURO) ON INTERNATIONAL BUSINESS.
ABSTRACT
The introduction of the euro was an immense political and symbolic step towards an integrated
Europe. It was also the world’s largest economic ‘experiment.’ This experiment opens the door to a
major advance in our understanding of how a common currency affects economic activity ranging
from trade and foreign direct investment to wage-setting behaviour and corporate business
strategies. A series of studies stretching back to the early years of the decade have begun to piece
together a wide range of results. The resulting collage is still not fully coherent, this report has
moved in that direction.
When it comes to the euro’s trade effects the first contribution of the report is to refine “the
number”. Using the latest data and best empirical methodology, we confirm the received wisdom
that the euro has promoted trade significantly, with the aggregate impact being in the range of 5%
or so. Note that we have made great efforts to separate the euro’s impact from the impact of other
pro-integration policies that were also being implemented in the 1999-2006 period, notably the
Single Market programmes. This effort has tended to shift down the aggregate number but it is
necessary to be absolutely sure that it was the euro causing the effect.
The second main contribution of the report was to advance and refine our understanding of exact
how the euro was boosting trade. Which economic channels were important and which were not.
Logically, there are two main channels to consider, each with a number of sub-channels. The first is
the relative price channel. Simply put, this argues that the euro boosted trade inside the Eurozone
since it lowered the relative price of traded goods coming from the Eurozone. Since prices depend
upon marginal cost and the price-cost mark-up, the lower relative price could come from two main
sources – a reduction in bilateral trade costs among Eurozone nations (e.g. lower transaction costs,
hedging costs, etc.), or an increase in competition that pushed down trade prices via a procompetitive effect. The two sources are easily distinguished since to the extent that the lower trade
costs were preferential – affecting only intra-Eurozone trade – it should have led to trade diversion.
It did not, so we can be fairly confident that the transaction cost story is not of first-order
importance. Direct evidence from pricing regressions suggests that the euro did indeed have a procompetitive effect on exporters’ prices, for both EZ and non-EZ based exporters. We also found
evidence that outsiders were moving towards pricing-to-market strategies suggestive of their
viewing the Eurozone as a single market. Indirectly evidence on this exact point comes from the
heighten convergence of export prices within the Eurozone.
The second main channel – first posited by Baldwin and Taglioni (2004) and elaborated in Baldwin
(2005, 2006) – is the newly-trade goods channel. The basic idea is that the euro induced firms to
export a wider range of their products to the Eurozone. Thus, it was not merely that trade in existing
products was stimulated; the pro-trade effect also came from newly trade goods. This report
presents new evidence based on four firm-level data sets (2 from insiders and 2 from outsiders) that
seems to confirm the new-goods hypothesis rather resoundingly. Moreover, this new evidence sheds
important light on the lack of trade diversion. Earlier studies had suggested that the lack of trade
diversion might have been caused by an expansion of the range of goods exported by the ‘outs’ to
the ‘ins’. Firm-level trade data from Sweden and Hungary, however, shows that this did not happen.
In the Swedish case the main rise in their exports to the Eurozone was due to the so-called intensive
margin, namely the old-fashioned way of raising trade – increasing the average sales per product
exported. Combining this evidence with our new pricing regressions suggest that the absence of
trade diversion was due to the pro-competitive effect of the euro on outsider’s export pricing
strategy. That is, as the euro made the euro-using nations more like a single market, boosting
pricing transparency and making third-party arbitrage safer, Eurozone import customers became
more price sensitive and the outsider exporters responded by cutting price-cost margins. This
lowered their relative prices and thus stimulated sales.
The report also looks at new evidence on this second channel that come from data that is more
aggregate than the firm level data but still very disaggregated and available for all nations. The new
evidence in this chapter confirms the firm-level findings.
The third main contribution of the report concerns the euro’s pro-FDI effects. The empirical work
on the FDI effects is much less rich than that on the trade effect. This is not due to a lack of interest;
in the world of modern business, cross-border investment is an integral part of firms’ international
strategies – especially when it comes to large firms. Moreover, it is widely thought that FDI brings
with it valuable foreign know-how that does come with just trade. The problem is that both the data
and the empirical methodology are much less well developed.
Using the best available data, theory and econometric techniques, the report concludes that both
Single Market integration and and euro area membership have pro-FDI effects. The key points
were:
• The euro’s pro-FDI effect was much larger in manufacturing versus services. It is likely that
the level of protection and barriers to entry in the service sector act as a strong deterrent to
cross-border M&As in services across countries. To the extent that the new 2006 services
directive breaks down such barriers, it may trigger a new wave of cross border M&As within
the EU.
• The euro’s pro-FDI effect was much larger for deals within sectors as opposed to across
sectors. Thus the euro facilitated cross-border M&As within the euro area, which aimed at
restructuring capital within the same sector of activity, rather then boosting the formation of
conglomerate activities between sectors.
• The euro fostered domestic and cross-border M&A activity by both large and small firms, but
its effect on small firms was biased towards cross-border activity.
• The euro’s adoption promoted FDI from outside the euro area, but this effect was only about
half as strong as the impact within the area.
• The ‘bottomline’ number – the overall pro-FDI effect – is not clear. Most authors find it is
positive, but the estimates range from +15% for in-to-in flows and +7.5% for out-to-in, to
+200% and +100%, respectively for the in-to-in and out-to-in flows.
The empirical work on FDI must be subject to an important caveat concerning data quality. Most of
the investigation was conducted on FDI data gathered for capital account statistics. This data deals
with financial flows which may or may not be good proxies for real investment activities such
production and employment. Indeed, for the one nation where we did have access to firm-level data
on FDI measures that include employment and sales, the correlation with the capital account data is
not very good and deviates significantly exactly aournd the euro’s introduction. Moreover, the FDI
data is dominated by M&A activity which is clearly influenced by financial market trends such as
the stock market booms and tax avoidence. For example, about 70% of all intra-Eurozone FDI
comes from or to Luxembourg – a fact that surely reflects the Grand Dutchy tax and transparency
advantage as concerns M&A activity.
TABLE OF CONTENT
Title page- – – – – – – – – i
Approval page – – – – – – – -ii
Dedication – – – – – – – – -iii
Acknowledgement – – – – – – – -iv
Abstract – – – – – – – – – -v
Table of content – – – – – – – -vi
CHAPTER ONE
INTRODUCTION – – – – – – – -1
1.0 Background of the study – – – – -1
1.1 Statement of the problem – – – – -5
1.2 Purpose of the study – – – – – -6
1.3 Significance of the study – – – – -8
1.4 Research questions – – – – – -9
1.5 Scope of the study – – – – – – -10
CHAPTER TWO
LITERATURE REVIEW – – – – – – -11
CHAPTER THREE
Research methodology – – – – – – -39
Design of study – – – – – – – -40
CHAPTER FOUR
Presentation, analysis and interpretation of data – -48
CHAPTER FIVE
Summary of findings – – – – – – -60
Conclusion – – – – – – – – -61
Recommendations – – – – – – – -62
Suggestions for further research – – – – -64
References – – – – – – – – -65
Appendix I – – – – — – – – -68
Questionnaire. – – – – – – – -69
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