Solowian Approach to European Convergence with GMM

Mehmet Aldonat BEYZATLAR ve Mehmet ETN Dokuz Eyll niversitesi ABSTRACT Optimum Currency Areas Theory constructs an important theoretical framework for European monetary integration. The degree of financial integration is a vital element in this process. In recent studies, financial integration as a part of the Lisbon Strategy is seemed as a key factor of the EUs economic strategies. One of the most important fundamental features of optimum currency area is the convergence of financial indicators to each other. This paper tests and analyzes the hypothesis of the convergence of interest rates depending on the convergence framework for the period 1993-2010 using Generalized Method of Moments method for EU15 countries. Keywords: Optimum Currency Areas Theory, Interest Rates, Financial Integration, GMM. AMS 1991 Classification: Primary 62M10 JEL Classification: C23, F15, F36
1. INTRODUCTION

Theoretical researches within financial integration that concentrates on what determines the variety of models sorely emphasizing different financial instruments, which might determine how financial integration affect other economic factors. Interest rates as a Maastricht criteria and an important financial instrument determines the efforts on effecting vital economic measurements such as inflation, credits, etc. An integrated financial market should meet the same relevant characteristics such as facing with a single set of rules, having equal access and treating equally when they decide to deal with financial instruments and/or financial services to be fully integrated. Therefore, financial integration is independent of the financial structures within regions, concerned with the symmetric or asymmetric effects of frictions on different regions, separates the supply and the demand for investment opportunities as the two constituents of a financial market. Several approaches to measuring how financial integration might have exacerbated the impact of the crisis in emerging Europe lead to more financial integration, even contractions of national accounts. Most of the studies among EU member states emphasize the existence of convergence among these countries. In this study, the hypothesis of the convergence of interest rates is analyzed and evaluated by convergence framework is based on Solows (1956) model. The analysis about convergence covers economic and econometric perspectives, where Generalized Method of Moments (GMM) method is used to analyze EU1

27 countries convergence with respect to interest rates for the period 1993-2010. It is argued in this paper that only when all economies are able to access to the financial integration it may eventually leads to convergence of interest rates in the long run. In the light of the econometric findings, policy implications are set. This Solowian neo-classical growth model predicts that poor economies tend to grow faster than rich ones. The speed of convergence, initial wealth, steady state circumstances and many other restrictions define convergence hypothesis but the assumption of diminishing returns is crucial to hold. Based on Solows model, inauguration of this literature is often attributed to Barro 1991; Barro and Sala-i-Martin (1991 and 1995); Neva and Gouryette (1995) and some other contributing studies in this strand of research are Button and Pentescot (1995), Mauro and Podrecca (1995), Lyberaki (1996), Fagerberg and Verspagen (1999) and etc. There are also a vast amount of studies devoted to convergence with respect to economic measurements from different perspectives, Baumol 1986; Barro and Sala-i-Martin 1992; Mankiw, Romer and Weil 1992; Jones 1997; Pritchett 1997 and De Long 1998; among others. This study aims to supply more substantial evidence on the convergence of interest rates by employing a comprehensive data set and GMM approach as an advanced econometric technique. GMM method is proposed because this testing procedure allows us to take into account convergence from a robust perspective (Caselli et al, 1996; Bond et al, 2001). These are described in detail in the next section. The organization of the article is as follows. Section II covers literature; Section III develops a GMM approach to reveal the convergence of interest rates to Maastricht criteria interest rate as financial integration. Section IV presents main conclusions.
2. OPTIMUM CURRENCY AREAS THEORY

The essence of modern Monetary Union Theory is based on Mundell (1961)s Optimum Currency Area (OCA) Theory. Mundell defines Optimum Currency Area as the size of the region that maximizes the difference of positive and negative effects of monetary union. McKinnon (1963) makes his definition on OCA as the region that the objectives of balance payments and price stability provided with lowest cost through economic policies of member countries. OCA theory focuses on conditions that OCA would be successful in a region in which fixed exchange rates policy is carried out (Patterson and Amati, 1998). Eventually not every monetary area is an OCA; potential members of OCA have some obvious economic characters. Analyzing these characters it can be tested if a monetary are is an OCA. Mundell (1961), McKinnon (1963) and Kenen (1969), the pioneers of the theory, discussed these characters for the first time. To create an OCA and to function successfully a monetary union requires some circumstances. According to the theory of OCA, the minimum conditions of union success can be listed as: Not to come across frequent and large-scaled asymmetric macroeconomic shocks, price stability and closeness of inflation rates, mobility of production factors among member countries and flexibility of price and real wage and thus to have ability to adapt to shocks, monetary union member countries should not have different inflationunemployment trade of preferences and a high financial integration level between member countries. In Mundell (1961), the most important missing point about OCA was financial integration and stability. The concept of financial integration is a sub-objective of economic integration and the determinant of monetary and fiscal policies in order to provide economic integration. 2

The degree of financial integration is a vital element in this process. In recent studies, financial integration as a part of the Lisbon Strategy is seemed as a key factor of the European Unions growth and strategies in the competitive world. Financial integration is considered to improve the allocation of efficient capital and the diversification of risks. One of the most important fundamental features of optimum currency area is the convergence of financial and monetary indicators to each other in where countries using the same currency as common currency area. According to the theory, borrowing interest rates and market interest rates of these countries is expected to converge to financial instruments in Euro as common currency and interest rates set out in the Treaty of Maastricht. Furthermore, the convergence of domestic borrowing interest rates of these countries to interest rates as an indicator of Euro as a common currency provide information about the existence of monetary convergence and thus financial integration. This could imply that the degree of convergence in political and economic performance and/or structures is important for the benefits of the reduction between countries economies. Moreover, perfect convergence is not necessary for the constitution of an optimum currency area, not even in its Pareto form (Collignon, 1997).
3. LITERATURE

The first study examining convergence in the Union was carried out by Barro and Sala-iMartin. Barro and Sala-i-Martin (1991) examined 73 European Region for the period 19501985. Barro and Sala-i-Martin (1995), as a result of their convergence analysis found the existence of and convergence among 90 regions of eight European countries between years 1950 and 1990. Sala-i-Martin (1996) included 90 regions in Europe to his analysis and as a result he estimated approximately 2% speed of convergence. Neva and Gouryette (1995), following the method of Sala-i-Martin, examined the 73 EU region taking into account the time interval 1950 1985 and showed that also it is not strong in the Southern Europe there is a overall convergence in the early 1980s. Button and Pentescot (1995), taking into account the history of European Union, examined the Western Zones of Union. However, also including 1980s, they did not come across any convergence tendency. Mauro and Podrecca (1995), has taken into consideration the Italian regions over the period 1970-1991 using time series method they especially investigated the existence of convergence. Despite the occurrence of weak convergence until the beginning of 1980s after taking into account the entire period they noted that there is not a continuous process of convergence. Lyberaki (1996), in his study on Greek economy, he stated that the hypothesis of convergence is not valid contrary there is a divergence from the European Union. Fagerberg and Verspagen (1999) analyzed the regions of EU9 and EU12 countries over the period 1960-1995, considering the convergence in terms of per capita income. Between period 1960 and 1980, on both regional and national level there was a significant decrease in the distribution in EU9. Thus, a path towards European convergence emerged. After 1980, the trend continued at the national level with a lower rate. According to the European Economic Research Report (2000), there is no tendency (-convergence) of fast growing up in the poor countries than rich countries however, when various structural variables has been added to the model, it is concluded that convergence (conditional convergence). Martin and Sanz (2001) examined Greece, Ireland, Portugal and Spain between the period from 1960 to 2000 in terms of per capita income convergence. According to the results both four countries converge to the EU average. However Ireland is the most successful and Greece is the last in this process. Brasili and Gutierrez (2004) analyzed the per-capita incomes convergence process across 140 3

NUTS2 European regions during the period 1980-1999 using panel unit root tests. They find the evidence of convergence among the EU regions. The distribution of per capita income converges toward the average pole and the tests strongly reject the null of divergence. Saraolu and Doan (2005) uses five different panel unit root tests to investigate income convergence for the European Union and candidate countries using quarterly data of these countries for the period between 1990 and 2004 on per capita GDP. The evidence suggests that the null hypothesis that subgroups of EU economies do not converge to the average GDP of the first 15 EU countries cannot be rejected. Sassi (2010) analyzes the role and sources of within and between sectors convergence in the context of the economic catching-up process across the European Union regions. The growth-accounting approach used in the study underlines the role of structural composition and change on the process of economic and between-sectors catching-up. The basic literature on convergence mainly focuses on growth rates. Nevertheless, related directly with this study, in some studies interest rates were also taken into account. One of the recent studies is Frmmel and Kruse (2009); in the study they analyze the convergence of interest rates in the EMS in a framework of changing persistence. Their empirical results suggest different convergence dates for analyzed member countries. The main factors driving interest rate convergence between analyzed countries were the coordination of budgetary and monetary policy leading to stable exchange rates in the run up-to EMU. Weber (2006) analyzes British state of convergence towards Euro area compared to USA. Although UK has been perceived as not aiming at strengthening of the European Integration the results are generally in favor of a growing British integration into the European Currency Union. In particular, overall literature has shown that a significant percentage of variation in convergence (across countries and in time) could be explained by variations in structural issues. This is often dubbed a direct causation between beginning situation and target level (Maastricht criteria in this study). It also seems to be logical to expect that the difference between countries economies also has some explanatory power on the future differences at many economic levels and even on its growth rate, which is often dubbed by many studies. There could be many mechanisms that may be backing this end result. It is natural to expect that kind of interaction, which complements and enhances disparateness. This linkage was first pointed out by Barro and Sala-i-Martin (1991). It has been studied elaborately from different angles theoretically and empirically since then. For empirical studies, see Caselli et al, 1996; Sala-i-Martin, 1996; Lee et al, 1997; Dowrick and Rogers, 2002; Badinger et al 2004; Weeks and Yao, 2003; Borys et al, 2006; Lau, 2009.
4. METHODOLOGY

In this study, convergence equation is derived from The Solow growth model with CobbDouglas production function under external technology. GMM approach provides significant outcomes in the context of convergence. In the following part, the general theoretical framework of convergence and GMM approach are given with their main dimensions briefly. 4.1 Convergence There are several approaches and methodologies that can be used in empirical studies of convergence, which is an important fundamental application of economic growth. The major distinction is between approach (economics) and empirical tests (econometrics). In this article, we opted to use long-run interest rates to test the convergence to Maastricht criteria 4

interest rates. Convergence equation derived from Solowian growth model is used to test empirically. Cobb-Douglas production function under external technology, Harrod-neutral and labor-saving restrictions is assumed as follows; (1.01) where under these restrictions fundamental equation of growth shown as follows; (1.02) and per efficient labor capita form of equation (1.03) denoted below; (1.03) per efficient labor type of fundamental equation of growth could be derived in log-differential where . by taking the

(1.04) The equation (1.04) is not linear and could not be used for an empirical test as a model. Therefore this equation should be used after linearization. Taylor approximation recipe is exploited for linearization process of that non-linear equation. Taylor approximation is an appropriate solution that produces approximation series in terms of polynomials related only to coefficients equal to the derivation of the function at that point. The basic representation of Taylor approximation where is a constant point

The constant point in model derivation is assumed the steady state point and Taylor approximation is applied to equation (1.04) the general form of equation denoted as follows (1.05) and to . (1.06) This equation exhibits the velocity of growth, where equation (1.06) is linear when compared to equation (1.04). difference denotes the distance of the current situation from its steady state. This is an important and fundamental element of growth literature in terms of income-growth rate comparison of relevant economies. 5 could be found by taking the derivative of equation with respect

In that equation is assumed and convergence rate equation is derived as follows. This equation gives at which speed the economy approximates its steady state.

(1.07) Equation (1.06) is linear hence, it should be solved with respect to where , and . Then both sides of the equation is multiplied by and is obtained. For t=0, and then equations solved for per capita income. To this end convergence equation is derived as a form used in empirical studies. (1.08) where this convergence equation regresses the interaction between growth rate with respect to starting point (left-hand side) and external variables. The sign of is negative, which corresponds the effect of initial income that is consistent with convergence theory. The more the magnitude of initial income contributes less to the speed of convergence to steady state. The less the magnitude of initial income contributes more to the speed of convergence to steady state. 4.2 GMM Approach The literature provides diversified methods for panel data estimation. Panel data approaches are distinguished from each other in terms of parameter estimation problems. Standard panel data approach take cross-section and period elements into account to reach robust multidimensional outcomes. GMM approach testing procedure in panel data models is classified as one of the main type of panel data approaches. The first one was pioneered by Lars Peter Hansen in 1982, which has provided a discussion of the large sample properties of a class of econometric estimators. These estimators are examined under different conditions such as consistency and asymptotic normality that are defined in terms of orthogonality conditions. GMM approach provide the exploitation of effective estimators when the number of moments extent the number of parameters. GMM estimator is directly derived from moment conditions and parameter vector is derived by showing variance moments as a scale and by minimizing the sum of squares of the difference between sample moments and population moments (Bronwyn, 1999). In many studies, moment conditions are emphasized as . That moment condition included an unknown parameter vector, which is estimated and tested conveniently by Hansen (1982). GMM approach requires instrument variables to overcome covariance discrepancies raised from the interaction between lagged values of dependent variable and error term. Instead of lagged values of dependent variables, which are relational with error term, one or more instrument variables could be used under some restrictions. 6

The advantages of GMM over other panel data approaches are clear: if heteroscedasticity is present, the GMM estimator is more efficient than other tests estimators. Nevertheless, the use of GMM provides substantial results for convergence (Caselli et al, 1996; Dowrick and Rogers, 2002; Weeks and Yao, 2003). In addition, GMM overcomes the exogeneity and externality problem between variables and takes into account the effect of excluded variables.
5. DATA, MODEL AND EMPIRICAL FINDINGS

The data of our study in an attempt to test the convergence by Maastricht criteria interest rates between EU countries in a panel data setting are derived from OECD statistical database. We have included balanced panel data set for long-term interest rate (LIR) and Maastricht criteria interest rate (MIR) on EU-15 countries between 1993Q1 and 2010Q4. At first, panel unit root tests are performed for the logarithm value of as variable. The first evidence in favor of divergence is presented in Table 1. According to all panel unit root tests, both variables are found integrated of order one, which denotes the non-existence of convergence. Table 1: Panel Unit Root Tests for Convergence in Interest Rates to Maastricht Criteria
Tests

Stationarity
Null Hypothesis: Common Unit Root

Levin-Lin-Chu Breitung

1.18829 5,14576

Has Unit Root Has Unit Root

Null Hypothesis: Individual Unit Root Im-Pesaran-Shin Fisher-ADF Fisher-PP 0,33059 28,5134 28,0261 Null Hypothesis: No Unit Root Hadri 12,7112 Has Unit Root Has Unit Root Has Unit Root Has Unit Root

Therefore, results obtained from panel unit root tests are favorable for GMM panel data approach. These variables are used to construct our convergence model is as follows: (1.09) First order difference of and and the final model comprised as follows: are taken for GMM testing procedure

(1.10) In the case of outputs, the period of analysis is from 1993 to 2010. The second evidence in favor of divergence is presented in Table 2-a and 2-b, which shows the positive relationship between (from 1993 to 2010) and at the initial level of long term 7

interest rates. This positive interaction holds from 1993 to 2001 before transition to single currency. The estimated coefficient in equation (1.10) is positive for 1993-2010 and 19932010, as expected and statistically significant. However, after transition to Euro, the first evidence in favor of convergence is presented in Table 2-c. The convergence rate is 1.15% (see Table 2-c). To get an idea of the speed (in quarters) with which this convergence should take place, we calculated the half-life for closing the gap between the long run interest rates of the relatively lower countries and the relatively higher ones. In this case, the convergence rate implies that half the gap should be closed in 13 quarters (see Table 5). Table 2: Panel GMM Test for Beta Convergence in Interest Rates to Maastricht Criteria
Coefficient a) - Constant Term - Convergence - Constant Term - Convergence - Constant Term - Convergence 1993Q1 2010Q4 -0,001248 (-0,727732) 0,228500** (2,238138) 1993Q1 2001Q4 0,025083** (2,567999) 3,192732*** (3,324163) 2002Q1 2010Q4 -0,002253 (-0,628633) -0,549417** (-2,079399) Convergence No Convergence

b)

No Convergence

c)

Convergence

Note: ***, ** and * denotes the significance level at 1%, 5% and 10% respectively and numbers in parentheses are t-statistics. The number of observations, cross-sections and periods included are 1050, 15 and 70 respectively.

The empirical evidence in Table 2-c tends to confirm the absolute convergence of interest rates to Maastricht criteria across EU-15 countries. The examination of panel unit root tests could be the evidence of divergence as an alternative test for beta convergence. Nevertheless, the findings confirm hypothesis that the interest rates across countries follow theoretical and empirical patterns drawn. Table 3: Country-Level Representation of Convergence 1993Q1 - 2010Q4
D Country Germany Denmark Netherlands Finland Sweden Luxembourg France United Kingdom Austria Belgium Italy Spain Portugal Ireland Greece = 0,025083 + 3,192732 Cross-Section Effects -0,0015110 -0,0024010 0,0000708 -0,0047840 -0,0041600 0,0000156 -0,0000312 -0,0016930 0,0004990 0,0017660 -0,0033510 -0,0001030 0,0026710 0,0118850 0,0011260 D + [CX=F] Country Based Convergence 3,1912210 3,1903310 3,1928028 3,1879480 3,1885720 3,1927476 3,1927008 3,1910390 3,1932310 3,1944980 3,1893810 3,1926290 3,1954030 3,2046170 3,1938580

In Table 3, for the whole period, cross section effects of Germany, Denmark, Finland, Sweden, France, United Kingdom, Italy and Spain have negative coefficients that indicate positive contribution to interest rate convergence. The convergence equation is regressed for the periods 1993 2001 and 2001 2010 before and after transition to single currency respectively. Table 4: Country-Level Representation of Convergence 1993Q1 - 2001Q4
Cross-Section Effects 0,0069020 0,0052860 0,0085670 -0,0014100 0,0013850 0,0045280 0,0063010 0,0031100 0,0073960 0,0060820 -0,0088240 -0,0058760 -0,0095800 0,0036780 -0,0275440 Country Based Convergence 0,7355870 0,7346970 0,7371688 0,7323140 0,7329380 0,7371136 0,7370668 0,7354050 0,7375970 0,7388640 0,7337470 0,7369950 0,7397690 0,7489830 0,7382240

Country Germany Denmark Netherlands Finland Sweden Luxembourg France United Kingdom Austria Belgium Italy Spain Portugal Ireland Greece

In Table 4 the results of country based cross section effects display another scenario that the signs of the coefficients of countries except Finland, Italy and Spain has changed. Parallel with the cross-section effects, convergence rates decreased, which implies a divergence across countries. This situation shows that, before the transition to common currency, the level of financial integration of the union seems to be lower with respect to European Monetary Union (EMU). The results after transition to Euro are included in Table 5. Convergence rates and speed consistency increased after 2002.

Table 5: Country-Level Representation of Convergence 2002Q1 - 2010Q4

D( Country Germany Denmark Netherlands Finland Sweden Luxembourg France United Kingdom Austria Belgium Italy Spain Portugal Ireland Greece ) = - 0,002253 - 0,549417 Cross Section Effects -0,0094560 -0,0096600 -0,0079530 -0,0079700 -0,0093980 -0,0042460 -0,0060120 -0,0062280 -0,0060150 -0,0023110 0,0018190 0,0053490 0,0142420 0,0196360 0,0282040 Country Based Convergence -0,5509280 -0,5518180 -0,5493462 -0,5542010 -0,5535770 -0,5494014 -0,5494482 -0,5511100 -0,5489180 -0,5476510 -0,5527680 -0,5495200 -0,5467460 -0,5375320 -0,5482910 D( ) + [CX=F] Convergence Period 0,1366592 0,1366944 0,1365965 0,1367885 0,1367639 0,1365987 0,1366006 0,1366664 0,1365795 0,1365292 0,1367320 0,1366034 0,1364931 0,1361234 0,1365546 Convergence Consistency Speed 0,0062693 0,0062775 0,0062548 0,0062995 0,0062937 0,0062553 0,0062557 0,0062710 0,0062508 0,0062391 0,0062863 0,0062564 0,0062308 0,0061454 0,0062450

The asymmetric effects of shocks on countries raised from crisis could be monitored with respect to the difference between borrowing interest rates while convergence rates are identical. That situation shows European Monetary Union is confronted with another handicap on the road to Optimum Currency Area. Moreover, the reversion or the discrepancy between interest rates, borrowing interest rates and amounts against convergence speed indicates the formation of financial repression, which is also reputed financial pressure. In that context, 1993 to 2010 period is examined separately; 1993-2001 as pre-Monetary Union and 2002-2010 as post-Monetary Union. That kind of distinction exposes the interaction between convergence and monetary union beneath monetary policy. Tables 4 and 5 demonstrate that, the acceleration of financial integration level convergence of countries after the transition to single currency could be indicated from the differentiation of convergence speed. Although, transition to Euro on the way to full economic integration is seemed an accurate policy move coordinated by EU, the existence of monetary union could not interact the general trend to convergence side. Despite the convergence of borrowing interest rates in the union, differentiation in the speed of convergence in time damaged the homogeneity of financial structure and possible symmetric prevention and reactions to financial crisis. As seen in Figure 1, countries have different borrowing rates and amounts. Greece, Italy, Belgium, Portugal and Ireland have greatest government debt to GDP ratio EU-wide. In the near future, Greece, Portugal and Ireland from these countries have debt crisis. Because of lower financial integration and common fiscal policy, economic coordination policies of EU have failed.

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Figure 1: EU-15 Government Debt/GDP Ratios

Source: IMF Statistical Database

6. Concluding Remarks European Monetary Union seems to be the most successful Union in the history with respect to its economic size. Accessing to a single currency was the most important moves against the superiority of US Dollar. Financial integration level is an important and fundamental criterion of OCA on the goal of full economic integration. Interest rate convergence is one of the basic indicators of financial integration. Moreover, after financial liberalization policies the financial capital could move across countries without any constraint and this will equalize interest rates. EU is in a blurred crisis and member countries do not have chance to use monetary and exchange rate policy instruments because of monetary union. In this framework, financial integration is vital in building up and prevailing common policies to neutralize the harmful effects of crisis. Because, EMU countries transfer the power of their monetary authorities to a common association. In this paper we examine the empirical validity of convergence across EU-15 countries using long-term interest rates during 1993Q1 to 2010Q4. Using panel unit root tests any strong evidence could not be found in support of beta convergence across EU-15 countries on longterm interest rates. In order to determine the financial integration by convergence of interest rates of EU countries to Maastricht criteria interest rate, GMM approach to a panel data model with fixed effects for cross-section. Significant results of testing GMM hypothesis shows the existence of convergence consistent with Barro and Sala-i-Martin, 1991 and 1992. Although, there is an overall convergence to Maastricht criterion interest rate, the speed of convergence differentiates across member economies. Therefore, the combination of this situation with different debt/GDP ratios causes discrete economic paths for economies. Under these circumstances, the findings will play a critical role on the destiny of the union. EU cannot achieve being a single currency area. The existence of single currency requires the commitment of the Law of one price that means the full monetary integration. Therefore, full monetary integration means a strong convergence. In that sense, the coefficient of convergence parameter should be less than or equal to -1, which reflects a strong convergence.

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