Marc Feustel takes a global view of the introduction of the euro, examining its potential claim to being a major world player in currency transactions. He explores the gains that could be reaped from attaining such a position, but concludes that international approbation of the euro will be gradual and much depends on the credibility of the process by which the currency is managed.
On 1 January 1999, Europe was host to one of the most important events in economic history: eleven of the fifteen EU member states formed an Economic and Monetary Union (EMU) and adopted the euro as their single currency. This development will lead to a fundamental transformation of today's global economic landscape. Much of the attention that EMU has received has been focused on its internal structure, but the impact of the euro on the global economy is also of paramount importance. This essay will take a global perspective in attempting to assess the impact of Europe's single currency on the international monetary system. It will address the question of whether the euro can be expected to become a major international currency and what benefits could be derived from this status.
For this analysis, we must ask whether international currency status is important. This status offers two kinds of benefits: political and economic. Firstly, it is clear that a position of global monetary supremacy offers substantial political benefits. Since World War II, global monetary affairs have been dominated by the American dollar. This has allowed the US to insulate its policy-making process from outside influences. It has also enabled them to pursue foreign policy objectives with increased clout and fewer constraints. There are economic gains too. If a currency is held internationally, the issuer will benefit from seignorage gains. This refers essentially to the gains made by governments from printing money. Seignorage can also be derived from a liquidity discount on short-term government debt. High international demand for a currency has the effect of reducing the real yields that the government has to pay on its debt, thus providing that government with seignorage gains. The total gains from seignorage are of the order of 0.2 or 0.3% of GDP. However the benefits of becoming a major world currency cannot be quantified purely in terms of economic profit. Should the euro become a powerful currency, the eurozone will benefit from boosted economic and political credibility.
How can the euro achieve this international currency standing? Three main factors are considered to determine the importance of a currency in the international system: the use of the currency as a ‘vehicle' currency, the use of the currency as a ‘reserve' currency and whether the currency is held in international private portfolios.
One of the main factors in establishing a currency's international importance is its use in trade transactions i.e. its use as a vehicle currency. A vehicle currency is issued between the two participants in trade transactions. Theory states that exporters generally have a preference for home currency, however when no such preference is stated they generally choose a currency with a deep and liquid foreign exchange market and a high degree of acceptability. Theory also tells us that the use of a currency as a vehicle will lead to ‘thick' externalities i.e. the more widely the currency is used for trade and invoicing, the longer it will continue to be used. In practice, world exports are disproportionately invoiced in the currencies of big exporters, with a clear majority (48%) of invoicing in US dollars. The advent of EMU has changed the balance of global trade transactions. The eurozone now controls the highest share of world trade, 20.9%, above 19.5% in the US. However, figures for 1997 show that only 21% of exports were invoiced in eurozone currencies. We could therefore anticipate a large increase in the use of the euro in international trade transactions. If we consider the 1:1.5 ratio of exports-to-invoicing for the Deutsche Mark and apply it to the single currency, we can expect it to become used in at least 40% of world exports. Here a caveat must be placed on this potential expansion of the euro as a vehicle currency. In the early stages of its existence, the uncertainty surrounding the new currency will delay its widespread use in trade transactions. Thus, the aforementioned expansion should be a gradual one. Let us now consider the euro's use as a reserve currency.
A reserve currency is one which is widely held in international central bank reserves. The dollar is currently the dominant reserve currency. Figures for the end of 1997 show that 57% of global official foreign exchange reserves were held in dollars. Will the euro put an end to this dominance? Central bank reserves are based strongly on trade links. Thus we can expect a strong shift towards the euro in Europe's main trade partners' reserve holdings. This essentially concerns Central and Eastern Europe. The Chinese Central Bank has also announced that it will hold a much higher proportion of its reserves in euros than in EMU component currencies in the past. However, in general this phenomenon is likely to be far less pronounced in Asia and Latin America due to their important trade ties with the US economy. We must also place the process of diversification of official reserves in its historical context. Over the past twenty years the share of the dollar in official reserves has dropped by at least 13%. The euro will not provide a trigger for the diversification of reserves, but will merely be a contributing factor to this phenomenon. Also, central bankers are notoriously risk-averse investors. They are likely to stay away from short-term eurozone government debt, as its credit risk will initially be very difficult to assess. They will also be wary of making abrupt changes in their reserves, as this process of diversification can be very disruptive for foreign exchange markets. Hence, the move towards the euro can be expected to be gradual.
The reserves of the eurozone's own European Central Bank will also affect the role of the euro as a reserve currency. In 1997, the participating countries held $45 billion of eurozone currencies. On January 1, 1999 $45 billion of eurozone currency reserves became domestic currency. These excess reserves added themselves on to the already high level of reserves in the European System of Central Banks (ESCB). Empirical evidence shows that the share of trade in an economy is strongly correlated to the reserve level. With the advent of EMU, intra-European trade became domestic, thus reducing the share of trade in the eurozone economy from 25% to 10% of GDP. Currently European central banks hold too many foreign reserves, up to six times those of the United States. These two factors both point to a decrease in foreign reserve holdings in the euro area. But once again this process will be gradual. The ECB has only just been formed and needs to establish its monetary credibility. In its early years it may want to maintain high reserve levels so as to achieve this. Like other central banks, the ECB will avoid abrupt adjustments of official reserve levels so as to avoid the disruption of foreign exchange markets. Robert Solomon also points out that "a currency can take on an increasing role as a reserve currency only if its issuer incurs an overall balance of payments deficit". This is something that the ECB may want to steer clear of before its monetary credibility is well established. Thus despite a clear movement towards the euro as a reserve currency, until EMU has established itself, this process will most likely remain very gradual. At this point, we must note that official reserve holdings are very small in comparison to global assets and liabilities. For instance official dollar holdings are small compared to US assets and liabilities, which are estimated at $3.5 trillion and $4 trillion respectively. The behaviour of private investors is thus likely to have a more sizeable impact on the international monetary status of Europe's single currency.
Global private portfolios amounted to $7.5 trillion in 1995. Of that amount more than half was denominated in US dollars. This is perhaps the area where the euro will have the biggest impact. In the World Economic Outlook Report of October 1998, the IMF states that "shifts in private sector supply and demand for euro-denominated assets will almost certainly swamp the effects of the re-balancing of official reserves". The reasons for this potential increase in euro-denominated assets are numerous. Firstly, the sheer size of the euro area will give rise to the development of a deep and liquid market. Also the stability-oriented policy mix of the ECB, driven by the price stability and budgetary discipline objectives, should make the euro an attractive store of value for investors. Current European securities markets are significantly underdeveloped compared to the US or to Britain. With the progression of EMU we can expect to see the integration of financial markets in euroland through alliances such as that between the London and Frankfurt stock exchanges. This deepening of securities markets usually results in the reduction of transaction costs. This in turn should increase the supply and demand for euro-denominated assets thus "tending to make the euro a major international currency". It is generally agreed that these portfolio shifts will not occur in the short-term. However, their impact in the medium and long-term is thought to be far more substantial. Hélène Rey and Richard Portes of the London School of Economics have conducted research on European financial market integration. They claim that if financial market integration in Europe progresses sufficiently, the overall size of European securities markets could bring transaction costs low enough for the euro to "replace the dollar as the main international currency for financial asset transactions". Once again these remarks must be placed in a broader context. The diversification of private portfolios has been increasing for quite some time. From 1988 to 1995 the share of EU currencies in private portfolios has risen from a quarter to a third. International portfolios have also been growing at an astounding rate, with a 300% increase from 1985 to 1995. Also, this greater securitisation in euroland will be a "grindingly slow" process, due to the need for highly controversial measures such as tax harmonisation, regulation, supervision and accounting and trading rules. Ultimately the area of private investment will be the most affected by the euro. However the behaviour of the private investor is often unpredictable. It is clear that a gradual shift into euro-denominated assets will occur. As for the extent of this shift, it is almost impossible to estimate.
This analysis has shown that the creation of the euro will lead to a distinct rise in European standing in the international monetary system. The euro will become a more powerful reserve and vehicle currency than any of Europe's pre-existing currencies. More importantly, we can expect a definite shift towards euro-denomiated assets in private portfolios, albeit one of uncertain magnitude. However, the point has recurred throughout this discussion that this process will be gradual. In any case, it is clear that the impact of the euro on the international monetary system will depend greatly, if not entirely, on the credibility of the single currency. This lies largely in the hands of the ECB. Theoretically the ECB's price stability and budgetary discipline objectives should ensure that the euro becomes a credible currency. However, this credibility also depends on the ECB's accountability to the eurozone population. These are the private investors that will have the option of investing in the euro. Since the inception of EMU there has been a highly animated debate as to whether the European Central Bank should be politically accountable. In early February of this year, France's Finance Minister, Dominique Strauss-Kahn, stated that the ECB needed to be part of the democratic system and not "purely a technical instrument". Politicians across Europe are rightly concerned with Europe's growth problem and the increasing dangers of deflation. However, their attempts to force the ECB to bend to their will is hindering, not helping, the process of establishing the euro. At such an early stage in its existence, the ECB's credibility can only be undermined if it is seen to be succumbing to political pressure.
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