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Helmut Schieber

Member of the Directorate of the German Bundesbank

at the 'EUROMONEY Publications plc' Conference
Frankfurt 21 September 1998


Just over three months separate us from the start of Stage Three of EMU. However, it is still not possible to judge what role the euro will play as an international currency - if only because European monetary union will create a completely new situation which will render it extremely difficult to make any reliable predictions. The international role of the euro will be defined first and foremost in the international financial markets.

The uncertainty that surrounds this area contrasts sharply with political considerations to establish a bipolar currency world and to reduce dependency on the dollar. Such considerations have been raised, for example, by the EC Commission, which envisages the euro being able to 'compete as an international vehicular currency with the dollar and the yen on an equal footing.' However, political ambitions say nothing about the prospects of realising these ambitions.

If we compare the economic size of the euro area, consisting initially of 11 countries, and the United States, there is no doubt that the euro has great potential as an international currency. Whereas 268 million people live in the US, the euro area has a population of 290 million. However, the euro area's GDP is roughly 80% of that of the United States. In terms of their share of world exports, it is the euro area which ranks first, at 19.5 %, compared with 14.8% for the US.

Economic size, however, does not guarantee the international success of a currency. An appropriate starting point for analysing the future role of the euro may be a look at the various functions performed by an international currency. This concerns the role of the euro as a reserve currency, as an investment currency and as a transaction currency.

The Euro as a Reserve Currency

World foreign exchange reserves amounted to around US$ 1.614 billion at the end of March 1998. The share of the US dollar was roughly 61%. This is partly due to the fact that the US dollar is an anchor currency for many currencies and is the preferred intervention currency of many central banks. At the same time, we have to consider that ever since the collapse of the Bretton Woods system, the share of the US dollar in world foreign exchange reserves has declined markedly in favour of other currencies, especially the D-Mark, in which roughly 13% of international foreign exchange reserves are denominated. European currencies (including balances in private ECU, but excluding the Swiss franc) together have a share of some 20%.

However, a substantial proportion of the reserve assets denominated in D-Mark is held by European central banks which will become part of the ESCB upon entry into Stage Three of EMU. All assets that are denominated in national currencies of the future euro area countries will be converted into euro assets and will lose their character as currency reserves for central banks inside the euro area. Therefore, the share of euro-denominated international currency reserves could initially be lower than the present market share of all EMU-currencies put together. According to BIS estimates, the share of US dollar-denominated international currency reserves might thus rise to some 75%.

The decisive question, however, is whether this purely arithmetical effect will be offset by an increase in euro-denominated foreign exchange reserves held by central banks outside the euro area. Besides participation in the EMS II, an additional driving force behind the demand for euro denominated reserves will be the exchange rate policies of the countries neighbouring the European Union. In particular, this includes the degree to which Central and Eastern European countries will use the euro, formally or informally, as a nominal anchor. In addition - and this holds equally for central banks outside Europe - portfolio theory generally favours diversification of currency reserves. Whether the euro will be able to exploit this potential will hinge decisively on the stability of the new currency - a topic I would like to comment on later.

Things are further complicated by the fact that the euro area's demand for reserves will decline. There are two reasons:

* First, for the euro countries the EMS-related need for foreign exchange reserves will cease to exist.

* Second, the degree of openness of the euro countries will sharply decrease because foreign trade between member countries of the euro area becomes internal trade for monetary union as a whole. The share of the euro area's GDP taken up by foreign trade will fall approximately to the respective ratio in the US.

Although the fall in the euro area's need for currency reserves is likely to affect primarily the US dollar, it is not yet possible to give quantitative estimates of this effect. All in all, we are not able to predict the trend that will emerge from the various factors mentioned above.

The Euro as an Investment Currency

Although central banks' reserve portfolios do matter, the role of the euro in the international financial markets will be determined predominantly by the decisions of private investors. As an investment currency, the US dollar outweighs any other currency. The share of the US dollar in the international market for bonds and notes amounts to 40 %, while the D-Mark accounts for 10%.

But the currencies of all EU member countries, taken together, make up one-third of this market. Even more important, however, is the fact that over the last 16 years, the market share of the European currencies has been rising. Assuming that the ECB's monetary policy is successful in achieving price stability, this trend is likely to pick up after the introduction of the euro.

The euro will promote the integration of the government debt markets by eliminating currency-related segmentation, so that their breadth, depth and liquidity will become comparable to those of the US and Japan. In addition, institutional investors outside the euro area may find the new euro financial market increasingly attractive as an instrument to diversify risk. All this clearly argues in favour of the euro.

However, we have to consider that different national regulations will continue to hamper the complete integration of financial markets in Europe and that the low stock market capitalisation of European firms is likely to guarantee the predominance of the US stock market - at least over the medium term. Furthermore, the full realisation of the euro's potential as an investment currency crucially hinges on the participation of Great Britain in EMU which, unfortunately, is still not certain.

In addition, uncertainty remains surrounding the investment instrument that will assume the benchmark function in the euro area and how credit risks and differences in liquidity, trading and settlement techniques will be reflected in interest rate spreads after the elimination of exchange rate risk. Furthermore, as regards investment instruments and their derivatives, no one knows as yet which interest rate will assume the guiding role. Will the Euribor predominate or will the Euro-Libor keep the upper hand?

All these uncertainties argue in favour of a gradual development of financial markets in the euro area instead of a one-stroke integration of financial markets.

However, the sharp rise in competition among the financial markets in the euro area in the run-up to monetary union, the rapid implementation of modern financial instruments and the dynamic development of new financial products could be seen as an indicator that the integration of European financial markets is more likely to take years rather than decades.

The Euro as a Transaction Currency

Let me finally discuss the euro's role as a transaction currency in foreign trade and in the foreign exchange markets. Since there is no reliable data on the percentages occupied by individual currencies in world-wide foreign trade invoicing, we are forced to rely on estimates. According to these estimates, roughly 50% of global exports are settled in US dollars, some 15% in D-Mark and around 6% each in French francs and pound sterling.

However, these figures are strongly biased by the respective countries' share of world trade. After adjustment for this distortion, only the US dollar and the D-Mark can be considered international invoicing currencies. In addition, since a relatively large share of what is now foreign trade will become internal trade under EMU, the euro's role as an international invoicing currency will be relatively limited - at least immediately following the introduction of the new currency. In future, though, the euro's prospects may brighten considerably, since the euro area's economic size and its share of world trade will play an important role in this regard.

The euro's role as a transaction currency in the foreign exchange markets may potentially be limited immediately after the start of EMU. A look at the status quo shows the US dollar clearly in the lead, followed by the D-Mark.

The importance of the D-Mark, however, hinges crucially on its role as a vehicle currency in the European foreign exchange market. A vehicle currency serves as the connecting link for bilateral transactions, when the market for direct foreign exchange transactions is narrow or virtually non-existent because of high transaction costs. Since foreign reserve transactions between euro countries will cease to exist, the importance of the euro as a vehicle currency is likely to be much smaller than the current role of the respective national currencies put together.

In future, however, the role of the euro as a vehicle currency in foreign exchange markets will depend on its importance as an investment currency and as a reserve currency. In particular, we may expect a synergy to occur between the vehicle currency role and trading of financial assets denominated in this currency: A surge in capital inflows, fostered by the growing depth, breadth and liquidity of European financial markets, will increase the liquidity in bilateral foreign exchange markets. The resulting decline in transaction costs, in return, will encourage not only the use of the euro as a vehicle currency, but also its use as an investment currency.

Despite the uncertainty surrounding the future role of the euro, it is reasonable to assume that the volume of international assets denominated in euros will initially be much lower than the size of the euro area in world GDP and trade. This has led some economists to assume that a private sector portfolio shift will bring the share of the euro asset holdings close to parity with the economic size of the euro area.

At the same time, it is often assumed that this portfolio shift will cause the euro to appreciate in real terms. This line of reasoning, however, is highly misleading, since bond suppliers will respond immediately to the increase in the demand for euro-denominated bonds. If euro liabilities increase at the same pace as the demand for euro assets, we simply do not know the future development of the euro exchange rate.


Much will depend on how smoothly the transition to Stage Three of EMU takes place. Will investors accept the changeover to the euro without reacting? We have to be aware that huge sums have been invested in the currencies of the countries participating in the future euro area. For example, private foreign investors have acquired approximately DM 1.4 trillion worth of D-Mark denominated financial assets. Along with financial assets denominated in the currencies of other future EMU participants there is an enormous 'flight potential'. Although, at present, the available forward-looking indicators seem to suggest a smooth transition, the acid test still lies ahead of us. Furthermore, even if the introduction of the euro will take place in 'calm waters', it might be judicious for international investors to adopt a wait-and-see attitude before shifting additional funds to the euro. In this context, we should remember that it took decades for the pound sterling to be replaced by the US dollar.

I am personally convinced that by far the most important and ultimately crucial question is whether it will be possible to give the euro lasting internal stability. And, since the key variable for long-term exchange rate expectations is the anticipated inflation differential, the external value of the euro is inseparably linked to internal stability. Only when internal stability is achieved will investors be willing to hold assets denominated in euros; only then will the importance of the euro as a transaction and reserve currency be able to increase; only then will the euro be able to take its place alongside the US dollar as an international currency.

As regards the ECB, the authors of the Maastricht Treaty have done everything conceivable to ensure the stability of the euro.

Monetary stability is clearly the primary objective, and an excellent institutional foundation is formed by the unique degree of central bank independence which is extremely well protected in legal terms, the strict ban on monetary financing of the public sector, and the comprehensive set of monetary policy instruments at the ECB's disposal. Therefore, the ECB deserves an advance stock of confidence. This is all the more true as, at present, the starting conditions for EMU, with a very low inflation rate in the euro area, are decidedly favourable.

However, there are also risks to the stability of the euro. The main risk is that, whereas the responsibility for monetary policy will be transferred to a supranational institution, the responsibilities for the areas of fiscal, economic and structural policy as well as wage and social policies will remain at the national level. This implies that, since the exchange and interest rates will no longer be available as a policy instrument at the national level, differing cyclical trends and structural conditions in individual EMU countries as well as asymmetric shocks will only be able to be offset by internal adjustment. Thus, for the euro area countries flexible markets for goods and services and, in particular, flexible labour markets which, if necessary, allow for the downward flexibility of wages, will take on even greater importance than before.

In addition, national fiscal and economic policies should be capable of reacting promptly in the event of one country lagging behind the general economic trend in the currency area without interfering with the monetary policy of the ECB. This is the reasoning behind the Stability and Growth Pact. Only if the national budgets are close to balance or in surplus under normal cyclical conditions, as provided for in this pact, will it be possible to use budgetary policies without reservations during a recession.

However, most EMU countries are still a long way from the medium-term objective of a balanced budget. Some countries were able to fulfil the Maastricht criterion of a deficit not exceeding 3 % of GDP only by resorting to substantial one-off measures. Even more important, the excessive stock of public debt harbours the potential of conflicts with monetary policy. Countries with a high level of public debt are very susceptible to interest rate increases, particularly if the debt is short-term or at variable interest rates.

Should the ECB - for whatever reason - be forced to pursue a tight-money policy, it would soon become clear that these countries have by no means achieved a sustainable financial position. Conversely, the deterioration of the financial position, specifically if large member countries were involved, would put additional upward pressure on the single interest rate level in the euro area. This could lead to governments or public opinion putting pressure on the ECB to change its course and assume a more accommodating monetary policy stance.

In order to prevent these potential conflicts from arising, it will be necessary to implement the Stability and Growth Pact in a determined manner. I am convinced that the role of the euro as an investment currency and, as a consequence, its international importance will hinge decisively on compliance with the requirements of this pact. Therefore, I am concerned about the fact that some of the future EMU countries, instead of making use of the relatively favourable cyclical conditions presently prevailing in Europe, seem to be allowing their deficit ratios to deteriorate even further - at least in structural terms. That is to say they do not use the 'stability dividend' to bring down their public debt but to buffer painful adjustment.

Another threat to internal stability in the euro area is the high level of unemployment in Europe - and not just because it could undermine the social consensus in EMU member states. There have been repeated suggestions that a weak euro could solve Europe's serious employment problems.

These suggestions are extremely dangerous, as they ignore the root causes of our unemployment problem and could potentially jeopardise acceptance of the euro. The high level of unemployment in Europe is largely structural and can only be overcome through more flexibility in labour markets. The responsibility for reforms of labour markets lies almost entirely at the national level. The only way EMU could foster growth and employment would be through low interest rates and a high level of investment. Exchange rate manipulations, however, are liable to destroy investors' confidence in the stability of the euro and to jeopardise its international use.

All this makes it obvious that the flexibility of the labour markets and the problems of public finance including the social security systems will be the Achilles' heel of EMU. In this regard, enormous efforts are still necessary in order to ensure the internal stability of the euro. We can only hope that the pressure of the single currency will prove to be great enough to prompt politicians in Europe to find satisfactory solutions to these urgent problems.

Given the clear stability orientation of the ECB, the success of the euro as an international currency will depend first and foremost on two factors: the determination of efforts to eliminate the market distortions prevailing in Europe, and the willingness of European governments to subordinate fiscal policies to the goal of macro-economic stability in the euro area as a whole. This is not only what the Maastricht Treaty calls for, this is also the constraint imposed upon us by globalisation - whether we like it or not.

* * *

For the BMDF synopsis of the speech of Helmut Schieber, please see Synopsis

Last update: 25 March 1999

© Copyright Anthony Cowgill and Andrew Cowgill, 1999

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