Introduction
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.
Conclusions
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.
