The international role of the euro
Speech presented by Dr. Willem F. Duisenberg, President of the ECB, at the Konrad-Adenauer-Stiftung, Berlin
The introduction of the euro is undoubtedly the most profound change in the international monetary system since the collapse of the Bretton Woods system in 1973. It is therefore understandable that a great deal of interest is being shown in the prospective role of the euro as an international currency and its implications, not least for the monetary policy of the European System of Central Banks (ESCB) (that is, the European Central Bank (ECB) and the euro area national central banks). In my presentation this evening, I shall try to shed some light on these issues by examining the developing role of the euro as a reserve and international currency, its relation with the monetary and exchange rate policy of the ESCB, some specific policy issues and its impact on the international monetary system. My principal conclusion is that there is little doubt that Monetary Union will entail an expanded role for the euro in the global arena relative to its constituent currencies. The ESCB will not shy away from the role that this development implies; it will contribute to the international policy discussions from the perspective of price stability in the euro area being its prime objective and, at the same time, the best longer-term contribution which it can make to stable international developments.
1. The euro as a reserve currency
The developing role of the euro as a currency may usefully be linked to the differing functions of money, notably as a store of value and a medium of exchange. One aspect of the international role of the euro will be its evolving use as a reserve asset (a store of value) and an instrument of intervention (a medium of exchange) by central banks. At present, the US dollar remains the by far most important reserve currency world-wide. According to data for the end of 1996, the share of dollar-denominated official reserves amounts to 64%, while euro area currencies account for 25% and the Japanese yen for 6%. As far as the future share of the euro in overall official reserves is concerned, it seems plausible to expect that the national central banks of non-euro area countries will generally re-assess their reserve management strategy in light of the improved global diversification opportunities offered by holding an increased share of their portfolios in this new currency. The euro will be of particular importance as a reserve asset to those other European countries which, formally or informally, intend to peg their exchange rate to the euro or to a (trade-weighted) basket of currencies including the euro as a large component. This may hold true not only for countries participating in the new European exchange rate mechanism (ERM II), but also for transition countries in central and eastern Europe and possibly for non-EU Mediterranean countries as well as for Switzerland and Norway. Meanwhile, the euro may in future come to represent a more important part of foreign currency reserves held by Asian central banks, which include at present mainly US dollar assets. Whether and to what extent this will happen depends, however, crucially on confidence in the ESCB's monetary policy and the euro's stability. As regards official reserve holdings in the future euro area, it has been argued that the introduction of the euro would generate so-called "excess reserves" within Europe. This is distinct from the issue that there will be an automatic fall in the euro's share of world reserves since some EU countries' reserves formerly held in Deutsche Marks will become "domestic euro assets". The main argument is that the degree of external openness of the euro area will be much lower than that currently prevailing in each of the future participating economies. As a result, the need for official reserves, as assessed on the basis of future euro area exports, should significantly decline. However, while not entirely dismissing this argument, I would suggest that the appropriate level of official reserves chosen by central banks depends on many more factors than suggested by this line of reasoning - for example, financial integration and the ease with which institutional investors can mobilise huge amounts within a brief period of time have increased the level of reserves needed for effective intervention, there is a need for reserves to take part in any concerted intervention that may be agreed and there is the "reputation effect" of substantial reserve holdings. Particularly given the uncertainties prevailing at the start of Stage Three of Economic and Monetary Union (EMU), caution is likely to be the watchword in this regard. I should stress that although reserve-management aspects have tended to receive a great deal of attention in respect of the future role of the euro, I believe that private portfolio flows and the prospective adoption of the euro as a vehicle currency will be predominant factors in the euro's prospective internationalisation. It is to these topics that I now turn.
2. The euro as an international investment currency
As is the case for foreign exchange reserves, the US dollar is at present the dominant investment currency in the global capital market, although some decline of its position as a store of value for private investors is already apparent. The share of dollar-denominated international bonds and notes amounted to 46% at end-June 1998, followed by the yen (11%) and the Deutsche Mark (10%), whereas all euro area currencies taken together accounted for 24%. A similar pattern can also be found for the denomination structure of international bank assets and liabilities. By contrast, the falling share of the US dollar even before the start of Stage Three of EMU can be seen from the fact that between 1981 and 1995, EU currencies' share of world private portfolios rose from 13% to 37%, while the US dollar's share fell from 67% to 40%. There are strong arguments to suggest that private investors will in future hold a greater proportion of their portfolios in euro assets than they have done in the constituent currencies to date. A key element in the potential attractiveness of the euro as an investment currency will be the emergence of large and integrated financial markets in the euro area as the euro removes currency-related fragmentation in the euro area and induces the establishment of uniform market standards. Market liquidity should benefit from this integration, thus inducing a virtuous cycle of increasing issuance and investment in euro instruments by domestic and foreign institutions. In particular, at the short end of the yield curve, the necessary conditions for the creation of a broad, deep and liquid European money market are likely to be met. The operational framework for monetary policy, with the major instrument being open market operations based on reverse transactions, will foster money market integration. Integration will be supported by the implementation of the TARGET system of interlinked real-time gross settlement (RTGS) systems of the participating countries. This will ensure a common overnight interest rate throughout the euro area, a smooth settlement of cross-border payments in the euro area and a reduction of systemic risks that might arise from settlement failures. TARGET will also be available to non-euro area banks for exchanging intraday liquidity in euro, albeit only subject to strict conditions being met. The introduction of the euro should also have favourable implications for bond markets by increasing market liquidity, broadening the range of maturities and potentially offering a wider variety of financial products. Nevertheless, capital markets are likely to remain more fragmented at the long end of the yield curve than at the short end, despite the redenomination on 1 January 1999 of outstanding government debt into euro. Credit spreads between euro government bonds are likely to prevail even after the start of Stage Three of EMU, reflecting differences in credit assessments based on the respective fiscal position of governments in the euro area, including future pension obligations, and hence giving appropriate market signals. Moreover, differences in national issuing procedures, market practices and conventions as well as fiscal differences mean that the euro bond market may take time to reach the level of homogeneity of the US bond market. Meanwhile, increasingly integrated money and government bond markets may stimulate the emergence of commercial paper and corporate bond markets in the euro area. A benchmark of government bonds or of swap rates, increasing economies of scale, narrower bid-ask spreads, lower hedging costs for debt securities issued by private firms and more competitive underwriting are likely to provide incentives for corporations to issue their own securities instead of borrowing from banks, while investors in search of a yield pick-up will find such securities attractive. Equity issuance and trading may also in due course become euro area-wide. Likewise, on the deposit side, a rapidly developing private repo or investment fund market in euro could become a serious alternative to traditional bank deposits for large investors, such as pension funds and insurance companies. The development of such new market segments is likely to attract both international investors and borrowers. A further issue which will influence internationalisation is the risk, return and diversification characteristics of the euro. One such aspect is that the euro should offer international investors and borrowers from outside the EU an attractive real rate of return adjusted for risk. Such an attractive risk/return profile should be enhanced by stability-oriented monetary and fiscal policies and the ESCB's independence, thus protecting holders against losses in purchasing power. Meanwhile, whether the euro would offer more or fewer opportunities for diversification than the situation in Stage Two is very difficult to predict, since it would depend on both the variances and the co-variances of the returns on assets denominated in euro and in other currencies. On the one hand, Monetary Union may induce a greater independence of euro yields vis-à-vis those of the United States, increasing diversification benefits. On the other, a case can be made that with the elimination of exchange risk premia and the adoption of a single monetary policy, investors in bonds of euro area countries are likely to lose some diversification benefits which are currently available to them. However, for the countries that have long maintained stable exchange rates, this loss of diversification benefits may, to a large extent, have already taken place. It is difficult to predict, a priori, the net effect of these influences on the demand for euro.
3. The euro as a transaction and vehicle currency
A further aspect of the internationalisation of the euro will be its developing role as a transaction and vehicle currency for cross-border transactions, i.e. as a medium of exchange, outside the euro area. Today, the US dollar is the most important transaction and vehicle currency. In foreign exchange markets, 71% of all spot transactions involved the dollar on one side of the deal, compared with 68% for euro area currencies, 22% for the yen and 39% for other currencies. The US dollar's share is considerably higher - over 80% - when derivatives transactions are also included. With respect to the invoicing of international trade, estimates suggest that in the early 1990s about one half of global exports were invoiced in US dollar, roughly one third was denominated in euro area currencies and only 5% in Japanese yen. Initially, following the introduction of the euro, its market share in foreign exchange transactions and foreign trade will decline "automatically, as a result of the purely mechanical effect of eliminating intra-euro area trade, which amounts to over 60% of total external trade of the future euro area countries. Its share could fall to around 20% for the invoicing of foreign trade and 56% for spot foreign exchange transactions. However, notably in respect of trade, the expected decline is likely to be a short-term development. In a medium-term perspective, the decline is likely to be offset, as international trade flows both between euro area and non-euro area countries, as well as euro-denominated trade between non-euro area residents increase. It is of interest to note in this context that according to recent press reports, some companies in non-euro area European countries such as Denmark, Sweden, the United Kingdom and Switzerland are considering switching wholly or partly to operations in euro. Nevertheless, at the global level it will clearly take time for the euro to attain a comparable stature to the dollar as a vehicle currency. Note that the value of US dollar-denominated international trade is nearly four times higher than US exports. As this ratio indicates, the use of the US dollar as an international currency on the goods and financial markets is less related to trade shares than to the convenience of using one standard currency - in other words, there are economies of scale. In this context, it is worth noting that it took several decades before the US dollar, as the currency of the largest economy in the world since the end of the last century, became the most important vehicle currency, replacing the pound. Thus, sterling was used as a standard despite the declining economic and trade weight of the United Kingdom.
4. The euro, exchange rate policy and monetary policy
The arguments that I have presented so far suggest that the euro will indeed become an international currency, albeit at different rates in different domains. As regards the approach of the ESCB to these matters, I should state quite categorically that its overriding objective is price stability for the euro area as a whole; there are no plans whatsoever to stimulate the use of the euro as an international currency, to use the euro as an instrument of foreign policy, or to rival the US dollar. Nevertheless we have to acknowledge that the euro will become an important international currency merely by the operation of market forces as outlined above. This role will probably develop gradually over time, at a pace linked to the success of the ESCB in maintaining price stability. In this context, it is important to stress the role which the euro's exchange rate will play in the conduct of the ESCB's monetary policy. At its meeting in December 1997 in Luxembourg, the European Council stressed in its conclusions that the exchange rate of the euro would be heavily influenced by the economic fundamentals of the euro area relative to those of other countries. In broad terms, this implies that the exchange rate should be seen as the outcome of all relevant economic policies rather than as an objective to be set independently. Underlying this position is of course the Treaty establishing the European Community, according to which the ESCB's primary objective is to maintain price stability. For the ESCB this objective will have pre-eminence over other policy objectives, including possible exchange rate targets. Equally, the EMI's Report entitled "The Single Monetary Policy in Stage Three" concluded that an exchange rate objective for monetary policy would not be appropriate for an area as large as the euro area, because it might not be consistent with the objective of price stability. Indeed, as I announced last week, the stability-oriented monetary policy strategy that the ECB will adopt involves a prominent role for money with a reference value for the growth of a monetary aggregate and a broadly based assessment of the outlook for future price developments. In addition, I announced a quantitative definition of the primary objective of the single monetary policy, price stability, namely a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. Following the same line of reasoning, although the Treaty provides for various possible exchange rate arrangements, the European Council also concluded in December last year that so-called "general orientations" for the exchange rate policy of the euro area may only be formulated in exceptional circumstances, for example, in the case of a clear misalignment. This implies that in normal circumstances and in the absence of formal exchange rate arrangements between the euro and other major currencies, the ESCB alone will be in charge of the implementation of exchange rate policy in the euro area. The ECB will of course monitor exchange rates as part of its overall assessment of a broad range of economic and financial indicators which are relevant to the conduct of monetary policy and respond wherever necessary - in other words, there will be no "benign neglect".
5. Policy issues raised by internationalisation
Having an international currency has advantages for economic agents, but may sometimes complicate monetary policy. For example, one aspect is that the currency is circulating to a much greater extent outside the own-currency area. This makes monetary aggregates harder to interpret and control. Such holdings may aggravate any distortions to the relationship between money and economic variables that could result from the "structural break" that Monetary Union may represent. Furthermore, there has been some debate as to whether the euro could initially be vulnerable to transitional problems owing to portfolio shifts. Certainly, it cannot be totally ruled out that large movements in the value of the dollar may have undesirable effects on the domestic situation of the euro area, at a time when the ESCB would be in the process of establishing its credibility. They may also have spillover effects on ERM II. The ESCB will, of course, be vigilant in respect of the potential consequences of such shifts for domestic monetary stability. However, there could be offsetting stabilising effects from capital flows at the beginning of Stage Three, not least because the attraction of the euro will be both on the assets and the liabilities side. More generally, there is the issue of managed floating and target zones. Some view exchange rate management as a desirable goal of international policy co-ordination, and also one that will become more feasible with the introduction of the euro. I take a less favourable view, as I shall now explain: Following the end of the Bretton Woods system, for almost 25 years now exchange rate relationships among the main currency blocs (the United States, Japan and the Deutsche Mark area) have been characterised by floating exchange rates and a de facto multi-polar international monetary system. This situation has reflected a number of important changes in the economic context relative to the one prevailing in the early years of the Bretton Woods system, notably a greater balance in the relative economic size of the main industrial countries and the tendency of the largest countries - and in future the euro area countries - to aim their monetary policies primarily at domestic objectives. At the same time, the liberalisation of capital movements has drastically diminished the ability of central banks and governments to control exchange rate movements. The priority assigned by large countries and currency areas to domestic objectives explains why in recent years policy co-ordination among the three main currency blocs has been essentially of a non-binding nature. Since the end of the Bretton Woods system and the move to floating rates, the three main currency areas have nevertheless occasionally taken ad hoc measures to correct exchange rate misalignments or to stabilise exchange rate levels. Examples of co-ordinated actions agreed by the main industrial countries have been the Plaza Agreement (September 1985) and the Louvre Accord (February 1987). However, these countries have always refrained from committing themselves to formal exchange rate arrangements or pre-defined rules for their management. I would acknowledge that within the limits set by its voluntary and ad hoc nature, policy co-ordination has in some cases proved effective in managing exchange rates. Joint policy action has notably been effective in specific situations, for example in the presence of speculative "bubbles" or of a high degree of uncertainty regarding the correct interpretation of fundamentals. Nevertheless, there remains deep concern, which I share, about the potential implications of such arrangements for monetary stability at the domestic level. The simple point is that they may well limit the scope for action and independence of monetary policy makers in a manner that would not be in conformity with equilibrium in the domestic economy. The current predicament of Japan may be partly traced back to its willingness to maintain an expansionary monetary policy in the late 1980s, in order to weaken the yen, which, in retrospect, fuelled credit expansion and asset price inflation, and, in due course, price inflation per se. Likewise, the boom in the United Kingdom in the same period, which eventually required severe monetary tightening, can be partly traced back to attempts to shadow the Deutsche Mark despite upward pressures on the currency. On balance, I would urge that discretionary action in this field should be entered into with considerable caution, and ill-advised or inconsistent action may have far worse consequences than largely leaving market forces to play themselves out, while strictly maintaining price stability at home. Moreover, even if all those concerned were to maintain price stability, there may well be justified shifts in exchange rates linked to cyclical differences between the major blocs. Total exchange rate stability at the global level may thus be neither attainable nor desirable.
6. The euro and the international monetary system
Discussion of policy co-ordination leads on to my final topic, namely the impact which Monetary Union may have on the development of the international monetary system itself. I note immediately that both the direction of these effects and the time that may be needed for them to be felt in full are difficult to predict. I shall make no comment on recent criticisms or proposals for reform of the system, but would rather prefer to highlight the underlying forces at work in promoting the weight of the euro. First, the greater cyclical synchronisation of the euro area (linked, inter alia, to a single monetary policy and common exchange rate), together with its size, will make economic developments in the euro area of considerable importance to the world. Moreover, the action of the ESCB will be made more important than those of the individual EU national central banks in the past. Second, the joining of a number of large industrial countries in a single currency area will reduce the number of major currency blocs in the global financial system. In principle, this should simplify the decision-making process on financial and economic issues at the international level. However, the net effect will also depend on the implementation of a unified internal decision-making process and external representation for the euro area. Third, the large size of the euro area will create a greater balance in the relative size of players in the global economy (the United States, the euro area and Japan). Each of the main players will be in a position to have a greater effect on the shape of the system than they had when Europe was fragmented and, at the same time, they will be more or less equally vulnerable to the possible consequences of instability. They may thus have enhanced incentives to take on a share of the responsibility for managing and preventing it. In the context of these developments, the ECB, acting on behalf of the ESCB, will clearly have an important role in international policy discussions, comparable to the current role of the US Federal Reserve. We shall not walk away from that role. Indeed, the ECB is already beginning to play a certain role at international meetings such as those at the BIS/G-10, IMF, OECD and in a G-7 context. This role will gain increased weight over time, There remain a number of unresolved issues in this area, but progress is being made on ensuring that practical and workable arrangements will be agreed - and they will evolve over time. Moreover, it has to be recognised that the ECB is not yet operational and also that the international role of the euro will develop over time. In all relevant fora, the ECB's role will be to contribute to the international policy discussions from the perspective of price stability in the euro area being its prime objective and at the same time the best longer-term contribution which it can make to stable international developments.
There is little doubt that Monetary Union will entail an expanded role for the euro in the global arena relative to its constituent currencies. This will occur not least as a consequence of a profound restructuring of the euro area financial markets, which will make them more efficient and internationally competitive. However, the confidence in future internal and external stability of the euro will also play a crucial role. In this respect, although we shall take a neutral stance on this issue, I am convinced that the unambiguous mandate conferred upon the ESCB to maintain price stability and the ESCB's institutional framework, which ensures a high degree of independence, will automatically foster the future international role of the euro. Changes in the structure of the international monetary system will take time to materialise, as past experience has shown in the case of the US dollar vis-à-vis the pound sterling. However, I am rather confident that the euro will indeed play a major role in the international financial arena. Our monetary policy will be the centre of attention in this context and our basic message will remain that the best means of securing stable exchange rates is fiscal and monetary stability.