The European perspective on the euro
Presentation by Ms Sirkka Hämäläinen at the Euro Conference, Fordham University, New York, on 26 October 1998.
1. The implications of the euro for the economic policy framework in Europe
On entering the European Monetary Union, the eleven participating countries will permanently give up their own national monetary policy. Monetary policy decisions will be taken by the Governing Council of the ECB and will be based on euro area wide considerations. The primary objective of the ESCB is to maintain price stability in the euro area. Price stability has been defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. In order to achieve this objective, the ESCB will pursue a strategy comprising two elements: 1) money will be assigned a prominent role through the announcement of a quantitative reference value for the growth of a broad monetary aggregate; and 2) there will be a broadly-based assessment of the outlook for price developments on the basis of a wide range of indicators. The focus on euro area wide developments implies that if an asymmetric shock were to hit a specific Member State, or if business cycles were not to be synchronised across the euro area, the necessary adjustment at the national level would have to be performed by fiscal and structural measures. In practice, this situation was apparent already in the process towards Monetary Union. The convergence process towards Monetary Union meant that a degree of nominal convergence never before experienced in Europe was achieved. The credibility established through the convergence process became evident during the recent turmoil in the international financial markets. Exchange rates remained stable within the exchange rate mechanism ERM and long-term interest rates spreads widened only slightly. While recognising the achievements made in embarking on a path towards stability-oriented policies and a high degree of nominal convergence, we also have to admit that unemployment is still unacceptably high in the euro area. However, I would like to stress that monetary policy is neither the cause of nor the solution to the unemployment problem in Europe. The problems with European labour markets are structural. Unemployment in Europe can thus only be effectively combated through reforms addressing these underlying structural problems. On the whole, the economic fundamentals of the euro area economies look better now than they have done for many decades. Inflation is low, savings are high, public finances have improved and domestic demand seems to continue being strong. Even if it is clear that external effects will hamper the growth prospects also in the euro countries, it appears that the euro area is presently experiencing more stable and favourable economic conditions than most other regions in the world.
2. The role of the euro in the international financial system
The introduction of the euro will be the biggest change in the international financial system since the collapse of the Bretton Woods system in 1973. It is likely that the euro will play a very important role in the international financial markets, benefiting from the reputation inherited from the currencies which it will replace. Several arguments seem to indicate that the euro may become a more attractive investment currency than all the currencies which it will replace taken together.
First, the integration of European markets will lead to lower transaction costs and higher market liquidity, thus possibly inducing a virtuous circle of increasing issuance and investment in euro denominated assets by international investors.
Second, the integrated euro area financial markets will offer a more diversified set of financial instruments than that which is currently available in any national market of the euro area today. This will give international investors a greater scope for portfolio diversification without their having to incur additional foreign exchange risk.
Third, to the extent that the euro area is a large and rather closed economy, yields on bonds denominated in euro are likely to become increasingly independent from changes in US yields as compared with the present situation for bonds denominated in the national currencies. If so, euro area bonds will provide an attractive opportunity for investors who would like to achieve increased risk diversification in relation to US financial instruments.
Fourth, the euro may also become an attractive currency for the investment of official reserves. It may become an important anchor currency in other European countries which, formally or informally, might find it useful to peg their exchange rate to the euro or to a basket of currencies in which the euro is a large component. Apart from the non-euro EU currencies to be included in the new exchange rate mechanism ERM II, this may also be an attractive solution for transition countries in Central and Eastern Europe and non-EU Mediterranean countries.
A further aspect of the internationalisation of the euro will be its developing role as a transaction and vehicle currency for cross-border transactions outside the euro area. Today, the US dollar is by far the most important international transaction currency. The euro may become an important currency for invoicing of foreign trade and for spot foreign exchange operations. On the whole, there is little doubt that the euro will have a more important role in the international financial system than any of its constituent currencies. Confidence in the future internal and external stability of the euro will be a key factor in determining the international importance of the euro. Another factor will be the efficiency and international competitiveness of the European financial markets.
3. The role of the euro for the development of the European financial markets
The European financial markets are currently undergoing a rapid development characterised by cross-border integration and provision of new financial services. I should like to highlight a few areas where the introduction of the euro is likely to directly influence the working of the financial markets in the euro area:
First, the conduct of a single monetary policy is expected to lead to a fully integrated money market in the euro area as from the start of Stage Three. The integration of the existing national money markets will be made possible thanks to the TARGET system, which will connect the national real-time gross settlement systems in the euro area. It will thereby facilitate banks' cross-border dealing and accessing of funds in euro.
Second, the ESCB has developed a market oriented monetary policy framework, largely relying on regular reverse transactions offered through tender procedures. This is likely to provide an incentive for the establishment of a euro area-wide interbank repo market and, possibly, at a later stage, a private repo market.
Third, the ESCB will also make use of a minimum reserve system so as to pursue the aims of stabilising money market rates and enlarging the structural deficit of the banking sector. Particular emphasis was placed on the establishment of a minimum reserve system which is compatible with market principles. For example, the reserve holdings will be remunerated at the rate of the ESCB's main refinancing operations.
Fourth, the ESCB will accept a wide range of public and private assets as collateral for its credit operations. It will also provide the counterparties' with the possibility to use collateral cross-border within the euro area. This approach is likely to provide a stimulus to the development of markets for private assets, portfolio diversification across the euro area and the integration of capital markets.
Fifth, the integration of the financial markets will benefit from the ESCB's work to harmonise market practices in the euro area-wide money market. The move to Monetary Union may in due time also contribute to a harmonisation of practices in bond and equity markets in the EU. This harmonisation will improve the effectiveness of price formation and contribute to more efficient financial markets across the board.
On a more general level, cross-border integration may promote the markets for commercial paper and corporate bonds in the euro area. The market value of corporate bonds outstanding in the US is at present almost ten times larger than in the euro area. There is thus plenty of scope for further securitisation in the euro area and the introduction of the euro certainly underpins this development. These developments will have important structural implications for the banking industry in the euro area in addition to the effects of increased cross-border competition. So far, the European banking industry has remained segmented into rather small national markets; the introduction of the euro is expected to give momentum to cross-border integration in the European banking sector resulting from the disappearance of the natural "protective barriers" implied by national currencies. To conclude: The developments of the European financial sector are likely to greatly improve the efficiency in the mobilisation of savings and in the channelling of these savings into productive investments - and thus improve the growth potential of the euro area as a whole.