The euro in the global financial market
Christian Noyer Vice-President of the European Central Bank Dinner speech at the European Banking Seminar organised by Julius Bär "The global financial market and the euro: strategies and prospects" Frankfurt am Main, 18 November 1998
The countdown is running. We are only 43 days away from the beginning of Stage Three of European Economic and Monetary Union (EMU). Starting conditions for a smooth launch of the euro remain favourable, while the wave of bad news on external economic developments has faded away and global financial markets have tended to stabilise over the last few weeks. A high degree of domestic macroeconomic convergence among designated participants has led to sound economic fundamentals throughout the euro area. Inflation remains subdued (1.0% in September 1998), the outlook for inflation in the near term is generally favourable and persistent deflation is very unlikely. Economic growth is supported by domestic demand. Nominal and real long-term interest rates are close to historical lows providing a benign investment climate. Moreover, even before its birth, the euro has proven its ability to protect the euro area against tensions in international financial markets and the euro area has benefited from "safe haven" capital inflows. However, downside risks caused by external factors cannot be ignored. The slow recovery from last year's financial crisis in Asia, the strong contraction of economic activity in Russia, the protracted economic downturn in Japan and tensions in Brazil and certain other Latin American countries inevitably exert dampening effects on global economic activity. And the consensus view is that the euro area will also be affected to some extent. In this context, concerns have been raised that the European System of Central Banks (ESCB) might be too complacent towards these external events and their potential systemic risks or lack the willingness to co-operate at the international level in containing such risks. These criticisms are unfounded. You can be assured that the ESCB is fully aware of the seriousness of these developments and their possible adverse effects. However, we also know that activism has never been good counsel. With regard to the current stage of the world economy, it appears all the more important to ensure a successful implementation of EMU. This will create the basis for further sound economic growth in the euro area, thereby also providing a positive impact for the world economy as a whole. The introduction of the euro is a quantum leap forwards in European integration and the most profound change in the international monetary system since the collapse of the Bretton Woods system in 1973. As of 1 January, the ESCB will run the monetary policy for a group of eleven countries, almost 300 million people and a GDP which is roughly 80% of that of the United States. It is therefore understandable that a great deal of attention is being shown, notably among financial market participants, in the prospective role of the euro as an international currency in its various functions as an investment, transaction, vehicle and reserve currency. In the following, I will try to shed some light on the developing role of the euro in the global financial market. First of all, I should like to examine the implications of the introduction of the euro for private portfolio management. Second, I will discuss the potential use of the euro as a transaction and vehicle currency in the private sector. Third, I will focus on the possible effects on the public sector's use of the euro as a reserve and an anchor currency. Finally, since the future international role of the euro will also depend on its expected internal and external value, I will turn briefly to the role of the euro's exchange rate in the conduct of the ESCB's monetary policy .
To start with, I should like to discuss the likely response of the private sector to the introduction of the euro. At present, the US dollar is the dominant investment currency in the global capital market. The share of dollar-denominated international bonds and notes amounted to 46% at the end of June 1998, followed by the Japanese yen (11%), 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. A major factor in the potential attractiveness of the euro as an investment currency will be the emergence of a large and integrated financial market in the euro area. The introduction of the euro will foster the growth of broader and more integrated euro area money and securities markets by removing currency-related fragmentation and inducing the establishment of uniform market standards. However, the euro area money market is likely to be more fully integrated than the bond market, at least in the early stages of EMU. At the short end of the yield curve, the necessary conditions for the creation of a broad, deep and liquid European money market will be met from the very outset. First, the operational framework for the single monetary policy relies mainly on market-based monetary policy instruments providing a favourable environment for trading activities of financial market participants. Open market operations based on reverse transactions with a broad spectrum of counterparties, as the major policy instrument, will foster money market integration. Second, the integration will technically be supported by the implementation of the European payment system TARGET (which stands for Trans-European Automated Real-time Gross Settlement Express Transfer). This system consists of the inter-linked real-time gross settlement (RTGS) systems of participating countries and, within certain limits, the non-euro area countries. It provides a major component of the financial infrastructure of the future euro area. It is designed not only to ensure a common overnight rate throughout the euro area and a smooth settlement of cross-border payments in the euro area, but also to reduce systemic risks that might arise from settlement failures. Even today, money market rates and swap yields on maturities ranging from one week to two years are almost identical in the future euro area countries. The introduction of the euro will also have favourable implications for bond markets as the euro will increase market liquidity, broaden the range of maturities and potentially offer a greater variety of financial products. Current pricing and ratings for bonds issued by euro area governments already show a significant degree of convergence, indicating that government bonds of the future euro area are increasingly being dealt with as a common class of assets. However, in the absence of a single issuer such as the US Government for the dollar area, capital markets are likely to remain more fragmented at the long end of the yield curve than at the short end. This holds true, despite the re-denomination of outstanding government debt into euro on 1 January 1999. Some of the credit spreads between euro government bonds issued by different national euro area treasuries are likely to prevail even after the elimination of exchange risk premia. These spreads may, at least to some extent, reflect differences in credit assessments based on the respective fiscal position of governments in the euro area, including future pension obligations. They may also reflect differences in market liquidity of benchmark issues, and in market practices and conventions. Turning to private sector issuers, increasingly integrated money and government bond markets may stimulate the emergence of commercial paper and corporate bond markets in the euro area. Increasing economies of scale, narrower bid-ask spreads, lower hedging costs for debt securities issued by private firms and a more competitive underwriting activity are likely to provide incentives for corporations to issue their own securities instead of borrowing from banks. In the same vein, investors in search for higher yields will find such securities attractive. This market segment might expand to an increasing extent in the euro area. Likewise, on the deposit side, a rapidly developing private repo market in euro could become a serious alternative to 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. Finally, other factors influencing internationalisation are the risk, return and diversification characteristics of the euro. In short, the attractiveness of the euro, which will foster low market interest rates all along the yield curve, and provide for a benign investment climate, will be enhanced by the stability-oriented monetary policy guaranteed by a highly independent ECB and by sound fiscal policies throughout the euro area.
Let me now turn to the role of the euro as a transaction and vehicle currency for cross-border transactions outside the euro area. That role will depend on its potential for becoming a means of payment in foreign trade and foreign exchange markets. In this context, relevant factors are the weight of the euro area in the global economy and the size of its foreign trade and financial linkages, since increasing economies of scale will play an important role in promoting the use of the euro. Today, the US dollar is the world's by far most important transaction and vehicle currency. Its share in all transactions (spot plus derivatives transactions) in foreign exchange markets is one and a half times higher than that of the euro area currencies. 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 dollars, while roughly one third was denominated in euro area currencies and only 5% in yen. Initially, following the introduction of the euro, the euro market share in foreign trade and foreign exchange transactions will decline as a result of the purely mechanical effect of the elimination of intra-European trade which accounts for about 60% in 1997 of the total external trade of the future euro area countries. However, notably in respect of trade, the expected decline is likely to be a short-term development. In a medium-term perspective, this decline is likely to be offset, as far as international trade flows both between the euro area and foreign countries and between non-euro area residents are concerned. It is worth noting that according to recent press reports, some companies in non-euro area countries in Europe, such as Denmark, Sweden, the United Kingdom and Switzerland, are considering switching wholly or partly to transactions in euro. However, the use of the US dollar as an international currency in the goods and financial markets is likely to remain predominant, at least for a certain period of time, since it is less related to trade shares than to the convenience of using one standard for pricing, in particular in commodity markets with homogenous goods and a large number of market participants. In this context, it is of interest to note 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 world's key vehicle currency, replacing the pound sterling.
So far, I have mainly discussed the implications for the international use of the euro from the perspective of the private sector. Although private portfolio flows will presumably be the dominant factor in the internationalisation of the euro, central bank demand for euro in the context of their official reserve portfolio management is likely to play a significant role. At present, the US dollar remains the most important reserve currency worldwide. At the end of 1996, the share of dollar-denominated official reserves amounted to 64%, while euro area currencies accounted for one-quarter and the yen for 6%. As regards official reserve holdings in the future euro area, it is to be noted that there will be a fall in the euro's share of world reserves, since a large part of euro area countries' reserves which were previously held as foreign assets (primarily Deutsche Mark) will become domestic euro assets after the entry into Stage Three. As far as the future share of the euro in overall official reserves is concerned, it seems plausible to expect that central banks of non-euro area countries will re-assess their reserve management strategy in light of the better global diversification opportunities offered by this new currency. Moreover, the euro might also assume a greater role as an anchor currency in 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 of the countries participating in the newly established exchange rate mechanism (ERM II) but also of transition countries in central and eastern Europe, possibly of non-EU Mediterranean countries as well as of Switzerland and Norway. Finally, the euro may increasingly become part of the total foreign currency reserves held by Asian central banks to the extent that they take the opportunity to diversify their reserves. Whether this will happen, however, depends crucially on the confidence in the ECB's monetary policy and the euro's stability.
I will now turn briefly to the role that the euro's exchange rate will play in the conduct of the ECB's monetary policy. At its meeting in December 1997 in Luxembourg, the European Council underlined in its conclusions that the exchange rate of the euro will be heavily influenced by 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. Hence, the euro exchange rate will clearly not play an instrumental role in the conduct of the euro area monetary policy, as was the case in the ERM. Underlying this position is of course Article 105 (1) of the Treaty establishing the European Community, according to which the ESCB's primary objective is to maintain price stability, irrespective of the exchange rate system agreed upon under the Treaty. For the ESCB, this objective will have pre-eminence over all other policy objectives, including the exchange rate. This is in line with the monetary policy strategy chosen for Stage Three of EMU, which was presented to the public a month ago. It assigns a prominent role to money, with a reference value for the growth of a monetary aggregate. The reference value for the growth of the monetary aggregate will be derived in a manner, which is consistent with - and will serve to maintain - price stability throughout the euro area. Moreover, a broadly based assessment of the outlook for future price developments will play a major role. Finally, the Governing Council of the ECB has defined price stability as a year-on-year increase in the Harmonised Index of Consumer Prices (HIPC) for the euro area of less than 2% which is to be maintained over the medium term. To make it quite clear: both persistent inflation and deflation are incompatible with this definition of price stability. The European Council also concluded in December last year that "general orientations" for the exchange rate policy of the euro area may be formulated only in exceptional circumstances, such as in the case of a clear misalignment of the euro which is likely to persist. This implies that, in normal circumstances and in the absence of formal exchange rate arrangements between the euro and other major currencies, the ESCB will be in charge of the day-to-day exchange rate policy in the euro area. But the ESCB will, of course, monitor exchange rate developments as part of its overall assessment of a broad range of economic and financial indicators which are relevant to the conduct of monetary policy. If the Governing Council of the ECB takes the view that the external value of the euro is out of line with fundamentals, it may take corrective action. In other words, we will not pursue a policy of "benign neglect" with respect to exchange rate developments.
At the end of my speech, let me quote Mark Twain by saying that predictions should be avoided, particularly those about the future. Specifically, that holds true of assessments of the future international role of the euro. Current conditions in the global financial markets can only be seen as a rough indication of the direction and magnitude of future developments. However, there is little doubt that the introduction of the euro will lead to a far-reaching restructuring of the euro area financial markets, which will make them more efficient and internationally competitive. Nevertheless, over a medium-term horizon, confidence in the future internal and external stability of the euro will play a crucial role. In this respect, I am convinced that the unequivocal mandate conferred upon the ESCB to maintain price stability and the ESCB's institutional framework, which ensures a high degree of independence, will foster the future international use of the euro in its various functions. The ESCB takes a neutral stance towards the development of the international role of the euro. It is not our objective to stimulate, or to hinder the development of this role. However, the more successful the ECB is in achieving its primary objective of maintaining price stability, the more will the international role of the euro be "automatically" fostered. In order to be successful in ensuring a stable price environment without being overburdened, the monetary policy of the ESCB needs to be supported by sound fiscal policies, structural reforms and responsible wage behaviour at the national level. The relatively favourable domestic conditions currently prevailing in Europe should be used to further reduce structural imbalances in government budgets, also with a view to creating greater policy flexibility over the whole business cycle. In this context, the slowing down of fiscal consolidation in some euro area countries since 1997 could prove to be counterproductive. As regards unemployment, which is largely structural in nature, only measures intended to improve the working of the labour and goods markets at the national level are bound to be effective. Let me close by saying that 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. I am nevertheless rather confident that the euro will indeed play a major role in the international financial arena as a result of both the stability-oriented monetary policy conducted by the ECB and the weight of the euro area in the global economy. At any rate, we at the ECB will of course spare no efforts and pains to make sure that our new currency becomes a success story.