The role of the euro in the international monetary system - reserve currency, trade currency and investment currency
Speech presented by Ms Sirkka Hämäläinen, Member of the Executive Board of the European Central Bank, at the City of Frankfurt Euro Symposium, Frankfurt, 5 February 1998
I should like to thank you for inviting me to speak here at the City of Frankfurt Euro Symposium. A few weeks ago, Frankfurt, as the location of the European Central Bank (ECB), was very much a focus of international media attention. The introduction of the euro on 1 January 1999 was a historic step towards European integration, which was followed with excitement - and perhaps also some anxiety - by the media and the public at large. On that date, the national currencies of 11 European countries became denominations of a single currency; the euro. At the same time, the "Eurosystem" (which is composed of the ECB and the 11 national central banks of the participating EU Member States) assumed responsibility for the monetary policy of the euro area.
I must admit that I personally was quite nervous about the changeover to the euro. Although I knew that the ECB was technically well prepared for the changeover, one can never entirely rule out unexpected problems in such a gigantic project. With hindsight, I am very relieved that the technical changeover to the euro went so smoothly.
However, the technical changeover was only the first hurdle for the successful establishment of the euro. We now have to focus on ensuring its long-term success. In today's presentation, I shall discuss some of the factors affecting the role of the euro in the international monetary system in the longer term. In this regard, I shall also give an overview of the possible development of the euro as an investment currency, a reserve currency and a trade currency.
1. Factors determining the international role of the euro
Clearly, it is still too early to be able to assess accurately how important the euro will become in the international monetary system. It is only natural that it should take some time for traders, investors, analysts and other financial market agents to become accustomed to a new currency and decide on the weight which they will assign to it for various purposes.
In practice, the international importance of a currency is mainly determined by three distinct factors:
the size of the economy backing the currency;
the economic policies of the country (or countries) where the currency is issued; and
the efficiency and competitiveness of the financial markets in which instruments denominated in the currency are traded.
Turning first to the size of the euro area economy, it may be of interest to make a brief comparison between the size of the euro area and that of the United States: the population of the euro area (292 million) is slightly larger than that of the United States (270 million), while the GDP of the euro area (EUR 5,800 billion) is somewhat smaller than the GDP of the United States (EUR 7,600 billion). The euro area is, however, a more open economy than the United States in the sense that foreign trade (exports and imports) amounts to 25% of GDP, while in the United States the corresponding figure is just below 20%. Altogether, the size of the euro area, regardless of which measure is applied, is comparable with that of the US economy. The large size of the euro area would suggest that the euro should, from the outset, assume the role of one of the world's leading currencies.
However, the sheer size of the euro area is not sufficient to ensure the importance of the euro in the international financial scene. It is also necessary for euro area economic policies to be perceived as ensuring stability and credibility. On this point, I think that the institutional set-up of the Eurosystem ensures that the euro will be a stable and credible currency. In practice, the credibility of a currency is built on many elements, some of which are beyond the control of the central bank.
A first fundamental building block is to ensure that the central bank's monetary policy decisions are independent of political pressures. This building block was enshrined in the Maastricht Treaty. The institutional set-up ensures that the ECB and the participating national central banks enjoy a very high degree of independence, possibly more than any other central bank in the world.
For the credibility of the monetary policy, it is also important that the overall objective is unambiguous, that the strategy for achieving this objective is transparent and that policy measures are clearly explained. By following a transparent approach, the central bank can directly improve the efficiency of monetary policy by promoting the right expectations among market participants concerning what the central bank hopes to achieve. Hence a predictable monetary policy may contribute to achieving stable prices with the lowest possible interest rates. For these reasons, the Eurosystem emphasises transparency in its monetary policy framework. In order to enhance transparency with regard to its policy measures, the Governing Council of the ECB intends to inform the public regularly and in detail about its assessment of the monetary, economic and financial situation in the euro area. Its policy measures will be explained in relation to the framework of the monetary policy strategy of the Eurosystem.
A third important building block for a credible monetary policy is to ensure that the operational framework makes it possible for the monetary policy decisions to be implemented efficiently. The Eurosystem has placed considerable emphasis on the establishment of an operational framework which is consistent with market principles and which ensures equal treatment of counterparties and financial systems across the euro area.
Apart from these three building blocks, which are largely under the direct control of the Eurosystem, credibility also relies to a considerable extent on the preparedness of governments to pursue stability-oriented policies of fiscal discipline and to undertake necessary structural reforms. On this point, the Stability and Growth Pact provides a basic framework for fiscal discipline and should enhance the governments' incentive to proceed with structural reforms.
I am also optimistic with regard to the development of efficient and internationally competitive financial markets in the euro area. Traditionally, financial market developments in continental Europe have lagged behind developments in the United States and the United Kingdom. A main factor behind the slower development of the financial markets in continental Europe is their strict national segmentation. This segmentation and a lack of cross-border competition have implied relatively low trading volumes, high transaction costs and a reluctance to implement innovative financial instruments. The segmentation is a function of tradition, differing practices and, of course, national regulations and tax regimes.
However, the European financial markets are currently undergoing rapid development characterised by cross-border integration and the provision of new financial services. These developments are partly due to the continuous technological development in the financial sector. They have also received new impetus from the establishment of the Single Market in the European Union and were further underpinned by the introduction of the euro, which removed the foreign exchange risk of cross-border operations in the euro area.
2. The role of the euro in the spot and forward foreign exchange markets
Turning to the role of the euro in different segments of the international financial markets, I should first like to say a few words about the spot and forward foreign exchange markets. In these markets, the US dollar has been the most important currency since it overtook the pound sterling in the 1930s. It is estimated that in 1997 the dollar was involved in 84% of all foreign exchange transactions. This compares with 55% for the currencies which were replaced by the euro and 24% for the Japanese yen.
The introduction of the euro immediately produced major changes in the functioning of foreign exchange markets. The disappearance of 11 national currencies and the introduction of the euro as a major international currency had an impact, in itself, on the turnover and focus of attention in the global foreign exchange markets. Euro/dollar trading has, from the start, established itself as the most active and liquid segment of the foreign exchange market. By contrast, the development of euro/yen trading has so far been surprisingly slow.
The role of the euro in the foreign exchange markets must be seen against the background of the exchange rate policy of the Eurosystem. By contrast with most of the currencies which it replaced, the euro is a freely floating currency. In the absence of any policy co-ordination between the three main currency blocs, the euro exchange rate will reflect the outcome of all relevant economic policies rather than being an objective in itself. Of course, the ECB will monitor exchange rate developments as part of its overall assessment of a broad range of economic and financial indicators which are relevant for inflation developments.
3. The role of the euro as an investment currency
How important will the euro become, though, as an investment currency in the global money and capital markets? At present, the US dollar is the predominant international investment currency. In 1997 the share of dollar-denominated instruments of the bonds outstanding in the international bond markets amounted to 46%, followed by Japanese yen-denominated debt (11%) and debt denominated in Deutsche Mark (10%). All the euro area currencies together accounted for approximately 24% of the international bond market.
Several arguments seem to indicate that the euro may become a more attractive currency for bond issuers than all the currencies which it replaced taken together. In fact, the euro was the most popular currency for bonds issued in the international markets in the first month after its introduction, accounting for approximately 55% of the volume of new bond issues, compared with 40% for the US dollar. However, the high figures for euro-denominated bond issuance in January 1999 may, to a certain extent, reflect a particularly high level of initial interest in euro-denominated instruments during the new currency's first month of existence. We may therefore experience a drop in the euro's market share of new bond issues from the high level experienced last month.
As I mentioned in my introduction, a key element in determining the longer-term attractiveness of the euro as an investment currency will be the emergence of efficient, large and integrated financial markets in the euro area. The introduction of the euro will remove currency risk, increase cross-border competition and provide an incentive for the harmonisation of market practices, thereby generally reducing transaction costs.
The conditions for financial market integration in the euro area seem to be best at the short end of the yield curve. In fact, the conduct of a single monetary policy by the Eurosystem gave market agents an incentive to start large-scale cross-border trade right from the outset, thereby creating an almost fully integrated money market in the euro area. The integration of the previous national money markets was made possible thanks to the TARGET system, which connects the national real-time gross settlement systems in the euro area. It thereby facilitates banks' cross-border dealing and accessing of funds in euro. The existence of an integrated money market implies that arbitrage should eliminate any cross-border differences in interest rates.
At the longer end of the yield curve, cross-border integration is likely to take more time. Before the introduction of the euro, European bond markets were highly segmented. Traditionally, this segmentation was a result partly of different currency denominations and partly of other market-specific conditions, such as differences in national regulations, tax regimes, practices and market conventions. The introduction of the euro did remove the foreign currency risks and has been accompanied by an increased harmonisation of market conventions. As a consequence, the substitutability between bonds traded in different national markets improved. In fact, the trading of euro area government bonds can already be considered to be largely integrated.
However, the markets for private bonds, and in particular for mortgage bonds, are still highly segmented owing to the differing institutional and regulatory frameworks across Member States. Nevertheless, the tendency towards increased cross-border competition and lower transaction costs in the national markets may also provide an incentive for increased issuance volumes of private bonds. We may experience a virtuous circle in which the increased issuance of bonds denominated in euro will draw the attention of international investors to euro-denominated assets, thereby making the euro an increasingly attractive currency for private as well as public bond issuers.
In this context, it is interesting to compare the current sizes of the bond markets in the euro area and the United States. The market value of the bonds issued in the United States (USD 10,700 billion) is currently twice as large as in the euro area (USD 5,300 billion). While the market value of government bonds is of a comparable magnitude in the United States and the euro area, there are large differences in the markets for corporate bonds. The market value of corporate bonds outstanding in the United States is, at present, almost ten times larger than in the euro area.
These figures seem to indicate that there is plenty of scope for further securitisation in the euro area. The introduction of the euro certainly underpins this development. The establishment of a benchmark for government bonds, 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 European corporations to issue their own securities instead of borrowing from banks.
Moreover, the euro area financial markets now offer a more diversified set of financial instruments than that which was previously available in any national market in the euro area. This will give international investors greater scope for portfolio diversification for investments in euro-denominated assets without their having to incur additional foreign exchange risk. 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 of changes in US yields compared with the present situation for bonds denominated in the national currencies. If this is the case, euro area bonds will provide an attractive opportunity for investors who would like to achieve increased risk diversification in relation to US financial instruments.
4. The role of the euro as an official reserve currency
The euro may also become an attractive currency for the investment of official reserves. Currently the US dollar is by far the most important official reserve currency world-wide; at the end of 1996 the share of dollar-denominated instruments in official reserves amounted to approximately 64%, while the euro area currencies accounted for 25% and the Japanese yen for 6%. The euro's share of world-wide official reserves is likely to have fallen at the start of Stage Three since the Deutsche Mark reserves previously held by euro area national central banks have become domestic euro area assets.
However, the euro's share of the global official reserves may soon increase again. The euro is likely to 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. This is the case at present for the "pre-in countries" participating in ERM II as well as for several countries in central and eastern Europe which link their currencies to the euro, whether by a currency board, a fixed or crawling peg or a managed float.
In addition, other countries will also have to reassess their reserve management strategies in the light of the improved diversification opportunities offered by the new currency. It is possible that countries in Asia and Latin America, which traditionally have predominantly held US dollar reserves, may find it useful to diversify their reserve holdings gradually by acquiring euro.
5. The role of the euro as a trade currency
A further aspect of the internationalisation of the euro is its developing role as an invoicing currency for foreign trade. Today, the US dollar is by far the most important international transaction currency. It is estimated that approximately 50% of world trade is currently priced in dollars, compared with less than one-third in the currencies which were replaced by the euro and 5% in Japanese yen. Initially, the "market share" of the euro will have fallen compared with the previous combined "market shares" of the currencies which it replaced. This was a result of the elimination of intra-euro area trade from the statistics on foreign trade and exchange transactions. However, in the longer term, the euro may become an important currency for the invoicing of foreign trade.
It should be emphasised, though, that at the global level, it will clearly take time for the euro to attain a stature comparable with that of the US dollar as the leading international transaction currency. The dollar is used as a standard for pricing in several areas, in particular in commodities trading. It usually takes a long time for changes in such conventions to take place.
In conclusion, I should like to underline once more that it is still too early to make any clear assessment of the possible role of the euro in the international monetary system. However, I am convinced that the mandate of the Eurosystem to maintain price stability in the euro area and its institutional framework, ensuring a high degree of independence, will be a good basis for developing the international role of the euro. In addition, I am convinced that the introduction of the euro will contribute to further development of the euro area financial markets with a view to achieving higher efficiency and international competitiveness. Against this background, I think there is little doubt that the euro will play a major role as an international currency.