The euro area in the global economy
Lecture delivered by Christian Noyer, Vice-President of the European Central Bank, as part of the "Distinguished Lecture Series" at the London Business Schoolon 19 July 1999 in London
First of all I should like to thank the London Business School, one of the most prestigious business schools in the world, for inviting me to address the role of the euro area in the global economy. Since 1 January 1999 the euro has become a reality and the Eurosystem - that is the European Central Bank and the 11 national central banks of the Member States which have adopted the euro - has taken over responsibility for the formulation and implementation of monetary policy in the euro area. It is the first time in monetary history that sovereign states have replaced their national currencies with a common currency and transferred their monetary policy competencies to a newly established supranational institution. The new monetary policy regime in Europe will have far-reaching implications not only for Europe but also for the world economy and the international monetary system.
The euro area is a large economy with a population of almost 300 million. In terms of both its economic weight and degree of openness, the euro area is broadly comparable to the US economy. It has a share of world GDP of almost 16%, significantly higher than that of Japan, although smaller than that of the United States. The euro area is the largest trade partner in the world economy with a share of 18.9 % of world exports, followed by the United States with a share of 14.5% and Japan with a share of 8.5%. The ratio of merchandise exports and imports to GDP for the euro area amounts to 26%, compared with around 20% in the United States.
Thus, the euro area, in view of its economic weight, is likely to play a significant role in shaping macroeconomic conditions at both the European and the global level. The Eurosystem is aware of its role in the world economy and will take up the corresponding responsibilities.
At the same time, one has to keep in mind that domestic policy objectives were the main motivation behind the introduction of the euro. First and foremost, the euro represents a major, although not final, step towards the completion of a fully integrated single market, encouraging competition and innovation at the euro area-wide level. As such the introduction of the euro marks a milestone in the process of European integration bringing considerable benefits to the citizens of the euro area itself. The predominance of domestic policy objectives is also confirmed by the Eurosystem's view that strict commitment to maintaining price stability in the euro area constitutes a major contribution to a stable environment at the global level.
In my remarks today, I shall try to shed some light on the international implications of the euro. First, I should like to focus on how we intend to achieve our primary task of maintaining price stability across the euro area in an internationally challenging environment. Then I shall turn to the current and prospective international role of the euro as an investment and financing currency, a vehicle currency and as an official reserve currency. Before concluding, I should say a few words about the external representation of the Eurosystem in international fora and organisations.
Monetary policy strategy and exchange rates
The Eurosystem's monetary policy strategy is clearly geared towards the maintenance of price stability. This primary objective is laid down in both the Treaty on European Union - as amended by the "Maastricht Treaty" - and the Statute of the European System of Central Banks (ESCB) and of the European Central Bank (ECB).
This does not imply that the Eurosystem ignores the exchange rate of the euro vis-à-vis other major international currencies. The exchange rate is monitored closely as one important indicator within our stability-oriented monetary policy strategy. This strategy consists of two pillars. The first is a prominent role for money, as signalled by the announcement of a reference value for the growth rate of the broad monetary aggregate M3, which is regarded as being compatible with price stability. The second comprises a broadly based assessment of the outlook for price developments and the risks to price stability using a variety of financial and economic indicators. The movements of the euro exchange rate are included in the overall monetary policy strategy within the second pillar.
Let me now turn to the next point: the international role of the euro.
The international role of the euro
In general, the international role of a currency has several dimensions, essentially relating to the three traditional functions of money as a unit of account, a means of exchange and a store of value. On the official side, these functions relate to the use of a currency as an anchor for exchange rate pegs, as a vehicle for foreign exchange intervention and as an asset for holding foreign exchange reserves. On the private side, they relate to its use as a quotation and invoicing currency, as a vehicle currency for international trade and exchange rate transactions, as an international investment and financing currency and as a substitute currency in circulation abroad.
Prior to EMU, some of the currencies that are now national denominations of the euro were already performing some of these functions beyond their own national boundaries. Therefore, it is only natural that the euro has immediately acquired the role of a widely used international currency as a legacy of these former national currencies.
This has also been made possible thanks to the successful changeover to Stage Three of EMU. During the so-called changeover weekend, the bulk of bonds, shares and other financial instruments were re-denominated in euro. Since the start of EMU investors have been able to borrow and lend funds in euro without any difficulty as well as to trade their euro securities on secondary markets.
Looking ahead, it is likely that in time international investors will start to hold a greater proportion of their portfolios in euro-denominated assets than they held in the former national currencies. In other words, the role of the euro as an international currency is likely to be greater than that of the sum of its parts. One reason why this may be the case is that the economy and the financial markets backing the euro are large relative to the world economy and, as I have already mentioned, second only to those of the United States. In this regard, one of the key elements influencing the international use of the euro is the creation of a large, liquid and integrated capital market in the euro area.
Since its inception, the single monetary policy has been able to rely on a liquid and well-integrated euro area money market, which ensures almost identical short-term interest rates across the euro area for similar instruments and credit risks. This was made possible by the implementation of TARGET, the new and efficient real-time gross settlement system in the participating countries, and was strengthened by the Eurosystem's monetary policy operational framework. At the longer end of the maturity spectrum, market integration was jump-started by the re-denomination of outstanding government debt in euro and by the convergence of interest rates towards narrower spreads following the elimination of exchange rate risk. The introduction of a common currency will also encourage the development of uniform market standards so that government bonds in the euro area will become close substitutes, creating a large and liquid bond market. Obviously, this requires sound and sustainable budgetary policies that ensure that credit risk spreads remain small. Organised exchange-trading facilities for euro area-wide financial instruments are emerging through the establishment of new exchanges and partnerships and alliances between existing derivatives and stock exchanges.
In addition, increasingly integrated money and financial markets may stimulate the emergence of new market segments, such as commercial paper and corporate bond markets, which have not been developed to any extent in Europe so far. Moreover, greater integration may also bring about lower transaction costs, increased liquidity and hedging opportunities. In turn, this is likely to attract increased recourse to the euro financial market on the part of both domestic and international investors so that a virtuous circle could develop.
In its first few months of existence, the euro was already widely used in the international financial market. The Bank for International Settlements reported last month that the share of euro-denominated issues of international debt securities announced in the first quarter of this year was over 34%, compared with 24% for the former euro area national currencies and the ECU together in the last quarter of 1998. US dollar-denominated issues amounted to almost half of the total, slightly below the level in the previous quarter, whereas over the same period the share of Japanese yen-denominated issuance dropped from 5.8% to 3.4%.
Accounting for securities redeemed in the period, net issues of euro-denominated international debt securities amounted to almost E130 billion in the first quarter of 1999. This was almost four times higher than in the last quarter of 1998 and almost twice as much as in the first quarter of 1998, compared with the sum of the former euro area national currencies and the ECU. Of all the other currencies, only the US dollar recorded a similar increase, and even this was not on the same scale in respect of the euro.
In terms of amounts outstanding at the end of March of this year, the stock of euro-denominated international debt securities represented a share of 27%, slightly above the share of the 11 former national currencies of the euro area and the ECU. At the same time, the shares of US dollar and Japanese yen-denominated international debt securities stood at 47% and 10% respectively.
In assessing the external prospects for the euro, I have first stressed the role of private agents in financial markets because, most probably, their behaviour will be the key factor in determining future developments. This view is based on two main elements. On the one hand, international financial flows have dwarfed international trade flows in the past decades both in terms of growth rates and in relation to GDP. For example, from 1983 to 1998, world exports rose by a factor of three whereas, over the same period, the international assets of banking institutions reporting to the BIS, a portion of international financial positions, increased by a factor of four. On the other hand, while the official sector holds a non negligible amount of financial resources which are invested internationally, mainly official reserves held by central banks, the investment behaviour of central bankers is much more conservative than that of private economic agents.
As for trade, the existence of a large capital market will also encourage and facilitate the use of the euro in international transactions. In particular, many euro area resident exporters and importers, who did not previously use their own domestic currency for invoicing, may now take the opportunity to do so with the euro. The same tendency could gain ground in those countries that have close economic ties with the euro area or which have chosen to peg their currency to the euro.
This brings me to some considerations on the use of the euro in the official sector. Apart from the EU countries participating in the ERM II, a number of countries - mainly in Central and Eastern Europe and in Africa - have unilaterally decided to peg their currencies to either the euro or one of its national denominations. Other countries are pursuing managed float policies with the euro being the main reference currency, whereas a final group of countries are pegging their currency to baskets of currencies, such as the Special Drawing Right, containing the euro or its national denominations.
Against this background, the use of the euro is likely to increase both as an intervention currency and as a reserve currency, even though in this last respect the number of central banks that might be interested in holding euros is likely to be higher.
As a matter of fact, just like private international investors, central banks may find it convenient to diversify their portfolios into a currency offering broader investment opportunities than its former constituent currencies.
In its latest Annual Report, the IMF estimated that at the end of 1997 total official assets, for which a currency breakdown was available, amounted to almost 1000 billion SDRs. Of this amount, the share represented by US dollar-denominated official reserves was 67%, while euro area currencies accounted for almost 23% and the Japanese yen for 5.7%. With the start of Stage Three of EMU, the share of euro area currencies in the foreign exchange reserve assets of central banks declined as a result of technical adjustments. First, on 31 December 1998 the Eurosystem unwound into gold and US dollars the official ECUs that were created by swapping part of reserve holdings denominated in gold and US dollars. Second, on 1 January 1999 the Eurosystem's reserves previously denominated in former euro area national currencies became domestic assets. Despite these technical adjustments, the euro should remain the second international reserve currency, as a legacy of the former euro area national currencies.
Apart from the weight of an economy and the size and liquidity of its financial markets, another major pre-requisite for the substantial use of a currency by foreign investors is confidence in the stability of its purchasing power in the long run. In this regard, internal price stability will provide a strong basis for supporting the euro's external value.
At the same time, the Eurosystem neither promotes nor hinders the development of the euro as an international currency as we consider that the international role of the euro will and should develop through the interaction of market forces. Let me now turn to the external representation of the euro area in European and international fora.
The external representation of the euro area
The creation of the euro certainly represents one of the most profound changes in the international monetary system since the collapse of the Bretton Woods system in the early 1970s. By reducing the number of key players, the euro will contribute to simplifying international policy co-operation between the major regional blocs. It will make this process more efficient by facilitating the exchange of information and views. Each of the main partners - the United States, the euro area and Japan - is in a position to speak for a relatively large economic region and is similarly vulnerable to adverse shocks to the international financial system.
The introduction of the euro implies a transfer of central banking competence from the national to the Community level. This refers to monetary and exchange rate policies, the conduct of foreign exchange operations, the holding and management of the official reserves of the Member States, the promotion of the smooth operation of payment systems and contributing to the smooth conduct of policies relating to prudential supervision and the stability of the financial system. With the exception of the exchange rate policy, which is a shared responsibility of the ECOFIN Council and the Eurosystem, and banking supervision policies, to which the Eurosystem contributes, monetary policy and related central banking tasks are an exclusive competence of the Eurosystem.
As far as other economic policies, for example fiscal policies, are concerned, these remain largely the preserve of the individual euro area Member States. However, EMU implies that these national policies are subject to enhanced co-ordination in accordance with Article 103 of the Treaty, on strengthened Surveillance and Broad Economic Policy Guidelines, and Article 104C, on strengthened excessive deficit procedure in the framework of the Stability and Growth Pact.
Depending on whether these economic policies are formulated at the Community or the national level, the external representation of the euro area is organised differently. Thus, the single monetary policy implies that on matters related to the Eurosystem's tasks it is the ECB that represents the euro area externally. The participation of the euro area NCBs may vary depending on the fora, as for instance the Eurosystem is represented by the ECB alone at meetings of ECOFIN Council or of the Euro-11, whereas the Eurosystem as a whole is represented at informal ECOFIN Council meetings.
Difficulties in devising the appropriate arrangements for the external representation of the euro area by the Eurosystem arise from two specific features. The first relates to the fact that membership of different fora (for example the G7 or the G10) varies across euro area Member States. The second derives from the fact that intergovernmental institutions such as the International Monetary Fund (IMF) or the Organisation for Economic Co-operation and Development (OECD) are organised on a strictly one currency, one country basis. Therefore, in all of these instances specific arrangements had to be devised in order to allow for the representation of the Eurosystem and ECB.
Formal and informal agreements have already been reached with the IMF, the OECD and the BIS and in the G7 and G10 context. In December of last year the ECB was granted permanent Observer status in the IMF. This was a particularly important step. The IMF, as the cornerstone of the international monetary system, plays a key role in the process of multilateral surveillance of economic policies. The ECB Observer attends all meetings of the IMF Executive Board that are of relevance to the Eurosystem, such as discussions on multilateral surveillance or the Fund's surveillance of euro area monetary and exchange rate policies. As far as the Interim Committee of the IMF is concerned, the President of the ECB participates in its meetings as an observer.
A similar agreement was reached within the OECD last February with the understanding that the ECB would be allowed to participate in the work of relevant committees and working groups. As a result, the ECB is a member of the European Community delegation to these meetings in its own right, alongside the European Commission.
Regarding the G7 Finance Ministers and Central Bank Governors, it was recently agreed that at future meetings the President of the ECB will be the sole representative of the Eurosystem in discussion on multilateral surveillance and exchange rate issues. This part of G7 meetings will also be attended by the Presidency of the Euro-11 Group.
With respect to central banking fora, the President of the ECB participates in meetings of the G10 Governors organised in the context of the Bank for International Settlements. In addition, ECB representatives also take part in the Basle-based Committees set up under the aegis of the G10 Governors.
At the European level, regular hearings of the President of the ECB and of other Executive Board members before the European Parliament's Sub-Committee on Monetary Affairs constitute the main part of the inter-institutional relationship between the European Parliament and the ECB. They reflect the readiness of the ECB to be open and accountable in discharging its basic tasks. Furthermore, the ECB participates in meetings of the Euro-11 Group, the ECOFIN Council, if relevant issues are discussed, and in the Economic and Financial Committee. These fora provide an opportunity for wide-ranging exchanges of information and views between the ECB and governments on issues related to both international and European developments.
Finally, the Eurosystem is building up contacts and working relationships with other central banks throughout the world. Bilateral relations as such are an important component of its international activities. Particular emphasis may have to be given to the development of bilateral relations with central banks of Central and Eastern European countries, which have applied for membership of the EU. Issues of common interest are primarily monetary and foreign exchange policy matters, financial market structures and the legal convergence of central bank statutes in applicant countries.
Globalisation is a key feature of today's world where interactions and interdependencies between countries have increased significantly.
In this context, it would not be possible for the euro area to insulate itself from the outside world. Nor would this be desirable, as I believe that the mutual benefits resulting from international openness far outweigh the possible costs.
Today, I have illustrated a few aspects of the role of the euro area in the global economy. Let me conclude by saying that the primary and fundamental contribution that the Eurosystem can make to a stable international economic and financial environment is maintaining stable prices in the euro area.
This will also provide the euro with clear potential to achieve a stronger external value, as well as being a further factor supporting the development of its role as an international currency.